##### Table of Contents

##### Index to Financial Statements

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549



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, 2003



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)



|                                                               |  |                                        
|-------------------------------------------------------------- |  | ---------------------------------------
|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)



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)



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. x



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 $94.2 million as of December 31, 2003, and approximately $75.5 million as of June 30, 2003, 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 February 27, 2004, the
registrant had 72,398,823 shares of Common Stock outstanding.



DOCUMENTS INCORPORATED BY REFERENCE



The registrant has
incorporated by reference into Part III of this Form 10-K portions of its definitive Proxy Statement for its 2003 Annual Meeting of Shareholders to be filed within 120 days after the end of the fiscal year (the Proxy Statement), which
meeting will be held on the date set forth in the Proxy Statement. Except with respect to information specifically incorporated by reference into this Form 10-K, the Proxy Statement is not deemed to be filed as a part hereof.



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##### 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                                                                                       |  |    
|           |  |                                                                                               
|           |  | Industry Background                                                                            |  | 1  
|           |  |                                                                                               
|           |  | Products and Services                                                                          |  | 2  
|           |  |                                                                                               
|           |  | Markets and Customers                                                                          |  | 4  
|           |  |                                                                                               
|           |  | Sales, Marketing and Customer Service                                                          |  | 4  
|           |  |                                                                                               
|           |  | Competition                                                                                    |  | 6  
|           |  |                                                                                               
|           |  | Intellectual Property and Proprietary Rights                                                   |  | 6  
|           |  |                                                                                               
|           |  | Employees                                                                                      |  | 6  
|           |  |                                                                                               
|ITEM 2.    |  | PROPERTIES                                                                                     |  | 7  
|           |  |                                                                                               
|ITEM 3.    |  | LEGAL PROCEEDINGS                                                                              |  | 7  
|           |  |                                                                                               
|ITEM 4.    |  | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                            |  | 7  
|           |  |                                                                                               
|ITEM 4A.   |  | EXECUTIVE OFFICERS OF THE REGISTRANT                                                           |  | 7  
|          
|PART II   
|           |  |                                                                                               
|ITEM 5.    |  | MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED SHAREHOLDER MATTERS                          |  | 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 
|           |  |                                                                                               
|           |  | Results of Operations                                                                          |  | 14 
|           |  |                                                                                               
|           |  | Liquidity and Capital Resources                                                                |  | 15 
|           |  |                                                                                               
|           |  | Certain Business Considerations                                                                |  | 16 
|           |  |                                                                                               
|ITEM 7A.   |  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                     |  | 24 
|           |  |                                                                                               
|ITEM 8.    |  | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                                    |  | 24 
|           |  |                                                                                               
|ITEM 9.    |  | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE           |  | 24 
|           |  |                                                                                               
|ITEM 9A.   |  | CONTROLS AND PROCEDURES                                                                        |  | 24 
|          
|PART III  
|           |  |                                                                                               
|ITEM 10.   |  | DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT                                             |  | 25 
|           |  |                                                                                               
|ITEM 11.   |  | EXECUTIVE COMPENSATION                                                                         |  | 26 
|           |  |                                                                                               
|ITEM 12.   |  | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS |  | 26 
|           |  |                                                                                               
|ITEM 13.   |  | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                                 |  | 26 
|           |  |                                                                                               
|ITEM 14.   |  | PRINCIPAL ACCOUNTING FEES AND SERVICES                                                         |  | 26 
|          
|PART IV   
|           |  |                                                                                               
|ITEM 15.   |  | EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K                                |  | 27 
|           |  |                                                                                               
|SIGNATURES |  |                                                                                                |  | 30 





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##### 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 subsidiary 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 6,700 radio stations and over 1,875 broadcast and cable television destinations 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 10,000 commercial radio and 1,100 commercial television stations 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 it has transitioned approximately
55% of the market for audio spot deliveries and approximately 20% of video spot deliveries, have 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 and StarGuide. 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 serving more than 5,000 advertisers and advertising agencies and more than 6,700 radio stations and over 1,875 broadcast and cable television destinations 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.



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##### 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 ADvantage Digital Video Playback Systems. 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 Digital Video Playback System 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,



3



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##### Index to Financial Statements

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.



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.



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.



StarGuide maintains established relationships with producers and broadcasters such as Infinity, Westwood One, Clear Channel, ABC Radio, Jacor, CBS,
Bloomberg, Jones Broadcast Programming, One-on-One Sports and Voice of America. As part of these relationships, StarGuide has sold approximately 6,000 of its StarGuide II Receiver systems, and has sold over 8,000 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.



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##### Index to Financial Statements

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 40% of its orders were entered electronically via the Internet during 2003 and 2002. In addition, DGS also offers its DG Upload service that allows audio content to be received
from clients via the Internet.



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. An inside sales
staff also represents DGS services to radio stations. 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
promote 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.



DGS markets to broadcast stations to arrange for the placement of its Receive
Playback Terminals, Digital Media Managers, and Digital Video Playback Systems 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 a customer booth and providing complimentary product
literature describing StarGuides systems. StarGuide also conducts several 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 and New York. 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.



5



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##### Index to Financial Statements

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 real-time video distribution network operated by Vyvx, an operating division of Willtel Communications. 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 technologies depends in part upon whether our systems can offer significant improvements in productivity and
sound 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,
2003, the Company had a total of 283 employees, including 54 in research and development, 31 in sales and marketing, 166 in operations and manufacturing, and 32 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.



6



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##### Table of Contents

##### 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 22,000 square feet in New York City
which is occupied by production service and sales personnel and expires in 2006; approximately 13,000 square feet in Los Angeles occupied by production service and sales personnel which expires in 2006; 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
Holmdel, New Jersey that is 30,000 square feet and includes audio operations and administrative staff for StarGuides wholly owned subsidiary, Corporate Computer Systems, Inc. (CCS), which expires on August 31, 2004.



|ITEM 3. | LEGAL PROCEEDINGS
|------- | -----------------



On October 12, 2001, StarGuide filed a complaint against Williams Communications Group, Inc. (Williams) in the United States District Court
for the District of Nevada alleging that Williams has willfully infringed three StarGuide patents. On March 4, 2002, StarGuide opposed Williams motion for summary judgment and moved to amend its complaint to add Williams Communications, LLC
(WCL), a subsidiary of Williams, as a party defendant. On July 3, 2002, WCL answered StarGuides complaint and asserted counterclaims seeking a declaratory judgment that the StarGuide patents are invalid and not infringed. On
July 28, 2003, StarGuide, DGS, Williams and WCL reached a settlement resolving all litigation. Both lawsuits were dismissed as part of the settlement and the company expensed related patent defense costs totaling $1.5 million.



In addition to the matters discussed above, 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 18, 2003, at which shareholders were asked (i) to elect two directors, to serve for
three-year terms or until their successors have been duly elected and qualified and (ii) to ratify the selection of KPMG LLP as the Companys independent accountants for the fiscal year ending December 31, 2003. The results are as follows:



|                                                                           |  |            |  |                        |  |             |  |                
|-------------------------------------------------------------------------- |  | ---------- |  | ---------------------- |  | ----------- |  | ---------------
|Matter                                                                     |  | Votes For  |  | Votes Against/Withheld |  | Abstentions |  | BrokerNon-Votes
|Election of the following directors for three-year terms expiring in 2006: |  |            |  |                        |  |             |  |                
|Omar A. Choucair                                                           |  | 63,119,374 |  | 3,683,160              |  | 0           |  | 0              
|David M. Kantor                                                            |  | 64,660,600 |  | 2,141,934              |  | 0           |  | 0              
|Ratify the appointment of KPMG LLP                                         |  | 66,135,313 |  | 621,921                |  | 45,300      |  | 0              



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



|ITEM 4A. | EXECUTIVE OFFICERS OF THE REGISTRANT
|-------- | ------------------------------------



The executive officers of the Company and their ages are as follows:



|                  |  |     |  |                                                                       
|----------------- |  | --- |  | ----------------------------------------------------------------------
|Name              |  | Age |  | Title(s)                                                              
|Scott K. Ginsburg |  | 51  |  | Chairman of the Board, President, Chief Executive Officer and Director
|Omar A. Choucair  |  | 41  |  | Chief Financial Officer and Director                                  



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.



7



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##### Table of Contents

##### Index to Financial Statements

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.



8



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##### Table of Contents

##### Index to Financial Statements

PART II



|ITEM 5. | MARKET FOR REGISTRANTS COMMON STOCK AND RELATED SHAREHOLDER MATTERS
|------- | --------------------------------------------------------------------



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, 2002 to December 31, 2003. Such prices represent
prices between dealers, do no include retail mark-ups, markdowns or commissions and may not represent actual transactions.



|               |  |                       |      |                       |   |      |  |     |      |  |   |     
|-------------- |  | --------------------- | ---- | --------------------- | - | ---- |  | --- | ---- |  | - | ----
|               |  | Fiscal YearEnded 2003 |      | Fiscal YearEnded 2002
|               |  | High                  |      | Low                   |   | High |  | Low
|First Quarter  |  | $                     | 2.73 |                       | $ | 1.07 |  | $   | 1.49 |  | $ | 1.10
|Second Quarter |  |                       | 3.90 |                       |   | 1.93 |  |     | 1.46 |  |   | 0.79
|Third Quarter  |  |                       | 2.75 |                       |   | 1.86 |  |     | 1.24 |  |   | 0.88
|Fourth Quarter |  |                       | 2.40 |                       |   | 1.67 |  |     | 1.15 |  |   | 0.85



As of December 31,
2003, the Company had issued 72,117,726 and outstanding 72,094,809 shares of its Common Stock. As of February 27, 2004, the Company had issued 72,421,740 and outstanding 72,398,823 shares of its Common Stock. As of February 27, 2004 the
Companys Common Stock was held by approximately 170 shareholders of record. The Company estimates that there are approximately 7,700 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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##### Table of Contents

##### Index to Financial Statements

|ITEM 6. | SELECTED FINANCIAL DATA
|------- | -----------------------



The selected data should be read in conjunction with the consolidated financial statements for the year ended December 31, 2003, the related notes, and
the independent auditors report, which refers to a change in the method for accounting for goodwill and other intangible assets and in conjunction with Managements Discussion and Analysis of Financial Condition and Results of
Operations. The selected data presented below under the captions Selected Statement of Operations Data and Selected Balance Sheet Data for, and as of the end of, each of the years ended December 31, 2000 and 1999, are
derived from the consolidated financial statements of StarGuide Digital Networks, Inc., which financial statements have been audited by KPMG LLP, independent auditors. The selected data presented below under the captions Selected Statement of
Operations Data and Selected Balance Sheet Data for, and as of the end of, each of the years in the three year period ended December 31, 2003, are derived from the consolidated financial statements of Digital Generation Systems,
Inc., which financial statements have been audited by KPMG LLP, independent auditors. The consolidated financial statements as of December 31, 2003 and 2002, and for each of the years in the three-year period ended December 31, 2003, and the report
thereon, are included elsewhere in this Report.



