**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

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**FORM 10-K**

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**x**                               ANNUAL REPORT PURSUANT TO SECTION 13OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934

**ForThe Fiscal Year Ended December 31, 2006**

**OR**

**o**                                  TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934

**Forthe Transition PeriodFrom                              to                              .**

**COMMISSIONFILE NUMBER: 0-27644**

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**DGFastChannel, Inc.**

(Exact Name of Registrantas Specified in its Charter)

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

 

**750 West John CarpenterFreeway, Suite 700Irving, Texas 75039**

(Address Of PrincipalExecutive Offices, Including Zip Code)

**(972) 581-2000**

(Registrant’s TelephoneNumber, Including Area Code)

Securities registeredpursuant to Section 12(b) of the Act:

| **Title of Each Class**        |   | **Name of each exchange on which registered** |
|--------------------------------|--------|-----------------------------------------------|
| Common Stock, $0.001 par value |   | Nasdaq Global Market                          |

 

Securities registered pursuant to Section 12(g) ofthe Act: **None**

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

Indicate by check mark if the Registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) ofthe Exchange Act.   Yes o  No x

Indicate by check mark whether the Registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months and (2) hasbeen subject to such filing requirements for the past 90 days.   Yes x  No o

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

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

Large acceleratedfiler o                Acceleratedfiler o                Non-acceleratedfiler x

Indicate by check mark if the Registrant is a shellcompany (as defined in Rule 12b-2 of the Exchange Act).   Yes o  No x

The aggregate market value of the Common Stock held bynon-affiliates of the registrant, computed by reference to the closing priceand shares outstanding, was approximately $177.6 million as of December 31,2006, and approximately $52.9 million as of June 30, 2006, the lastbusiness day of the registrant’s most recently completed second quarter. Sharesof Common Stock held by each officer and director of the registrant and by eachperson who may be deemed to be an affiliate have been excluded. Thisdetermination of affiliate status is not necessarily a conclusive determinationfor other purposes.

As of March 31, 2007,the registrant had 15,849,796 shares of Common Stock outstanding.

**DOCUMENTSINCORPORATED BY REFERENCE**

**Portionsof our definitive Proxy Statement for our 2007 Annual Meeting of Stockholdersto be filed with the Securities and Exchange Commission within 120 days afterthe end of our 2006 fiscal year are incorporated by reference intoPart III of this Annual Report on Form 10-K.**

 

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**DG FASTCHANNEL,INC.**

The discussion in thisReport contains forward-looking statements that involve risks anduncertainties. The statements contained in this Report that are not purelyhistorical are forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933, as amended, and Section 21E of theSecurities Exchange Act of 1934, as amended. Words such as “anticipates,” “believes,”“plans,” “expects,” “future,” “intends,” and similar expressions are used toidentify forward-looking statements. All forward-looking statements included inthis document are based on information available to the Company on the datehereof, and we assume no obligation to update any such forward-lookingstatements, except as required by law. The Company’s actual results coulddiffer materially from those anticipated in these forward-looking statements asa result of certain factors, including, but not limited to, those discussed in “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” and “RiskFactors” as well as those discussed elsewhere in this Report, and the risksdiscussed in the Company’s other filings with the United States Securities andExchange Commission.

