** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-K**

 
| **ý** | ** ** | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**                                                                                                                                                                                                               |
|------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                                                              |
| ** ** | ** ** | **for the Fiscal Year Ended March 31, 2005**                                                                                                                                                                                                                                                            |
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                                                              |
| ** ** | ** ** | **OR**                                                                                                                                                                                                                                                                                                  |
|       |       |                                                                                                                                                                                                                                                                                                    |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**                                                                                                                                                                                                           |
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                                                              |
| ** ** | ** ** | **for the Transition Period from                      To                      ** |

 

**CommissionFile Number 0-11071**

** **

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**IMAGE ENTERTAINMENT, INC.**

(Exact name of registrant as specified in its charter)

 
| **California**                                                                                   | ** ** | **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 the Act: **None**                            |
|                                                                                             |       |                                    |
| Securities  registered pursuant to Section 12(g) of the Act:** Common Stock, no par value** |

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.  YES ý NO o

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of the registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Act).  YES o NO ý

 

The aggregate market value ofthe common stock held by non-affiliates of the registrant, based upon theclosing price of $4.14 for shares of the registrant’s common stock on September30, 2004, the last business day of the registrant’s most recently completedsecond fiscal quarter as reported by the NASDAQ National Market®, wasapproximately $39,848,527. In calculating such aggregate market value, sharesof common stock owned of record or beneficially by officers, directors andpersons known to the registrant to own more than five percent of the registrant’svoting securities (other than such persons of whom the registrant became awareonly through the filing of a Schedule 13G filed with the Securities andExchange Commission) were excluded because such persons may be deemed to beaffiliates. The registrant disclaims the existence of control or any admissionthereof for any other purpose.

 

The number of sharesoutstanding of the registrant’s common stock as of June 2, 2005: 21,251,916

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Part III – Portions of theregistrant’s proxy statement for its 2005 Annual Meeting of Shareholders to beheld on September 9, 2005, are incorporated by reference into Part III of thisreport.

 

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**IMAGE ENTERTAINMENT, INC.**

**Form 10-K Annual Report**

**For The Fiscal Year Ended March 31, 2005**

 

**TABLE OF CONTENTS**

 
| PART I     |      |
|------------|-----------|
|       |      |
|       | ITEM  1.  | Business |   |
|       | 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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** **

**PARTI**

 

**FORWARD-LOOKING STATEMENTS**

 

This report containsforward-looking statements that involve risks and uncertainties. Our actualresults may differ materially from those discussed due to factors such asdependence 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 followingdiscussion, including the “Risks Factors” section below, as well as in Item 7.Management’s Discussion and Analysis of Financial Condition and Results ofOperations.

 

**ITEM1.                 BUSINESS**

 

**OVERVIEW**

 

We are a homeentertainment company, primarily engaged in the domestic acquisition andwholesale distribution of content for release on DVD. We acquire and exploitexclusive distribution rights to a diverse array of general and specialtycontent on DVD, CD and other home entertainment formats, including:

 

•                  comedy

•                  music concerts

•                  urban

•                  television andtheatrical

•                  country

•                  gospel

•                  foreign andsilent films

•                  youthculture/lifestyle

 

Through ourwholly-owned subsidiary, Egami Media, Inc., we acquire the rights to exploitexclusive digital content and are beginning to exploit it through video ondemand, streaming video and download channels.

 

We may alsoacquire the rights to exploit content via broadcast, including pay-per-view,in-flight, radio, satellite, cable and broadcast television, and exploit themas opportunities allow. We acquire content mainly by entering into exclusivelicensing or distribution arrangements with producers and other contentproviders. We typically supplement such content by designing and producing additionalcontent and value-added features, such as compelling:

 

•                  interactivemenus

•                  audiocommentaries

•                  packaging

•                  marketingmaterials

 

We alsoproduce our own original entertainment content, focused on DVD live performancemusic concerts and urban genre content. We are also co-producing feature horrorand other “genre” titles through deals with Dark Horse Entertainment, Inc. andContentFilm plc.

 

We strive togrow a stream of revenues by maintaining and building a library of titles thatcan be exploited in a variety of formats and distribution channels. Our activecatalogue currently contains over 2,800 exclusive DVD titles.

 

We wereincorporated in Colorado as Key International Film Distributors, Inc. in April1975, our present name was adopted in 1983, and we reincorporated in Californiain November 1989. Our principal executive offices are located at 20525 NordhoffStreet, Suite 200, Chatsworth, California 91311. We maintain a Web site atwww.image-entertainment.com. The content of this site is not incorporated byreference and does not constitute a part of this report.

 

The followingtable sets forth the percentage of consolidated net revenues derived from thedistribution of entertainment content by format for our last three fiscalyears. The financial information presented excludes that of our wholly-ownedsubsidiary, DVDPlanet, Inc., whose assets we sold in September 2003. Theinformation does not

 

1

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represent our business segments(see below “Business Segments”), but rather shows net revenue trends by productcategory:

 
| ** **         | ** ** | **Fiscal Years Ended** | ** ** |
|--------------------|------------|------------------------|------------|
| ** **         | ** ** | **March 31,**          | ** ** |
| **(in thousands)** | ** ** | **2005**               | ** ** | **2004** | ** ** | **2003** | ** ** |
|               |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| DVD                |       | $                      | 100,374    |   | 84.8 | % | $ | 71,683 |   | 84.5 | % | $ | 76,564 |   | 88.1 | % |
| CD                 |       | 12,142                 |       | 10.3 |   | 5,591 |   | 6.6 |   | 2,947 |   | 3.4 |   |
| Sublicense         |       | 4,830                  |       | 4.1 |   | 5,607 |   | 6.6 |   | 2,101 |   | 2.4 |   |
| VHS                |       | 550                    |       | 0.4 |   | 1,415 |   | 1.7 |   | 3,593 |   | 4.1 |   |
| Broadcast          |       | 487                    |       | 0.4 |   | 544 |   | 0.6 |   | 1,724 |   | 2.0 |   |
| TOTAL              |       | $                      | 118,383    |   | 100 | % | $ | 84,840 |   | 100 | % | $ | 86,929 |   | 100 | % |

 

**BUSINESSSEGMENTS**

 

We currentlyhave two business segments:

 

•                  *Domestic*

•                  *International*

 

Our domesticsegment primarily consists of acquisition, production and distribution ofexclusive DVD content and, through Egami Media, exclusive content for digital distributionvia video on demand, streaming video and download. Our international segmentincludes international sublicensing and worldwide broadcast rightsexploitation.

 

The followingtable presents consolidated net revenues, net of eliminations, by reportablebusiness segment for the periods presented:

 
| ** **                            | ** ** | **Fiscal Years Ended  March 31,** | ** ** | ** ** | ** ** |
|---------------------------------------|------------|-----------------------------------|------------|------------|------------|
| ** **                            | ** ** | **2005**                          | ** ** | **2004**   | ** ** | **% Change** | ** ** |
| Net  revenues:* (in  thousands)* |       |                              |       |       |       |   |   |
| Domestic                              |       | $                                 | 113,219    |       | $          | 78,370 |   | 44.5 | % |
| International                         |       | 5,164                             |       | 6,470      |       | (20.2 | ) |
| Consolidated                          |       | $                                 | 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 44,000 DVD titles available in the domestic market, ofwhich more than 2,800 are actively and exclusively distributed by us. We havedeveloped a specialty niche in the distribution of exclusive music-relatedentertainment content. We are a leading independent supplier of DVD content inthe music, special interest, episodic television, urban and lifestyle genres. Thefollowing chart reflects the number of cumulative titles we have released bytype of content, compared with the cumulative DVD software titles released bythe industry through the week ended May 6, 2005, excluding discontinued titles.The following chart does not intend to indicate our market share of DVDrevenues, only cumulative titles released.

 
| **Type of DVD Content**                         | ** ** | **Total Number  of DVD Titles** | ** ** | **Number of  Image Titles** | ** ** | **Image  Percentage** | ** ** |
|-------------------------------------------------|------------|---------------------------------|------------|-----------------------------|------------|-----------------------|------------|
| Music                                           |       | 5,245                           |       | 546                         |       | 10.4                  | %          |
| Special Interest                                |       | 8,857                           |       | 512                         |       | 5.8                   | %          |
| Theatrical Catalog (pre-1997)                   |       | 8,062                           |       | 404                         |       | 5.0                   | %          |
| Foreign Language (including distributed  lines) |       | 3,428                           |       | 197                         |       | 5.7                   | %          |
| Television Programming                          |       | 2,383                           |       | 139                         |       | 5.8                   | %          |
| Direct to DVD                                   |       | 5,975                           |       | 337                         |       | 5.6                   | %          |
| All Other                                       |       | 10,582                          |       | 689                         |       | 6.5                   | %          |
| Total Releases – Cumulative through 5/6/05 |       | 44,532                          |       | 2,824                       |       | 6.3                   | %          |

 

*Source: DVDRelease Report Revised 5/4/05*

 

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We believethat the 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.

 

*Exclusive Acquisition.*We generally acquire exclusive rights to our content. Our active catalogcurrently contains over 2,800 exclusive DVD titles and over 175 exclusive CDtitles. We currently release an average of 35 new exclusive DVD titles and fivenew exclusive CD titles each month. We acquire our exclusive titles from a widerange of content holders, including independent content suppliers, producers,music artists, record labels and artist management, and also produce our own originalentertainment content focused on DVD live performance stand-up comedy, musicconcerts and urban genre content, and in light of our agreements with DarkHorse Entertainment and ContentFilm, feature horror and other genre titles. Weproduce, market and sell our exclusive content according to exclusive licenseor distribution agreements. We actively pursue and secure both domestic (U.S.and Canada) and international distribution rights to exclusive titles.

 

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 milestones.

 

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 thecontent owner such as production, manufacturing, music publishing, andmarketing fees. In some cases, the net profit of a title is split between us andthe content supplier according to a contractual percentage. In many such cases,advances or minimum guarantees on an exclusive distribution deal are paid andrecouped by us similar to an exclusive licensing arrangement.

 

Under ourexclusive license and distribution arrangements, we often secure the right to distributeentertainment content in a range of home entertainment formats, which mayinclude:

 

•                  DVD

•                  VHS

•                  CD

•                  Universal MediaDisc (UMD) for the Sony Playstation® Portable (PSP)

•                  other home videoformats

 

To a lesser extent, we alsopursue and secure exclusive broadcast rights which include exploitation via:

 

•                  broadcasttelevision

•                  cable

•                  satellite

•                  pay-per-view

•                  in-flight

•                  radio

•                  other broadcastmedia

 

Through Egami Media, we alsoacquire exclusive digital content and are beginning to exploit it via:

 

•                  Video on Demand(VOD)

•                  streaming video

•                  downloadchannels

 

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While our corebusiness remains the domestic acquisition and distribution of content on DVD,we seek to secure and exploit exclusive content from the broadest possiblegrant of home entertainment programming rights. As part of our strategic goalto secure the broadest possible range of exploitation rights for exclusiveprogramming, we may finance all or part of the production of some of ourentertainment content. The rights we retain in connection with ourself-financed productions generally cover all territories throughout the world,all now-known and hereafter-devised video home entertainment formats, and otherformats including broadcast, audio, in-flight, Internet streaming, digitaldownloading, direct response, sponsorship and bundling rights, for an extendedterm.

 

Because of ourgrowing library of exclusive titles in a wide variety of genres, we believethat we are positioned to benefit from the market growth of the DVD format. Weintend to continue expansion of our exclusive DVD library.

 

In January2005, we perfected formation of a wholly-owned subsidiary, Image Entertainment(UK), Inc. On February 7, 2005, Image UK opened a content acquisition office inLondon, England.  Our Vice President of Programming temporarily relocatedto London to become the office’s managing director.  Image UK acts as our exclusivecontent acquisition agent, and facilitates the securing of licensing and distributionrights from content providers from its overseas headquarters. Rights acquiredwith the assistance of Image UK will be held by us. Additionally, productionand distribution services will be performed by our personnel out of ourheadquarters in Chatsworth, California. We expect first-year expenses for theleased office, leased apartment which is temporarily leased through July 15,2005, and related expenses, including salaries, to be approximately £17,000(approximately $30,000) per month.

 

*Egami Media.* Our wholly-owned subsidiary, Egami Media,engages in the exclusive wholesale distribution of the digital rights to ourcatalogue of audio and video content.  While many top-grossing, popularmovie titles are available online, only a relatively small number of niche oraffinity video titles such as classic television shows, live music, comedyclips and other programming are available today.  Egami seeks todifferentiate itself competitively by being a one-stop source for the large,diverse collection of entertainment represented by our digital catalogue, whichcurrently includes over 1,600 music tracks and over 800 video titles andepisodes.

 

Egami enters intononexclusive video distribution arrangements with retail and consumer entitieswhose business models include digital delivery of content. Delivery will be inthe form of secure encoded files with playback options being controlled byembedded Digital Rights Management (DRM). The consumer will find variouspurchasing options that include:

 

•                  Download to Own

•                  VOD

•                  Subscription VOD

 

Download to Own isessentially the digital equivalent of buying a DVD. VOD is essentially thedigital equivalent of renting a DVD. Subscription VOD is essentially thedigital equivalent of a club-type model, where users pay recurring monthly feesin exchange for access to a larger library without individual transactioncharges.

 

In the audio market, Egamiis entering into nonexclusive distribution arrangements with retail andconsumer entities whose business models include digital delivery of content. Theaudio marketplace is more mature, yet audio business models continue to evolve.Egami is selling full albums as well as individual tracks from our library ofcontent. We are also seeing various subscription models emerge, and we intendto support them.

 

*FilmProduction.* With Dark Horse, we have completedprincipal photography and are in post-production on two feature films, *Splinter*, a multicultural action-adventure supernaturalthriller starring Edward James Olmos and Tom Sizemore which we may consider fortheatrical exploitation, and *Monarchs of the Moon*,a stylized feature designed to pay homage to the classic science-fiction moviesof the 1950s.  Through Dark Horse, we acquired *DestinationMars*, a feature similar to *Monarchs of the Moon*. We are currently in development on a “hauntedhouse” script currently entitled *Gone*, based ona short story from “The Dark Horse Book of Hauntings,” written — and to bedirected — by famed director John Landis (*American Werewolf in London*,*Animal House, Beverly Hills Cop III*, *Blues Brothers*, *Coming to America*,*Into the Night*, *KentuckyFried Movie*, *Trading Places*). We have also begun development of two additional Dark Horse projects, onecurrently entitled *Driftwood*, a

 

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ghost story about a boys’reformatory, and a yet-to-be-titled project starring, written and directed byrenowned genre actor Bruce Campbell.

 

Our agreementwith ContentFilm has focused primarily on content acquisition, as theco-production portion of our agreement has been assigned to Ed PressmanProductions, controlled by highly successful independent film producer EdPressman (*Bad Lieutenant*, *Conan theBarbarian*, *The Cooler*, *The Crow*, *Das Boot*, *Sisters*, *Talk Radio*). With ContentFilm, we have acquired feature films *Evil Aliens*and *Wilderness Survival for Girls*. With Ed Pressman, we are in discussions to develop the remake of Brian De Palma’s*Sisters* and other films.

 

*Nonexclusive Distribution**.* We do not generally distributenonexclusive content, including DVD releases of major motion pictures. However,at the request of seven of our largest domestic accounts (AEC One Stop Group,Best Buy, Borders, Musicland Group Inc., Tower Records & Video, Trans WorldEntertainment and Virgin), we act as a nonexclusive supplier to them for threelines of smaller independent content.

 

*Additional Services.*We provide a variety of value-added services relative to our licensed contentand many of our exclusively distributed titles, including: creation ofpackaging, DVD authoring and compression, menu design, video master qualitycontrol, manufacturing, marketing, sales, music clearance, warehousing,distribution, and, for some titles, the addition of enhancements such asmultiple audio tracks, commentaries, foreign language tracks, and otherancillary materials such as behind-the-scenes footage, interviews anddiscographies. These services are typically performed in-house, with theexception of DVD, CD and UMD disc manufacturing and tape replication, packageprinting, and packaging of the finished product which are generally performedby third party vendors.

 

*Manufacturing.* Typically,a content supplier delivers a title master and artwork to us, and our in-housepost-production facility creates a sub master with specifications for thenecessary format and on-screen menus for each title. Our in-house authoring andcompression team then generally performs the work necessary to prepare a DVDmaster for manufacturing. Occasionally, because of the large volume of ourexclusive releases, we may use an outside facility to perform such services. Ourin-house creative services department, staffed with graphic designers,copywriters and proofreaders, creates original and innovative packagingfundamental to the marketing success of our product. Deluxe Media Services,Inc., formerly Ritek Global Media, manufactures and packages our domestic DVDprogramming. We use two other vendors for CD manufacturing, L&M OpticalWest and Sony DADC Global. Sony DADC Global currently manufactures all UMDprogramming.

 

*Marketing.* Ourin-house marketing department directs marketing efforts toward consumers, DVDand CD retailers, and DVD and CD player retailers. Our marketing efforts involve:

 

•                  point-of-saleadvertising

•                  print advertisingin trade and consumer publications

•                  nationaltelevision and radio advertising 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.

 

We maintain aWeb site at www.image-entertainment.com to help promote us and our exclusivecontent. The Web site includes investor information, such as press releases,information regarding our exclusive titles, and information of general interestto the home entertainment consumer. The content of this site does notconstitute a part of this report.

 

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*Customers.* We typicallydistribute our titles domestically through our Las Vegas, Nevada distributioncenter. We sell our product to:

 

•                  retailers

•                  Internetretailers

•                  distributors

•                  alternativedistribution

•                  direct-to-consumerprint catalogs

•                  direct responsecampaigns

•                  subscriptionservice/club sales

•                  home shoppingtelevision channels

•                  othernon-traditional sales channels

 

We sell directly to many largeand small retailers. Some of our key sell-through customers include:

 

•                  AEC One StopGroup

•                  Amazon.com, Inc.

•                  AndersonMerchandisers

•                  Best Buy Co.,Inc.

•                  HandlemanCompany

•                  IngramEntertainment, Inc.

•                  Musicland GroupInc.

•                  Target

•                  Tower Records

•                  Trans WorldEntertainment

•                  VidCanada

 

In addition,we sell to rental-retail hybrid customers such as:

 

•                  Blockbuster Inc.

•                  Hollywood EntertainmentCorporation

**•**                  Movie Gallery,Inc.

•                  Netflix, Inc.

 

Over the lastseveral years, many of our sell-through DVD customers have helped grow ouraudio revenues.

 

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 include:

 

•                  Barjan

•                  Big Lots

•                  Columbia House

•                  CrutchfieldCorporation

•                  DiscoveryChannel

•                  Doubleday

•                  Guitar Center

•                  Hot Topic

•                  KSG Distribution

•                  Metropolitan OperaGuild

•                  QVC, Inc.

 

On aconsolidated basis, Anderson Merchandisers (who supplies Wal-Mart), Best Buyand AEC One Stop accounted for 17%, 12% and 10%, respectively, of our fiscal2005 net revenues. Best Buy and AEC One Stop accounted for 17% and 12%, respectively,of our fiscal 2004 net revenues, and Best Buy, which included itsthen-subsidiary Musicland Group until its sale in June 2003, accounted for 21%of our fiscal 2003 net revenues. No other

 

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customers accounted for netrevenues individually in excess of 10% of our total net revenues for fiscal2005, 2004 or 2003.

 

We allowretail customers to return a portion of their unsold inventory on a quarterlybasis. We reserve for estimated returns at the time the sale is recognized,based in part upon our historical returns experience and knowledge of specificproduct movement within distribution channels.  Our inventory returns, as a percentageof our gross distribution (as opposed to net) revenues, were 18.8% in fiscal2005, 19.2% in fiscal 2004 and 15.7% in fiscal 2003, respectively.  Returns of defective product have been minimaland are generally covered by manufacturers’ warranties.

 

As of June 1,2005, we had approximately $5.0 million of backlog orders, 70% from DVD product,from domestic wholesale customers compared with approximately $5.3 million ofbacklog orders, 71% from DVD product, as of June 17, 2004. We expect to fill100% of the backlog orders, less any cancelled orders, this fiscal year.

 

***International***

 

*International Sublicensing.*We have an exclusive sublicense agreement for our DVD content, primarilymusic-related DVDs, with BMG Music International Service, GmbH (now known asSony BMG) for Europe, Africa, and most of the Middle East, an exclusivesubdistribution agreement with Sony BMG for Mexico and Central America, and anexclusive sublicense agreement with Digital Site, an affiliate of RayCorporation, for Japan. We have an exclusive sublicense agreement with theWarner Music Group for Australia and New Zealand. These agreements containterms and conditions similar to those governing our underlying rightsagreements. Sony BMG, Digital Site and Warner Music pay royalties based on eitherretail or wholesale revenues they generate, and are responsible for sales, taxes,marketing, publishing, manufacturing (except for Mexico and Central America,where we provide finished goods) and distribution of our content in theirrespective territories. We have similar sublicenses with others for smallerterritories.

 

*Worldwide Broadcast.*Buyers of our standard and high-definition broadcast content are typicallycable, pay-per-view, or satellite broadcasters, and sometimes terrestrial(free) television or in-flight broadcasters. Under a typical broadcast licensewe receive payment of a one-time, fixed, non-refundable fee for a multi-yearexploitation term and in many instances for a specified number of airings. Withrespect to pay-per-view, we typically receive a non-refundable advance againstroyalties that are based on a percentage of customer buys. Our obligationsunder broadcast licensing are usually only to provide a broadcast master of thetitle and to ensure that music synchronization rights are secured.

 

We have an exclusive sales agency agreement withLondon-based NBD Television LTD for worldwide broadcast television sublicensesof the majority of the current catalogue of programming for which we holdbroadcast rights (in excess of 200 programs) as well as our new releaseacquisitions which include broadcast rights. NBD represents us for conventionaltelevision broadcast sales, whether standard or high-definition, includingcable, pay-per-view, video on demand, satellite television, and sales tonon-theatrical venues. Programs that were sublicensed to third parties forbroadcast prior to January 2003 will be handled by NBD upon the expiration ofthe existing licenses. The agreement with NBD expires 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.

 

Upon enteringinto a 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 netrevenues. Upon our recoupment of the advance, we pay the content supplierroyalty overages at the same rate. If we do not recoup our initial advance by

 

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the end of the agreement’sterm, the content supplier receives no additional royalties but is nottypically liable for reimbursement of our unrecouped advance. Royalty advancesmay be used by the content supplier to actually produce the content in caseswhere 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 atypical exclusive distribution agreement, we may pay upfront fees, which areexpressed as advances against future net profits, or we may pay for the cost ofthe content’s production in advance. Our net profits for these deals usuallytake the form of our distribution fee which is deducted first. Any remainingnet profits 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.

 

In addition toadvances, upfront fees and production costs, the other significant costs weincur are for:

 

•                  DVD and CDreplication

•                  packaging

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

•                  domesticshipping costs from self-distribution of exclusive content

•                  personnel costs

•                  music publishingon 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 acquiringexclusive content distribution rights, we continue to face increasingcompetition from:

 

•                  Special MarketDivisions of the Major Motion Picture Studios

•                  Sony/ColumbiaTri-Star (which recently purchased MGM)

•                  Disney

•                  Dreamworks

•                  Fox

•                  Paramount

•                  Universal

•                  Warner

•                  Mini-Majors

•                  Lions Gate

•                  Miramax

•                  New Line

•                  Major Music Labels

•                  Sony BMG

•                  Capital/EMI

•                  Universal

•                  Warner MusicGroup

•                  Independent MusicLabels

•                  Independent DVDand CD Content Suppliers

 

For limitedretail shelf space, we also continue to face increasing competition from:

 

•                  major motionpicture studios

•                  independent DVD andCD suppliers

•                  major andindependent music labels who offer DVD content

 

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•                  other homeentertainment providers

 

Besideslimited retail 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.

 

***Competition for Content***

 

We faceincreasing competition from other independent distribution companies, majormotion picture studios and music labels in securing exclusive content licenseand distribution rights. As DVD player-household penetration increases (throughincreasing sales of stand-alone DVD players and DVD-based video game playersystems) and as retail shelf space for home video formats increases, more andmore companies view DVD licensing and distribution as an attractive business. Many,including New Line, Lions Gate, Navarre Corporation, and several of the majorstudios, are expanding or launching efforts in the DVD licensing market,sometimes in the form of direct-to-video motion pictures. Because the homevideo rights to most newly released and catalogue motion pictures are alreadyowned by the major studios, the market for high-profile DVD content to anindependent supplier is limited. Moreover, the market for availablehigh-profile music-related DVD content is also limited as major and independentrecord labels continue to increase the number of music-related titles releasedon DVD through their own labels.

 

In light ofthe increase in demand and limitation in supply, obtaining quality DVD contentat reasonable prices has become 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 advance offers from competitors who may at times be willingto pay larger advances. This challenge is compounded when competitors who lackbroad expertise in the field of DVD licensing occasionally offer advances orother terms for content which we believe to be unrealistic based upon our owninternal forecasts and historical experience in a particular genre. 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 theavailability of quality content. Additionally, as we see more and moreopportunities for higher-profile content, we are increasingly finding ourselvesin competition 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.

 

We believethat we will continue to compete successfully in obtaining exclusive rights tohome entertainment content. This is due in large part to our ability to offeran array of other assets to our program suppliers, including:

 

•                                          thehigh quality of expertise and the service our employees provide

•                                          oursuperior, long-standing reputation within the home entertainment industry andour status as a public company which is particularly helpful when competingagainst private independents

•                                          ourstatus as an independent which allows freedom from the major labels, more creativecontrol to the content creator, comparatively fewer obstacles in contentcreation, marketing and distribution, and comparatively simpler accounting forroyalties and net profits to the supplier

•                                          ournotable ability to obtain and sustain ongoing relationships with valuablesuppliers 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

 

***Competition for 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 often 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,which typically require more shelf space to support.

 

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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 of shelfreal estate, whether real or virtual, is becoming more expensive as the totalnumber 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 that are our core customers.

 

Retailers areincreasingly 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% 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 decreased gross margins.

 

***Competition for Retailer Open to Buy Dollars***

 

We competewith other content suppliers for limited open to buy dollars allocated byretailers to purchase new release or catalogue DVD and CD titles. Open to buydollars are becoming more scarce for independents like us, since such dollarsare often devoted to high-profile new releases from major studios, particularlyduring the holiday season. Reduced wholesale DVD pricing instituted by themajor studios 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.

 

We believethat titles from an independent content supplier like us continue to beattractive to retailers because of the gross margins retained by the retailersfrom the sale of independent titles. In contrast, there is a great deal ofpricing competition among retailers for the new release theatricalblockbusters, as such major hits are often advertised as loss leaders to bringin retail traffic. We do not sell new release major studio titles, and ourtitles are typically sold at a lower discount to the consumer by the retailer.

 

***Increasing Competition***

 

As our industrymatures, with DVD set-top and DVD game player penetration of U.S. televisionhouseholds having exceeded 70% at the close of calendar 2004, and new retail spacebeing allocated for DVD programming, the competition level will continue torise. The major studios remain consistent and prolific in their ability tobring new theatrical titles to retailers. They have large libraries of contentto release on DVD. New independent suppliers are continually emerging, furtheradding to the competition. The additional promotional opportunities and open tobuy dollars may be severely compromised by the new major theatricalprogramming, new independent suppliers and the vast catalogues of contentcontrolled by the major studios.

 

**INDUSTRYTRENDS**

 

According toAdams Media Research (Hollywood Aftermarket report dated February 28, 2005),DVD set-top penetration of television households reached 64.4% through December31, 2004, excluding DVD game players, with 71.3 million of 110.7 million televisionhouseholds having at least one DVD player. Adams Media expects this penetrationto reach 90.2% within the next 5 years. This represents an estimated 8.5%annual compound growth rate in DVD set-top player households. Additionally,Adams Media estimates that DVD game player households without a set-top DVDplayer reached a penetration level of 8 million, or 7.2% of televisionhouseholds, through December 31, 2004. They expect this number to decline to2.5 million, or 2.1% of television households, within the next 5 years.

 

According to Adams Media(Hollywood Aftermarket report dated January 31, 2005), consumer DVDsell-through spending increased 27.3% to $15.4 billion in 2004, from $12.1billion in 2003. Consumer DVD sell-through spending is expected to grow 51.9%to $23.4 billion through 2009, a compound annual growth rate of approximately9%. Net supplier revenue from DVD sell-through was $12.6 billion in 2004, up27.3% from $9.9 billion in 2003. Net supplier revenue from DVD sell-through isexpected to grow 46% to $18.4 billion through 2009, a compound annual growthrate of approximately 8%. Annual DVD disc buys per DVD set-top household were15.8 discs in 2004, at an average price of $15.01 per disc, slightly higherthan 15.5 discs per household in 2003, at a lower average price than

 

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2003’s $16.16 per disc. VHSsell-through consumer spending, on the other hand, continues to decline rapidly,down 48% from $2.3 billion in 2003 to $1.2 billion in 2004.

 

We believe the recentpopularity of television content on DVD illustrates the consumer appetite fornon-feature DVD content. Non-feature DVD content is our primary focus in lightof our diverse array of general and specialty content. Adams Media reports(Hollywood Aftermarket report dated February 28, 2005) that the new release andcatalogue feature market share is shrinking in favor of non-feature video. In2002, 82% of total sell-through video revenues were new release and cataloguefeatures, with 18% representing non-feature categories. In 2004, 74% werefeatures while non-features grew to 26%, with the largest growth being in TV onDVD.