Selected Statement of
Operations Data:



|                                                                                                                |  |                                  |        |                                          |   |          |      |  |   |        |   |  |      |         |   |  |   |        |  
|--------------------------------------------------------------------------------------------------------------- |  | -------------------------------- | ------ | ---------------------------------------- | - | -------- | ---- |  | - | ------ | - |  | ---- | ------- | - |  | - | ------ | -
|                                                                                                                |  | For the years ended December 31, |       
|                                                                                                                |  | 2003                             |        | 2002                                     |   |          | 2001 |  |   | 2000   |   |  | 1999 |        
|                                                                                                                |  |                                  |        | (in thousands, except per share amounts) |  
|Revenues                                                                                                        |  | $                                | 57,687 |                                          | $ | 66,294   |      |  | $ | 70,700 |   |  | $    | 14,419  |   |  | $ | 13,068 |  
|                                                                                                                |  |                                  |        |                                          |   |          |      |  |   |        |   |  |      |         |   |  |   |        |  
|Costs and expenses                                                                                              |  |                                  |        |                                          |   |          |      |  |   |        |   |  |      |         |   |  |   |        |  
|Cost of revenues                                                                                                |  |                                  | 29,207 |                                          |   | 33,328   |      |  |   | 37,413 |   |  |      | 9,802   |   |  |   | 8,128  |  
|Sales and marketing                                                                                             |  |                                  | 4,499  |                                          |   | 5,005    |      |  |   | 5,615  |   |  |      | 2,742   |   |  |   | 3,209  |  
|Research and development                                                                                        |  |                                  | 3,289  |                                          |   | 3,941    |      |  |   | 4,604  |   |  |      | 3,111   |   |  |   | 3,383  |  
|General and administrative expenses:                                                                            |  |                                  |        |                                          |   |          |      |  |   |        |   |  |      |         |   |  |   |        |  
|Noncash stock award charges                                                                                     |  |                                  |       |                                          |   |         |      |  |   |       |   |  |      | 19,630  |   |  |   |       |  
|Other                                                                                                           |  |                                  | 7,142  |                                          |   | 9,642    |      |  |   | 12,187 |   |  |      | 5,330   |   |  |   | 3,087  |  
|Restructuring charges                                                                                           |  |                                  |       |                                          |   | 771      |      |  |   | 791    |   |  |      |        |   |  |   |       |  
|Depreciation and amortization                                                                                   |  |                                  | 7,897  |                                          |   | 7,390    |      |  |   | 17,065 |   |  |      | 824     |   |  |   | 973    |  
|                                                                                                                |  |                                  |        |                                          |   |          |      |  |   |        |   |  |      |         |   |  |   |        |  
|Total expenses                                                                                                  |  |                                  | 52,034 |                                          |   | 60,077   |      |  |   | 77,675 |   |  |      | 41,439  |   |  |   | 18,780 |  
|                                                                                                                |  |                                  |        |                                          |   |          |      |  |   |        |   |  |      |         |   |  |   |        |  
|Income (loss) from operations                                                                                   |  | $                                | 5,653  |                                          | $ | 6,217    |      |  | $ | (6,975 | ) |  | $    | (27,020 | ) |  | $ | (5,712 | )
|Other (income) expense                                                                                          |  |                                  |        |                                          |   |          |      |  |   |        |   |  |      |         |   |  |   |        |  
|Interest and other (income) expense, net                                                                        |  |                                  | 963    |                                          |   | 1,520    |      |  |   | 2,054  |   |  |      | (279    | ) |  |   | 258    |  
|Equity in losses of joint venture                                                                               |  |                                  |       |                                          |   |         |      |  |   |       |   |  |      | 1,125   |   |  |   | 3,030  |  
|                                                                                                                |  |                                  |        |                                          |   |          |      |  |   |        |   |  |      |         |   |  |   |        |  
|Net income (loss) before income taxes and cumulative effect of change in accounting principle                   |  |                                  | 4,690  |                                          |   | 4,697    |      |  |   | (9,029 | ) |  |      | (27,866 | ) |  |   | (9,000 | )
|Provision for income taxes                                                                                      |  |                                  | 491    |                                          |   | 1,848    |      |  |   |       |   |  |      |        |   |  |   |       |  
|                                                                                                                |  |                                  |        |                                          |   |          |      |  |   |        |   |  |      |         |   |  |   |        |  
|Net income (loss) before cumulative effect of change in accounting principle                                    |  |                                  | 4,199  |                                          |   | 2,849    |      |  |   | (9,029 | ) |  |      | (27,866 | ) |  |   | (9,000 | )
|Cumulative effect of change in accounting principle                                                             |  |                                  |       |                                          |   | (130,234 | )    |  |   |       |   |  |      |        |   |  |   |       |  
|                                                                                                                |  |                                  |        |                                          |   |          |      |  |   |        |   |  |      |         |   |  |   |        |  
|Net income (loss)                                                                                               |  | $                                | 4,199  |                                          | $ | (127,385 | )    |  | $ | (9,029 | ) |  | $    | (27,866 | ) |  | $ | (9,000 | )
|                                                                                                                |  |                                  |        |                                          |   |          |      |  |   |        |   |  |      |         |   |  |   |        |  
|Basic and diluted net income (loss) per common share before cumulative effect of change in accounting principle |  | $                                | 0.06   |                                          | $ | 0.04     |      |  | $ | (0.13  | ) |  | $    | (0.68   | ) |  | $ | (0.23  | )
|                                                                                                                |  |                                  |        |                                          |   |          |      |  |   |        |   |  |      |         |   |  |   |        |  
|Basic and diluted net loss per common share                                                                     |  | $                                | 0.06   |                                          | $ | (1.80    | )    |  | $ | (0.13  | ) |  | $    | (0.68   | ) |  | $ | (0.23  | )
|                                                                                                                |  |                                  |        |                                          |   |          |      |  |   |        |   |  |      |         |   |  |   |        |  
|Weighted average common shares outstanding                                                                      |  |                                  |        |                                          |   |          |      |  |   |        |   |  |      |         |   |  |   |        |  
|Basic                                                                                                           |  |                                  | 71,367 |                                          |   | 70,718   |      |  |   | 70,443 |   |  |      | 40,912  |   |  |   | 39,183 |  
|                                                                                                                |  |                                  |        |                                          |   |          |      |  |   |        |   |  |      |         |   |  |   |        |  
|Diluted                                                                                                         |  |                                  | 74,891 |                                          |   | 70,807   |      |  |   | 70,443 |   |  |      | 40,912  |   |  |   | 39,183 |  
|                                                                                                                |  |                                  |        |                                          |   |          |      |  |   |        |   |  |      |         |   |  |   |        |  



10



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##### Index to Financial Statements

Selected Balance Sheet Data



|                                          |  |              |        |      |   |        |  |   |         |   |  |      |         |   |  |   |         |  
|----------------------------------------- |  | ------------ | ------ | ---- | - | ------ |  | - | ------- | - |  | ---- | ------- | - |  | - | ------- | -
|                                          |  | December 31, |       
|                                          |  | 2003         |        | 2002 |   | 2001   |  |   | 2000    |   |  | 1999 |        
|Cash and cash equivalents                 |  | $            | 7,236  |      | $ | 2,527  |  | $ | 2,724   |   |  | $    | 2,891   |   |  | $ | 2,145   |  
|Working capital                           |  |              | 7,202  |      |   | 477    |  |   | (1,011  | ) |  |      | 918     |   |  |   | 3,259   |  
|Property and equipment, net               |  |              | 9,735  |      |   | 12,757 |  |   | 16,535  |   |  |      | 870     |   |  |   | 725     |  
|Total assets                              |  |              | 92,933 |      |   | 97,205 |  |   | 235,800 |   |  |      | 11,102  |   |  |   | 14,062  |  
|Long-term debt, excluding current portion |  |              | 2,400  |      |   | 4,548  |  |   | 9,496   |   |  |      |        |   |  |   | 5,000   |  
|Shareholders equity (deficit)            |  |              | 75,474 |      |   | 69,213 |  |   | 196,682 |   |  |      | (11,498 | ) |  |   | (14,675 | )



|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 and Chicago 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.



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. We intend to roll out this new technology beginning during the second quarter of 2004.



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 DGs 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 DG Systems believes 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 2004.



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



11



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##### Index to Financial Statements

This strategy is not without risks. Our 2003 revenue decreased after losing a significant customer; the
Company believes this was an isolated incident and does not anticipate a trend. Also, given the ongoing cost containment efforts evident in the advertising industry, it is essential that we continue to provide customers with effective, easy-to-use
and efficient solutions. We intend to utilize our product awareness, people, industry connections and cash flow to grow our business and vigorously compete for market share.



Critical Accounting Policies



The SEC recently released Financial Reporting Release No. 60, which requires all companies to include a discussion of critical accounting policies or methods used in the preparation of financial statements. In addition, Financial Reporting
Release No. 61 was recently released by the SEC to require all companies to include a discussion to address, among other matters, liquidity, off-balance sheet arrangements, contractual obligations and commercial commitments. 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 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.



12



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##### Index to Financial Statements

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 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 intangibles 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.



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. The Company recorded approximately $9.5 million of goodwill amortization
during 2001. 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. 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
principals. 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 $63.3 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.



New Accounting Pronouncement



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.



In August 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations. SFAS No. 143 requires entities to record the fair
value of a liability for an asset retirement obligation in the period in which it is incurred. The Company adopted SFAS No. 143 in fiscal year 2003. The adoption of SFAS No. 143 did not have any significant impact on the Companys financial
condition or results of operations.



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.



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##### Index to Financial Statements

FASB Interpretation No. 45 (FIN 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.



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.



Results of Operations



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 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 based upon projected taxable
income.



2002 versus 2001



Revenues. Revenues for the year ended December 31, 2002 decreased
$4.4 million, or 6%, primarily due to satellite receiver sales of $5.4 million during the year ended December 31, 2001 and a $1.7 million decline in consulting revenues. These declines were partially offset by increased advertising distribution
revenues of $2.7 million.



Cost of Revenues. Cost of
revenues, which includes delivery and material costs and customer operations, decreased $4.1 million, or 11%, for the year ended December 31, 2002 primarily due to cost reductions implemented during 2002 and lower revenues.



Sales and Marketing. Sales and marketing expense decreased $0.6
million, or 11%, for the year ended December 31, 2002 primarily due to reductions in headcount and cost reductions, including reduced spending on the Companys CoolCast service, which was terminated during August 2002.



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##### Index to Financial Statements

Research and Development. Research and development expense for the year ended December 31, 2002
decreased $0.7 million, or 14%, as compared to the prior year, due to the capitalization of salaries, 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 21%, as compared to the prior year, primarily due to reductions in headcount and the consolidation of administrative support functions. 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 represents employee termination costs, lease obligations and the write-down of certain leasehold improvements. During the
year ended December 31, 2001, the Company incurred costs of approximately $0.8 million for the move of its Network Operating Center and corporate accounting department from San Francisco, California to Irving, Texas.



