##### Table of Contents

##### Index to Financial Statements

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549



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FORM 10-K



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|x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ------------------------------------------------------------------------------------



For The Fiscal Year Ended December 31, 2004



OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



For the Transition Period From  to
.



COMMISSION FILE NUMBER: 0-27644



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Digital Generation Systems, Inc.

(Exact Name of Registrant as Specified in its Charter)



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|                                                               |  |                                        
|-------------------------------------------------------------- |  | ---------------------------------------
|Delaware                                                       |  | 94-3140772                             
|(State or Other Jurisdiction of Incorporation or Organization) |  | (I.R.S. Employer Identification Number)



750 West John
Carpenter Freeway, Suite 700

Irving, Texas 75039

(Address Of Principal Executive Offices, Including Zip Code)



(972) 581-2000

(Registrants Telephone Number, Including Area Code)



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Securities registered pursuant to Section 12(b) of the Act: None

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



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Indicate by check mark whether the registrant (1)
has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 days.    YES  
x    NO ̈



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



Indicate by check mark if the registrant is an accelerated filer.    YES  x    NO ̈



The aggregate market value of the Common Stock held by non-affiliates of the registrant, computed by reference to the closing price and shares outstanding, was approximately $60.6 million as of December 31, 2004, and approximately $72.4
million as of June 30, 2004, the last business day of the registrants most recently completed second quarter. Shares of Common Stock held by each officer and director of the registrant and by each person who may be deemed to be an affiliate
have been excluded. This determination of affiliate status is not necessarily a conclusive determination for other purposes.



As of March 8, 2005, the registrant had 72,748,192 shares of Common Stock outstanding.



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC.



The discussion in this Report contains forward-looking statements that involve risks and uncertainties. The statements contained in this
Report that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, 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-looking statements. All forward-looking statements included in this
document are based on information available to the Company on the date hereof, and we assume no obligation to update any such forward-looking statements, except as required by law. The Companys actual results could differ materially from those
anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those discussed in Managements Discussion and Analysis of Financial Condition and Results of OperationsCertain Business
Considerations as well as those discussed elsewhere in this Report, and the risks discussed in the Companys other filings with the United States Securities and Exchange Commission.



TABLE OF CONTENTS



|           |  |                                                                                                             |  |    
|---------- |  | ----------------------------------------------------------------------------------------------------------- |  | ---
|           |  |                                                                                                             |  | Pg.
|           |  | PART I                                                                                                      |  |    
|ITEM 1.    |  | BUSINESS                                                                                                    |  | 1  
|           |  | General                                                                                                     |  | 1  
|           |  | Available Information                                                                                       |  | 1  
|           |  | Industry Background                                                                                         |  | 1  
|           |  | Products and Services                                                                                       |  | 2  
|           |  | Markets and Customers                                                                                       |  | 4  
|           |  | Sales, Marketing and Customer Service                                                                       |  | 5  
|           |  | Competition                                                                                                 |  | 6  
|           |  | Intellectual Property and Proprietary Rights                                                                |  | 7  
|           |  | Employees                                                                                                   |  | 7  
|ITEM 2.    |  | PROPERTIES                                                                                                  |  | 8  
|ITEM 3.    |  | LEGAL PROCEEDINGS                                                                                           |  | 8  
|ITEM 4.    |  | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                         |  | 8  
|           |  | PART II                                                                                                     |  |    
|ITEM 5.    |  | MARKET FOR REGISTRANTS COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES |  | 9  
|ITEM 6.    |  | SELECTED FINANCIAL DATA                                                                                     |  | 10 
|ITEM 7.    |  | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                       |  | 11 
|           |  | Overview                                                                                                    |  | 11 
|           |  | Critical Accounting Policies                                                                                |  | 12 
|           |  | New Accounting Pronouncement                                                                                |  | 14 
|           |  | Results of Operations                                                                                       |  | 14 
|           |  | Liquidity and Capital Resources                                                                             |  | 15 
|           |  | Certain Business Considerations                                                                             |  | 16 
|ITEM 7A.   |  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                  |  | 25 
|ITEM 8.    |  | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                                                 |  | 25 
|ITEM 9.    |  | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                        |  | 25 
|ITEM 9A.   |  | CONTROLS AND PROCEDURES                                                                                     |  | 25 
|ITEM 9B.   |  | OTHER INFORMATION                                                                                           |  | 25 
|           |  | PART III                                                                                                    |  |    
|ITEM 10.   |  | DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT                                                          |  | 26 
|ITEM 11.   |  | EXECUTIVE COMPENSATION                                                                                      |  | 28 
|ITEM 12.   |  | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT                                              |  | 30 
|ITEM 13.   |  | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                                              |  | 32 
|ITEM 14.   |  | PRINCIPAL ACCOUNTING FEES AND SERVICES                                                                      |  | 32 
|           |  | PART IV                                                                                                     |  |    
|ITEM 15.   |  | EXHIBITS, FINANCIAL STATEMENT SCHEDULES                                                                     |  | 33 
|SIGNATURES |  | 36                                                                                                         



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC.



PART I



ITEM 1. BUSINESS



General



Digital Generations
Systems, Inc., incorporated in 1991, offers a suite of digital technology products and services through Digital Generation Systems, Inc. (DGS) and its wholly owned subsidiaries AGT Broadcast, Inc. (Broadcast), SourceTV, Inc.
(Source) and StarGuide Digital Networks, Inc. (StarGuide). Through DGS, the Company operates a nationwide digital network out of its Network Operation Center (NOC) located in Irving, Texas. The network
beneficially links more than 5,000 advertisers and advertising agencies with more than 3,100 television, cable, and network broadcast destinations and over 10,000 radio stations across the United States and Canada. Through the NOC, the Company
delivers audio, video, image and data content that comprise transactions between the advertising and broadcast industries. Through StarGuide, the Company develops and sells proprietary digital software, hardware and communications technology,
including various bandwidth satellite receivers, audio compression codes and software to operate integrated digital multimedia networks, and offers related engineering consulting services.



Available Information



The
Company files annual reports, quarterly reports, proxy statements and other documents with the Securities and Exchange Commission (SEC) under the Securities Exchange Act of 1934 (the Exchange Act). The public may read and
copy any materials that the Company files with the SEC at the SECs Public Reference Room at 450 Fifth Street N.W., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at
1-800-SEC-0330. Also, the SEC maintains a website that contains reports, proxy and information statements, and other information regarding issuers, including the Company, that file electronically with the SEC. The public can obtain any documents
that the Company files with the SEC at http://www.sec.gov.



The
Company also makes available free of charge through its website (www.dgsystems.com) the Companys Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and, if applicable, amendments to those reports filed or
furnished pursuant to the Exchange Act as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to, the SEC.



Industry Background



Increasing
demand for reliable and rapid means of information transfer in the broadcast, scientific, education, entertainment, home-computing, and telecommunications industries has driven a number of technical innovations in recent years. In particular,
digital distribution technologies are increasingly used for distributing information in forms such as audio, video, text, and data. Digitized information can be stored, manipulated, transmitted, and reproduced more easily, more rapidly, with less
degradation, and in greater volumes than traditional analog or hard copy information.



While many radio and television broadcasters now embrace digital technology for much of their production processes and in-station media management, current methods for the distribution of audio and video advertising
content are based primarily on the manual duplication and physical delivery of analog tapes. According to industry sources, there are approximately 11,000 commercial radio and 4,565 television, cable, and network broadcast destinations in the United
States. These stations generate revenue by selling airtime to advertisers. Advertising is most frequently produced under the direction of advertising agencies for large national or regional advertisers or by station personnel for local advertisers.
Advertising is characterized as network or spot, depending on how it is bought and distributed. Network advertising typically is delivered to stations as part of a network feed (bundled with network programming),
while spot advertising is delivered to stations independently of other programming content.



Spot advertising airtime typically is purchased by advertising agencies or media buying firms, on behalf of advertisers. Advertisers and their agencies select individual stations or groups of stations to support
marketing objectives, which usually are based on the stations geographic and other demographic characteristics. The actual commercials or spots typically are produced at a digital production studio and recorded on digital tape.
Variations of the spot intended for specific demographic groups also are produced at this time. The spots undergo a review of quality and content before being cleared for distribution to broadcast stations. Tapes containing the spot and its
variations are then duplicated on analog tape, packaged, labeled and shipped to the radio and television stations and cable head-ends specified by the advertiser or its agency.



1



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##### Index to Financial Statements

The predominant method for distributing spot advertisements to radio and television stations
traditionally has been physical delivery of analog audio or videotapes. The Company estimates that approximately 35% of radio spots and more than 60% of video spots are delivered by air express services. Many companies, commonly known as dub
and ship houses, are in the business of duplicating audio and video tapes, assembling them according to agency-specified bills of material and packing them for air express delivery. The Company estimates that approximately 55% of the market
for audio spot deliveries and approximately 20% of video spot deliveries has transitioned to digital distribution.



To meet their growing need for solutions that offer reliable, high-quality digital information distribution, some companies have deployed their own
terrestrial-based local and wide area computer networks. These systems are typically very costly to deploy, use, and maintain. Additionally, upgrading these systems to keep abreast of technical innovations can be particularly difficult and costly.



Other digital communication and transmission technologies,
such as private network satellite systems, can offer more cost-effective and reliable solutions for the digital transmission requirements of data intensive businesses, including radio and television broadcasting. Satellite distribution can be
particularly effective at meeting the needs of point-to-multipoint transmission, or multicasting, and other broadcasting applications.



The Company has developed proprietary software and hardware systems that can address the need for data distribution services that are both economically
and technologically suitable to various commercial applications. Many of these systems are currently deployed and in service, and the Company continues to upgrade its technology, and to deploy additional units in the marketplace.



Products and Services



The
Company currently markets and provides its products and services through DGS (which includes Broadcast), StarGuide and Source. See Note 17 to the Companys consolidated financial statements and related notes, included herein, for financial
information related to the Companys business segments.



DGS provides electronic and physical distribution of and ancillary post-production services for broadcast commercial content to advertising agencies, production studios, and broadcast stations throughout the United States and Canada.
Through its NOC, DGS operates a digital network, currently connecting more than 5,000 advertisers and advertising agencies with more than 3,100 television, cable, and network broadcast destinations and over 10,000 radio stations across the United
States and Canada. This network enables the rapid, cost-effective, and reliable electronic transmission of audio and video spots and other content and provides a high level of quality, accountability, and flexibility to both advertisers and
broadcasters. With the DGS network, transmissions are automatically routed to stations through a computerized on-line transaction and delivery system and arrive, in text format, at stations in as little as one hour after an order is received.
Typically, associated traffic instructions are simultaneously transmitted by facsimile to minimize station handling and scheduling errors. Shortly after a spot is delivered to a station, DGS sends the customer a confirmation specifying the time of
delivery. Additionally, DGS digital network delivers close to master quality audio or video to broadcast stations, which is equal to or superior to that currently delivered on analog tape.



DGS generates its revenues from advertising agencies as well as from
production studios and dub and ship houses that consolidate and forward the deliveries to broadcast stations. DGS has historically operated and currently operates without substantial backlog. DGS receives distribution orders with specific bills of
material, routing and timing instructions provided by the customer. These orders are entered into DGS computer system either by the customer (through an internet-based order-entry system) or by DGS customer service personnel, and are scheduled
for electronic delivery, if a station is on DGS network, or for physical delivery via DGS various dub and ship facilities, if a destination station is not on the network.



Audio content is received electronically at DGS NOC from Record Send Terminals and Client Workstations that are owned
by DGS and deployed primarily in production studios. In addition, audio can be received using DGS Upload internet audio collection system (DG Upload). When audio spots are received, company personnel quality-assure the audio
content and then initiate the electronic transaction to transmit various combinations of audio to designated radio stations. Audio transmissions are delivered over standard telephone or ISDN lines to servers that DGS has placed in each radio station
on its network. The audio spots are thereafter available to the station on demand.



Video content is received electronically at DGS NOC primarily from Video Record Transmission Systems that are owned by DGS and deployed in video production studios. Video content also can be received through
high-speed communication lines from collection points in locations where Video Record Transmission Systems are not available. When video spots are received, company personnel quality-assure the spots and release the video to the NOC, where it is
combined with the customers electronic transaction to transmit the various combinations of video to designated television stations. Video transmissions are sent via a high-speed fiber link to the digital satellite uplink facility over which
they are then delivered directly to servers that DGS has placed in television stations and cable interconnects.



2



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##### Table of Contents

##### Index to Financial Statements

Audio and video transmissions are received at designated radio and television stations on DGS-owned
servers, called Receive Playback Terminals, Client Workstations, Digital Media Managers and DG Spotboxes. The servers enable stations to receive and play back material delivered through DGS digital distribution network. The units are owned by
DGS and typically are installed in the master control or production area of the stations. Upon receipt, station personnel generally review the content and transfer the spot to a standardized internal station format for subsequent
broadcast. Through its NOC, DGS monitors the spots stored in each Receive Playback Terminal, Client Workstation, Digital Media Manager and DG Spotbox and ensures that space is always available for new transmissions. DGS can quickly transmit audio or
video at the request of a station or in response to the request of a customer who wishes to alter an existing order, enabling responsiveness not possible in a physical tape distribution system.



DGS offers various levels of digital audio and video distribution services
from its NOC to broadcast advertisers distributing content to broadcast stations. These include the following: DG Priority, a service which guarantees arrival of the first audio spot on an order within one hour (available for audio only); DG
Express, which guarantees arrival within four hours; DG Standard, which guarantees arrival by noon the next day; and DG Economy, which guarantees arrival by noon on the second day. DGS also offers a set of premium services enabling advertisers to
distribute audio or video spots provided after normal business hours.



In addition to its standard services, DGS has developed unique products to service markets with particular time-sensitive delivery needs. Sweeps delivery is a specialized service for television stations that wish to advertise on
radio with either topical or cooperative content to stimulate viewership during the periods of ratings measurements conducted by the A.C. Nielsen Company. DGS also offers delivery of advertising for daily newspapers seeking to expand their
readership based on a dissemination of breaking news during the morning rush hour. DGS distributes first release music singles and uses unique software functionality to insure that the singles are released throughout the country to all stations
simultaneously thereby eliminating concerns of favoritism or premature release. Finally, DGS delivers political advertising during election campaigns, providing a rapid response mechanism for candidates and issue groups.



StarGuide designs and provides high-speed digital information transmission
and distribution systems. StarGuides patented technologydigital distribution, compression, and transmission systems combined with satellite and Internet technologiesallow StarGuide to achieve high-quality, economical, flexible, and
high-throughput information flow without the need for point-to-point connections, regardless of digital formatting or compression protocols. Integrated into many of StarGuides systems are StarGuides proprietary digital audio compression
and decompression, or codec, techniques and products.



StarGuides satellite transmission systems combine varying types of information into one single transmission, maximizing the amount of information transmitted through the satellite in a more cost-effective and reliable manner than
other distribution systems available on the market. The systems are also readily upgradeable, secure, and able to direct transmissions, or components of transmissions, to multiple points simultaneously. StarGuides transmission systems are
capable of receiving any type of digitized media including audio, simultaneous audio, video, text and data from a variety of sources including satellite, high-bandwidth connections such as ISDN or T1 lines, and other wired and wireless systems.



StarGuide has developed a patented store-and-forward system
called Transportal 2000(TM), a cost-effective, reliable, high-speed electronic media delivery system that serves the broadcast industry with Internet connectivity, compatible StarGuide satellite transmission and terrestrial overlays, automatic
fall-back dub and ship service, and automated confirmation of delivery. This proprietary automated media distribution system is being deployed across the radio broadcasting industry. StarGuide intends to expand its presence in the broadcasting
industry and to target new market opportunities for high-quality, high-throughput digital information systems.



In the United States radio industry, StarGuide has deployed its digital transmission systems to radio stations owned by or affiliated with Jacor, ABC
Radio, Clear Channel, Infinity, Westwood One, CBS, Bloomberg, Jones Broadcast Programming, One-On-One Sports, and Voice of America. Abroad, StarGuide has deployed its digital transmission systems for Osaka-Yusen (Japan), the Shenzhen Stock Exchange
(China), and other entities in Australia, New Zealand, and South America.



The core of the StarGuide transmission system is StarGuides patented MX3 Multiplexer and the StarGuide Receiver. The MX3 Multiplexer can accept up to 120 simultaneous digital, audio, video, or data services in
various digital formats. The MX3 Multiplexer then breaks up these differing digital service streams and re-orders and consolidates the various data streams into a single data stream. The system can then cost-effectively transmit this data stream in
a single transmission signal, via satellites or other wired or wireless communications vehicles. The MX3 Multiplexer does so in a highly efficient manner, resulting in less consumption of costly bandwidth capacity on the satellites than other
transmission systems on the market, such as DVB systems.



Upon
receipt of a transmission, the patented StarGuide II and III Receivers re-assemble and transmit data packets into their respective types of digital information streams (audio, video, text, or data). StarGuides receivers are flexible and
adaptable, employing low cost insertion cards that are installed in any of a number of slots in the receivers, thus adapting the capabilities of the receivers to varying needs of broadcasters who use them.



3



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##### Table of Contents

##### Index to Financial Statements

Current StarGuide receiver insertion cards include:



| |  |  | eDAS (Ethernet Enabled Digital Audio Storage) Card: a unique, patented store-and-forward card that allows a live broadcast through the StarGuide Receiver to be
automatically mixed with pre-transmitted audio or video clips or advertising spots, thus allowing broadcasters to broadcast or regionalize national programs or advertisements distributed through the StarGuide transmission system;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | 10/100 Based-T Ethernet Interface Card: a unique, patented card that allows StarGuide Receivers to receive and route digital content, particularly Internet Protocol content,
directly onto a 10 or 100 Based-T local or wide area computer network;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Musicam(R) MPEG Layer II Digital Audio Decoder Card: a proprietary audio decoder card that provides CD quality audio and additional network control capabilities for broadcasters who
use the StarGuide transmission systems to transmit radio broadcasts or other audio content;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Relay Expansion Card: a system card that allows a broadcaster to remotely control a network through the StarGuide Receiver; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------------



| |  |  | MPEG2 Digital Video Decoder Card: a video decoder card that provides VCR quality video and additional network control capabilities for broadcasters who use the StarGuide
transmission systems to transmit video broadcasts or other video content.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



StarGuides transmission systems are controlled by StarGuides Windows-based, propriety Network Management Control System, or NMCS, which allows a system operator to maintain and control the entire
transmission system locally or remotely. The StarGuide NMCS allows the system operator to control both the use of satellite bandwidth by the system and the accessing of transmitted data by the individual StarGuide Receivers in the field.



StarGuide also has developed a StarGuide DVB Multiplexer and mating
StarGuide DVB Receiver. StarGuide developed its StarGuide DVB transmission system for applications requiring transmission in compliance with the DVB standard. StarGuides DVB system is being deployed throughout Japan by Osaka-Yusen.



Source offers an information service for the advertising and TV commercial
production industry. Founded in 1989, Sources database documents virtually all the content and credits on U.S. television commercials since its inception.



Source services most of the major U.S. advertising agencies and production companies, as well as television networks, programs, and industry
associations. Source has a comprehensive database that includes information relating to commercials, individuals and companies. Sources database allows its customers to obtain answers to questions they may have, such as who
directed, who owns the rights, etc. Source provides this type of information via fax, phone, e-mail and most recently through its Online Services. Source Online allows access to TV commercials with detailed credit information that
can be viewed in a Quicktime® format. Source also
has credits on music videos and a database of ad agency creative personnel. The site also allows companies to showcase their reels online for a fee.



Source generates revenues by charging customers for the information, either on a per transaction or subscription basis. Customers can sign up
automatically online using their credit cards for immediate access to the online services. However, most customers have unlimited access to the information resources and are billed accordingly for an annual subscription.



Source has grown over the years by expanding its product lines to include
in-house digital products, research and clearance, and marketing software.



Markets and Customers



A large
portion of DGS revenue is derived from the delivery of spot radio and television advertising to broadcast stations, cable systems and networks. DGS derives revenue from brand advertisers and advertising agencies, and from its marketing
partners, which are typically dub and ship houses that have signed agreements with DGS to consolidate and forward the deliveries of their advertising agency customers to broadcast stations, cable systems and networks via DGS electronic
delivery service in exchange for price discounts from DGS. The advertisements distributed by DGS are representative of the five leading national advertising categories of automotive, retail, business and consumer services, food and related products
and entertainment. The volume of advertising from these segments is subject to seasonal and cyclical variations.