 

As evidencedby our 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. Product returns as a percentage of sales have increasedover the past three years, from 16% in fiscal year 2003, to 19% and 21% infiscal years 2004 and 2005, respectively. In particular, DVD retailers who alsospecialize 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,reorganizations and restructurings, as well as a significant number of storeclosures among CD retailers, appear to support an industry trend towardconsolidations and reductions within the retail space, including retail spacededicated to DVD.

 

Our DVD and CDrevenues from mass merchants and warehouse-style retailers have increased. Thelarger retailers typically return titles which do not meet their internalminimum sales velocities. To save costs, other retailers with multiple retaillocations return titles with low sales velocities in a particular store back totheir vendors, like us, and reorder the same titles for sale in a differentretail store. To save the costs of returns processing at their own distributioncenters, retailers generally require their vendors incur such costs. Thispractice has contributed to our higher returns percentage in recent years. Webelieve that the DVD and CD return rates experienced by major studios andrecord labels are substantially higher than our return rates, due to the sheervolume of big-budget theatrical and audio new releases sold into retail.

 

The typicalDVD buying consumer has largely shifted from a catalogue programming-focusedearly adopter to a mass market buyer driven by high-profile, big-budgettheatrical films. Both major studio and independent DVD suppliers now see thatthe primary drivers of revenues are new releases, which generate both retailand consumer interest and also help drive the sale of catalogue programming. Wehave a diverse catalogue of content, and according to DVD Release ReportRevised 5/4/05, we are the second-largest source for music on DVD, behind onlythe recently merged Sony BMG library, with 546 titles in active release, andthe top source for special interest programming on DVD with 512 titles inactive release. We typically add an average of 35 new DVD titles per month,with content spanning over many genres, to our current catalogue of over 2,800active DVD titles. In addition, we typically add an average of five new CDtitles per month, and our current active catalogue contains over 175 audio titles.Sales of our catalogue titles are affected by the strength of our new releases,continued customer demand and the availability of retail shelf space andretailer open to buy dollars.

 

**TRADEMARKS**

 

We haveobtained federal registrations of the trademarks “Image,” “Image Entertainment,”the Image Entertainment logo, and “Image Music Group,” and have filed a federaltrademark application for “Egami Media.” It is our policy to protect and defendour trademark rights.

 

**EMPLOYEES**

 

As of June 2,2005, we had 197 full-time employees and four part-time employees employed by us,two full-time employees employed by Egami Media, and two full-time employeesemployed by Image UK. Nine of our employees, including all of our executiveofficers and senior vice presidents, are covered by employment agreements, withthe remainder being at-will employees.

 

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**RISKFACTORS THAT MAY AFFECT FUTURE RESULTS**

 

You should carefullyconsider and evaluate all of the information in this report, including the riskfactors listed below. If any of these risks occur, our business, results ofoperations and financial condition could be harmed, the price of our commonstock could decline, and future events and circumstances could differsignificantly from those anticipated in the forward-looking statementscontained in this report.

 

Risks Relating to Our Business.

 

**We Have a High Concentration of Sales FromRelatively Few Titles.** Our top five fiscal 2005 new release exclusive titles (DVD *Larry the Cable Guy: Git R Done*, DVD *Ron White:They Call Me Tater Salad*, CD *The Source Presents HipHop Hits 9*, DVD *Bill Engvall: Here’s YourSign*, and DVD *Jeff Foxworthy: You MightBe a Redneck If.../ Check Your Neck*) accounted for approximately 21%of our fiscal 2005 net revenues. Our top ten fiscal 2005 new release exclusivetitles accounted for approximately 29% of our fiscal 2005 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, such as with our former perennial best-seller*Eagles: Hell Freezes Over* (worldwide netrevenues from the sale of this Eagles title during fiscal 2005 were $2,982,000),for which our sell-off rights expire on June 30, 2005. Net revenues from newrelease DVD titles, where a new release title is defined as released duringfiscal 2005, accounted for approximately 65% of fiscal 2005 net DVD revenuesand net revenues from catalogue DVD titles, where catalogue is defined as atitle first released in a previous fiscal year, accounted for approximately 35%of fiscal 2005 net DVD revenues. Revenues from new release and catalogue DVDtitles accounted for approximately 58% and 42% of fiscal 2004 net DVD revenues,respectively. If we cannot acquire titles of equal or greater strength andpopularity, our future net revenues would be negatively impacted.

 

**We Havea High Concentration of Sales to Relatively Few Customers.**Anderson Merchandisers (who supplies Wal-Mart),Best Buy and AEC One Stop Group together accounted for approximately 39% of ournet revenues for the year ended March 31, 2005. Additionally, our top fiveretail customers accounted for over 50% of our fiscal 2005 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.****Ourtop 25 retail customers accounted for approximately 86% of our fiscal 2005 netrevenues. We are not an exclusive supplier to any of our retailcustomers, and there is no guarantee that we will continue recognizingsignificant revenue from sales to any particular customer. If we are unable tomaintain the sale of our titles at their current levels to any these fivecustomers, and are unable to find other customers to replace these sales, therewould be a negative impact on our revenues and future profitability.

 

**We Have Extended More Favorable Payment Termsto Our Customers, Which Increases Our Credit Risk.** We created a fourth quarter catalogue salesprogram which included the offering of net 120, 150 and 180 day payment terms, ratherthan our customary net 60 to 75 days, on specific catalogue orders from retailcustomers who chose to participate in the program. In addition, we offereddiscounts of three to five percent, a standard practice for us on particularlylarge catalogue sales orders, on these extended dating purchases. Our extendedpayment terms allowed some of our customers — most notably AEC One Stop, Critic’sChoice, Ingram, Musicland and Trans World Entertainment — to expand the sizeand breadth of what they would have purchased otherwise. Nevertheless, theextended payment terms increase the risk of larger outstanding accountsreceivable, which may become uncollectible or less collectible in the event anyof these customers file for bankruptcy. The catalogue sales program alsoincreases the risk that participating customers will order fewer cataloguetitles from us in upcoming quarters.

 

**The Risks Inherent in Our Strategic AlliancesCould Have a Material Adverse Affect on Our Business.** We have co-production deals in place withDark Horse Entertainment and ContentFilm, and we plan to continue our strategyof developing key alliances with other third party content producers. We will rely on our co-producers to developand produce films. Particularly when produced by independentfilmmakers, each film is a separate business venture with its own management,employees, equipment and budgetary requirements. There are substantial risksassociated with film production, including contract problems with, ordisability of, directors, actors and other key artistic and technicalpersonnel, weather and other delays, damage to sets, equipment or film, and theinability of production personnel to comply with budgetary or schedulingrequirements. Such problems could materially increase the cost of production,increase the amount of time between our expenditure of funds and receipt ofrevenues, or cause the project to be abandoned at any stage if furtherexpenditures do not appear commercially feasible. Accordingly, there is no assurance that we will besuccessful in our strategic alliances, and any failure of our present andfuture

 

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alliances to producecommercially viable content at an acceptable cost could have a material adverseeffect on our business. Additionally, there is no assurance that we will beable to find further desirable strategic alliances as we continue pursuing newco-production deals and similar relationships.

 

**If Our Current DVD and CD GenreConcentrations Become Unpopular With Our Retail Customers and End Consumers,Our Business May Be Adversely Affected.** During fiscal2004, our DVD title genre concentration was heavily weighted towardmusic-related DVD programming. We were successful in our fiscal 2005 efforts todiversify our exclusive content into multiple DVD genres and grow our revenuesin the CD format. Approximately 23%, 18% and 13% of our domestic net revenuesgenerated in fiscal 2005 were derived from sales of exclusivelyproduced/acquired comedy, television- and music-related DVD entertainmentcontent, respectively, with the remaining 46% spread over multiple specialinterest genres. This compares to an approximately 24% concentration inmusic-related DVD content in fiscal 2004 with the remainder spread amongspecial interest genres. During fiscal 2005 we were able to grow our audiobusiness to over 10% of our total net revenues, compared to approximately 7% infiscal 2004, further diversifying the source of our revenues. We cannot assureyou that we will be able to compete successfully to continually produce and/oracquire content in the same genres, however, or that we will achieve the samestrength within the genres with which we were successful in fiscal 2005. If wecannot compete successfully in the home entertainment market for higher-profileDVD and CD content, our business may be adversely affected.

 

**We May Need Additional Funding to ContinueAcquiring Desirable Programming.** Availability ofworking 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.

 

**Inventory Obsolescence Poses a Risk to Us.** Wemaintain a substantial investment in DVD and CD inventory, and if weoverestimate the demand for a particular title, we may retain significantquantities of that title in our warehouse. Retained inventory occupies valuablestorage space and may become obsolete as our distribution term for the titleexpires. Although we may sell such inventory at a steeply discounted pricetoward the end of the distribution term in order to recoup our manufacturing,storage and other costs, there is no guarantee that a market will exist for agiven title, even at the steeply discounted price. Additionally, our licenseand/or distribution agreements sometimes contain terms, such as minimumroyalties per unit and music publishing fees, which effectively prevent us fromsteeply discounting the price on some titles.

 

**We Face Risks Associated with Deluxe’sPerformance Under Our Manufacturing Services Agreement.**We source substantially all of our DVD replication from Deluxe. Any failure ofDeluxe to manufacture and deliver our product in a timely manner and with thesame consistent quantity and quality that we and our customers have come toexpect may adversely affect our revenues and profits. Additionally, although webelieve we have the ability to shift our product manufacturing from Deluxe toanother facility should the need arise; we may be adversely affected by theperiod of time that we would need to direct manufacturing duties to anothercompany.

 

**We Face Risks in Distributing Our ProgrammingInternationally.** We distribute our programminginternationally and derive a decreasing percentage of our revenues from salesactivity outside of North America. As a result, our business may be subject tovarious risks inherent in international trade, many of which are beyond ourcontrol. Risks faced in distributing our programming internationally include: cancellationor renegotiation of contracts, changes in laws and policies affectinginternational trade (including taxes), credit risk, fluctuating foreignexchange rates and controls, civil strife, acts of war, guerilla activities,insurrection, terrorism, changing retailer and consumer tastes and preferenceswith regard to our programming, differing degrees of protection of ourintellectual property, cultural barriers, and potential instability of foreigneconomies and governments.

 

**TheMajority of International Revenues Are Generated By Three Sublicensees.**Revenues generated from internationaldistribution are primarily from the manufacturing, marketing and distributionefforts of Sony BMG, Warner Music Group and, in the future, Digital Site. Shouldany of Sony BMG, Warner or Digital Site default on their respective sublicenseagreements with us or fail to successfully perform, an important part of ourbusiness strategy, financial condition, results of operations and cash flowswould be negatively impacted.

 

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**We HaveDirect and Indirect Foreign Currency Exchange Risk.**Although our Sony BMG and Digital Sitesublicense agreements are U.S. Dollar denominated, with these parties reportingto us and paying us in U.S. Dollars, the underlying Sony BMG sales transactionsare in Euros and the underlying Digital Site sales transactions are in Yen. On June1, 2005, the Euro was equivalent to approximately U.S. $1.23 and the Yen wasequivalent to approximately U.S. $0.009214. Should the U.S. Dollar strengthencompared to either the Euro or the Yen, our sublicensors’ reported royalties tous on a title-by-title basis and in the aggregate would decline (assumingconsistent unit sales) and thus reduce our revenues recognized.

 

**We Havean Accumulated Deficit and May Incur Additional Losses.**While we were profitable for fiscal 2005, wesustained net losses for the three preceding fiscal years ending March 31,2004. Our accumulated deficit at March 31, 2005, was $9.5 million. While wehave made changes to our business that we hope will successfully lead toconsistent profitability, due to the inherent unpredictability of high-profilecontent acquisition and competition for limited retail shelf space, we mayincur losses again in the future.

 

**If We Cannot Maintain Relationships with OurProgram Suppliers and Vendors, Our Business May Be Adversely Affected.**We receive a significant amount of our revenue from the distribution of thoseDVDs for which we already have exclusive agreements with program suppliers. Wecan give no assurances, however, that titles in production which have beenfinanced by us will be timely delivered as agreed or of the expected quality. Delaysor inadequacies in delivery, including rights clearances, could negativelyimpact the performance of any given quarter or fiscal year. We can give noassurance that such content will ultimately be purchased in internallyforecasted quantities by our retail customers or ultimately desired by theend-consumer. We also cannot be sure that we will be able to renew theseexclusive rights as existing agreements with program suppliers expire. We alsocannot assure you that our current program suppliers will continue to supportthe DVD format in accordance with our exclusive agreements, that our currentcontent suppliers will continue to license titles to us on the current terms oron terms favorable to us, or that we will be able to establish new beneficialsupplier relationships to ensure acquisition of exclusive titles in a timelyand efficient manner.

 

**The Full Exploitation of Our Rights Requires Us to Conduct Business inAreas Where Our Expertise Is Limited.** In order tofully exploit some of the rights we have acquired, we are required to conductbusiness in sectors (e.g. Internet, rental, broadcast, video on demand,in-flight, satellite) where we are not as experienced as we are in the DVD andhome video sectors. Accordingly, when exploiting such sectors in which we areless experienced, we may realize a greater proportion of costs, or we may notrealize as much of a proportion of revenue, as we would in the DVD and homevideo sectors.

 

**If We Do Not Effectively Implement Our Salesand Marketing Efforts, Our Profitability May Suffer.** Wehave increased our internal sales staff in order to enhance our sales efforts. Wecannot assure you that our sales team can successfully compete against the moreextensive and well-funded sales operations of our current and futurecompetitors, however.

 

**If Our Key Personnel Leave Us, Our BusinessMay Be Adversely Affected.** Our success greatly dependson the performance of our executive management, including the President andChief Executive Officer, Chief Operating Officer and Chief Financial Officer,as well as our five senior vice presidents responsible for the critical areasof content acquisition, legal, marketing & product development, operations,and sales. The loss of the services of key persons of our executive and seniormanagement could have an adverse material effect on our operating results andfinancial condition.

 

**If We Do Not Successfully Optimize andOperate Our Warehouse and Distribution Facility, Our Business Could Be Harmed.**Domestic wholesale distribution of our exclusive programming is fulfilled froma single warehouse and distribution facility in Las Vegas, Nevada. If we areunable to operate this facility for any reason, it could significantly limitour ability to meet customer demand. Because it is difficult to predict salesincreases or declines, we may not manage our facility in an optimal way, whichmay result in excess inventory, warehousing and distribution problems. Ourfailure to handle inventory properly could result in unexpected costs, delaysand harm to our business and reputation.

 

**Occurrence of Events for Which We Are NotInsured May Adversely Affect Our Business.** We maintaininsurance to protect ourselves against various risks related to our operations.This insurance is maintained in types and

 

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amounts that we believe to bereasonable depending upon the circumstances surrounding each identified risk. However,we may elect to limit coverage or not to carry insurance for some risks becauseof the high premiums associated with insuring those risks or for various otherreasons. For example, we do not carry earthquake insurance in light of thesteep increase in premiums in Southern California after the Northridgeearthquake on January 17, 1994. Occurrence of events for which we are notinsured may affect our cash flows and overall profitability.

 

Risks Relating to Our Industry.

 

**Our Success Depends on the UnpredictableCommercial Success of Our Programming.** Operating inthe 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 activities, general economic conditions and other tangible andintangible factors, all of which are subject to change and cannot be predictedwith certainty. Our success will depend in part on the popularity of ourcontent which, in turn, depends on our ability to gauge and predict expectedpopularity. Even if a film achieves success during its theatrical release, thepopularity of a particular program and its ratings may diminish over time,which may have a material adverse affect on our business, results of operationsor financial condition. Timing and timeliness are also sometimes relevant to aprogram’s success, especially when the program concerns a recent event orhistorically relevant material (e.g. an anniversary of a historical event whichfocuses media attention on the event and accordingly spurs interest in relatedcontent).

 

**DecreasingRetail Shelf Space May Limit Sales of Our Programming**. We face increasing competition from majormotion picture studios, music labels and other independent distributioncompanies for limited retail shelf space and retailer open to buy dollars. Ourexclusive content competes for a finite amount of shelf space against a growingsupply of entertainment content. Because the new DVD releases of major studiosoften have extremely high visibility and sales velocity in the millions of units,which typically require more shelf space to support, we may not be able toafford or obtain the product placement necessary to maximize sales,particularly among the limited number of major retailers that are our corecustomers, which could result in decreased revenues and gross margins. See“Competition” above.

 

**If We Do Not Effectively Implement aTransition to Vendor Managed Inventory, Our Business May Be Adversely Affected.** Larger retailers are starting to move toward a Vendor Managed Inventory (VMI)system whereby independent suppliers like us would be responsible formonitoring, stocking and fulfilling directly to individual retail stores andoutlets.  We currently have one major customer who is requiring VMI in thenear future, and other customers are likely to follow suit.  The firsttarget date for VMI compliance for music DVD and CD is August 2005,and target dates for other categories of DVD are expected to be later in 2005or 2006.  While we currently expect to have a VMI system in place to testin late 2005 or early 2006, with full implementation projected a few monthsthereafter, we may not be able to do so in a timely and effective manner. Also, the corresponding expense to upgrade our existing Oracle system, add aVMI Oracle module, plus associated training and consulting costs, are presentlyunknown.  Failure to implement VMI in a timely manner 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.

 

**We May Not Be Able to Keep Pace withTechnological Advances.** The entertainment industry ingeneral, and the music and motion picture industries in particular, arecontinuing to undergo significant changes, primarily due to technologicaldevelopments. As an independent supplier, we believe we have a superior abilityto adapt to changing formats and distribution methods, as we did when shiftingour focus from laserdiscs to DVDs, and that our customer base will continue topurchase programming from us through new distribution methods. However, becauseof the rapid growth of technology, shifting consumer tastes and the popularityand availability of other forms of entertainment, it is impossible to predictthe overall effect these factors could have on potential revenue from, andprofitability of, distributing entertainment programming. It is also impossibleto predict the overall effect these factors could have on our ability tocompete effectively in a changing market.

 

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**Product Returns Pose a Significant Risk to Us.**Aswith the major studios and other independent companies in this industry, weexperience a relatively high level of product returns as a percentage of ourrevenues. Although our past experience indicates that our allowances for salesreturns are adequate to cover potential returns, there can be no assurance thatthese reserves will be adequate in the future, in the case of consolidationwithin the home video retail marketplace which, when it occurs, tends to resultin inventory consolidation and increased returns.

 

**Illegal Piracy May Reduce Our Revenues.**Themusic industry is facing a major challenge in the form of illegal piracyresulting from Internet downloading and/or CD recorders. This piracy hasnegatively affected industry revenues and profits. Although we currently deriveonly 10.2% of our revenues from audio CDs, we expect that our proportionalrevenues in this sector will increase. Additionally, DVD recorders aregradually gaining greater market penetration. According to In-Stat, the DVD recordermarket, not including units connected to PCs, doubled in size in 2004 and is expectedto grow 87% in 2005. They expect worldwide DVD recorders to grow from 9.4million in 2004 to 67.7 million in 2009. As DVD recorders and high-speedInternet connections become more popular, and the storage capacity of personalcomputers increases, we may face greater piracy concerns with respect to ourcore DVD business.

 

**Others’ Failure to Promote Our ProgrammingMay Adversely Affect Our Business.** Decisions regardingthe timing of release and promotional support of programming which we licenseand distribute are important in determining the success of a particular musicconcert, feature film or related product. We may not control the manner inwhich 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.

 

**If DVD Cannot Compete Successfully with OtherFormats of Home Entertainment, Our Revenues May Be Negatively Impacted.**The DVD format competes with other formats of in-home entertainment, such asnetwork, syndicated, cable and pay-per-view television and home satellitesystems. The DVD format also competes with new and emerging technologies in theentertainment industry, such as entertainment programming on the Internet, videoon demand, high-definition television, digital videotape and optical discs withgreater storage capacity. While we are actively seeking to exploit thesealternate home entertainment formats and emerging content deliverytechnologies, they nevertheless could negatively impact the overall market forour DVD sales, especially if we are unable to continue to adapt and exploit thedevelopment and advancement of such technology.

 

**DVD Sales May Not Sustain the Same Level ofGrowth.** We believe that consumer interest in the DVDformat is due partly to interest in building the consumer’s personal DVDlibrary of desired entertainment programming. Although our exclusive titleshave generally shown stable sales over extended periods, as consumers buildtheir DVD libraries, or with the introduction of new home entertainmentformats, DVD sales may decline and adversely affect our operations. See “IndustryTrends” above.

 

****DecreasingRetail Prices for DVDs May Negatively Impact Our Revenues.**** The home entertainment programming market inwhich we compete is rapidly evolving and intensely competitive. Many of ourcompetitors, including major studios, are increasingly offering programming,particularly DVD programming, at lower prices. They may be able to produce orsecure content on more favorable terms and may be able to adopt more aggressivepricing policies than we are able to do. While we strive to improve ouroperating efficiencies and leverage our fixed costs so that we can afford topass along these savings to our customers in the form of lower prices, theindustry trend of lowering prices may, over time, lead to higher levels ofcompetition and, therefore, lost sales, decreased profit margins or decreasedoverall revenues.

 

**Conflicting High-Definition DVD Formats May Cause Inefficiencies.**Currently, two major platforms are competing to become the dominanthigh-definition player, and recent talks to unify the platforms have beenunsuccessful. The HD-DVD platform is purported to launch in late 2005, whilethe Blu-Ray Disc® platform is purported to launch in early-mid 2006. For manyof our titles, we hold rights to both platforms, but simultaneously supportingboth platforms will cause increased production costs and decreased efficiencieswith respect to inventory management and sales. Moreover, competing platformsmay cause a delay in high-definition player market penetration, and mainstreamacceptance of high-definition DVD in general, as consumers may decide to waitand see which platform prevails before purchasing a player.

 

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**OurFilm Production Efforts May Not be Financially Successful.** Our co-produced films are more expensive tocreate than our DVD co-productions, and the time between our expenditure offunds and receipt of revenues is longer. While much of our programming is soldto retailers on a sell-through basis, the financial success of our filmedprogramming will depend on our ability to generate higher sales to retailerswho primarily rent programming such as Blockbuster, Movie Gallery, Hollywood Entertainment(now a wholly-owned subsidiary of Movie Gallery) and Netflix, as well as tomass merchants such as Wal-Mart, Costco and Target. Our filmed programming maynot ultimately be as desirable to our target customers as we would hope, whichwould lead to lower than expected sales, decreased profit margins or losses.

 

**If We Cannot Continue to Secure DVD Licenseand Distribution Rights, Our Business May Be Materially Adversely Affected.**We cannot assure you that we will be able to continue to secure DVD and otherlicense and distribution rights on terms acceptable to us. See “Competition”above. Major motion picture studios have normally not granted, nor are theyexpected to grant, exclusive DVD licenses to us for new releases and popularcatalogue titles. Instead, the major motion picture studios will most likelycontinue to sell DVD titles directly to retailers. We expect to continue tolicense exclusive DVD and other home entertainment format content, but wecannot assure you that we can remain competitive against licensing entitieswith greater financial resources or that independent program suppliers will notdistribute their programming themselves. In addition, our success will continueto be dependent upon our ability to identify and secure rights to exclusivecontent that appeal to consumers.

 

**We May Not Possess Satisfactory Rights in OurProperties.** Although we require satisfactory chain oftitle information to our exclusively licensed content, the risk exists thatsome programs may have a defective chain of title. The validity and ownershipof rights to some titles can be uncertain and may be contested by thirdparties.

 

**Our Results of Operations Fluctuate Based onSeasonality and Variability.** We have generallyexperienced higher sales of DVDs and CDs in the quarters ended December 31 andMarch 31 due to increased consumer spending associated with the year-endholidays. 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

 

**Protecting and Defending against IntellectualProperty Claims May Have a Material Adverse Effect on Our Business.**Our ability to compete in the home entertainment industry depends, in part,upon successful protection of our proprietary and intellectual property. Weprotect our property rights to our productions through available copyright andtrademark laws and licensing and distribution arrangements with reputableinternational companies in specific territories and media for limiteddurations. Despite these precautions, existing copyright and trademark lawsafford only limited practical protection in some jurisdictions. In somejurisdictions of our distribution, there are no copyright and/or trademarkprotections available. As a result, it may be possible for unauthorized thirdparties to copy and distribute our productions or portions or applications ofour intended productions.

 

In addition,litigation may be necessary in the future to enforce our intellectual propertyrights, to protect our trade secrets, to determine the validity and scope ofthe proprietary rights of others or to defend against claims of infringement orinvalidity. Any such litigation could result in substantial costs and the resultingdiversion of resources could have an adverse effect on our business, operatingresults or financial condition. From time to time, we may also receive claimsof infringement of other parties’ proprietary rights. Regardless of thevalidity or the success of the claims, we could incur significant costs anddiversion of resources in defending against such claims, which could have anadverse effect on our business, financial condition or results of operations.

 

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Risks Relating to Our Stock.

 

**Our Stock Price May Be Subject to Substantial Volatility, and You MayLose All or a Substantial Part of Your Investment.** Ourcommon stock is traded on the Nasdaq National Market. There is a limited publicfloat (even after our recent private placement), and trading volumehistorically has been limited and sporadic. Over the last year, the closingprice of our common stock ranged between $2.72 and $6.69 per share on volumeranging from 700 to over 2.2 million shares per day. As a result, the currentprice for our common stock is not necessarily a reliable indicator of our fairmarket value. The price at which our common stock will trade may be highlyvolatile and may fluctuate as a result of a number of factors, including,without limitation, the number of shares available for sale in the market,quarterly variations in our operating results, and actual or anticipatedannouncements of new releases by us or competitors, the gain or loss of significantcustomers, changes in the estimates of our operating performance, marketconditions in our industry and the economy as a whole.

 

**The Resale of Our Private Placement SharesMay Significantly Impact the Market Price of Our Common Stock.**In December 2004, we sold 2,904,763shares of our common stock in a private placement. The effective registrationand resale of shares by the purchasers in the placement may significantlyaffect the market price of our stock. We have 21,251,916 shares of common stockoutstanding as of June 2, 2005. The shares sold in the offering representapproximately 13.7% of our currently outstanding shares. Assuming all of thewarrants we issued in connection with the placement were exercised for cash of$5,145,000, we would have 22,036,200 outstanding shares of common stock, andthe 3,689,047 shares in the offering would represent 16.7% of our outstandingshares. Because the shares were registered on behalf of the SellingShareholders, we have no control over which of them will actually resell all orany portion of their shares, or at what price.

 

**We May Incur Increased Costs as a Result of Laws andRegulations Relating to Corporate Governance Matters.** Laws and regulations affecting publiccompanies, including the provisions of the Sarbanes-Oxley Act of 2002 and rulesadopted or proposed by the Securities and Exchange Commission and by NASDAQ,will result in increased costs to us as we evaluate the implications of any newrules and respond to their requirements.  If our public float exceeds$75 million at the end of our second fiscal quarter on September30, 2005, we will become an accelerated filer and be subject to additionalregulatory requirements, including Section 404 ofSarbanes-Oxley which would the require us to include in our annual reportfor the period ending March 31, 2006 a report by management on our internalcontrol over financial reporting and an accompanying auditor’s report. The additional costs and efforts to do so could be substantial.  Ifwe remain a non-accelerated filer, we will not have to comply until March 31,2007.  New rules could make it more difficult or more costly for us toobtain certain types of insurance, including director and officer liabilityinsurance, and we may be forced to accept reduced policy limits and coverage orincur substantially higher costs to obtain the same or similar coverage. Theimpact of these events could also make it more difficult for us to attract andretain qualified persons to serve on our board of directors, our board committeesor as executive officers. We cannot predict or estimate the amount of theadditional costs we may incur or the timing of such costs to comply with anynew rules and regulations.

 

**Any Future Sales of Equity May SignificantlyImpact the Market Price of Our Common Stock.** Futuresales of substantial amounts of our common stock, including shares that we mayissue upon exercise of outstanding options and warrants, could adversely affectthe market price of our common stock. Further, if we raise additional fundsthrough the issuance of common stock or securities convertible into orexercisable for common stock, the percentage ownership of our stockholders willbe reduced and the price of our common stock may fall.

 

**ITEM2.                 PROPERTIES**

 

Our headquarters are located inChatsworth, California and consists of approximately 62,000 square feet on onefloor of a multi-tenant building. The monthly rent is $1.26 per square foot, ona gross basis, or approximately $78,000 per month, and increases approximately3% annually. The office lease has an initial 10-year term with two five-yearoptions. The lease started on July 1, 2004, upon completion of approximately$1.5 million in tenant improvements. Substantially all of the tenantimprovement expenses were borne by the landlord. Although a base level of operating expenses is included in the rentpayment, we will be responsible for a percentage of actual annual operatingexpense increases capped at 5% annually.

 

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We also lease our 76,000 square footwarehouse and distribution facility located in Las Vegas, Nevada. The monthlyrent is approximately $39,000, subject to annual adjustment based on increasesin the consumer price index, and the lease will terminate on November 4, 2012. Inaddition, we lease approximately 4.07 acres of adjacent vacant land in theevent we need to expand our current warehouse and distribution facility. Themonthly rent is approximately $9,000 and the lease will terminate on November4, 2007. Beginning in January 2004, we leased an additional 10,000 square footwarehouse storage space in Las Vegas, Nevada for a monthly rent ofapproximately $5,000 for a term of two years.