Depreciation and Amortization. Depreciation and amortization decreased
$9.7 million for the year ended December 31, 2002, as compared to the prior year, primarily due to the elimination of amortization expense for goodwill. Effective January 1, 2002, the Company adopted SFAS No. 142, and as a result, ceased to amortize
goodwill beginning January 1, 2002. During the year ended December 31, 2001, the Company recorded approximately $9.5 million in goodwill amortization expense. In accordance with SFAS No. 142, the Company tested goodwill for impairment and as a
result, recorded an impairment charge of approximately $130.2 million as a cumulative effect of change in accounting principle during the three months ended March 31, 2002.



Interest and Other Expense. Interest and other expense decreased $0.6 million for the year ended December 31, 2002,
as compared to the prior year, due to lower average outstanding long-term debt and capital lease obligations.



Income tax expense. The Companys effective income tax rate was approximately 39% for 2002, which differed from the federal statutory rate of
34%, primarily due to state income taxes. For fiscal 2001, the Companys book loss was offset by goodwill amortization resulting in no income tax expense in fiscal 2001.



Liquidity and Capital Resources



The Companys operating activities provided cash of $8.9 million in 2003 compared to $7.5 million in 2002. Cash provided by operating activities was $4.9 million in 2001. Cash flows from operating activities increased during 2003 as
compared to 2002 and 2001 primarily due to higher income, improved collection efforts and the resulting $3.6 million reduction in accounts receivable in 2003 versus a $0.8 million reduction in 2002. The improvement in accounts receivable was offset,
to some extent, by a similar reduction in accounts payable and accrued liabilities which was a use of cash totaling $2.7 million.



The Company used $1.1 million, $0.7 million and $3.2 million of cash in 2003, 2002 and 2001, respectively, to purchase property and equipment. In
addition, $1.6 million of property and equipment was acquired through capital leases during 2001. 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.



On May 5, 2003, the Company signed a new
long-term credit agreement with its current lender that includes a term loan of $8.0 million, which matures on September 30, 2005, and a revolving credit facility with a borrowing base subject to the Companys eligible accounts receivable
balance up to $24.5 million, which matures on May 5, 2006. There were no amounts outstanding under the revolving credit facility at December 31, 2003 and approximately $6.5 million was available for borrowing. The proceeds from the term loan were
used to refinance the Companys outstanding debt of $8.0 million. 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 twelve-month period and limitations on capital lease borrowings on an annual basis. The Company was in compliance with these covenants for the period ended December
31, 2003. 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, 2003, the weighted average interest rate on outstanding borrowings was 4.68%. 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.



Net principal payments on long-term debt were $4.4 million, $6.8 million and $0.6 million in 2003, 2002 and 2001, respectively.



The Company has raised cash through the sale of common and preferred stock in the past, most recently in 2003 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



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##### Index to Financial Statements

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 2004 and 2005. 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                     |  | $     | 5,600  |                        | 3,200 |          | 2,400 |          |  |              | 
|Capital Leases                     |  |       | 49     |                        | 49    |          |      |          |  |              | 
|Operating Leases                   |  |       | 4,902  |                        | 2,128 |          | 2,774 |          |  |              | 
|Unconditional Purchase Obligations |  |       | 4,960  |                        | 2,480 |          | 2,480 |          |  |              | 
|                                   |  |       |        |                        |       |          |       |          |   |              |  
|Total Contractual Cash Obligations |  | $     | 15,511 |                        | 7,857 |          | 7,654 |          |  |              | 
|                                   |  |       |        |                        |       |          |       |          |   |              |  



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. In 2002, the
Company was profitable only after excluding the effect of a change in accounting principle. We could continue to generate net losses in the future, which could depress our stock price. Recent decreases in revenues could continue, 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 achieve or
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



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##### Index to Financial Statements

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 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 such products must continue to develop and we must expand our product offering to include additional applications within the broadcast market. Such new products
and applications for existing products in new markets such as 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;
| | - | --------------------------------------------------------------



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##### Index to Financial Statements

| |  | 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 become profitable in the future would be jeopardized.



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 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.
| | - | ---------------------------------------------------------



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##### Index to Financial Statements

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 investor 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 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 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.



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##### Index to Financial Statements

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



20



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##### Index to Financial Statements

| |  | 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.



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;
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



21



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##### Index to Financial Statements

| |  | 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 42% 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.



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 the investor 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;
| | - | ------------------



22



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##### Index to Financial Statements

| |  | 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 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 2005. 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 and $0.5 million per year, respectively. The agreement provides 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



23



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##### Index to Financial Statements

these requirements. The agreement states that Hughes can terminate the agreement if we do not make timely payments or become insolvent.



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.



|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, 2003, the Company had $5.6 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 $44,000 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
|-------- | -----------------------



The Company maintains a system of disclosure controls and procedures that is designed to ensure information required to be disclosed by the Company is
accumulated and communicated to management, including our chief executive officer and chief financial officer, in a timely manner.



An evaluation of the effectiveness of this system of disclosure controls and procedures was performed under the supervision and with the participation of
the Companys management, including the Companys chief executive officer and chief financial officer, as of the end of the period covered by this report. Based upon this evaluation, the Companys management, including the
Companys chief executive officer and chief financial officer, concluded that the current system of controls and procedures is effective.



The Company maintains a system of internal control over financial reporting. There has been no change in the Companys internal control over
financial reporting that occurred during the Companys fourth fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Companys internal control over financial reporting.



24



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##### Index to Financial Statements

PART III



|ITEM 10. | DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
|-------- | --------------------------------------------------



|                     |  |     |  |                                                   |  |                  
|-------------------- |  | --- |  | ------------------------------------------------- |  | -----------------
|Name                 |  | Age |  | Title(s)                                          |  | Expirationof Term
|Scott K. Ginsburg(1) |  | 51  |  | Chief Executive Officer and Chairman of the Board |  | 2004             
|Omar A. Choucair     |  | 41  |  | Chief Financial Officer and Director              |  | 2006             
|David M. Kantor(1)   |  | 46  |  | Director                                          |  | 2006             
|Cappy R. McGarr(2)   |  | 51  |  | Director                                          |  | 2005             
|Kevin C. Howe(2)     |  | 54  |  | Director                                          |  | 2005             

---

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



|(2) | Member of the Audit Committee; see Resignation of Directors for notes with respect to composition of the audit 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.



Resignation of Directors



Two members of the Board of Directors resigned their Board positions subsequent to the annual shareholders meeting that took place on November 18,
2003. Lawrence D. Lenihan resigned on January 9, 2004 and Robert J. Schlegal resigned on December 23, 2003. Both individuals resigned their positions without any disagreement with the Company on any matter relating to the Companys operations,
policies or practices.



25



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##### 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 Securities Exchange Act of 1934 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. The appeal is pending.



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 2003 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 2003 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 2003 fiscal year.



Certain other information
required by this item is incorporated by reference to the section captioned Directors in the Proxy Statement.



|ITEM 11. | EXECUTIVE COMPENSATION
|-------- | ----------------------



The information required by this item is incorporated by reference to the section captioned Executive Compensation in the Proxy Statement.



|ITEM 12. | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
|-------- | ----------------------------------------------------------------------------------------------



The information required by this item is incorporated by reference to the sections captioned Security Ownership of
Certain Beneficial Owners and Management and Securities Authorized for Issuance Under Equity Compensation Plans in the Proxy Statement.



|ITEM 13. | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
|-------- | ----------------------------------------------



The information required by this item is incorporated by reference to the sections captioned Compensation Committee Interlocks and Insider
Participation and Certain Transactions with Management in the Proxy Statement.



|ITEM 14. | PRINCIPAL ACCOUNTING FEES AND SERVICES
|-------- | --------------------------------------



The information required by this item is incorporated by reference to the section captioned Principal Accounting Fees and Services in the
Proxy Statement.



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##### Index to Financial Statements

PART IV



|ITEM 15. | EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
|-------- | ---------------------------------------------------------------



|                                                                                                      |  |     
|----------------------------------------------------------------------------------------------------- |  | ----
|(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, 2003 and 2002                                          |  | F-3 
|Consolidated Statements of Operations for the three years ended December 31, 2003                     |  | F-4 
|Consolidated Statements of Stockholders Equity (Deficit) for the three years ended December 31, 2003 |  | F-5 
|Consolidated Statements of Cash Flows for the three years ended December 31, 2003                     |  | 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.                            



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|      |     |  |                                                                                                                                                     
|----- | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------
|      |    
|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
|      |    
|10.21 | **  |  | Employment Agreement, dated December 10, 2003, between Digital Generation Systems, Inc. and Omar Choucair, Chief Financial Officer.                 
|      |    
|21.1  | **  |  | Subsidiaries of the Registrant.                                                                                                                     
|      |    
|23.1  | **  |  | Consent of KPMG LLP                                                                                                                                 
|      |    
|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. Omitted portions have been filed separately with the Commission.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(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.
|-- | ---------------



|(b) | Reports on Form 8-K
|--- | -------------------



Current report on Form 8-K dated February 20, 2004, furnishing its press release announcing financial results for the three and twelve month periods ended
December 31, 2003.



28



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##### Index to Financial Statements

Current report on Form 8-K dated February 20, 2004, furnishing its press release outlining strategies for
growth in 2004.



|(c) | Exhibits
|--- | --------



See Item 15 (a) (3) above.



|(d) | Financial Statement Schedules
|--- | -----------------------------



See Item 15(a) (2) above.



29



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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 12, 2004 |  |  |  | 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
GINSBURGScott K.
Ginsburg |  | Chairman of the Board of Directors and Chief Executive Officer                    |  | March 12, 2004
|                                         |  |                                                                                  
|/s/    OMAR A.
CHOUCAIROmar A.
Choucair  |  | Chief Financial Officer and Director (Principal Financial and Accounting Officer) |  | March 12, 2004
|                                         |  |                                                                                  
|/s/    DAVID M.
KANTORDavid M.
Kantor    |  | Director                                                                          |  | March 12, 2004
|                                         |  |                                                                                  
|/s/    CAPPY
MCGARRCappy
McGarr          |  | Director                                                                          |  | March 12, 2004
|                                         |  |                                                                                  
|/s/    KEVIN C.
HOWEKevin C. Howe        |  | Director                                                                          |  | March 12, 2004



30



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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, 2003 and 2002                                          |  | F-3 
|Consolidated Statements of Operations for the three years ended December 31, 2003                     |  | F-4 
|Consolidated Statements of Stockholders Equity (Deficit) for the three years ended December 31, 2003 |  | F-5 
|Consolidated Statements of Cash Flows for the three years ended December 31, 2003                     |  | 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

INDEPENDENT AUDITORS REPORT



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, 2003 and 2002, 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, 2003. 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 auditing standards
generally accepted in the United States of America. 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 statements referred to above present fairly, in all material respects, the financial position of Digital Generation Systems, Inc. and subsidiaries as of December 31, 2003 and
2002, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. 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 12, 2004