4



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##### Table of Contents

##### Index to Financial Statements

StarGuide maintains established relationships with producers and broadcasters such as Infinity, Westwood
One, Clear Channel, ABC Radio, Jacor, CBS, Bloomberg and Jones Broadcast Programming. As part of these relationships, StarGuide has sold approximately 6,000 of its StarGuide II Receiver systems, and has sold over 8,500 of its StarGuide III Receiver
systems. In addition, StarGuides audio Codecs are recognized and used throughout the radio production and broadcast industries. StarGuide intends to utilize its existing relationships to leverage its technology to develop new customers in the
broadcast industry.



Sales, Marketing and Customer Service



Brand Strategy. DGS brand strategy is to position itself as the standard transaction method for the radio, television, cable, and network broadcast industries. DGS focuses its marketing messages and programs at multiple
segments within the advertising and broadcast industries. Each of the segments interacts with DGS for a different reason. Agencies purchase services from DGS on behalf of their advertisers. Production studios facilitate the transmission of audio and
video to DGS NOC. Production studios and dub and ship houses resell delivery services to agencies. Stations join the network to receive the content from their customers: the agencies and advertisers.



Internet/E-Commerce Strategy. In 2002, DGS introduced Open Interface,
an industry first that allows agency traffic systems to interface directly with DGS order management system, reducing duplicate entry of information. In 2001, DGS introduced AdCatalog, a web-based asset management system that allows
geographically dispersed marketing groups the ability to view and request distribution for corporate broadcast commercial content. Additionally, DGS introduced Netclear, a web-based system that allows brand advertisers, advertising agencies and
broadcasters the ability to approve spots for network clearance. DGS estimates that approximately 52% of its orders were entered electronically via the Internet during 2004 and 2003. In addition, DGS also offers its DG Upload service that allows
audio content to be received from clients via the Internet.



The new DGConnect online order entry and management system adds functionality to our online management tool that opens up our network so customers can see the status of their media asset as it moves from endpoint to endpointfrom the
time it leaves their possession until it arrives at the media outlet. With new system architecture and user-friendly applications, DGConnect provides advertisers and agencies with an intuitive web portal to visualize and manage the distribution of
their valuable advertising content. Users can upload spots, choose or create new destination groups, attach traffic instructions, view invoices, distribute media electronically to thousands of destinations across DGS massive digital network
and confirm delivery at the station level through DGS powerful new media server, the DG Spot Box. Users have immediate access to key statistics, order status and other data, while workflow automation tools help user groups save routing
instructions and destination paths for repeat orders. Users can search billing history and view invoices from any web-connected location. Customized search features let users research order history by brand, service level or transmission date. In
addition, spots can be previewed at any time of the day or point in the order process. This design introduces new levels of simplicity, transparency, accountability and customer satisfaction to the spot distribution process. Wide availability of
DGConnect to the entire advertising marketplace will begin on February 28, 2005.



Sales. DGS employs a direct sales force that calls on various departments at advertising agencies to communicate the capabilities and comparative advantages of DGS electronic distribution system and
related products and services. In addition, DGS sales force calls on corporate advertisers who are in a position to either direct or influence agencies in directing deliveries to DGS. A separate staff sells to and services audio and video
dealers, who resell DGS distribution services. DGS currently has regional sales offices in New York, Los Angeles and Chicago. DGS sales force includes regional sales, inside sales, and telemarketing personnel.



StarGuide presently markets and sells its transmission and distribution
systems and audio compression products directly to corporate and commercial end-users, distributors, and to radio stations and networks. StarGuide currently promotes and sells the StarGuide integrated transmission and distribution systems and
promotes the digital distribution services provided to the radio broadcast industry. StarGuide also employs salespersons that market and sell StarGuides audio compression products. StarGuide currently maintains relationships with distributors
marketing and selling StarGuides audio compression products in Europe, Asia, South America, and Australia. StarGuide is presently seeking to expand these relationships to include the distribution of StarGuide transmission and information
management systems.



Marketing. DGS marketing
programs are directed to stimulate demand with an emphasis on popularizing the benefits of digital delivery, including fast turnaround (same day services), increased flexibility, higher quality, and greater reliability and accountability. These
marketing programs include direct mail and telemarketing campaigns, newsletters, collateral material (including brochures, data sheets, etc.), application stories, and corporate briefings in major United States cities. DGS also engages in public
relations activities including trade show participation, the stimulation of articles in the trade and business press, press tours and advertisements in advertising and broadcast oriented trade publications.



5



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##### Table of Contents

##### Index to Financial Statements

DGS markets to broadcast stations to arrange for the placement of its Receive Playback Terminals, Digital
Media Managers, and DG Spot Boxes for the receipt of audio and video advertisements, or Client Workstations, which provide the ability to both receive and to originate distribution of audio advertisements to other radio stations.



StarGuide currently engages in several promotions and other activities to
generate interest in its systems and to consummate sales, including trade shows. StarGuide seeks to maximize its visibility at trade shows by hosting customer booths and providing complimentary product literature describing StarGuides systems.
StarGuide also conducts on-site demonstrations with technical and other senior level personnel and regularly contacts potential customers who have indicated an interest in utilizing StarGuides systems or products.



Customer Service. DGS approach to customer service is based on a
model designed to provide focused support from key market centered offices, located in Los Angeles, Dallas, Chicago, Detroit, New York and Wilmington, Ohio. Clients work with specific, assigned account coordinators to place production service and
distribution orders. National distribution orders are electronically routed to the NOC for electronic distribution or, for off-line destinations, to DGS national duplication center in Louisville, Kentucky. DGS distributed service
approach provides direct support in key market cities enabling DGS to develop closer relationships with clients as well as the ability to support client needs for local production services. DGS also maintains a customer service team dedicated to
supporting the needs of radio, television, and network stations. This support is available 7 days a week, 24 hours a day, to respond to station requests for information, traffic instructions or additional media. Providing direct support alleviates
the need for client traffic departments to deal with individual stations or the challenges of staffing for off-hours support. DGS customer service operation centers are linked to DGS order management and media storage systems, and
national distribution network. These resources enable DGS to manage the distribution of client orders to the fulfillment location best suited to meet critical customer requirements as well as providing order status and fulfillment confirmation. This
distribution model also provides DGS with significant redundancy and re-route capability, enabling DGS to meet customer needs when weather or other conditions prevent deliveries using traditional courier services.



An important element of StarGuides product offering is to support its
sales efforts with comprehensive technical support. Technical personnel often accompany sales personnel when meeting with prospective customers and aid in the implementation of StarGuides products. Customer feedback received through the sales
process is incorporated into the product development process and allows StarGuide to upgrade its service and support capabilities.



Competition



DGS competes with a
variety of dub and ship houses and production studios that have traditionally distributed taped advertising spots via physical delivery. As local distributors, these entities have long-standing ties with advertising agencies that are often difficult
for DGS to replace. In addition, these dub and ship houses and production studios often provide an array of ancillary video services, including archival storage and retrieval, closed captioning and format conversions, enabling them to deliver to
their advertiser and agency customers a full range of customizable, media postproduction, preparation, distribution and trafficking services. DGS plans to continue pursuing potential dub and ship house partners where such partnerships make strategic
sense.



In the video marketplace, DGS competes with dub and
ship houses across the country but additionally with a satellite-based video distribution network operated by Vyvx, an operating division of Willtel Communications, which is controlled by Leucadia, and other electronic networks, including Media DVX
and Fast Channel Network. DGS also anticipates that certain common and/or value-added telecommunications carriers may develop and deploy high bandwidth network services targeted at the advertising and broadcast industries, although DGS believes that
no such carriers have yet entered the market for spot distribution.



We are aware of other companies that are focusing or may in the future focus significant resources on developing and marketing products and services that will compete with ours. We believe that our ability to compete
successfully depends on a number of factors, both within and outside of our control, including: (1) the price, quality and performance of our products and those of our competitors; (2) the timing and success of new product introductions; (3) the
emergence of new technologies; (4) the number and nature of our competitors in a given market; (5) the protection of intellectual property rights; and (6) general market and economic conditions.



The Company expects competition to continue to intensify as existing and new
competitors begin to offer products, services, or systems that compete with our products. Our current or future competitors, many of whom, individually or together with their affiliates, have substantially greater financial resources, research, and
development resources, distribution, marketing, and other capabilities than us, may apply these resources and capabilities to compete successfully against our products and service. A number of the markets in which we sell our products and services
are also served by technologies that currently are more widely accepted than ours. Although we believe that our products and services are less expensive to use and more functional than competing products and services that rely on other technologies,
it is uncertain whether our potential customers will be willing to make the initial capital investment that may be necessary to convert to our products and services. The success of our systems against these competing



6



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##### Table of Contents

##### Index to Financial Statements

technologies depends in part upon whether our systems can offer significant improvements in productivity and sound and
video quality in a cost-effective manner. It is uncertain whether our competitors will be able to develop systems compatible with, or that are alternatives to, our proprietary technology or systems. It is also not certain that we will be able to
compete successfully against current or future competitors or that competitive pressures faced by us will not materially adversely affect our business, operating results, and financial condition.



Intellectual Property and Proprietary Rights



The Company primarily relies upon a combination of copyright, trademark and trade secret laws and license agreements to establish and protect proprietary rights in its technologies. The Company currently has
twenty-eight patents issued and five other allowed and awaiting issuance and thirty other patent applications pending domestically and abroad. The Company also has nine trademark registrations and one hundred ninety-two copyright registrations.



Employees



As of December 31,
2004, the Company had a total of 403 employees, including 58 in research and development, 34 in sales and marketing, 259 in operations and manufacturing, and 52 in finance and administration. All of these employees were located in the United States.
The Companys employees are not represented by a collective bargaining agreement and the Company has not experienced a work stoppage. The Company considers its relations with its employees to be good.



The Companys business and prospects depend in significant part upon the
continued service of its key management, sales and marketing and administrative personnel. The loss of key management or technical personnel could materially adversely affect the Companys operating results and financial condition. The Company
believes that its prospects depend in large part upon its ability to attract and retain highly skilled managerial, sales and marketing and administrative personnel. Competition for such personnel is intense, and the Company may not be successful in
attracting and retaining such personnel. Failure to attract and retain key personnel could have a material adverse effect on the Companys operating results and financial condition.



7



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##### Index to Financial Statements

ITEM 2. PROPERTIES



The
Companys principal executive offices are at 750 West John Carpenter Freeway in Irving, Texas. The Irving offices include 26,000 square feet of leased space, for which the lease expires in June 2006. In addition, the Company leases
approximately 3,000 square feet in Louisville, Kentucky for its dub and ship facility which expires in 2006; approximately 32,000 square feet in two New York City facilities which are occupied by production service and sales personnel and expire in
2006 and 2008; approximately 17,500 square feet in two Los Angeles area facilities occupied by production service and sales personnel which expire in 2005 and 2006; 4,500 square feet in Detroit, which is occupied by production service and sales
personnel which expires in 2007; 19,000 square feet in Wilmington, Ohio, which is occupied by production service and sales personnel which expires in 2009; and 25,000 square feet in Chicago, which is occupied by production service and sales
personnel which expires in 2006. An additional 11,305 square feet of space in San Diego that expires on April 30, 2005 is currently being sublet to a lessee. In addition, the Company leases an office in Boca Raton, Florida that is approximately
2,600 square feet and includes sales, operations and administrative staff for Source, which expires in 2006. Finally, the Company leases an office in Holmdel, New Jersey that is 11,000 square feet and includes audio operations and administrative
staff for StarGuides wholly owned subsidiary, Corporate Computer Systems, Inc. (CCS), which expired on August 31, 2004 and is currently being leased on a month to month basis.



ITEM 3. LEGAL PROCEEDINGS



The
Company is subject, from time to time, to various legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business. While the outcome of these claims cannot be predicted with certainty, management does not
believe that the outcome of any of these legal matters asserted to date will have a material effect on the financial condition or results of operations of the Company.



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



The Company held its annual shareholders meeting on November 3, 2004, at which shareholders were asked (i) to elect a director, to serve for a three-year term or until a successor has been duly elected and qualified
and (ii) to ratify the selection of KPMG LLP as the Companys independent accountants for the fiscal year ended December 31, 2004. The results are as follows:



|                                                                           |  |            |  |                        |  |             |  |                 
|-------------------------------------------------------------------------- |  | ---------- |  | ---------------------- |  | ----------- |  | ----------------
|Matter                                                                     |  | Votes For  |  | Votes Against/Withheld |  | Abstentions |  | Broker Non-Votes
|Election of the following director for a three-year term expiring in 2007: |  |            |  |                        |  |             |  |                 
|Scott K. Ginsburg                                                          |  | 68,421,725 |  | 1,279,357              |  | 0           |  | 0               
|Ratify the appointment of KPMG LLP                                         |  | 68,782,875 |  | 879,195                |  | 39,012      |  | 0               



Information regarding
the other directors whose term of office continued after the meeting is included under Part III, Item 10  Directors and Executive Officers of the Registrant.



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##### Index to Financial Statements

PART II



ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES



The Common Stock of the Company has been traded on the Nasdaq National Market under the symbol DGIT since the Companys initial public offering on
February 6, 1996. Prior to that time there was no public market for the Companys Common Stock or other securities.



The following table sets forth the high and low closing sales prices of our Common Stock from January 1, 2003 to December 31, 2004. Such prices represent
prices between dealers, do no include retail mark-ups, markdowns or commissions and may not represent actual transactions.



|               |  |                        |      |                        |   |      |  |     |      |  |   |     
|-------------- |  | ---------------------- | ---- | ---------------------- | - | ---- |  | --- | ---- |  | - | ----
|               |  | Fiscal Year Ended 2004 |      | Fiscal Year Ended 2003
|               |  | High                   |      | Low                    |   | High |  | Low
|First Quarter  |  | $                      | 2.30 |                        | $ | 1.04 |  | $   | 2.73 |  | $ | 1.07
|Second Quarter |  |                        | 1.76 |                        |   | 1.20 |  |     | 3.90 |  |   | 1.93
|Third Quarter  |  |                        | 1.49 |                        |   | 1.15 |  |     | 2.75 |  |   | 1.86
|Fourth Quarter |  |                        | 1.35 |                        |   | 1.05 |  |     | 2.40 |  |   | 1.67



The following table
sets forth the purchases of equity securities by the Company during the period December 1, 2004 to December 31, 2004. All purchases were made on the open market during the time periods specified.



|                                           |  |                                 |  |                             |      |                                                                     |         |                                                                     |   |          
|------------------------------------------ |  | ------------------------------- |  | --------------------------- | ---- | ------------------------------------------------------------------- | ------- | ------------------------------------------------------------------- | - | ---------
|                                           |  | Total Number of SharesPurchased |  | Average PricePaid per Share |      | Total Numberof SharesPurchased asPart of PubliclyAnnouncedPlans (1) |         | Maximum DollarValue of Sharesthat May Yet bePurchased underthe Plan
|December 1, 2004 through December 31, 2004 |  | 455,705                         |  | $                           | 1.27 |                                                                     | 455,705 |                                                                     | $ | 2,905,871

---

|(1) | The authorization by the Board of Directors to repurchase of up to $3.5 million of its common stock was announced to the public via a press release filing on Form 8-K on November
30, 2004. No expiration date was specified.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



As
of December 31, 2004, the Company had issued 73,226,113 and outstanding 72,747,491 shares of its Common Stock. As of March 8, 2005, the Company had issued 73,226,814 and outstanding 72,748,192 shares of its Common Stock. As of February 28, 2005 the
Companys Common Stock was held by approximately 166 shareholders of record. The Company estimates that there are approximately 7,902 beneficial shareholders.



See Note 13 to the Companys consolidated financial statements and related notes, included herein, for a description of
the securities authorized for issuance under equity compensation plans.



The Company has never declared or paid cash dividends on its capital stock. The Company currently expects to retain any future earnings for use in the operation and expansion of its business and does not anticipate paying any cash dividends
in the foreseeable future.



9



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##### Index to Financial Statements

ITEM 6. SELECTED FINANCIAL DATA



The following selected historical consolidated financial data should be read in conjunction with the Companys consolidated financial statements and related notes and the Companys Managements Discussion and Analysis
of Financial Condition and Results of Operations. The consolidated statement of operations data for the year ended December 31, 2000 and the consolidated balance sheet data at December 31, 2000 are derived from the consolidated financial
statements of StarGuide, which have been audited by KPMG LLP, independent public accountants. The consolidated statement of operations data for the years ended December 31, 2004, 2003, 2002 and 2001 and the consolidated balance sheet data at
December 31, 2004, 2003, 2002 and 2001 are derived from the consolidated financial statements of the Company, which were audited by KPMG LLP, independent public accountants.



Statement of Operations:



|                                                                                                                |  |                                          |        |   |      |   |        |  |   |          |   |  |      |        |   |  |   |         |  
|--------------------------------------------------------------------------------------------------------------- |  | ---------------------------------------- | ------ | - | ---- | - | ------ |  | - | -------- | - |  | ---- | ------ | - |  | - | ------- | -
|                                                                                                                |  | For the years ended December 31,         |       
|                                                                                                                |  | 2004                                     |        |   | 2003 |   | 2002   |  |   | 2001     |   |  | 2000 |       
|                                                                                                                |  | (in thousands, except per share amounts) |       
|Revenues                                                                                                        |  | $                                        | 62,366 |   |      | $ | 57,687 |  | $ | 66,294   |   |  | $    | 70,700 |   |  | $ | 14,419  |  
|                                                                                                                |  |                                          |        |   |      |   |        |  |   |          |   |  |      |        |   |  |   |         |  
|Costs and expenses                                                                                              |  |                                          |        |   |      |   |        |  |   |          |   |  |      |        |   |  |   |         |  
|Cost of revenues                                                                                                |  |                                          | 33,355 |   |      |   | 29,207 |  |   | 33,328   |   |  |      | 37,413 |   |  |   | 9,802   |  
|Sales and marketing                                                                                             |  |                                          | 4,707  |   |      |   | 4,499  |  |   | 5,005    |   |  |      | 5,615  |   |  |   | 2,742   |  
|Research and development                                                                                        |  |                                          | 2,079  |   |      |   | 3,289  |  |   | 3,941    |   |  |      | 4,604  |   |  |   | 3,111   |  
|General and administrative expenses:                                                                            |  |                                          |        |   |      |   |        |  |   |          |   |  |      |        |   |  |   |         |  
|Noncash stock award charges                                                                                     |  |                                          |       |   |      |   |       |  |   |         |   |  |      |       |   |  |   | 19,630  |  
|Other                                                                                                           |  |                                          | 7,151  |   |      |   | 7,142  |  |   | 9,642    |   |  |      | 12,187 |   |  |   | 5,330   |  
|Restructuring charges                                                                                           |  |                                          |       |   |      |   |       |  |   | 771      |   |  |      | 791    |   |  |   |        |  
|Impairment charges                                                                                              |  |                                          | 9,131  |   |      |   |       |  |   |         |   |  |      |       |   |  |   |        |  
|Depreciation and amortization                                                                                   |  |                                          | 5,797  |   |      |   | 7,897  |  |   | 7,390    |   |  |      | 17,065 |   |  |   | 824     |  
|                                                                                                                |  |                                          |        |   |      |   |        |  |   |          |   |  |      |        |   |  |   |         |  
|Total expenses                                                                                                  |  |                                          | 62,220 |   |      |   | 52,034 |  |   | 60,077   |   |  |      | 77,675 |   |  |   | 41,439  |  
|                                                                                                                |  |                                          |        |   |      |   |        |  |   |          |   |  |      |        |   |  |   |         |  
|Income (loss) from operations                                                                                   |  | $                                        | 146    |   |      | $ | 5,653  |  | $ | 6,217    |   |  | $    | (6,975 | ) |  | $ | (27,020 | )
|Other (income) expense                                                                                          |  |                                          |        |   |      |   |        |  |   |          |   |  |      |        |   |  |   |         |  
|Interest and other (income) expense, net                                                                        |  |                                          | 1,284  |   |      |   | 963    |  |   | 1,520    |   |  |      | 2,054  |   |  |   | (279    | )
|Equity in losses of joint venture                                                                               |  |                                          |       |   |      |   |       |  |   |         |   |  |      |       |   |  |   | 1,125   |  
|                                                                                                                |  |                                          |        |   |      |   |        |  |   |          |   |  |      |        |   |  |   |         |  
|Net income (loss) before income taxes and cumulative effect of change in accounting principle                   |  |                                          | (1,138 | ) |      |   | 4,690  |  |   | 4,697    |   |  |      | (9,029 | ) |  |   | (27,866 | )
|Provision for income taxes                                                                                      |  |                                          | (4,342 | ) |      |   | 491    |  |   | 1,848    |   |  |      |       |   |  |   |        |  
|                                                                                                                |  |                                          |        |   |      |   |        |  |   |          |   |  |      |        |   |  |   |         |  
|Net income (loss) before cumulative effect of change in accounting principle                                    |  |                                          | 3,204  |   |      |   | 4,199  |  |   | 2,849    |   |  |      | (9,029 | ) |  |   | (27,866 | )
|Cumulative effect of change in accounting principle                                                             |  |                                          |       |   |      |   |       |  |   | (130,234 | ) |  |      |       |   |  |   |        |  
|                                                                                                                |  |                                          |        |   |      |   |        |  |   |          |   |  |      |        |   |  |   |         |  
|Net income (loss)                                                                                               |  | $                                        | 3,204  |   |      | $ | 4,199  |  | $ | (127,385 | ) |  | $    | (9,029 | ) |  | $ | (27,866 | )
|                                                                                                                |  |                                          |        |   |      |   |        |  |   |          |   |  |      |        |   |  |   |         |  
|Basic and diluted net income (loss) per common share before cumulative effect of change in accounting principle |  | $                                        | 0.04   |   |      | $ | 0.06   |  | $ | 0.04     |   |  | $    | (0.13  | ) |  | $ | (0.68   | )
|                                                                                                                |  |                                          |        |   |      |   |        |  |   |          |   |  |      |        |   |  |   |         |  
|Basic and diluted net loss per common share                                                                     |  | $                                        | 0.04   |   |      | $ | 0.06   |  | $ | (1.80    | ) |  | $    | (0.13  | ) |  | $ | (0.68   | )
|                                                                                                                |  |                                          |        |   |      |   |        |  |   |          |   |  |      |        |   |  |   |         |  
|Weighted average common shares outstanding                                                                      |  |                                          |        |   |      |   |        |  |   |          |   |  |      |        |   |  |   |         |  
|Basic                                                                                                           |  |                                          | 72,768 |   |      |   | 71,367 |  |   | 70,718   |   |  |      | 70,443 |   |  |   | 40,912  |  
|                                                                                                                |  |                                          |        |   |      |   |        |  |   |          |   |  |      |        |   |  |   |         |  
|Diluted                                                                                                         |  |                                          | 73,302 |   |      |   | 74,891 |  |   | 70,807   |   |  |      | 70,443 |   |  |   | 40,912  |  
|                                                                                                                |  |                                          |        |   |      |   |        |  |   |          |   |  |      |        |   |  |   |         |  