 

Image UK leases approximately 500 square feetof business space in London inside the offices of ContentFilm plc, located at 19 HeddonStreet 3rd Floor, London W1B 4BG. Image UK currently pays £7,500 (approximately$14,000) per quarter in rent to ContentFilm, which includes a prorated share ofutilities and use of ContentFilm’s common areas. The lease is terminable upon90 days notice by either party. Image UK also leases a residential apartment inLondon for £720 per week, but this lease terminates on July 15, 2005 and willnot be renewed.

 

We believe that our current office andwarehouse space is adequate to meet our needs, and that additional facilitieswill be available for lease, if necessary, to meet our future needs.

 

**ITEM3.                 LEGAL PROCEEDINGS**

 

In the normalcourse of business, we are subject to proceedings, lawsuits and other claims,including proceedings under government laws and regulations relating toemployment and tax matters. While it is not possible to predict the outcome ofthese matters, it is the opinion of management, based on consultations withlegal counsel, that the ultimate disposition of known proceedings will not havea material adverse impact on our financial position, results of operations orliquidity.

 

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

 

None.

 

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**EXECUTIVEOFFICERS OF THE REGISTRANT**

 

Executive officers serve at thepleasure of our board of directors. There is no family relationship between anyexecutive officer or director. The following table sets forth informationregarding our executive officers at June 1, 2005:

 
| **Executive Officer** | ** ** | **Age** | ** ** | **Position & Background**                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|-----------------------|------------|---------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                  |       |    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| Martin W.  Greenwald  |       | 63      |       | 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    |       | 40      |       | 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       |       | 44      |       | 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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**PARTII**

 
| **ITEM 5.** |   | **MARKET FOR REGISTRANT’S COMMON EQUITY,  RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES** |
|-------------|--------|------------------------------------------------------------------------------------------------------------------------|

 

Our commonstock trades on The NASDAQ National Market® under the symbol DISK. The tablebelow presents the quarterly high and low closing prices on the NASDAQ duringthe past two fiscal years.

 
| **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 |   |

 
| **Fiscal Year Ended March 31,  2004** | ** ** | **High** | ** ** | **Low** | ** ** |
|---------------------------------------|------------|----------|------------|---------|------------|
| Quarter ended June 30, 2003           |       | $        | 2.340      |    | $          | 1.860 |   |
| Quarter ended September 30, 2003      |       | $        | 3.140      |    | $          | 2.200 |   |
| Quarter ended December 31, 2003       |       | $        | 4.980      |    | $          | 2.750 |   |
| Quarter ended March 31, 2004          |       | $        | 4.040      |    | $          | 2.720 |   |

 

As of June 2,2005, there were 1,292 holders of record of our common stock. As of May 3,2005, we estimate there were 4,377 beneficial owners of our common stock.

 

We have neverpaid a cash dividend on our common stock and we presently intend to retain anyfuture earnings for business development. In addition, we are party to loanagreements which prohibit our payment of dividends.

 

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**ITEM6.                 SELECTED FINANCIALDATA**

 

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)**                      | ** ** | **2005**                  | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| **Statement of Operations Data:**                               |       |                      |       |   |   |   |   |   |   |   |   |
| Net revenues                                                    |       | $                         | 118,383    |   | $ | 84,840 |   | $ | 86,929 |   | $ | 76,135 |   | $ | 83,147 |   |
| Operating costs and expenses                                    |       | 112,380                   | (1)        | 85,106 |   | 82,924 | (4) | 72,797 | (6) | 74,576 |   |
| Earnings (loss) from operations                                 |       | 6,003                     |       | (266 | ) | 4,005 |   | 3,338 |   | 8,571 |   |
| Interest expense, net                                           |       | 665                       |       | 818 |   | 1,359 |   | 1,711 |   | 1,629 |   |
| Other expense (income)                                          |       | 49                        |       | (213 | ) | 698 |   | 192 |   | (289 | ) |
| Earnings (loss) from continuing operations  before income taxes |       | 5,289                     |       | (871 | ) | 1,948 |   | 1,435 |   | 7,231 |   |
| Income tax expense (benefit)                                    |       | 162                       | (2)        | 6,244 | (3) | 1,306 | (5) | 562 |   | (2,981 | )(7) |
| Earnings (loss) from continuing operations                      |       | 5,127                     |       | (7,115 | ) | 642 |   | 873 |   | 10,212 |   |
| Loss from discontinued operations                               |       | —                    |       | 2,441 |   | 1,096 |   | 1,068 |   | 1,780 |   |
| Earnings (loss) before cumulative effect of  accounting change  |       | 5,127                     |       | (9,556 | ) | (454 | ) | (195 | ) | 8,432 |   |
| Cumulative effect of accounting change                          |       | —                    |       | — |   | (3,766 | ) | — |   | — |   |
| Net earnings (loss)                                             |       | $                         | 5,127      |   | $ | (9,556 | ) | $ | (4,220 | ) | $ | (195 | ) | $ | 8,432 |   |
| Earnings (loss) per share:                                      |       |                      |       |   |   |   |   |   |   |   |   |
| Continuing operations                                           |       |                      |       |   |   |   |   |   |   |   |   |
| Basic                                                           |       | $                         | .27        |   | $ | (.39 | ) | $ | .04 |   | $ | .06 |   | $ | .63 |   |
| Diluted                                                         |       | $                         | .26        |   | $ | (.39 | ) | $ | .04 |   | $ | .06 |   | $ | .60 |   |
| Discontinued operations                                         |       |                      |       |   |   |   |   |   |   |   |   |
| Basic                                                           |       | $                         | —     |   | $ | (.13 | ) | $ | (.07 | ) | $ | (.07 | ) | $ | (.11 | ) |
| Diluted                                                         |       | $                         | —     |   | $ | (.13 | ) | $ | (.07 | ) | $ | (.07 | ) | $ | (.10 | ) |
| Earnings (loss) before cumulative effect of  accounting change  |       |                      |       |   |   |   |   |   |   |   |   |
| Basic                                                           |       | $                         | .27        |   | $ | (.52 | ) | $ | (.03 | ) | $ | (.01 | ) | $ | .52 |   |
| Diluted                                                         |       | $                         | .26        |   | $ | (.52 | ) | $ | (.03 | ) | $ | (.01 | ) | $ | .50 |   |
| Cumulative effect of accounting change                          |       | $                         | —     |   | $ | — |   | $ | (.22 | ) | — |   | — |   |
| Net earnings (loss) per share:                                  |       |                      |       |   |   |   |   |   |   |   |   |
| Basic                                                           |       | $                         | .27        |   | $ | (.52 | ) | $ | (.25 | ) | $ | (.01 | ) | $ | .52 |   |
| Diluted                                                         |       | $                         | .26        |   | $ | (.52 | ) | $ | (.25 | ) | $ | (.01 | ) | $ | .50 |   |
| Weighted average shares outstanding                             |       |                      |       |   |   |   |   |   |   |   |   |
| Basic                                                           |       | 19,100                    |       | 18,250 |   | 16,812 |   | 15,821 |   | 16,257 |   |
| Diluted                                                         |       | 19,912                    |       | 18,250 |   | 17,002 |   | 15,898 |   | 17,637 |   |

 

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| (1) |   | Includes a $499,000 non-recurring noncash credit  related to the discontinuation of our international distribution of DVDs  through subdistributors.                                                                      |
|-----|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) |   | Income tax expense reflects the use of NOLs against  taxable income.                                                                                                                                                      |
| (3) |   | Income tax expense reflects establishing a valuation  allowance against 100% of net deferred tax assets.                                                                                                                  |
| (4) |   | Includes the reduction to gross margin of $480,000  for estimated subdistributor returns and inventory write downs as a result of  our transition from direct European distribution to European sublicense.               |
| (5) |   | Includes a provision for a valuation allowance  against deferred tax assets of $551,000 relating primarily to foreign tax  credits.                                                                                       |
| (6) |   | Includes $1,818,000 in one-time noncash credit  relating to the discontinuation of our laserdisc operations and a $696,000  write down of advance royalties, relating to a line of programming, to  estimated fair value. |
| (7) |   | Income tax benefit  reflects the elimination of the valuation allowance recorded against deferred  tax assets.                                                                                                            |

 

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| ** **                    | ** ** | **March 31,** | ** ** |
|-------------------------------|------------|---------------|------------|
| **(In thousands)**            | ** ** | **2005**      | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| **Balance Sheet Data:**       |       |          |       |   |   |   |   |   |   |   |   |
| Total assets                  |       | $             | 75,186     |   | $ | 64,132 |   | $ | 74,251 |   | $ | 81,898 |   | $ | 74,991 |   |
| Total liabilities             |       | 33,353        |       | 41,797 |   | 42,586 |   | 49,390 |   | 42,516 |   |
| Net shareholders’ equity |       | 41,833        |       | 22,335 |   | 31,665 |   | 32,508 |   | 32,475 |   |
|                               |            |               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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| **ITEM 7****.** | ** ** | **MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS** |
|-----------------|------------|-------------------------------------------------------------------------------------------------|

 

The following discussion andanalysis should be read together with “Item 1. Business,” “Item 6.  SelectedFinancial Data” and the consolidated financial statements, the related notesthereto and other financial information contained elsewhere in this report.

 

**Forward-LookingStatements**

 

Thisreport includes forward-looking statements within the meaning of the PrivateSecurities Litigation Reform Act of 1995. Other than statements of historical fact, all statements made in thisreport are forward-looking, including but not limited to statements regardingindustry prospects, future results of operations or financial position, andstatements of our intent, belief and current expectations about our strategicdirection, prospective and future results. In some cases forward-looking statements may be identified by words suchas “will,” “should,” “expect,” “anticipate,” “believe,” “estimate,” “continue,”“future,” “intend” or similar words. Forward-looking statements involve risks and uncertainties that areinherently difficult to predict, which could cause actual outcomes and resultsto differ materially from our expectations, forecasts and assumptions.  The following important factors, in additionto those discussed above, could affect our future results and could cause thoseresults to differ materially from those expressed in such forward-lookingstatements:

 

•                                          changes in company-wide or business-unitstrategies, which may result in changes in the types or mix of businesses inwhich the we are involved or choose to invest

•                                          changes in U.S. and global financial andequity markets, including market disruptions and significant interest ratefluctuations, which may impede our access to, or increase the cost of, externalfinancing for its operations and investments

•                                          increased competitive pressures, bothdomestically and internationally, which may, among other things, affect theperformance of our business operations and profit margins

•                                          changes in the mix of titles sold tocustomers and/or customer spending patterns

•                                          legal and regulatory developments that mayaffect the protection of intellectual property

•                                          the imposition by foreign countries of traderestrictions on motion picture or television content requirements or quotas,and changes in international tax laws or currency controls

•                                          technological developments that may affectthe distribution of our products or create new risks to our ability to protectour intellectual property

•                                          changing public and consumer taste, which mayamong other things, affect the entertainment and consumer products businessesgenerally

 

All forward-lookingstatements should be evaluated with the understanding of inherentuncertainty.  The inclusion of suchforward-looking statements should not be regarded as a representation thatcontemplated future events, plans or expectations will be achieved.  Unless otherwise required by law, weundertake no obligation to release publicly any updates or revisions to anysuch forward-looking statements that may reflect events or circumstancesoccurring after the date of this report. Important factors that could cause or contribute to such materialdifferences include those discussed in Item 1. “Risk Factors That May Affect Future Results” and “Competition”above.  You are cautioned not to placeundue reliance on such forward-looking statements.

 

**Overview**

 

*Sourcesof Revenue*

 

Our primary source ofrevenues continues to be derived from the acquisition and distribution ofexclusive DVD content in North America, which accounted for over 84% of ouroverall net sales in fiscal 2005.  Agrowing source of revenues in fiscal 2005 is derived from the distribution ofCD content in North America, which accounted for over 10% of our fiscal 2005net revenues.

 

Internationally, weprimarily receive royalty income from sublicenses with Sony BMG, Warner Musicand Digital Site for the distribution of our exclusive DVD content.

 

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*CostStructure*

 

Our most significant costsand cash expenditures relate to acquiring content for exclusive distributionand, more recently, the funding of content production or co-production forexclusive distribution.  With the popularityof DVD growing, the cost of acquiring content for exclusive distribution isalso growing.  Additionally, the cost ofproduct placement, co-op advertising and market development funds provided to ourretail customers continues to increase.

 

*Competition*

 

Wecontinue to face increasing competition from major motion picture studios,music labels and other independent distribution companies:

 

(1)   to acquire exclusive content distributionrights

(2)  for limited retail shelf space

(3)   for retaileropen to buy dollars

 

Homevideo rights to most motion pictures are owned by major studios and distributeddirectly to the large retail customers.  Recordlabels continue to increase their music-related titles released through theirown labels, and other independent content suppliers are aggressively competingfor non-major studio content.  Obtainingquality DVD programming at reasonable prices based upon internally forecastedsales is becoming more challenging.

 

Ourexclusive content competes for a finite amount of shelf space, against agrowing supply of entertainment content. Available “open to buy” dollars allocated by retailers to purchase DVDand CD titles are becoming more scarce, since the majority of dollars are oftendevoted to high-profile new releases from major studios and major music labels.  We believe our expenses to provide marketdevelopment funds and cooperative advertising dollars to our retail customerswill continue to increase, and availability of opportunities will continue to betitle dependent.  Internet retailers dooffer virtual shelf space by virtue of being able to show far more titlesthrough the Internet to the consumer than physical space allows and are agrowing source of revenues for us.

 

*ContentAcquisition Strategy*

 

Our content acquisition strategyhas expanded to include genres such as:

 

•                  comedy

•                  television

•                  feature films

•                  urban

•                  youth culture/lifestyle

•                  Latin

 

Weintend to maintain our focus on genres that have been successful in the past,as well as to seek out early trend opportunities in advance of mainstreamacceptance in an effort to keep acquisition costs lower by bringing titles tomarket before spikes in demand, especially in growing genres such as urban andLatin.  We also have a successful trackrecord of releasing classic television content on DVD, with our success ontitles such as the original *The Twilight Zone*,*The Richard Pryor Show,*and *The Dick Van Dyke Show* resulting in new opportunities torelease popular television shows such as cult favorite *Pee-wee’sPlayhouse*, *Combat, Saved by the Bell:The College Years* and *The New Class*and *The Twilight Zone: The 80’s*.  We have also become a leader in comedycontent on DVD after releasing successful comedy programs from recent Oscarwinner Jamie Foxx; “Blue Collar” comedians Larry the Cable Guy, Ron White, BillEngvall and Jeff Foxworthy (three of the four were produced by us), the HowardStern show’s Artie Lange; and several branded comedy series including Jamie Foxx’s*Laffapalooza*.  Our success with comedy titles helped usrecently acquire the rights to distribute “Just for Laughs,” aninternationally-known Canadian brand with a deep and diverse library of gag andstand-up comedy content.

 

Our music-related DVDbusiness continues to expand in an increasingly competitive market, withpopular fiscal 2005 releases such as *Ramones: Raw*, themusic documentary about the recording of the classic charity song *We Are The World, Vans Warped Tour,* and *Doors of the21st Century: L.A. Woman Live*.  Fiscal 2006 DVD releases will include the *Taste of Chaos* concert tour, *Hall andOates:**Live*(featuring renditions ofsoul classics); *Yes:**9012 Live*,

 

25

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classic R & B group *MintCondition:**Live*, *Chicago and Earth Wind & Fire: Live at the Greek,*and *Rockin’ The Corps: An American Thank You* (a salute to ourarmed forces featuring live performances from Destiny’s Child, KISS, TedNugent, Godsmack, Richie Sambora and Hootie & the Blowfish).  Other new initiatives include the developmentof multicultural niches including Latin/Hispanic product such as *Bienvenidos* titles, *Latinologues*, *La Lucha*, and *Ciudad Del So*l(Sun City).

 

Weare also continuing to expand our sales of audio CD programming with titlessuch as The Source magazine’s brandedcompilation series *Hip Hop Hits**Volumes 8 and 9*, *Mint Condition: Livin’ the Luxury Brown*,soundtracks for television shows *Cursed*and *Summerland*, *The Roots: Present*, the *Live at Billy Bob’s**Texas*country music series, and other audio soundtrack companions to our video releases.  Fiscal 2006 new releases will include *The Source Presents Hip Hop Hits: Volumes 10 and 11*, TheSource Magazine’s *Five Mics* (formerly known as *30th Anniversary of Hip-Hop*) and the CD of *Rockin’ The Corps* (featuring all groups on the DVD exceptDestiny’s Child).

 

Weare looking for attractive opportunities to acquire smaller independent contentproviders, their desirable titles, output distribution agreements or otherassets, in order expand our catalogue of exclusive programming and growrevenues and earnings.

 

*Salesand Marketing Initiatives*

 

In order to deal withincreasing competition more effectively, we continue to develop new marketinginitiatives, including revenue growth-related incentives to encourage retailersto carry our titles.  We have recentlyexpanded our catalogue sales force to grow sales of titles which have been indistribution for over a year.  We also continueto adjust our price points on new release programming and selectively repriceand reposition our secondary and tertiary catalogue programming to driverevenues.  For example, while retailersare sometimes hesitant to bring in new individual titles, they have typicallybeen more receptive to newly-designed box sets. These compilations have a higher perceived value among retailers andconsumers, making both shelf space and retail sales easier to obtain.  Repackaging existing product in this manneralso typically creates higher margins. Accordingly, we have created and released additional box sets to betterexploit our existing catalogue, such as *TheTwilight Zone, Dick Van Dyke, Pee-wee’s Playhouse, The Endless SummerCollection*, box sets for *Eames* and *Phenomenon*,and collections for *Mission Mars*,*Mad Monster* and *Ed Wood*. We recently released a CD/DVD combination of our hit *Roy Orbison: Black and White Night*.  We plan to release future box sets includingthe *Combat* TV series and theUrban music documentary series *Beef*.

 

Additionally, the favorable impact upon our cashflow of the closing of our $15.25 million private placement allowed us theability to create a fourth quarter catalogue sales program which included theoffering of net 120, 150 and 180 day payment terms, rather than our customarynet 60 to 75 days, on specific catalogue orders from retail customers who choseto participate in the program, a concession that some of our customers had beenrequesting for some time.  In addition,we offered discounts of three to five percent, a standard practice for us onparticularly large catalogue sales orders, on these extended dating purchases.

 

We will continue seekinghigh-quality programming to market and distribute in many genres.  The following list identifies some of ourhigher-profile titles released in fiscal year 2005, as well as some projectedhigher-profile titles scheduled for release in fiscal 2006:

 

*See following page*

 

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| ***Titles Released in Fiscal Year 2005***                            | *** *** | ***Projected Titles for Fiscal Year 2006***             |
|----------------------------------------------------------------------|--------------|---------------------------------------------------------|
|                                                                 |         |                                                    |
| **DVD Titles**                                                       | ** **   | **DVD Titles**                                          |
|                                                                 |         |                                                    |
| Comedy:                                                              |         | Comedy:                                                 |
| *Larry the Cable Guy: Git R Done*                                    | * *     | *Eddie Griffin: Voodoo Child*                           |
| *Ron White: They Call Me Tater Salad*                                | * *     | *Richard Lewis: Hell Trilogy*                           |
| *Jeff Foxworthy: You Might Be a Redneck If.../Check  Your Neck*   | * *     | *Bill Maher: Live*                                      |
| *Bill Engvall: Here’s Your Sign*                                | * *     | *Just For Laughs: Gags Volumes 1 and 2*                 |
| *Artie Lange: It’s the Whiskey Talking*                         | * *     | *Just For Laughs: Stand-up Volumes 1 and 2*             |
| Jamie Foxx’s *FoxxBoxx*  Collection                             | * *     | *Pee-wee Herman: Live at the Roxy*                      |
| *Laffapalooza 1 – 4*(with Jamie Foxx)                           | * *     | *Latinologues Volumes 1 and 2*                          |
| TV:                                                                  | * *     | *Laffapalooza Five & Six* (with Jamie Foxx)         |
| *Twilight Zone: The Definitive Edition Seasons 1  and 2*             | * *     | *Howie Mandel: First Special*                           |
| *Twilight Zone: The 80’s Season 1*                              | * *     | *Kathleen Madigan*                                      |
| *Combat* (classic TV) *Seasons 1, 2 and 3*                           |         | TV:                                                     |
| *Father Murphy Seasons 1 and 2*                                      | * *     | *Combat: Seasons 4 and 5*                               |
| *Lost World Seasons 2 and 3*                                         | * *     | *Combat: Battle Box*                                    |
| *Pee-wee’s Playhouse Seasons 1 and 2*                           | * *     | *Twilight Zone: Definitive Edition Seasons 3 – 5*  |
| *Dick Van Dyke, Seasons 4 and 5*                                     | * *     | *Twilight Zone: 80’s Seasons 2 and 3*              |
| *Cinderella*(Original 1957 version with Julie Andrews)               | * *     | *Dick Van Dyke: Complete Box Set*                       |
| *Nick & Jessica Variety Hour*                                    | * *     | *Nowhere Man*(Complete TV Series)                       |
| *Saved by the Bell: The College Years*                               | * *     | *Naked City*(Classic TV) Box Set                        |
| *Saved By the Bell: New Class Seasons 1 and 2*                       | * *     | *Saved By the Bell: New Class Seasons 3, 4 and 5*       |
| Music-Related:                                                       |         | Music-Related:                                          |
| *Vans Warped Tour*                                                   | * *     | *Chicago and Earth Wind & Fire: Live at the  Greek* |
| *We Are the World*                                                   | * *     | *We are the Future*(Quincy Jones)                       |
| *Ramones: Raw*                                                       | * *     | *Taste of Chaos*                                        |
| *Doors of the 21**st**  Century: L.A. Woman Live*          | * *     | *Moody Blues: Live at the Greek*                        |
| *Roy Orbison: Black and White Night* (reissue with multi-channel CD) | * *     | *Rockin’ the Corps: An American Thank You*         |
| *The Roots: Present*                                                 | * *     | *Roy Orbison Live in Australia*                         |
| Urban:                                                               | * *     | *Hall and Oates Live Soul*                              |
| *Beef II*(QD3)                                                       | * *     | *Chick Corea* (multiple titles)                         |
| *F.E.D.S.* (Simmons-Lathan)                                          | * *     | *Mint Condition Live*                                   |
| *The MC: Why We Do It* (QD3)                                         | * *     | *Candide*                                               |
| Features:                                                            |         | Urban:                                                  |
| *Rosencrantz and Guildenstern*                                       | * *     | *Christian Hosoi Biopic*(QD3)                           |
| *The Hillz* (with Paris Hilton)                                      | * *     | *Letter to the President*(QD3)                          |
|                                                                 | * *     | *Beef III* (QD3)                                        |
| **CD Titles**                                                        | * *     | *Beef Box Set* (QD3)                                    |
|                                                                 | * *     | *The MC 2: How We Do It* (QD3)                          |
| *The Source Presents: Hip Hop Hits, Volumes 8 and  9*                | * *     | *The Industry*(Simmons-Lathan)                          |
| *The Roots: Present*                                                 |         | Features/Other:                                         |
| *Ronnie Milsap: Just For a Thrill* (Grammy Nominated)                | * *     | *Wilderness Survival for Girls* (ContentFilm)           |
| *Willie Nelson: Live at Billy Bob’s*                            | * *     | *Evil Aliens* (ContentFilm)                             |
| *Merle Haggard: Live At Billy Bob’s*                            | * *     | *Destination Mars* (Dark Horse)                         |
| *Power of Soul: Jimi Hendrix Tribute*                                | * *     | *Monarch of the Moon* (Dark Horse)                      |
| *Assassins: Original Broadway Cast Recording*                        | * *     | *Splinter* (Dark Horse)                                 |
| *Fiddler on the Roof: Original Broadway Cast  Recording*             | * *     | *Bastards of Young*                                     |
| *Frogs: Original Broadway Cast Recording*                            | * *     | *Volcanoes of the Deep Sea*(filmed in IMAX)             |
| *Cursed* TV Series (Soundtrack)                                      |         |                                                    |
| *Summerland* TV Series (Soundtrack)                                  | ** **   | **CD Titles**                                           |
| * *                                                             |         |                                                    |
| * *                                                             | * *     | *The Source Presents Hip Hop Hits Volumes 10 and  11*   |
| * *                                                             | * *     | *Mint Condition: Livin’ the Luxury Brown*          |
| * *                                                             | * *     | *Mint Condition: Live*                                  |
| * *                                                             | * *     | *Live at Billy Bob’s* (multiple titles)            |
| * *                                                             | * *     | *Billy Gilman*                                          |
| * *                                                             | * *     | *Rockin’ The Corps: An American Thank You*         |
| * *                                                             | * *     | *Yes* (2 titles)                                        |
| * *                                                             | * *     | *Five Mics*(f.k.a. *30th  Anniversary of Hip-Hop*)      |
| * *                                                             | * *     | *Taste of Chaos*                                        |
| * *                                                             | * *     | *Charmed*TV Series (Soundtrack)                         |

 

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**Liquidity and Capital Resources**

 

Our working capital generally comes from two sources:

 

•                                          operating cash flows

•                                          borrowing availability

 

In December 2004, we raised approximately $14.2 million in net proceedsthrough the sale of our common stock.  InOctober 2004, we received a recoupable but non-refundable $2 million royaltyadvance in connection with a new Japan sublicense agreement.  We used the proceeds of the private placementand the royalty advance to repay our then-outstanding borrowing under ourrevolving line of credit and term loan facilities with Wells Fargo Foothill.

 

*Private Placement*

 

On December 20, 2004, we sold 2,904,763 shares of our common stock at$5.25 per share for gross proceeds of $15.25 million, in a privateplacement.  We also issued three-yearwarrants to the investors to purchase up to 726,189 shares at $6.56 pershare.  The warrants may be exercised forcash beginning June 20, 2005.  Expensesof the private placement totaled $1,052,000, which included the cash fee paidto our exclusive placement agent and legal, accounting and other relatedexpenses.  We also issued the placementagent a three-year warrant to purchase up to 58,095 shares of common stock onthe same terms as the investors, except this warrant includes a cashlessexercise provision.  The privateplacement allowed us to pay down our outstanding loan balances, strengthens ourability to acquire and produce exclusive content, and allows us to offerextended dating in certain circumstances as part of periodic sales programs.

 

*Japan Sublicense Agreement and $2 Million Advance*

 

On October 6, 2004, we entered into an exclusive five-year home videooutput sublicense agreement with Digital Site Corporation for exclusivedistribution of our programming in Japan. We previously distributed our programming in Japan through sublicenseagreements with various third parties on a title-by-title basis.  Some of these sublicense agreements forcertain titles remain in force.

 

Digital Site is responsible for sales, marketing, manufacturing anddistribution in Japan.  The agreementincludes our available existing catalogue as well as previously-sublicensedtitles as they become available and future new releases through the end of2009.  The distribution term for eachprogram is five years or the expiration date of our rights.  Programming is marketed and released underthe brand, “Image Entertainment Japan.” The first releases under the agreement occurred in January 2005.

 

Royalty payments are set at a percentage of suggested retail price, andany overages will be paid after recoupment of the $2 million non-refundableadvance received in October 2004.  Theadvance was recorded as a component of deferred revenue and will be recognizedas revenue when royalties are earned, as reported to us on a quarterlybasis.  At March 31, 2005, approximately$1.9 million of the $2.0 million advance is classified as a component ofdeferred revenue in the accompanying balance sheet.

 

*Advance from BMG (Now Sony BMG) Received in Fiscal 2003 and SubsequentAdvances and Recoupment*

 

We received a $3.0 millioninitial royalty advance under the Sony BMG agreement in March 2003, fully recoupablefrom revenues generated by Sony BMG against quarterly royalties due to us underthe agreement.  Based upon actualquarterly sales of our programming in the territories, Sony BMG recoupsquarterly royalties from the $3.0 million previously advanced.  Sony BMG provides additional quarterlyroyalty advances such that for the first three years of the agreement term(through December 31, 2005), the outstanding royalty advance to us at any giventime will be a constant $3.0 million. During the first three quarters of the fourth year of the term (the ninemonths ending September 30, 2006), Sony BMG will reduce, through recoupment,the outstanding royalty advance to $1.5 million.  Once the entire royalty advance is recouped,Sony BMG will continue to pay quarterly royalties based on revenuesgenerated.  During the fourth quarter ofthe fourth year (the quarter ending December 31, 2006), Sony BMG may recoup theentire remaining balance of $1.5 million by not re-advancing royaltiesquarterly.  The agreement contains aformula to pay an additional lesser advance at the beginning of the fifth andfinal year of the term (calendar 2007) which is to be recouped by Sony BMGduring that year.  We must repay anyoutstanding unrecouped royalty advance within 

 

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30 days following the final Sony BMGreporting at the conclusion of Sony BMG’s sell-off period after expiration ofthe five-year term.

 

*Revolving Credit and Term Loan Facility*

 

On September 30, 2004, we amended our credit facility with Wells FargoFoothill.  The maximum revolving creditavailability under the agreement was increased $6 million, from $17 million to$23 million.  Actual borrowingavailability under the line remains substantially based upon eligible tradeaccounts receivable levels.  While theinterest rate remains at the prevailing prime rate plus 0.75% (6.50% at March31, 2005), the interest rate floor was reduced from 5.75% to 5.00%.  The option to borrow at LIBOR plus 3.50% wasalso added.  The maximum capitalexpenditures limit covenant was increased for fiscal 2005 to $3.25 million plus$359,000 unused from fiscal 2004, from $2.5 million plus the same$359,000.  The capital expenditurescovenant maximum was lowered to $2.5 million in fiscal 2006, plus any unusedcarryover from fiscal 2005.  The term ofthe agreement was extended two years through December 28, 2007.