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 31,2003 |          |   | December 31,2002 |  
|Assets                                                                                                                                                                                                 |  |                  |          |   |                  |   |          |  
|CURRENT ASSETS:                                                                                                                                                                                        |  |                  |          |   |                  |   |          |  
|Cash and cash equivalents                                                                                                                                                                              |  | $                | 7,236    |   |                  | $ | 2,527    |  
|Accounts receivable (less allowance for doubtful accounts of $588 in 2003 and $1,114 in 2002)                                                                                                          |  |                  | 9,288    |   |                  |   | 12,971   |  
|Inventories                                                                                                                                                                                            |  |                  | 2,114    |   |                  |   | 2,195    |  
|Deferred income taxes                                                                                                                                                                                  |  |                  | 301      |   |                  |   | 239      |  
|Other current assets                                                                                                                                                                                   |  |                  | 827      |   |                  |   | 605      |  
|                                                                                                                                                                                                       |  |                  |          |   |                  |   |          |  
|Total current assets                                                                                                                                                                                   |  |                  | 19,766   |   |                  |   | 18,537   |  
|                                                                                                                                                                                                       |  |                  |          |   |                  |   |          |  
|Property and equipment, net                                                                                                                                                                            |  |                  | 9,735    |   |                  |   | 12,757   |  
|Goodwill, net                                                                                                                                                                                          |  |                  | 48,759   |   |                  |   | 53,306   |  
|Deferred income taxes                                                                                                                                                                                  |  |                  | 4,054    |   |                  |   |         |  
|Intangible and other assets, net                                                                                                                                                                       |  |                  | 10,619   |   |                  |   | 12,605   |  
|                                                                                                                                                                                                       |  |                  |          |   |                  |   |          |  
|TOTAL ASSETS                                                                                                                                                                                           |  | $                | 92,933   |   |                  | $ | 97,205   |  
|                                                                                                                                                                                                       |  |                  |          |   |                  |   |          |  
|Liabilities and Stockholders Equity                                                                                                                                                                   |  |                  |          |   |                  |   |          |  
|CURRENT LIABILITIES:                                                                                                                                                                                   |  |                  |          |   |                  |   |          |  
|Accounts payable                                                                                                                                                                                       |  | $                | 2,980    |   |                  | $ | 4,362    |  
|Accrued liabilities                                                                                                                                                                                    |  |                  | 3,687    |   |                  |   | 4,946    |  
|Deferred revenue, net                                                                                                                                                                                  |  |                  | 2,650    |   |                  |   | 3,283    |  
|Current portion of long-term debt and capital leases                                                                                                                                                   |  |                  | 3,247    |   |                  |   | 5,469    |  
|                                                                                                                                                                                                       |  |                  |          |   |                  |   |          |  
|Total current liabilities                                                                                                                                                                              |  |                  | 12,564   |   |                  |   | 18,060   |  
|                                                                                                                                                                                                       |  |                  |          |   |                  |   |          |  
|Deferred revenue, net                                                                                                                                                                                  |  |                  | 2,495    |   |                  |   | 5,145    |  
|Long-term debt and capital leases, net of current portion                                                                                                                                              |  |                  | 2,400    |   |                  |   | 4,548    |  
|Deferred income taxes                                                                                                                                                                                  |  |                  |         |   |                  |   | 239      |  
|                                                                                                                                                                                                       |  |                  |          |   |                  |   |          |  
|TOTAL LIABILITIES                                                                                                                                                                                      |  |                  | 17,459   |   |                  |   | 27,992   |  
|                                                                                                                                                                                                       |  |                  |          |   |                  |   |          |  
|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, 2003; 72,118 issued and 72,095 outstanding at December 31, 2003
and 70,834 issued and 70,811 outstanding at December 31, 2002 |  |                  | 72       |   |                  |   | 72       |  
|Additional paid-in capital                                                                                                                                                                             |  |                  | 267,885  |   |                  |   | 265,928  |  
|Accumulated deficit                                                                                                                                                                                    |  |                  | (192,382 | ) |                  |   | (196,581 | )
|Receivables from issuance of common stock                                                                                                                                                              |  |                  |         |   |                  |   | (105     | )
|Treasury stock, at cost                                                                                                                                                                                |  |                  | (101     | ) |                  |   | (101     | )
|                                                                                                                                                                                                       |  |                  |          |   |                  |   |          |  
|TOTAL STOCKHOLDERS EQUITY                                                                                                                                                                             |  |                  | 75,474   |   |                  |   | 69,213   |  
|                                                                                                                                                                                                       |  |                  |          |   |                  |   |          |  
|TOTAL LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                             |  | $                | 92,933   |   |                  | $ | 97,205   |  
|                                                                                                                                                                                                       |  |                  |          |   |                  |   |          |  



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, |       
|                                                                                                      |  | 2003                         |        | 2002 |   |          | 2001 | 
|Revenues:                                                                                             |  |                              |        |      |   |          |      |  |   |        |  
|Audio and video content distribution                                                                  |  | $                            | 47,928 |      | $ | 53,144   |      |  | $ | 50,447 |  
|Product sales                                                                                         |  |                              | 6,401  |      |   | 8,045    |      |  |   | 13,875 |  
|Other                                                                                                 |  |                              | 3,358  |      |   | 5,105    |      |  |   | 6,378  |  
|                                                                                                      |  |                              |        |      |   |          |      |  |   |        |  
|Total revenues                                                                                        |  |                              | 57,687 |      |   | 66,294   |      |  |   | 70,700 |  
|                                                                                                      |  |                              |        |      |   |          |      |  |   |        |  
|Cost of revenues:                                                                                     |  |                              |        |      |   |          |      |  |   |        |  
|Audio and video content distribution                                                                  |  |                              | 23,870 |      |   | 26,336   |      |  |   | 27,762 |  
|Product sales                                                                                         |  |                              | 3,851  |      |   | 4,673    |      |  |   | 5,392  |  
|Other                                                                                                 |  |                              | 1,486  |      |   | 2,319    |      |  |   | 4,259  |  
|                                                                                                      |  |                              |        |      |   |          |      |  |   |        |  
|Total cost of revenues                                                                                |  |                              | 29,207 |      |   | 33,328   |      |  |   | 37,413 |  
|                                                                                                      |  |                              |        |      |   |          |      |  |   |        |  
|Operating expenses:                                                                                   |  |                              |        |      |   |          |      |  |   |        |  
|Sales and marketing                                                                                   |  |                              | 4,499  |      |   | 5,005    |      |  |   | 5,615  |  
|Research and development                                                                              |  |                              | 3,289  |      |   | 3,941    |      |  |   | 4,604  |  
|General and administrative expenses                                                                   |  |                              | 7,142  |      |   | 9,642    |      |  |   | 12,187 |  
|Restructuring charges                                                                                 |  |                              |       |      |   | 771      |      |  |   | 791    |  
|Depreciation and amortization                                                                         |  |                              | 7,897  |      |   | 7,390    |      |  |   | 17,065 |  
|                                                                                                      |  |                              |        |      |   |          |      |  |   |        |  
|Total operating expenses                                                                              |  |                              | 22,827 |      |   | 26,749   |      |  |   | 40,262 |  
|                                                                                                      |  |                              |        |      |   |          |      |  |   |        |  
|Income (loss) from operations                                                                         |  | $                            | 5,653  |      | $ | 6,217    |      |  | $ | (6,975 | )
|Other (income) expense:                                                                               |  |                              |        |      |   |          |      |  |   |        |  
|Interest income and other (income) expense, net                                                       |  |                              | 99     |      |   | (20      | )    |  |   | 282    |  
|Interest expense                                                                                      |  |                              | 864    |      |   | 1,540    |      |  |   | 1,772  |  
|                                                                                                      |  |                              |        |      |   |          |      |  |   |        |  
|Net income (loss) before income taxes and cumulative effect of change in accounting principle         |  | $                            | 4,690  |      | $ | 4,697    |      |  | $ | (9,029 | )
|Provision for income taxes                                                                            |  |                              | 491    |      |   | 1,848    |      |  |   |       |  
|                                                                                                      |  |                              |        |      |   |          |      |  |   |        |  
|Net income (loss) before cumulative effect of change in accounting principle                          |  |                              | 4,199  |      |   | 2,849    |      |  |   | (9,029 | )
|                                                                                                      |  |                              |        |      |   |          |      |  |   |        |  
|Cumulative effect of change in accounting principle                                                   |  |                              |       |      |   | (130,234 | )    |  |   |       |  
|                                                                                                      |  |                              |        |      |   |          |      |  |   |        |  
|Net income (loss)                                                                                     |  | $                            | 4,199  |      | $ | (127,385 | )    |  | $ | (9,029 | )
|                                                                                                      |  |                              |        |      |   |          |      |  |   |        |  
|Basic net income (loss) per common share before cumulative effect of change in accounting principle   |  | $                            | 0.06   |      | $ | 0.04     |      |  | $ | (0.13  | )
|                                                                                                      |  |                              |        |      |   |          |      |  |   |        |  
|Diluted net income (loss) per common share before cumulative effect of change in accounting principle |  | $                            | 0.06   |      | $ | 0.04     |      |  | $ | (0.13  | )
|                                                                                                      |  |                              |        |      |   |          |      |  |   |        |  
|Basic net income (loss) per common share                                                              |  | $                            | 0.06   |      | $ | (1.80    | )    |  | $ | (0.13  | )
|                                                                                                      |  |                              |        |      |   |          |      |  |   |        |  
|Diluted net income (loss) per common share                                                            |  | $                            | 0.06   |      | $ | (1.80    | )    |  | $ | (0.13  | )
|                                                                                                      |  |                              |        |      |   |          |      |  |   |        |  
|Basic weighted average common shares outstanding                                                      |  |                              | 71,367 |      |   | 70,718   |      |  |   | 70,443 |  
|                                                                                                      |  |                              |        |      |   |          |      |  |   |        |  
|Diluted weighted average common shares outstanding                                                    |  |                              | 74,891 |      |   | 70,807   |      |  |   | 70,443 |  
|                                                                                                      |  |                              |        |      |   |          |      |  |   |        |  



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 |    |        |      |   |        |   |      |                          |  |   |                 |   | 
|                                                                 |  | Shares       |  | Amount         |    | Shares |      |   | Amount |   |      | AdditionalPaid-inCapital |  |   | NotesReceivable |   |  | AccumulatedDeficit |      |   | TotalStockholdersEquity(Deficit) |  
|Balance at December 31, 2000                                     |  | 41,660       |  | $              | 42 |        | (463 | ) |        | $ | (971 | )                        |  | $ | 49,598          |   |  | $                  |     |   |                                   | $ | (60,167  | ) |  | $ | (11,498  | )
|                                                                 |  |              |  |                |    |        |      |   |        |   |      |                          |  |   |                 |   |  |                    |      |   |                                   |   |          |   |  |   |          |  
|Shares issued to effect DGS/StarGuide merger                     |  | 27,796       |  |                | 28 |        | 440  |   |        |   | 870  |                          |  |   | 211,591         |   |  |                    | (93  | ) |                                   |   |         |   |  |   | 212,396  |  
|Musicam Express acquisition                                      |  | 693          |  |                | 1  |        |     |   |        |   |     |                          |  |   | 3,999           |   |  |                    |     |   |                                   |   |         |   |  |   | 4,000    |  
|Exercise of stock options                                        |  | 611          |  |                | 1  |        |     |   |        |   |     |                          |  |   | 367             |   |  |                    |     |   |                                   |   |         |   |  |   | 368      |  
|Issuance of common stock under employee stock purchase plan      |  | 47           |  |                |   |        |     |   |        |   |     |                          |  |   | 74              |   |  |                    |     |   |                                   |   |         |   |  |   | 74       |  
|Noncash stock compensation                                       |  |             |  |                |   |        |     |   |        |   |     |                          |  |   | 371             |   |  |                    |     |   |                                   |   |         |   |  |   | 371      |  
|Net loss                                                         |  |             |  |                |   |        |     |   |        |   |     |                          |  |   |                |   |  |                    |     |   |                                   |   | (9,029   | ) |  |   | (9,029   | )
|                                                                 |  |              |  |                |    |        |      |   |        |   |      |                          |  |   |                 |   |  |                    |      |   |                                   |   |          |   |  |   |          |  
|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   |  
|                                                                 |  |              |  |                |    |        |      |   |        |   |      |                          |  |   |                 |   |  |                    |      |   |                                   |   |          |   |  |   |          |  



