**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,DC 20549**

 

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**FORM 10-K/A**

 

**Amendment No. 2**

 

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**ý****                         ****ANNUAL REPORT PURSUANTTO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For The Fiscal Year Ended December 31, 2004**

 

**OR**

 

**o****                         ****TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For the Transition Period From             to            .**

 

**COMMISSIONFILE NUMBER: 0-27644**

 

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**Digital Generation Systems, Inc.**

(ExactName of Registrant as Specified in its Charter)

 
| **Delaware**                                                    | ** ** | **94-3140772**                           |
|-----------------------------------------------------------------|------------|------------------------------------------|
| (State  or Other Jurisdiction ofIncorporation  or Organization) |       | (I.R.S.  EmployerIdentification  Number) |

 

**750 WestJohn Carpenter Freeway, Suite 700**

**Irving,Texas 75039**

(AddressOf Principal Executive Offices, Including Zip Code)

 

**(972) 581-2000**

(Registrant’sTelephone Number, Including Area Code)

 

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**Securitiesregistered pursuant to Section 12(b) of the Act: None**

**Securitiesregistered pursuant to Section 12 (g) of the Act: Common Stock($0.001 par value)**

 

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Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 of theSecurities Act. Yes o    Noý

 

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or 15(d)of the Securities Exchange Act of 1934. Yes o     Noý

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months and (2) has been subject to such filing requirements for the past90 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 markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer.  See definition of“accelerated filer and large accelerated filer” in Rule 12b-2 of the ExchangeAct.

Large Accelerated Filer o Accelerated Filer o Non-accelerated Filer ý

Indicate bycheck mark whether the registrant is a shell company (as defined in ExchangeAct Rule 12b-2).   Yes o  No   ý

Theaggregate market value of the Common Stock held by non-affiliates of theregistrant, computed by reference to the closing price and shares outstanding,was approximately $60.6 million as of December 31, 2004, and approximately$49.9 million as of June 30, 2005, the last business day of the registrant’smost recently completed second quarter. Shares of Common Stock held by eachofficer and director of the registrant and by each person who may be deemed tobe an affiliate have been excluded. This determination of affiliate status isnot necessarily a conclusive determination for other purposes.

As of January 17, 2006, theregistrant had 74,207,104 shares of Common Stock outstanding.

 

 

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**DIGITALGENERATION SYSTEMS, INC.**

 

The discussion in this Report containsforward-looking statements that involve risks and uncertainties. The statementscontained in this Report that are not purely historical are forward-lookingstatements within the meaning of Section 27A of the Securities Act of1933, as amended, and Section 21E of the Securities Exchange Act of 1934,as amended. Words such as “anticipates,” “believes,” “plans,” “expects,” “future,”“intends,” and similar expressions are used to identify forward-lookingstatements. All forward-looking statements included in this document are basedon information available to the Company on the date hereof, and we assume noobligation to update any such forward-looking statements, except as required bylaw. The Company’s actual results could differ materially from thoseanticipated in these forward-looking statements as a result of certain factors,including, but not limited to, those discussed in “Management’s Discussion andAnalysis of Financial Condition and Results of Operations—Certain BusinessConsiderations” included in the Company’s Annual Report on Form 10-K filed onMarch 31, 2005 as well as those discussed elsewhere in this Report, and therisks discussed in the Company’s other filings with the United StatesSecurities and Exchange Commission.

 

**TABLE OFCONTENTS**

 
| ** ** | ** **                                  | **Pg.** |
|------------|---------------------------------------------|---------|
| ** ** | **PART II**                            |    |
| ** ** | ** **                                  |    |
| ITEM  8.   | FINANCIAL  STATEMENTS AND SUPPLEMENTAL DATA | 2       |
| ** ** | ** **                                  |    |
| ** ** | **PART IV**                            |    |
| ** ** | ** **                                  |    |
| ITEM  15.  | EXHIBITS,  FINANCIAL STATEMENT SCHEDULES    | 6       |
|       |                                        |    |
|       | SIGNATURES                                  | 8       |

 

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**EXPLANATORY NOTE**

 

Digital Generation Systems, Inc. (the “Company”)is filing this Amendment No. 2 on Form 10-K/A (the “Amendment”) tothe Company’s Annual Report on Form 10-K for the year ended December 31,2004 (which was filed with the Securities and Exchange Commission (the “SEC”)on March 31, 2005) in order to amend footnote 2 of the NOTES TO THECONSOLODATED FINANCIAL STATEMENTS, “Summary of Significant Accounting Policies—StockOption Plans”.  In preparation for theCompany’s compliance with the provisions of SFAS No. 123[R] effective asof January 1, 2006, the Company amended the total stock-based employee proforma compensation expense determined under fair value-based method for allawards, net of related tax effects, proforma net income, and pro forma basicand diluted earnings per share of common stock for the year ended December 31,2004 to reflect the fair value of the modification of certain warrants during2004.  The specific sections that havebeen amended are as follows: (i) Part II, Item 8, Financial Statements andSupplementary Data; and (ii) Part IV, Item 15, Exhibits to file new exhibits23.1, 31.1, 31.2 and 32.1.

 

As a result of this Amendment, (1) thecertifications pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act of2002, filed and furnished, respectively, as exhibits to the original filing,have been re-executed and re-filed as of the date of this Amendment; and (2) aConsent of Independent Registered Public Accounting Firm dated January 20, 2006to cover their report related to our consolidated financial statements is beingfiled.

 

Except for the amendments described above, thisAmendment does not modify or update the Company’s previously reported financialstatements and other financial disclosures in, or exhibits to, the originalfiling. Unaffected items have not been repeated in this Amendment.

 

1

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**ITEM 8. FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

 

The information required by this Item is set forth inthe Company’s Consolidated Financial Statements and the Notes thereto beginningat Page F-1 of this report.

 

**ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES**

 
| (a)        | **1. FINANCIAL STATEMENTS**                                                                                      |     |
|------------|------------------------------------------------------------------------------------------------------------------|----------|
|       |                                                                                                             |     |
|       | The following financial statements are filed as part of this  Report:                                            |     |
|       |                                                                                                             |     |
| ** ** | ** **                                                                                                       | **Page** |
|       | Independent Auditors’ Report                                                                                | F-2      |
|       | Consolidated Balance Sheets as of  December 31, 2004 and 2003                                               | F-3      |
|       | Consolidated Statements of Operations for the  three years ended December 31, 2004                          | F-4      |
|       | Consolidated Statements of Stockholders’ Equity  (Deficit) for the three years ended December 31, 2004 | F-5      |
|       | Consolidated Statements of Cash Flows for the  three years ended December 31, 2004                          | F-6      |
|       | Notes to Consolidated Financial Statements                                                                       | F-7      |
|       |                                                                                                             |     |
|       | **2. FINANCIAL STATEMENT SCHEDULES**                                                                             |     |
|       |                                                                                                             |     |
|       | II—Valuation and Qualifying Accounts                                                                        | S-1      |
|       |                                                                                                             |     |
|       | **3. EXHIBITS**                                                                                                  |     |

 
| **Exhibit  Number** | ** ** | **Exhibit Title**                                                                                                                                                   |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1(a)              |       | Certificate of  Incorporation of registrant.                                                                                                                             |
|                |       |                                                                                                                                                                     |
| 3.2(a)              |       | Bylaws of  registrant, as amended to date.                                                                                                                               |
|                |       |                                                                                                                                                                     |
| 4.1(b)              |       | Form of  Common Stock Certificate.                                                                                                                                  |
|                |       |                                                                                                                                                                     |
| 10.1(b)             |       | 1992 Stock  Option Plan (as amended) and forms of Incentive Stock Option Agreement and  Non-statutory Stock Option Agreement. *                                          |
|                |       |                                                                                                                                                                     |
| 10.2(b)             |       | Form of  Directors’ and Officers’ Indemnification Agreement.                                                                                              |
|                |       |                                                                                                                                                                     |
| 10.3(b)             |       | 1995 Director  Option Plan and form of Incentive Stock Option Agreement thereto. *                                                                                       |
|                |       |                                                                                                                                                                     |
| 10.4(b)             |       | Form of  Restricted Stock Agreement. *                                                                                                                              |
|                |       |                                                                                                                                                                     |
| 10.5(c)             |       | Content Delivery  Agreement between the Company and Hughes Network Systems, Inc., dated  November 28, 1995.                                                    |
|                |       |                                                                                                                                                                     |
| 10.6(c)             |       | Equipment  Reseller Agreement between the Company and Hughes Network Systems, Inc.,  dated November 28, 1995.                                                  |
|                |       |                                                                                                                                                                     |
| 10.7(e)             |       | Special Customer  Agreement between the Company and MCI Telecommunications Corporation, dated  May 5, 1997.                                                         |
|                |       |                                                                                                                                                                     |
| 10.8(i)             |       | Credit  Agreement, dated as of June 1, 2001, between Digital Generation  Systems, Inc. as borrower and JP Morgan and Bank of New York as Lenders.              |
|                |       |                                                                                                                                                                     |
| 10.9(f)             |       | Amendment and  Restatement No. 5 of the Registration Rights Agreement, dated  July 14, 1997, by and among the Registrant and certain of its security  holders. |
|                |       |                                                                                                                                                                     |
| 10.10(f)            |       | Amended and  Restated Registration Rights Agreement, dated December 9, 1998, by and  among the Registrant and certain of its security holders.                      |
|                |       |                                                                                                                                                                     |
| 10.11(f)            |       | Registration  Rights Agreement, dated December 9, 1998, by and among the Registrant  and certain of its security holders.                                           |
|                |       |                                                                                                                                                                     |
| 10.12(g)            |       | Common Stock and  Warrant Purchase Agreement dated December 9, 1998 by and among the  Registrant and investors listed in Schedule A thereto.                   |
|                |       |                                                                                                                                                                     |
| 10.13(g)            |       | Common Stock  Subscription Agreement dated December 9, 1998 by and among the  Registrant and Scott Ginsburg.                                                        |
|                |       |                                                                                                                                                                     |
| 10.14(g)            |       | Warrant Purchase  Agreement dated December 9, 1998 by and among the Registrant and Scott  Ginsburg.                                                                 |
|                |       |                                                                                                                                                                     |
| 10.15(g)            |       | Warrant  No. 1 to Purchase Common Stock dated December 9, 1998 by and among  Registrant and Scott K. Ginsburg.                                                 |
|                |       |                                                                                                                                                                     |
| 10.16(g)            |       | Warrant  No. 2 to Purchase Common Stock dated December 9, 1998 by and among  Registrant and Scott K. Ginsburg.                                                 |
|                |       |                                                                                                                                                                     |
| 10.17(h)            |       | Registration  Rights Agreement, dated December 17, 1999, by and among the Registrant  and certain of its security holders.                                          |
|                |       |                                                                                                                                                                     |
| 10.18(h)            |       | Common Stock  Purchase Agreement dated December 17, 1999 by and among the Registrant  and investors listed in Schedule A thereto.                              |

 

2

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| **Exhibit Number** | ** ** | **Exhibit Title**                                                                                                                                             |
|--------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.19(j)           |       | Customer Service  Agreement, dated September 12, 2002 between Digital Generation  Systems, Inc. and Sprint Communications Company L.P.                   |
|               |       |                                                                                                                                                               |
| 10.20(k)           |       | Credit  Agreement, dated as of May 5, 2003 between Digital Generation  Systems, Inc. as borrower and JP Morgan Chase Bank and Comerica Bank as  Lenders. |
|               |       |                                                                                                                                                               |
| 21.1***            |       | Subsidiaries of  the Registrant.                                                                                                                                   |
|               |       |                                                                                                                                                               |
| 23.1**             |       | Consent of  Independent Registered Public Accounting Firm.                                                                                                         |
|               |       |                                                                                                                                                               |
| 24.1***            |       | Power of  Attorney (included on signature page).                                                                                                                   |
|               |       |                                                                                                                                                               |
| 31.1**             |       | Rule 13a-14(a)/15d-14(a) Certifications.                                                                                                                 |
|               |       |                                                                                                                                                               |
| 31.2**             |       | Rule 13a-14(a)/15d-14(a) Certifications.                                                                                                                 |
|               |       |                                                                                                                                                               |
| 32.1**             |       | Section 1350  Certifications.                                                                                                                                 |

 

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(a)                   Incorporated by reference to exhibit bearing the same title filed withregistrant’s Annual Report on Form 10-K filed March 27, 2003.