 

At March 31, 2005, we had cash of $6,339,000 and borrowing availabilityof $17.3 million and $1 million, respectively, under our revolving credit andterm loan facilities with Foothill. Comparatively, at March 31, 2004, we had cash of $540,000 and borrowingavailability of $6,245,000 and $1,000,000, respectively, under our revolvingcredit and term loan facilities.

 

*Other Sources and Uses of Working Capital**forFiscal 2005*

 

Our pretax net earnings fromcontinuing operations were $5,289,000 for fiscal 2005.  Net revenues for the last two quarters offiscal 2005 grew approximately 28% from the last two quarters of fiscal 2004,contributing to an increase in trade accounts receivable (gross of reserves forsales returns, allowances and doubtful accounts) to $31.6 million at March 31,2005, as compared to $29.2 million at March 31, 2004.  In anticipation of forecasted retail customerdemand for our new release and catalogue titles, we increased our inventorylevels, excluding production costs, to $12.7 million at March 31, 2005, from$11.2 million at March 31, 2004.

 

Weincurred $3.4 million in capital expenditures during fiscal 2005, far higherthan our normal annual expenditures.  Wespent approximately $1.6 million to improve our information technologyinfrastructure and business systems.  Wecompleted the conversion from our legacy Qantel sales order management andproduction/creative services systems to Oracle, and invested funds to automateelements of our returns processing in our Las Vegas distribution facility.  Coordinated investments in hardware, softwareand consulting services are being applied with the goal of reducing laborcosts, increasing customer service and streamlining operating proceduresrelated to returns processing.  We spentapproximately $1.3 million for furniture and fixtures covering additional workspace systems and construction of our new in-house production department andinformation technology facilities in connection with our new corporateheadquarters.  Although we will continueto upgrade production, creative services and distribution technology, we intendto spend far less on capital expenditures in fiscal 2006, compared to fiscal2005.

 

Wepaid down long-term debt and capital lease obligations by $1.7 million duringfiscal 2005.  As a result of our netrevenue growth, our trade accounts payable and accrued royalties, distributionfees and music publishing fees grew by $3 million at March 31, 2005, comparedto levels at March 31, 2004.  We financedthese expenditures from cash flows from operations and through our revolvingline of credit.  Primarily as a result ofour net $14.2 million private placement funding and the $2 million royaltyadvance from our Japanese sublicensor, there were no outstanding borrowingsunder the revolving and term loan facility at March 31, 2005, compared to $10.2million in borrowings under our revolving credit facility at March 31, 2004.

 

We believe that projected cash flows from operations, borrowingavailability under our revolving line of credit, cash on hand, and trade creditwill provide the necessary capital to meet our projected cash requirements forat least the next 12 months.  Should wefind attractive corporate acquisitions, we may seek additional debt or equityfinancing in order to fund the transaction, in the form of bank financing,convertible debt, or the issuance of convertible preferred or common stock.

 

*Contractual Obligations and Commercial Commitments*

 

The following table summarizes our contractual obligations at March 31,2005, and the effects such obligations are expected to have on liquidity andcash flow in future periods:

 

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| ** **                                       | ** ** | **Payments due by period** | ** ** |
|--------------------------------------------------|------------|----------------------------|------------|
| **(in thousands)**                               | ** ** | **2006**                   | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
| Contractual obligations:                         |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Long-term debt obligations                       |       | $                          | 1,337      |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 1,337 |   |
| Capital lease obligations                        |       | 109                        |       | — |   | — |   | — |   | — |   | — |   | 109 |   |
| Operating lease obligations                      |       | 1,607                      |       | 1,573 |   | 1,615 |   | 1,658 |   | 1,701 |   | 6,399 |   | 14,553 |   |
| Licensing and exclusive distribution  agreements |       | 12,414                     |       | 3,455 |   | 288 |   | — |   | — |   | — |   | 16,157 |   |
| Employment Agreements                            |       | 1,199                      |       | 1,173 |   | — |   | — |   | — |   | — |   | 2,372 |   |
| Total                                            |       | $                          | 16,666     |   | $ | 6,201 |   | $ | 1,903 |   | $ | 1,658 |   | $ | 1,701 |   | $ | 6,399 |   | $ | 34,528 |   |

 

Advances and guarantees included in the table above, under licensingand exclusive distribution agreements, are recoupable against future royaltiesand distribution fees earned by our exclusive program suppliers in connectionwith revenues generated by those rights. As we have historically, we expect to fund these commitments throughrecoupment of existing advances, our existing bank line of credit, and otherworking capital.

 

We do not expect our obligations for property and equipmentexpenditures, including information technology related expenditures, to exceed$2.5 million per year.

 

*Lease Guarantee*

 

In connection with the 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 a guarantor in the event thatPlanet Entertainment and Infinity default on their financial obligations underthe lease.  The remaining payments underthe lease total approximately $491,000 through December 2007.

 

*Corporate Headquarters*

 

Our headquarters are located in Chatsworth,California and consists of approximately 62,000 square feet on one floor of amulti-tenant building.  The monthly rentis $1.26 per square foot, on a gross basis, or approximately $78,000 per month,and increases approximately 3% annually. The office lease has an initial 10-year term with two five-yearoptions.  The lease started on July 1,2004, upon completion of approximately $1.5 million in tenant improvements.  Substantially all of the tenant improvementexpenses were borne by the landlord.  Weare expensing the total rent commitment, including the scheduled rentincreases, on a straight-line basis over the term of the lease.  Although a base level of operating expensesis included in the rent payment, we will be responsible for a percentage ofactual annual operating expense increases capped at 5% annually.

 

*Long-Term Debt*

 

Long-term debt at March 31,2005 and March 31, 2004, consisted of the following:

 
| **(In thousands)**                            | ** ** | **March 31, 2005** | ** ** | **March 31, 2004** | ** ** |
|-----------------------------------------------|------------|--------------------|------------|--------------------|------------|
| Subordinated note payable – Ritek Taiwan |       | $                  | 1,337      |               | $          | 2,561 |   |
| Note payable to bank                          |       | —             |       | 255                |       |
|                                          |       | 1,337              |       | 2,816              |       |
| Current portion of long-term debt             |       | 1,337              |       | 1,592              |       |
| Long-term debt less current portion           |       | $                  | —     |               | $          | 1,224 |   |

 

*Debt Instruments and RelatedCovenants*

 

Our loan agreements with Wells Fargo Foothillrequire us to comply with minimum financial and operating covenants.  At September 30, 2004, we amended our capitalexpenditures covenant for fiscal 2005. The maximum capital expenditures limit covenant was increased for fiscal2005 to $3.25 million plus $359,000 unused from fiscal 2004, from $2.5 millionplus the same $359,000.  The capitalexpenditures covenant maximum was lowered to $2.5 million in fiscal 2006, plusany unused carryover from fiscal 2005.  Throughoutthe year ended March 31, 2005, we were in 

 

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compliance with the financial and operating covenants under the loanagreement, and we believe that we will be able to achieve the minimum covenantrequirements for at least the next 12 months.

 

*Off-Balance Sheet Arrangements*

 

We currently do not have any off-balance sheet arrangements.

 

**Critical Accounting Policies**

 

The discussion and analysisof our financial condition and results of operations are based upon ourfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States.  Generally accepted accounting principlesrequire management to make estimates, judgments and assumptions that affect thereported amounts of assets, liabilities, revenues and expenses, and thedisclosure of contingent assets and liabilities.  We base our estimates on experience and onvarious other assumptions that we believe to be reasonable under the circumstances,the results of which form the basis for making judgments about the carryingvalues of assets and liabilities that may not be readily apparent from othersources.  Our actual results may differfrom those estimates.

 

We consider our criticalaccounting policies to be those that involve significant uncertainties, requirejudgments or estimates that are more difficult for management to determine, orthat may produce materially different results when using differentassumptions.  We consider the followingaccounting policies to be critical:

 

*Revenue Recognition*

 

Werecognize revenue upon meeting the recognition requirements of AmericanInstitute of Certified Public Accountants Statement of Position (SOP) 00-2, *Accounting by Producers or Distributors of Films* and Staff Accounting Bulletin No. 104, *Revenue Recognition*.  We recognize revenues from home videodistribution, net of an allowance for estimated returns, as well as relatedcosts, in the period in which the product is available for sale by ourcustomers (at the point that title and risk of loss transfer to the customer,which is generally upon receipt by the customer, and in the case of newreleases, after “street date” restrictions lapse).  We recognize revenues from domestic andinternational broadcast licensing and home video sublicensing, as well asassociated costs, when the titles are available to the licensee and otherrecognition requirements of SOP 00-2 are met. We defer fees received in advance of availability, usually in the caseof advances received from Sony BMG, Digital Site, Warner Music Group and otherinternational sublicensees, and for broadcast, until other revenue recognitionrequirements have been satisfied.  Provisionsfor uncollectible accounts receivable are provided at the time of sale.  As of March 31, 2005, deferred revenuetotaled $5,392,000, up from $3,360,000, primarily as a result of deferring theDigital Site royalty advance received.

 

*Royalty and Distribution Fees*

 

For each reporting period,we estimate the ultimate total revenues to be received throughout a title’sexclusive license or distribution period from exploitation of that title inmultiple home entertainment formats. While we charge royalty and distribution fee advances to operations asrelated revenues are earned, estimates of ultimate revenues are important indetermining whether we should record additional royalty and distribution feeexpense as cost of sales in any given reporting period.  We amortize royalty and distribution feeadvances to expense in the same ratio that the current period revenues for atitle or group of titles bear to the estimated remaining unrecognized ultimaterevenues for that title.  Additionally,in circumstances required by SOP 00-2, we recognize additional amortization tothe extent that capitalized advance royalty and distribution fees exceed theirestimated fair value in the period when estimated.

 

We base our estimates ofultimate revenue for each title on the historical performance of that title,similar titles and specific genre performance. We attempt to reflect in our estimates the most current availableinformation on the title.  We update suchestimates based upon the actual results of each format’s revenueperformance.  Estimates of ultimaterevenues on a title-by-title basis are subject 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 consumerdemand.  Any above the above factors cancontribute to a title’s actual performance exceeding our expectations prior torelease or failure to meet pre-release expectations.  Overestimation of ultimate revenues wouldcause unamortized costs to be amortized at a slower rate or a delay in adjustingcosts to their 

 

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fair value until such time estimates arereduced, causing unamortized costs to be overstated and increased amortizationof costs in a later period. Underestimation of ultimate revenues would cause unamortized costs to beamortized more quickly until ultimate revenue estimates are increased, causingunamortized costs to be understated and decreased amortization of costs in alater period.

 

*Inventory Valuation*

 

For each reporting period,we evaluate our ending inventories for excess quantities and obsolescence.  This evaluation includes analysis ofhistorical sales levels by title, format and genre, and projections of futuredemand.  In addition, we write downinventories that are considered obsolete or overstocked.  Remaining inventory balances are adjusted toapproximate the lower-of-cost or market value, and result in a new basis insuch inventory until sold.  If futuredemand or 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 upon the continued retail customeracceptance of our content, future demand by end-user consumer, advertising,promotions and price reductions, market conditions (either favorable orunfavorable) and future warehouse storage limitations.  Should projections of future inventory demandbe overstated, the value of inventory would be overstated and current cost ofsales understated, with future cost of sales overstated.  Conversely, should projections of futuredemand be understated, the value of inventory would be understated and thecurrent cost of sales overstated, with future cost of sales understated.

 

*Allowance for Sales Returns and Doubtful AccountsReceivable*

 

For each reporting period,we evaluate product sales and accounts receivable to estimate their effect onrevenues due to product returns, sales allowances and other credits given anddelinquent accounts.  Our estimates ofproduct sales that will be returned and the amount of receivables that willultimately be collected require the exercise of judgment and affect reportedrevenues and net earnings.  Indetermining the estimate of product sales that will be returned, we analyze historicalreturns (quantity of returns and time to receive returned product), historicalpricing and other credit memo data, current economic trends, and changes incustomer demand and acceptance of our products, including reorderactivity.  Based on this information, wereserve a percentage of each dollar of product sales where the customer has theright to return such product and receive either a pricing or credit memo.  Actual returns could be different from ourestimates and current provisions for sales returns and allowances, resulting infuture charges to earnings.  Estimates offuture sales returns and other credits are subject to substantialuncertainty.  Factors affecting actualreturns include retailer financial difficulties, the perception of comparativelypoor retail performance in one or several retailer locations, limited retailshelf space at various times of the year, inadequate advertising or promotions,retail prices being too high for the perceived quality of the content or othercomparable content, the near term release of similar titles, and poor responsesto package designs.  Underestimation ofproduct sales returns and other credits would result in an overstatement ofcurrent revenues and lower revenues in future periods.  Conversely, overestimation of product salesreturns would result in an understatement of current revenues and higherrevenues in future periods.

 

Similarly, we evaluateaccounts receivables to determine if they will ultimately be collected.  In performing this evaluation, significantjudgments and estimates are involved, including an analysis of specific riskson a customer-by-customer basis for our larger customers and an analysis of thelength of time receivables have been past due. Based on this information, we reserve an amount that we believe to bedoubtful of collection.  If the financialcondition of our customers were to deteriorate or if economic conditionsworsened, additional allowances may be required in the future.  Underestimation of this allowance would causeaccounts receivable to be overstated and current period expenses to beunderstated.  Overestimation of thisallowance would cause accounts receivable to be understated and current periodexpenses to be overstated.

 

*Valuation of Deferred Income Taxes*

 

Income taxes are accountedfor under the asset and liability method. Deferred tax assets and liabilities are recognized for the future taxconsequences attributable to differences between the financial statement carryingamounts of existing assets and liabilities and their respective tax bases andoperating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax ratesexpected to apply to taxable income in the years in which those temporarydifferences are expected to be recovered or settled.  We must assess the likelihood that ourdeferred tax assets will be recovered from future taxable income, and to theextent that it is more likely than not that such deferred 

 

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tax assets will not be realized, we mustestablish a valuation allowance.  Theestablishment, or increase, of a valuation allowance increases income taxexpense for such year.

 

*Establishment of Valuation Allowance on Net Deferred Tax Assets*. During our third quarter ended December 31, 2003, we established avaluation allowance against 100% of our net deferred tax assets, which arecomposed primarily of net operating loss (NOL) carry forwards, resulting in therecording of an income tax expense equal to the net deferred tax assets as ofMarch 31, 2003.  The valuation allowancewas recorded in the third quarter primarily as a result of operating lossessustained during our normally seasonally strong third quarter as well as itsthen-expected impact on the full fiscal year results of operations.  Income tax expense relating to ourestablishment of a valuation allowance totaled $6,244,000 for the year endedMarch 31, 2004.  Even though we havefully reserved these net deferred tax assets for book purposes, we would stillbe able to utilize them to reduce future income taxes payable, should we havefuture earnings.  To the extent suchdeferred tax assets relate to NOL carry forwards, the ability to use such NOLsagainst future earnings will be subject to applicable carry forwardperiods.  As of March 31, 2005, we hadnet operating loss carryforwards for Federal and state tax purposes of $6,694,000and $1,603,000, respectively, which are available to offset taxable incomethrough 2024 and 2014, respectively.

 

Although we had pretaxearnings of $5,289,000 for fiscal 2005, we have not had a strong earningshistory.  We enjoyed the benefits of a strongschedule of new DVD and CD releases during fiscal 2005.  In light of the extremely strong retailsuccess of a relatively few individual titles, we cannot provide assurancesthat our fiscal 2006 DVD and CD new releases will perform as well as, or betterthan, our fiscal 2005 releases.  Wecontinue to maintain a 100% valuation allowance against our net deferred taxassets at March 31, 2005, due to the following factors: (1) we had a pretaxloss for fiscal 2004; (2) we had an accumulated deficit at March 31, 2005; and (3)a significant portion (approximately 21%) of our fiscal 2005 revenues, and byextension, fiscal 2005 profitability, was generated by only five titles.

 

**Results of Operations**

 

***Net Revenues***

 

Approximately 89% of consolidated netrevenues were generated from our worldwide sale of DVDs during fiscal 2005,compared to 91% in fiscal 2004 and 2003. CDs contributed approximately 10% of consolidated net revenues forfiscal 2005, compared to 7% and 3% of fiscal 2004 and 2003, respectively.  The following table presents consolidated netrevenues by reportable business segment for the years ended March 31, 2005,2004 and 2003, respectively:

 
| ** **    | ** ** | **2005**           | ** ** | **2004**   | ** **         | **% Change** | ** ** | **2004** | ** ** | **2003** | ** ** | **% Change** | ** ** |
|---------------|------------|--------------------|------------|------------|--------------------|--------------|------------|----------|------------|----------|------------|--------------|------------|
| ** **    | ** ** | **(in thousands)** | ** ** | ** ** | **(in thousands)** | ** **   | ** ** |
| Net revenues: |       |               |       |       |               |         |       |     |       |     |       |         |       |
| Domestic      |       | $                  | 113,219    |       | $                  | 78,370       |       | 44.5     | %          | $        | 78,370     |         | $          | 77,484 |   | 1.1 | % |
| International |       | 5,164              |       | 6,470      |               | (20.2        | )          | 6,470    |       | 9,445    |       | (31.5        | )          |
| Consolidated  |       | $                  | 118,383    |       | $                  | 84,840       |       | 39.5     | %          | $        | 84,840     |         | $          | 86,929 |   | (2.4 | )% |
|               |            |                    |            |            |                    |              |            |          |            |          |            |              |            |  |  |  |  |  |

 

*Fiscal 2005 Compared to2004 and 2003*

 

*Domestic Revenue*

 

Net revenues weresignificantly higher in fiscal 2005, as compared to fiscal 2004 and fiscal2003, primarily because of strong revenue performance from our new exclusiveDVD and CD releases.  We also hadcomparatively stronger sales of previously released DVD and CD cataloguetitles, driving overall net revenues higher.

 

Our top ten new release DVDand CD titles contributed approximately 29% of our fiscal 2005 domestic netrevenues compared to only approximately 15% for fiscal 2004.  We produced live stand-up comedy concertsfrom “Blue Collar” comedians Larry the Cable Guy, Ron White and Bill Engvall,and we released a combined two-titles-in-one DVD from a fourth Blue Collarcomedian, Jeff Foxworthy.  Net revenuesfrom these four titles constituted approximately 18% of our consolidated netrevenues for the year.  Also included inthe top ten were *The Source Presents Hip Hop Hits Volumes 8and 9* (CDs), *Pee-wee’s PlayhouseSeasons 1 and 2*, the *Twilight Zone DefinitiveEdition: Season 1*, and *Combat: Season 1 Campaign1*.

 

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Our CD net revenues have increased steadilyover the past three fiscal years based primarily on the success of our Sourceand Live at Billy Bob’s lines.  CD netrevenues were $12.1 million, $5.6 million and $2.9 million for fiscal 2005,2004 and 2003, respectively.

 

Our December 1998 exclusivelicense agreement for the distribution of our former perennial best-selling music DVD catalogue title *Eagles: HellFreezes Over* is in its nonexclusive sell-off period, which expireson June 30, 2005.  The distribution termfor this agreement had been renewed several times in the past, but we wereunable to renew it this time and the rights reverted back to the licensor.  Our domestic net revenues from the sale of theEagles during fiscal 2005 were $1,850,000.

 

In fiscal 2005, we alsoexperienced significantly increased sales to large retailers, particularlyWal-Mart, Amazon.com and Target, who purchased more titles in greaterquantities than in fiscal 2004 and 2003. The increase was primarily because of our strong new release schedule,as well as our more specifically targeted and personalized sales efforts.  If we continue acquiring the type ofprogramming that we have identified as being attractive to these retailers, webelieve increased sales to them will continue. As our sales to larger retailers increase, however, so does our relativedependence on them.  If any of our largercustomers were to reduce purchases of our programming or file for bankruptcy,it could significantly decrease our revenues and negatively impact ourearnings.

 

The favorableimpact upon our cash flow of the closing of our $15.25 million privateplacement allowed us the ability to create a fourth quarter catalogue salesprogram which included the offering of net 120, 150 and 180 day payment terms,rather than our customary net 60 to 75 days, on specific catalogue orders fromretail customers who chose to participate in the program, a concession thatsome of our customers had been requesting for some time.  In addition, we offered discounts of three tofive percent, a standard practice for us on particularly large catalogue salesorders, on these extended dating purchases. Our extended payment terms allowed some of our customers — most notablyAEC One Stop Group, Critic’s Choice, Ingram, Musicland Group and Trans WorldEntertainment — to expand the size and breadth of what they would havepurchased otherwise.  This particular cataloguesales program generated revenues of $4.0 million in the fourth quarter of fiscal2005.  We are unable to provideassurances that this program, or programs similar to it, will not have adetrimental impact on the amount of catalogue purchases such customers willmake in upcoming quarters.

 

Our inventory returns, as apercentage of our gross distribution (as opposed to net) revenues, were 18.8%in fiscal 2005, 19.2% in fiscal 2004 and 15.7% in fiscal 2003, respectively.  We are selling more programming to largerretailers, who tend to return a higher percentage of their purchases, both tous and to the major studios.  Many ofthese retailers have chosen not to process their own store returns at their owndistribution center level, but instead return them to their vendors, includingus, for credit.  A retailer may return atitle from one store while ordering the same title for another store.  Additionally, some retailers have returnedmore programming than their historical levels over the last year due to afinancial restructuring in one case and a customer’s move to a differentwarehouse and distribution center in the other case.  We have increased our allowances for salesreturns in expectation of this trend continuing for the foreseeable future.

 

We have also provided increased marketdevelopment funds to our customers for which are taken as a credit againstrevenues and are recorded by us as a reduction in revenues.  These market development fund expenditurestotaled $4,530,000, $2,437,000 and $1,886,000 or 3.7%, 2.8% and 2.1% of netrevenues, before reduction for such market development funds, for fiscal 2005,2004 and 2003, respectively.

 

*International Revenue*

 

The decrease in the fiscal 2005 internationalrevenues over that of fiscal 2004 was primarily due to lower royalty revenuesreported by our international sublicensees. A significant contributing factor was a lack of internationallydesirable new DVD releases during the last half of fiscal 2005.  Because of language barriers and culturaldifferences, much of our recent successful new release programming — particularlyurban and comedy titles — has not been released internationally or has not soldas well as in North America.

 

Additionally, we believe internalrestructuring at Sony BMG associated with the merger had a negative impact onthe sales performance of our titles in Europe, the Middle East and Africaduring the last half of fiscal 2005.

 

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We continue our efforts toacquire programming that sells well not only domestically, but alsointernationally.  Music-related DVDs havedone well internationally and we believe the urban music and documentary genreshave revenue growth potential overseas.  Ourinternational revenues for fiscal 2006 will be negatively affected by the lossof our perennial best selling international title*Eagles: Hell Freezes Over* as of June 30, 2005 as well as alack of significant new international DVD releases.  Ourinternational net revenues from the sale of our Eagles titles during fiscal2005 were $1,133,000, or 22% of international net revenues.  The opening of our UK office, however, mayhelp us acquire new titles which perform better in international distribution.

 

Broadcast sales decreased to $487,000 forfiscal 2005, compared to $544,000 for fiscal 2004 and $1,724,000 for fiscal2003.  We continue to place less of anemphasis on acquiring broadcast rights for music programming, due to the highcost of music clearance in relation to the fees broadcasters are willing to payto air the programming.

 

***Cost of Sales***

 

The following table presents consolidatedcost of sales by reportable business segment and as a percentage of related-segmentnet revenues for the years ended March 31, 2005, 2004 and 2003, respectively:

 
| ** **                               | ** ** | **2005**           | ** ** | **2004**   | ** ** | ** **         | ** ** | **2004**   | ** ** | **2003**   | ** ** | ** **   | ** ** |
|------------------------------------------|------------|--------------------|------------|------------|------------|--------------------|------------|------------|------------|------------|------------|--------------|------------|
| ** **                               | ** ** | **(in thousands)** | ** ** | ** ** | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| Cost of sales:                           |       |               |       |       |       |               |       |       |       |       |       |         |       |
| Domestic                                 |       | $                  | 84,827     |       | $          | 61,331             |       |       |       | $          | 61,331     |         | $          | 58,920 |   |   |   |
| International                            |       | 3,608              |       | 5,264      |       |               |       | 5,264      |       | 7,533      |       |         |       |
| Consolidated                             |       | $                  | 88,435     |       | $          | 66,595             |       |       |       | $          | 66,595     |         | $          | 66,453 |   |   |   |
|                                     |       |               |       |       |       |               |       |       |       |       |       |         |       |
| ** **                               | ** ** | ** **         | ** ** | ** ** | ** ** | **% Change**       | ** ** | ** ** | ** ** | ** ** | ** ** | **% Change** | ** ** |
| As a percentage of segment net revenues: |       |               |       |       |       |               |       |       |       |       |       |         |       |
| Domestic                                 |       | 74.9               | %          | 78.3       | %          | (3.4               | )%         | 78.3       | %          | 76.0       | %          | 2.3          | %          |
| International                            |       | 69.9               |       | 81.4       |       | (11.5              | )          | 81.4       |       | 79.8       |       | 1.6          |       |
| Consolidated                             |       | 74.7               | %          | 78.5       | %          | (3.8               | )%         | 78.5       | %          | 76.4       | %          | 2.1          | %          |

 

We are now classifyingproduction cost amortization as a component of cost of sales and therefore areduction to gross profit margins for all periods presented.  We previously amortized production costs as aseparate line item within operating costs and expenses.  Because we disclose programming productioncosts as a component of inventory, we believe classification of the relatedexpense of such costs as a component of cost of sales is more meaningful.  Amortization of domestic and internationalproduction costs, as a percentage of net revenues, for the three years endedMarch 31, 2005, were 3.4%, 4.7% and 4.9%, respectively.  The decline in production cost amortizationas a percentage of net revenues is primarily due to significantly increaseddomestic revenues in fiscal 2005.

 

Consolidated cost of sales for fiscal 2005,were $88,435,000, or 74.7% of net revenues, compared to $66,595,000, or 78.5%for fiscal 2004 and 76.4% for fiscal 2003. Consolidated gross margins for fiscal 2005 were $29,948,000, or 25.3% ofnet revenues, compared to 21.5% for fiscal 2004 and 23.6% for fiscal 2003.  For comparative purposes, exclusive of thefiscal 2005 non-recurring credit of $499,000 to cost of sales related to thediscontinuation of our distribution of DVDs internationally through subdistributors,consolidated gross profit margin would have been 24.9%, or higher by 3.4% than fiscal2004.

 

*Fiscal 2005 Compared to2004 and 2003*

 

*Domestic Gross Margins*

 

Domestic gross margins, as a percentage ofsegment net revenues, increased by 3.4% to 25.1% for fiscal 2005, from 21.7%for fiscal 2004 and from 24.0% for fiscal 2003.

 

The increase in segment gross profit marginsfor fiscal 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 grossmargins for fiscal 2005 as compared to fiscal 2004 were increases in marketdevelopment funds offered to our retail customers of $2,093,000.  Market development funds are recorded as a 

 

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reduction in net revenues.  Weexpect the trend of increasing market development funds paid to customers tocontinue for the foreseeable future.

 

The decrease in segment gross profit marginsfor fiscal 2004 from fiscal 2003 was primarily due to increased charges tosegment cost of sales from comparably increased amortization of royaltyadvances and adjustments to fair value as a result of lower ultimate revenueforecasts for some of our exclusive programming.  Additionally, the comparatively increased marketdevelopment funds we provide to our retail customers, and comparatively higherwrite downs of some inventory titles to the lower of cost or market value, alsocontributed to the decrease in segment gross margins in fiscal 2004 compared to2003.

 

*International GrossMargins*

 

International gross margins, as a percentageof segment net revenues, increased by 11.5% to 30.1% for fiscal 2005, from 18.6%for fiscal 2004 and 20.2% for fiscal 2003. Exclusive of the aforementioned credit to cost of sales related tointernational subdistribution of our DVDs, gross margins for the segmentincreased by 1.9% to 20.5% for fiscal 2005 from 18.6% for fiscal 2004.

 

Gross margins for this segment in fiscal 2005and 2004 were positively impacted primarily by fluctuations in royalties anddistribution fees due to our program suppliers on a title-by-title basis, withrevenues consisting almost entirely of royalty sublicense income.  For fiscal 2003, gross margins were not onlygenerated from sublicense royalty income and broadcast revenues, but also fromsubdistribution revenues.  Gross marginswere impacted by both fluctuations in royalties and distribution fees due toour program suppliers and by overall expenses, including manufacturing costs,music publishing fees and market development funds provided to subdistributorsfor marketing.

 

Cost of sales, andconversely gross margins, will fluctuate in the future based upon revenueperformance of individual titles and royalties and distribution fees due to ourprogram supplies on a title-by-title or agreement-by agreement basis.