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, |        
|                                                                                         |  | 2003                     |         |   | 2002 |   |          | 2001 | 
|Cash flows from operating activities:                                                    |  |                          |         |   |      |   |          |      |  |   |         |  
|Net income (loss)                                                                        |  | $                        | 4,199   |   |      | $ | (127,385 | )    |  | $ | (9,029  | )
|Adjustments to reconcile net income (loss) to net cash provided by operating activities: |  |                          |         |   |      |   |          |      |  |   |         |  
|Depreciation of property and equipment                                                   |  |                          | 4,104   |   |      |   | 5,312    |      |  |   | 4,550   |  
|Amortization of goodwill and other intangibles                                           |  |                          | 3,793   |   |      |   | 2,078    |      |  |   | 12,515  |  
|Impairment of goodwill                                                                   |  |                          |        |   |      |   | 130,234  |      |  |   |        |  
|Noncash stock award charges                                                              |  |                          |        |   |      |   |         |      |  |   | 371     |  
|Deferred income taxes                                                                    |  |                          | 193     |   |      |   | 791      |      |  |   |        |  
|Tax benefits from employee stock options                                                 |  |                          | 55      |   |      |   |         |      |  |   |        |  
|Provision for doubtful accounts                                                          |  |                          | 73      |   |      |   | 715      |      |  |   | 1,954   |  
|Changes in operating assets and liabilities, net of working capital from acquisitions:   |  |                          |         |   |      |   |          |      |  |   |         |  
|Accounts receivable                                                                      |  |                          | 3,610   |   |      |   | 156      |      |  |   | 301     |  
|Inventories                                                                              |  |                          | 81      |   |      |   | (68      | )    |  |   | 46      |  
|Other assets                                                                             |  |                          | (1,332  | ) |      |   | (853     | )    |  |   | 1,033   |  
|Accounts payable and accrued liabilities                                                 |  |                          | (2,641  | ) |      |   | (201     | )    |  |   | (3,214  | )
|Deferred revenue, net                                                                    |  |                          | (3,283  | ) |      |   | (3,284   | )    |  |   | (3,593  | )
|                                                                                         |  |                          |         |   |      |   |          |      |  |   |         |  
|Net cash provided by operating activities                                                |  |                          | 8,852   |   |      |   | 7,495    |      |  |   | 4,934   |  
|                                                                                         |  |                          |         |   |      |   |          |      |  |   |         |  
|Cash flows from investing activities:                                                    |  |                          |         |   |      |   |          |      |  |   |         |  
|Purchases of property and equipment                                                      |  |                          | (1,082  | ) |      |   | (723     | )    |  |   | (3,219  | )
|Acquisitions, net of cash acquired                                                       |  |                          |        |   |      |   |         |      |  |   | (768    | )
|Loan to employee for issuance of common stock                                            |  |                          |        |   |      |   | (105     | )    |  |   |        |  
|                                                                                         |  |                          |         |   |      |   |          |      |  |   |         |  
|Net cash used in investing activities                                                    |  |                          | (1,082  | ) |      |   | (828     | )    |  |   | (3,987  | )
|                                                                                         |  |                          |         |   |      |   |          |      |  |   |         |  
|Cash flows from financing activities:                                                    |  |                          |         |   |      |   |          |      |  |   |         |  
|Proceeds from issuance of common stock                                                   |  |                          | 1,902   |   |      |   | 21       |      |  |   | 442     |  
|Payment of shareholder note receivable                                                   |  |                          | 105     |   |      |   |         |      |  |   |        |  
|Payments to secure financing                                                             |  |                          | (698    | ) |      |   | (112     | )    |  |   | (977    | )
|Borrowings under long-term debt                                                          |  |                          | 9,000   |   |      |   | 6,500    |      |  |   | 40,864  |  
|Payments on long-term debt                                                               |  |                          | (13,370 | ) |      |   | (13,273  | )    |  |   | (41,443 | )
|                                                                                         |  |                          |         |   |      |   |          |      |  |   |         |  
|Net cash used in financing activities                                                    |  |                          | (3,061  | ) |      |   | (6,864   | )    |  |   | (1,114  | )
|                                                                                         |  |                          |         |   |      |   |          |      |  |   |         |  
|Net increase (decrease) in cash and cash equivalents                                     |  |                          | 4,709   |   |      |   | (197     | )    |  |   | (167    | )
|Cash and cash equivalents at beginning of year                                           |  |                          | 2,527   |   |      |   | 2,724    |      |  |   | 2,891   |  
|                                                                                         |  |                          |         |   |      |   |          |      |  |   |         |  
|Cash and cash equivalents at end of year                                                 |  | $                        | 7,236   |   |      | $ | 2,527    |      |  | $ | 2,724   |  
|                                                                                         |  |                          |         |   |      |   |          |      |  |   |         |  
|Interest paid                                                                            |  | $                        | 465     |   |      | $ | 1,181    |      |  | $ | 928     |  
|                                                                                         |  |                          |         |   |      |   |          |      |  |   |         |  
|Noncash financing activities:                                                            |  |                          |         |   |      |   |          |      |  |   |         |  
|Property and equipment acquired through capital lease                                    |  | $                        |        |   |      | $ |         |      |  | $ | 1,569   |  
|                                                                                         |  |                          |         |   |      |   |          |      |  |   |         |  



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 6,700 radio stations and over 1,875 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.



In January 2001, the
Company completed its merger with StarGuide Digital Networks, Inc. (StarGuide) pursuant to the Agreement and Plan of Merger. The merger has been accounted for as a reverse acquisition, and accordingly, historical results of the Company
prior to the merger are that of StarGuide. The results of operations subsequent to January 1, 2001, the consummation date, included both the Company and StarGuide.



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, 2003 and 2002, 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



F-7



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



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.



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.



F-8



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



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.



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. Gains (losses) on foreign currency transactions of $6,
$(3) and $(28) were recognized for the years ended December 31, 2003, 2002 and 2001, respectively and 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, 2003, 2002 and 2001 (in thousands, except per share amounts).



|                                                                                                                                    |  |      |       |   |      |   |          |      |  |   |         |  
|----------------------------------------------------------------------------------------------------------------------------------- |  | ---- | ----- | - | ---- | - | -------- | ---- |  | - | ------- | -
|                                                                                                                                    |  | 2003 |       |   | 2002 |   |          | 2001 | 
|Net income (loss):                                                                                                                  |  |      |       |   |      |   |          |      |  |   |         |  
|As reported                                                                                                                         |  | $    | 4,199 |   |      | $ | (127,385 | )    |  | $ | (9,029  | )
|Stock-based employee compensation cost included in reported net income, net of related tax effects                                  |  |      |      |   |      |   |         |      |  |   | 156     |  
|Total stock-based employee compensation expense determined under fair value-based method for all awards, net of related tax
effects |  |      | (552  | ) |      |   | (1,456   | )    |  |   | (3,296  | )
|                                                                                                                                    |  |      |       |   |      |   |          |      |  |   |         |  
|Pro forma                                                                                                                           |  | $    | 3,647 |   |      | $ | (128,841 | )    |  | $ | (12,169 | )
|                                                                                                                                    |  |      |       |   |      |   |          |      |  |   |         |  
|Basic earnings per share of common stock:                                                                                           |  |      |       |   |      |   |          |      |  |   |         |  
|As reported                                                                                                                         |  | $    | 0.06  |   |      | $ | (1.80    | )    |  | $ | (0.13   | )
|Pro forma                                                                                                                           |  | $    | 0.05  |   |      | $ | (1.82    | )    |  | $ | (0.17   | )
|Diluted earnings per share of common stock:                                                                                         |  |      |       |   |      |   |          |      |  |   |         |  
|As reported                                                                                                                         |  | $    | 0.06  |   |      | $ | (1.80    | )    |  | $ | (0.13   | )
|Pro forma                                                                                                                           |  | $    | 0.05  |   |      | $ | (1.82    | )    |  | $ | (0.17   | )



F-9



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



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 2003, 2002 and 2001, respectively: risk-free interest rates of 2.9%, 4.1% and 5.1%; a dividend yield of 0%; expected terms of 3.5, 3.1 and 3.4
years; and volatility factors of the expected market price of the Companys common stock of 77%, 100% and 136%.



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 year ended 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. No single customer accounted for more than 10% of the Companys revenue during the year ended December 31, 2001.



3. Acquisitions:



During January 2001, the Company completed its merger with StarGuide, which was accounted for under the purchase method of
accounting. In this merger, the holders of StarGuide common stock received approximately 1.7332 shares of the Companys common stock for each StarGuide share held, and the holders of Company common stock continued to hold their shares.
StarGuide effectively issued approximately 27,796,000 shares of common stock as a result of the merger. StarGuide was the acquirer for financial reporting purposes. The total purchase consideration of $217.2 million included $212.6 million related
to the fair value of the Companys common stock (at $6.50 per share), options and warrants and merger transaction costs of $4.6 million. The purchase price was allocated to working capital ($6.0 million), property and equipment ($15.0 million),
other assets ($0.4 million), long-term debt ($1.7 million) and identifiable intangible assets ($16.0 million) based on their fair values. The Company also acquired Net Operating Loss Carryforwards (NOLs) as a result of the merger. These
NOLs were fully reserved as part of the original purchase price allocation. During 2002 and 2003, purchased NOLs were utilized to offset federal income taxes, resulting in purchase price adjustments to goodwill. In addition, during the
third quarter of 2002, the Company recorded certain adjustments to the original purchase price allocation related to the components of property and equipment. The net impact of these adjustments was insignificant to the Companys results of
operations and financial position for all periods subsequent to the acquisition. The excess of purchase price over fair value of net assets acquired of $181.5 million was allocated to goodwill and was being amortized over a 20-year period during the
year ended December 31, 2001. For the year ended December 31, 2002, goodwill amortization was discontinued in accordance with SFAS No. 142, Goodwill and Other Intangible Assets, with $130.2 million being recorded as a change in
accounting principle.