 

(b)                  Incorporatedby reference to the exhibit bearing the same title filed with registrant’sRegistration Statement on Form S-1 (Registration No. 33-80203).

 

(c)                   Incorporated by reference to the exhibit bearing the same title filedwith registrant’s Registration Statement on Form S-1 (Registration No. 33-80203).The registrant has received confidential treatment with respect to certainportions of this exhibit. Such portions have been omitted from this exhibit andhave been filed separately with the SEC.

 

(d)                  Incorporatedby reference to the exhibit bearing the same title filed with registrant’sQuarterly Report on Form 10-Q filed November 13, 1996.

 

(e)                   Incorporated by reference to the exhibit bearing the same title filedwith registrant’s Quarterly report on Form 10-Q filed August 14,1997. Confidential treatment has been requested with respect to certain portionsof this exhibit pursuant to a request for confidential treatment filed with theSEC, which request was granted. Omitted portions have been filed separatelywith the SEC.

 

(f)                     Incorporated by reference to the exhibit bearing the same title filedwith registrant’s Registration Statement on Form S-3 filed on December 31,1998.

 

(g)                  Incorporatedby reference to the exhibit bearing the same title filed with registrant’sAnnual Report on Form 10-K filed March 29, 1999.

 

(h)                  Incorporatedby reference to the exhibit bearing the same title filed with registrant’sQuarterly Report on Form 10-Q filed May 11, 2000.

 

(i)                      Incorporated by reference to the exhibit bearing the same title filedwith registrant’s Quarterly Report on Form 10-Q filed on August 15,2001.

 

(j)                      Incorporated by reference to the exhibits bearing the same title filedwith registrant’s Annual Report on Form 10-K filed on March 27, 2003.The registrant has requested confidential treatment with respect to certainportions of this exhibit.

 

(k)                   Incorporated by reference to the exhibits bearing the same title filedwith registrant’s Quarterly Report on Form 10-Q filed on May 15, 2003.

 

*                          Management contract or compensatory plan orarrangement.

 

**                   Filed herewith.

 

***            Previouslyfiled with the Company’s Annual Report on Form 10-K for the year ended December 31,2004, filed on March 31, 2005.

 

3

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**SIGNATURES**

 

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

 

 
|                    | DIGITAL  GENERATION SYSTEMS, INC. |
|-------------------------|-----------------------------------|
|                    |                              |   |
| Dated: January 20, 2006 | By:                               | /s/ SCOTT K. GINSBURG |
|                    |                              | Scott K. Ginsburg  Chairman of the Board 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.

 
| **Signature**          | ** ** | **Title**                                                       | ** ** | **Date**         |
|------------------------|------------|-----------------------------------------------------------------|------------|------------------|
| /s/ SCOTT K.  GINSBURG |       | Chairman of the Board of Directors and Chief  Executive Officer |       | January 20, 2006 |
| Scott  K. Ginsburg     |       |                                                            |       |             |
|                   |       |                                                            |       |             |
| /s/ OMAR A.  CHOUCAIR  |       | Chief Financial Officer and Director                            |       | January 20, 2006 |
| Omar  A. Choucair      |       | (Principal Financial and Accounting Officer)                    |       |             |
|                   |       |                                                            |       |             |
| *                      |       | Director                                                        |       | January 20, 2006 |
| David  M. Kantor       |       |                                                            |       |             |
|                   |       |                                                            |       |             |
| *                      |       | Director                                                        |       | January 20, 2006 |
| Cappy  McGarr          |       |                                                            |       |             |
|                   |       |                                                            |       |             |
| *                      |       | Director                                                        |       | January 20, 2006 |
| Kevin  C. Howe         |       |                                                            |       |             |
|                   |       |                                                            |       |             |
| *                      |       | Director                                                        |       | January 20, 2006 |
| Anthony  J. LeVecchio  |       |                                                            |       |             |

 

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| *By:   | /s/ OMAR A. CHOUCAIR                   |   |
|--------|----------------------------------------|--------|
|   | Omar A.  Choucair, as attorney-in-fact |   |

 

4

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**DIGITALGENERATION SYSTEMS, INC. AND SUBSIDIARIESINDEX TO CONSOLIDATED FINANCIAL STATEMENTS**

 
| ** **                                                                                                        | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|------------|
| Independent  Auditors’ Report                                                                                |       |       |
| Consolidated  Balance Sheets as of December 31, 2004 and 2003                                                |       |       |
| Consolidated  Statements of Operations for the three years ended December 31, 2004                           |       |       |
| Consolidated  Statements of Stockholders’ Equity (Deficit) for the three years ended December 31,  2004 |       |       |
| Consolidated  Statements of Cash Flows for the three years ended December 31, 2004                           |       |       |
| Notes to  Consolidated Financial Statements                                                                       |       |       |

 

F-1

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**DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIESREPORT OF INDEPENDENTREGISTERED PUBLIC ACCOUNTING FIRM**

 

The Board of DirectorsDigital Generation Systems, Inc.:

 

We have audited theaccompanying consolidated balance sheets of Digital Generation Systems, Inc.and subsidiaries as of December 31, 2004 and 2003, and the relatedconsolidated statements of operations, stockholders’ equity (deficit) and cashflows for each of the years in the three-year period ended December 31,2004. In connection with our audits of the consolidated financial statements,we have also audited the related financial statement schedule. Theseconsolidated financial statements and financial statement schedule are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements and financial statement schedule basedon our audits.

 

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

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Digital Generation Systems, Inc.and subsidiaries as of December 31, 2004 and 2003, and the results oftheir operations and their cash flows for each of the years in the three-yearperiod ended December 31, 2004, in conformity with U.S. generally acceptedaccounting principles. Also in our opinion, the related financial statementschedule, when considered in relation to the basic consolidated financialstatements taken as a whole, presents fairly, in all material respects, theinformation set forth therein.

 

As discussed in Note 6 tothe consolidated financial statements, the Company changed its method ofaccounting for goodwill and other intangible assets in accordance withStatement of Financial Accounting Standards No. 142, “Goodwill and OtherIntangible Assets” in 2002.

 

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of Digital Generation Systems, Inc.’sinternal controls over financial reporting as of December 31, 2004, basedupon criteria established in Internal Control – Integrated Framework issued bythe Committee of Sponsoring Organizations of the Treadway Commission (COSO) andour report dated April 28, 2005 expressed an unqualified opinion onmanagement’s assessment of, and an adverse opinion of the effective operationsof, internal control over financial reporting as of December 31, 2004.

 

KPMG LLP

 

Dallas, Texas

February 15, 2005, except for Note 2 – stockoption plans, which is as of January 17, 2006

 

F-2

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**DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(In thousands, except per share amounts)**

 
| ** **                                                                                                                                                                               | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                               |       |                        |       |                        |       |
| CURRENT ASSETS:                                                                                                                                                                          |       |                        |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                               |       | $                           | 8,059      |                        | $          | 7,236 |   |
| Accounts  receivable (less allowance for doubtful accounts of $507 in 2004 and $588 in  2003)                                                                                            |       | 12,559                      |       | 9,288                       |       |
| Inventories                                                                                                                                                                              |       | 1,475                       |       | 2,114                       |       |
| Current deferred  income taxes                                                                                                                                                           |       | 3,396                       |       | 301                         |       |
| Other current  assets                                                                                                                                                                    |       | 987                         |       | 827                         |       |
| Total current  assets                                                                                                                                                                    |       | 26,476                      |       | 19,766                      |       |
| Property and  equipment, net                                                                                                                                                             |       | 12,453                      |       | 9,735                       |       |
| Goodwill, net                                                                                                                                                                            |       | 34,974                      |       | 48,759                      |       |
| Deferred income  taxes, net                                                                                                                                                              |       | 14,578                      |       | 4,054                       |       |
| Intangible and  other assets, net                                                                                                                                                        |       | 19,036                      |       | 10,619                      |       |
|                                                                                                                                                                                     |       |                        |       |                        |       |
| TOTAL ASSETS                                                                                                                                                                             |       | $                           | 107,517    |                        | $          | 92,933 |   |
|                                                                                                                                                                                     |       |                        |       |                        |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                           |       |                        |       |                        |       |
| CURRENT  LIABILITIES:                                                                                                                                                                    |       |                        |       |                        |       |
| Accounts payable                                                                                                                                                                         |       | $                           | 3,280      |                        | $          | 2,980 |   |
| Accrued  liabilities                                                                                                                                                                     |       | 3,718                       |       | 3,687                       |       |
| Deferred  revenue, net                                                                                                                                                                   |       | 1,965                       |       | 2,650                       |       |
| Current portion  of long-term debt and capital leases                                                                                                                                    |       | 9,656                       |       | 3,247                       |       |
| Total current  liabilities                                                                                                                                                               |       | 18,619                      |       | 12,564                      |       |
| Deferred  revenue, net                                                                                                                                                                   |       | 729                         |       | 2,495                       |       |
| Long-term debt  and capital leases, net of current portion                                                                                                                               |       | 8,737                       |       | 2,400                       |       |
| TOTAL  LIABILITIES                                                                                                                                                                       |       | 28,085                      |       | 17,459                      |       |
|                                                                                                                                                                                     |       |                        |       |                        |       |
| STOCKHOLDERS’  EQUITY:                                                                                                                                                              |       |                        |       |                        |       |
| Preferred stock,  $0.001 par value—                                                                                                                                                 |       |                        |       |                        |       |
| Authorized 15,000 shares; Issued and outstanding –  none                                                                                                                            |       | —                      |       | —                      |       |
| Common stock,  $0.001 par value—                                                                                                                                                    |       |                        |       |                        |       |
| Authorized 200,000 shares at December 31, 2004;  73,226 issued and 72,747 outstanding at December 31, 2004 and 72,118  issued and 72,095 outstanding at December 31, 2003 |       | 73                          |       | 72                          |       |
| Additional  paid-in capital                                                                                                                                                              |       | 269,232                     |       | 267,885                     |       |
| Accumulated  deficit                                                                                                                                                                     |       | (189,178                    | )          | (192,382                    | )          |
| Treasury stock,  at cost                                                                                                                                                                 |       | (695                        | )          | (101                        | )          |
| TOTAL  STOCKHOLDERS’ EQUITY                                                                                                                                                         |       | 79,432                      |       | 75,474                      |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                         |       | $                           | 107,517    |                        | $          | 92,933 |   |

 

The accompanying notes arean integral part of these financial statements.