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##### Index to Financial Statements

Balance Sheet Data



|                                          |  |              |         |      |   |        |  |      |        |  |      |         |   |  |   |         |  
|----------------------------------------- |  | ------------ | ------- | ---- | - | ------ |  | ---- | ------ |  | ---- | ------- | - |  | - | ------- | -
|                                          |  | December 31, |        
|                                          |  | 2004         |         | 2003 |   | 2002   |  | 2001 |        |  | 2000 |        
|Cash and cash equivalents                 |  | $            | 8,059   |      | $ | 7,236  |  | $    | 2,527  |  | $    | 2,724   |   |  | $ | 2,891   |  
|Working capital                           |  |              | 7,857   |      |   | 7,202  |  |      | 477    |  |      | (1,011  | ) |  |   | 918     |  
|Property and equipment, net               |  |              | 12,453  |      |   | 9,735  |  |      | 12,757 |  |      | 16,535  |   |  |   | 870     |  
|Total assets                              |  |              | 107,517 |      |   | 92,933 |  |      | 97,205 |  |      | 235,800 |   |  |   | 11,102  |  
|Long-term debt, excluding current portion |  |              | 8,737   |      |   | 2,400  |  |      | 4,548  |  |      | 9,496   |   |  |   |        |  
|Shareholders equity (deficit)            |  |              | 79,432  |      |   | 75,474 |  |      | 69,213 |  |      | 196,682 |   |  |   | (11,498 | )



ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS



Overview



The following
Managements Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Consolidated Financial Statements and Notes and contains forward-looking statements that involve risks and
uncertainties. Actual results could differ materially from those indicated in the forward-looking statements as a result of various factors.



We are the leading provider of digital media distribution services to the advertising and broadcast industries. In addition, we operate this
industrys largest electronic digital distribution network. Our primary source of revenue is the delivery of television and radio advertisements, or spots, which is typically performed digitally but sometimes physically; we introduced a digital
alternative to dub-and-ship delivery of spots. We bill our services on a per transaction basis on payment terms of net 30 days.



Our services include audio/video distribution services, production services and the sale/license of audio/video transmission equipment. We rely on the
national TV/radio spot advertising industry for the majority of our revenues and we operate in a very competitive industry. We have offices in New York, Los Angeles, Chicago, Detroit, Louisville, Kentucky, Boca Raton, Florida and Wilmington, Ohio
while our network operations center (NOC) is located in Irving, Texas.



We seek to grow and broaden our revenue base through a combination of new business initiatives and strategic acquisitions. We intend to pursue complementary acquisitions that leverage the Companys sales force, network infrastructure
and close agency/advertiser relationships. During 2004, the Company made two strategic acquisitions.



Source TV



Effective August 31, 2004, the Company completed the acquisition of certain assets and assumed certain liabilities of Mayhthenyi, Inc., which was the
operator of SourceTV (Source). Accordingly, the results of Sources operations have been included in the Companys consolidated financial statements since that date. Source is a Florida-based provider of a complete online
resource and searchable database of over 350,000 television commercials, both on a subscription and per-transaction basis. The Company acquired the assets for $3.8 million in cash, of which $3.7 million was allocated to the on-line resource and
database and is being amortized over the estimated useful life of 10 years.



AGT Broadcast



Effective June 1, 2004, the Company purchased substantially all of the net assets and assumed certain liabilities of the Broadcast Division (Broadcast) of Applied Graphics Technologies, Inc. (AGT). Accordingly, the
results of Broadcasts operations have been included in the Companys consolidated financial statements since that date. Based in New York, Broadcasts core services are the distribution of program and/or advertising content to
television and radio stations throughout the country utilizing conventional and electronic duplication technology. Broadcast currently distributes content to radio stations and television destinations across the United States and maintains
operations in California, Michigan, New York and Ohio.



The
Company paid $15.0 million in cash to AGT as consideration for the assets of Broadcast. The purchase included $0.4 million in receivables due from Broadcast to the Company which were forgiven as a result of the acquisition. The cash payment was
comprised of $1.0 million of the Companys cash reserves and $14.0 million borrowed under the Companys long-term credit agreement. According to the terms of the Asset Purchase Agreement (the Agreement), the purchase price was
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 the



11



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##### Index to Financial Statements

current estimated fair values of the assets acquired and liabilities assumed at the date of acquisition. Subsequent to
the acquisition date, the Company obtained a third-party valuation of certain intangible assets of Broadcast and, accordingly, allocated the purchase price to those assets. The excess of the purchase price over the net assets acquired was allocated
to Goodwill. Goodwill created as a result of the acquisition totaled $3.3 million.



Furthermore, we are currently investing in new digital distribution technology that combines satellite, Internet and physical means to fulfill the delivery of video content to our network of broadcast and cable
television destinations. By leveraging our existing satellite transmission assets with an added Internet component, we seek to provide customers with the most reliable, flexible and cost efficient broadcast server network in the industry.



In addition, we are updating and enhancing our business
platform via the newest version of DG Online(TM), the Internet-based software application our customers utilize to enter and track orders. The upgraded interface will provide customers fully automated access to DGs services through a more
streamlined, easier-to-navigate portal. As part of this platform upgrade, we plan to integrate new features into the DG Media Manager(TM) hardware that links stations to the DGS network, including a wider range of storage, delivery and spot
management options, among other enhancements. DGS is working with a top IT services vendor to develop this application, one that we believe will be unrivaled in the industry in terms of functionality, convenience and ease-of-use. The Company intends
to continue to invest in the re-design, re-launch and re-branding of additional new customer applications throughout 2005.



Finally, we are streamlining back office functions at our operations in New York, Detroit, Wilmington, Los Angeles and Chicago to simplify customer
interaction and deliver services more efficiently.



Critical Accounting Policies



The Companys significant accounting policies and methods used in the preparation of the Consolidated Financial Statements are discussed in Note 2 of the Notes to Consolidated Financial Statements. The following is a listing of the
Companys critical accounting policies and a brief discussion of each:



| |  |  | allowance for doubtful accounts;
| | - |  | --------------------------------



| |  |  | revenue recognition;
| | - |  | --------------------



| |  |  | long-lived assets and goodwill; and
| | - |  | -----------------------------------



| |  |  | deferred taxes and the deferred tax valuation allowance.
| | - |  | --------------------------------------------------------



Allowance for Doubtful Accounts.The Companys allowance for doubtful accounts relates to trade accounts receivable. Financial
Statement Schedule II summarizes the activity in this account. The allowance for doubtful accounts is an estimate prepared by management based on identification of the collectibility of specific accounts and the overall condition of the receivable
portfolios. The Company specifically analyzes trade receivables, historical bad debts, customer credits, customer concentrations, customer credit-worthiness, current economic trends and changes in customer payment terms when evaluating the adequacy
of the allowance for doubtful accounts. If the financial condition of the Companys customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Likewise, should the Company
determine that it would be able to realize more of its receivables in the future than previously estimated, an adjustment to the allowance would increase income in the period such determination was made. The allowance for doubtful accounts is
reviewed on a monthly basis and adjustments are recorded as deemed necessary.



Revenue Recognition.The Company derives revenue from primarily two sources- (1) serviceswhich consist primarily of revenue for digital and analog audio, video and videotape distribution and (2)
product saleswhich consist of sales of audio and video distribution equipment.



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



The Company recognizes product revenue when persuasive
evidence of an arrangement exists, delivery has occurred, the sales price is fixed and determinable and collectibility is probable. Generally for product sales, these criteria are met at the time of delivery to a common carrier. Provision is made at
the time the related revenue is recognized for estimated product returns, which historically have been immaterial. The Company analyzes historical returns, current economic trends, and changes in customer demand when



12



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##### Index to Financial Statements

evaluating the adequacy of provisions for sales returns. At the time of the transaction, the Company assesses whether the
fee associated with revenue transactions is fixed and determinable and whether or not collection is reasonably assured. The Company assesses whether the fee is fixed and determinable based on the payment terms associated with the transaction. The
Company assesses collectibility based on a number of factors, including past transaction history with the customer and the credit-worthiness of the customer. The Company does not request collateral from customers. For all sales, the Company uses
either a binding purchase order or signed sales agreement as evidence of an arrangement. Shipping and handling revenues are included in product revenues and costs are included in product costs. Revenue from arrangements for the sale of products that
include software components that are more than incidental to the functionality of the related product are accounted for under AICPA Statement of Position 97-2, Software Revenue Recognition (SOP 97-2). SOP 97-2 requires that
when a product is sold that contains a significant software component, and the Company has no objective third party evidence as to the relative fair values of each of the components sold, the total sales value should be deferred and recognized on a
straight line basis over the life of the arrangement as documented in the sales agreement.



Long-Lived Assets and Goodwill.The Company assesses the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors that
the Company considers important which could trigger an impairment review include the following:



| |  |  | significant underperformance relative to expected historical or projected future operating results;
| | - |  | ---------------------------------------------------------------------------------------------------



| |  |  | significant changes in the manner or use of the acquired assets or the strategy for the Companys overall business;
| | - |  | -------------------------------------------------------------------------------------------------------------------



| |  |  | significant negative industry or economic trends;
| | - |  | -------------------------------------------------



| |  |  | significant decline in its stock price for a sustained period; and
| | - |  | ------------------------------------------------------------------



| |  |  | the Companys market capitalization relative to net book value.
| | - |  | ---------------------------------------------------------------



If the Company determines that the carrying value of long-lived or intangible assets may not be recoverable based upon the existence of one or more of the
above indicators of impairment, the Company assesses the recoverability of the long-lived or intangible asset by determining whether the amortization of the asset balance over its remaining life can be recovered through undiscounted future operating
cash flow of the acquired operations. Any impairment is measured based on a projected discounted cash flow method using a discount rate reflecting the Companys average cost of funds. During 2004, the Company upgraded its distribution network
and, during the process, removed selected fixed assets from operating in the field. Certain of these fixed assets were not yet fully depreciated and, accordingly, their remaining book value became impaired. The Company recognized a loss for $1.0
million related to these assets that have been removed from service.



In 2002, Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets became effective, and as a result, the Company ceased amortization of goodwill beginning January 1, 2002 and
evaluates goodwill for impairment at least annually. SFAS No. 142 requires the Company to test goodwill for impairment at a level referred to as a reporting unit. Goodwill is considered impaired and a loss is recognized, when its carrying value
exceeds its implied fair value. As an overall check on the reasonableness of the fair values attributed to the Companys reporting units, the Company is required to compare and contrast the aggregate fair values for all reporting units with the
Companys average total market capitalization for a reasonable period of time. SFAS No.142 states that the fair value may exceed market capitalization due to factors such as control premiums and synergies. The Company completed its initial
impairment review during the first quarter of 2002 and recorded an impairment of approximately $130.2 million, which is reported as a cumulative effect of change in accounting principle. During the evaluation of goodwill for the year ended December
31, 2004, the Company determined that the carrying value of a portion of its goodwill was impaired. Accordingly, the company recognized a loss of $8.1 million related to this impairment. There were no impairments of either long-lived assets or
goodwill during 2003.



Deferred Taxes and the Deferred
Tax Valuation Allowance.The Company has recorded both assets and liabilities for deferred taxes that arise as the result of timing differences between amounts recorded for federal income tax purposes versus items recorded in accordance with
generally accepted accounting principles. The Company offsets deferred tax liabilities against deferred tax assets for the purpose of financial statement disclosure.



The Company also has net operating loss carryforwards (NOLs) of approximately $58.0 million which will expire on
various dates ranging from 2016 to 2020. Generally accepted accounting principles require that the Company record a valuation allowance against the deferred tax asset associated with this NOL if it is more likely than not that the
Company will not be able to utilize it to offset future taxes. During 2003, the Company concluded that realization of a portion of its tax benefits from NOL carryforwards was more likely than not. As a result, $4.4 million of the valuation allowance
for deferred tax assets was reversed, resulting in a non-cash tax benefit of $1.4 million, which offset fiscal 2003 income tax expense of $1.9 million. The remaining $1.6 million reduction in the valuation allowance was due to the reduction in net
deferred tax assets attributable to 2003 income.



13



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##### Index to Financial Statements

In 2004, the Company concluded that it was more likely than not that all deferred tax assets would
ultimately be realized, so it reversed the remaining valuation allowance of $15.7 million. As a result, $6.7 million was recorded as a non-cash tax benefit, which offset income tax expense of $2.4 million. The remaining $9.0 million reduction in the
valuation allowance related to acquired deferred tax assets and therefore was recorded as a reduction to goodwill. In connection with the allocation of the reversal of the valuation allowance, management identified a material weakness in its
internal control over financial reporting, which is described in Item 9A of this report.



New Accounting Pronouncements



In May 2003, the FASB issued SFAS No. 150Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity (SFAS 150).SFAS 150, which became effective July 1, 2003,
established standards for the classification and measurement of certain financial instruments with characteristics of both liabilities and equity. The adoption of SFAS 150 did not have any effect on the Companys financial statements.



FASB Interpretation No. 46 (revised December 2003),
Consolidation of Variable Interest Entities, or FIN 46R, replaces FIN 46, which was issued July 1, 2003. FIN 46R clarifies the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements to certain
entities in which equity investors do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support. There was no effect on the Company as a result of the adoption of these rules.



FASB Interpretation No. 45 (FIN 45) requires that
enhanced disclosures be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a
guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. There was no effect on the Company as a result of the adoption of this rule.



The Company adopted the provisions of Emerging Issues Task Force (EITF) 00-21, Accounting for Revenue
Arrangements with Multiple Deliverables. EITF 00-21 governs how to identify whether goods or services, or both, that are to be delivered separately in a bundled sales arrangement should be accounted for separately. The adoption of EITF 00-21
had no impact on the Companys financial statements.



In
December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment (SFAS 123(R)). SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the
financial statements based on their fair values. SFAS 123(R) is effective for public companies beginning with the first interim period that begins after June 15, 2005. Under SFAS 123(R), the Company will recognize compensation expense for the
portion of outstanding awards for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under SFAS 123 for pro forma disclosures. The Company has not completed its evaluation of the
impact of SFAS 123(R) on its financial statements.



Results of Operations



2004 versus 2003



Revenues. Revenues for the year ended December 31,
2004 increased $4.6 million, or 8%, primarily due to revenues generated from the recently acquired assets of Broadcast, which results were included since the June 1, 2004 acquisition date. The increase was also driven, in part, by increases in
political spending in the Companys Digital Generations Systems, Inc. (DGS) division resulting from the 2004 presidential election. This was partially offset by product sales reductions in the Companys StarGuide division.



Cost of Revenues. Cost of revenues, which includes
delivery and material costs and customer operations, increased $4.1 million, or 14%, for the year ended December 31, 2004. The increase was primarily attributable to costs associated with the Broadcast division, which results were included since the
June 1, 2004 acquisition date. These increases were partially offset by cost reductions implemented by management during 2003 at the DGS division.



Research and Development. Research and development expense for the year ended December 31, 2004 decreased $1.2 million, or 37%, as compared to the
prior year, due to the fact that several offices were closed during the second quarter of 2003.



Sales and Marketing and General and Administrative. Sales and marketing and general and administrative expenses remained consistent year over year.



Impairment Charges. Impairment charges for the year
ended December 31, 2004 increased $9.1 million or 100% from prior year results due to the fact that the Company recognized impairment losses of $1.0 million related to fixed assets removed from service early and $8.1 million as a result of the
write-down of the goodwill associated with the 2001 merger with StarGuide.



Depreciation and Amortization. Depreciation and amortization decreased $2.1 million, or 27%, for the year ended December 31, 2004, as compared to the prior year, primarily due to the fact that certain
intangible assets acquired as result of the 2001 merger between DGS and StarGuide became fully amortized during 2003, as well as a non-recurring $1.5 million amortization of a patent defense settlement that occurred during 2003.



14



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##### Index to Financial Statements

Interest Expense. Interest expense increased $0.3 million, or 34%, for the year ended December 31,
2004, as compared to the prior year, due to borrowings made in conjunction with the acquisitions of Broadcast and SourceTV during 2004.



Income Tax Expense (Benefit). Income tax expense (benefit) decreased $4.8 million for the year ended December 31, 2004, as compared to the prior
year, due to the fact that the Company reversed its deferred tax valuation allowance. At December 31, 2004, the Company determined that ultimate realization of the benefits of its deferred tax assets was more likely than not, and therefore, reversed
the remaining valuation allowance on its deferred tax assets, which consist primarily of NOL Carryforwards. The Company has used already utilized $22.2 million in NOL Carryforwards to offset taxable income since 2001, and the Company believes all
remaining NOL Carryforwards will be utilized.



2003 versus 2002



Revenues. Revenues for the year ended December 31,
2003 decreased $8.6 million, or 13%, primarily due to a decrease in advertising distribution revenues at DGS which reflects increased competition in the advertising market, loss of a key customer, non-recurring StarGuide licensing revenue in 2002
and also 2002 political revenues not recurring during 2003.



Cost of Revenues. Cost of revenues, which includes delivery and material costs and customer operations, decreased $4.1 million, or 12%, for the year ended December 31, 2003 primarily due to cost reductions implemented by management
during 2003 and lower revenues. Year over year, product margins remained constant at approximately 50%.