During March 2001, the Company completed
its purchase of the 50% interest in Musicam Express L.L.C. (Musicam) owned by Westwood One, Inc. and Infinity Broadcasting Corporation. The transaction was accounted for under the purchase method of accounting. The total purchase price
of $13.7 million included $4.0 million for the issuance of approximately 693,000 shares of common stock plus the assumption of outstanding bank debt and other liabilities of Musicam of $9.7 million. The purchase price was allocated to working
capital ($2.2 million) and property and equipment ($0.4 million) based on their fair values. The excess of purchase price over fair value of net assets acquired of $11.1 million was allocated to goodwill and was being amortized over a 20-year period
during the year ended December 31, 2001. For the year ended December 31, 2002, goodwill amortization was discontinued in accordance with SFAS No. 142. Prior to the purchase, the Company accounted for its 50% interest in Musicam under the equity
method of accounting and recognized losses in excess of its investment and its guaranteed minimum contribution based on its intent to fund these excess losses. Results of operations of Musicam have been consolidated beginning January 1, 2001.
Pre-acquisition losses of $96,000 related to the 50% acquired interest have been eliminated in determining net loss and are included in interest expense and other in the condensed consolidated statement of operations.



F-10



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



4. Inventories:



Inventories as of December 31, 2003 and 2002 are summarized as follows (in thousands) :



|                  |  |      |       |      |   |      
|----------------- |  | ---- | ----- | ---- | - | -----
|                  |  | 2003 |       | 2002
|Raw materials     |  | $    | 697   |      | $ | 724  
|Work-in-process   |  |      | 631   |      |   | 677  
|Finished goods    |  |      | 786   |      |   | 794  
|                  |  |      |       |      |   |      
|Total inventories |  | $    | 2,114 |      | $ | 2,195
|                  |  |      |       |      |   |      



5. Property and Equipment:



Property and equipment as of December 31, 2003 and 2002
are summarized as follows (in thousands):



|                                               |  |      |         |   |      |   |         |  
|---------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|                                               |  | 2003 |         |   | 2002 |  
|Network equipment                              |  | $    | 18,624  |   |      | $ | 17,818  |  
|Office furniture and equipment                 |  |      | 5,829   |   |      |   | 5,626   |  
|Leasehold improvements                         |  |      | 665     |   |      |   | 622     |  
|                                               |  |      |         |   |      |   |         |  
|                                               |  |      | 25,118  |   |      |   | 24,066  |  
|Less accumulated depreciation and amortization |  |      | (15,383 | ) |      |   | (11,309 | )
|                                               |  |      |         |   |      |   |         |  
|                                               |  | $    | 9,735   |   |      | $ | 12,757  |  
|                                               |  |      |         |   |      |   |         |  



During the second
quarter of 2003, the Company increased its estimate of the useful lives of its network equipment from 5 to 7 years. This change had the effect of decreasing depreciation expense and increasing net income by $0.8 million for the year ended December
31, 2003. Basic earnings per share was not affected while diluted earnings per share was increased by $0.01 on a year to date basis only, before taxes. The increase in estimated useful lives was based on the Companys planned usage of such
equipment.



6. Intangible and Other Assets:



Other assets as of December 31, 2003 and 2002 are summarized as follows (in
thousands):



|                               |  |      |        |   |      |   |        |  
|------------------------------ |  | ---- | ------ | - | ---- | - | ------ | -
|                               |  | 2003 |        |   | 2002 |  
|Brand name                     |  | $    | 8,804  |   |      | $ | 8,804  |  
|Customer relationships         |  |      | 3,044  |   |      |   | 3,044  |  
|Other assets                   |  |      | 6,443  |   |      |   | 4,685  |  
|                               |  |      |        |   |      |   |        |  
|                               |  |      | 18,291 |   |      |   | 16,533 |  
|Less: accumulated amortization |  |      | (7,672 | ) |      |   | (3,928 | )
|                               |  |      |        |   |      |   |        |  
|                               |  | $    | 10,619 |   |      | $ | 12,605 |  
|                               |  |      |        |   |      |   |        |  



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
Financial Accounting Standards Board (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 identified two reporting units, as defined in SFAS No. 142, with goodwill, a Services unit and a Products unit, which are included in the Audio and Video Content Distribution Segment. The Company recorded goodwill
impairment of $130.2 million in the Services reporting 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. The fair value of the Services reporting unit was determined by estimating the present value of future cash flows expected to be generated by
this reporting unit.



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



The following adjusts reported net income (loss) before cumulative effect of change in accounting
principle and earnings (loss) per share before cumulative effect of change in accounting principle to exclude goodwill amortization (in thousands, except per share amounts):



|                                                     |  |                         |       |      |   |          |      |  |   |        |  
|---------------------------------------------------- |  | ----------------------- | ----- | ---- | - | -------- | ---- |  | - | ------ | -
|                                                     |  | Year Ended December 31, |      
|                                                     |  | 2003                    |       | 2002 |   |          | 2001 | 
|Reported net income (loss)                           |  | $                       | 4,199 |      | $ | (127,385 | )    |  | $ | (9,029 | )
|Goodwill amortization                                |  |                         |      |      |   |         |      |  |   | 9,545  |  
|Employee workforce amortization                      |  |                         |      |      |   |         |      |  |   | 1,391  |  
|                                                     |  |                         |       |      |   |          |      |  |   |        |  
|Adjusted net income (loss)                           |  | $                       | 4,199 |      | $ | (127,385 | )    |  | $ | 1,907  |  
|                                                     |  |                         |       |      |   |          |      |  |   |        |  
|Reported basic and diluted earnings (loss) per share |  | $                       | 0.06  |      | $ | (1.80    | )    |  | $ | (0.13  | )
|Goodwill amortization per share                      |  |                         |      |      |   |         |      |  |   | 0.16   |  
|                                                     |  |                         |       |      |   |          |      |  |   |        |  
|Adjusted basic and diluted earnings (loss) per share |  | $                       | 0.06  |      | $ | (1.80    | )    |  | $ | 0.03   |  
|                                                     |  |                         |       |      |   |          |      |  |   |        |  



Goodwill totaled $48.8 million at
December 31, 2003 and $53.3 million at December 31, 2002. The changes in the carrying value of goodwill by segment for the twelve months ended December 31, 2003 are as follows (in thousands):



|                                             |  |                                      |          |   |       |   |          |  
|-------------------------------------------- |  | ------------------------------------ | -------- | - | ----- | - | -------- | -
|                                             |  | Segment                              |         
|                                             |  | Audio and Video Content Distribution |          |   | Total |  
|Balance as of December 31, 2001              |  | $                                    | 183,228  |   |       | $ | 183,228  |  
|Reclassification of employee workforce       |  |                                      | 1,726    |   |       |   | 1,726    |  
|Final purchase price adjustments             |  |                                      | (623     | ) |       |   | (623     | )
|Reversal of deferred tax valuation allowance |  |                                      | (791     | ) |       |   | (791     | )
|Impairment loss                              |  |                                      | (130,234 | ) |       |   | (130,234 | )
|                                             |  |                                      |          |   |       |   |          |  
|Balance at December 31, 2002                 |  |                                      | 53,306   |   |       |   | 53,306   |  
|                                             |  |                                      |          |   |       |   |          |  
|Reversal of deferred tax valuation allowance |  |                                      | (4,547   | ) |       |   | (4,547   | )
|                                             |  |                                      |          |   |       |   |          |  
|Balance at December 31, 2003                 |  | $                                    | 48,759   |   |       | $ | 48,759   |  
|                                             |  |                                      |          |   |       |   |          |  



Intangible assets as
of December 31, 2003 and December 31, 2002 are as follows (in thousands):



|                       |  |                    |  |                       |        |                         |   |        |                     |  |   |      
|---------------------- |  | ------------------ |  | --------------------- | ------ | ----------------------- | - | ------ | ------------------- |  | - | -----
|                       |  | AmortizationPeriod |  | GrossIntangibleAssets |        | AccumulatedAmortization |   |        | NetIntangibleAssets
|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
|                       |  |                    |  |                       |        |                         |   |        |                     |  |   |      
|December 31, 2002      |  |                    |  |                       |        |                         |   |        |                     |  |   |      
|Customer relationships |  | 3 years            |  | $                     | 3,044  |                         | $ | (2,029 | )                   |  | $ | 1,015
|Brand name             |  | 20 years           |  |                       | 8,804  |                         |   | (881   | )                   |  |   | 7,923
|                       |  |                    |  |                       |        |                         |   |        |                     |  |   |      
|                       |  |                    |  | $                     | 11,848 |                         | $ | (2,910 | )                   |  | $ | 8,938
|                       |  |                    |  |                       |        |                         |   |        |                     |  |   |      



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.



F-12



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##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Amortization expense related to intangible assets totaled $3.8 million, $1.5 million and $2.8 million
during the years ended December 31, 2003, 2002 and 2001, respectively. The estimated aggregate future amortization expense for intangible assets remaining as of December 31, 2003 is as follows (in thousands):



|           |  |   |      
|---------- |  | - | -----
|2004       |  | $ | 440  
|2005       |  |   | 440  
|2006       |  |   | 440  
|2007       |  |   | 440  
|2008       |  |   | 440  
|Thereafter |  |   | 5,283
|           |  |   |      
|           |  | $ | 7,483
|           |  |   |      



7. Accrued Liabilities:



Accrued liabilities consist of the following (in
thousands):



|                         |  |      |       |      |   |      
|------------------------ |  | ---- | ----- | ---- | - | -----
|                         |  | 2003 |       | 2002
|Telecommunications costs |  | $    | 112   |      | $ | 489  
|Employee compensation    |  |      | 701   |      |   | 707  
|Merger liabilities       |  |      | 1,020 |      |   | 1,020
|Property tax liabilities |  |      | 428   |      |   | 439  
|Lease obligations        |  |      | 151   |      |   | 251  
|Other                    |  |      | 1,275 |      |   | 2,040
|                         |  |      |       |      |   |      
|                         |  | $    | 3,687 |      | $ | 4,946
|                         |  |      |       |      |   |      



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 AICPA
Statement of Position 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) $5,109 and $1,826, respectively during 2003 and $5,109 and $1,826, respectively during 2002 and $5,025 and $1,783, respectively, during 2001.



The components of deferred revenue at December 31, 2003 and 2002 are as follows (in thousands):



|                         |  |      |        |   |      |   |        |  
|------------------------ |  | ---- | ------ | - | ---- | - | ------ | -
|                         |  | 2003 |        |   | 2002 |  
|Deferred revenue         |  | $    | 7,794  |   |      | $ | 12,903 |  
|Deferred cost of revenue |  |      | (2,649 | ) |      |   | (4,475 | )
|                         |  |      |        |   |      |   |        |  
|                         |  |      | 5,145  |   |      |   | 8,428  |  
|Less current portion     |  |      | (2,650 | ) |      |   | (3,283 | )
|                         |  |      |        |   |      |   |        |  
|                         |  | $    | 2,495  |   |      | $ | 5,145  |  
|                         |  |      |        |   |      |   |        |  



9. Long-Term Debt:



Long-term debt as of December 31, 2003 is summarized as follows (in
thousands):



|                          |  |   |        |  
|------------------------- |  | - | ------ | -
|Term loan                 |  | $ | 5,600  |  
|Capital lease obligations |  |   | 47     |  
|                          |  |   |        |  
|                          |  |   | 5,647  |  
|Less current portion      |  |   | (3,247 | )
|                          |  |   |        |  
|                          |  | $ | 2,400  |  
|                          |  |   |        |  



F-13



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



On May 5, 2003, the Company signed a new long-term credit agreement with its current lender that
included a term loan, which matures on September 30, 2005, and a revolving credit facility with a borrowing base subject to the Companys eligible accounts receivable balance up to $24.5 million, which matures on May 5, 2006. There was $5.6
million outstanding under the term loan while there were no amounts outstanding under the revolving credit facility at December 31, 2003. Approximately $6.5 million was available for borrowing under the revolving credit facility. The proceeds from
the term loan were used to refinance the Companys outstanding debt of $8.0 million. 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 twelve-month period and limitations on capital lease borrowings on an annual basis. The Company was in compliance with these covenants for the period ended December
31, 2003. 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, 2003, the weighted average interest rate on outstanding borrowings was 4.68%. 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.