 

F-3

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**DIGITALGENERATION SYSTEMS, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Inthousands, except per share amounts)**

 
| ** **                                                                                       | ** ** | **For years ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                       | ** ** | **2004**                              | ** ** | **2003** | ** ** | **2002** | ** ** |
| Revenues:                                                                                        |       |                                  |       |   |   |   |   |
| Audio and video  content distribution                                                            |       | $                                     | 52,970     |   | $ | 47,928 |   | $ | 53,144 |   |
| Product sales                                                                                    |       | 8,796                                 |       | 9,759 |   | 12,799 |   |
| Other                                                                                            |       | 600                                   |       | — |   | 351 |   |
| Total revenues                                                                                   |       | 62,366                                |       | 57,687 |   | 66,294 |   |
| Cost of  revenues:                                                                               |       |                                  |       |   |   |   |   |
| Audio and video  content distribution                                                            |       | 28,806                                |       | 23,870 |   | 26,336 |   |
| Product sales                                                                                    |       | 4,414                                 |       | 5,337 |   | 6,627 |   |
| Other                                                                                            |       | 135                                   |       | — |   | 365 |   |
| Total cost of  revenues                                                                          |       | 33,355                                |       | 29,207 |   | 33,328 |   |
| Operating  expenses:                                                                             |       |                                  |       |   |   |   |   |
| Sales and  marketing                                                                             |       | 4,707                                 |       | 4,499 |   | 5,005 |   |
| Research and  development                                                                        |       | 2,079                                 |       | 3,289 |   | 3,941 |   |
| General and  administrative expenses                                                             |       | 7,151                                 |       | 7,142 |   | 9,642 |   |
| Restructuring  charges                                                                           |       | —                                |       | — |   | 771 |   |
| Impairment  charges                                                                              |       | 9,131                                 |       | — |   | — |   |
| Depreciation and  amortization                                                                   |       | 5,797                                 |       | 7,897 |   | 7,390 |   |
| Total operating  expenses                                                                        |       | 28,865                                |       | 22,827 |   | 26,749 |   |
| Income from  operations                                                                          |       | $                                     | 146        |   | $ | 5,653 |   | $ | 6,217 |   |
| Other (income)  expense:                                                                         |       |                                  |       |   |   |   |   |
| Interest income  and other (income) expense, net                                                 |       | (7                                    | )          | 99 |   | (20 | ) |
| Interest expense                                                                                 |       | 1,291                                 |       | 864 |   | 1,540 |   |
| Net income  (loss) before income taxes and cumulative effect of change in accounting  principle  |       | $                                     | (1,138     | ) | $ | 4,690 |   | $ | 4,697 |   |
| Provision  (benefit) for income taxes                                                            |       | (4,342                                | )          | 491 |   | 1,848 |   |
| Net income  before cumulative effect of change in accounting principle                           |       | 3,204                                 |       | 4,199 |   | 2,849 |   |
| Cumulative  effect of change in accounting principle                                             |       | —                                |       | — |   | (130,234 | ) |
| Net income  (loss)                                                                               |       | $                                     | 3,204      |   | $ | 4,199 |   | $ | (127,385 | ) |
| Basic net income  per common share before cumulative effect of change in accounting principle    |       | $                                     | 0.04       |   | $ | 0.06 |   | $ | 0.04 |   |
| Diluted net  income per common share before cumulative effect of change in accounting  principle |       | $                                     | 0.04       |   | $ | 0.06 |   | $ | 0.04 |   |
| Basic net income  (loss) per common share                                                        |       | $                                     | 0.04       |   | $ | 0.06 |   | $ | (1.80 | ) |
| Diluted net  income (loss) per common share                                                      |       | $                                     | 0.04       |   | $ | 0.06 |   | $ | (1.80 | ) |
| Basic weighted  average common shares outstanding                                                |       | 72,768                                |       | 71,367 |   | 70,718 |   |
| Diluted weighted  average common shares outstanding                                              |       | 73,302                                |       | 74,891 |   | 70,807 |   |

 

The accompanying notesare an integral part of these financial statements.

 

F-4

----

 

**DIGITALGENERATION SYSTEMS, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)**

**(Inthousands)**

 
| ** **                                                        | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Notes  Receivable** | ** ** | **Accumulated  Deficit** | ** ** | **Total  Stockholders’  Equity  (Deficit)** | ** ** |
|-------------------------------------------------------------------|------------|---------------------|------------|------------|------------|------------|------------|------------|------------|----------------------------------|------------|-----------------------|------------|--------------------------|------------|--------------------------------------------------|------------|
| ** **                                                        | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** |
| **Common  Stock**                                                 | ** ** | **Treasury  Stock** |
| **Shares**                                                        | ** ** | **Amount**          | ** ** | **Shares** | ** ** | **Amount** |
| Balance at  December 31, 2001                                |       | 70,807              |       | $          | 72         |       | (23        | )          | $          | (101                             | )          | $                     | 266,000    |                     | $          | (93                                              | )          | $ | (69,196 | ) | $ | 196,682 |   |
|                                                              |       |                |       |       |       |       |       |       |       |                             |       |                  |       |                     |       |                                             |       |
| Exercise of stock  options                                        |       | 1                   |       | —     |       | —     |       | —     |       | —                           |       | —                |       | —                   |       | —                                           |       |
| Issuance of  common stock under employee stock purchase plan      |       | 26                  |       | —     |       | —     |       | —     |       | 21                               |       | —                |       | —                   |       | 21                                               |       |
| Note receivable  issued to employee for exercise of stock options |       | —              |       | —     |       | —     |       | —     |       | —                           |       | (105                  | )          | —                   |       | (105                                             | )          |
| Collection of  note receivable from former employee               |       | —              |       | —     |       | —     |       | —     |       | (93                              | )          | 93                    |       | —                   |       | —                                           |       |
| Net loss                                                          |       | —              |       | —     |       | —     |       | —     |       | —                           |       | —                |       | (127,385                 | )          | (127,385                                         | )          |
| Balance at  December 31, 2002                                |       | 70,834              |       | $          | 72         |       | (23        | )          | $          | (101                             | )          | $                     | 265,928    |                     | $          | (105                                             | )          | $ | (196,581 | ) | $ | 69,213 |   |
|                                                              |       |                |       |       |       |       |       |       |       |                             |       |                  |       |                     |       |                                             |       |
| Exercise of stock  options                                        |       | 1,271               |       | —     |       | —     |       | —     |       | 1,887                            |       | —                |       | —                   |       | 1,887                                            |       |
| Issuance of  common stock under employee stock purchase plan      |       | 13                  |       | —     |       | —     |       | —     |       | 15                               |       | —                |       | —                   |       | 15                                               |       |
| Tax benefits from  employee stock option plans                    |       | —              |       | —     |       | —     |       | —     |       | 55                               |       | —                |       | —                   |       | 55                                               |       |
| Repayment of  Shareholder note receivable                         |       | —              |       | —     |       | —     |       | —     |       | —                           |       | 105                   |       | —                   |       | 105                                              |       |
| Net income                                                        |       | —              |       | —     |       | —     |       | —     |       | —                           |       | —                |       | 4,199                    |       | 4,199                                            |       |
| Balance at  December 31, 2003                                |       | 72,118              |       | $          | 72         |       | (23        | )          | $          | (101                             | )          | $                     | 267,885    |                     | $          | —                                           |       | $ | (192,382 | ) | $ | 75,474 |   |
|                                                              |       |                |       |       |       |       |       |       |       |                             |       |                  |       |                     |       |                                             |       |
| Exercise of stock  options                                        |       | 1,090               |       | 1          |       | —     |       | —     |       | 1,253                            |       | —                |       | —                   |       | 1,254                                            |       |
| Issuance of  common stock under employee stock purchase plan      |       | 18                  |       | —     |       | —     |       | —     |       | 19                               |       | —                |       | —                   |       | 19                                               |       |
| Tax benefits from  employee stock option plans                    |       | —              |       | —     |       | —     |       | —     |       | 75                               |       | —                |       | —                   |       | 75                                               |       |
| Repurchase of  common stock                                       |       | —              |       | —     |       | (456       | )          | (594       | )          | —                           |       | —                |       | —                   |       | (594                                             | )          |
| Net income                                                        |       | —              |       | —     |       | —     |       | —     |       | —                           |       | —                |       | 3,204                    |       | 3,204                                            |       |
| Balance at  December 31, 2004                                |       | 73,226              |       | $          | 73         |       | (479       | )          | $          | (695                             | )          | $                     | 269,232    |                     | $          | —                                           |       | $ | (189,178 | ) | $ | 79,432 |   |

 

The accompanying notesare an integral part of these financial statements.