Sales and Marketing. Sales and marketing expense decreased $0.5 million, or 10%, for the year ended December 31, 2003 primarily due to reductions
in headcount and cost reductions, including reduced spending on the Companys CoolCast service, which was terminated during August 2002.



Research and Development. Research and development expense for the year ended December 31, 2003 decreased $0.7 million, or 17%, as compared to the
prior year, due to the capitalization of salaries for internally developed software initiatives, benefits and other costs related to the development of new software and cost reductions due to reductions in personnel.



General and Administrative and Restructuring Charges. General and
administrative expenses decreased $2.5 million, or 26%, as compared to the prior year, primarily due to a decrease in the Companys provision for bad debts as well as savings from continued cost reductions implemented by management during 2003.
During the first quarter 2002, the Company recorded a restructuring charge of $0.8 million related to the consolidation of certain corporate functions and facilities. The charge represented employee termination costs, lease obligations and the
write-down of certain leasehold improvements.



Depreciation
and Amortization. Depreciation and amortization increased $0.5 million, or 7%, for the year ended December 31, 2003, as compared to the prior year, primarily due to the $1.5 million amortization of patent defense costs related to the settlement
of a large patent case.



Interest and Other Expense.
Interest and other expense decreased $0.6 million, or 37%, for the year ended December 31, 2003, as compared to the prior year, due to lower average outstanding long-term debt and capital lease obligations as well as a reduction in interest rates,
year over year.



Income tax expense. The Companys
effective income tax rate was approximately 10.5% for 2003, which differed from the federal statutory rate of 34% primarily due to a $1.4 million deferred tax benefit recognized when the Company adjusted its deferred tax asset valuation allowance.



Liquidity and Capital Resources



The Companys operating activities provided cash of $11.4 million in 2004 compared to $8.9 million in 2003. Cash provided by operating activities was $7.5 million in 2002. Cash flows from operating activities increased during 2004 as
compared to 2003 and 2002 primarily due to changes in operating income. After the removal of non-cash impairment charges totaling $9.1 million, operating income increased to $9.3 million in 2004 from $5.6 million and $6.2 million in 2003 and 2002,
respectively.



The Company used $3.3 million, $1.1 million and
$0.7 million of cash in 2004, 2003 and 2002, respectively, to purchase property and equipment. In addition, $2.3 million of property and network equipment was acquired through capital leases or vendor financing during 2004. The capital additions for
each of the three years were a result of the Companys continued expansion of its network and continued product development.



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##### Index to Financial Statements

The Company amended the long-term credit agreement with its current lender twice during 2004; the
long-term credit agreement was originally signed on May 5, 2003. The two amendments provided for additional term loans, the proceeds of which the Company used to fund the acquisitions of Broadcast and SourceTV; the Company utilized cash reserves to
fund the portions of the purchase prices not covered by term loans. The Term B Loan was created as a result of the first amendment on June 10, 2004 and totaled $6.0 million; this loan, along with the previously outstanding Term A Loan, matures
September 30, 2005. The Term C Loan was a result of the second amendment on August 31, 2004 and totaled $2.5 million; the Term C Loan matures December 31, 2005. At December 31, 2004, the Company had $2.4 million, $4.5 million and $2.0 million
outstanding pursuant to the Term A Loan, the Term B Loan and the Term C Loan, respectively. Once repaid, no amounts may be re-borrowed under any of the three outstanding term loan facilities.



The long-term credit agreement also provides for a revolving credit facility
with a borrowing base subject to the Companys eligible accounts receivable balance up to $23.5 million. At December 31, 2004, the Company had $7.3 million outstanding under the revolving credit facility and approximately $1.4 million was
available for borrowing. The revolving facility matures on May 5, 2006. The Company does not anticipate an operational need for borrowings under the revolving credit facility during the next 12 months, however, it retains the right under the
facility to use it for acquisitions, capital improvements and general corporate purposes.



Under the long-term credit agreement, the Company is required to maintain certain fixed charge coverage ratios, certain leverage ratios and current ratios on a quarterly basis and is subject to limitations on capital
expenditures for a rolling six-month period as well as limitations on capital lease borrowings on an annual basis. The Company was in compliance with these covenants for the period ended December 31, 2004. The Company pays interest on borrowings at
a variable rate based on the lenders Prime Rate or LIBOR, plus an applicable margin. The applicable margin fluctuates based on the Companys leverage ratios as defined in the long-term credit agreement. At December 31, 2004, the weighted
average interest rate on outstanding borrowings was 5.81%. The credit facility requires the Company to pay a quarterly facility fee of 0.50% of the average unused portion of the revolving line of credit and a commission fee on outstanding letters of
credit. There were no outstanding letters of credit at December 31, 2004.



Net principal payments (borrowings) on long-term debt were $(12.7) million, $4.4 million and $6.8 million in 2004, 2003 and 2002, respectively.



The Company has raised cash through the sale of common and preferred stock in the past, most recently in 2004 via the
exercise of employee stock options and prior to that during 1999. Proceeds from the sale of stock have been used to fund acquisitions, make capital expenditures, repay debt and fund continuing operations. There can be no assurances that the Company
could raise additional funds through the sale of common or preferred stock in the future.



The Company currently has no significant capital commitments other than the commitments under capital leases. The Company also has ongoing commitments with a telephone service provider to spend a minimum of $2.0
million in 2005 and 2006. Based on managements current plans and forecasts, the Company believes that its existing sources of liquidity will satisfy the Companys projected working capital and capital lease commitments and other cash
requirements through the foreseeable future. The Company believes that is has the resources necessary either on hand or available under its revolving credit facility or through the issuance of common stock to execute its business plan, to continue
to build infrastructure or to make accretive acquisitions.



The
table below summarizes the Companys contractual obligations (in thousands):



|                                   |  |       |        |                        |        |          |        |          |    |              |  
|---------------------------------- |  | ----- | ------ | ---------------------- | ------ | -------- | ------ | -------- | -- | ------------ | -
|                                   |  |       |        | Payments Due by Period
|Contractual Obligation             |  | Total |        | Less Than1 Year        |        | 1-3Years |        | 4-5Years |    | After 5Years
|Long-Term Debt                     |  | $     | 16,150 |                        | 8,900  |          | 7,250  |          |   |              | 
|Capital Leases                     |  |       | 2,243  |                        | 756    |          | 1,487  |          |   |              | 
|Operating Leases                   |  |       | 4,468  |                        | 2,190  |          | 2,212  |          | 66 |              | 
|Unconditional Purchase Obligations |  |       | 4,480  |                        | 2,480  |          | 2,000  |          |   |              | 
|                                   |  |       |        |                        |        |          |        |          |    |              |  
|Total Contractual Cash Obligations |  | $     | 27,341 |                        | 14,326 |          | 12,949 |          | 66 |              | 
|                                   |  |       |        |                        |        |          |        |          |    |              |  



Investment in Verance Corporation



On March 15, 2005, the Company entered into an exclusive
agreement with the Verance Corporation and its subsidiary, ConfirMedia(TM) (Verance), to enable third party airplay verification and advertising campaign reconciliation services across all major U.S. television, cable and radio networks and local
television and radio stations.



The Company simultaneously
announced that it is making a $5 million strategic equity investment in Verance in a private placement of convertible preferred stock. As part of the transaction, Verance will issue a warrant to the Company to allow it to increase its equity stake
in the future. The investment will take place in two equal installments the first of which took place on March 21, 2005 whereby the Company purchased 6,286,146 shares of Series B Convertible Preferred Stock, $0.0001 par value per share (the
Series B Preferred Stock), from Verance for $2.5 million. The Company expects to purchase an additional 6,286,146 shares of Series B Preferred Stock from Verance for $2.5 million by July 5, 2005. The Company will own less than 20% of
Verance on an as-converted basis following this additional purchase.



The Series B Preferred Stock is convertible into common stock, $0.0001 par value per share (the Common Stock), and will be automatically converted into Common Stock (1) upon the election of the holders of 66 2/3% of the Series A
Preferred Stock and Series B Preferred Stock acting together, (2) immediately prior to a qualified public offering by Verance, or (3) if the additional $2.5 million purchase of Series B Preferred Stock is not made by the Company. The holders of
Series B Preferred Stock are entitled to cumulative cash dividends of 7% per annum per share. Verance has the option to pay such dividends in kind with shares of Series B Preferred Stock. For purposes of liquidation or in connection with a sale or
merger by Verance, the Series B Preferred Stock is senior to any other capital stock of Verance. Holders of Verances preferred stock vote together with holders of its Common Stock on an as-converted basis.



Certain Business Considerations



In evaluating an investment in our Company, the following business considerations should be considered.



We have a history of losses and our future operating results are uncertain.



2003 was the first year the Company has reported net income after having been unprofitable since its inception; we reported
profit again in 2004. In 2002, the Company was profitable only after excluding the effect of a change in accounting principle. We



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##### Index to Financial Statements

could begin to generate net losses in the future, which could depress our stock price. Decreases in revenues could occur,
which could impair our ability to operate profitably in the future. Future success also depends in part on obtaining continued reductions in delivery and service costs, particularly our ability to continue to automate order processing and to reduce
telecommunications costs. Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in new and rapidly evolving markets, such as risks that the market might fail to grow, expenses relating
to modifying products and services to meet industry standards as they change over time, and difficulties in gaining and maintaining market share. To address these risks, we must, among other things, respond to competitive developments, continue to
attract, retain and motivate qualified persons, continue to upgrade our technologies and begin to commercialize products incorporating such technologies. We may not be successful in addressing any or all of these risks and may not be able to sustain
profitability.



Our revenues are subject to seasonal buying patterns and
lengthy sales cycles that can adversely affect operating results and lead to potential fluctuations in quarterly results.



We have historically experienced lower sales for services in the first quarter and higher sales in the fourth quarter due to increased customer
advertising volumes for the Christmas selling season. Additionally, in any single period, our service revenues and delivery costs are subject to variation based on changes in the volume and mix of deliveries performed during such period. In
particular, our service operating results have historically been significantly influenced by the volume of deliveries ordered by television stations during the sweeps rating periods that currently take place in February, May, August and
November. We have historically operated with little or no backlog. The absence of backlog increases the difficulty of predicting revenues and operating results. Fluctuations in revenues due to seasonality may become more pronounced as revenue
increases or decreases. In addition, service revenues are influenced by political advertising, which generally occurs every two years.



Due to the complexity and substantial cost associated with providing integrated product solutions to provide audio, video, data and other information
across a variety of media and platforms, licensing and selling our products to customers typically involves a significant technical evaluation and commitment of cash and other resources. In addition, there are frequently delays associated with
educating customers as to the productive applications of our products, complying with customers internal procedures for approving large expenditures and evaluating and accepting new technologies that affect key operations. In addition, certain
of our foreign customers have lengthy purchasing cycles that may increase the amount of time it takes us to place our products with these customers. For these and other reasons, the sales cycle associated with the licensing and selling of our
products is lengthy and subject to a number of significant risks, including customers budgetary constraints and internal acceptance evaluations, both of which are beyond our control. Because of the lengthy sales cycle and the large size of
customers average orders, if revenue projected from a specific customer for a particular quarter is not realized in that quarter, our product revenues and operating results for that quarter could be negatively affected. We expect revenues to
vary significantly as a result of the timing of product purchases and introductions, fluctuations in the rate of development of new markets and new applications, the degree of market acceptance of new and enhanced versions of our products and
services, and the level of use of satellite networking and other transmission systems. In addition, increased competition and the general strength of domestic and international economic conditions also impact revenues.



Our expense levels are based, in part, on our expectations of future revenue
levels. If revenue levels are below expectations, operating results are likely to be seriously harmed. To the extent that some of our costs are relatively fixed, such as personnel and facilities costs, any unanticipated shortfall in revenue in any
fiscal quarter would have an adverse effect on our results of operations in that quarter.



We may not be able to secure additional financing to satisfy future capital needs.



We may require additional capital sooner than currently anticipated in order to fund future operations and growth and we may not be able to obtain
additional funds adequate for our needs. We intend to continue making capital expenditures to produce and install various equipment required by our customers to receive our services and to introduce additional services. In addition, we will continue
to analyze the costs and benefits of acquiring certain additional businesses, products or technologies that we may from time to time identify. Assuming that we do not pursue one or more additional acquisitions funded by internal cash reserves, we
anticipate that existing capital, cash from operations and funds available under existing line of credit agreements should be adequate to satisfy our capital requirements through the foreseeable future. Our capital needs depend upon numerous
factors, including:



| |  |  | the progress of product development activities;
| | - |  | -----------------------------------------------



| |  |  | the cost of increasing sales and marketing activities; and
| | - |  | ----------------------------------------------------------



| |  |  | the amount of revenues generated from operations.
| | - |  | -------------------------------------------------



We cannot predict any of the foregoing factors with certainty. In addition, we cannot predict the precise amount of future capital that we will require,
particularly if we pursue one or more additional acquisitions. Furthermore, additional financing may not be available to us, or if it is available, it may not be available on acceptable terms. Our inability to obtain financing for additional
acquisitions on acceptable terms may prevent us from completing advantageous acquisitions and consequently could seriously harm



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##### Index to Financial Statements

our prospects and future rates of growth. Our inability to obtain additional funding for continuing operations or an
acquisition would deter the growth of our business and could impair our operations. Consequently, we could be required to significantly reduce or suspend operations, seek an additional merger partner or sell additional securities on terms that are
dilutive to existing investors.



We operate in developing markets. If these
markets do not continue to develop, or do not accept our products and services, our future growth could be jeopardized.



Our products and services are relatively new, and alternative technologies are rapidly evolving. It is difficult to predict the rate at which the market
for such products and services will grow, if at all. If the market fails to grow, or grows more slowly than anticipated, we may also fail to grow. Even if the market does grow, our products and services may not achieve commercial success. We may not
be able to conform our products to existing and emerging industry standards in a timely fashion, if at all. We believe that our future growth will depend, in part, on our ability to add these services and additional customers in a timely and
cost-effective manner. However, we may not be successful in developing such services or in obtaining new customers for such services. Furthermore, we may not be successful in obtaining a sufficient number of radio and television stations, radio and
television networks, advertisers, advertising agencies, production studios and audio and video distributors who are willing to bear the costs of expanding and increasing the integration of the Companys network, including the Companys
field receiving equipment and rooftop satellite antennae.



Our
marketing efforts to date with regard to our products and services have involved identification and characterization of specific market segments for these products and services with a view to determining the target markets that will be the most
receptive to such products and services. We may not have correctly identified such markets and our planned products and services may not address the needs of such markets. Furthermore, our technologies, in their current form, may not be suitable for
specific applications and further design modifications, beyond anticipated changes to accommodate different markets, may be necessary. Broad commercialization of our products and services will require us to overcome significant market development
hurdles, many of which we cannot predict. To achieve sustained growth, the market for our products must continue to develop and we must expand our product offering to include additional applications within the broadcast market. Potential new
products and applications for existing products in new markets include distance learning and training, finance and retail. We believe that our products and services are among the first commercial products to serve the convergence of several industry
segments, including digital networking, telecommunications, compression products and Internet services. However, the market may not accept our products. In addition, it is possible that:



| |  |  | the convergence of several industry segments may not continue;
| | - |  | --------------------------------------------------------------



| |  |  | markets may not develop as a result of such convergence; or
| | - |  | -----------------------------------------------------------



| |  |  | if markets develop, such markets may not develop either in a direction beneficial to our products or product positioning or within the time frame in which we expect to launch new
products and product enhancements.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Because the
convergence of digital networking, telecommunications, compression products and Internet services is new and evolving, we cannot predict the growth rate, if any, and the size of the potential market for our products. If markets for our products fail
to develop, develop more slowly than expected or become served by numerous competitors, or if our products do not achieve the anticipated level of market acceptance, our future growth could be jeopardized.



If we are not able to develop new products and services to respond to rapid technological
changes, our success could be compromised.



If we are not
able to develop new products and services in a timely and cost-effective fashion to respond to technological changes and deliver products and services at competitive prices, operating results will likely suffer and our stock price could decline. The
markets for our products and services are characterized by rapidly changing technology. The introduction of new products and services can render existing products obsolete or unmarketable. We may not be successful in identifying, developing,
contracting for the manufacture of and marketing product enhancements for new products and services that respond to technological change or meet emerging industry standards. In addition, we may experience difficulties that could delay or prevent the
successful development, introduction and marketing of any new products, product enhancements or services, and these products and services may not adequately meet the requirements of the marketplace and achieve market acceptance. If we experience
delays in introducing new products and services or enhancements to existing products and services, our customers may begin to use the products and services of our competitors, resulting in a loss of revenue. Furthermore, new or enhanced products
offered by us may contain defects when they are first introduced or released. If we are unable to develop and introduce new products and services or enhancements of existing products and services in a timely manner and with a significant degree of
market acceptance, our ability to maintain profitability in the future will be jeopardized.



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##### Index to Financial Statements

If we are not able to maintain and improve service quality, our business and results of operations will be susceptible
to decline.



We depend on making cost-effective deliveries
to broadcast stations within the time periods requested by our customers. If we are unsuccessful, for whatever reason, a station might be prevented from selling airtime that it otherwise could have sold. Although we disclaim any liability for lost
air-time, stations may nevertheless assert claims for lost air-time in these circumstances and dissatisfied advertisers may refuse to make further deliveries through us in the event of a significant occurrence of lost deliveries, which would result
in a decrease in our revenues or an increase in our expenses, either of which could lead to a reduction in net income or an increase in net loss. Although we maintain insurance against business interruption, such insurance may not be adequate to
protect us from significant loss in these circumstances or from the effects of a major catastrophe (such as an earthquake or other natural disaster), which could result in a prolonged interruption of our business. Our ability to make deliveries to
stations within the time periods requested by customers depends on a number of factors, some of which are outside of our control, including:



| |  |  | equipment failure;
| | - |  | ------------------



| |  |  | interruption in services by telecommunications service providers; and
| | - |  | ---------------------------------------------------------------------



| |  |  | our inability to maintain our installed base of audio and video units that comprise our distribution network.
| | - |  | -------------------------------------------------------------------------------------------------------------



Our business is highly dependent on radio and television advertising; if demand for, or
margins from, our radio and television advertising delivery services declines, our business results will decline.



We expect that a significant portion of our revenues will continue to be derived from the delivery of radio and television advertising spots from
advertising agencies, production studios and dub and ship houses to radio and television stations in the United States. A decline in demand for, or average selling prices of, our radio and television advertising delivery services for any of the
following reasons, or otherwise, would seriously harm our business:



| |  |  | competition from new advertising media;
| | - |  | ---------------------------------------



| |  |  | new product introductions or price competition from competitors;
| | - |  | ----------------------------------------------------------------



| |  |  | a shift in purchases by customers away from DGS premium services; and
| | - |  | ----------------------------------------------------------------------



| |  |  | a change in the technology used to deliver such services.
| | - |  | ---------------------------------------------------------



Additionally, we are dependent on our relationship with the radio and television stations in which we have installed communications equipment. Should a
substantial number of these stations go out of business, experience a change in ownership or discontinue the use of our equipment in any way, our revenues and results of operations would decline.



Our business is highly dependent on electronic video advertising delivery service
deployment.



Our inability to place units necessary for
the receipt of electronically delivered video advertising content in an adequate number of television stations or our inability to capture market share among content delivery customers, which may be the result of price competition, new product
introductions from competitors or otherwise, would be detrimental to our business objectives and deter future growth. We have made a substantial investment in upgrading and expanding our NOC and in populating television stations with the units
necessary for the receipt of electronically delivered video advertising content. However, we cannot assure the shareholders that the placement of these units will cause this service to achieve adequate market acceptance among customers that require
video advertising content delivery.



In addition, we believe
that to more fully address the needs of potential video delivery customers we will need to develop a set of ancillary services that typically are provided by dub and ship houses. These ancillary services include cataloging, physical archiving,
closed-captioning, modification of slates and format conversions. We will need to provide these services on a localized basis in each of the major cities in which we provide services directly to agencies and advertisers. We currently provide certain
of such services to a portion of our customers through our facilities in New York, Los Angeles, Detroit and Chicago. However, we may not be able to successfully provide these services to all customers in those markets or any other major metropolitan
area at competitive prices. Additionally, we may not be able to provide competitive video distribution services in other United States markets because of the additional costs and expenses necessary to do so and because we may not be able to achieve
adequate market acceptance among current and potential customers in those markets.