The following table details future debt repayments under the Companys credit facility:



|     |  |   |      
|---- |  | - | -----
|2004 |  | $ | 3,200
|2005 |  |   | 2,400
|     |  |   |      
|     |  | $ | 5,600
|     |  |   |      



On July 3, 2003, the
Company executed an amendment to its long-term credit agreement that added a new lender to the facility and increased the revolving credit facility by $7.5 million to $32 million.



10. Income Taxes:



Components of deferred tax assets at December 31, 2003 and 2002 are as follows (in thousands):



|                                                  |  |      |         |   |      |   |         |  
|------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|                                                  |  | 2003 |         |   | 2002 |  
|Deferred Tax Assets                               |  |      |         |   |      |   |         |  
|Net operating loss carryforwards                  |  | $    | 23,727  |   |      | $ | 26,512  |  
|Current temporary differences                     |  |      | 879     |   |      |   | 764     |  
|Other                                             |  |      | 764     |   |      |   | 690     |  
|                                                  |  |      |         |   |      |   |         |  
|Total gross deferred tax assets                   |  |      | 25,370  |   |      |   | 27,966  |  
|Less valuation allowance                          |  |      | (16,668 | ) |      |   | (22,621 | )
|                                                  |  |      |         |   |      |   |         |  
|Net deferred tax assets after valuation allowance |  | $    | 8,702   |   |      | $ | 5,345   |  
|                                                  |  |      |         |   |      |   |         |  
|Deferred Tax Liabilities                          |  |      |         |   |      |   |         |  
|Non-deductible intangibles and fixed asset basis  |  |      | (4,347  | ) |      |   | (5,345  | )
|                                                  |  |      |         |   |      |   |         |  
|Net deferred tax assets                           |  | $    | 4,355   |   |      | $ |        |  
|                                                  |  |      |         |   |      |   |         |  



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:



|                                                                              |  |      |        |   |      |   |       |      |  |   |        |  
|----------------------------------------------------------------------------- |  | ---- | ------ | - | ---- | - | ----- | ---- |  | - | ------ | -
|                                                                              |  | 2003 |        |   | 2002 |   |       | 2001 | 
|Expected tax expense (benefit)                                                |  | $    | 1,595  |   |      | $ | 1,597 |      |  | $ | (3,070 | )
|State income taxes, net of federal benefit                                    |  |      | 239    |   |      |   | 251   |      |  |   |       |  
|Alternative minimum taxes                                                     |  |      | 136    |   |      |   |      |      |  |   |       |  
|Other                                                                         |  |      | (73    | ) |      |   |      |      |  |   |       |  
|Non-deductible amortization of goodwill and other intangibles                 |  |      |       |   |      |   |      |      |  |   | 3,070  |  
|Utilization of acquired deferred tax assets recorded as reduction to goodwill |  |      | 4,547  |   |      |   | 791   |      |  |   |       |  
|Valuation allowance                                                           |  |      | (5,953 | ) |      |   | (791  | )    |  |   |       |  
|                                                                              |  |      |        |   |      |   |       |      |  |   |        |  
|                                                                              |  | $    | 491    |   |      | $ | 1,848 |      |  | $ |       |  
|                                                                              |  |      |        |   |      |   |       |      |  |   |        |  



The net operating
losses (NOL) carryforwards of approximately $63.3 million will expire on various dates ranging from 2016 to 2020. Utilization of approximately $31.0 million 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.



F-14



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##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



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.



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 2003 of $12,000. 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 2003, 2002 or 2001.



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, 2003 expire on various dates from 2004 through 2008. A summary of outstanding warrants at December 31, 2003, 2002 and 2001 and changes during the years then ended
follows:



|                                     |  |            |   |      |                        |      |          |           |                        |   |          |  |           |                        |  |   |     
|------------------------------------ |  | ---------- | - | ---- | ---------------------- | ---- | -------- | --------- | ---------------------- | - | -------- |  | --------- | ---------------------- |  | - | ----
|                                     |  | 2003       |   | 2002 |                        | 2001
|                                     |  | Warrants   |   |      | Wtd. Avg.ExercisePrice |      | Warrants |           | Wtd. Avg.ExercisePrice |   | Warrants |  |           | Wtd. Avg.ExercisePrice
|Outstanding at beginning of the year |  | 8,544,870  |   |      | $                      | 2.48 |          | 8,544,870 |                        | $ | 2.48     |  | 4,766,300 |                        |  | $ | 2.62
|Issued as a result of merger         |  |           |   |      |                        |     |          |          |                        |   |         |  | 3,891,070 |                        |  |   | 3.57
|Canceled                             |  | (1,165,752 | ) |      |                        | 3.62 |          |          |                        |   |         |  | (112,500  | )                      |  |   | 7.20
|                                     |  |            |   |      |                        |      |          |           |                        |   |          |  |           |                        |  |   |     
|Outstanding at end of the year       |  | 7,379,118  |   |      | $                      | 2.30 |          | 8,544,870 |                        | $ | 2.48     |  | 8,544,870 |                        |  | $ | 2.48
|                                     |  |            |   |      |                        |      |          |           |                        |   |          |  |           |                        |  |   |     



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



F-15



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



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, 2003, 2002 and 2001 and changes during the years then ended is presented below:



|                                               |  |            |   |      |                        |      |        |            |   |                        |   |        |  |            |                        |  |   |     
|---------------------------------------------- |  | ---------- | - | ---- | ---------------------- | ---- | ------ | ---------- | - | ---------------------- | - | ------ |  | ---------- | ---------------------- |  | - | ----
|                                               |  | 2003       |   | 2002 |                        | 2001
|                                               |  | Shares     |   |      | Wtd. Avg.ExercisePrice |      | Shares |            |   | Wtd. Avg.ExercisePrice |   | Shares |  |            | Wtd. Avg.ExercisePrice
|Outstanding at beginning of the year           |  | 9,050,501  |   |      | $                      | 2.49 |        | 8,055,828  |   |                        | $ | 2.92   |  | 5,356,888  |                        |  | $ | 1.75
|Issued as a result of the merger               |  |           |   |      |                        |     |        |           |   |                        |   |       |  | 3,427,608  |                        |  |   | 4.78
|Granted                                        |  | 1,484,571  |   |      | $                      | 1.53 |        | 2,747,724  |   |                        | $ | 1.15   |  | 1,811,500  |                        |  |   | 3.22
|Exercised                                      |  | (1,270,604 | ) |      | $                      | 1.66 |        | (500       | ) |                        | $ | 0.30   |  | (609,810   | )                      |  |   | 1.26
|Canceled                                       |  | (2,097,048 | ) |      | $                      | 2.49 |        | (1,752,551 | ) |                        | $ | 2.38   |  | (1,930,358 | )                      |  |   | 3.93
|                                               |  |            |   |      |                        |      |        |            |   |                        |   |        |  |            |                        |  |   |     
|Outstanding at end of the year                 |  | 7,167,420  |   |      | $                      | 2.42 |        | 9,050,501  |   |                        | $ | 2.49   |  | 8,055,828  |                        |  | $ | 2.92
|                                               |  |            |   |      |                        |      |        |            |   |                        |   |        |  |            |                        |  |   |     
|Exercisable at end of the year                 |  | 5,447,991  |   |      | $                      | 2.69 |        | 6,341,868  |   |                        | $ | 2.79   |  | 6,090,862  |                        |  | $ | 2.69
|Weighted average fair value of options granted |  |            |   |      | $                      | 0.80 |        |            |   |                        | $ | 0.76   |  |            |                        |  | $ | 2.31



The following table
summarizes information about stock options outstanding at December 31, 2003:



|                         |  |                     |  |                                          |  |                               |      |                   |           |                               |   |     
|------------------------ |  | ------------------- |  | ---------------------------------------- |  | ----------------------------- | ---- | ----------------- | --------- | ----------------------------- | - | ----
|                         |  | Options Outstanding |  | Options Exercisable                     
|Range of Exercise Prices |  | NumberOutstanding   |  | Weighted-AverageRemainingContractualLife |  | Weighted-AverageExercisePrice |      | NumberExercisable |           | Weighted-AverageExercisePrice
|$0.89$1.14              |  | 1,605,530           |  | 8.75 years                               |  | $                             | 1.05 |                   | 708,711   |                               | $ | 1.08
|$1.15$1.29              |  | 1,786,847           |  | 7.65 years                               |  | $                             | 1.22 |                   | 1,439,045 |                               | $ | 1.18
|$1.44$2.94              |  | 1,717,055           |  | 7.43 years                               |  | $                             | 2.29 |                   | 1,366,111 |                               | $ | 2.24
|$3.00$6.38              |  | 2,057,988           |  | 6.75 years                               |  | $                             | 4.64 |                   | 1,934,124 |                               | $ | 4.72
|                         |  |                     |  |                                          |  |                               |      |                   |           |                               |   |     
|$0.89$6.38              |  | 7,167,420           |  |                                          |  |                               |      |                   | 5,447,991 |                               |   |     
|                         |  |                     |  |                                          |  |                               |      |                   |           |                               |   |     



As of December 31,
2003, there were 9,789,771 shares available for future grant under the stock option plans.



14. Commitments and Contingencies:



(a) Leases



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



At December 31, 2003, future minimum annual payments under capital leases and non-cancelable operating leases are as follows (in thousands):



|                       |  |       |       |                         |       |      |       |      |       |      |   |      |  
|---------------------- |  | ----- | ----- | ----------------------- | ----- | ---- | ----- | ---- | ----- | ---- | - | ---- | -
|                       |  |       |       | Payments Due Per Period
|Contractual Obligation |  | Total |       | 2004                    |       | 2005 |       | 2006 |       | 2007 |   | 2008
|Capital Leases         |  | $     | 47    |                         | 47    |      |      |      |      |      |  |      | 
|Operating Leases       |  | $     | 4,902 |                         | 2,128 |      | 1,670 |      | 1,104 |      |  |      | 



The present value of
obligations under capital lease was $43, of which $43 is classified as a current liability.



Rent expense totaled $2,419, $2,603 and $2,908 in 2003, 2002 and 2001, respectively.



As of December 31, 2003, the Company has non-cancelable future minimum purchase commitments with its telephone service providers of approximately $2.5
million for each of 2004 and 2005.