 

***Selling Expenses***

 

The following tables present consolidatedselling expenses by reportable business segment and as a percentage of relatedsegment net revenues for the years ended March 31, 2005, 2004 and 2003,respectively:

 
| ** **                               | ** ** | **2005**           | ** ** | **2004**   | ** **         | **% Change** | ** ** | **2004** | ** ** | **2003** | ** ** | **% Change** | ** ** |
|------------------------------------------|------------|--------------------|------------|------------|--------------------|--------------|------------|----------|------------|----------|------------|--------------|------------|
| ** **                               | ** ** | **(in thousands)** | ** ** | ** ** | **(in thousands)** | ** **   | ** ** |
| Selling expenses:                        |       |               |       |       |               |         |       |     |       |     |       |         |       |
| Domestic                                 |       | $                  | 9,795      |       | $                  | 5,902        |       | 66.0     | %          | $        | 5,902      |         | $          | 5,010 |   | 17.8 | % |
| International                            |       | 58                 |       | 184        |               | (68.5        | )          | 184      |       | 934      |       | (80.3        | )          |
| Consolidated                             |       | $                  | 9,853      |       | $                  | 6,086        |       | 61.9     | %          | $        | 6,086      |         | $          | 5,944 |   | 2.4 | % |
|                                     |       |               |       |       |               |         |       |     |       |     |       |         |       |
| As a percentage of segment net revenues: |       |               |       |       |               |         |       |     |       |     |       |         |       |
| Domestic                                 |       | 8.7                | %          | 7.5        | %                  | 1.2          | %          | 7.5      | %          | 6.5      | %          | 1.0          | %          |
| International                            |       | 1.1                |       | 2.8        |               | (1.7         | )          | 2.8      |       | 9.9      |       | (7.1         | )          |
| Consolidated                             |       | 8.3                | %          | 7.2        | %                  | 1.1          | %          | 7.2      | %          | 6.8      | %          | 0.4          | %          |
|                                          |            |                    |            |            |                    |              |            |          |            |          |            |              |            |  |  |  |  |  |

 

*Fiscal 2005 Compared to2004 and 2003*

 

*Domestic Selling Expenses*

 

Domestic selling expenses for fiscal 2005 were significantly higherthan fiscal 2004 in absolute dollars and as a percentage of domestic netrevenues and reflect a continuing trend of higher advertising and promotionalexpenses as a percentage of net revenues. We incurred a $1,727,000 increase in expenses for print, television,radio and co-operative advertising as well as a $344,000 increase in expensesfor special event audio and video promotions and publicity consultants.  Personnel costs, including wages, benefitsand sales commissions, were up $1,055,000 for fiscal 2005 over fiscal 2004 dueto added sales personnel and annual raises. Sales commissions paid to outside consultants increased by $263,000 forfiscal 2005, primarily as a result of a significant increase in fiscal 2005sales to Target.  Rent expense allocatedto the domestic selling department for our new headquarters in excess of fiscal2004 was $157,000.  Lastly, travel andentertainment expenses were higher by $155,000 over that of fiscal 2004.

 

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Print, television, radio and cooperativeadvertising, audio and in-store promotions are increasingly important to ourretail customers and influence the size and breadth of their initial orders forour titles.  The likelihood of our largerretailers placing an order for our DVD and CD titles in a significant quantityis enhanced with a convincing outlay of marketing funds to increase productawareness and sales to the end consumer. It is common and increasingly necessary to spend from seventy cents toin excess of one dollar per unit in order to effectively promote the availabilityof a higher-profile title at retail.

 

We spent approximately$4,632,000, or 3.9% of net revenues, for title promotion, advertising in tradeand consumer publications in fiscal 2005, almost entirely for domesticwholesale distribution, and approximately $2,445,000, or 2.9% of net revenues,for title promotion and advertising in trade and consumer publications infiscal 2004.

 

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

 

•                  sales opportunities with Wal-Mart

•                  specific focus on catalogue product promotionand sales (specifically product in release over one year)

•                  face-to-face sales coverage of key nationalcustomers

•                  marketing and sales efforts to grow our audioonly brands

•                  marketing and sales efforts to grow ourfeature film genre, specifically rental customer sales

•                  sales of urban and Latin content

•                  sales administration for the aboveinitiatives

 

*International SellingExpenses*

 

Our international selling expenses for fiscal2005 were significantly lower than fiscal 2004 and 2003 because Sony BMG,Digital Site and Warner Music Group, our primary international sublicensees,are responsible for the majority of selling expenses relating to sales of ourprogramming internationally.  Our segmentexpenses for the fiscal 2005 period reflect a full period of Sony BMG sales andmarketing responsibility, whereas fiscal 2004 and 2003 did not.  Additional segment expense reductions infiscal 2004 compared to fiscal 2003 came from the repurposing of employeespreviously classified as international selling to the program acquisitions andbusiness development department, classified as general and administrativeexpenses, as well as expense savings from the closing of the offices of AvivaInternational, LLC, our 50% controlled joint venture that ceased operations atthe end of our third fiscal quarter ended December 31, 2002, and was dissolvedDecember 31, 2004.

 

***General and AdministrativeExpenses***

 

The following tables present consolidatedgeneral and administrative expenses by reportable business segment and as apercentage of related segment net revenues for the years ended March 31, 2005,2004 and 2003, respectively:

 
| ** **                               | ** ** | **2005**           | ** ** | **2004**   | ** **         | **% Change** | ** ** | **2004** | ** ** | **2003** | ** ** | **% Change** | ** ** |
|------------------------------------------|------------|--------------------|------------|------------|--------------------|--------------|------------|----------|------------|----------|------------|--------------|------------|
| ** **                               | ** ** | **(in thousands)** | ** ** | ** ** | **(in thousands)** | ** **   | ** ** |
| General and administrative expenses:     |       |               |       |       |               |         |       |     |       |     |       |         |       |
| Domestic                                 |       | $                  | 13,651     |       | $                  | 11,937       |       | 14.4     | %          | $        | 11,937     |         | $          | 9,374 |   | 27.3 | % |
| International                            |       | 441                |       | 488        |               | (9.6         | )          | 488      |       | 1,153    |       | (57.7        | )          |
| Consolidated                             |       | $                  | 14,092     |       | $                  | 12,425       |       | 13.4     | %          | $        | 12,425     |         | $          | 10,527 |   | 18.0 | % |
|                                     |       |               |       |       |               |         |       |     |       |     |       |         |       |
| As a percentage of segment net revenues: |       |               |       |       |               |         |       |     |       |     |       |         |       |
| Domestic                                 |       | 12.1               | %          | 15.2       | %                  | (3.1         | )%         | 15.2     | %          | 12.1     | %          | 3.1          | %          |
| International                            |       | 8.5                |       | 7.5        |               | 1.0          |       | 7.5      |       | 12.2     |       | (4.7         | )          |
| Consolidated                             |       | 11.9               | %          | 14.6       | %                  | (2.7         | )%         | 14.6     | %          | 12.1     | %          | 2.5          | %          |
|                                          |            |                    |            |            |                    |              |            |          |            |          |            |              |            |  |  |  |  |  |

 

*Fiscal 2005 Compared to2004 and 2003*

 

*Domestic General andAdministrative Expenses*

 

Although our domestic general andadministrative expenses were lower as a percentage of domestic net revenues infiscal 2005 as compared to fiscal 2004, absolute dollar general andadministrative expenses were higher for fiscal 2005.  For fiscal 2005, we accrued performance-basedbonuses of $659,000 compared to none for fiscal 2004.  Rent expense for our new headquarters inexcess of rent for our old headquarters in fiscal 2004 was $329,000.  We 

 

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incurred increased depreciation expense of $256,000 for fiscal 2005resulting from our increased capital expenditures in the areas of informationtechnology, furniture, leasehold improvements and equipment.  Expenditures on information technology andaccounting/royalty consulting and temporary support contributed $414,000 of theincrease in fiscal 2005, primarily attributable to the support of the first andsecond phases of our Oracle implementation implemented in fiscal 2004 discussedbelow, and the fiscal 2005 implementation of order management software,including accounting and information technology infrastructure support.  Lastly, personnel costs were up $221,000 forfiscal 2005, largely due to annual raises. Offsetting the fiscal 2005 increases were lower legal expenses of $233,000.  In the prior year we had higher litigationexpenses relating to our efforts to protect our rights from infringers.

 

For fiscal 2004 comparedwith fiscal 2003, we incurred significant expenses in personnel and consultingservices in connection with the replacement of our legacy applications systemand improvements in our technology infrastructure for the year ended March 31, 2004.  The migration to and maintenance of theOracle Enterprise Applications software required us to add additional technicalresources, including both internal hires and external consulting.  Infrastructure improvements through fiscal2004 and into fiscal 2005 included a program to upgrade desktop computers,email, data storage and networks.  Manyof these expenditures, including maintenance contracts, were not capitalizablein accordance with our capitalization policy. We incurred higher information technology department personnel costsrepresenting additional headcount, higher consulting, recruitment, computermaintenance and training in fiscal 2004 compared to fiscal 2003.

 

In fiscal 2004, werepurposed employees previously dedicated to our international distributionsegment as well as our domestic sales department and transferred them to ourprogram acquisitions and business development department.  With Sony BMG responsible for Europeandistribution of our exclusive titles, we wanted to strengthen our internalefforts to acquire commercially compelling exclusive programming in multiplegenres.  Accordingly, related increasedpersonnel costs of approximately $451,000, previously classified asinternational segment selling and general and administrative expenses anddomestic selling expenses in fiscal 2003, are included in fiscal 2004 domesticsegment general and administrative expenses.

 

In fiscal 2004, we increasedour personnel costs in our accounting and finance departments to handle theincreased workload associated with the accounting and reporting requirements ofthe exclusive distribution agreements added during fiscal 2004 as well as inthe area of credit and collections.  Expensesincreased $206,000 due to additional personnel and $142,000 due to outsidelabor, including consulting and recruitment, during fiscal 2004 as compared tofiscal 2003.

 

In fiscal 2004, we incurred $372,000more in insurance premium costs than for the year ended March 31, 2005, and $171,000more in legal expenses, primarily associated with our efforts to protect ourrights to our exclusive programming from infringers, as compared to fiscal2003.

 

*International General andAdministrative Expenses*

 

The expense reduction forfiscal 2005 compared to fiscal 2004 was primarily due to the cost savingsassociated with the Sony BMG European distribution transition.  The significant segment expense reduction forfiscal year 2004 was primarily due to the repurposing of employees into theprogram acquisitions and business development department within the domesticsegment as discussed above.

 

***Other Income and Expenses***

 

Other expenses for the year ended March 31,2005, primarily consisted primarily of losses on disposal of fixed assets.  Other expenses for fiscal 2004 primarilyconsisted of foreign currency transaction gains and a minority interest in thenet loss of Aviva.  Other expenses forfiscal 2003 primarily consisted of an impairment charge of $322,000 as a resultof the sale and leaseback of our Las Vegas, Nevada real estate, a minorityinterest in the net earnings of Aviva of $573,000, and $121,000 representingthe fair value (based on a Black-Scholes valuation) of the warrant issued toIIC in connection with the partial conversion of their subordinated notepayable in March 2003, net of foreign currency gains for fiscal 2003 of$318,000.

 

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***Interest Expense***

 

Interest expense, net of interest income, forfiscal 2005, decreased 18.7% to $665,000 or 0.6% of consolidated net revenues, from$818,000 or 1.0% of consolidated net revenues for fiscal 2004.  The decrease was attributable to lowerweighted average outstanding debt levels during fiscal 2005 compared to fiscal2004, principally as a result of paying down our revolving credit facility withproceeds from our December 2004 private placement.  As a result of lower average debt levels,interest expense net of interest income for fiscal 2004 decreased 39.8%, from$1,359,000 for fiscal 2003.

 

***Income Taxes***

 

We recorded Federal andstate alternative minimum tax expense of $162,000 for fiscal 2005, based uponan estimated income tax rate of 3.1%.  Weutilized net operating loss carry forwards to offset taxable earnings forfiscal 2005, which reduced our income tax expense down to the alternativeminimum tax level.

 

Income taxes are accountedfor under the asset and liability method. Deferred tax assets and liabilities are recognized for the future taxconsequences attributable to differences between the financial statement carryingamounts of existing assets and liabilities and their respective tax bases andoperating loss 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, orincrease, of a valuation allowance increases income tax expense for such year.

 

*Establishment of ValuationAllowance on Net Deferred Tax Assets in Fiscal 2004, Continued in Fiscal 2005*

 

In assessing therealizability of a deferred tax asset, Statement of Financial AccountingStandards (SFAS) No. 109 requires that all available evidence, both positiveand negative, be considered to determine whether, based on the weight of thatevidence, a valuation allowance is needed. SFAS No. 109 further provides that “cumulative losses in recent years”are significant pieces of negative evidence to overcome when determiningwhether it is “more likely than not” that the recorded deferred tax assets willbe realized in the future by reducing future income taxes payable.  Such cumulative losses from prior years mustbe considered on a pretax consolidated basis from all operations.  In addition to fiscal 2004 pretax losses forboth continuing and discontinued operations, we also incurred aggregate netpretax losses for fiscal years 2003 and 2002. Accordingly, during fiscal 2004 we established a valuation allowanceagainst 100% of our net deferred tax assets, which were composed primarily ofoperating loss carry forwards, resulting in a fiscal 2004 tax expense of$6,244,000.  The valuation allowance wasrecorded in the third quarter of fiscal 2004 primarily as a result of operatinglosses sustained during our normally seasonally strong third quarter as well asits then-expected impact on the full fiscal year results of operations.

 

Although in fiscal 2005 wehad pretax earnings of $5,289,000, we have not had a strong earningshistory.  We enjoyed the benefits of astrong schedule of new DVD and CD releases during fiscal 2005 which we will bechallenged to duplicate or exceed in fiscal 2006.  We continue to maintain a 100% valuationallowance against our net deferred tax assets at March 31, 2005, due to thefollowing factors:

 

(1)                    we had a pretax loss for fiscal 2004

(2)                    we had an accumulated deficit at March 31,2005

(3)                    a significant portion (approximately 21%) ofour fiscal 2005 revenues, and by extension, fiscal 2005 profitability, wasgenerated by only five titles

 

Even though we have fullyreserved our net deferred tax assets for book purposes, we would still be ableto utilize them to reduce future income taxes payable, should we have futureearnings.  To the extent such deferredtax assets relate to NOL carry forwards, the ability to use such NOLs againstfuture earnings will be subject to applicable carry forward periods.  As of March 31, 2005, we had net operatingloss carryforwards for Federal and state tax purposes of $6,694,000 and$1,603,000, respectively, which are available to offset taxable income through 2024and 2014, respectively.

 

Forfiscal 2003, we recorded income tax expense from continuing operations of$1,306,000.  Included as a component ofincome tax expense is a provision for a valuation allowance against ourdeferred tax assets of $551,000.  

 

39

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Thevaluation allowance fully reserved foreign tax credit carry forwards which havea 5-year carry forward period.  Alsoduring 2003 we allocated an income tax benefit of $618,000 to discontinuedoperations.

 

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

 

Earnings from continuing operations were $5,127,000,or $.26 per diluted share, for fiscal 2005. For fiscal 2004, loss from continuing operations was $7,115,000, or $.39per diluted share, which included the above mentioned income tax expense of$6,244,000, or $.34 per diluted share. Loss from discontinued operations was $2,441,000, or $.13 per dilutedshare, for fiscal 2004.  The fiscal 2004loss from discontinued operations comprises a loss from operations of$1,742,000 and a loss on the sale of DVDPlanet of $699,000.

 

Earnings from continuing operations were$642,000, or $.04 per diluted share, for fiscal 2003.  Loss from discontinued operations was$1,096,000, or $.07 per diluted share. During fiscal 2003 an income tax benefit of $618,000 was allocated todiscontinued operations.

 

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

 

Net earnings for fiscal 2005 were $5,127,000,or $.26 per diluted share.  Net loss forfiscal 2004 was $9,556,000, or $.52 per diluted share.  The loss before cumulative effect ofaccounting change for fiscal 2003 was $454,000, or $.03 per diluted share.  During fiscal 2003 a cumulative effect ofaccounting change of $3,766,000, or $.22 per diluted share, net of income taxbenefit of $2,231,000, was recorded, resulting in a net loss for fiscal 2003 of$4,220,000, or $.25 per diluted share.

 

**Recently Issued Accounting Pronouncements**

 

In December 2004, the Financial Accounting StandardsBoard (“FASB”) issued revised Statement of Financial Accounting Standards (“SFAS”)No. 123(R), “Share-Based Payment – an Amendment of FASB Statement Nos. 123 and95.”  SFAS 123(R) establishes standardsfor the accounting for transactions in which an entity exchanges its equityinstruments for goods or services or incurs liabilities in exchange for goodsor 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) requires public entities tomeasure the cost of employee services received in exchange for an award ofequity instruments based on the grant-date fair value of the award (withlimited exceptions) and recognize the cost over the period during which anemployee is required to provide service in exchange for the award.  In April 2005, the SEC deferred the effectivedate of SFAS 123(R) so that companies may now adopt its provisions at thebeginning of their first *annual* periodbeginning after June 15, 2005 which would be fiscal 2007, beginning April 1,2006, for us.  We are evaluating theimpact of SFAS No. 123(R) and expect that we will record non-cash compensationexpenses.  The adoption of SFAS No.123(R) is not expected to have a significant effect on our financial conditionor cash flows, but is expected to have a negative effect on the reporting ofour results of operations.

 

InDecember 2004, the FASB issued FASB Staff Position No. FAS 109-1 (FSP FAS109-1), “Application of FASB Statement No. 109, Accounting for Income Taxes,for the Tax Deduction on Qualified Production Activities Provided by theAmerican Jobs Creation Act of 2004.”  FSPFAS 109-1 clarifies that the deduction will be treated as a “special deduction”as described 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.  The impact of the deduction will be reportedin the period in which the deduction is claimed.  We do not believe that this pronouncementwill have a material effect on our consolidated financial statements.

 

InDecember 2004, the FASB issued the SFAS No. 153, “Exchange of NonmonetaryAssets, and An Amendment of APB Opinion No. 29.”  SFAS No 153 addresses the measurement ofexchanges of nonmonetary assets.  SFASNo. 153 eliminates the exception from fair value measurement for nonmonetaryexchanges of similar productive assets 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 nonmonetaryexchange has commercial substance if the future cash flows of the entity areexpected to change significantly as a result of the exchange.  The provisions of SFAS No. 153 shall beeffective for nonmonetary asset exchanges occurring in fiscal periods beginningafter June 15, 2005.  Earlier applicationis permitted for nonmonetary asset exchanges occurring in fiscal periodsbeginning after the date this Statement is issued.  The provisions of this Statement shall beapplied 

 

40

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prospectively.  We do not believe that this pronouncementwill have a material effect on our consolidated financial statements.

 

In November 2004, the FASB issued SFAS No. 151, “InventoryCosts – an Amendment of ARB No. 43,” which is the result of its efforts toconverge U.S. accounting standards for inventories with InternationalAccounting Standards.  SFAS No. 151requires idle facility expenses, freight, handling costs, and wasted material(spoilage) costs to be recognized 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 inventory costs incurred during fiscal yearsbeginning after June 15, 2005.  We areevaluating the impact of this standard on our financial statements.  We do not expect that the adoption of SFASNo. 151 will have an impact on our financial position, results of operations orcash flows.

 

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

 

**Interest Rate Fluctuations.**  AtMarch 31, 2005, we had no outstanding borrowings subject to variable interestrates. We do not use derivatives to manage interest rate risk.  Our interest rate exposure is linked to theprime rate and LIBOR.  We believe thatmoderate changes in the prime rate or LIBOR would not materially affect our operatingresults or financial condition.

 

**Foreign Exchange Rate Fluctuations.**  AtMarch 31, 2005, approximately $48,000 of our accounts receivable related tointernational distribution and were denominated in foreign currencies subjectto future foreign exchange rate risk.  Wedistribute some of our licensed DVD and VHS programming internationally throughsubdistributors and sublicensees.  Additionally,we exploit international broadcast rights to our licensed entertainmentprogramming.  We believe that moderatechanges in the foreign exchange rates for those agreements denominated inforeign currencies will not materially affect our operation results orfinancial condition.  For example, a 10%change in exchange rates would result in an approximate $5,000 impact on pretaxincome (loss) based upon those outstanding receivables at March 31, 2005.  Although our Sony BMG and Digital Sitesublicense agreements are U.S. Dollar denominated, with these parties reportingto us and paying us in U.S. Dollars, the underlying Sony BMG sales transactionsare in Euros and the underlying Digital Site sales transactions are inYen.  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, we have not entered into foreigncurrency exchange contracts.

 

41

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** **

**ITEM 8****.****                                                 ****FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

 
| **INDEX TO CONSOLIDATED FINANCIAL STATEMENTS**                                                           | ** ** |   |
|----------------------------------------------------------------------------------------------------------|------------|--------|
|                                                                                                     |       |   |
| Reports  of Independent Registered Public Accounting Firms                                               |       |   |
|                                                                                                     |       |   |
| Consolidated  Balance Sheets at March 31, 2005 and 2004                                                  |       |   |
|                                                                                                     |       |   |
| Consolidated Statements of  Operations for the years ended March 31, 2005, 2004 and 2003                 |       |   |
|                                                                                                     |       |   |
| Consolidated  Statements of Shareholders’ Equity for the years ended March 31, 2005, 2004  and 2003 |       |   |
|                                                                                                     |       |   |
| Consolidated Statements of  Cash Flows for the years ended March 31, 2005, 2004 and 2003                 |       |   |
|                                                                                                     |       |   |
| Notes to  Consolidated Financial Statements                                                              |       |   |
|                                                                                                     |       |   |
| Schedule  II – Valuation and Qualifying Accounts for the years ended March 31, 2005,  2004 and 2003 |       |   |

 

42

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**Report of Independent** Registered Public Accounting Firm

 

Boardof Directors and Stockholders

ImageEntertainment, Inc.

Chatsworth,California

 

Wehave audited the accompanying consolidated balance sheet of ImageEntertainment, Inc. as of March 31, 2005 and the related consolidatedstatements of operations, shareholders’ equity and cash flows for the year thenended.  We also have audited the scheduleas listed in the accompanying index. These consolidated financial statements and schedule are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these consolidatedfinancial statements and schedule based on our audits.

 

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States).  Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit included consideration of internal control over financialreporting as a basis for designing audit procedures that are appropriate in thecircumstances, but not for the purpose of expressing an opinion on theeffectiveness of the Company’s internal control over financial reporting.  Accordingly, we express no such opinion.  An audit also includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation.  We believe that our auditprovides a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position of ImageEntertainment, Inc. as of March 31, 2005, and the results of its operations andits cash flows for the year then ended in conformity with accounting principlesgenerally accepted in the United States of America.

 

Also, in our opinion, the schedule presents fairly, in all materialrespects, the information set forth therein.

 

 
| /s/  BDO SEIDMAN LLP     |   |
|--------------------------|--------|
|                     |
| Los  Angeles, California |
| June  14, 2005           |

 

43

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**Report of IndependentRegistered Public Accounting Firm**

 

TheBoard of Directors and Shareholders

ImageEntertainment, Inc.:

 

Wehave audited the consolidated balance sheet of Image Entertainment, Inc. and subsidiariesas of March 31, 2004 and the related consolidated statements of operations,shareholders equity, and cash flows for each of the years in the two-yearperiod ended March 31, 2004.  Inconnection with our audits of the consolidated financial statements, we alsohave audited financial statement schedule II as of and for each of the years inthe two-year period ended March 31, 2004. These consolidated financial statements and financial statement scheduleare the responsibility of the Company’s management.  Our responsibility is to express an opinionon these consolidated financial statements and financial statement schedulebased on our audits.

 

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States).  Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amountsand disclosures in the financial statements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation.  Webelieve that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position of ImageEntertainment, Inc. and subsidiaries as of March 31, 2004, and the results oftheir operations and their cash flows for each of the years in the two-yearperiod ended March 31, 2004 in conformity with accounting principles generallyaccepted in the United States of America. Also, in our opinion, the relatedfinancial statement schedule, when considered in relation to the basicconsolidated financial statements taken as a whole, presents fairly, in allmaterial respects, the information set forth therein.

 

On April 1, 2002, the Company adopted Financial Accounting StandardsBoard Statement No. 142, *Accounting for Goodwill*.

 

 
| /s/  KPMG LLP    |   |
|------------------|--------|
|             |
|             |
| Los  Angeles, CA |
| June  25, 2004   |

 

44

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**CONSOLIDATED BALANCE SHEETS**

 

### **March 31, 2005 and 2004**

 

**ASSETS**

 
| **(In thousands)**                                                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Current assets:                                                                      |       |     |       |     |       |
| Cash and cash equivalents                                                            |       | $        | 6,339      |     | $          | 540 |   |
| Accounts receivable, net of allowances of   $8,646 – 2005;   $7,413 – 2004 |       | 22,993   |       | 21,742   |       |
| Inventories (Note 6)                                                                 |       | 15,408   |       | 13,725   |       |
| Royalty and distribution fee advances                                                |       | 8,142    |       | 7,540    |       |
| Prepaid expenses and other assets                                                    |       | 803      |       | 887      |       |
| Total current assets                                                                 |       | 53,685   |       | 44,434   |       |
| Noncurrent inventories, principally  production costs (Note 6)                       |       | 2,189    |       | 2,604    |       |
| Noncurrent royalty and distribution  advances                                        |       | 12,563   |       | 11,037   |       |
| Property, equipment and improvements, net  (Notes 7 and 10)                          |       | 6,563    |       | 5,782    |       |
| Other assets                                                                         |       | 186      |       | 275      |       |
|                                                                                 |       | $        | 75,186     |     | $          | 64,132 |   |

 

*See accompanying notes to consolidated financial statements.*

 

45

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**CONSOLIDATED BALANCE SHEETS**

 

### **March 31, 2005 and 2004**

 

**LIABILITIES AND SHAREHOLDERS’ EQUITY**

 
| **(In thousands, except share  data)**                                                                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Current liabilities:                                                                                                                        |       |     |       |     |       |
| Accounts payable                                                                                                                            |       | $        | 6,175      |     | $          | 8,124 |   |
| Accrued liabilities                                                                                                                         |       | 3,300    |       | 2,472    |       |
| Accrued royalties and distribution fees                                                                                                     |       | 12,423   |       | 9,255    |       |
| Accrued music publishing fees                                                                                                               |       | 4,617    |       | 5,196    |       |
| Deferred revenue (Notes 2 and 5)                                                                                                            |       | 5,392    |       | 3,360    |       |
| Revolving credit facility (Notes 8 and 12)                                                                                                  |       | —   |       | 10,218   |       |
| Current portion of long-term debt (Note 9)                                                                                                  |       | 1,337    |       | 1,592    |       |
| Current portion of capital lease  obligations (Note 9)                                                                                      |       | 109      |       | 247      |       |
| Total current liabilities                                                                                                                   |       | 33,353   |       | 40,464   |       |
| Long-term debt, less current portion (Note  9)                                                                                              |       | —   |       | 1,224    |       |
| Capital lease obligations, less current  portion (Note 9)                                                                                   |       | —   |       | 109      |       |
| Total liabilities                                                                                                                           |       | 33,353   |       | 41,797   |       |
| Commitments and Contingencies (Notes 8, 9,  10 and 11)                                                                                      |       |     |       |     |       |
| Shareholders’ equity (Notes 9 and 12):                                                                                                 |       |     |       |     |       |
| Preferred stock, $1 par value, 3,366,000  shares authorized; none issued and outstanding                                                    |       | —   |       | —   |       |
| Common stock, no par value, 30,000,000  shares authorized; 21,252,000 and 18,268,000 issued and outstanding in 2005  and 2004, respectively |       | 47,513   |       | 33,142   |       |
| Additional paid-in capital                                                                                                                  |       | 3,774    |       | 3,774    |       |
| Accumulated deficit                                                                                                                         |       | (9,454   | )          | (14,581  | )          |
| Net shareholders’ equity                                                                                                               |       | 41,833   |       | 22,335   |       |
|                                                                                                                                        |       | $        | 75,186     |     | $          | 64,132 |   |

 

*See accompanying notes to consolidated financial statements.*

 

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**CONSOLIDATED STATEMENTS OFOPERATIONS**

 

### **For the Years Ended March 31, 2005, 2004 and 2003**

 
| **(In thousands, except per share  data)**                                                                             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| NET REVENUES                                                                                                           |       | $        | 118,383    |     | $          | 84,840   |       | $ | 86,929 |   |
| OPERATING COSTS AND EXPENSES:                                                                                          |       |     |       |     |       |     |       |
| Cost of sales                                                                                                          |       | 88,435   |       | 66,595   |       | 66,453   |       |
| Selling expenses                                                                                                       |       | 9,853    |       | 6,086    |       | 5,944    |       |
| General and administrative expenses                                                                                    |       | 14,092   |       | 12,425   |       | 10,527   |       |
|                                                                                                                   |       | 112,380  |       | 85,106   |       | 82,924   |       |
| EARNINGS (LOSS) FROM OPERATIONS                                                                                        |       | 6,003    |       | (266     | )          | 4,005    |       |
| OTHER EXPENSES (INCOME):                                                                                               |       |     |       |     |       |     |       |
| Interest expense, net                                                                                                  |       | 665      |       | 818      |       | 1,359    |       |
| Other (Notes 7 and 15)                                                                                                 |       | 49       |       | (213     | )          | 698      |       |
|                                                                                                                   |       | 714      |       | 605      |       | 2,057    |       |
| EARNINGS (LOSS) FROM CONTINUING OPERATIONS  BEFORE INCOME TAXES                                                        |       | 5,289    |       | (871     | )          | 1,948    |       |
| INCOME TAX EXPENSE (Notes 14 and 15)                                                                                   |       | 162      |       | 6,244    |       | 1,306    |       |
| EARNINGS (LOSS) FROM CONTINUING OPERATIONS                                                                             |       | 5,127    |       | (7,115   | )          | 642      |       |
| DISCONTINUED OPERATIONS:                                                                                               |       |     |       |     |       |     |       |
| Loss from operations of discontinued retail  distribution segment (less applicable income tax benefit of $618 in 2003) |       | —   |       | (1,742   | )          | (1,096   | )          |
| Loss on sale of retail distribution segment                                                                            |       | —   |       | (699     | )          | —   |       |
| LOSS FROM DISCONTINUED OPERATIONS                                                                                      |       | —   |       | (2,441   | )          | (1,096   | )          |
| EARNINGS (LOSS) BEFORE CUMULATIVE EFFECT OF  ACCOUNTING CHANGE                                                         |       | 5,127    |       | (9,556   | )          | (454     | )          |
| CUMULATIVE EFFECT OF ACCOUNTING CHANGE, NET  OF INCOME TAX BENEFIT OF $2,231                                           |       | —   |       | —   |       | (3,766   | )          |
| NET EARNINGS (LOSS)                                                                                                    |       | $        | 5,127      |     | $          | (9,556   | )          | $ | (4,220 | ) |
| NET EARNINGS (LOSS) PER SHARE:                                                                                         |       |     |       |     |       |     |       |
| Continuing operations – basic                                                                                     |       | $        | .27        |     | $          | (.39     | )          | $ | .04 |   |
| Continuing operations –diluted                                                                                    |       | $        | .26        |     | $          | (.39     | )          | $ | .04 |   |
| Discontinued operations – basic and diluted                                                                       |       | —   |       | (.13     | )          | (.07     | )          |
| Cumulative effect of accounting change, net  – basic and diluted                                                  |       | —   |       | —   |       | (.22     | )          |
| Net earnings (loss) – basic                                                                                       |       | $        | .27        |     | $          | (.52     | )          | $ | (.25 | ) |
| Net earnings (loss) – diluted                                                                                     |       | $        | .26        |     | $          | (.52     | )          | $ | (.25 | ) |
| WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:                                                                            |       |     |       |     |       |     |       |
| Basic                                                                                                                  |       | 19,100   |       | 18,250   |       | 16,812   |       |
| Diluted                                                                                                                |       | 19,912   |       | 18,250   |       | 17,002   |       |