While we are taking the steps we believe are required to achieve the network capacity and scalability necessary to deliver video content reliably and cost effectively as video advertising delivery volume grows, we may
not achieve such goals because they are



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##### Index to Financial Statements

highly dependent on the services provided by our telecommunication providers and the technological capabilities of both
our customers and the destinations to which content is delivered. If our telecommunication providers are unable or unwilling to provide us the services necessary at a rate we are willing to pay or if our customers and/or their delivery destinations
do not have the technological capabilities necessary to send and/or receive video content, our goals of adequate network capacity and scalability could be jeopardized.



In addition, we may be unable to retain current audio delivery customers or attract future audio delivery customers who may
ultimately demand delivery of both media content unless we can successfully continue to develop and provide video transmission services. The failure to retain such customers could result in a reduction of revenues, thereby decreasing our ability to
achieve and maintain profitability.



The markets in which we operate are
highly competitive, and we may be unable to compete successfully against new entrants and established companies with greater resources.



We provide services that compete with a variety of dub and ship houses and production studios in the market for the distribution of audio advertising
spots to radio stations and the distribution of video advertising spots to television stations. The principal competitive factors affecting these markets are ease of use, price, timeliness and accuracy of delivery. Although such dub and ship houses
and production studios generally do not offer electronic delivery, they have long-standing ties to local distributors that may be difficult for us to replace. Some of these dub and ship houses and production studios have greater financial,
distribution and marketing resources and have achieved a higher level of brand recognition than we have. Certain of our competitors in the video distribution market are also our marketing partners in the audio distribution market.



To the extent that we are successful in entering new markets, such as the
delivery of other forms of content to radio and television stations, we would expect to face competition from companies in related communications markets and/or package delivery markets. Some of these companies in related markets could offer
products and services with functionality similar or superior to ours. Telecommunications providers, such as AT&T, MCI Worldcom and Regional Bell Operating Companies, could also enter the market as competitors with materially lower electronic
delivery transportation costs. We could also face competition from entities with package delivery expertise such as Federal Express, United Parcel Service, DHL and Airborne if any such companies enter the electronic data delivery market. Radio
networks such as ABC or Westwood One could also become competitors by selling and transmitting advertisements as a complement to their content programming.



We expect that an increasingly competitive environment will result in price reductions that could result in lower profits and loss of market share.
Moreover, the market for the distribution of audio and video transmissions has become increasingly concentrated in recent years as a result of acquisitions, which are likely to permit many of our competitors to devote significantly greater resources
to the development and marketing of new competitive products and services. We expect that competition will increase substantially as a result of these and other industry consolidations and alliances, as well as the emergence of new competitors.
Accordingly, we may not be able to compete successfully with new or existing competitors, and the effects of such competition could result in a decrease in our anticipated future growth.



The markets in which we sell products are highly competitive, and we may be unable to compete successfully against new
entrants and established companies with greater resources. We believe that our ability to compete successfully depends on a number of factors, both within and outside of our control, including the price, quality and performance of our products and
those of our competitors, the timing and success of new product introductions, the emergence of new technologies and the number and nature of competitors in a given market. In addition, the assertion of intellectual property rights by others and
general market and economic conditions factor into our ability to compete successfully.



We are aware of other companies that are intensifying their focus and may commit significant resources on developing and marketing products and services that will compete with ours. Such competitors and potential
competitors may have substantially greater financial, technical, research and development, distribution, marketing and other resources and larger installed customer bases than us. We may not be able to compete successfully against current and future
competitors based on these and other factors. A number of the markets in which our products are sold are also served by technologies that are currently more widely accepted. Our potential customers may not be willing to make the initial capital
investment necessary to convert to StarGuides products and services. The success of our systems against these competing technologies depends in part upon whether our systems can offer significant improvements in productivity and sound quality
in a cost-effective manner. Additionally, competitors may be able to develop systems compatible with, or that are alternatives to, our proprietary technology or systems.



Our business may be adversely affected if we are not able to protect our intellectual property rights from third-party challenges.



We cannot assure that our intellectual property does not
infringe on the proprietary rights of third parties. The steps that we have taken to protect our proprietary information may not prevent misappropriation of such information, and such protection may not



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##### Index to Financial Statements

preclude competitors from developing confusingly similar brand names or promotional materials or developing products and
services similar to ours. We consider our trademarks, copyrights, advertising and promotion design and artwork to be of value and important to our business. We rely on a combination of trade secret, copyright and trademark laws and nondisclosure and
other arrangements to protect our proprietary rights. We generally enter into confidentiality or license agreements with our employees, distributors and customers and limit access to and distribution of our software, documentation and other
proprietary information. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or obtain and use information that we regard as proprietary. In addition, the laws of some foreign countries do not protect our
proprietary rights to the same extent as do the laws of the United States.



While we believe that our trademarks, copyrights, advertising and promotion design and artwork do not infringe upon the proprietary rights of third parties, we may still receive future communications from third
parties asserting that we are infringing, or may be infringing, on the proprietary rights of third parties. Any such claims, with or without merit, could be time-consuming, require us to enter into royalty arrangements or result in costly litigation
and diversion of management attention. If such claims are successful, we may not be able to obtain licenses necessary for the operation of our business, or, if obtainable, such licenses may not be available on commercially reasonable terms, either
of which could prevent our ability to operate our business.



We may enter
into or seek to enter into business combinations and acquisitions that may be difficult to integrate, disrupt our business, dilute shareholder value or divert management attention.



Our business strategy includes the acquisition of complementary businesses and product lines. Any such acquisitions would be
accompanied by the risks commonly encountered in such acquisitions, including:



| |  |  | the difficulty of assimilating the operations and personnel of the acquired companies;
| | - |  | --------------------------------------------------------------------------------------



| |  |  | the potential disruption of our business;
| | - |  | -----------------------------------------



| |  |  | the inability of our management to maximize our financial and strategic position by the successful incorporation of acquired technology and rights into our product and service
offerings;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the maintenance of uniform standards, controls, procedures and policies;
| | - |  | ------------------------------------------------------------------------



| |  |  | the potential loss of key employees of acquired companies; and
| | - |  | --------------------------------------------------------------



| |  |  | the impairment of relationships with employees and customers as a result of changes in management and operational structure.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------



We may not be able to successfully complete any acquisition or, if completed,
the acquired business or product line may not be successfully integrated with our operations, personnel or technologies. Any inability to successfully integrate the operations, personnel, and technologies associated with an acquired business and/or
product line may negatively affect our business and results of operation. We may dispose of any of the Companys businesses or product lines in the event that we are unable to successfully integrate them, or in the event that management
determines that any such business or product line is no longer in the strategic interests of the Company or for other business reasons.



Failure to manage future growth could hinder the future success of our business.



Our personnel, systems, procedures and controls may not be adequate to support our existing and future operations. To
accommodate any potential future growth and to compete effectively and manage future growth, if any, we must continue to implement and improve our operational, financial and management information systems, procedures and controls on a timely basis
and to expand, train, motivate and manage our work force. We must continue to further develop our products and services while we manage anticipated growth by implementing effective planning and operating processes, such as continuing to implement
and improve our operational, financial and management information systems; hiring and training additional qualified personnel; continuing to expand and upgrade our core technologies; and effectively managing multiple relationships with various
customers, joint venture and technological partners and other third parties.



We depend on our key personnel to manage the business effectively, and if we are unable to retain our key employees or hire additional qualified personnel, our ability to compete could be harmed.



We believe that our future success will depend to a significant extent upon
the services of Scott K. Ginsburg, our Chairman of the Board and Chief Executive Officer; and Omar A. Choucair, our Chief Financial Officer. Uncontrollable circumstances, such as the death or incapacity of any key executive officer, could have a
serious impact on our business.



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##### Index to Financial Statements

Our future success also depends upon our ability to retain and to attract and retain highly qualified
management, sales, operations, technical and marketing personnel. We believe there is, and will continue to be, intense competition for personnel with experience in the markets applicable to our products and services. Because of this intense
competition, we may not be able to retain our key personnel or attract, assimilate or retain other highly qualified technical and management personnel in the future. Our inability to retain or to attract additional qualified personnel as needed
could have a considerable impact on our business.



Certain provisions of our
bylaws may have anti-takeover effects that could prevent a change in control even if the change would be beneficial to our shareholders.



Our classified board might discourage the acquisition of a controlling interest of our stock because such acquirer would not have the ability to replace
our directors, except as the term of each class expires. Our directors are divided into three classes with respect to the time for which they hold office. The term of office of one class of directors expires at each annual meeting of stockholders.
At each annual meeting of stockholders, directors elected to succeed those directors whose terms then expire are elected for a term of office to expire at the third succeeding annual meeting of stockholders after their election.



Because the Nasdaq National Market is likely to continue to experience extreme price and
volume fluctuations, the price of our common stock may decline, thus making your investment more risky.



The stock markets, particularly the Nasdaq National Market, on which our common stock is listed, have experienced extreme price and volume fluctuations.
These fluctuations have particularly affected the market prices of equity securities of technology-related companies and have often been unrelated or disproportionate to the operating performance of those companies. Our common stock may not trade at
the same levels of shares as that of other technology companies.



Some of the factors that may cause the market price of our common stock to fluctuate significantly, include:



| |  |  | the addition or departure of key personnel;
| | - |  | -------------------------------------------



| |  |  | variations in our quarterly operating results;
| | - |  | ----------------------------------------------



| |  |  | announcements by us or our competitors of significant contracts, new or enhanced products or service offerings, acquisitions, distribution partnerships, joint ventures or capital
commitments;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | changes in financial estimates by securities analysts;
| | - |  | ------------------------------------------------------



| |  |  | sales of common stock or other securities in the future;
| | - |  | --------------------------------------------------------



| |  |  | changes in market valuations of networking, Internet and telecommunications companies;
| | - |  | --------------------------------------------------------------------------------------



| |  |  | fluctuations in stock market prices and trading volumes generally;
| | - |  | ------------------------------------------------------------------



| |  |  | sale of shares of common stock by significant holders; and
| | - |  | ----------------------------------------------------------



| |  |  | changes in general economic conditions, including interest rate levels.
| | - |  | -----------------------------------------------------------------------



Sales of substantial amounts of our common stock in the public market could negatively affect the market price of our common stock.



Sales of substantial amounts of common stock, or the perception that these
sales could occur, may depress prevailing market prices for the common stock. The sale of substantial amounts of our shares (including shares issued upon exercise of outstanding options) may cause substantial fluctuations in the price of our common
stock. In addition, sales of a substantial amount of our shares within a short period of time could cause our stock price to steeply fall. Because investors would more than likely be reluctant to purchase shares of our common stock following
substantial sales, our ability to raise capital through the sale of additional stock could be impaired.



Insiders have substantial control over us, which will limit an investors ability to influence corporate actions, including changes in control.



Our executive officers and directors and their respective affiliates own
approximately 33% of our common stock, not including options or warrants to purchase additional shares of common stock. As a result, these shareholders are able to control or significantly influence all matters requiring shareholder approval,
including the election of directors and the approval of significant corporate transactions. Such concentration of ownership may have the effect of delaying or preventing a change in control even if a change of control is in the best interest of all
shareholders.



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##### Index to Financial Statements

We face risks associated with being delisted from the Nasdaq National Market.



The holders of our common stock currently enjoy a substantial benefit in
terms of liquidity by having such common stock listed on the Nasdaq National Market. This benefit would be lost if we were to be delisted from the Nasdaq National Market. Nasdaq rules require, among other things, that our common stock trade at $1
per share or more on a consistent basis. While we believe we are currently in compliance with Nasdaqs listing requirements and corporate governance rules, we cannot assure shareholders that this is the case or that we will be able to continue
to keep our common stock listed on the Nasdaq National Market or a similar securities exchange.



Our inability to enter into or develop strategic relationships in our key industry segments could impact our operating results.



Our strategy depends in part on the development of strategic relationships with leading companies in key industry segments,
including media broadcasters and digital system providers. We may not be able to successfully form or enter into such relationships, which may jeopardize our ability to generate sales of our products or services in those segments. Specific product
lines are dependent to a significant degree on strategic alliances and joint ventures formed with other companies. Various factors could limit our ability to enter into or develop strategic relationships, including, but not limited to, our
relatively short operating history, history of losses and the resources available to our competitors.



Our business will suffer if it is not able to overcome the numerous risks associated with the use of complex technology.



The networks and the individual components within networks used in providing our distribution services are highly complex. Our services may be subject
to errors and defects in software or hardware. Additional problems in delivery of service could result from a variety of causes, including human error, physical or electronic security breaches, natural disasters, power loss, sabotage or vandalism.
Such problems or defects could result in:



| |  |  | loss of or delay in revenues and loss of market share;
| | - |  | ------------------------------------------------------



| |  |  | loss of customers;
| | - |  | ------------------



| |  |  | failure to attract new customers or achieve market acceptance;
| | - |  | --------------------------------------------------------------



| |  |  | diversion of development resources;
| | - |  | -----------------------------------



| |  |  | loss of credibility;
| | - |  | --------------------



| |  |  | increased service costs; or
| | - |  | ---------------------------



| |  |  | legal action by our customers.
| | - |  | ------------------------------



In addition, because some equipment involved in providing our information distribution services are located in the facilities of others, such as broadcast
affiliates, Internet service providers and broadband access providers, we must rely on third parties to care for equipment needed to provide our services. For example, after we place our equipment in the facilities of others and ensure it is
functioning properly, we rely on the facility to monitor the equipment to ensure that it maintains power, continues to receive a signal from the carrier and is connected to the facilities network in order to deliver the signal.



We depend upon single or limited-source suppliers, and our ability to produce audio and
video distribution equipment could be impacted if those relationships were discontinued.



We rely on fewer than five single or limited-source suppliers for integral components used in the assembly of our audio and video units. Although these suppliers are generally large, well-financed organizations, in
the event that a supplier were to experience financial or operational difficulties that resulted in a reduction or interruption in component supply to us, it would delay our deployment of audio and video units. We rely on our suppliers to
manufacture components for use in our products. Some of our suppliers also sell products to our competitors and may in the future become our competitors, possibly entering into exclusive arrangements with our existing competitors. In addition, our
suppliers may stop selling their products or components to us at commercially reasonable prices or completely stop selling their products or components to us. If a reduction or interruption of supply were to occur, it could take a significant period
of time for us to qualify an alternative subcontractor, redesign its products as necessary and contract for the manufacture of such products. This would have the effect of depressing our business until we were able to



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##### Index to Financial Statements

establish sufficient component supply through an alternative source. We believe that there are currently alternative
component manufacturers that could supply the components required to produce our products, but based on the financial condition and service levels of our current suppliers, we do not feel the need to pursue agreements or understandings with such
alternative sources or pursue long-term contracts with our current suppliers. We have experienced component shortages in the past, and material component shortages or production or delivery delays may occur in the future.



We obtain our local access transmission services and long distance telephone
access through contracts with Sprint and MCI that expire in 2006 and 2005, respectively. Our agreements with Sprint and MCI provide for reduced pricing on various services provided in exchange for minimum purchases under the contracts of $2.0
million for each year of the Sprint contract and $0.5 million for 2005 for MCI. The agreements provide for certain achievement credits once specified purchase levels are met. Any material interruption in the supply or a material change in the price
of either local access or long distance carrier service could increase our costs or cause a significant decline in our revenues, thereby decreasing our operating results.



We face various risks associated with purchasing satellite capacity.



As part of our strategy of providing transmittal of audio, video, data, and other information using satellite technology, we
periodically purchase satellite capacity from third parties owning satellite systems. Although we attempt to match these expenditures against anticipated revenues from sales of our products to customers, we may not be successful at estimating
anticipated revenues, and actual revenues from sales of our products may not exceed our expenditures for satellite capacity. In addition, purchases of satellite capacity require a significant amount of capital. Any inability to purchase satellite
capacity or to achieve revenues sufficient to offset the capital expended to purchase satellite capacity may make our business more vulnerable and significantly affect our financial condition and results of operations.



If our relationship with Hughes Network Systems is terminated, or if Hughes fails to
perform as required under our agreement, our business could be interrupted.



We have designed and developed the necessary software to enable our current video delivery systems to receive digital satellite transmissions over the Hughes Network Systems satellite system. However, the Hughes
satellite system may not have the capacity to meet our future delivery commitments and broadcast quality requirements on a cost-effective basis, if at all. We have a non-exclusive agreement with Hughes that expires in December 2005. The agreement
provides for fixed pricing on dedicated bandwidth and gives us access to satellite capacity for electronic delivery of digital audio and video transmissions by satellite. Hughes is required to meet performance specifications as outlined in the
agreement, and we are given a credit allowance for future fees if Hughes does not meet these requirements. The agreement states that Hughes can terminate the agreement if we do not make timely payments or become insolvent. The Company is currently
reviewing alternatives for replacing the Hughes satellite system.



Certain
of our products depend on satellites; any satellite failure could result in interruptions of our service that could negatively impact our business and reputation.



A reduction in the number of operating satellites or an extended disruption of satellite transmissions would impair the
current utility of the accessible satellite network and the growth of current and additional market opportunities. Satellites and their ground support systems are complex electronic systems subject to weather conditions, electronic and mechanical
failures and possible sabotage. The satellites have limited design lives and are subject to damage by the hostile space environment in which they operate. The repair of damaged or malfunctioning satellites is nearly impossible. If a significant
number of satellites were to become inoperable, there could be a substantial delay before they are replaced with new satellites. In addition, satellite transmission can be disrupted by natural phenomena causing atmospheric interference, such as
sunspots.



Certain of our products rely on signals from
satellites, including, but not limited to, satellite receivers and head-end equipment. Any satellite failure could result in interruptions of our service, negatively impacting our business. We attempt to mitigate this risk by having our customers
procure their own agreements with satellite providers.



24



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##### Index to Financial Statements

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



The Company provides some services to entities located outside of the United States and, therefore, is subject to the risk that the exchange rates will
adversely impact the Companys results of operations. The Company believes this risk to be immaterial to the Companys results of operations.



The Company is exposed to interest rate risk primarily through its borrowing activities. As of December 31, 2004, the Company had $16.2 million
outstanding under its credit facility and other variable rate debt. A one-percentage point increase in the variable interest rate based on debt amounts outstanding would result in approximately $125,000 reduction in annual pre-tax earnings. See
Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations  Liquidity and Capital Resources for additional discussion of the terms of the Companys credit facility.



ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA



The information required by this Item is set forth in the Companys Consolidated Financial Statements and the Notes thereto beginning at Page F-1 of this report.



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



None.



ITEM 9A. CONTROLS AND PROCEDURES



Evaluation
of Disclosure Controls and Procedures



As required by
Rules 13a-15 and 15d-15 under the Securities and Exchange Act of 1934 the Company has evaluated, with the participation of management, including the Companys Chief Executive Officer and Chief Financial Officer, the effectiveness of the
Companys disclosure controls and procedures as of the end of the period covered by this report. In designing and evaluating the Companys disclosure controls and procedures, management recognizes that any controls and procedures, no
matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating and implementing possible controls and procedures.



As described below under the caption Internal Control
Over Financial Reporting, a material weakness was identified in the Companys internal control over financial reporting. The Public Company Accounting Oversight Boards Auditing Standard No. 2 defines a material weakness as a
significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. As a result of the
material weakness, the Companys Chief Executive Officer and Chief Financial Officer have concluded that, as of December 31, 2004, the end of the period covered by this report, the Companys disclosure controls and procedures were not
effective to ensure that information required to be disclosed in the reports the Company files or submits under the Exchange Act is recorded, processed, summarized, and reported, within the time periods specified in the Securities and Exchange
Commissions rules and forms.



Internal Control Over Financial
Reporting



This report does not contain
Managements Annual Report on Internal Control Over Financial Reporting (the Management Report), the related Attestation Report of the Companys Independent Registered Public Accounting Firm (the
Attestation Report), or certain portions of the certifications of the Companys Chief Executive Officer and Chief Financial Officer required by Exchange Act Rule 13a-14(a) (the Omitted Certifications). Securities
Exchange Act Release No. 34-50754, Order Under Section 36 of the Securities Exchange Act of 1934 Granting an Exemption from Specified Provisions of Exchange Act Rules 13a-1 and 15d-1, which was issued on November 30, 2004, and the guidance of
the Securities and Exchange Commission (SEC) released in the Frequently Asked Questions related thereto, provide that the Company may defer filing the Management Report, the Attestation Report and the Omitted Certifications
for up to 45 days after the due date of the report. Management expects that the Company will file an amendment to this report no later than May 2, 2005, which will include both the Management Report and the Attestation Report as well as the Omitted
Certifications and revised disclosure under this Item 9A.



Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. Internal control over financial reporting refers to the process designed by, or under the supervision of, the
Companys Chief Executive Officer and Chief Financial Officer, and effected by the Companys board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with generally accepted accounting principles, and includes those policies and procedures that:



| | (1) | pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company;
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (2) | provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles,
and that receipts and expenditures of the Company are being made only in accordance with authorization of management and directors of the Company; and
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (3) | provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Companys assets that could have a material effect
on the financial statements.
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Internal control
over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is
subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material
misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design safeguards
into the process that reduce, but do not eliminate, this risk.



Management is using the framework set forth in the report entitled Internal Control-Integrated Framework published by the Committee of Sponsoring Organizations of the Treadway Commission (referred to as COSO) to
evaluate the effectiveness of the Companys internal control over financial reporting. As permitted under the guidance of the SEC released October 16, 2004, in Question 3 of its Frequently Asked Questions regarding Securities
Exchange Act Release No. 34-47986, Managements Report on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports, the scope of managements evaluation excluded the Broadcast
Division of Applied Graphics Technologies, Inc. (Broadcast), the assets of which the Company acquired on June 1, 2004, and the Source TV business (Source), the assets of which the Company acquired on August 31, 2004.
Accordingly, managements assessment of the Companys internal control over financial reporting does not include internal control over financial reporting of either Broadcast or Source. The Broadcast assets represented 18% of our total
assets at December 31, 2004, and generated 18% of our total revenues during the year ended December 31, 2004. The Source assets represented 3.8% of our total assets at December 31, 2004, and generated 1% of our total revenues during the year ended
December 31, 2004.



As a result of its evaluation of the
Companys internal control over financial reporting, management has identified a material weakness. Specifically, management has concluded that the Companys review of the reversal of valuation allowances with respect to its deferred tax
assets was inadequate. This material weakness resulted in accounting errors. These errors, which are described below, were related to the reversal of a valuation allowance taken in respect of certain of the Companys tax deferred assets.



From its inception until September 30, 2003, management
recorded a full valuation allowance with respect to all of its deferred tax assets in accordance with Financial Accounting Standards Board Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (SFAS No. 109). At
September 30, 2003, management assessed the deferred tax asset valuation allowance in accordance with SFAS No. 109 and concluded that a portion of the valuation allowance should be reversed. At December 31, 2004, management again assessed the
deferred tax asset valuation allowance and concluded that the remainder of the valuation allowance should be reversed.



In order to reflect the valuation allowance reversals on the Companys consolidated balance sheet and consolidated statements of operations, at the
time of each reversal the Company needed to specifically differentiate between reversed amounts related to deferred tax assets that had been generated by the Company and those related to deferred tax assets that had been acquired in the
Companys 2001 merger with StarGuide. No deferred tax assets were acquired in either of the Broadcast or Source asset purchases described above or in any other business combinations. Management made the required specific differentiations with
respect to the reversed amounts related to the September 30, 2003 reversal and with respect to all of the amounts reversed at December 31, 2004 that related to federal net operating loss carryforwards (NOLs). However, at December 31,
2004, management did not make a specific differentiation between reversed amounts related to certain state NOLs and other miscellaneous deferred tax assets that were Company-generated and those that were acquired in the merger with StarGuide.
Instead of making a specific differentiation, management estimated which of these deferred tax assets were Company-generated and which were acquired by reference to the ratio applicable to reversals related to the federal NOLs. The use of the
estimate caused an error in the Companys financial statements.



The error was detected in connection with the audit of the Companys 2004 financial statements, as members of the Companys accounting team and the Companys independent auditors worked through the December 31, 2004 reversal.
Upon identifying the error, management recorded two audit adjustments. These audit adjustments affected the consolidated statements of operations by decreasing tax expense by $0.3 million for the three months ended December 31, 2004 and affected the
consolidated balance sheet by increasing goodwill by $0.3 million and decreasing accumulated deficit by $0.3 million, in each case at December 31, 2004. The net impact of these adjustments on the Companys consolidated statements of operations
was to decrease the Companys net loss for the three months ended December 31, 2004 from $(0.5) million to $(0.2) million and to increase the Companys net income for the year ended December 31, 2004 from $2.9 million to $3.2 million. The
net impact of these adjustments on the Companys consolidated balance sheet at December 31, 2004 was to increase each of the Companys total assets and stockholders equity by $0.3 million. The error was corrected prior to the release
of the Companys financial results in the Companys earnings release dated February 17, 2005 and no restatement of financial statements for any period was required.



As a result of the material weakness, management has concluded that the Companys internal control over financial
reporting was ineffective as of December 31, 2004.



Changes in Internal
Control over Financial Reporting



In order to remediate
the material weakness described above and enhance its internal control over financial reporting, management has implemented the following changes:



| |  |  | Management has engaged Grant Thornton, LLP (Grant Thornton) to be directly involved in the review and accounting evaluation of the Companys future calculations of
its provision for income taxes and any other future complex or non-routine transaction.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Management has revised the Companys procedures related to internal control over financial reporting to require the involvement of both internal accounting personnel and Grant
Thornton in the evaluation of, and the application of generally accepted accounting principals to, any future complex or non-routine transaction.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Management has engaged a professional accounting services firm to provide an internal audit function. The professional accounting services firm will report to the Companys
Audit Committee and assist management in its ongoing review and, to the extent necessary, revision of the Companys policies and procedures related to its internal control over financial reporting.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Management has required certain internal accounting personnel, including the Companys senior accounting personnel to receive additional training regarding accounting for
income taxes and other complex or non-routine transactions. To date, the Companys controller has completed two training courses on the subject of SFAS No. 109. Additional training will be required on an ongoing basis.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Management believes that the material weakness will be remediated upon the
implementation of these internal control enhancements.



There
were no changes in the Companys internal control over financial reporting that occurred during the three months ended December 31, 2004 that materially affected, or that are reasonably likely to materially affect, the Companys internal
control over financial reporting. However, management believes the measures that have been implemented to remediate the material weakness have had a material impact on the Companys internal control over financial reporting since December 31,
2004, and anticipates that these measures and other ongoing enhancements will continue to have a material impact on the Companys internal control over financial reporting in future periods.



ITEM 9B. OTHER INFORMATION



Not
applicable.



25



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##### Table of Contents

##### Index to Financial Statements

PART III



ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT



|                         |  |     |  |                                                   |  |                   
|------------------------ |  | --- |  | ------------------------------------------------- |  | ------------------
|Name                     |  | Age |  | Title(s)                                          |  | Expiration of Term
|Scott K. Ginsburg (3)    |  | 52  |  | Chief Executive Officer and Chairman of the Board |  | 2007              
|Omar A. Choucair (3)     |  | 42  |  | Chief Financial Officer and Director              |  | 2006              
|David M. Kantor (1)      |  | 48  |  | Director                                          |  | 2006              
|Cappy R. McGarr (2)      |  | 53  |  | Director                                          |  | 2005              
|Kevin C. Howe (1)(2)     |  | 55  |  | Director                                          |  | 2005              
|Anthony J. LeVecchio (2) |  | 58  |  | Director                                          |  | 2005              

---

|(1) | Member of the Compensation Committee
|--- | ------------------------------------

|(2) | Member of the Audit Committee
|--- | -----------------------------

|(3) | Member of the Executive Committee
|--- | ---------------------------------



Scott K. Ginsburg joined the Company in December 1998 as Chief Executive Officer and Chairman of the Board. In July 1999, Matthew E. Devine assumed
the responsibilities as Chief Executive Officer, but Mr. Ginsburg remained the Companys Chairman. Mr. Ginsburg reassumed the responsibilities as Chief Executive Officer of the Company in November 2003. Mr. Ginsburg founded the Boardwalk Auto
Group in 1998, which consists of several car dealerships located in the Dallas area. From 1997 to 1998, Mr. Ginsburg served as Chief Executive Officer and Director of Chancellor Media (now AMFM Corporation). Mr. Ginsburg founded Evergreen Media
Corporation in 1988, and was the co-founder of Statewide Broadcasting, Inc. and H&G Communications, Inc. Mr. Ginsburg earned a B.A. from George Washington University in 1974 and a J.D. from Georgetown University in 1978.



Omar A. Choucairjoined the Company as Chief Financial Officer in July
1999. Prior to joining the Company, Mr. Choucair served as Vice President of Finance for AMFM Corporation (formerly Chancellor Media), and served as Vice President of Finance for Evergreen Media before it was acquired by Chancellor Media in 1997.
Prior to entering the media industry, Mr. Choucair was a Senior Manager at KPMG LLP, where he specialized in media and telecommunications clients. Mr. Choucair received a B.B.A. from Baylor University and became a Director in February 2001.



David M. Kantorhas been a member of the Board of
Directors of the Company since August 1999. Mr. Kantor is a media industry consultant and Vice Chairperson and CEO of Reach Media, a company that develops, acquires and partners in quality media and marketing opportunities targeting the
African-American population. Formerly, he was Senior Vice President for Network Operations of AMFM, Inc. (formerly Chancellor Media Corporation) and President of ABC Radio Network, having previously served as Executive Vice President. Prior to
joining ABC Radio Network, he held executive positions with Cox Cable and Satellite Music Network. Mr. Kantor holds a B.S. from the University of Massachusetts and an MBA from Harvard Business School.



Cappy R. McGarr has been a member of the Board of Directors of the
Company since February 2001. Mr. McGarr is President of McGarr Capital Holdings, LLC, an asset management company. He received Bachelor of Arts, Bachelor of Journalism and Master of Business Administration degrees from the University of Texas at
Austin. Upon completing his graduate degree in 1977, Mr. McGarr was employed by Goldman, Sachs & Co. He serves on the Board of Trustees of The National Archives Foundation and the Board of Directors of the Lyndon Baines Johnson Foundation.



Kevin C. Howeis the Managing Partner of Mercury
Ventures and has been a member of the Board of Directors of the Company since February 2001. Mercury Ventures manages 3 different funds that invest in emerging technology companies that focus on Internet applications. Mr. Howe serves on the board of
two publicly traded technology firms, the Company and The Sage Group, plc., which is traded on the London Stock Exchange. Mr. Howe also sits on the boards of seven privately held technology firms. In 1985, he co-founded DacEasy, an early leader in
packaged application software. In 1987, Mr. Howe led the sale of DacEasy to Insilco (a Fortune 500 company). In 1991, Mr. Howe led the carve-out of DacEasy from Insilco and subsequent sale to The Sage Group, plc., which had market capitalization of
over $7 billion. He was CEO of the US operations responsible for operations and acquisitions until 1999. In 1993, Mr. Howe also co-founded Martin Howe Associates, which was an early leader in the merchant credit card processing industry and a
pioneer in wireless solutions. The company was sold in 1997 to PMT, a Nasdaq listed company. Mr. Howe received his MBA from SMU in 1976.



Anthony J. LeVecchio has been a member of the Board of Directors of the Company since August 2004. Since its formation in 1988, he has been the
President of The James Group, a general business consulting firm that has advised clients across a range of high-tech industries. Prior to forming The James Group in 1988, Mr. LeVecchio was the Senior Vice President and Chief Financial Officer for
VHA Southwest, Inc., a regional healthcare system. Mr. LeVecchio was appointed to the Board of Directors on August 27, 2004 to fill a vacancy on the Board, to serve a term expiring at the 2005 annual meeting.



26



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##### Table of Contents

##### Index to Financial Statements

Audit Committee



The Audit Committee operates under an Amended and Restated Charter of the Audit Committee adopted by the Companys
Board of Directors.



The Audit Committees
functions include:



| |  |  | engaging independent auditors and determining their compensation;
| | - |  | -----------------------------------------------------------------



| |  |  | making recommendations to the Board of Directors for reviewing the completed audit and audit report with the independent auditors, the conduct of the audit, significant accounting
adjustments, recommendations for improving internal controls, and all other significant findings during the audit;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | meeting at least quarterly with the Companys management and auditors to discuss internal accounting and financial controls, as well as results of operations reviews performed
by the auditors;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | determining the scope of and authorizing or approving any permitted non-audit services provided by the independent auditors and the compensation for those services; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | initiating and supervising any special investigation it deems necessary regarding the Companys accounting and financial policies and controls.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------



The Audit Committee is composed solely of directors who are not officers or
employees of the Company and who, the Company believes, have the requisite financial literacy to serve on the Audit Committee, have no relationship to the Company that might interfere with the exercise of their independent judgment, and meet the
standards of independence for members of an audit committee under the rules of the SEC and under the Nasdaq Marketplace Rules.



In accordance with the rules and regulations of the SEC, the preceding paragraph regarding the independence of the members of the Audit Committee shall
not be deemed to be soliciting material or to be filed with the SEC or subject to Regulations 14A or 14C of the Exchange Act, or to the liabilities of Section 18 of the Exchange Act and shall not be deemed to be incorporated
by reference into any filing under the Securities Act of 1933, or the Exchange Act, notwithstanding any general incorporation by reference of this section of this Annual Report into any other filed document.



Messrs. LeVecchio (Chairman), McGarr and Howe are the current members of the
Audit Committee, and Messrs. McGarr and Howe were the members of the Audit Committee during 2004. The Board of Directors, after reviewing all of the relevant facts, circumstances and attributes, has determined that Mr. LeVecchio, the Chairman of the
Audit Committee, is the sole audit committee financial expert on the Audit Committee.



Code of Ethics



We have adopted a code of ethics that applies to all our officers and employees. A copy of the code of ethics is available, without charge, upon request,
by addressing your request to: Corporate Secretary, Digital Generation Systems, Inc., 750 West John Carpenter Freeway, Suite 700, Irving, Texas 75039 and on our website at www.dgsystems.com. We will disclose any amendments to our code of ethics and
all waivers from any provisions of our code of ethics granted to any of our executive officers on our website.



Section 16(a) Beneficial Ownership Reporting Compliance



The members of the Board of Directors, the executive officers of the Company and persons who hold more than 10% of the Companys outstanding
common stock are subject to the reporting requirements of Section 16 (a) of the Securities Exchange Act of 1934, as amended, which require them to file reports with respect to their ownership of the Companys common stock and their transactions
in such common stock. Based upon (i) the copies of Section 16(a) reports that the Company received from such persons for their 2004 fiscal year transactions in the common stock and their common stock holdings and (ii) the written representation
received from one or more of such persons that no annual Form 5 reports were required to be filed by them for the 2004 fiscal year, the Company believes that all reporting requirements under Section 16(a) for such fiscal year were met in a timely
manner by its executive officers, Board members and greater than ten-percent shareholders at all times during the 2004 fiscal year, except that an initial Form 3 and one Form 4 to report one transaction in August 2004 required of Anthony J.
LeVecchio was filed late as well as one Form 4 to report one transaction in November 2004 required of Kevin C. Howe was filed late.



27



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##### Table of Contents

##### Index to Financial Statements

Other Information



In September 1999, a civil lawsuit was filed by the SEC in the United States District Court for the Southern District of
Florida against Scott Ginsburg, the Chairman of the Board of the Company, his brother and his father. The lawsuit alleged that Mr. Ginsburg had violated the insider trading provisions of the federal securities laws by communicating material,
non-public information to his brother in 1996 regarding the securities of EZ Communications, Inc. (EZ) and in 1997 regarding the securities of Katz Media, Inc. (Katz). The lawsuit further alleged that Mr. Ginsburgs
father and brother, relying upon the information allegedly furnished by Mr. Ginsburg, purchased securities in EZ and Katz, and subsequently profited from the sale of such securities.



In April 2002, a jury found that Mr. Ginsburg did make these communications, known as tipping, and therefore
concluded that he had violated Sections 10(b) and 14(e) of the Exchange Act and Rules 10b-5 and 14e-3 thereunder. In July 2002, the United States District Court imposed a $1,000,000 civil penalty against Mr. Ginsburg.



Mr. Ginsburg filed a motion asking the Court to set aside its ruling and the
verdict of the jury. On December 19, 2002, the United States District Court granted Mr. Ginsburgs motion for judgment notwithstanding the verdict. The Court overturned the jury verdict in its entirety and set aside the civil penalty.



On February 13, 2003, the SEC filed a Notice of Appeal,
seeking to reverse the Courts decision and challenging the Courts earlier refusal to impose an injunction against Mr. Ginsburg. On March 19, 2004 a decision of a three-judge panel of the Eleventh Circuit U.S. Court of Appeals reversed
the decision by the U.S. District Court for the Southern District of Florida on December 19, 2002. The Court of Appeals (i) reinstated the jury verdict that Mr. Ginsburg had, in matters unrelated to the Company, violated Sections 10(b) and 14(e) of
the Exchange Act and Rules 10b-5 and 14e-3 thereunder, (i) reinstated a $1 million civil penalty against Mr. Ginsburg and (iii) remanded the case to the District Court with instructions to enjoin Mr. Ginsburg from violations of the federal
securities laws and regulations. The Court of Appeals did not bar Mr. Ginsburg from serving as an officer or director of a public company and the Companys Board immediately and unanimously moved to affirm Mr. Ginsburg in his capacity as
Chairman of the Board of Directors.



ITEM 11. EXECUTIVE COMPENSATION



Summary Compensation Table



The following
Summary Compensation Table sets forth the compensation earned by the Companys Chief Executive Officer and the other executive officer (collectively, the Named Officers).



|                                                                  |  |              |  |                     |                       |       |                               |                          |  |     |                              |           |  |                 
|----------------------------------------------------------------- |  | ------------ |  | ------------------- | --------------------- | ----- | ----------------------------- | ------------------------ |  | --- | ---------------------------- | --------- |  | ----------------
|                                                                  |  |              |  | Annual Compensation |                       |       | Long-Term Compensation Awards
|Name and Principal Position                                       |  | Year         |  | Salary              |                       | Bonus |                               | Other AnnualCompensation |  |     | Securities UnderlyingOptions
|Scott K. GinsburgChairman of the Board and Chief ExecutiveOfficer |  | 200420032002 |  | $$$                 | 250,000250,000250,000 |       | $$$                           | 20,000                 |  | $$$ | 12,46212,000755,848          | (2)(2)(1) |  |   25,000      
|Omar A. ChoucairChief Financial Officer                           |  | 200420032002 |  | $$$                 | 190,000184,731175,000 |       | $$$                           | 20,00021,250            |  | $$$ | 6,000500                    | (2)(2)    |  |   25,000250,000

---

|(1) | For 2002, represents reimbursement of automobile expenses ($32,612), travel expenses incurred during 1999 and 2000 but not reimbursed by the Company until 2002 ($706,305) and
miscellaneous expenses ($16,931). The Company did not reimburse Mr. Ginsburg for airplane expenses incurred in 2002, 2003, or 2004, to the extent that such amounts should be considered compensation.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Reimbursement of automobile expenses.
|--- | -------------------------------------



Stock Option Grants



No stock option grants were made to any Named Officers in 2004 and no stock appreciation rights were granted to any Named Officer during such year.



28



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##### Table of Contents

##### Index to Financial Statements

Stock Option Exercises



The following table sets forth information concerning option exercises during the 2004 fiscal year and option holdings as of
the end of the 2004 fiscal year with respect to any of the Named Officers. No stock appreciation rights were outstanding at the end of the year.



|                  |  |                             |  |                |   |                                                                      |         |                                                                  |        |               |   |   |  |   |  
|----------------- |  | --------------------------- |  | -------------- | - | -------------------------------------------------------------------- | ------- | ---------------------------------------------------------------- | ------ | ------------- | - | - |  | - | -
|                  |  | Shares Acquired on Exercise |  | Value Realized |   | Number of SecuritiesUnderlying UnexercisedOptions at Fiscal Year End |         | Value of Unexercised in-the-Money Options at Fiscal Year End (1)
|Name              |  |                             |  | Exercisable    |   | Unexercisable                                                        |         | Exercisable                                                      |        | Unexercisable
|Scott K. Ginsburg |  |                            |  | $              |  |                                                                      | 499,967 |                                                                  | 8,333  |               | $ |  |  | $ | 
|Omar A. Choucair  |  |                            |  | $              |  |                                                                      | 659,779 |                                                                  | 88,541 |               | $ |  |  | $ | 

---

|(1) | Based on the fair market value of the Companys common stock at December 31, 2004, of $1.25 per share, less the exercise price payable for each share.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------



Director Compensation



Non-employee Directors receive $2,500 per meeting plus $1,000 per audit
committee meeting. Employee Directors are not compensated for their participation as Directors. In addition, non-employee Directors receive reimbursement for documented reasonable expenses incurred in connection with attendance at meetings of the
Companys Board of Directors and the committees thereof. Typically, the Company has not paid compensation for special assignments of the Board of Directors.