 

F-5

----

 

**DIGITALGENERATION SYSTEMS, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Inthousands)**

 
| ** **                                                                                | ** ** | **Years ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2002** | ** ** |
| Cash flows from  operating activities:                                                    |       |                              |       |   |   |   |   |
| Net income  (loss)                                                                        |       | $                                 | 3,204      |   | $ | 4,199 |   | $ | (127,385 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |       |                              |       |   |   |   |   |
| Depreciation of  property and equipment                                                   |       | 3,864                             |       | 4,104 |   | 5,312 |   |
| Amortization of  goodwill and other intangibles                                           |       | 1,933                             |       | 3,793 |   | 2,078 |   |
| Impairment of  fixed assets                                                               |       | 1,048                             |       | — |   | — |   |
| Impairment of  goodwill                                                                   |       | 8,083                             |       | — |   | 130,234 |   |
| Deferred income  taxes                                                                    |       | (4,678                            | )          | 193 |   | 791 |   |
| Tax benefits  from employee stock options                                                 |       | 75                                |       | 55 |   | — |   |
| Provision for  doubtful accounts                                                          |       | 275                               |       | 73 |   | 715 |   |
| Changes in  operating assets and liabilities, net of working capital from acquisitions:   |       |                              |       |   |   |   |   |
| Accounts  receivable                                                                      |       | 1,051                             |       | 3,691 |   | 88 |   |
| Other assets                                                                              |       | (380                              | )          | (1,332 | ) | (853 | ) |
| Accounts payable  and accrued liabilities                                                 |       | (568                              | )          | (2,641 | ) | (201 | ) |
| Deferred  revenue, net                                                                    |       | (2,537                            | )          | (3,283 | ) | (3,284 | ) |
| Net cash  provided by operating activities                                                |       | 11,370                            |       | 8,852 |   | 7,495 |   |
|                                                                                      |       |                              |       |   |   |   |   |
| Cash flows from  investing activities:                                                    |       |                              |       |   |   |   |   |
| Purchases of  property and equipment                                                      |       | (3,342                            | )          | (1,082 | ) | (723 | ) |
| Acquisitions,  net of cash acquired                                                       |       | (18,251                           | )          | — |   | — |   |
| Net cash used in  investing activities                                                    |       | (21,593                           | )          | (1,082 | ) | (723 | ) |
|                                                                                      |       |                              |       |   |   |   |   |
| Cash flows from  financing activities:                                                    |       |                              |       |   |   |   |   |
| Proceeds from  issuance of common stock                                                   |       | 1,273                             |       | 1,902 |   | 21 |   |
| Purchases of  treasury stock                                                              |       | (594                              | )          | — |   | — |   |
| (Issuance)  payment of shareholder note receivable                                        |       | —                            |       | 105 |   | (105 | ) |
| Payments to  secure financing                                                             |       | (78                               | )          | (698 | ) | (112 | ) |
| Borrowings under  long-term debt                                                          |       | 16,500                            |       | 9,000 |   | 6,500 |   |
| Payments on  long-term debt                                                               |       | (6,055                            | )          | (13,370 | ) | (13,273 | ) |
| Net cash  provided by (used in) financing activities                                      |       | 11,046                            |       | (3,061 | ) | (6,969 | ) |
| Net increase  (decrease) in cash and cash equivalents                                     |       | 823                               |       | 4,709 |   | (197 | ) |
| Cash and cash  equivalents at beginning of year                                           |       | 7,236                             |       | 2,527 |   | 2,724 |   |
| Cash and cash  equivalents at end of year                                                 |       | $                                 | 8,059      |   | $ | 7,236 |   | $ | 2,527 |   |
| Cash paid for  interest                                                                   |       | $                                 | 991        |   | $ | 465 |   | $ | 1,181 |   |
| Cash paid for  income taxes                                                               |       | $                                 | 183        |   | $ | 73 |   | $ | — |   |
| Noncash  financing activities:                                                            |       |                              |       |   |   |   |   |
| Vendor financed  acquisition of software                                                  |       | $                                 | 1,544      |   | $ | — |   | $ | — |   |
| Equipment  purchased under capital lease                                                  |       | $                                 | 757        |   | $ | — |   | $ | — |   |

 

The accompanying notesare an integral part of these financial statements.

 

F-6

----

 

**DIGITALGENERATION SYSTEMS, INC. AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**1. The Company:**

 

Digital Generations Systems, Inc.(the “Company”) owns a nationwide digital network that beneficially links morethan 5,000 advertisers and advertising agencies with more than 10,000 radiostations and over 3,100 broadcast and cable television destinations across theUnited States and Canada. The Company also owns proprietary digital software,hardware and communications technology, including various bandwidth satellitereceivers, audio compression codes, software to operate integrated digitalmultimedia networks, software development for satellite applications andengineering consulting services. The Company has a Network Operation Centerlocated in Irving, Texas that delivers audio, video, image and data contentthat comprise transactions between the advertising and broadcast industries.

 

Certain prior year amountshave been reclassified to conform to current year presentations.

 

**2. Summary of SignificantAccounting Policies:**

 

**Consolidation**

 

The consolidated financialstatements include the accounts of the Company and its subsidiaries. Allsignificant intercompany balances and transactions have been eliminated inconsolidation.

 

**Cash and Cash Equivalents**

 

Cash and cash equivalentsconsist of liquid investments with original maturities of three months or less.The Company maintains substantially all of its cash and cash equivalents withina few major financial institutions in the United States. As of December 31,2004 and 2003, cash equivalents consisted primarily of investments in U.S.money market funds.

 

**Allowance for Doubtful Accounts**

 

The Company maintains anallowance for doubtful accounts related to trade accounts receivable. Theallowance is an estimate prepared by management based on identification of thecollectibility of specific accounts and the overall condition of the receivableportfolio. The Company specifically analyzes trade receivables, historical baddebts, customer credits, customer concentrations, customer credit-worthiness,current economic trends and changes in customer payment terms when evaluatingthe adequacy of the allowance for doubtful accounts.

 

**Inventories**

 

Inventories are stated atthe lower of cost (determined on a first-in, first-out basis) or market. TheCompany’s inventories include parts and components that are specialized innature or subject to rapid technological obsolescence. While the Company hasprograms to minimize the required inventories on hand and considerstechnological obsolescence when estimating allowances required to reducerecorded amounts to market values, such estimates could change in the future.

 

**Property and Equipment**

 

Property and equipment arestated at cost. Depreciation is computed over the estimated useful lives ofassets using the straight-line method. Equipment held under capital leases andleasehold improvements are amortized straight-line over the shorter of thelease term or estimated useful life of the asset. Estimated useful lives generallyrange from 2 to 7 years for network equipment, 3 to 5 years for officeequipment and furniture and 3 to 6 years for leasehold improvements.

 

**Impairment of Long-Lived Assets**

 

Long-lived assets arereviewed for impairment whenever events or changes in circumstances indicatethat the carrying value of assets may not be recoverable. Recoverability ofassets to be held and used is measured by a comparison of the carrying amountof an asset to future net cash flows expected to be generated by the asset. Ifsuch assets are considered to be impaired, the impairment to be recognized ismeasured by the amount by which the carrying amount of the assets exceeds thefair value of the assets. Assets to be disposed of are reported at the lower ofthe carrying amount or fair value less costs to sell.

 

F-7

----

 

**Goodwill**

 

Goodwill, which representsthe excess of purchase price over the fair value of net identifiable assetsacquired, is assessed annually for recoverability based on its estimated fairvalue.

 

**Intellectual Property Rights**

 

Acquired intellectualproperty rights, which include patents, copyrights, trademarks, know-how andcertain other intangible assets, are recorded as other long-term assets at costand amortized over estimated useful lives ranging from five to seven yearsusing the straight-line method.

 

**Use of Estimates**

 

The preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States of America requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period. Onan ongoing basis, the Company evaluates its estimates, including those relatedto the allowance for doubtful accounts, inventories, intangible assets andincome taxes. The Company bases its estimates on historical experience and on otherrelevant assumptions that are believed to be reasonable under thecircumstances, the results of which form the basis for making judgments aboutthe carrying values of assets and liabilities that are not readily apparentfrom other sources. Actual results could differ from those estimates.

 

**Revenue Recognition**

 

The Company’s servicesrevenue from digital distribution of audio and video advertising content isbilled based on a rate per transmission, and the Company recognizes revenue forthese services upon notification of successful transmission of the content atthe broadcast destination. Revenue for distribution of analog audio and videocontent by tape is recognized when delivery has occurred, which is at the timethe tapes are delivered to a common carrier.

 

The Company recognizesproduct revenue when persuasive evidence of an arrangement exists, delivery hasoccurred, the sales price is fixed and determinable and collectibility isprobable. Generally for product sales, these criteria are met at the time ofdelivery to a common carrier. Provision is made at the time the related revenueis recognized for estimated product returns, which historically have beenimmaterial. The Company analyzes historical returns, current economic trends,and changes in customer demand when evaluating the adequacy of provisions forsales returns. At the time of the transaction, the Company assesses whether thefee associated with revenue transactions is fixed and determinable and whetheror not collection is reasonably assured. The Company assesses whether the feeis fixed and determinable based on the payment terms associated with thetransaction. The Company assesses collectibility based on a number of factors,including past transaction history with the customer and the credit-worthinessof the customer. The Company does not request collateral from customers. Forall sales, the Company uses either a binding purchase order or signed salesagreement as evidence of an arrangement. Shipping and handling revenues areincluded in product revenues and costs are included in product costs. Revenuefrom arrangements for the sale of products that include software componentsthat are more than incidental to the functionality of the related product areaccounted for under AICPA Statement of Position 97-2, “Software RevenueRecognition” (“SOP 97-2”). SOP 97-2 requires that when a product is sold thatcontains a significant software component, and the Company has no objectivethird party evidence as to the relative fair values of each of the componentssold, the total sales value should be deferred and recognized on a straightline basis over the life of the arrangement as documented in the salesagreement.

 

**Research and Development andSoftware Development Costs**

 

Research and development andother costs incurred to establish the technological feasibility of a softwareproduct to be sold are expensed as incurred. Costs of producing product mastersincurred subsequent to establishing technological feasibility are capitalized.Capitalized software development costs are amortized on a product-by-productbasis over the estimated economic life of the product (generally 3-5 years).Amortization is computed by using either the ratio that current gross revenuesfor a product bear to the total of current and anticipated gross revenues forthat product or the straight-line method, whichever results in a greater annualamortization.

 

Research and development andother costs incurred for the creation of internal use software are capitalizedwhen the preliminary project stage is completed and only costs incurred duringthe application development stage are capitalized. Upon completion of theproject, amortization is initiated and capitalized software development costsare amortized over their estimated useful lives, generally expected to be 3years.

 

F-8

----

 

**Income Taxes**

 

Income taxes are accountedfor under the asset and liability method. Deferred tax assets and liabilitiesare recognized for the future tax consequences attributable to differencesbetween financial statement carrying amounts of existing assets and liabilitiesand their respective tax basis and operating loss and tax credit carryforwards.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. The effect on deferred taxassets and liabilities of a change in tax rates is recognized in income in theperiod that includes the enactment date.

 

**Foreign Currencies**

 

The Company providesservices to certain entities located outside of the United States of America.The Company had no gains (losses) on foreign currency transactions during 2004but had gains (losses) on foreign currency transactions totaling $6 and $(3) forthe years ended December 31, 2003 and 2002, respectively. Gains (losses)on foreign currency transactions are included in interest and other (income)expense in the consolidated statements of operations.