 

*See accompanying notes to consolidated financial statements.*

 

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**CONSOLIDATED STATEMENTSOF SHAREHOLDERS’ EQUITY (Notes 9 and 12)**

 

**For the Years Ended March 31, 2005, 2004 and 2003**

 
| ** **                           | ** ** | ** **       | ** ** | ** **  | ** ** | **Additional**  | ** ** | ** **  | ** ** |
|--------------------------------------|------------|------------------|------------|-------------|------------|-----------------|------------|-------------|------------|
| ** **                           | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Accumulated** | ** ** |
| **(In thousands)**                   | ** ** | **Shares**       | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Deficit** | ** ** |
| BALANCES, March 31, 2002             |       | 15,828           |       | $           | 29,850     |            | $          | 3,463       |       | $ | (805 | ) |
| Issuance of common stock             |       | 2,369            |       | 2,861       |       | —          |       | —      |       |
| Issuance of restricted stock units   |       | 26               |       | 201         |       | —          |       | —      |       |
| Exercise of options                  |       | 2                |       | 4           |       | —          |       | —      |       |
| Issuance of stock warrants           |       | —           |       | —      |       | 311             |       | —      |       |
| Net loss                             |       | —           |       | —      |       | —          |       | (4,220      | )          |
|                                 |       |             |       |        |       |            |       |        |       |
| 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 | ) |

 

*See accompanying notes to consolidated financial statements.*

 

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**CONSOLIDATED STATEMENTS OF CASHFLOWS**

 

### **For the Years Ended March 31, 2005, 2004 and 2003**

 
| **(In thousands)**                                                                                    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| CASH FLOWS FROM CONTINUING OPERATING  ACTIVITIES:                                                     |       |     |       |     |       |     |       |
| Net earnings (loss)                                                                                   |       | $        | 5,127      |     | $          | (9,556   | )          | $ | (4,220 | ) |
| Adjustments to reconcile net loss to net  cash provided by (used in) continuing operating activities: |       |     |       |     |       |     |       |
| Loss from discontinued operations, net of  tax benefit in 2003                                        |       | —   |       | 1,742    |       | 1,096    |       |
| Loss on sale of discontinued retail  distribution segment                                             |       | —   |       | 699      |       | —   |       |
| Cumulative effect of accounting change, net  of deferred tax benefit of $2,231                        |       | —   |       | —   |       | 3,766    |       |
| Amortization of production costs                                                                      |       | 4,070    |       | 3,957    |       | 4,287    |       |
| Depreciation and other amortization                                                                   |       | 2,568    |       | 2,313    |       | 2,314    |       |
| Amortization of stock warrant and restricted  stock units                                             |       | 25       |       | 132      |       | 394      |       |
| Provision for lower of cost or market  inventory write downs                                          |       | 1,396    |       | 766      |       | 307      |       |
| Provision for doubtful accounts, sales  returns and other credits                                     |       | 2,036    |       | 2,481    |       | 1,258    |       |
| Impairment charge - Las Vegas, Nevada real  estate                                                    |       | —   |       | —   |       | 322      |       |
| Loss on disposal of assets                                                                            |       | 59       |       | 7        |       | 106      |       |
| Deferred income taxes – continuing  operations                                                   |       | —   |       | 6,244    |       | 1,030    |       |
| Changes in assets and liabilities  associated with continuing operating activities:                   |       |     |       |     |       |     |       |
| Accounts receivable                                                                                   |       | (3,287   | )          | (3,769   | )          | (3,382   | )          |
| Inventories                                                                                           |       | (2,909   | )          | (1,694   | )          | (333     | )          |
| Royalty and distribution fee advances                                                                 |       | (2,128   | )          | 319      |       | (680     | )          |
| Production cost expenditures                                                                          |       | (3,827   | )          | (3,328   | )          | (4,395   | )          |
| Prepaid expenses and other assets                                                                     |       | 165      |       | (123     | )          | 914      |       |
| Accounts payable, accrued royalties, fees  and liabilities                                            |       | 1,531    |       | 2,204    |       | (572     | )          |
| Deferred revenue                                                                                      |       | 2,032    |       | (477     | )          | 3,837    |       |
| Net cash provided by continuing operating  activities                                                 |       | 6,858    |       | 1,917    |       | 6,049    |       |
| CASH FLOWS FROM CONTINUING INVESTING  ACTIVITIES:                                                     |       |     |       |     |       |     |       |
| Capital expenditures                                                                                  |       | (3,408   | )          | (2,140   | )          | (1,463   | )          |
| Net proceeds from sale of land                                                                        |       | —   |       | —   |       | 5,668    |       |
| Net cash provided by (used in) continuing  investing activities                                       |       | (3,408   | )          | (2,140   | )          | 4,205    |       |
|                                                                                                       |            |          |            |          |            |          |            |  |  |  |

 

*See accompanying notes to consolidated financial statements*

 

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| **(In thousands)**                                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| CASH FLOWS FROM CONTINUING FINANCING  ACTIVITIES:               |       |     |       |     |       |     |       |
| Borrowings under revolving credit facility                      |       | $        | 84,960     |     | $          | 92,874   |       | $ | 106,592 |   |
| Repayments of borrowings under revolving  credit facility       |       | (95,178  | )          | (93,176  | )          | (106,192 | )          |
| Repayments of long-term debt                                    |       | (1,479   | )          | (1,591   | )          | (8,487   | )          |
| Principal payments under capital lease  obligations             |       | (248     | )          | (569     | )          | (637     | )          |
| Issuance of common stock                                        |       | 14,198   |       | —   |       | 2,000    |       |
| Exercise of employee stock option                               |       | 96       |       | 40       |       | 3        |       |
| Net cash provided by (used in) continuing  financing activities |       | 2,349    |       | (2,422   | )          | (6,721   | )          |
| INCREASE (DECREASE) IN CASH AND CASH  EQUIVALENTS:              |       | 5,799    |       | (2,645   | )          | 3,533    |       |
| Cash provided by (used in) discontinued  operations             |       | —   |       | 513      |       | (1,164   | )          |
| NET INCREASE (DECREASE) IN CASH AND CASH  EQUIVALENTS:          |       | 5,799    |       | (2,132   | )          | 2,369    |       |
| Cash and cash equivalents at beginning of  year                 |       | 540      |       | 2,672    |       | 303      |       |
| Cash and cash equivalents at end of year                        |       | $        | 6,339      |     | $          | 540      |       | $ | 2,672 |   |
| SUPPLEMENTAL DISCLOSURES OF CASH FLOW  INFORMATION:             |       |     |       |     |       |     |       |
| Cash paid during the year for:                                  |       |     |       |     |       |     |       |
| Interest                                                        |       | $        | 713        |     | $          | 833      |       | $ | 1,481 |   |
| Income taxes                                                    |       | $        | 175        |     | $          | 6        |       | $ | 10 |   |

 

*See accompanying notes to consolidated financial statements*

 

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SUPPLEMENTAL DISCLOSURES OF NONCASH OPERATING, INVESTING AND FINANCINGACTIVITIES:

 

During fiscal 2005, a former financial consultant exercised theirwarrant to purchase 50,000 shares issued in fiscal 2002 by surrenderingapproximately 17,000 shares in a cashless exercise, an option in the originalwarrant agreement.  The value of theoriginal 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 paymentof related income taxes) in connection with the vesting of restricted stockunits.  We increased common stock at July1, 2004, and June 30, 2003, by approximately $87,000 and $186,000, respectively,representing the value of the total vested shares as of the grant dates, lessthe value of shares withheld for payment of related income taxes on the vestingdates.

 

In March 2003, we issued 567,568 shares of our unregistered commonstock to retire the remaining $1,050,000 in principal due under the convertiblesubordinated note payable with Image Investors Co., our largestshareholder.  In connection with thepartial conversion of the note, we issued Image Investors Co. a warrant topurchase up to 100,000 shares of our unregistered common stock at $2.04. Thefair value of the warrant on the issuance date, $121,000, was calculated usingthe Black-Scholes valuation model and was recorded as other expenses in theaccompanying consolidated statement of operations for fiscal 2003 and additionalpaid in capital in the accompanying consolidated balance sheets at March 31,2003.

 

*See accompanying notes to consolidated financial statements*

 

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NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

 

**Note 1.****  ****Basis of Presentation andSummary of Significant Accounting Policies.**

 

*Basis of Presentation andPrinciples of Consolidation.*  The accompanying consolidatedfinancial statements include the accounts of Image Entertainment, Inc., itssubsidiaries Egami Media, Inc. (fiscal 2005 only), Image Entertainment (UK),Inc. (fiscal 2005 only), DVDPlanet, Inc. (which was dissolved as of December31, 2004) and Aviva International, LLC (which was dissolved as of December 31,2004) (collectively, “we,” “our” or “us”). All significant inter-company balances and transactions have beeneliminated in consolidation.  AvivaInternational, LLC ceased active operations effective December 31, 2002.  DVDPlanet ceased operations in December 2003subsequent to the sale of substantially all of its assets.  See “Note 4. Discontinued Operations –Sale of DVD Planet”.

 

*Business.*  Weengage primarily in the domestic acquisition and wholesale distribution of homeentertainment content for release on DVD, and in other home entertainment formats,via exclusive license and distribution agreements.  We also distribute our exclusive DVDprogramming internationally, primarily by relying on sublicensees (particularlySony BMG), from whom we receive revenues in the form of royalty income.  Exclusive distribution of music content on CDis a growing source of revenues.

 

*Use of Estimates in Preparationof Financial Statements.*  The preparation of ourconsolidated financial statements in conformity with generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the amounts reported in the financial statements.  The significant areas requiring the use ofmanagement estimates are related to provisions for lower-of-cost or marketinventory write downs, doubtful accounts receivables, unrecouped royalty anddistribution fee advances, valuation of deferred taxes, and sales returns.  Although these estimates are based onmanagement’s knowledge of current events and actions management may undertakein the future, actual results may ultimately differ from those estimates.

 

*Cash and Cash Equivalents*. Cash and cash equivalents include all cash balances and highly liquidinvestments with an initial maturity of three months or less. We place ourtemporary cash investments with high credit quality financial institutions. Attimes our cash deposits may be in excess of the Federal Deposit InsuranceCorporation (FDIC) insurance limit. At March 31, 2005, we had approximately $918,000in excess of FDIC insured limits.

 

*Fair Value of FinancialInstruments.*  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.

 

Thefair value of our debt instruments approximate the amount of future cash flowsassociated with each instrument.  AtMarch 31, 2005 and 2004, the carrying value of all financial instruments wasnot materially different from fair value, as the fixed rate debt approximatesrates currently available to us.

 

*Revenue Recognition.* Revenue is recognized upon meeting the recognition requirements ofAmerican Institute of Certified Public Accountants Statement of Position(“SOP”) 00-2, *Accounting by Producers orDistributors of Films* andStaff Accounting Bulletin (“SAB”) No. 104, *RevenueRecognition*.  Revenuesfrom home video distribution are recognized, net of an allowance for estimatedreturns, as well as related costs, in the period in which the product isavailable for sale by our customers (at the point that title and risk of losstransfer to the customer, which is generally upon receipt by the customer andin the case of new releases, after “street date” restrictions lapse).  Revenues from domestic and internationalbroadcast licensing and home video sublicensing, as well as associated costs,are recognized when the programming is available to the licensee and otherrecognition requirements of SOP 00-2 are met. Fees received in advance of availability, usually in the case ofadvances received from Sony BMG, Digital Site, other international sublicenseesand for broadcast programming, are deferred until earned and all revenuerecognition requirements have been satisfied. As of March 31, 2005, and March 31, 2004, deferred revenue totaled$5,392,000 and $3,360,000, respectively. Provisions for uncollectible accounts receivable are provided at thetime of sale.

 

*Inventories.* Inventories consist primarily of finished products for sale (which arestated at the lower-of-cost or market, with cost being determined on an averagecost basis) and unamortized non-recoupable production costs.

 

*Non-Recoupable Production Costs.*  Thecosts to produce licensed content for domestic and international distributioninclude the cost of converting film prints or tapes into the optical discformat.  Costs also include menu design,authoring, compression, subtitling, closed captioning, service charges relatedto disc manufacturing, ancillary material production, product packaging designand related services and the overhead of our creative services and productiondepartments.  A percentage of thecapitalized production costs is amortized to expense each month based upon:  (i) a projected revenue stream resulting fromdistribution of new and previously released exclusive programming related tosuch production costs; and (ii) management’s estimate of the ultimate netrealizable value of the production costs. Estimates of future revenues are reviewed periodically and amortizationof production costs is adjusted 

 

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accordingly.  If estimated future revenues are notsufficient to recover the unamortized balance of production costs, such costsare reduced to their estimated fair value.

 

*Royalty and Distribution FeeAdvances, Recoupable Production Advances.* Royalty and distribution fee advances represent fixed minimum paymentsmade to program suppliers for exclusive content distribution rights.  A program supplier’s share of exclusiveprogram distribution revenues is retained by us until the share equals theadvance(s) paid to the program supplier plus recoupable production costs.  Thereafter, any excess is paid to the programsupplier.  In the event of an excess, werecord, as a cost of sales, an amount equal to the program supplier’s share ofthe net distribution revenues.  Royaltyand distribution fee advances are charged to operations as revenues areearned.  Royalty distribution feeadvances and recoupable production costs are amortized to expense in the sameratio that current period revenue for a title or group of titles bear to theestimated remaining unrecognized ultimate revenue for that title.  Revenue and cost forecasts are continuallyreviewed by management and revised when warranted by changing conditions.  When estimates of total revenues and costsindicated that an individual title or group of cross-collateralized titleswhich we exploit via home entertainment formats such as home video, CD or broadcast,will result in an ultimate loss, an impairment charge is recognized to theextent that capitalized advance royalties and distribution fees and recoupableproduction costs exceed estimated fair value, based on discounted cash flows,in the period when estimated. Advances for the acquisition of completed filmsnot released or films in development under our agreements with ContentFilm andDark Horse totaled $517,000 at March 31, 2005.

 

*Property, Equipment andImprovements.*  Property, equipment and improvements arestated at cost less accumulated depreciation and amortization.  Major renewals and improvements arecapitalized; minor replacements, maintenance and repairs are charged to currentoperations.  Some costs in developinginternal use software are capitalized pursuant to the SOP 98-1, *Accounting for Costs of Computer Software Developedor Obtained for Internal Use*. Depreciation and amortization are computed by applying the straight-linemethod over the estimated useful lives of the machinery, equipment and software(3-7 years).  Leasehold improvements areamortized over the shorter of the useful life of the improvement or the life ofthe related lease.

 

*Advertising Costs.*  Ouradvertising expense comprises expenditures related to advertising in trade andconsumer publications, product brochures and catalogs, booklets for salespromotion, radio advertising and other promotional costs.  In accordance with SOP 93-7, *Reporting on Advertising Costs*, we expenseadvertising costs in the period in which the advertisement first takesplace.  Product brochures and catalogsand various other promotional costs are capitalized and amortized over theexpected period of future benefit, but generally not exceeding six months.  Our co-op advertising is expensed in accordancewith Emerging Issues Task Force (“EITF”) 01-09, *Accounting for Consideration Given by a Vendor to a Customer or aReseller of the Vendor’s Products*. At March 31, 2005 and 2004, our prepaid advertising costs were $151,000and $224,000, respectively.  For fiscal2005, 2004 and 2003, advertising and promotion expense was $4,632,000,$2,445,000 and $1,530,000, respectively.

 

*Market Development Funds.*  Inaccordance with EITF 01-09, *Accounting forConsideration Given by a Vendor to a Customer or a Reseller of the Vendor’sProducts*, we classify market development funds, including funds forspecific product positioning, deducted from payment for purchases by customersas a reduction to revenues.  Thefollowing reductions to consolidated net revenues have been made in accordancewith the guidelines of this issue: $4,530,000 for 2005, $2,437,000 for 2004 and $1,886,000 for 2003.

 

*Allowances Received From Vendors.*  Inaccordance with EITF 02-16, *Accounting by aCustomer (Including a Reseller) for Certain Consideration Received from aVendor*, we classify consideration received as a reduction in cost ofsales in the accompanying statements of operations unless we receive anidentifiable benefit in exchange for the consideration or the considerationrepresents a reimbursement of a specific identifiable cost incurred by us inselling the vendor’s product.

 

*Shipping Income and Expenses.*  Inaccordance with EITF 00-10, *Accounting forShipping and Handling Fees and Costs*, we classify amounts billed tocustomers for shipping fees as revenues, and classify costs related to shippingas cost of sales in the accompanying statements of operations.

 

*Major Customers and Suppliers.*  On aconsolidated basis, Anderson Merchandisers (who supplies Wal-Mart), Best Buyand AEC One Stop Group accounted for approximately 17%, 12%, and 10%,respectively, of our net revenues for the year ended March 31, 2005.  Best Buy and AEC One Stop accounted for 17%and 12% of fiscal 2004 sales, respectively. Best Buy and Musicland Group (which was owned by Best Buy through June16, 2003) together accounted for 21% of fiscal net revenues.  No other customers accounted for more than10% of net revenues in fiscal 2005, 2004 and 2003.  At March 31, 2005 and 2004, three and twocustomers, respectively, each of who accounted for more than 10% of our grossaccounts receivable, accounted for 42% and 28%, respectively, of our totalaccounts receivable in the aggregate.

 

Wesource substantially all of our DVD replication from Deluxe. Any failure ofDeluxe to manufacture and deliver our product in a timely manner and with thesame consistent quantity and quality that we and our customers have come toexpect may adversely affect our revenues and profits. Additionally, although webelieve we have the ability to shift our product manufacturing from Deluxe toanother facility should the need arise: we may be adversely affected by theperiod of time that we would need to direct manufacturing duties to another company.

 

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*Goodwill.*  InJune 2001, the Financial Accounting Standards Board (“FASB”) issued Statementof Financial Accounting Standards (“SFAS”) No. 141, *Business Combinations*, and No. 142, *Goodwill and other Intangible Assets*.  SFAS No. 141 requires that the purchasemethod be used for all business combinations initiated after June 30,2001.  SFAS No. 142 requires thatgoodwill no longer be amortized to earnings, but instead be reviewed forimpairment.  The amortization of goodwillceases upon adoption of SFAS No. 142.  Weadopted the new rules for measuring the impairment of goodwill and variousintangible assets on April 1, 2002.

 

Duringour fourth quarter ended March 31, 2002, the carrying value of our acquiredgoodwill was determined to be impaired pursuant to the new valuation guidelinesof SFAS No. 142.  The adoption of SFASNo. 142 resulted in a charge of $3,766,000, or $.22 per diluted share, net ofan income tax benefit of $2,231,000.  Theimpairment charge was recorded as a cumulative effect of a change in accountingprinciple, net of the income tax benefit, in the accompanying consolidatedstatement of operations for fiscal 2003. As a result of this write down, DVDPlanet had no remaininggoodwill.  Prior to the adopting the newvaluation guidelines of SFAS No. 142, we accounted for goodwill under SFAS No.121.  Under SFAS No. 121, projectedundiscounted cash flows expected from DVDPlanet exceeded the recorded carryingvalue of DVDPlanet.  Accordingly, we didnot have any goodwill in periods subsequent to the impairment.

 

*Long-Lived Assets.*  We reviewfor the impairment of long-lived and specific, identifiable intangible assetswhenever events or changes in circumstances indicate the carrying amount of anasset may not be recoverable.  Animpairment loss would be recognized when estimated undiscounted future cashflows expected to result from the use of the asset and its eventual dispositionis less than its carrying amount.

 

Priorto the sale of our Las Vegas, Nevada warehouse and distribution facility andadjacent vacant land, we wrote down the net book value of the land and buildingto approximate the estimated sales price less estimated related transactionalcosts.  The impairment charge totaled$322,000 and is included as a component of other expenses in the accompanyingstatement of operations for fiscal 2003. No impairment charges were recorded during fiscal 2005 and 2004.

 

*Foreign Currency Transactions.* Foreign currency denominated transactions are recorded at the exchangerate in effect at the time of occurrence, and the gains or losses resultingfrom subsequent translation of the corresponding receivable or payable atcurrent exchange rates are included as a component of other income and expensesin the accompanying statements of operations.

 

*Income Taxes.*  Weaccount for income taxes pursuant to the provisions of SFAS No. 109, *Accounting for Income Taxes*, wherebydeferred 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 valuationallowance on our deferred tax assets when it is more likely than not that suchdeferred tax assets will not be realized. We have a valuation allowance against 100% of our net deferred taxassets at March 31, 2005 and 2004.

 

*Earnings per Share.*  Basicearnings per share is computed using the weighted average number of commonshares outstanding during the period. Diluted earnings per share is computed using the combination of dilutivecommon share equivalents and the weighted average shares outstanding during theperiod.

 

*Comprehensive Income.* Comprehensive income is the change in equity of a business enterpriseduring a period resulting from transactions and all other events andcircumstances from non-owner sources.  Wedid not have components of comprehensive income during the three years endedMarch 31, 2005.

 

*Stock Options.*  Weaccount for stock options granted to employees in accordance with AccountingPrinciples Board Opinion No. 25, *Accounting for StockIssued to Employees*, and related interpretations.  Because the exercise price of all optionsgranted by us was greater than or equal to the market price of the underlyingcommon stock on the date of the grant, no compensation expense wasrecognized.  Total compensation costrecognized for stock-based employee compensation awards under restricted stockgrants, net of cancellations, is added back to our consolidated net loss, andreported in the table below. Compensation expense related to stock options granted to non-employeesis accounted for under SFAS No. 123, *Accounting for Stock-BasedCompensation*, which requires us to recognize an expense based on thefair value of the related awards.  If wehad accounted for stock options issued to employees in 

 

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accordancewith SFAS No. 123, its pro forma net earnings (loss) and net earnings (loss)per share would have been reported as follows:

 
| **(In thousands, except per share  data)**                                                                                                    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                                                                                          |       |     |       |     |       |     |       |
| Consolidated net earnings (loss), as  reported                                                                                                |       | $        | 5,127      |     | $          | (9,556   | )          | $ | (4,220 | ) |
| Add: Stock-based employee compensation  expense included in the reported consolidated net earnings (loss), net of  related tax effects        |       | —   |       | —   |       | —   |       |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |       | (455     | )          | (536     | )          | (195     | )          |
|                                                                                                                                          |       |     |       |     |       |     |       |
| Pro forma consolidated net loss                                                                                                               |       | $        | 4,672      |     | $          | (10,092  | )          | $ | (4,415 | ) |
|                                                                                                                                          |       |     |       |     |       |     |       |
| Consolidated net earnings (loss) per share:                                                                                                   |       |     |       |     |       |     |       |
| As reported                                                                                                                                   |       |     |       |     |       |     |       |
| Basic                                                                                                                                         |       | $        | .27        |     | $          | (.52     | )          | $ | (.25 | ) |
| Diluted                                                                                                                                       |       | $        | .26        |     | $          | (.52     | )          | $ | (.25 | ) |
| Pro forma                                                                                                                                     |       |     |       |     |       |     |       |
| Basic                                                                                                                                         |       | $        | .24        |     | $          | (.55     | )          | $ | (.26 | ) |
| Diluted                                                                                                                                       |       | $        | .23        |     | $          | (.55     | )          | $ | (.26 | ) |

 

Thefair value of the options at the date of grant was estimated using theBlack-Scholes model with the following assumption:

 
| ** **            | ** ** | **2005**         | ** ** | **2004**         | ** ** | **2003** | ** ** |
|-----------------------|------------|------------------|------------|------------------|------------|----------|------------|
| Expected life (years) |       | 2.5 – 5.0   |       | 5.0              |       | 5.0      |       |
| Interest rate         |       | 2.76 – 3.88 | %          | 3.03 – 3.52 | %          | 1.20     | %          |
| Volatility            |       | 60-67            | %          | 74-79            | %          | 79       | %          |
| Dividend yield        |       | 0.00             | %          | 0.00             | %          | 0.00     | %          |

 

*RecentlyIssued Accounting Standards.*

 

In December 2004, the Financial Accounting StandardsBoard (“FASB”) issued revised Statement of Financial Accounting Standards(“SFAS”) No. 123(R), “Share-Based Payment – an Amendment of FASB Statement Nos.123 and 95.” SFAS 123(R) establishes standards for the accounting fortransactions in which an entity exchanges its equity instruments for goods orservices or incurs liabilities in exchange for goods or services that are basedon the fair value of the entity’s equity instruments, focusing primarily onaccounting for transactions in which an entity obtains employee services inshare-based payment transactions. SFAS No. 123(R) requires public entities tomeasure the cost of employee services received in exchange for an award ofequity instruments based on the grant-date fair value of the award (withlimited exceptions) and recognize the cost over the period during which anemployee is required to provide service in exchange for the award. In April2005, the SEC deferred the effective date of SFAS 123(R) so that companies maynow adopt its provisions at the beginning of their first annual period beginningafter June 15, 2005 (which would be fiscal 2007, beginning April 1, 2006, forus).  We are evaluating the impact ofSFAS No. 123(R) and expect that we will record non-cash compensation expenses.  The adoption of SFAS No. 123(R) is notexpected to have a significant effect on our financial condition or cash flowsbut is expected to have a negative effect on the reporting of our results ofoperations.

 

InDecember 2004, the FASB issued FASB Staff Position No. FAS 109-1 (FSP FAS109-1), “Application of FASB Statement No. 109, Accounting for Income Taxes,for the Tax Deduction on Qualified Production Activities Provided by theAmerican Jobs Creation Act of 2004.”  FSPFAS 109-1 clarifies that the deduction will be treated as a “special deduction”as described 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.  The impact of the deduction will be reportedin the period in which the deduction is claimed.  We do not believe that this pronouncementwill have a material effect on our consolidated financial statements.

 

InDecember 2004, the FASB issued the SFAS No. 153, “Exchange of NonmonetaryAssets, An Amendment of APB Opinion No. 29.” SFAS No 153 addresses the measurement of exchanges of nonmonetaryassets.  SFAS No. 153 eliminates theexception from fair value measurement for nonmonetary exchanges of similarproductive assets 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 nonmonetaryexchange has commercial substance if the future cash flows of the entity areexpected to change significantly as a result of the 

 

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exchange.  The provisions of SFAS No. 153 shall beeffective for nonmonetary asset exchanges occurring in fiscal periods beginningafter June 15, 2005.  Earlier applicationis permitted for nonmonetary asset exchanges occurring in fiscal periodsbeginning after the date this Statement is issued.  The provisions of this Statement shall beapplied 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 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 not expectthat the adoption of SFAS No. 151 will have an impact on our financialposition, results of operations or cash flows.

 

*Reclassifications.*  Somefiscal 2004 and 2003 balances have been reclassified to conform to the fiscal2005 presentation.

 

**Note 2.****  ****Japan Sublicense Agreement and $2Million Advance**

 

On October 6, 2004, we entered into an exclusive five-year home videooutput sublicense agreement with Digital Site Corporation for exclusivedistribution of our programming in Japan. We previously distributed our programming in Japan through sublicenseagreements with various third parties on a title-by-title basis.  Some of these sublicense agreements forcertain titles remain in force.

 

Under the terms of the output sublicense agreement, Digital Site is responsiblefor sales, marketing, manufacturing and distribution in Japan.  The agreement includes our available existingcatalogue as well as previously-sublicensed titles as they become available andfuture new releases through the end of 2009. The distribution term for each program is five years or the expirationdate of our underlying rights, whichever is sooner.  Programming will be marketed and releasedunder the brand, “Image Entertainment Japan,” and the first releases under theagreement occurred in January 2005.