Non-employee Board members are eligible for option grants pursuant to the provisions of the Companys 1995 Director
Option Plan. The exercise price per share of all options granted under the 1995 Director Option Plan shall be equal to the fair market value of a share of the Companys common stock on the date of grant of the option. The terms of the options
granted are ten years.



Directors who are also employees of the
Company are eligible to receive options for common stock directly under the 1992 Stock Option Plan and, if officers of the Company, are eligible to receive incentive cash bonus awards and are eligible to participate in the 1996 Employee Stock
Purchase Plan.



Employment Contracts and Change in Control
Arrangements



Pursuant to an employment agreement dated
December 10, 2003 between Mr. Choucair and the Company (the Agreement), the Company agreed to employ Mr. Choucair as its Senior Vice President and Chief Financial Officer from the date of the Agreement through December 31, 2006. Under
the Agreement, Mr. Choucair received an annualized base salary of $190,000 for 2004 which amount is to escalate by $5,000 per annum for each of the next two years. The Company retained the right to increase the base compensation as it deems
necessary. In addition, Mr. Choucair is entitled to participate in the Companys stock option plans, is entitled to four weeks of paid vacation per calendar year and is to receive a car allowance totaling $500 per month for the term of the
contract. Finally, during the term of the Agreement, the Company shall pay the amount of premiums or other costs incurred for the coverage of Mr. Choucair and his spouse and dependent family members under the Companys health plan.



The Agreement also includes provisions respecting severance,
non-solicitation, non-competition, and confidentiality obligations. Pursuant to the Agreement, if Mr. Choucair terminates his employment for Good Reason (as defined in the Agreement), he shall be entitled to all remaining salary to the end of the
Employment Term, plus salary from the end of the Employment Term through the end of the third anniversary of the Date of Termination, at the rate of salary in effect on the Date of Termination in a lump sum payment. He shall have no obligation to
seek other employment and any income so earned shall not reduce the foregoing amounts. If Mr. Choucair is terminated by the Company for Cause (as defined in the Agreement), or at the end of the Employment Term, he shall not be entitled to further
compensation. Following the end of the Employment Term, upon termination of his employment with the Company for any reason other than Cause, but upon ninety days prior written notice if such termination is by Mr. Choucair, the Company shall pay to
Mr. Choucair his salary as then in effect for a period of six months.



Compensation Committee Interlocks and Insider Participation



The members of the Compensation Committee during 2004 were Messrs. Howe and Kantor. Neither of these individuals were at any time during 2004, or at any other time, an officer or employee of the Company.



29



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##### Table of Contents

##### Index to Financial Statements

No executive officer of the Company serves as a member of the board of directors or compensation
committee of any entity that has one or more executive officers serving as a member of the Companys Board of Directors or Compensation Committee.



ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT



Equity Compensation Plan Information



The following table provides information about the securities authorized for issuance under the Companys equity compensation plans as of December
31, 2004:



|                                                           |  |                                                                                              |  |                                                                             |      |                                                                                                                                              |           
|---------------------------------------------------------- |  | -------------------------------------------------------------------------------------------- |  | --------------------------------------------------------------------------- | ---- | -------------------------------------------------------------------------------------------------------------------------------------------- | ----------
|                                                           |  | (a)                                                                                          |  | (b)                                                                         |      | (c)                                                                                                                                         
|Plan Category                                              |  | Number of securitiesto be issued uponexercise of outstanding options,warrants and rights (1) |  | Weighted-average exercise price of outstanding options, warrants and rights |      | Number of securitiesremaining available for future issuanceunder equity compensationplans (excluding securities reflected in column (a)) (2)
|Equity compensation plans approved by security holders     |  | 7,593,400                                                                                    |  | $                                                                           | 3.03 |                                                                                                                                              | 10,445,346
|Equity compensation plans not approved by security holders |  |                                                                                             |  | $                                                                           |     |                                                                                                                                              |          
|                                                           |  |                                                                                              |  |                                                                             |      |                                                                                                                                              |           
|Total                                                      |  | 7,593,400                                                                                    |  | $                                                                           | 3.03 |                                                                                                                                              | 10,445,346
|                                                           |  |                                                                                              |  |                                                                             |      |                                                                                                                                              |           

---

|(1) | This table excludes an aggregate of 5,165,666 shares issuable upon exercise of outstanding options and warrants assumed by the Company in connection with the Companys merger
with StarGuide Digital Networks, Inc. in January 2001. The weighted-average exercise price of the excluded options and warrants is $1.60 per share.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Includes 37,367 shares issuable under the Companys Employee Stock Purchase Plan.
|--- | ---------------------------------------------------------------------------------



30



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##### Table of Contents

##### Index to Financial Statements

Security Ownership of Certain Beneficial Owners and Management



The following table sets forth, as of December 31, 2004 (except where
otherwise noted), certain information with respect to shares beneficially owned by (i) each person who is known by the Company to be the beneficial owner of more than five percent of the Companys outstanding shares of common stock, (ii) each
of the Companys directors and the Named Officers and (iii) all directors and executive officers as a group. Beneficial ownership has been determined in accordance with Rule 13d-3 under the Exchange Act. Under this rule, certain shares may be
deemed to be beneficially owned by more than one person (if, for example, persons share the power to vote or the power to dispose of the shares). In addition, shares are deemed to be beneficially owned by a person if the person has the right to
acquire shares (for example, upon exercise of an option or warrant) within sixty (60) days of the date as of which the information is provided; in computing the percentage ownership of any person, the amount of shares is deemed to include the amount
of shares beneficially owned by such person (and only such person) by reason of such acquisition rights. As a result, the percentage of outstanding shares of any person as shown in the following table does not necessarily reflect the persons
actual voting power at any particular date. As of December 31, 2004, the directors and executive officers of the Company owned 24,266,856 shares of Common Stock entitled to vote, representing 33.4% of the outstanding shares of Common Stock.



|                                                                |  |                                                         |  |                     |  
|--------------------------------------------------------------- |  | ------------------------------------------------------- |  | ------------------- | -
|                                                                |  | Shares Beneficially Ownedas of December 31, 2004 (1)(2) | 
|Beneficial Owner                                                |  | Number ofShares                                         |  | Percentage of Class |  
|Scott K. Ginsburg (3)Moon Doggie Family Partnership             |  | 30,881,638                                              |  | 38.7                | %
|Omar A. Choucair (4)                                            |  | 782,282                                                 |  | 1.1                 | %
|Jeffrey A. DankworthP.O. Box 484Verdi, NV 89439                 |  | 5,391,146                                               |  | 7.4                 | %
|David M. Kantor (5)                                             |  | 95,694                                                  |  | *                   |  
|Cappy R. McGarr (6)                                             |  | 275,694                                                 |  | *                   |  
|Kevin C. Howe (6)                                               |  | 232,354                                                 |  | *                   |  
|Anthony J. LeVecchio (7)                                        |  | 26,666                                                  |  | *                   |  
|All directors and executive officers as a group (6 persons) (8) |  | 32,294,328                                              |  | 40.0                | %

---

|* | Less than 1% of the outstanding shares of common stock.
|- | -------------------------------------------------------

|(1) | Except as indicated in the footnotes to this table and pursuant to applicable community property laws, to the Companys knowledge, the persons and entities named in the table
have sole voting and investment power with respect to all shares of Common stock shown as beneficially owned by them. Unless otherwise indicated, the business address of each beneficial owner listed is 750 West John Carpenter Freeway, Suite 700,
Irving, Texas 75039.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | The number of shares of common stock outstanding as of December 31, 2004 was 72,747,491. The number of beneficially owned shares includes shares issuable pursuant to stock options
and warrants that may be exercised within sixty days after December 31, 2004.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Based on a filing with the Securities and Exchange Commission, dated January 22, 2001, indicating beneficial ownership as of such date. Includes 20,941,197 shares held of record by
Scott K. Ginsburg and 2,920,134 shares held in the name of Moon Doggie Family Partnership, L.P. Scott K. Ginsburg, the Companys Chief Executive Officer and Chairman of the Board, is the sole general partner of Moon Doggie Family Partnership,
L.P. Includes options exercisable into 502,050 shares of common stock, warrants issued to Moon Doggie Family Partnership, L.P. exercisable into 3,008,527 shares of common stock and warrants issued to Scott K. Ginsburg exercisable into 3,509,730
shares of common stock.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | Includes options exercisable into 671,757 shares of common stock and warrants exercisable into 86,660 shares of common stock.
|--- | -----------------------------------------------------------------------------------------------------------------------------

|(5) | Includes options exercisable into 85,694 shares of common stock.
|--- | ----------------------------------------------------------------

|(6) | Includes options exercisable into 75,694 shares of common stock.
|--- | ----------------------------------------------------------------

|(7) | Includes options exercisable into 1,666 shares of common stock.
|--- | ---------------------------------------------------------------

|(8) | Includes options exercisable into 1,412,555 shares of common stock and warrants exercisable into 6,604,917 shares of common stock.
|--- | ----------------------------------------------------------------------------------------------------------------------------------



31



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##### Table of Contents

##### Index to Financial Statements

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS



None.



ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES



The shareholders ratified the appointment of the independent accounting firm KPMG LLP (KPMG) to serve as independent auditors of the Company for the year ended December 31, 2004. KPMG served as the
Companys independent auditors since 1999 and is considered by management of the Company to be well qualified. KPMG has advised the Company that neither it nor any of its members has any financial interest, direct or indirect, in the Company in
any capacity.



Fee Disclosure



The following is a summary of the fees billed to the Company by KPMG for
professional services rendered for the fiscal years ended December 31, 2004 and December 31, 2003:



|                   |  |                         |         |      |   |        
|------------------ |  | ----------------------- | ------- | ---- | - | -------
|                   |  | Year Ended December 31,
|                   |  | 2004                    |         | 2003
|Audit Fees(1)      |  | $                       | 821,000 |      | $ | 221,000
|Audit Related Fees |  |                         | 25,000  |      |   | 33,000 
|Tax Fees(2)        |  |                         | 74,000  |      |   | 177,000
|All Other Fees     |  |                         |        |      |   |       
|                   |  |                         |         |      |   |        
|Total              |  | $                       | 920,000 |      | $ | 431,000

---

|(1) | Audit Fees. These are fees for professional services for the audit of the Companys annual financial statements, and for the review of the financial statements included
in the Companys filings on Form 10-Q, and for services that are normally provided in connection with statutory and regulatory filings or engagements, including fees relating to compliance with the provisions of the Sarbanes-Oxley Act, Section
404 and audits of acquired entities pursuant to Rule 3.05.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Tax Fees. These are fees for professional services with respect to tax compliance, tax advice, and tax planning.
|--- | ----------------------------------------------------------------------------------------------------------------



The Audit Committee has considered whether (and has determined that) the
provision by KPMG of the services described under Tax Fees is compatible with maintaining KPMGs independence from management and the Company. In addition, all of the services rendered to the Company by KPMG were pre-approved by the Audit
Committee.



32



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##### Index to Financial Statements

PART IV



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



|              |     |  |                                                                                                                                                            
|------------- | --- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |     |  | 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.                            



33



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##### Index to Financial Statements

|              |     |  |                                                                                                                                                     
|------------- | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |     |  | 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                                                                                                                         

---

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

|(b) | Incorporated by reference to the exhibit bearing the same title filed with registrants Registration Statement on Form S-1 (Registration No. 33-80203).
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------

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

|(d) | Incorporated by reference to the exhibit bearing the same title filed with registrants Quarterly Report on Form 10-Q filed November 13, 1996.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------

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

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

|(g) | Incorporated by reference to the exhibit bearing the same title filed with registrants Annual Report on Form 10-K filed March 29, 1999.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------

|(h) | Incorporated by reference to the exhibit bearing the same title filed with registrants Quarterly Report on Form 10-Q filed May 11, 2000.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------

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

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

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

|* | Management contract or compensatory plan or arrangement.
|- | --------------------------------------------------------

|** | Filed herewith.
|-- | ---------------



34



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##### Index to Financial Statements

|(b) | Exhibits
|--- | --------



See Item 15 (a) (3) above.



|(c) | Financial Statement Schedules
|--- | -----------------------------



See Item 15(a) (2) above.



35



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##### Index to Financial Statements

SIGNATURES



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



|                      |  |                                  |  |                                                                    
|--------------------- |  | -------------------------------- |  | -------------------------------------------------------------------
|                      |  | DIGITAL GENERATION SYSTEMS, INC.
|                      |  |                                 
|Dated: March 31, 2005 |  | By:                              |  | /s/ SCOTT K. GINSBURG                                              
|                      |  |                                  |  | Scott K. Ginsburg Chairman of the Board and Chief
Executive Officer



POWER OF ATTORNEY



KNOW ALL MEN BY THESE PRESENTS, that each person whose
signature appears below constitutes and appoints Scott K. Ginsburg and Omar A. Choucair, and each of them, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him in his name, place and stead, in
any and all capacities, to sign any or all amendments to this Form 10-K and to file the same, with all exhibits thereto, and all other documents in connection therewith, with the Securities and Exchange Commission, granting unto said
attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in
person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue thereof.



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



|                         |  |                                                                                   |  |               
|------------------------ |  | --------------------------------------------------------------------------------- |  | --------------
|Signature                |  | Title                                                                             |  | Date          
|/s/ SCOTT K. GINSBURG    |  | Chairman of the Board of Directors and Chief Executive Officer                    |  | March 31, 2005
|Scott K. Ginsburg        |  |                                                                                   | 
|                         |  |                                                                                  
|/s/ OMAR A. CHOUCAIR     |  | Chief Financial Officer and Director (Principal Financial and Accounting Officer) |  | March 31, 2005
|Omar A. Choucair         |  |                                                                                   | 
|                         |  |                                                                                  
|/s/ DAVID M. KANTOR      |  | Director                                                                          |  | March 31, 2005
|David M. Kantor          |  |                                                                                   |  |               
|                         |  |                                                                                  
|/s/ CAPPY McGARR         |  | Director                                                                          |  | March 31, 2005
|Cappy McGarr             |  |                                                                                   |  |               
|                         |  |                                                                                  
|/s/ KEVIN C. HOWE        |  | Director                                                                          |  | March 31, 2005
|Kevin C. Howe            |  |                                                                                   |  |               
|                         |  |                                                                                  
|/s/ ANTHONY J. LeVECCHIO |  | Director                                                                          |  | March 31, 2005
|Anthony J. LeVecchio     |  |                                                                                   |  |               



36



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##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



|                                                                                                      |  |     
|----------------------------------------------------------------------------------------------------- |  | ----
|                                                                                                      |  | 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 



F-1



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##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



The Board of Directors

Digital Generation Systems, Inc.:



We have audited the accompanying consolidated balance sheets of Digital Generation Systems, Inc. and subsidiaries as of December 31, 2004 and 2003, and
the related consolidated statements of operations, stockholders equity (deficit) and cash flows 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. These consolidated financial statements and financial statement schedule are the responsibility of the Companys management. Our responsibility is to express an opinion on these
financial statements and financial statement schedule based on our audits.



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



In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financial position of Digital Generation Systems, Inc. and
subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also in
our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.



As discussed in Note 6 to the consolidated financial statements, the Company
changed its method of accounting for goodwill and other intangible assets in accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets in 2002.



KPMG LLP



Dallas, Texas

February 15, 2005



F-2



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##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED 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
are an integral part of these financial statements.



F-3



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##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, 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 notes
are an integral part of these financial statements.



F-4



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
(DEFICIT)

(In thousands)



|                                                                 |  |              |  |                |    |        |                          |   |        |                 |      |   |                    |   |         |                                   |  |   |      |   |  |   |          |   |  |   |          |  
|---------------------------------------------------------------- |  | ------------ |  | -------------- | -- | ------ | ------------------------ | - | ------ | --------------- | ---- | - | ------------------ | - | ------- | --------------------------------- |  | - | ---- | - |  | - | -------- | - |  | - | -------- | -
|                                                                 |  | Common Stock |  | Treasury Stock |    |        | AdditionalPaid-inCapital |   |        | NotesReceivable |      |   | AccumulatedDeficit |   |         | TotalStockholdersEquity(Deficit) | 
|                                                                 |  | 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 notes
are an integral part of these financial statements.



F-5



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)



|                                                                                         |  |                          |         |   |      |   |         |      |  |   |          |  
|---------------------------------------------------------------------------------------- |  | ------------------------ | ------- | - | ---- | - | ------- | ---- |  | - | -------- | -
|                                                                                         |  | 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 notes
are an integral part of these financial statements.



F-6



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION 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 more than 5,000 advertisers and advertising agencies with more than 10,000 radio stations and over 3,100 broadcast and cable television destinations across the
United States and Canada. The Company also owns proprietary digital software, hardware and communications technology, including various bandwidth satellite receivers, audio compression codes, software to operate integrated digital multimedia
networks, software development for satellite applications and engineering consulting services. The Company has a Network Operation Center located in Irving, Texas that delivers audio, video, image and data content that comprise transactions between
the advertising and broadcast industries.



Certain prior year
amounts have been reclassified to conform to current year presentations.



2.
Summary of Significant Accounting Policies:



Consolidation



The consolidated financial statements include the
accounts of the Company and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.



Cash and Cash Equivalents



Cash and cash equivalents consist of liquid investments with original maturities of three months or less. The Company maintains substantially all of its
cash and cash equivalents within a 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 an allowance for doubtful accounts related to trade
accounts receivable. The allowance is an estimate prepared by management based on identification of the collectibility of specific accounts and the overall condition of the receivable portfolio. The Company specifically analyzes trade receivables,
historical bad debts, customer credits, customer concentrations, customer credit-worthiness, current economic trends and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts.



Inventories



Inventories are stated at the lower of cost (determined on a first-in, first-out basis) or market. The Companys
inventories include parts and components that are specialized in nature or subject to rapid technological obsolescence. While the Company has programs to minimize the required inventories on hand and considers technological obsolescence when
estimating allowances required to reduce recorded amounts to market values, such estimates could change in the future.



Property and Equipment



Property and equipment are stated at cost. Depreciation is computed over the estimated useful lives of assets using the straight-line method. Equipment
held under capital leases and leasehold improvements are amortized straight-line over the shorter of the lease term or estimated useful life of the asset. Estimated useful lives generally range from 2 to 7 years for network equipment, 3 to 5 years
for office equipment and furniture and 3 to 6 years for leasehold improvements.



Impairment of Long-Lived Assets



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



F-7



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Goodwill



Goodwill, which represents the excess of purchase price over the fair value of net identifiable assets acquired, is assessed
annually for recoverability based on its estimated fair value.



Intellectual
Property Rights



Acquired intellectual property rights,
which include patents, copyrights, trademarks, know-how and certain other intangible assets, are recorded as other long-term assets at cost and amortized over estimated useful lives ranging from five to seven years using the straight-line method.



Use of Estimates



The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, the Company evaluates its estimates, including those related to the allowance for doubtful accounts, inventories, intangible
assets and income taxes. The Company bases its estimates on historical experience and on other relevant assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the
carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates.



Revenue Recognition



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



The Company recognizes product revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed and determinable and collectibility is probable. Generally for product sales, these criteria are met
at the time of delivery to a common carrier. Provision is made at the time the related revenue is recognized for estimated product returns, which historically have been immaterial. The Company analyzes historical returns, current economic trends,
and changes in customer demand when evaluating the adequacy of provisions for sales returns. At the time of the transaction, the Company assesses whether the fee associated with revenue transactions is fixed and determinable and whether or not
collection is reasonably assured. The Company assesses whether the fee is fixed and determinable based on the payment terms associated with the transaction. The Company assesses collectibility based on a number of factors, including past transaction
history with the customer and the credit-worthiness of the customer. The Company does not request collateral from customers. For all sales, the Company uses either a binding purchase order or signed sales agreement as evidence of an arrangement.
Shipping and handling revenues are included in product revenues and costs are included in product costs. Revenue from arrangements for the sale of products that include software components that are more than incidental to the functionality of the
related product are accounted for under AICPA Statement of Position 97-2, Software Revenue Recognition (SOP 97-2). SOP 97-2 requires that when a product is sold that contains a significant software component, and the Company
has no objective third party evidence as to the relative fair values of each of the components sold, the total sales value should be deferred and recognized on a straight line basis over the life of the arrangement as documented in the sales
agreement.