 

**Stock Option Plans**

** **

The Company applies theintrinsic value-based method of accounting prescribed by Accounting PrinciplesBoard (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,”and related interpretations, in accounting for its fixed plan stock options. Assuch, compensation expense would be recorded on the date of grant only if thecurrent market price of the underlying stock exceeded the exercise price.Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting forStock-Based Compensation,” established accounting and disclosure requirementsusing a fair value-based method of accounting for stock-based employeecompensation plans. As allowed by SFAS No. 123, the Company has elected tocontinue to apply the intrinsic value-based method of accounting describedabove, and has adopted the disclosure requirements of SFAS No. 123. Proforma net income and earnings per share disclosures, as if the Company recordedcompensation expense based on the fair value for stock-based awards, have beenpresented in accordance with the provisions of SFAS No. 148, “Accountingfor Stock-based Compensation—Transition and Disclosure,” and are asfollows for the three years ended December 31, 2004, 2003 and 2002 (inthousands, except per share amounts).

 
| ** **                                                                                                                                 | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                 | ** ** | **2004**              | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                                                                 | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income  (loss):                                                                                                                        |       |                  |       |   |   |   |   |
| As reported                                                                                                                                |       | $                     | 3,204      |   | $ | 4,199 |   | $ | (127,385 | ) |
| Total  stock-based employee compensation expense determined under fair  value-based method for all awards, net of related tax effects |       | (2,999                | )          | (552 | ) | (1,456 | ) |
| Pro forma                                                                                                                                  |       | $                     | 205        |   | $ | 3,647 |   | $ | (128,841 | ) |
| Basic earnings  per share of common stock:                                                                                                 |       |                  |       |   |   |   |   |
| As reported                                                                                                                                |       | $                     | 0.04       |   | $ | 0.06 |   | $ | (1.80 | ) |
| Pro forma                                                                                                                                  |       | $                     | 0.00       |   | $ | 0.05 |   | $ | (1.82 | ) |
| Diluted earnings  per share of common stock:                                                                                               |       |                  |       |   |   |   |   |
| As reported                                                                                                                                |       | $                     | 0.04       |   | $ | 0.06 |   | $ | (1.80 | ) |
| Pro forma                                                                                                                                  |       | $                     | 0.00       |   | $ | 0.05 |   | $ | (1.82 | ) |

 

The fair value of eachoption grant is estimated on the date of grant using the multiple optionapproach of the Black-Scholes option pricing model with the followingassumptions used for grants for the years ended December 31, 2004, 2003and 2002, respectively: risk-free interest rates of 3.5%, 2.9% and 4.1%; adividend yield of 0%; expected terms of 3.2, 3.5 and 3.1 years; and volatilityfactors of the expected market price of the Company’s common stock of 62%, 71%,71%, 77% and 100%.

 

OnJanuary 17, 2006, the Company amended the total stock-based employeecompensation expense determined under fair value-based method for all awards,net of related tax effects, pro forma net income, and pro forma basic anddiluted earnings per share of common stock for the year ended December 31, 2004to reflect the fair value of the modification of certain warrants during 2004.

 

InDecember 2004, the Financial Accounting Standards Board (the “FASB”)issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”).SFAS 123(R) requires all share-based payments to employees, includinggrants of employee stock options, to be recognized in the financial statementsbased on their fair values. Under SFAS 123(R), the Company will recognizecompensation expense for the portion of outstanding awards for which therequisite service has not yet been rendered, based on the grant-date fair valueof those awards calculated under SFAS 123 for pro forma disclosures.SFAS 123(R) is effective for the Company beginning in fiscal year 2006.The Company has not completed its evaluation of the impact of SFAS123(R) on its financial statements.

 

F-9

----

 

**Financial Instruments andConcentration of Credit Risk**

 

Financialinstruments that potentially subject the Company to a concentration of creditrisk consist primarily of cash and cash equivalents and accounts receivable.The Company performs ongoing credit evaluations of its customers, generallydoes not require collateral from its customers and maintains a reserve forpotential credit losses. The Company believes that a concentration of creditrisk with respect to accounts receivable related to audio and video contentdistribution (the primary source of revenues and related accounts receivable)is limited because its customers are geographically dispersed and the end users(the customers’ clients) are diversified across industries. The Company’sreceivables are principally from advertising agencies, dub and ship houses, andsyndicated programmers. The Company’s revenues are not contingent on itscustomers’ sales or collections. However, the timing of collections from itscustomers is affected by the billing cycle in which the customer bills itsend-users (the customers’ clients). The Company provides reserves for creditlosses.

 

The carrying values ofaccounts receivable and accounts payable approximate fair value due to theirshort maturities. The carrying value of long-term debt approximates fair valuedue to the variable rate of interest.

 

During the years ended December 31,2004 and December 31, 2003, the Company had no customers that accountedfor more than 10% of the Company’s total revenue. During the year ended December 31,2002, the Company had one customer, BBDO, that accounted for $7.8 million (12%)of its revenue.

 

**3. Acquisitions:**

 

*Source TV*

 

Effective August 31,2004, the Company completed the acquisition of certain assets and assumedcertain liabilities of Maythenyi, Inc., which was the operator of SourceTV (“Source”). Accordingly, the results of Source’s operations have beenincluded in the consolidated financial statements since that date. Source is aFlorida-based provider of a complete online resource and searchable database ofover 350,000 television commercials, both on a subscription and per-transactionbasis. The Company acquired the assets for $3.8 million in cash, of which $3.7million was allocated to the on-line resource and database and is beingamortized over the estimated useful life of 10 years.

 

*AGTBroadcast*

 

Effective June 1, 2004,the Company purchased substantially all of the net assets and assumed certainliabilities of the Broadcast Division (“Broadcast”) of Applied GraphicsTechnologies, Inc. (“AGT”). Accordingly, the results of Broadcast’soperations have been included in the consolidated financial statements sincethat date. Based in New York, Broadcast’s core services are the distribution ofprogram and/or advertising content to television and radio stations throughoutthe country utilizing conventional and electronic duplication technology.Broadcast currently distributes content to radio stations and televisiondestinations across the United States and maintains operations in California,Michigan, New York and Ohio.

 

The Company paid $15.0million in cash to AGT as consideration for the assets of Broadcast. Thepurchase price also included $0.4 million in receivables due from Broadcast tothe Company which were forgiven as a result of the acquisition. The cashpayment was comprised of $1.0 million of the Company’s cash reserves and $14.0million borrowed under the Company’s long-term credit agreement. According tothe terms of the Asset Purchase Agreement (the “Agreement”), the purchase pricewas later reduced by $0.9 million as a result of a working capital adjustment,as defined by the Agreement. The net purchase price was allocated based on thecurrent estimated fair values of the assets acquired and liabilities assumed atthe date of acquisition. Subsequent to the acquisition date, the Companyobtained a third-party valuation of certain intangible assets of Broadcast and,accordingly, allocated the purchase price to those assets. The remaining excessof the purchase price over the net assets acquired was allocated to Goodwill.Goodwill created as a result of the acquisition totaled $3.3 million.

 

The following tablesummarizes the estimated fair values of the assets acquired and the liabilitiesassumed at the date of the acquisition for Source. The table also summarizesthe fair values of the assets acquired and liabilities assumed of Broadcastadjusted to incorporate the results of a third party valuation analysis. TheCompany does not anticipate any further modifications to the purchase priceallocation for Broadcast. The purchase price allocation for Source has not yetbeen completed. The Company is still gathering data that will be used to refineits initial valuation of the identifiable intangible assets. The purchase priceallocations for the acquisitions are as follows (in thousands):

 
| ** **                     | ** ** | **Source** | ** ** | **Broadcast** | ** ** |
|--------------------------------|------------|------------|------------|---------------|------------|
| Current assets                 |       | $          | 150        |          | $          | 5,196 |   |
| Property, plant and equipment  |       | 19         |       | 1,967         |       |
| Other non-current assets       |       | —     |       | 26            |       |
| Identifiable intangible assets |       | 3,786      |       | 5,420         |       |
| Goodwill                       |       | —     |       | 3,269         |       |
| Total assets  acquired         |       | $          | 3,955      |          | $          | 15,878 |   |
| Current liabilities            |       | 182        |       | 926           |       |
| Net assets  acquired           |       | $          | 3,773      |          | $          | 14,952 |   |

 

F-10

----

 

The excess of the purchaseprice over the tangible net assets related to the Source acquisition wasallocated in its entirety to the On-line resource and database (the “Database”).The Database is being amortized over its ten year estimated useful life. Theexcess of the purchase price over the net tangible assets related to Broadcasttotaled $8.7 million. Of this amount, $5.1 million was allocated to thecustomer list, which is being amortized over 10 years, $0.2 million wasallocated to acquired technology which is being amortized over 1 year and $0.2million was allocated to trademarks which is being amortized over 3 years. Theremaining excess, $3.3 million was allocated to Goodwill, all of which isexpected to be deductible for tax purposes.

 

The following unaudited proforma information details the results of operations as if the acquisitions ofSource and Broadcast had taken place on January 1, 2003 and 2004 (inthousands, except per share amounts):

 
| ** **                                 | ** ** | **Year ended  December 31,** | ** ** |
|--------------------------------------------|------------|-----------------------------------|------------|
| ** **                                 | ** ** | **2004**                          | ** ** | **2003** | ** ** |
| Revenue                                    |       | $                                 | 71,387     |   | $ | 78,827 |   |
| Income from Operations                     |       | 1,779                             |       | 9,279 |   |
| Net income                                 |       | $                                 | 4,011      |   | $ | 5,923 |   |
| Basic earnings per share of common stock   |       | $                                 | 0.06       |   | $ | 0.08 |   |
| Diluted earnings per share of common stock |       | $                                 | 0.05       |   | $ | 0.08 |   |

 

**4. Inventories:**

 

Inventories as of December 31,2004 and 2003 are summarized as follows (in thousands):

 
| ** **        | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------|------------|----------|------------|----------|------------|
| Raw materials     |       | $        | 623        |     | $          | 697 |   |
| Work-in-process   |       | 479      |       | 631      |       |
| Finished goods    |       | 373      |       | 786      |       |
| Total inventories |       | $        | 1,475      |     | $          | 2,114 |   |

 

**5. Property and Equipment:**

 

Property and equipment as ofDecember 31, 2004 and 2003 are summarized as follows (in thousands):

 
| ** **                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|
| Network equipment                              |       | $        | 22,944     |     | $          | 18,624 |   |
| Office furniture and equipment                 |       | 7,524    |       | 5,829    |       |
| Leasehold improvements                         |       | 947      |       | 665      |       |
|                                           |       | 31,415   |       | 25,118   |       |
| Less accumulated depreciation and amortization |       | (18,962  | )          | (15,383  | )          |
|                                           |       | $        | 12,453     |     | $          | 9,735 |   |

 

The Company upgraded itsdistribution network during 2004 and, as a result, removed certain oldernetwork assets from service. In accordance with Statement of FinancialAccounting Standards Number 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets” (“SFAS 144”), at December 31, 2004, the Companyrecorded an impairment charge of $1.0 million related to these assets. The fairvalue of the assets removed from service was determined based on their carryingvalue.

 

F-11

----

 

**6. Intangible and Other Assets:**

 

Other assets as of December 31,2004 and 2003 are summarized as follows (in thousands):

 
| ** **                      | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
| Brand name                      |       | $        | 8,804      |     | $          | 8,804 |   |
| Customer  relationships         |       | 5,420    |       | 3,044    |       |
| On-line Resource  and Database  |       | 3,786    |       | —   |       |
| Software  development costs     |       | 6,029    |       | 5,120    |       |
| Other assets                    |       | 983      |       | 1,323    |       |
|                            |       | 25,022   |       | 18,291   |       |
| Less:  accumulated amortization |       | (5,986   | )          | (7,672   | )          |
|                            |       | $        | 19,036     |     | $          | 10,619 |   |

 

During July 2003, the Companysettled an outstanding patent case and, based on the settlement, amortized allfees related to the case. As a result of the settlement, the Company recordedapproximately $1.5 million in amortization expense during the year ended December 31,2003 related to the settlement.