**TABLE OF CONTENTS**

| **PART I**  |
|------------------|
| ITEM 1.          |   | BUSINESS |   | 4 |   |
|             |   | General |   | 4 |   |
|             |   | Available  Information |   | 4 |   |
|             |   | Industry  Background |   | 4 |   |
|             |   | Services |   | 6 |   |
|             |   | Markets and  Customers |   | 8 |   |
|             |   | Sales,  Marketing and Customer Service |   | 8 |   |
|             |   | Competition |   | 10 |   |
|             |   | Intellectual  Property and Proprietary Rights |   | 10 |   |
|             |   | Employees |   | 11 |   |
| ITEM 1A.         |   | RISK FACTORS |   | 11 |   |
| ITEM 1B.         |   | UNRESOLVED  STAFF COMMENTS |   | 22 |   |
| ITEM 2.          |   | PROPERTIES |   | 23 |   |
| ITEM 3.          |   | LEGAL  PROCEEDINGS |   | 23 |   |
| ITEM 4.          |   | SUBMISSION OF  MATTERS TO A VOTE OF SECURITY HOLDERS |   | 23 |   |
| **PART II** |
| ITEM 5.          |   | MARKET  FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER  PURCHASES OF EQUITY SECURITIES |   | 24 |   |
| ITEM 6.          |   | SELECTED  FINANCIAL DATA |   | 26 |   |
| ITEM 7.          |   | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL  CONDITION AND RESULTS OF OPERATIONS |   | 28 |   |
|             |   | Cautionary Note Regarding Forward-Looking Statements |   | 28 |   |
|             |   | Critical  Accounting Policies |   | 28 |   |
|             |   | New  Accounting Pronouncement |   | 31 |   |
|             |   | Results of Operations |   | 33 |   |
|             |   | Liquidity and Capital Resources |   | 36 |   |
| ITEM 7A.         |   | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET  RISK |   | 37 |   |
| ITEM 8.          |   | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA |   | 37 |   |
| ITEM 9.          |   | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON  ACCOUNTING AND FINANCIAL DISCLOSURE |   | 37 |   |

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| ITEM 9A.          |   | CONTROLS AND PROCEDURES                                                                          |   | 38 |   |
|-------------------|--------|--------------------------------------------------------------------------------------------------|--------|----|--------|
| ITEM 9B.          |   | OTHER  INFORMATION                                                                               |   | 39 |   |
| **PART III** |
| ITEM 10.          |   | DIRECTORS,  EXECUTIVE OFFICERS AND CORPORATE  GOVERNANCE                                         |   | 40 |   |
| ITEM 11.          |   | EXECUTIVE  COMPENSATION                                                                          |   | 40 |   |
| ITEM 12.          |   | SECURITY  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER  MATTERS |   | 40 |   |
| ITEM 13.          |   | CERTAIN  RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE                       |   | 40 |   |
| ITEM 14.          |   | PRINCIPAL  ACCOUNTING FEES AND SERVICES                                                          |   | 40 |   |
| **PART IV**  |
| ITEM 15.          |   | EXHIBITS,  FINANCIAL STATEMENT SCHEDULES                                                         |   | 41 |   |
| SIGNATURES        |   | 45                                                                                               |   |

 

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**DG FASTCHANNEL,INC.**

**PART I**

**ITEM 1.**                BUSINESS

**General**

DG FastChannel, Inc. (the “Company” or “DGF”) isthe leading provider of digital technology services that enable the electronicdelivery of advertisements from advertising agencies to traditional broadcastersand other media outlets. We operate a nationwide digital network out of ourNetwork Operation Center (“NOC”), located in Irving, Texas, which links morethan 5,000 advertisers and advertising agencies with more than 21,000 radio,television, cable, network and print publishing destinations electronicallythroughout the United States and Canada. Through our NOC, we deliver video,audio, image and data content that comprise transactions among advertisers andvarious media outlets, including those in the broadcast industries.

For the year ended December 31, 2006, we provideddelivery services for 18 of the top 25 advertisers, as ranked by Ad Age. Themajority of our revenue is derived from multiple services relating toelectronic delivery of video and audio advertising content. Our primary sourceis the delivery of television and radio advertisements, or spots, which istypically performed digitally but sometimes physically. We offer a digitalalternative to dub and ship delivery of spot advertising. We generally bill ourservices on a per transaction basis.

Our services includeonline creative research, media production and duplication, distribution,management of existing advertisements and broadcast verification. This suite ofinnovative services addresses the needs of our customers at multiple stagesalong the value chain of advertisement creation and delivery in acost-effective manner and helps simplify the overall process of contentdelivery.