F-16



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



(b) Litigation



On October 12, 2001, StarGuide filed a complaint against Williams Communications Group, Inc. (Williams) in the United States District Court
for the District of Nevada alleging that Williams has willfully infringed three StarGuide patents. On March 4, 2002, StarGuide opposed Williams motion for summary judgment and moved to amend its complaint to add Williams Communications, LLC
(WCL), a subsidiary of Williams, as a party defendant. On July 3, 2002, WCL answered StarGuides complaint and asserted counterclaims seeking a declaratory judgment that the StarGuide patents are invalid and not infringed. On July
28, 2003, StarGuide, DGS, Williams and WCL reached a settlement resolving all litigation. Both lawsuits were dismissed as part of the settlement and the company expensed related patent defense costs totaling $1.5 million.



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. Due to losses for fiscal year
2001, inclusion of common stock equivalents would be anti-dilutive. Therefore, basic and diluted loss per share for the Company are the same for that year.



A reconciliation of net income (loss) per basic and diluted share for the three years ended December 31, 2003 follows (in thousands, except per share
amounts):



|                                                    |  |      |        |      |   |          |      |  |   |        |  
|--------------------------------------------------- |  | ---- | ------ | ---- | - | -------- | ---- |  | - | ------ | -
|                                                    |  | 2003 |        | 2002 |   |          | 2001 | 
|Basic:                                              |  |      |        |      |   |          |      |  |   |        |  
|Net income (loss) applicable to common shareholders |  | $    | 4,199  |      | $ | (127,385 | )    |  | $ | (9,029 | )
|Weighted average shares outstanding                 |  |      | 71,367 |      |   | 70,718   |      |  |   | 70,443 |  
|                                                    |  |      |        |      |   |          |      |  |   |        |  
|Net loss per share                                  |  | $    | 0.06   |      | $ | (1.80    | )    |  | $ | (0.13  | )
|                                                    |  |      |        |      |   |          |      |  |   |        |  
|Diluted:                                            |  |      |        |      |   |          |      |  |   |        |  
|Net income (loss) applicable to common shareholders |  | $    | 4,199  |      | $ | (127,385 | )    |  | $ | (9,029 | )
|                                                    |  |      |        |      |   |          |      |  |   |        |  
|Weighted average shares outstanding                 |  |      | 71,367 |      |   | 70,718   |      |  |   | 70,443 |  
|Add: Net effect of potentially dilutive shares      |  |      | 3,524  |      |   | 89       |      |  |   |       |  
|                                                    |  |      |        |      |   |          |      |  |   |        |  
|Total shares                                        |  |      | 74,891 |      |   | 70,807   |      |  |   | 70,443 |  
|                                                    |  |      |        |      |   |          |      |  |   |        |  
|Net income (loss) per share                         |  | $    | 0.06   |      | $ | (1.80    | )    |  | $ | (0.13  | )
|                                                    |  |      |        |      |   |          |      |  |   |        |  



16. Unaudited Quarterly Financial
Information (in thousands, expect per share amounts)



|                          |  |               |          |      |              |   |                   |  |                  |        |  |   |       
|------------------------- |  | ------------- | -------- | ---- | ------------ | - | ----------------- |  | ---------------- | ------ |  | - | ------
|                          |  | 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  
|                          | 
|                          |  | Quarter Ended
|                          |  | March 31,2002 |          |      | June 30,2002 |   | September 30,2002 |  | December 31,2002
|Revenues                  |  | $             | 14,997   |      |              | $ | 16,039            |  | $                | 16,421 |  | $ | 18,837
|Gross profit              |  |               | 6,366    |      |              |   | 8,049             |  |                  | 8,223  |  |   | 10,328
|Net income (loss)         |  |               | (130,754 | )(1) |              |   | 713               |  |                  | 717    |  |   | 1,939 
|Earnings (loss) per share |  | $             | (1.85    | )    |              | $ | 0.01              |  | $                | 0.01   |  | $ | 0.03  



|(1) | Includes cumulative effect of implementation of SFAS No. 142 of $130.2 million.
|--- | -------------------------------------------------------------------------------



F-17



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



17. Segment Information:



The Company operates predominantly in two industry segments: digital and physical distribution of audio and video content
and transmission and compression technology and consulting. 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, 2003       
|                                      |  | Audio and VideoContent Distribution |         | Other (a) |   |       | IntersegmentEliminations (b) |  |   | ConsolidatedTotals
|Revenues                              |  | $                                   | 55,148  |           | $ | 2,539 |                              |  | $ |                   |   |  | $ | 57,687
|Interest expense                      |  |                                     | 864     |           |   |      |                              |  |   |                   |   |  |   | 864   
|Depreciation and amortization expense |  |                                     | 7,782   |           |   | 115   |                              |  |   |                   |   |  |   | 7,897 
|Net income                            |  | $                                   | 4,384   |           | $ | (185  | )                            |  | $ |                   |   |  | $ | 4,199 
|                                      |  |                                     |         |           |   |       |                              |  |   |                    |   |  |   |       
|Purchases of property and equipment   |  | $                                   | 1,062   |           | $ | 20    |                              |  | $ |                   |   |  | $ | 1,082 
|                                      |  |                                     |         |           |   |       |                              |  |   |                    |   |  |   |       
|Total assets                          |  | $                                   | 131,834 |           | $ | 3,381 |                              |  | $ | (42,282            | ) |  | $ | 92,933
|                                      |  |                                     |         |           |   |       |                              |  |   |                    |   |  |   |       



|                                      |  |                                     |          |   |           |   |       |                              |  |   |                    |   |  |   |          |  
|------------------------------------- |  | ----------------------------------- | -------- | - | --------- | - | ----- | ---------------------------- |  | - | ------------------ | - |  | - | -------- | -
|                                      |  | Year ended December 31, 2002        |         
|                                      |  | Audio and VideoContent Distribution |          |   | Other (a) |   |       | IntersegmentEliminations (b) |  |   | ConsolidatedTotals |  
|Revenues                              |  | $                                   | 62,728   |   |           | $ | 3,566 |                              |  | $ |                   |   |  | $ | 66,294   |  
|Interest expense                      |  |                                     | (1,539   | ) |           |   | (1    | )                            |  |   |                   |   |  |   | (1,540   | )
|Depreciation and amortization expense |  |                                     | (7,375   | ) |           |   | (15   | )                            |  |   |                   |   |  |   | (7,390   | )
|Impairment loss                       |  |                                     | (130,234 | ) |           |   |      |                              |  |   |                   |   |  |   | (130,234 | )
|Net income (loss)                     |  | $                                   | (127,552 | ) |           | $ | 167   |                              |  | $ |                   |   |  | $ | (127,385 | )
|                                      |  |                                     |          |   |           |   |       |                              |  |   |                    |   |  |   |          |  
|Purchases of property and equipment   |  | $                                   | 706      |   |           | $ | 17    |                              |  | $ |                   |   |  | $ | 723      |  
|                                      |  |                                     |          |   |           |   |       |                              |  |   |                    |   |  |   |          |  
|Total assets                          |  | $                                   | 130,791  |   |           | $ | 3,027 |                              |  | $ | (36,613            | ) |  | $ | 97,205   |  
|                                      |  |                                     |          |   |           |   |       |                              |  |   |                    |   |  |   |          |  



|                                      |  |                                     |         |   |           |   |       |                              |  |   |                    |   |  |   |         |  
|------------------------------------- |  | ----------------------------------- | ------- | - | --------- | - | ----- | ---------------------------- |  | - | ------------------ | - |  | - | ------- | -
|                                      |  | Year ended December 31, 2001        |        
|                                      |  | Audio and VideoContent Distribution |         |   | Other (a) |   |       | IntersegmentEliminations (b) |  |   | ConsolidatedTotals |  
|Revenues                              |  | $                                   | 65,228  |   |           | $ | 5,472 |                              |  | $ |                   |   |  | $ | 70,700  |  
|Interest income                       |  |                                     | 130     |   |           |   | 2     |                              |  |   |                   |   |  |   | 132     |  
|Interest expense                      |  |                                     | (1,772  | ) |           |   |      |                              |  |   |                   |   |  |   | (1,772  | )
|Depreciation and amortization expense |  |                                     | (16,984 | ) |           |   | (81   | )                            |  |   |                   |   |  |   | (17,065 | )
|Net income (loss)                     |  | $                                   | (9,175  | ) |           | $ | 146   |                              |  | $ |                   |   |  | $ | (9,029  | )
|                                      |  |                                     |         |   |           |   |       |                              |  |   |                    |   |  |   |         |  
|Purchases of property and equipment   |  | $                                   | 3,191   |   |           | $ | 28    |                              |  | $ |                   |   |  | $ | 3,219   |  
|                                      |  |                                     |         |   |           |   |       |                              |  |   |                    |   |  |   |         |  
|Total assets                          |  | $                                   | 244,207 |   |           | $ | 2,819 |                              |  | $ | (11,226            | ) |  | $ | 235,800 |  
|                                      |  |                                     |         |   |           |   |       |                              |  |   |                    |   |  |   |         |  



|(a) | Other includes operations of Corporate Computer Systems, Inc. (CCS), responsible for the
Companys digital compression technology and consulting.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------



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



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 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.



In August 2001, the FASB issued SFAS No. 143, Accounting
for Asset Retirement Obligations. SFAS No. 143 requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred. The Company adopted SFAS No. 143 in fiscal year 2003. The
adoption of SFAS No. 143 did not have any significant impact on the Companys financial condition or results of operations.



F-18



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED 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) 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.



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.



19. Subsequent Event



On January 22, 2004, the Company filed a Registration Statement on Form
S-3 with the SEC using a shelf registration process. Under the shelf registration process, the Company may offer, from time to time, 7,000,000 shares of common stock and up to $5,000,000 in preferred shares.



F-19



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##### Table of Contents

##### Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

SCHEDULE IIVALUATION AND QUALIFYING ACCOUNTS

(in thousands)



|                                |  |                              |       |                               |       |       |       |     |            |        |   |                         |   |      
|------------------------------- |  | ---------------------------- | ----- | ----------------------------- | ----- | ----- | ----- | --- | ---------- | ------ | - | ----------------------- | - | -----
|Classification                  |  | Balance atBeginningof Period |       | AdditionsCharged toOperations |       | Other |       |     | Write-offs |        |   | Balance atEnd of Period
|Allowance for Doubtful Accounts |  |                              |       |                               |       |       |       |     |            |        |   |                         |   |      
|Year Ended:                     |  |                              |       |                               |       |       |       |     |            |        |   |                         |   |      
|December 31, 2001               |  | $                            | 847   |                               | 1,954 |       | 2,907 | (a) |            | (2,825 | ) |                         | $ | 2,883
|December 31, 2002               |  | $                            | 2,883 |                               | 715   |       |      |     |            | (2,484 | ) |                         | $ | 1,114
|December 31, 2003               |  | $                            | 1,114 |                               | 73    |       |      |     |            | (599   | ) |                         | $ | 588  



|(a) | Represents allowance assumed as a result of the merger between DGS and StarGuide in January
2001.
|--- | -------------------------------------------------------------------------------------------------



S-1