 

In June 2001, the FASBissued SFAS No. 142. This accounting standard addresses financialaccounting and reporting for goodwill and other intangible assets and requiresthat goodwill amortization be discontinued and replaced with periodic tests ofimpairment. A two-step impairment test is used to first identify potentialgoodwill impairment and then measure the amount of goodwill impairment loss, ifany.

 

In accordance with SFAS No. 142,goodwill amortization was discontinued as of January 1, 2002. The Companyhas identified two reporting units, as defined in SFAS No. 142, withgoodwill, an Audio and Video Content Distribution unit and a Product Salesunit. Upon initial adoption of SFAS No. 142, the Company recorded goodwillimpairment of $130.2 million in the Audio and Video Content Distribution unit,or $1.84 per diluted share, as a cumulative effect of change in accountingprinciple in the first quarter of 2002. The assessment was performed primarilydue to changes in the economy and the decline in our stock price since thevaluation date of the shares issued in the DG/StarGuide merger.

 

As part of the Company’sannual assessment of goodwill impairment required by SFAS No. 142, at December 31,2004, the Company recorded an impairment charge of $8.1 million related to itsProduct Sales reporting unit. The fair value of the Product Sales reportingunit was determined by estimating the present value of future cash flowsexpected to be generating by the reporting unit.

 

Goodwill totaled $35.0million at December 31, 2004 and $48.8 million at December 31, 2003.The changes in the carrying value of goodwill by segment for the twelve monthsended December 31, 2004 are as follows (in thousands):

 
| ** **                                               | ** ** | **Segment**                                              | ** ** |
|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                               | ** ** | **Audio and Video  Content Distribution** | ** ** | **Product Sales** | ** ** | **Total** | ** ** |
| Balance at  December 31, 2002                       |       | 42,818                                                   |       | 10,488 |   | 53,306 |   |
| Reversal of  deferred tax valuation allowance            |       | (4,547                                                   | )          | — |   | (4,547 | ) |
| Balance at  December 31, 2003                       |       | 38,271                                                   |       | 10,488 |   | 48,759 |   |
| Reversal of  deferred tax valuation allowance            |       | (8,971                                                   | )          | — |   | (8,971 | ) |
| Impairment loss                                          |       | —                                                   |       | (8,083 | ) | (8,083 | ) |
| Goodwill created  by acquisition of Broadcast subsidiary |       | 3,269                                                    |       | — |   | 3,269 |   |
| Balance at  December 31, 2004                       |       | $                                                        | 32,569     |   | $ | 2,405 |   | $ | 34,974 |   |
|                                                          |            |                                                          |            |  |  |  |  |  |  |  |

 

F-12

----

 

Identifiable intangibleassets as of December 31, 2004 and December 31, 2003 are as follows(in thousands):

 
| ** **                     | ** ** | **Amortization  Period** | ** ** | **Gross  Intangible  Assets** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Intangible  Assets** | ** ** |
|--------------------------------|------------|--------------------------|------------|-------------------------------|------------|-------------------------------|------------|-----------------------------|------------|
| **December 31,  2004**    |       |                     |       |                          |       |                          |       |                        |       |
| Customer  relationships        |       | 10 years            |       | $                             | 5,420      |                          | $          | (257                        | )          | $ | 5,163 |   |
| Brand name                     |       | 20 years                 |       | 8,804                         |       | (1,761                        | )          | 7,043                       |       |
| On-line resource  and database |       | 10 years                 |       | 3,786                         |       | (122                          | )          | 3,664                       |       |
|                           |       |                     |       | $                             | 18,010     |                          | $          | (2,140                      | )          | $ | 15,870 |   |
| **December 31,  2003**    |       |                     |       |                          |       |                          |       |                        |       |
| Customer relationships         |       | 3 years                  |       | $                             | 3,044      |                          | $          | (3,044                      | )          | $ | — |   |
| Brand name                     |       | 20 years                 |       | 8,804                         |       | (1,321                        | )          | 7,483                       |       |
|                           |       |                     |       | $                             | 11,848     |                          | $          | (4,365                      | )          | $ | 7,483 |   |

 

F-13

----

 

In accordance with SFAS No. 142,the net book value of the Company’s employee workforce was subsumed intogoodwill on January 1, 2002, thus amortization of this asset wasdiscontinued.

 

Amortization expense relatedto intangible assets totaled $1.9 million, $3.8 million and $1.5 million duringthe years ended December 31, 2004, 2003 and 2002, respectively. Theestimated aggregate future amortization expense for intangible assets remainingas of December 31, 2004 is as follows (in thousands):

 

| 2005       |   | $     | 2,153  |   |
|------------|--------|-------|--------|--------|
| 2006       |   | 2,094 |   |
| 2007       |   | 1,857 |   |
| 2008       |   | 1,744 |   |
| 2009       |   | 1,333 |   |
| Thereafter |   | 8,882 |   |
|       |   | $     | 18,063 |   |

 

**7. Accrued Liabilities:**

 

Accrued liabilities consistof the following (in thousands):

 
| ** **               | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
| Telecommunications costs |       | $        | 120        |     | $          | 112 |   |
| Employee compensation    |       | 498      |       | 701      |       |
| Merger liabilities       |       | 1,020    |       | 1,020    |       |
| Property tax liabilities |       | 374      |       | 428      |       |
| Lease obligations        |       | 19       |       | 151      |       |
| Other                    |       | 1,687    |       | 1,275    |       |
|                     |       | $        | 3,718      |     | $          | 3,687 |   |

 

**8. Deferred Revenue, net:**

 

During 1999, the Companyentered into contracts with two major radio broadcasting companies to produceand supply the Company’s receivers, hubs and other items. The terms of thecontracts are five and seven years and cover the related equipment andsoftware, future software enhancements, technical support, development work andtraining. As the equipment to be sold under the contracts includes softwarecomponents that are more than incidental to the functionality of the equipment,the entire arrangement has been accounted for under SOP 97-2, “Software RevenueRecognition.” Cash received related to these contracts is recorded as deferredrevenue, with revenue and cost of revenue being recognized on a straight-linebasis over the respective contract terms.

 

Revenues and cost ofrevenues under these two contracts were (in thousands) $4,074 and $1,424,respectively during 2004 and $5,109 and $1,826, respectively during 2003 and$5,109 and $1,826, respectively, during 2002.

 

The components of deferredrevenue at December 31, 2004 and 2003 are as follows (in thousands):

 
| ** **               | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
| Deferred revenue         |       | $        | 3,919      |     | $          | 7,794 |   |
| Deferred cost of revenue |       | (1,225   | )          | (2,649   | )          |
|                     |       | 2,694    |       | 5,145    |       |
| Less current portion     |       | (1,965   | )          | (2,650   | )          |
|                     |       | $        | 729        |     | $          | 2,495 |   |

 

F-14

----

 

**9. Long-Term Debt:**

 

Long-term debt as of December 31,2004 is summarized as follows (in thousands):

 
| Term loan                 |   |   |   | $      | 8,900  |   |
|---------------------------|--------|--------|--------|--------|--------|--------|
| Revolving credit facility |   |   |   | 7,250  |   |
| Capital lease obligations |   |   |   | 2,243  |   |
|                      |   |   |   | 18,393 |   |
| Less current portion      |   |   |   | (9,656 | )      |
|                      |   |   |   | $      | 8,737  |   |

 

The Company entered into theoriginal long-term credit agreement on May 5, 2003 and the Company amendedthe long-term credit agreement twice with its current lender during 2004. Thetwo amendments provided for additional term loans, the proceeds of which theCompany used to fund, in part, the acquisitions of Broadcast and Source. The TermB Loan was created as a result of the first amendment on June 10, 2004 andtotaled $6.0 million; this loan, along with the previously outstanding Term ALoan, matures September 30, 2005. The Term C Loan was created as a resultof the second amendment on August 31, 2004 and totaled $2.5 million; theTerm C Loan matures December 31, 2005. At December 31, 2004, theCompany had $2.4 million, $4.5 million and $2.0 million outstanding pursuant tothe Term A Loan, the Term B Loan and the Term C Loan, respectively. Oncerepaid, no amounts may be re-borrowed under any of the three outstanding termloan facilities.

 

The long-term creditagreement also provides for a revolving credit facility with a borrowing basesubject to the Company’s eligible accounts receivable balance up to $23.5million. At December 31, 2004, the Company had $7.3 million outstandingunder the revolving credit facility and approximately $1.4 million wasavailable for borrowing. The revolving facility matures on May 5, 2006.

 

The long-term creditagreement is secured by substantially all of the assets of the Company. Underthe long-term credit agreement, the Company is required to maintain certainfixed charge coverage ratios, certain leverage ratios and current ratios on aquarterly basis and is subject to limitations on capital expenditures for arolling six-month period as well as limitations on capital lease borrowings onan annual basis. The Company was in compliance with these covenants for theperiod ended December 31, 2004. The Company pays interest on borrowings ata variable rate based on the lender’s Prime Rate or LIBOR, plus an applicablemargin. The applicable margin fluctuates based on the Company’s leverage ratiosas defined in the long-term credit agreement. At December 31, 2004, theweighted average interest rate on outstanding borrowings was 5.81%. The creditfacility requires the Company to pay a quarterly facility fee of 0.50% of theaverage unused portion of the revolving line of credit and a commission fee onoutstanding letters of credit. There were no outstanding letters of credit at December 31,2004.

 

The following table detailsfuture debt repayments under the Company’s credit facility (in thousands):

 
| 2005   |   | $     | 8,900  |   |
|--------|--------|-------|--------|--------|
| 2006   |   | 7,250 |   |
|   |   | $     | 16,150 |   |

 

**10. Income Taxes:**

 

Components of deferred taxassets at December 31, 2004 and 2003 are as follows (in thousands):

 
| ** **                                         | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred Tax  Assets                               |       |     |       |     |       |
| Net operating  loss carryforwards                  |       | $        | 20,826     |     | $          | 22,753 |   |
| Current  temporary differences                     |       | 519      |       | 879      |       |
| Other                                              |       | 1,116    |       | 764      |       |
| Total gross  deferred tax assets                   |       | 22,461   |       | 24,396   |       |
| Less valuation  allowance                          |       | —   |       | (15,694  | )          |
| Net deferred tax  assets after valuation allowance |       | $        | 22,461     |     | $          | 8,702 |   |
| Deferred Tax  Liabilities                          |       |     |       |     |       |
| Non-deductible  intangibles and fixed asset basis  |       | (4,487   | )          | (4,347   | )          |
| Net deferred tax  assets                           |       | $        | 17,974     |     | $          | 4,355 |   |

 

F-15

----

 

Components of the provisionfor income taxes are as follows (in thousands):