 

Royalty payments are set at a percentage of suggested retail price, andany overages will be paid after recoupment of the $2 million non-refundableadvance received from Digital Site in October 2004.  The advance was recorded as a component ofdeferred revenue and is recognized as revenue when royalties are earned, asreported to us on a quarterly basis.

 

**Note 3.****  ****Egami Media, Inc. and Opening ofLondon Office**

 

*Egami Media, Inc.*

 

On January 1, 2005, weperfected the formation of a new wholly-owned subsidiary, Egami Media, Inc., aDelaware corporation.  We also approved astock-based incentive compensation plan for our and Egami’s employees,directors and consultants and reserved for issuance under the plan shares ofcommon stock equal to approximately twenty percent of the initially outstandingshares.

 

We capitalized Egami andentered into an exclusive sublicense and subdistribution agreement grantingEgami our rights to exploit video on demand, broadband streaming and digitaldownloading, amounting to over 1,600 music tracks and over 800 video titles andepisodes.  The agreement also grants Egami the digital rights for futuretitles for which we acquire such rights, subject to Egami contributing aproportionate share of any required advances against rights assigned to Egami,and a limited term in the event of a change in control.  The agreementalso allows Egami to utilize our services, including production, informationtechnology and royalty processing, at fair market rates on an as needed and asavailable basis.

 

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*Opening of London Office*

 

In January 2005, weperfected a wholly-owned subsidiary, Image Entertainment (UK), Inc.  On February 7, 2005, Image UK opened acontent acquisition office in London, England.  Our Vice President ofProgramming temporarily relocated to London to become the office’s managingdirector.  Image UK acts as our exclusive content acquisition agent, andfacilitates the securing of licensing and distribution rights from contentproviders from its overseas headquarters. Rights acquired with the assistance of Image UK will be held by us.  Additionally, production and distributionservices will be performed by our personnel out of our headquarters inChatsworth, California.  We expectfirst-year expenses for the leased office, temporarily leased apartment andrelated expenses, including salaries, to be approximately £17,000(approximately $30,000) per month.

 

**Note 4.****  ****Discontinued Operations –Sale of DVDPlanet.**

 

On September 23, 2003, ourwholly-owned subsidiary DVDPlanet, Inc., sold substantially all of its assetsto Planet Entertainment, Inc., a subsidiary of Infinity Resources, Inc.(“Infinity”) for approximately $2,644,000 in net proceeds in connection withthe sale: $1,655,000 from the sale of the net assets, and $989,000 inaccelerated payments for purchased inventory under the June 2003 fulfillmentagreement between DVDPlanet and I-Serve Direct Commerce Services, Inc. (also asubsidiary of Infinity).  We received $2,354,000on September 23, 2003, ($1,424,000 of which was attributable to the assetsale), and $290,000 in October 2003 ($231,000 of which represented theremaining amount due on the sale). DVDPlanet’s cash, accounts receivable, accounts payable and accruedexpenses on the date of sale were retained by us.  We incurred a loss of approximately $699,000on the sale of the assets.  We expensedapproximately $293,000 in remaining severance-related compensation liability inconnection with the sale during the quarter ended December 31, 2003, which isincluded as a component of the loss from discontinued operations for the yearended March 31, 2004.

 

The following is summaryfinancial information for our discontinued retail distribution segment for thethree years ended March 31, 2005:

 
| **(In thousands)**                                            | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                          |       |     |       |     |       |     |       |
| Net revenues                                                  |       | $        | —     |     | $          | 8,991    |       | $ | 21,264 |   |
| Pretax loss from discontinued operations                      |       | —   |       | (1,742   | )          | (1,714   | )          |
| Pretax loss from the sale of the retail  distribution segment |       | —   |       | (699     | )          | —   |       |
| Income tax benefit                                            |       | —   |       | —   |       | 618      |       |
| Net loss from discontinued operations                         |       | $        | —     |     | $          | (2,441   | )          | $ | (1,096 | ) |

 

**Note 5.****  ****Transition of InternationalSales to Sony BMG.**

 

Duringfiscal 2004, we completed our transition of 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 millioninitial royalty advance under the Sony BMG agreement in March 2003, fullyrecoupable from revenues generated by Sony BMG against quarterly royalties dueto us under the agreement.  Based uponactual quarterly sales of our programming in the territories, Sony BMG recoupsquarterly royalties from the $3.0 million previously advanced.  Sony BMG provides additional quarterlyroyalty advances such that for the first three years of the agreement term(through December 31, 2005), the outstanding royalty advance to us at any giventime will be a constant $3.0 million. During the first three quarters of the fourth year of the term (the ninemonths ending September 30, 2006), Sony BMG will reduce, through recoupment,the outstanding royalty advance to $1.5 million.  Once the entire royalty advance is recouped,Sony BMG will continue to pay quarterly royalties based on revenuegenerated.  During the fourth quarter ofthe fourth year (the quarter ending December 31, 2006), Sony BMG may recoup theentire remaining balance of $1.5 million by not re-advancing royaltiesquarterly.  The agreement contains aformula to pay an additional lesser advance at the beginning of the fifth andfinal year of the term (calendar 2007) which is to be recouped by Sony BMGduring that year.  We must repay anyoutstanding unrecouped royalty advance within 30 days following the final SonyBMG reporting at the conclusion of Sony BMG’s sell-off period after expirationof the five-year term.  Royalty advancesreceived from Sony BMG are recorded as deferred revenue until earned.  Deferred revenue at March 31, 2005,attributable to Sony BMG was $2,231,000.

 

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To facilitate an orderly transition to SonyBMG from our previous network of independent subdistributors, we contractuallyelected to purchase any product inventory from our subdistributors (includingany of their customer returns) upon the expiration of their respective terms(plus an additional time period to allow for their customer returns) ratherthan allow the subdistributors to exercise a six-month nonexclusive sell-offperiod.

 

Under the Sony BMG agreement, Sony BMGcommitted to purchase our international DVD inventory, which would include anyinventory repurchased from the subdistributors, at our manufacturing price (fordisc and case only, excluding booklets and inserts).  We recorded a charge during fiscal 2003 of$174,000, to provide for the difference between the ultimate purchase price ofthe inventory paid or credited to the subdistributors upon the expiration of theirrespective terms and the manufacturing cost paid to us by Sony BMG for thatinventory.  At March 31, 2003, we accruedfor estimated subdistributor returns resulting in a reduction of revenues andgross margin of $831,000 and $278,000, respectively, and accrued for thewrite-down (to Sony BMG purchase cost) of the inventory to be returned by thesubdistributors, as well as inventory held at our Germany-based warehousingagent, representing an incremental charge to cost of sales of $202,000 duringthe fourth quarter ended March 31, 2003.

 

Our accounting for international generatedrevenues differs under the Sony BMG agreement because the revenues aregenerated under a sublicense agreement, rather than the subdistributionagreements previously in place.  Underour subdistribution agreements, we recorded net revenues based upon the sellingprice of its programming sold to our distribution network customers.  We recorded as cost of sales the actualmanufacturing/packaging cost, shipping cost, royalties/distribution fees andmusic publishing.  Under the Sony BMGagreement, we record royalty income as revenue based upon royalties we receivefrom Sony BMG.  Royalty income isrecorded in the period in which the product is sold by Sony BMG.  We report as cost of goods sold the royaltiesor distribution fees accrued to our licensors or program suppliers ascalculated against the royalties we receive from Sony BMG.  The majority of international selling andmarketing expenses are borne by Sony BMG. Additionally, Sony BMG is responsible for manufacturing and packagingcosts as well as music publishing.

 

**Note 6.****  ****Inventories.**

 

Inventoriesat March 31, 2005 and 2004, are summarized as follows:

 
| **(In thousands)**                                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------------------|------------|----------|------------|----------|------------|
| DVD                                                                  |       | $        | 11,112     |     | $          | 10,037 |   |
| Other                                                                |       | 1,616    |       | 1,180    |       |
|                                                                 |       | 12,728   |       | 11,217   |       |
| Production costs, net                                                |       | 4,869    |       | 5,112    |       |
|                                                                 |       | 17,597   |       | 16,329   |       |
| Less current portion of inventories                                  |       | 15,408   |       | 13,725   |       |
| Noncurrent inventories, principally  non-recoupable production costs |       | $        | 2,189      |     | $          | 2,604 |   |

 

Non-recoupableproduction costs are net of accumulated amortization of $12,364,000 and$16,422,000 at March 31, 2005 and 2004, respectively.  We expect to amortize approximately 75% ofthe March 31, 2005 unamortized production costs by March 31, 2007.

 

**Note 7.****  ****Property, Equipment andImprovements.**

 

Property,equipment and improvements at March 31, 2005 and 2004, are summarized asfollows:

 
| **(In thousands)**                              | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Machinery, equipment and software               |       | $        | 16,934     |     | $          | 15,584 |   |
| Leasehold improvements                          |       | 864      |       | 791      |       |
| Other                                           |       | 147      |       | 124      |       |
|                                            |       | 17,945   |       | 16,499   |       |
| Less accumulated depreciation and  amortization |       | 11,382   |       | 10,717   |       |
|                                            |       | $        | 6,563      |     | $          | 5,782 |   |

 

Depreciation and amortization expense for the years ended March 31,2005, 2004 and 2003 was $2,568,000, $2,313,000 and $2,314,000, respectively.

 

*Sale and Leaseback of Land andDistribution Facility in Fiscal 2003.*  OnSeptember 3, 2002, we entered into an agreement with Spencer Street Investors,LLC, an affiliate of RDS Investment & Development, LLC, an unrelated realestate developer, to sell and leaseback our Las Vegas, Nevada warehouse anddistribution facility and adjacent vacant land. On November 8, 2002, escrow on the sale closed for approximately 8.11acres, consisting of our 76,000 

 

58

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squarefoot warehouse and distribution facility on 4.04 acres, and the adjacent 4.07acres of vacant land for $6.0 million. We received net proceeds of approximately $3.0 million, after deductingtransactional costs (such as sales commissions and escrow fees, etc.), andapproximately $2.7 million was paid to Bank of America in Nevada to retire ourrevolving credit facility that was secured by the real estate sold.  We wrote down the net book value of the landand building to approximate the sales price less the estimated relatedtransactional costs.  The impairmentcharge totaled $322,000 and is included as a component of other expenses in theaccompanying statement of operations for fiscal 2003.  The gain on the sales transaction wasnominal.

 

On November 8, 2002, we entered into two lease agreements with thebuyer: a ten-year building lease for the existing warehouse and distributionfacility with three five-year extension options, and a five-year lease for theadjacent vacant land which may be used for future expansion of the warehouseand distribution facility, if necessary. The monthly rent approximates market rent charged for like properties inthe Las Vegas, Nevada area.

 

**Note 8.****  ****Revolving Credit and TermLoan Facilities.**

 

*Revolving Credit and Term LoanFacilities**.*  On September 30, 2004, we amended our creditfacility with Wells Fargo Foothill.  Themaximum revolving credit availability under the agreement was increased $6million, from $17 million to $23 million. Actual borrowing availability under the line remains substantially basedupon eligible trade accounts receivable levels. While the interest rate remains at the prevailing prime rate plus 0.75%(6.50% at March 31, 2005), the interest rate floor was reduced from 5.75% to5.00%.  An option to borrow at LIBOR plus3.50% was added.  The maximum capitalexpenditures limit covenant was increased for fiscal 2005 to $3.25 million plus$359,000 unused from fiscal 2004, from $2.5 million plus the same $359,000.  The capital expenditures covenant maximum waslowered to $2.5 million in fiscal 2006, plus any unused carryover from fiscal2005.  The term of the agreement wasextended two years through December 28, 2007.

 

At March 31, 2005, we had cash of $6,339,000 and borrowing availabilityof $17.3 million and $1 million under our revolving credit and term loanfacilities, respectively, with Foothill. Comparatively, at March 31, 2004, we had cash of $540,000 and borrowingavailability of $6,245,000 and $1,000,000 under our revolving credit and termloan facilities, respectively.

 

The agreement imposesrestrictions on such items as encumbrances and liens, payment of dividends,other indebtedness, stock repurchases and capital expenditures.  We would need to obtain Foothill’s approvalprior to any future debt or equity financing or any corporate acquisitions orinvestments.  Any outstanding borrowingsare secured by our assets.  Our loanagreements with Foothill require us to comply with minimum financial andoperating covenants.  Throughout the yearended March 31, 2005, we were in compliance with the financial and operatingcovenants under the loan agreement, and we believe that we will be able toachieve the minimum covenant requirements for at least the next 12 months.

 

**Note 9.****  ****Long-Term Debt.**

 

*Subordinated Note Payable – RitekTaiwan.*  In March 2002, we amended the provisions ofour note payable with Ritek Corporation, a Taiwanese Corporation and formerparent of Ritek Global Media (now Deluxe Media Services, our exclusive DVDmanufacturer).  The amended note is payablein equal monthly installments of approximately $111,000 plus accrued interestat the fixed rate of 6% per annum through its maturity on March 1, 2006.  Outstanding balances under the note aresubordinate to all of our senior debt obligations and all replacements andrefinancing of such debt.  At March 31,2005, $1,337,000 was outstanding under the note.

 

*Note Payable to Bank.*  OnJune 28, 2000, we entered into a Business Loan Agreement with Bank of America,N.A. in Nevada for an equipment line of credit. On September 30, 2001, this line was converted into a note payable.  Outstanding borrowings were repaid in equalmonthly installments through February 28, 2005 and bore interest at LIBOR plus2.50%, per annum, payable monthly.  Werepaid this note in full in accordance with its terms in February 2005.

 

*Convertible Subordinated NotePayable.*  This debt was repaid in fiscal 2003.  In March 2003, we entered into a Terminationand Exchange Agreement with Image Investors Co. (“IIC”), which terminated the September29, 1997 Credit Agreement.  IIC is ourlargest shareholder, and is owned and controlled by John W. Kluge and StuartSubotnick. 

 

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TheTermination Agreement retired early the remaining balance due under theconvertible subordinated note payable to IIC with a combination of cash and ourcommon stock.

 

Toretire the obligation early, we paid $1,500,000 in cash, plus accrued interestof $54,000.  We issued 567,568 shares ofour common stock at $1.85 per share to satisfy the remaining $1,050,000 inprincipal due.  In connection with thepartial conversion of the balance due under the note into common stock, weissued IIC a five-year warrant to purchase up to 100,000 more shares at $2.04per share. The warrant is exercisable beginning one year from itsissuance.  The restricted stock will beunregistered and subject to Rule 144 under the Securities Act of 1933, asamended.  IIC will have limitedregistration rights.  We recorded acharge of $121,000 as a component of other expenses in the accompanyingstatement of operations for fiscal 2003 for the estimated fair market value ofthe warrant (valued using the Black-Scholes valuation model).

 

Long-termdebt at March 31, 2005 and 2004, consists of the following:

 
| **(In thousands)**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|
| Subordinated note payable – Ritek Taiwan |       | $        | 1,337      |     | $          | 2,561 |   |
| Note payable to bank                          |       | —   |       | 255      |       |
|                                          |       | $        | 1,337      |     | $          | 2,816 |   |
| Current portion of long-term debt             |       | $        | 1,337      |     | $          | 1,592 |   |
|                                          |       |     |       |     |       |
| Long-term debt less current portion           |       | $        | —     |     | $          | 1,224 |   |

 

**Note 10.********Capital Lease Obligations.**

 

Our July 2001 capital leaseagreement with General Electric Capital Corporation bears interest at a fixed7.58% per annum, payable monthly, and expires September 2005.  At March 31, 2005, $109,000 was outstandingunder the lease.

 

Machineryand equipment under capital leases at March 31, 2004 and 2003, are summarizedas follows:

 
| **(In thousands)**                              | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Machinery, equipment and software               |       | $        | 915        |     | $          | 915 |   |
| Less accumulated depreciation and  amortization |       | 781      |       | 583      |       |
|                                            |       | $        | 134        |     | $          | 332 |   |

 

Futureminimum lease payments by year at March 31, 2005, for property under capitalleases are as follows:

 
| **(In thousands)**                         | ** ** | **2006** | ** ** |
|--------------------------------------------|------------|----------|------------|
| Total minimum lease payments               |       | $        | 111        |   |
| Less amount representing interest at 7.58% |       | 2        |       |
| Present value of minimum lease payments    |       | 109      |       |
| Less current portion                       |       | 109      |       |
| Noncurrent portion                         |       | $        | —     |   |

 

**Note 11.********Commitments andContingencies.**

 

**Operating Leases.**

 

*New Corporate Offices.*  OnJanuary 7, 2004, we entered into a corporate office lease starting July 1,2004, for approximately 62,000 square feet in a multi-tenant building inChatsworth, California.  The initial costof the office space was $1.23 per square foot on a gross basis and increasesapproximately 3% annually.  The lease hasan initial 10-year term with two five-year options.

 

We also leaseour 76,000 square foot warehouse and distribution facility located in LasVegas, Nevada. The monthly rent is approximately $39,000, subject to annualadjustment based on increases in the consumer price index, and the lease willterminate on November 4, 2012. In addition, we lease approximately 4.07 acresof adjacent vacant land in the event we need to expand our current warehouseand distribution facility. The monthly rent is approximately $9,000 and the leasewill terminate on November 4, 2007. Beginning in January 2004, we leased anadditional 10,000 square foot warehouse storage space in Las Vegas, Nevada fora monthly rent of approximately $5,000 for a term of two years.

 

Future minimum annual rentalpayments by year under operating leases at March 31, 2005, are approximately asfollows:

 

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| **Fiscal** | ** ** | **Amount**          | ** ** |
|------------|------------|---------------------|------------|
| ** ** | ** ** | **(In  thousands)** | ** ** |
| 2006       |       | $                   | 1,607      |   |
| 2007       |       | 1,573               |       |
| 2008       |       | 1,615               |       |
| 2009       |       | 1,658               |       |
| 2010       |       | 1,701               |       |
| Thereafter |       | 6,399               |       |
|       |       | $                   | 14,553     |   |

 

Rentexpense was $1,455,000, $911,000 and $562,000 for fiscal 2005, 2004, and 2003,respectively.

 

*Lease Guarantee.*  In connection with the assetsale of DVDPlanet, Planet Entertainment assumed the obligations under DVDPlanet’sleases for its retail store and various other liabilities related to the assetsbeing acquired and its parent Infinity Resources guaranteed PlanetEntertainment’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 lease total approximately $491,000through December 2007.

 

*EmploymentContracts.*  Futurecontractual obligations under employment contracts totaled $1,199,000 and $1,173,000for fiscal years ending March 31, 2006 and 2007, respectively.

 

*Other.*  AtMarch 31, 2005, our future obligations by year for royalty advances, minimumroyalty guarantees and exclusive distribution fee guarantees under the terms ofour existing licenses and exclusive distribution agreements, respectively, areas follows:

 

| **Fiscal** | ** ** | **Amount**         | ** ** |
|------------|------------|--------------------|------------|
| ** ** | ** ** | **(in thousands)** | ** ** |
| 2006       |       | $                  | 12,414     |   |
| 2007       |       | 3,455              |       |
| 2008       |       | 288                |       |
|       |       | $                  | 16,157     |   |

 

*Legal Proceedings.*  Inthe normal course of business, we are subject to proceedings, lawsuits andother claims, including proceedings under government laws and regulationsrelating to employment and tax matters. While it is not possible to predict the outcome of these matters, it isthe opinion of management, based on consultations with legal counsel, that theultimate disposition of known proceedings will not have a material adverseimpact on our financial position, results of operations or liquidity.

 

**Note 12.********Shareholders’ Equity.**

 

*Private Placement of Image Common Stock*

 

On December 20, 2004, wesold 2,904,763 shares of our common stock at $5.25 per share for gross proceedsof $15.25 million, in a private placement. We also issued three-year warrants to the investors to purchase up to726,189 shares at $6.56 per share.  Thewarrants may be exercised for cash beginning June 20, 2005.  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 also issued the placement agent athree-year warrant to purchase up to 58,095 shares of common stock on the sameterms as the investors, except this warrant includes a cashless exerciseprovision.  We used the net proceeds ofthe transaction to pay down outstanding obligations under our credit facilitywith Wells Fargo Foothill, Inc.  Theremaining proceeds will be used for working capital and general corporatepurposes, including content acquisition.

 

*Stock Awards, Options and Warrants*

 

In September 2004, ourshareholders approved an incentive compensation plan (the “2004 Plan”) pursuantto which an additional 1,000,000 shares of our common stock were made availablefor annual incentive and specific performance awards, including options.  The 2004 Plan provides for awards to ouremployees 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.  Thelimitation on overall number of shares of stock reserved and available fordelivery in connection with awards under the 2004 Plan shall be the sum of1,000,000 shares above, plus the number of shares with respect to awardspreviously granted under the 2004 Plan that terminate without being exercised,expire, are forfeited or canceled, and the number of shares of stock that aresurrendered in payment of any awards, or any tax withholding with regardthereto.  The 2004 Plan requires that theexercise price for any incentive or non-qualified option be at least 100% ofthe closing price of our common stock on the date such option is granted.  

 

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The maximum term allowed for an option is 10years and a stock unit shall either vest or be forfeited not more than 10 yearsfrom the date of grant.

 

InJuly 1999 and 1998 an aggregate 91,662 and 88,359, respectively, restrictedstock units were granted to our officers under our 1998 incentive plan.  These grants vested annually in increments of20% over the five-year period commencing June 30, 2000 and 1999,respectively.  There were no restrictedstock units granted to officers during fiscal 2001 through 2005.  These restricted stock units were payablesolely 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 relating to these stockunits for fiscal 2005, 2004 and 2003 was approximately $25,000, $132,000, and$195,000, respectively.

 

InOctober 2001, 2000 and 1999, the automatic annual awards to the Board ofDirectors aggregating 6,720 restricted stock units for each year weregranted.  These restricted stock unitswere paid in shares.  We amortized thetotal value of the restricted stock units on the date of the grant ratably overthe one-year vesting period as compensation expense ending in fiscal 2003.  Compensation expense relating to these restrictedstock units for fiscal 2005, 2004 and 2003 was approximately none, none and$6,000, respectively.

 

Stockoption transactions, including our former plans, for the three years endedMarch 31, 2005, are as follows:

 
| **(In thousands, except per share  data)** | ** ** | **Shares** | ** ** | **Per Share   Price Range** | ** ** | **Weighted Average   Price Per Share** | ** ** |
|--------------------------------------------|------------|------------|------------|-----------------------------|------------|----------------------------------------|------------|
| Outstanding, March 31, 2002                |       | 1,622      |       | 1.75-9.75                   |       | 5.124                                  |       |
| Granted                                    |       | 156        |       | 1.68-1.78                   |       | 1.767                                  |       |
| Exercised                                  |       | (2         | )          | 1.75                        |       | 1.750                                  |       |
| Canceled                                   |       | (17        | )          | 1.75-9.75                   |       | 7.595                                  |       |
| 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                   |       | 3.98                                   |       |
| Exercised                                  |       | (36        | )          | 1.68-3.75                   |       | 2.64                                   |       |
| Canceled                                   |       | (273       | )          | 1.75-8.75                   |       | 6.88                                   |       |
| Outstanding, March 31, 2005                |       | 2,444      |       | 1.68-7.94                   |       | 4.18                                   |       |

 

Ofthe options reflected as outstanding on March 31, 2005, options to purchaseapproximately 1,339,000 shares of common stock were exercisable.  At March 31, 2005, there were approximately276,000 shares of common stock available for new awards, including stockoptions, to our directors and employees.

 

Thefollowing table summarized significant ranges of outstanding and exercisableoptions at March 31, 2005:

 
| ** **                     | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                           | ** ** |
|--------------------------------|------------|-------------------------|------------|---------------------------------------------------|------------|
| **Range of   Exercise Prices** | ** ** | **Shares**              | ** ** | **Weighted   Average   Remaining   Life (Years)** | ** ** | **Weighted   Average   Exercise Price** | ** ** | **Shares** | ** ** | **Weighted   Average   Exercise Price** | ** ** |
| ** **                     | ** ** | **(In thousands)**      | ** ** | ** **                                        | ** ** | ** ** | ** ** | **(In thousands)** | ** ** | ** ** | ** ** |
| Under $2.00                    |       | 452                     |       | 7.0                                               |       | $ | 1.757 |   | 408 |   | $ | 1.755 |   |
| $2.01 to $4.00                 |       | 1,333                   |       | 8.4                                               |       | 3.739 |   | 440 |   | 3.697 |   |
| $4.01 to $6.00                 |       | 200                     |       | 8.9                                               |       | 5.072 |   | 33 |   | 5.369 |   |
| $6.01 to $8.00                 |       | 459                     |       | 1.7                                               |       | 7.127 |   | 459 |   | 7.127 |   |
|                           |       | 2,444                   |       |                                              |       |   |   | 1,340 |   |   |   |
|                                |            |                         |            |                                                   |            |  |  |  |  |  |  |  |  |

 

Thefollowing table summarized significant ranges of outstanding and exercisablewarrants at March 31, 2005:

 
| ** **                     | ** ** | **Warrants Outstanding** | ** ** | **Warrants Exercisable**                          | ** ** |
|--------------------------------|------------|--------------------------|------------|---------------------------------------------------|------------|
| **Range of   Exercise Prices** | ** ** | **Shares**               | ** ** | **Weighted   Average   Remaining   Life (Years)** | ** ** | **Weighted   Average   Exercise Price** | ** ** | **Shares** | ** ** | **Weighted   Average   Exercise Price** | ** ** |
| ** **                     | ** ** | **(In thousands)**       | ** ** | ** **                                        | ** ** | ** ** | ** ** | **(In thousands)** | ** ** | ** ** | ** ** |
| $1.22                          |       | 270                      |       | 2.50                                              |       | $ | 1.22 |   | 270 |   | $ | 1.22 |   |
| $2.04 to $2.58                 |       | 200                      |       | 2.25                                              |       | 2.23 |   | 200 |   | 2.23 |   |
| $6.56                          |       | 784                      |       | 2.72                                              |       | 6.56 |   | — | *  | — |   |
|                           |       | 1,254                    |       |                                              |       |   |   | 470 |   |   |   |
|                                |            |                          |            |                                                   |            |  |  |  |  |  |  |  |  |

 

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*The warrants for 784,000 shares with an exercise price of $6.56 will beexercisable beginning June 20, 2005.

 

62

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*Warrant Issued to IIC in Fiscal 2003*

 

See“Note 9.  Long-Term Debt – *Convertible Subordinated Note Payable*.”

 

*Private Placement of Common Stock and Warrant in Fiscal 2003*

 

On September 25, 2002, we sold $2.0 million of our common stock toStandard Broadcasting Corporation Limited in a private placement.  Standard Broadcasting is the largestprivately-owned multi-media company in Canada. Video One, a wholly-owned subsidiary of Standard Broadcasting and theparent company of VidCanada, is Canada’s largest distributor of pre-recordedhome entertainment programming, including DVD, VHS and video games.  VidCanada is our exclusive distributor ofhome entertainment programming in Canada. Contemporaneous with the private placement, we extended the term ofVidCanada’s exclusive distribution agreement from June 2003 to October 2007.

 

The $2.0 million transaction represented a purchase of 1,801,315 sharesof our common stock at $1.11 per share, the closing price on September 10,2002.  Additionally, we issued StandardBroadcasting a five-year warrant to purchase up to 270,198 additional shares at$1.22 per share.  The fair value of thewarrant, using the Black-Scholes valuation model, is $189,000 and was recordedin shareholders’ equity as part of the $2.0 million net proceeds.

 

In August 2004, Standard Broadcasting sold Video One, includingVidCanada, to Canadian-based ROW Entertainment.

 

**Note 13. 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, 2005:

 
| **(In thousands, except per share  data)**                                                    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                                          |       |     |       |     |       |     |       |
| Earnings (loss) from continuing operations                                                    |       | $        | 5,127      |     | $          | (7,115   | )          | $ | 642 |   |
| Loss from discontinued operations                                                             |       | —   |       | (2,441   | )          | (1,096   | )          |
| Earnings (loss) before cumulative effect of  accounting change                                |       | 5,127    |       | (9,556   | )          | (454     | )          |
| Cumulative effect of accounting change, net  of tax benefit                                   |       | —   |       | —   |       | (3,766   | )          |
| Net earnings (loss) – basic numerator                                                    |       | $        | 5,127      |     | $          | (9,556   | )          | $ | (4,220 | ) |
| Interest, net of taxes, on assumed  conversion of dilutive security                           |       | —   |       | —   |       | —   |       |
| Net earnings (loss) – diluted numerator                                                  |       | $        | 5,127      |     | $          | (9,556   | )          | $ | (4,220 | ) |
| Weighted average common shares outstanding –  basic denominator                          |       | 19,100   |       | 18,250   |       | 16,812   |       |
| Effect of dilutive securities                                                                 |       | 812      |       | —   |       | 190      |       |
| Weighted average common shares outstanding –  diluted denominator                        |       | 19,912   |       | 18,250   |       | 17,002   |       |
| Basic and diluted net earnings (loss) per  share:                                             |       |     |       |     |       |     |       |
| Continuing operations                                                                         |       | $        | .27        |     | $          | (.39     | )          | $ | .04 |   |
| Discontinued operations                                                                       |       | .26      |       | (.13     | )          | (.07     | )          |
| Basic and diluted earnings (loss) per share  before cumulative effect of an accounting change |       | $        | .27        |     | $          | (.52     | )          | $ | (.03 | ) |
| Cumulative effect of an accounting change,  net of tax benefit                                |       | —   |       | —   |       | (.22     | )          |
| Basic net earnings (loss) per share                                                           |       | .27      |       | (.52     | )          | (.25     | )          |
| Diluted net earnings (loss) per share                                                         |       | $        | .26        |     | $          | (.52     | )          | $ | (.25 | ) |

 

Outstandingcommon stock options and warrants not included in the computation of dilutednet earnings (loss) per share totaled 1,443,000, 1,079,000 and 1,480,000,respectively, for the years ended March 31, 2005, 2004 and 2003.  For fiscal 2005, 2004 and 2003, they wereexcluded as their effect would be antidilutive. The common shares underlying the convertible subordinated note payablewere excluded in fiscal 2003 because the assumed conversion would beantidilutive.