Research and Development and Software Development Costs



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



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



F-8



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Income Taxes



Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for
the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax basis and operating loss and tax credit carryforwards. Deferred tax assets and
liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in income in the period that includes the enactment date.



Foreign Currencies



The Company provides
services to certain entities located outside of the United States of America. The Company had no gains (losses) on foreign currency transactions during 2004 but had gains (losses) on foreign currency transactions totaling $6 and $(3) for the 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 the intrinsic value-based method of accounting prescribed by Accounting Principles Board
(APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, in accounting for its fixed plan stock options. As such, compensation expense would be recorded on the date of grant only if the
current market price of the underlying stock exceeded the exercise price. Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, established accounting and disclosure requirements
using a fair value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to continue to apply the intrinsic value-based method of accounting described above, and has adopted the
disclosure requirements of SFAS No. 123. Pro forma net income and earnings per share disclosures, as if the Company recorded compensation expense based on the fair value for stock-based awards, have been presented in accordance with the provisions
of SFAS No. 148, Accounting for Stock-based Compensation  Transition and Disclosure, and are as follows for the three years ended December 31, 2004, 2003 and 2002 (in thousands, except per share amounts).



|                                                                                                                                    |  |      |       |   |      |   |       |      |  |   |          |  
|----------------------------------------------------------------------------------------------------------------------------------- |  | ---- | ----- | - | ---- | - | ----- | ---- |  | - | -------- | -
|                                                                                                                                    |  | 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 |  |      | (296  | ) |      |   | (552  | )    |  |   | (1,456   | )
|                                                                                                                                    |  |      |       |   |      |   |       |      |  |   |          |  
|Pro forma                                                                                                                           |  | $    | 2,908 |   |      | $ | 3,647 |      |  | $ | (128,841 | )
|                                                                                                                                    |  |      |       |   |      |   |       |      |  |   |          |  
|Basic earnings per share of common stock:                                                                                           |  |      |       |   |      |   |       |      |  |   |          |  
|As reported                                                                                                                         |  | $    | 0.04  |   |      | $ | 0.06  |      |  | $ | (1.80    | )
|Pro forma                                                                                                                           |  | $    | 0.04  |   |      | $ | 0.05  |      |  | $ | (1.82    | )
|Diluted earnings per share of common stock:                                                                                         |  |      |       |   |      |   |       |      |  |   |          |  
|As reported                                                                                                                         |  | $    | 0.04  |   |      | $ | 0.06  |      |  | $ | (1.80    | )
|Pro forma                                                                                                                           |  | $    | 0.04  |   |      | $ | 0.05  |      |  | $ | (1.82    | )



The fair value of each
option grant is estimated on the date of grant using the multiple option approach of the Black-Scholes option pricing model with the following assumptions used for grants in 2004, 2003 and 2002, respectively: risk-free interest rates of 3.5%, 2.9%
and 4.1%; a dividend yield of 0%; expected terms of 3.2, 3.5 and 3.1 years; and volatility factors of the expected market price of the Companys common stock of 71%, 77% and 100%.



In December 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, including grants of employee stock options, to be recognized in the financial statements based on their fair values. SFAS 123(R)
is effective for public companies beginning with the first interim period that begins after June 15, 2005. Under SFAS 123(R), the Company will recognize compensation expense for the portion of outstanding awards for which the requisite service has
not yet been rendered, based on the grant-date fair value of those awards calculated under SFAS 123 for pro forma disclosures. The Company has not completed its evaluation of the impact of SFAS 123(R) on its financial statements.



F-9



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Financial Instruments and Concentration of Credit Risk



Financial instruments that potentially subject the Company to a
concentration of credit risk consist primarily of cash and cash equivalents and accounts receivable. The Company performs ongoing credit evaluations of its customers, generally does not require collateral from its customers and maintains a reserve
for potential credit losses. The Company believes that a concentration of credit risk with respect to accounts receivable related to audio and video content distribution (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s receivables are principally from advertising agencies, dub and ship houses, and syndicated
programmers. The Companys revenues are not contingent on its customers sales or collections. However, the timing of collections from its customers is affected by the billing cycle in which the customer bills its end-users (the
customers clients). The Company provides reserves for credit losses.



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



During the years ended December 31, 2004 and December 31,
2003, the Company had no customers that accounted for 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 assumed certain liabilities of Maythenyi, Inc., which was the
operator of Source TV (Source). Accordingly, the results of Sources operations have been included in the consolidated financial statements since that date. Source is a Florida-based provider of a complete online resource and
searchable database of over 350,000 television commercials, both on a subscription and per-transaction basis. The Company acquired the assets for $3.8 million in cash, of which $3.7 million was allocated to the on-line resource and database and is
being amortized over the estimated useful life of 10 years.



AGT Broadcast



Effective June 1, 2004, the
Company purchased substantially all of the net assets and assumed certain liabilities of the Broadcast Division (Broadcast) of Applied Graphics Technologies, Inc. (AGT). Accordingly, the results of Broadcasts operations
have been included in the consolidated financial statements since that date. Based in New York, Broadcasts core services are the distribution of program and/or advertising content to television and radio stations throughout the country
utilizing conventional and electronic duplication technology. Broadcast currently distributes content to radio stations and television destinations across the United States and maintains operations in California, Michigan, New York and Ohio.



The Company paid $15.0 million in cash to AGT as consideration
for the assets of Broadcast. The purchase price also included $0.4 million in receivables due from Broadcast to the Company which were forgiven as a result of the acquisition. The cash payment was comprised of $1.0 million of the Companys cash
reserves and $14.0 million borrowed under the Companys long-term credit agreement. According to the terms of the Asset Purchase Agreement (the Agreement), the purchase price was 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 the current estimated fair values of the assets acquired and liabilities assumed at the date of acquisition. Subsequent to the acquisition date,
the Company obtained a third-party valuation of certain intangible assets of Broadcast and, accordingly, allocated the purchase price to those assets. The remaining excess of 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 table summarizes the estimated fair values of the assets acquired and the liabilities assumed at the date of the acquisition for Source. The table also summarizes the fair values of the assets acquired and liabilities assumed
of Broadcast adjusted to incorporate the results of a third party valuation analysis. The Company does not anticipate any further modifications to the purchase price allocation for Broadcast. The purchase price allocation for Source has not yet been
completed. The Company is still gathering data that will be used to refine its initial valuation of the identifiable intangible assets. The purchase price allocations 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



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



The excess of the purchase price over the tangible net assets related to the
Source acquisition was allocated in its entirety to the On-line resource and database (the Database). The Database is being amortized over its ten year estimated useful life. The excess of the purchase price over the net tangible assets
related to Broadcast totaled $8.7 million. Of this amount, $5.1 million was allocated to the customer list, which is being amortized over 10 years, $0.2 million was allocated to acquired technology which is being amortized over 1 year and $0.2
million was allocated to trademarks which is being amortized over 3 years. The remaining excess, $3.3 million was allocated to Goodwill, all of which is expected to be deductible for tax purposes.



The following unaudited pro forma information details the results of
operations as if the acquisitions of Source and Broadcast had taken place on January 1, 2003 and 2004 (in thousands, 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 of December 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
its distribution network during 2004 and, as a result, removed certain older network assets from service. In accordance with Statement of Financial Accounting Standards Number 144, Accounting for the Impairment or Disposal of Long-Lived
Assets (SFAS 144), at December 31, 2004, the Company recorded an impairment charge of $1.0 million related to these assets. The fair value of the assets removed from service was determined based on their carrying value.



F-11



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



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
Company settled an outstanding patent case and, based on the settlement, amortized all fees related to the case. As a result of the settlement, the Company recorded approximately $1.5 million in amortization expense during the year ended December
31, 2003 related to the settlement.



In June 2001, the FASB
issued SFAS No. 142. This accounting standard addresses financial accounting and reporting for goodwill and other intangible assets and requires that goodwill amortization be discontinued and replaced with periodic tests of impairment. A two-step
impairment test is used to first identify potential goodwill impairment and then measure the amount of goodwill impairment loss, if any.



In accordance with SFAS No. 142, goodwill amortization was discontinued as of January 1, 2002. The Company has identified two reporting units, as defined
in SFAS No. 142, with goodwill, an Audio and Video Content Distribution unit and a Product Sales unit. Upon initial adoption of SFAS No. 142, the Company recorded goodwill impairment 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 accounting principle in the first quarter of 2002. The assessment was performed primarily due to changes in the economy and the decline in our stock price since the valuation date
of the shares issued in the DG/StarGuide merger.



As part of
the Companys annual 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 its Product Sales reporting unit. The fair value of the Product Sales
reporting unit was determined by estimating the present value of future cash flows expected to be generating by the reporting unit.



Goodwill totaled $35.0 million 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 months ended 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 |  
|                                                        |  |                                      |        |   |               |   |        |       |  |   |        |  



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



|                              |  |                    |  |                       |        |                         |   |        |                     |  |   |       
|----------------------------- |  | ------------------ |  | --------------------- | ------ | ----------------------- | - | ------ | ------------------- |  | - | ------
|                              |  | AmortizationPeriod |  | GrossIntangibleAssets |        | AccumulatedAmortization |   |        | NetIntangibleAssets
|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-12



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



In accordance with SFAS No. 142, the net book value of the Companys
employee workforce was subsumed into goodwill on January 1, 2002, thus amortization of this asset was discontinued.



Amortization expense related to intangible assets totaled $1.9 million, $3.8 million and $1.5 million during the years ended December 31, 2004, 2003 and
2002, respectively. The estimated aggregate future amortization expense for intangible assets remaining as 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 consist of 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 Company entered into contracts with two
major radio broadcasting companies to produce and supply the Companys receivers, hubs and other items. The terms of the contracts are five and seven years and cover the related equipment and software, future software enhancements, technical
support, development work and training. As the equipment to be sold under the contracts includes software components that are more than incidental to the functionality of the equipment, the entire arrangement has been accounted for under SOP 97-2,
Software Revenue Recognition. Cash received related to these contracts is recorded as deferred revenue, with revenue and cost of revenue being recognized on a straight-line basis over the respective contract terms.



Revenues and cost of revenues 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 deferred revenue 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-13



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



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



The long-term credit agreement also provides for a revolving credit facility
with a borrowing base subject to the Companys eligible accounts receivable balance up to $23.5 million. At December 31, 2004, the Company had $7.3 million outstanding under the revolving credit facility and approximately $1.4 million was
available for borrowing. The revolving facility matures on May 5, 2006.



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



The following table details future debt repayments under the Companys credit facility (in thousands):



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



10. Income Taxes:



Components of deferred tax assets 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-14



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Components of the provision for 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 statutory rate of 34% to the Companys net income (loss) before income taxes and cumulative 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 dates ranging from 2016 to 2020. Utilization of approximately $29.7million of these carryforwards will be limited on an annual basis as a result of the merger, pursuant to
Section 382 of the Internal Revenue Code.



Generally accepted
accounting principles require the Company to record a valuation allowance against its deferred tax assets if it is more likely than not that the Company will not be able to utilize them in the future. For the period from 2001 through
2004, the Company has utilized $22.2 million in NOL carryforwards to offset its current tax liability. During 2004, the Company concluded that realization of all tax benefits from NOL carryforwards and other deferred tax assets was more likely than
not. As a result, $15.7 million of the valuation allowance for deferred tax assets was reversed, resulting in a non-cash tax benefit of $6.7 million, which offset fiscal 2004 income tax expense of $2.4 million. The remaining $9.0 million reduction
in the valuation allowance related to acquired deferred tax assets and was recorded as a reduction to goodwill.



11. Employee Benefit Plan:



The Company has a 401(k) retirement plan for full-time U.S. based employees. Employees who are at least 21 years of age and have completed at least 90
days of service are eligible to participate in the plan. Employees may contribute up to 20% of gross pay with a maximum dollar limit for 2004 of $13,000. The employer contribution is made at the end of the plan year in an amount set by corporate
resolution, based on participants compensation. The Company made no contributions to the plan in 2004, 2003 or 2002.



12. Stockholders Equity (Deficit):



Warrants



The Company has issued warrants in connection with certain financing and leasing transactions as well as through common stock offerings. All outstanding
warrants are convertible into common stock. The warrants outstanding at December 31, 2004 expire on various 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:



|                                     |  |           |  |                        |      |          |            |   |                        |   |          |  |                        |  |   |     
|------------------------------------ |  | --------- |  | ---------------------- | ---- | -------- | ---------- | - | ---------------------- | - | -------- |  | ---------------------- |  | - | ----
|                                     |  | 2004      |  | 2003                   |      | 2002    
|                                     |  | Warrants  |  | Wtd. Avg.ExercisePrice |      | Warrants |            |   | Wtd. Avg.ExercisePrice |   | Warrants |  | Wtd. Avg.ExercisePrice
|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-15



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



13. Stock Plans:



The Company has three Stock Option Plans:



1992 Stock Option Plan



Under the Companys 1992 Stock Option Plan, (the 1992 Plan), the Company may issue up to 14,950,000 shares of common stock to employees,
officers, directors and consultants. The exercise price and terms of the options granted are determined by the Board of Directors, provided that such price cannot be less than the fair value of the common stock on the date of grant for incentive
stock options or, in the case of non-statutory options, less than 85 percent of the fair value of the common stock on the date of grant. The options generally vest over four years. The 1992 Plan provides that, in the event of a change in control of
the Company, executive officers of the Company will receive accelerated vesting for a portion of their unvested option shares. The term of the options granted is seven years. No options have been granted at less than fair value under this plan.



1996 Supplemental Option Plan



Under the Companys 1996 Supplemental Option Plan, the Company may
issue up to 750,000 shares of common stock to employees, officers, directors and consultants. The exercise price and terms of the options granted are determined by the Board of Directors. The options generally vest over four years. The term of the
options granted is seven years.



1995 Director Option Plan



Under the Companys 1995 Director Option Plan (the Director
Plan), the Company may issue up to 800,000 shares of common stock to non-employee directors. The Director Plan provides that each future non-employee director of the Company will be automatically granted 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 the Company and an additional option to purchase 2,500 shares of common stock (the Subsequent Option) on each
anniversary date thereafter. The exercise price per share of all options granted under the Director Plan shall be equal to the fair market value of a share of the Companys common stock on the date of grant. Shares subject to the First Option
vest over 36 months, and the Subsequent Option shares vest over 12 months beginning with the month following the second anniversary of its date of grant. The term of the options granted is ten years.



A summary of the Companys fixed plan stock options at December 31,
2004, 2003 and 2002 and changes during the years then ended is presented below:



|                                               |  |            |   |      |                        |      |        |            |   |                        |   |        |  |            |                        |  |   |     
|---------------------------------------------- |  | ---------- | - | ---- | ---------------------- | ---- | ------ | ---------- | - | ---------------------- | - | ------ |  | ---------- | ---------------------- |  | - | ----
|                                               |  | 2004       |   | 2003 |                        | 2002
|                                               |  | Shares     |   |      | Wtd. Avg.ExercisePrice |      | Shares |            |   | Wtd. Avg.ExercisePrice |   | Shares |  |            | Wtd. Avg.ExercisePrice
|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-16



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



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



|                         |  |                     |  |                                            |  |                                |      |                    |           |                                |   |     
|------------------------ |  | ------------------- |  | ------------------------------------------ |  | ------------------------------ | ---- | ------------------ | --------- | ------------------------------ | - | ----
|Options Outstanding      |  | Options Exercisable
|Range of Exercise Prices |  | Number Outstanding  |  | Weighted- AverageRemainingContractual Life |  | Weighted-AverageExercise Price |      | Number Exercisable |           | Weighted-AverageExercise 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 stock option plans.



14. Commitments and Contingencies:



The Company leases its facilities and certain equipment under non-cancelable capital and operating leases.



At December 31, 2004, future minimum annual payments under capital leases and non-cancelable operating 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 of
obligations under capital lease was $2,043, of which $756 is classified as a current 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 with its telephone service
providers of approximately $2.5 million for 2005 and $2.0 million for 2006.



The Company is involved in various legal actions arising from the ordinary course of business. Management does not believe the ultimate resolution of these matters will have a material effect on the Companys
financial position.



15. Net Income (Loss) Per Share:



Under SFAS No. 128, Earnings per Share, the Company is required
to compute earnings per share under two different methods (basic and diluted). Basic earnings per share is calculated by dividing net income (loss) attributable to common shareholders by the weighted average shares of common stock outstanding during
the period. Diluted earnings per share is calculated by dividing net income attributable to common shareholders by the weighted average shares of outstanding common stock and common stock equivalents during the period.



A reconciliation of net income (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-17



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



16. Unaudited Quarterly Financial Information (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 operates predominantly in two industry
segments: digital and physical distribution of audio and video content and product sales of transmission and compression technology equipment. The Company has defined its reportable segments based on internal financial reporting used for corporate
management and decision-making purposes. The information in the following tables is derived directly from the segments internal financial reporting used for corporate management purposes (in thousands).



|                                      |  |                                    |          |   |               |   |        |       |  |   |                              |   |  |                    |         |   |  |   |          |  
|------------------------------------- |  | ---------------------------------- | -------- | - | ------------- | - | ------ | ----- |  | - | ---------------------------- | - |  | ------------------ | ------- | - |  | - | -------- | -
|                                      |  | Year ended December 31, 2004       |         
|                                      |  | Audio and VideoContentDistribution |          |   | Product Sales |   |        | Other |  |   | IntersegmentEliminations (a) |   |  | ConsolidatedTotals |        
|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 VideoContentDistribution |          |   | Product Sales |   |        | Other |  |   | IntersegmentEliminations (a) |   |  | ConsolidatedTotals |        
|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 VideoContentDistribution |          |   | Product Sales |   |        | Other |  |   | IntersegmentEliminations (a) |   |  | ConsolidatedTotals |        
|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   |  
|                                      |  |                                    |          |   |               |   |        |       |  |   |                              |   |  |                    |         |   |  |   |          |  

---

|(a) | Intersegment eliminations relate to intercompany receivables and payables that occur when one operating segment pays costs that are related to another operating segment.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------



F-18



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



18. New Accounting Pronouncements:



In May 2003, the FASB issued SFAS No. 150,Accounting for
Certain Financial Instruments with Characteristics of Both Liabilities and Equity.SFAS No. 150, which became effective July 1, 2003, established standards for the classification and measurement of certain financial instruments with
characteristics of both liabilities and equity. The adoption of SFAS No. 150 did not have any effect on the Companys financial statements.



FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities, or FIN 46R, replaces FIN 46, which was issued
July 1, 2003. FIN 46R clarifies the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements to certain entities in which equity investors do not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support. There was no effect on the Company as a result of the adoption of these rules.



FASB Interpretation No. 45 enhances the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under
certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. There was no effect on the
Company as a result of the adoption of this rule.



In December
2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment (SFAS 123(R)). SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial
statements based on their fair values. SFAS 123(R) is effective for public companies beginning with the first interim period that begins after June 15, 2005 (July 1, 2005 for AMR). Under SFAS 123(R), the Company will recognize compensation expense
for the portion of outstanding awards for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under SFAS 123 for pro forma disclosures. The Company has not completed its evaluation of
the impact of SFAS 123(R) on its financial statements.



F-19



---

##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

SCHEDULE IIVALUATION AND QUALIFYING ACCOUNTS

(in thousands)



|                                |  |                              |       |                               |     |       |     |             |        |   |                         |   |      
|------------------------------- |  | ---------------------------- | ----- | ----------------------------- | --- | ----- | --- | ----------- | ------ | - | ----------------------- | - | -----
|Classification                  |  | Balance atBeginning ofPeriod |       | AdditionsCharged toOperations |     | Other |     | Write- offs |        |   | Balance atEnd 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