 

| ** **          | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------|------------|----------|------------|----------|------------|----------|------------|
| Current             |       |     |       |     |       |     |       |
| US  Federal         |       | $        | 176        |     | $          | 136      |       | $ | — |   |
| State               |       | 85       |       | 107      |       | —   |       |
|                |       | 261      |       | 243      |       | —   |       |
| Deferred            |       |     |       |     |       |     |       |
| US  Federal         |       | 1,950    |       | 1562     |       | 1,597    |       |
| State               |       | 170      |       | 92       |       | 251      |       |
|                |       | 2,120    |       | 1,654    |       | 1,848    |       |
|                |       |     |       |     |       |     |       |
| Valuation allowance |       | (6,723   | )          | (1,406   | )          | —   |       |
|                |       | $        | (4,342     | )        | $          | 491      |       | $ | 1,848 |   |

 

Income tax expense (benefit)differs from the amounts that would result from applying the federal statutoryrate of 34% to the Company’s net income (loss) before income taxes andcumulative effect of change in accounting principle as follows (in thousands):

 

| ** **                                                                     | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected  tax expense (benefit)                                                |       | $        | (387       | )        | $          | 1,595    |       | $ | 1,597 |   |
| State  income taxes, net of federal benefit                                    |       | 227      |       | 239      |       | 251      |       |
| Alternative  minimum taxes                                                     |       | —   |       | 136      |       | —   |       |
| Other                                                                          |       | (207     | )          | (73      | )          | —   |       |
| Non-deductible  goodwill impairment                                            |       | 2,748    |       | —   |       | —   |       |
| Utilization  of acquired deferred tax assets recorded as reduction to goodwill |       | 8,971    |       | 4,547    |       | 791      |       |
| Valuation  allowance                                                           |       | (15,694  | )          | (5,953   | )          | (791     | )          |
|                                                                           |       | $        | (4,342     | )        | $          | 491      |       | $ | 1,848 |   |

 

The net operating loss (NOL)carryforwards of approximately $58.0 million will expire on various datesranging from 2016 to 2020. Utilization of approximately $29.7million of these carryforwardswill be limited on an annual basis as a result of the merger, pursuant to Section 382of the Internal Revenue Code.

 

Generally acceptedaccounting principles require the Company to record a valuation allowanceagainst its deferred tax assets if it is “more likely than not” that theCompany will not be able to utilize them in the future. For the period from2001 through 2004, the Company has utilized $22.2 million in NOL carryforwardsto offset its current tax liability. During 2004, the Company concluded thatrealization of all tax benefits from NOL carryforwards and other deferred taxassets was more likely than not. As a result, $15.7 million of the valuationallowance for deferred tax assets was reversed, resulting in a non-cash taxbenefit of $6.7 million, which offset fiscal 2004 income tax expense of $2.4million. The remaining $9.0 million reduction in the valuation allowancerelated to acquired deferred tax assets and was recorded as a reduction togoodwill.

 

**11. Employee Benefit Plan:**

 

The Company has a 401(k)retirement plan for full-time U.S. based employees. Employees who are at least21 years of age and have completed at least 90 days of service are eligible toparticipate in the plan. Employees may contribute up to 20% of gross pay with amaximum dollar limit for 2004 of $13,000. The employer contribution is made atthe end of the plan year in an amount set by corporate resolution, based onparticipants’ compensation. The Company made no contributions to the plan in2004, 2003 or 2002.

 

**12. Stockholders’ Equity (Deficit):**

 

**Warrants**

 

The Company has issuedwarrants in connection with certain financing and leasing transactions as wellas through common stock offerings. All outstanding warrants are convertibleinto common stock. The warrants outstanding at December 31, 2004 expire onvarious dates from 2005 through 2008. A summary of outstanding warrants at December 31,2004, 2003 and 2002 and changes during the years then ended follows:

 

F-16

----

 
| ** **                            | ** ** | **2004**     | ** ** | **2003**                            | ** ** | **2002**     | ** ** |
|---------------------------------------|------------|--------------|------------|-------------------------------------|------------|--------------|------------|
| ** **                            | ** ** | **Warrants** | ** ** | **Wtd. Avg.  Exercise  Price** | ** ** | **Warrants** | ** ** | **Wtd. Avg.  Exercise  Price** | ** ** | **Warrants** | ** ** | **Wtd. Avg.  Exercise  Price** | ** ** |
| Outstanding  at beginning of the year |       | 7,379,118    |       | $                                   | 2.30       |         | 8,544,870  |   | $ | 2.48 |   | 8,544,870 |   | $ | 2.48 |   |
| Canceled                              |       | —       |       | —                              |       | (1,165,752   | )          | 3.62 |   | — |   | — |   |
| Outstanding  at end of the year       |       | 7,379,118    |       | $                                   | 2.30       |         | 7,379,118  |   | $ | 2.30 |   | 8,544,870 |   | $ | 2.48 |   |

 

F-17

----

 

**13. Stock Plans:**

 

The Company has three StockOption Plans:

 

**1992 Stock Option Plan**

 

Under the Company’s 1992Stock Option Plan, (the “1992 Plan”), the Company may issue up to 14,950,000shares of common stock to employees, officers, directors and consultants. Theexercise price and terms of the options granted are determined by the Board ofDirectors, provided that such price cannot be less than the fair value of thecommon stock on the date of grant for incentive stock options or, in the caseof non-statutory options, less than 85 percent of the fair value of the commonstock on the date of grant. The options generally vest over four years. The1992 Plan provides that, in the event of a change in control of the Company,executive officers of the Company will receive accelerated vesting for aportion of their unvested option shares. The term of the options granted isseven years. No options have been granted at less than fair value under thisplan.

 

**1996 Supplemental Option Plan**

 

Under the Company’s 1996Supplemental Option Plan, the Company may issue up to 750,000 shares of commonstock to employees, officers, directors and consultants. The exercise price andterms of the options granted are determined by the Board of Directors. Theoptions generally vest over four years. The term of the options granted isseven years.

 

**1995 Director Option Plan**

 

Under the Company’s 1995Director Option Plan (the “Director Plan”), the Company may issue up to 800,000shares of common stock to non-employee directors. The Director Plan providesthat each future non-employee director of the Company will be automaticallygranted an option to purchase 10,000 shares of common stock (the “First Option”)on the date on which the optionee first becomes a non-employee director of theCompany and an additional option to purchase 2,500 shares of common stock (the “SubsequentOption”) on each anniversary date thereafter. The exercise price per share ofall options granted under the Director Plan shall be equal to the fair marketvalue of a share of the Company’s common stock on the date of grant. Sharessubject to the First Option vest over 36 months, and the Subsequent Optionshares vest over 12 months beginning with the month following the secondanniversary of its date of grant. The term of the options granted is ten years.

 

A summary of the Company’sfixed plan stock options at December 31, 2004, 2003 and 2002 and changesduring the years then ended is presented below:

 
| ** **                                      | ** ** | **2004**   | ** ** | **2003**                            | ** ** | **2002**   | ** ** |
|-------------------------------------------------|------------|------------|------------|-------------------------------------|------------|------------|------------|
| ** **                                      | ** ** | **Shares** | ** ** | **Wtd. Avg.  Exercise  Price** | ** ** | **Shares** | ** ** | **Wtd. Avg.  Exercise  Price** | ** ** | **Shares** | ** ** | **Wtd. Avg.  Exercise  Price** | ** ** |
| Outstanding  at beginning of the year           |       | 7,167,420  |       | $                                   | 2.42       |       | 9,050,501  |   | $ | 2.49 |   | 8,055,828 |   | $ | 2.92 |   |
| Granted                                         |       | 222,500    |       | $                                   | 1.28       |       | 1,484,571  |   | $ | 1.53 |   | 2,747,724 |   | $ | 1.15 |   |
| Exercised                                       |       | (1,090,584 | )          | $                                   | 1.15       |       | (1,270,604 | ) | $ | 1.66 |   | (500 | ) | $ | 0.30 |   |
| Canceled                                        |       | (919,387   | )          | $                                   | 2.24       |       | (2,097,048 | ) | $ | 2.49 |   | (1,752,551 | ) | $ | 2.38 |   |
| Outstanding  at end of the year                 |       | 5,379,949  |       | $                                   | 2.66       |       | 7,167,420  |   | $ | 2.42 |   | 9,050,501 |   | $ | 2.49 |   |
| Exercisable  at end of the year                 |       | 4,534,560  |       | $                                   | 2.89       |       | 5,447,991  |   | $ | 2.69 |   | 6,341,868 |   | $ | 2.79 |   |
| Weighted  average fair value of options granted |       |       |       | $                                   | 0.64       |       |       |   | $ | 0.80 |   |   |   | $ | 0.76 |   |

 

F-18

----

 

The following tablesummarizes information about stock options outstanding at December 31,2004:

 
| **Options Outstanding**       | ** ** | **Options Exercisable** | ** ** |
|-------------------------------|------------|-------------------------|------------|
| **Range  of Exercise Prices** | ** ** | **Number  Outstanding** | ** ** | **Weighted-  Average  Remaining  Contractual Life** | ** ** | **Weighted-  Average  Exercise Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted-  Average  Exercise Price** | ** ** |
| $0.89—$1.07              |       | 719,897                 |       | 7.74 years |   | $ | 1.01 |   | 401,277 |   | $ | 1.00 |   |
| $1.13—$1.23              |       | 788,590                 |       | 6.13 years |   | $ | 1.15 |   | 633,569 |   | $ | 1.14 |   |
| $1.29—$1.84              |       | 533,270                 |       | 7.19 years |   | $ | 1.31 |   | 343,229 |   | $ | 1.30 |   |
| $2.03—$2.94              |       | 1,545,726               |       | 6.41 years |   | $ | 2.26 |   | 1,372,851 |   | $ | 2.24 |   |
| $3.11—$5.77              |       | 1,792,466               |       | 5.86 years |   | $ | 4.74 |   | 1,783,634 |   | $ | 4.75 |   |
| $0.89—$5.77              |       | 5,379,949               |       |   |   |   |   | 4,534,560 |   |   |   |

 

As of December 31,2004, there were 10,407,797 shares available for future grant under the stockoption plans.

 

**14. Commitments and Contingencies:**

 

The Company leases itsfacilities and certain equipment under non-cancelable capital and operatingleases.

 

At December 31, 2004,future minimum annual payments under capital leases and non-cancelableoperating leases are as follows (in thousands):

 
| ** **                  | ** ** | **Payments Due Per Period** | ** ** |
|-----------------------------|------------|-----------------------------|------------|
| **Contractual  Obligation** | ** ** | **Total**                   | ** ** | **2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** |
| Capital Leases              |       | $                           | 2,243      |   | 756 |   | 1,487 |   | — |   | — |   | — |   |
| Operating Leases            |       | $                           | 4,468      |   | 2,190 |   | 1,530 |   | 367 |   | 315 |   | 66 |   |

 

The present value ofobligations under capital lease was $2,043, of which $756 is classified as acurrent liability.

 

Rent expense totaled $2,422,$2,419 and $2,603 in 2004, 2003 and 2002, respectively.

 

As of December 31,2004, the Company has non-cancelable future minimum purchase commitments withits telephone service providers of approximately $2.5 million for 2005 and $2.0million for 2006.

 

The Company is involved invarious legal actions arising from the ordinary course of business. Managementdoes not believe the ultimate resolution of these matters will have a materialeffect on the Company’s financial position.