 

63

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**Note 14. Income Taxes.**

 

Incometax expense (benefit), including the benefits attributable to discontinuedoperations and the cumulative effect of accounting change, for the years endedMarch 31, 2005, 2004 and 2003, are summarized as follows:

 
| **(In thousands)**                         | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current                                    |       |     |       |     |       |     |       |
| Federal                                    |       | $        | 54         |     | $          | —   |       | $ | (9 | ) |
| State                                      |       | 30       |       | —   |       | 4        |       |
| Foreign                                    |       | 78       |       | —   |       | 280      |       |
|                                       |       | 162      |       | —   |       | 275      |       |
| Deferred                                   |       |     |       |     |       |     |       |
| Federal                                    |       | —   |       | 5,593    |       | 1,022    |       |
| State                                      |       | —   |       | 651      |       | 9        |       |
|                                       |       | —   |       | 6,244    |       | 1,031    |       |
| Total Tax Expense                          |       | —   |       | 6,244    |       | 1,306    |       |
|                                       |       |     |       |     |       |     |       |
| Discontinued Operations                    |       |     |       |     |       |     |       |
| Current                                    |       |     |       |     |       |     |       |
| Federal                                    |       | —   |       | —   |       | —   |       |
| State                                      |       | —   |       | —   |       | —   |       |
| Foreign                                    |       | —   |       | —   |       | —   |       |
|                                       |       | —   |       | —   |       | —   |       |
|                                       |       |     |       |     |       |     |       |
| Deferred                                   |       |     |       |     |       |     |       |
| Federal                                    |       | —   |       | —   |       | (535     | )          |
| State                                      |       | —   |       | —   |       | (83      | )          |
|                                       |       | —   |       | —   |       | (618     | )          |
| Total Tax Benefit                          |       | —   |       | —   |       | (618     | )          |
|                                       |       |     |       |     |       |     |       |
| Cumulative Effect – Accounting Change |       |     |       |     |       |     |       |
| Deferred                                   |       |     |       |     |       |     |       |
| Federal                                    |       | —   |       | —   |       | (2,039   | )          |
| State                                      |       | —   |       | —   |       | (192     | )          |
| Total Tax Benefit                          |       | —   |       | —   |       | (2,231   | )          |
|                                       |       |     |       |     |       |     |       |
| Total Tax Expense (Benefit)                |       | $        | 162        |     | $          | 6,244    |       | $ | (1,543 | ) |

 

Thetax effects of temporary differences that give rise to a significant portion ofthe net deferred tax assets at March 31, 2005 and 2004, are presented below:

 
| **(In thousands)**                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax assets:                                         |       |     |       |     |       |
| Provision for lower of cost or market  inventory write downs |       | $        | 797        |     | $          | 406 |   |
| Net operating loss carry forwards                            |       | 2,369    |       | 6,061    |       |
| Allowance for sales returns                                  |       | 1,055    |       | 325      |       |
| Allowance for doubtful accounts receivable                   |       | 121      |       | 373      |       |
| Tax credits                                                  |       | 1005     |       | 738      |       |
| Other                                                        |       | 547      |       | 410      |       |
| Deferred tax assets                                          |       | 5,894    |       | 8,313    |       |
| Less valuation allowance                                     |       | (5,406   | )          | (7,987   | )          |
| Net deferred tax assets                                      |       | 488      |       | 326      |       |
|                                                         |       |     |       |     |       |
| Deferred tax liabilities:                                    |       |     |       |     |       |
| Depreciation and amortization                                |       | 235      |       | 300      |       |
| Write downs of royalty advances                              |       | 253      |       | —   |       |
| Other                                                        |       | 488      |       | 26       |       |
| Deferred tax liabilities                                     |       | —   |       | 326      |       |
| Net deferred tax assets                                      |       | $        | —     |     | $          | — |   |

 

SFASNo. 109 requires that we assess the likelihood that our deferred tax assets arerealizable, and to the extent that it is more likely than not that all, or aportion, of such deferred tax assets will not be realized, a valuationallowance, increasing tax expense for the year, must be established.

 

In assessing therealizability of a deferred tax asset, Statement of Financial AccountingStandards (SFAS) No. 109 requires that all available evidence, both positiveand negative, be considered to determine whether, based on the 

 

64

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weight of that evidence, a valuation allowance is needed.  SFAS No. 109 further provides that“cumulative losses in recent years” are significant pieces of negative evidenceto overcome when determining whether it is “more likely than not” that therecorded deferred tax assets will be realized in the future by reducing futureincome taxes payable.  Such cumulativelosses from prior years must be considered on a pretax consolidated basis fromall operations.  In addition to fiscal 2004pretax losses for both continuing and discontinued operations, we also incurredaggregate net pretax losses 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 in the third quarter of fiscal 2004primarily as a result of operating losses sustained during our normallyseasonally strong third quarter as well as its then-expected impact on the fullfiscal year results of operations.

 

Although for fiscal 2005 wehad pretax earnings of $5,289,000, we have not had a strong earningshistory.  We enjoyed the benefits of astrong schedule of new DVD and CD releases during fiscal 2005 which we will bechallenged to duplicate or exceed in fiscal 2006.  We continue to maintain a 100% valuationallowance against our net deferred tax assets at March 31, 2005, due to thefollowing factors:

 

(1)                    we had a pretax loss for fiscal 2004

(2)                    we had an accumulated deficit at March 31,2005

(3)                    a significant portion (approximately 21%) ofour fiscal 2005 revenues, and by extension, fiscal 2005 profitability, wasgenerated by only five titles

 

Eventhough we have fully reserved our net deferred tax assets, we would still beable to utilize them to reduce future income taxes payable, should we havefuture earnings.  To the extent suchdeferred tax assets relate to NOL carry forwards, the ability to use such NOLsagainst future earnings will be subject to applicable carry forward periods.

 

Asof March 31, 2005, we had net operating loss carry forwards for Federal andstate income tax purposes of $6,694,000 and $1,603,000, respectively, which areavailable to offset future taxable income through 2024 and 2014, respectively.

 

Expectedincome tax expense (benefit) based on Federal statutory rates for the threeyears ended March 31, 2005 differed from actual tax expense (benefit) asfollows:

 
| **(In thousands, except per share  data)** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected income tax benefit                |       | $        | 1,798      |     | $          | (1,126   | )          | $ | (1,959 | ) |
| State income taxes, net of Federal benefit |       | 128      |       | 2        |       | (174     | )          |
| Change in valuation allowance              |       | (1,894   | )          | 7,422    |       | 551      |       |
| Non-deductible expenses                    |       | 51       |       | 26       |       | 25       |       |
| Other                                      |       | 79       |       | (80      | )          | 14       |       |
|                                       |       | $        | 162        |     | $          | 6,244    |       | $ | (1,543 | ) |

 

**Note 15. Other Items –Statement of Operations**

 

**Fourth Quarter Adjustments.**

 

Fiscal2005.  During the fourth quarter we reducedestimated publishing liabilities relating to our international distribution ofDVD’s through subdistributors. Approximately $499,000 was recorded as a non-recurring, noncash, pretaxcredit to cost of sales in the accompanying consolidated statement ofoperations for fiscal 2005.  Our jointventure Aviva International, LLC recently dissolved and Sony BMG is responsiblefor publishing for the European territories under our sublicense agreement.

 

Fiscal2004.  None.

 

Fiscal 2003.  In March 2003, we accrued for estimatedsubdistributor returns resulting in a reduction of revenues and gross margin of$346,000 and $116,000, respectively, during the fourth quarter ended March 31,2003, and for the write-down (to Sony BMG purchase cost) of the inventory to bereturned by the subdistributors representing an incremental charge to cost ofsales of $202,000 during the fourth quarter ended March 31, 2003.

 

65

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During the fourth quarter of fiscal 2003, we revised our operatingprojections as a result of recent changes to our revenues.  As a result of the revised projections, itwas determined that a valuation allowance was required on some tax creditsexpiring within five years.

 

**Note 16. EmployeeBenefit Plan.**

 

Wehave a 401(k) savings plan covering substantially all of our employees.  Eligible employees may contribute throughpayroll deductions.  We match employees’contributions at the rate of 50% of the first 4% of salary contributed.  Our 401(k) savings plan matching expenses forfiscal 2005, 2004 and 2003 were $143,000, $149,000 and $125,000, respectively.

 

**Note 17. SegmentInformation.**

 

Inaccordance with the requirements of SFAS No. 131, *Disclosures about Segments of and Enterprises and Related Information*,selected financial information regarding our reportable business segments,domestic and international, are presented below.  Domestic wholesale distribution of homeentertainment programming on DVD accounted for approximately 85% of our netrevenue for fiscal 2005, 84% for fiscal 2004 and 80% for fiscal 2003.  Management currently evaluates segment performancebased primarily on net revenues, operation costs and expenses and income (loss)before income taxes.  Interest income andexpense is evaluated on a consolidated basis and not allocated to our businesssegments.

 

For the Year Ended March 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 (LOSS) FROM OPERATIONS                                 |       | 4,945        |       | 1,058 |   | — |   | 6,003 |   |
| OTHER EXPENSES (INCOME)                                         |       | 735          |       | 15 |   | (36 | ) | 714 |   |
| EARNINGS (LOSS) FROM CONTINUING OPERATIONS  BEFORE INCOME TAXES |       | $            | 4,210      |   | $ | 1,043 |   | $ | 36 |   | $ | 5,289 |   |

 

For the Year Ended March 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 | ) |

 

For the Year Ended March 31, 2003:

 
| ** **                                                      | ** ** | **2003**     | ** ** |
|-----------------------------------------------------------------|------------|--------------|------------|
| **(In thousands)**                                              | ** ** | **Domestic** | ** ** | **International** | ** ** | **Inter-segment   Eliminations** | ** ** | **Consolidated** | ** ** |
| NET REVENUES                                                    |       | $            | 77,484     |   | $ | 9,445 |   | $ | — |   | $ | 86,929 |   |
| OPERATING COSTS AND EXPENSES                                    |       | 73,304       |       | 9,620 |   | — |   | 82,924 |   |
| EARNINGS (LOSS) FROM OPERATIONS                                 |       | 4,180        |       | (175 | ) | — |   | 4,005 |   |
| OTHER EXPENSES (INCOME)                                         |       | 1,784        |       | (300 | ) | 573 |   | 2,057 |   |
| EARNINGS (LOSS) FROM CONTINUING OPERATIONS  BEFORE INCOME TAXES |       | $            | 2,396      |   | $ | 125 |   | $ | (573 | ) | $ | 1,948 |   |

 
| ** **                | ** ** | **As of March 31,** | ** ** |
|---------------------------|------------|---------------------|------------|
| **(In thousands)**        | ** ** | **2005**            | ** ** | **2004** | ** ** |
| TOTAL ASSETS:             |       |                |       |   |   |
| DOMESTIC                  |       | $                   | 74,431     |   | $ | 62,638 |   |
| INTERNATIONAL             |       | 755                 |       | 1,494 |   |
| CONSOLIDATED TOTAL ASSETS |       | $                   | 75,186     |   | $ | 64,132 |   |

 

66

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**Note 18. QuarterlyFinancial Data.  (Unaudited)**

 

Summarizedquarterly consolidated financial data for fiscal 2005 and 2004 is as follows:

 
| ** **                                                                           | ** ** | **Quarter  Ended** |
|--------------------------------------------------------------------------------------|------------|--------------------|
| ** **                                                                           | ** ** | **June 30,**       | ** ** | **September  30,** | ** ** | **December  31,** | ** ** | **March  31,** | ** ** |
| **(In thousands, except per share data)**                                            | ** ** | **2004**           | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                 |       |               |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net revenues                                                                         |       | $                  | 26,541 |   | $ | 15,164 |   | $ | 28,556 |   | $ | 20,316 |   | $ | 34,391 |   | $ | 22,791 |   | $ | 28,895 |   | $ | 26,569 |   |
| Earnings (loss)  from continuing operations before income tax                        |       | 911                |   | (1,401 | ) | 1,244 |   | (55 | ) | 2,001 |   | (388 | ) | 1,133 | (2)  | 973 |   |
| Earnings (loss)  from continuing operations net of tax                               |       | 890                |   | (893 | ) | 1,215 |   | (35 | ) | 1,955 |   | (7,160 | )(4) | 1,067 |   | 973 |   |
| Loss from  discontinued operations, net of taxes (for June and Sept. quarters only)  |       | —             |   | (301 | ) | — |   | (999 | )(3) | — |   | (1,141 | )(4) | — |   | — |   |
| Net earnings  (loss)                                                                 |       | $                  | 890 |   | $ | (1,194 | ) | $ | 1,215 |   | $ | (1,034 | ) | $ | 1,955 |   | $ | (8,301 | ) | $ | 1,067 |   | $ | 973 |   |
| Net earnings  (loss) per share:                                                      |       |               |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Continuing  operations – basic                                                  |       | $                  | .05 |   | $ | (.05 | ) | $ | .07 |   | $ | (.00 | ) | $ | .10 |   | $ | (.39 | ) | $ | .05 |   | $ | .05 |   |
| Continuing  operations – diluted                                                |       | $                  | .05 |   | $ | (.05 | ) | $ | .06 |   | $ | (.00 | ) | $ | .10 |   | $ | (.39 | ) | $ | .05 |   | $ | .05 |   |
| Loss from  discontinued operations – basic and diluted                          |       | —             |   | (.02 | ) | — |   | (.06 | ) | — |   | (.06 | ) | — |   | — |   |
| Net earnings  (loss) per share(1) –                                             |       |               |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                                                |       | $                  | .05 |   | $ | (.07 | ) | $ | .07 |   | $ | (.06 | ) | $ | .10 |   | $ | (.45 | ) | $ | .05 |   | $ | .05 |   |
| Diluted                                                                              |       | $                  | .05 |   | $ | (.07 | ) | $ | .06 |   | $ | (.06 | ) | $ | .10 |   | $ | (.45 | ) | $ | .05 |   | $ | .05 |   |
| Weighted average  common shares used in computation of net earnings (loss) per share |       |               |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                                                |       | 18,268             |   | 18,225 |   | 18,278 |   | 18,248 |   | 18,642 |   | 18,262 |   | 21,244 |   | 18,266 |   |
| Diluted                                                                              |       | 18,588             |   | 18,225 |   | 18,697 |   | 18,248 |   | 19,746 |   | 18,262 |   | 22,373 |   | 18,795 |   |

 

----

(1)          Net earnings (loss) per share are computedindependently for each of the quarters represented in accordance with SFAS No.128.  Therefore, the sum of the quarterlynet earnings (loss) per share may not equal the total computed for the fiscalyear or any cumulative interim period.

(2)          Includes $499,000 in a non-recurring noncashcredits relating to the discontinuation of our international distribution ofDVDs through subdistributors.

(3)          Includes loss on sale of DVDPlanet of$447,000 (less income tax benefit of $252,000)

(4)          Includes income tax expense of $6,772,000allocated to continuing operations and $732,000 allocated to discontinuedoperations as a result of establishing a valuation allowance against 100% ofour deferred tax assets.

 

67

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| **ITEM 9****.** | ** ** | **CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING  AND FINANCIAL DISCLOSURE** |
|-----------------|------------|-------------------------------------------------------------------------------------------|

 

 

None.

 

**ITEM 9A****.****                   ****CONTROLS AND PROCEDURES**

 

As of the end of the periodcovered by this report, we carried out an evaluation, under the supervision andwith the participation of our Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of the design and operation of our disclosurecontrols and procedures.  Based on thisevaluation, our Chief Executive Officer and Chief Financial Officer concludedthat our disclosure controls and procedures are effective in timely alertingthem to material information required to be included in our periodic SECreports.

 

There have been nosignificant changes in our internal controls or in other factors that couldsignificantly affect those controls subsequent to the date of this most recentevaluation.

 

**ITEM 9B****.****                   ****OTHER INFORMATION**

 

None.

 

**PARTIII**

 

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 2005 annual meetingof shareholders.

 

68

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**PART IV**

 

**ITEM 15****.****                                             ****EXHIBITS AND FINANCIALSTATEMENT SCHEDULES**

 

(a)                                  THE FOLLOWING DOCUMENTS ARE FILED AS A PARTOF THIS REPORT.

 
| 1.     | Financial  Statements:         |                                                                                                     |
|--------|--------------------------------|----------------------------------------------------------------------------------------------------------|
|   |                           | Reports of Independent Registered  Public Accounting Firms                                               |   |
|   |                           | Consolidated Balance Sheets at March 31,  2005 and 2004                                                  |   |
|   |                           | Consolidated Statements of  Operations for the years ended March 31, 2005, 2004 and 2003                 |   |
|   |                           | Consolidated  Statements of Shareholders’ Equity for the years ended March 31, 2005, 2004  and 2003 |   |
|   |                           | Consolidated Statements of  Cash Flows for the years ended March 31, 2005, 2004 and 2003                 |   |
|   |                           | Notes to Consolidated  Financial Statements                                                              |   |
|   |                           |                                                                                                     |
| 2.     | Financial  Statement Schedule: |                                                                                                     |
|   |                           | Schedule II –  Valuation and Qualifying Accounts                                                    |   |
|   |                           |                                                                                                     |
| 3.     | Exhibits:                      |                                                                                                     |
|        |                                |                                                                                                          |  |  |

 
| 2.1    |   | Asset  Purchase Agreement dated September 22, 2003, between DVDPlanet, Inc. and  Planet Entertainment, Inc.  Filed as  Exhibit 2.1 to Image’s Form 8-K dated September 23, 2003, and incorporated by  reference herein.                                                                                                                                     |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 3.1    |   | Restated  Articles of Incorporation.  Filed as  Exhibit 3.1 of Image’s Form 10-K for the year ended March 31, 1995, and  incorporated by reference herein.                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 3.2    |   | Bylaws.  Filed as Exhibit 3.2 of Image’s Form 10-K  for the year ended March 31, 1995, and incorporated by reference herein.                                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 4.1    |   | Specimen  Common Stock certificate.  Filed as  Exhibit 4 to Image’s Registration Statement on Form S-2 (No. 333-65611),  effective December 21, 1998, and incorporated by reference herein.                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 4.2    |   | Form  of Registration Rights Agreement dated as of March 24, 2003 between Image and  Image Investors Co.  Filed as Exhibit  4.1 to Image’s Form 8-K dated March 24, 2003, and incorporated by reference  herein.                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 10.1   |   | Amendment  No. 9, effective as of September 22, 2003, to Loan and Security Agreement,  dated as of December 28, 1998, by and between Image and Wells Fargo Foothill,  Inc. (formerly known as Foothill Capital Corporation).  Filed as Exhibit 10.1 to Image’s Form 10-Q  for the quarter ended September 30, 2003, and incorporated by reference  herein.  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 10.2   |   | Amendment  No. 10, effective as of December 31, 2003, to Loan and Security Agreement,  dated as of December 28, 1998, by and between Image and Wells Fargo Foothill,  Inc. (formerly known as Foothill Capital Corporation).  Filed as Exhibit 10.1 to Image’s Form 10-Q  for the quarter ended December 31, 2003, and incorporated by reference  herein.   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 10.3   |   | Amendment  No. 11, effective as of March 31, 2004, to Loan and Security Agreement, dated  as of December 28, 1998, by and between Image and Wells Fargo Foothill, Inc.  (formerly known as Foothill Capital Corporation).  Filed as Exhibit 10.33(k) to Image’s Form  10-K for the fiscal year ended March 31, 2004, and incorporated by reference  herein. |
|   |   |                                                                                                                                                                                                                                                                                                                                                                  |
| 10.4   |   | Amendment  No. 12, effective as of September 30, 2004, to Loan and Security Agreement,  dated as of December 28, 1998, by and between Image and Wells Fargo Foothill,  Inc. (formerly known as                                                                                                                                                                        |

 

69

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|             |   | Foothill  Capital Corporation).  Filed as Exhibit  10.1 to Image’s Form 10-Q for the quarter ended September 30, 2004, and  incorporated by reference herein.                                                                                                                    |
|------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |   |                                                                                                                                                                                                                                                                                       |
| 10.5             |   | Termination  and Exchange Agreement entered into on March 24, 2003, effective as of March  14, 2003, between Image and Image Investors Co.  Filed as Exhibit 99.1 to Image’s Form 8-K  dated March 24, 2003, and incorporated by reference herein.                               |
|             |   |                                                                                                                                                                                                                                                                                       |
| 10.6             |   | Form  of Warrant, dated March 24, 2003, between Image and Image Investors Co.  Filed as Exhibit 99.2 to Image’s Form 8-K  dated March 24, 2003, and incorporated by reference herein.                                                                                            |
|             |   |                                                                                                                                                                                                                                                                                       |
| 10.7**†**   |   | Employment  Agreement, dated as of April 1, 2004, between Image and Martin W.  Greenwald.  Filed as Exhibit 10.42 to  Image’s Form 10-K for the fiscal year ended March 31, 2004, and incorporated  by reference herein.                                                         |
|             |   |                                                                                                                                                                                                                                                                                       |
| 10.8**†**   |   | Amendment No. 1, dated as of June 1, 2004, to  Employment Agreement, dated as of April 1, 2004, by and between Image and  Martin W. Greenwald.  Filed as Exhibit 10.42(a) to Image’s Form  10-K for the fiscal year ended March 31, 2004, and incorporated by reference  herein. |
|             |   |                                                                                                                                                                                                                                                                                       |
| 10.9**†**   |   | Employment  Agreement, dated as of April 1, 2004, between Image and David Borshell.  Filed as Exhibit 10.43 to Image’s Form 10-K  for the fiscal year ended March 31, 2004, and incorporated by reference  herein.                                                               |
|             |   |                                                                                                                                                                                                                                                                                       |
| 10.10**†**  |   | Employment  Agreement, dated as of April 1, 2004, between Image and Jeff Framer.  Filed as Exhibit 10.44 to Image’s Form 10-K  for the fiscal year ended March 31, 2004, and incorporated by reference  herein.                                                                  |
|             |   |                                                                                                                                                                                                                                                                                       |
| 10.11            |   | Form  of Purchase 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.                                                                                         |
|             |   |                                                                                                                                                                                                                                                                                       |
| 10.12            |   | Form  of Warrant, dated December 20, 2004, between Image and investors. Filed as  Exhibit 99.2 to Image’s Form 8-K dated December 21, 2004, and incorporated by  reference herein.                                                                                                    |
|             |   |                                                                                                                                                                                                                                                                                       |
| 10.13**†**  |   | Image’s  2004 Incentive Compensation Plan.   Filed as Exhibit A to Image’s Notice of Annual Meeting and Proxy  Statement dated July 29, 2004, and incorporated herein by this reference.                                                                                    |
|             |   |                                                                                                                                                                                                                                                                                       |
| 10.14**†*** |   | 2005  Incentive Compensation Plan of Egami Media, Inc.                                                                                                                                                                                                                                     |
|             |   |                                                                                                                                                                                                                                                                                       |
| 14.1             |   | Code  of Ethics Policy, dated November 1, 2003.   Filed as Exhibit 10.45 to Image’s Form 10-K for the fiscal year ended  March 31, 2004, and incorporated by reference herein.                                                                                                   |
|             |   |                                                                                                                                                                                                                                                                                       |
| 16.1             |   | Letter  from KPMG, LLP dated October 12, 2004.   Filed as Exhibit 16.1 to Image’s Form 8-K dated October 12, 2004, and  incorporated by reference herein.                                                                                                                        |
|             |   |                                                                                                                                                                                                                                                                                       |
| 21*              |   | Subsidiaries  of the Registrant.                                                                                                                                                                                                                                                           |
|             |   |                                                                                                                                                                                                                                                                                       |
| 23.1*            |   | Consent  Letter of BDO Seidman LLP, Independent Registered Public Accounting Firm.                                                                                                                                                                                                         |
|             |   |                                                                                                                                                                                                                                                                                       |
| 23.2*            |   | Consent  Letter of KPMG LLP, Independent Registered Public Accounting Firm.                                                                                                                                                                                                                |
|             |   |                                                                                                                                                                                                                                                                                       |
| 31.1*            |   | Certification  by the Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                  |
|             |   |                                                                                                                                                                                                                                                                                       |
| 31.2*            |   | Certification  by the Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                  |
|             |   |                                                                                                                                                                                                                                                                                       |
| 32.1*            |   | Certification  by the Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                  |

 

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| 32.2* |   | Certification  by the Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|-------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|

 

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***   Exhibit(s) not previously filed with theSecurities and Exchange Commission.**

**†   Management Contracts, Compensatory Plans orArrangements.**

 

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**SCHEDULE II**

**– Valuation and Qualifying Accounts –**

**For the Years Ended March 31, 2005, 2004 and 2003**

 
| ** **                         | ** ** | **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, 2005: |       | $                                    | 1,002      |   | $ | 41 |   | $ | (803 | ) | $ | 240 |   |
|                               |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| For the Year Ended March 31, 2004: |       | $                                    | 1,020      |   | $ | 72 |   | $ | (90 | ) | $ | 1,002 |   |
|                               |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| For the Year Ended March 31, 2003  |       | $                                    | 1,474      |   | $ | 108 |   | $ | (562 | ) | $ | 1,020 |   |

 
| ** **                         | ** ** | **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, 2005: |       | $                                    | 6,411      |   | $ | 30,457 |   | $ | (28,462 | ) | $ | 8,406 |   |
|                               |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| For the Year Ended March 31, 2004: |       | $                                    | 5,050      |   | $ | 20,091 |   | $ | (18,730 | ) | $ | 6,411 |   |
|                               |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| For the Year Ended March 31, 2003  |       | $                                    | 3,900      |   | $ | 17,486 |   | $ | (16,336 | ) | $ | 5,050 |   |

 

Reconciliationto Consolidated Balance Sheets

 
| ** **                       | ** ** | **At March 31,** | ** ** |
|----------------------------------|------------|------------------|------------|
| **(In thousands)**               | ** ** | **2005**         | ** ** | **2004** | ** ** |
| Allowance for Doubtful Accounts: |       |             |       |   |   |
| Balance at End of Year           |       | $                | 240        |   | $ | 1,002 |   |
| Allowance for Sales Returns:     |       |             |       |   |   |
| Balance at End of Year           |       | 8,406            |       | 6,411 |   |
| Allowances                       |       | $                | 8,646      |   | $ | 7,413 |   |

 

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**SIGNATURES**

 

Pursuant to the requirementsof Section 13 or 15(d) of the Securities Exchange Act of 1934, the registranthas duly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 
|                  |   | IMAGE  ENTERTAINMENT, INC.                                    |   |     |
|-----------------------|--------|---------------------------------------------------------------|--------|----------|
|                  |   | A  California corporation                                     |   |     |
|                  |   |                                                          |   |     |
|                  |   |                                                          |   |     |
| Dated:  June 16, 2005 |   | */s/ MARTIN W. GREENWALD*                                     |   | * * | * * |
|                  |   | MARTIN  W. GREENWALD                                          |   |     |
|                  |   | Chairman  of the Board, President and Chief Executive Officer |   |     |
|                  |   |                                                          |   |     |
|                       |        |                                                               |        |          |  |

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, this report has been signed below bythe following persons on behalf of the registrant and in the capacities and onthe dates indicated.

 
| Dated:  June 16, 2005 |   | */s/ MARTIN W. GREENWALD*                                             |   | * * | * * |
|-----------------------|--------|-----------------------------------------------------------------------|--------|----------|----------|
|                  |   | MARTIN  W. GREENWALD                                                  |   |     |
|                  |   | Chairman  of the Board, President and Chief Executive Officer         |   |     |
|                  |   | (Principal  Executive Officer)                                        |   |     |
|                  |   |                                                                  |   |     |
|                  |   |                                                                  |   |     |
| Dated:  June 16, 2005 |   | */s/ JEFF M. FRAMER*                                                  |   | * * | * * |
|                  |   | JEFF  M. FRAMER                                                       |   |     |
|                  |   | Chief  Financial Officer (Principal Financial and Accounting Officer) |   |     |
|                  |   |                                                                  |   |     |
| Dated:  June 16, 2005 |   | */s/ IRA EPSTEIN*                                                     |   | * * | * * |
|                  |   | IRA  EPSTEIN                                                          |   |     |
|                  |   | Director                                                              |   |     |
|                  |   |                                                                  |   |     |
| Dated:  June 16, 2005 |   | */s/ GARY HABER*                                                      |   | * * | * * |
|                  |   | GARY  HABER                                                           |   |     |
|                  |   | Director                                                              |   |     |
|                  |   |                                                                  |   |     |
| Dated:  June 16, 2005 |   | */s/ M. TREVENEN HUXLEY*                                              |   | * * | * * |
|                  |   | M.  TREVENEN HUXLEY                                                   |   |     |
|                  |   | Director                                                              |   |     |
|                  |   |                                                                  |   |     |
| Dated:  June 16, 2005 |   | */s/ ROBERT J. MCCLOSKEY*                                             |   | * * | * * |
|                  |   | ROBERT  J. MCCLOSKEY                                                  |   |     |
|                  |   | Director                                                              |   |     |

 

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