 

**15. Net Income (Loss) Per Share:**

 

Under SFAS No. 128, “Earningsper Share,” the Company is required to compute earnings per share under twodifferent methods (basic and diluted). Basic earnings per share is calculatedby dividing net income (loss) attributable to common shareholders by theweighted average shares of common stock outstanding during the period. Dilutedearnings per share is calculated by dividing net income attributable to commonshareholders by the weighted average shares of outstanding common stock andcommon stock equivalents during the period.

 

A reconciliation of netincome (loss) per basic and diluted share for the three years ended December 31,2004 follows (in thousands, except per share amounts):

 
| ** **                                           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Basic:                                               |       |     |       |     |       |     |       |
| Net  income (loss) applicable to common shareholders |       | $        | 3,204      |     | $          | 4,199    |       | $ | (127,385 | ) |
| Weighted  average shares outstanding                 |       | 72,768   |       | 71,367   |       | 70,718   |       |
| Net  income (loss) per share                         |       | $        | 0.04       |     | $          | 0.06     |       | $ | (1.80 | ) |
| Diluted:                                             |       |     |       |     |       |     |       |
| Net  income (loss) applicable to common shareholders |       | $        | 3,204      |     | $          | 4,199    |       | $ | (127,385 | ) |
| Weighted  average shares outstanding                 |       | 72,768   |       | 71,367   |       | 70,718   |       |
| Add:  Net effect of potentially dilutive shares      |       | 534      |       | 3,524    |       | 89       |       |
| Total  shares                                        |       | 73,302   |       | 74,891   |       | 70,807   |       |
| Net  income (loss) per share                         |       | $        | 0.04       |     | $          | 0.06     |       | $ | (1.80 | ) |
|                                                      |            |          |            |          |            |          |            |  |  |  |  |  |  |

 

F-19

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**16. Unaudited Quarterly FinancialInformation (in thousands, expect per share amounts)**

 

| ** **         | ** ** | **Quarter Ended**        | ** ** |
|--------------------|------------|--------------------------|------------|
| ** **         | ** ** | **March 31,  2004** | ** ** | **June 30,  2004** | ** ** | **September 30,  2004** | ** ** | **December 31,  2004** | ** ** |
| Revenues           |       | $                        | 13,381     |   | $ | 14,890 |   | $ | 15,613 |   | $ | 18,482 |   |
| Gross profit       |       | 6,490                    |       | 7,511 |   | 6,274 |   | 8,736 |   |
| Net income (loss)  |       | 1,317                    |       | 1,587 |   | 547 |   | (247 | ) |
| Earnings per share |       | $                        | 0.02       |   | $ | 0.02 |   | $ | 0.01 |   | $ | 0.00 |   |
|                    |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **         | ** ** | **Quarter Ended**        | ** ** |
|--------------------|------------|--------------------------|------------|
| ** **         | ** ** | **March 31,  2003** | ** ** | **June 30,  2003** | ** ** | **September 30,  2003** | ** ** | **December 31,  2003** | ** ** |
| Revenues           |       | $                        | 15,656     |   | $ | 15,294 |   | $ | 13,357 |   | $ | 13,380 |   |
| Gross profit       |       | 7,891                    |       | 7,875 |   | 6,408 |   | 6,306 |   |
| Net income         |       | 1,090                    |       | 815 |   | 1,880 |   | 414 |   |
| Earnings per share |       | $                        | 0.02       |   | $ | 0.01 |   | $ | 0.03 |   | $ | 0.01 |   |
|                    |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |

 

**17. Segment Information:**

 

The Company operatespredominantly in two industry segments: digital and physical distribution ofaudio and video content and product sales of transmission and compressiontechnology equipment. The Company has defined its reportable segments based oninternal financial reporting used for corporate management and decision-makingpurposes. The information in the following tables is derived directly from thesegments’ internal financial reporting used for corporate management purposes(in thousands).

 

| ** **                             | ** ** | **Year ended December 31, 2004**                | ** ** |
|----------------------------------------|------------|------------------------------------------------------|------------|
| ** **                             | ** ** | **Audio and Video  Content  Distribution** | ** ** | **Product  Sales** | ** ** | **Other** | ** ** | **Intersegment  Eliminations (a)** | ** ** | **Consolidated  Totals** | ** ** |
| Revenues                               |       | $                                                    | 52,970     |   | $ | 8,796 |   | $ | 600 |   | $ | — |   | $ | 62,366 |   |
| Interest expense                       |       | 572                                                  |       | 671 |   | 48 |   | — |   | 1,291 |   |
| Depreciation and  amortization expense |       | 4,579                                                |       | 1,094 |   | 124 |   | — |   | 5,797 |   |
| Impairment charges                     |       | 1,048                                                |       | 8,083 |   | — |   | — |   | 9,131 |   |
| Net income (loss)                      |       | $                                                    | 10,463     |   | $ | (7,292 | ) | $ | 33 |   | $ | — |   | $ | 3,204 |   |
| Purchases of property  and equipment   |       | $                                                    | 3,287      |   | $ | 55 |   | $ | — |   | $ | — |   | $ | 3,342 |   |
| Total assets                           |       | $                                                    | 151,738    |   | $ | 15,797 |   | $ | 4,533 |   | $ | (64,551 | ) | $ | 107,517 |   |

 

| ** **                             | ** ** | **Year ended December 31, 2003**      | ** ** |
|----------------------------------------|------------|--------------------------------------------|------------|
| ** **                             | ** ** | **Audio and Video  Content  Distribution** | ** ** | **Product  Sales** | ** ** | **Other** | ** ** | **Intersegment  Eliminations (a)** | ** ** | **Consolidated  Totals** | ** ** |
| Revenues                               |       | $                                          | 47,928     |   | $ | 9,759 |   | $ | — |   | $ | — |   | $ | 57,687 |   |
| Interest expense                       |       | 112                                        |       | 752 |   | — |   | — |   | 864 |   |
| Depreciation and  amortization expense |       | 4,230                                      |       | 3,667 |   | — |   | — |   | 7,897 |   |
| Net income (loss)                      |       | $                                          | 8,229      |   | $ | (4,030 | ) | $ | — |   | $ | — |   | $ | 4,199 |   |
| Purchases of property  and equipment   |       | $                                          | 1,061      |   | $ | 21 |   | $ | — |   | $ | — |   | $ | 1,082 |   |
| Total assets                           |       | $                                          | 110,371    |   | $ | 24,834 |   | $ | 10 |   | $ | (42,282 | ) | $ | 92,933 |   |

 

| ** **                             | ** ** | **Year ended December 31, 2002**      | ** ** |
|----------------------------------------|------------|--------------------------------------------|------------|
| ** **                             | ** ** | **Audio and Video  Content  Distribution** | ** ** | **Product  Sales** | ** ** | **Other** | ** ** | **Intersegment  Eliminations (a)** | ** ** | **Consolidated  Totals** | ** ** |
| Revenues                               |       | $                                          | 53,144     |   | $ | 12,799 |   | $ | 351 |   | $ | — |   | $ | 66,294 |   |
| Interest expense                       |       | 696                                        |       | 844 |   | — |   | — |   | 1,540 |   |
| Depreciation and  amortization expense |       | 5,021                                      |       | 2,235 |   | 134 |   | — |   | 7,390 |   |
| Impairment charges                     |       | 130,234                                    |       | — |   | — |   | — |   | 130,234 |   |
| Net loss                               |       | $                                          | (125,142   | ) | $ | (1,410 | ) | $ | (833 | ) | $ | — |   | $ | (127,385 | ) |
| Purchases of property  and equipment   |       | $                                          | 673        |   | $ | 24 |   | $ | 26 |   | $ | — |   | $ | 723 |   |
| Total assets                           |       | $                                          | 106,916    |   | $ | 26,884 |   | $ | 18 |   | $ | (36,613 | ) | $ | 97,205 |   |

 

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(a)                   Intersegment eliminations relate to intercompany receivables andpayables that occur when one operating segment pays costs that are related toanother operating segment.

 

F-20

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**18. New Accounting Pronouncements:**

 

In May 2003, the FASBissued SFAS No. 150,**“**Accountingfor Certain Financial Instruments with Characteristics of Both Liabilities andEquity.”****SFAS No. 150, whichbecame effective July 1, 2003, established standards for theclassification and measurement of certain financial instruments withcharacteristics of both liabilities and equity. The adoption of SFAS No. 150did not have any effect on the Company’s financial statements.

 

FASB Interpretation No. 46(revised December 2003), “Consolidation of Variable Interest Entities”, orFIN 46R, replaces FIN 46, which was issued July 1, 2003. FIN 46R clarifiesthe application of Accounting Research Bulletin No. 51, “ConsolidatedFinancial Statements” to certain entities in which equity investors do not havesufficient equity at risk for the entity to finance its activities withoutadditional subordinated financial support. There was no effect on the Companyas a result of the adoption of these rules.

 

FASB Interpretation No. 45enhances the disclosures to be made by a guarantor in its interim and annualfinancial statements about its obligations under certain guarantees that it hasissued. It also clarifies that a guarantor is required to recognize, at theinception of a guarantee, a liability for the fair value of the obligationundertaken in issuing the guarantee. There was no effect on the Company as aresult of the adoption of this rule.

 

In December 2004, theFASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS123(R)”). SFAS 123(R) requires all share-based payments to employees, includinggrants of employee stock options, to be recognized in the financial statementsbased on their fair values. SFAS 123(R) is effective for public companiesbeginning with the first interim period that begins after June 15, 2005.Under SFAS 123(R), the Company will recognize compensation expense for theportion of outstanding awards for which the requisite service has not yet beenrendered, based on the grant-date fair value of those awards calculated underSFAS 123 for pro forma disclosures. The Company has not completed itsevaluation of the impact of SFAS 123(R) on its financial statements.

 

F-21

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**DIGITALGENERATION SYSTEMS, INC. AND SUBSIDIARIES**

**SCHEDULE II—VALUATIONAND QUALIFYING ACCOUNTS**

**(in thousands)**

 
| **Classification**                | ** ** | **Balance at  Beginning of  Period** | ** ** | **Additions  Charged to  Operations** | ** ** | **Other** | ** ** | **Write-  offs** | ** ** | **Balance at  End of Period** | ** ** |
|-----------------------------------|------------|------------------------------------------------|------------|--------------------------------------------|------------|-----------|------------|------------------|------------|----------------------------------------------|------------|
| *Allowance for Doubtful Accounts* |       |                                           |       |                                       |       |      |       |             |       |                                         |       |
| Year Ended:                       |       |                                           |       |                                       |       |      |       |             |       |                                         |       |
| December 31, 2002            |       | $                                              | 2,883      |                                       | 715        |      | —     |             | (2,484     | )                                            | $          | 1,114 |   |
| December 31, 2003            |       | $                                              | 1,114      |                                       | 73         |      | —     |             | (599       | )                                            | $          | 588 |   |
| December 31, 2004            |       | $                                              | 588        |                                       | 275        |      | 181        |             | (537       | )                                            | $          | 507 |   |

 

S-1

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