**AvailableInformation**

We file annual reports, quarterly reports, proxystatements and other documents with the Securities and Exchange Commission (“SEC”)under the Securities Exchange Act of 1934 (the “Exchange Act”). The public mayread and copy any materials that we file with the SEC at the SEC’s PublicReference Room at 450 Fifth Street N.W., Washington, D.C. 20549. Thepublic may obtain information on the operation of the Public Reference Room bycalling the SEC at 1-800-SEC-0330. Also, the SEC maintains awebsite that contains reports, proxy and information statements, and otherinformation regarding issuers, including us, that file electronically with theSEC. The public can obtain any documents that we file with the SEC athttp://www.sec.gov.

We also make availablefree of charge through our website (www.dgfastchannel.com) our Annual Report onForm 10-K, Quarterly Reports on Form 10-Q, CurrentReports on Form 8-K, and, if applicable, amendments to those reportsfiled or furnished pursuant to the Exchange Act as soon as reasonablypracticable after we electronically file such material with, or furnish it to,the SEC.

**Industry Background**

We believe there are approximately 11,000 commercialradio and 4,500 television, cable and network broadcast stations in the UnitedStates. These stations primarily generate revenue by selling airtime toadvertisers. In addition, there are approximately 8,100 daily and weeklynewspapers in circulation in the United States. Newspapers also primarilygenerate revenues from advertising. Advertising is most frequently producedunder the direction of advertising agencies for large national or regionaladvertisers or by station personnel for local advertisers. Television advertisingis characterized as network or spot, depending on how it is purchased anddistributed. Network advertising typically is delivered to stations as 

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part of a network feed(bundled with network programming), while spot advertising is delivered tostations independently of other programming content. 

Advertising agencies and advertisers use third-partyservice companies to ensure their media assets are delivered to multiplebroadcast destinations on a time-sensitive basis. Certain advertising campaignscan be extremely complex and include dozens of commercial television and radiospots which may require delivery to hundreds of discrete media locations acrossthe United States. Additionally, advertising agencies and advertisers requirecertain quality control standards, web-based order management capabilities andcertain tagging/editing functions by the third party service provider. Finally,these service providers must offer immediate confirmation of the delivery ofthe commercial content to the media outlet and detailed billing services.

Spot advertising airtime is typically purchased byadvertising agencies or media buying firms on behalf of advertisers.Advertisers, their agencies and media buying firms select individual stationsor groups of stations to support marketing objectives, which usually are basedon the stations’ geographic and demographic characteristics. The actualcommercials or spots are typically produced at a digital production studio andrecorded on digital tape. Variations of the spot intended for specificdemographic groups are also produced at this time. The spots undergo a reviewof quality and content before being cleared for distribution to broadcaststations, and can be delivered physically, via the traditional dub and shipmethod, or electronically.

While many radio and television broadcasters nowembrace digital technology for much of their production processes andin-station media management, current methods for the distribution of audio andvideo advertising content still include manual duplication and physicaldelivery of analog tapes. Many companies, commonly known as dub and shiphouses, duplicate audio and video tapes, assemble them according to agencyspecified bills of material and package them for air express delivery.Advertisers and their agencies can choose to have advertising content deliveredelectronically via the Internet and satellite transmissions. Electronictransmission has several advantages over dub and ship delivery, including:cost, transmission time, labor, materials, quality of content and control ofdistribution. The amount of advertising content transmitted electronically hassteadily increased, and we estimate that approximately 95% of radio spots andapproximately 50% of video spots are now electronically distributed. We believethat these figures will continue to grow as advertisers continue to takeadvantage of the benefits of electronic distribution.

Radio and television continue to attract significantportions of the advertising dollars spent by advertisers and advertisingagencies and represent powerful mediums for cost-effectively reaching large,targeted audiences and offer the accountability and returns that advertisersincreasingly demand.

We believe there are several key drivers that areincreasing the growth of digital delivery of advertising:

*Increasein demand for reliable and rapid means of content delivery.**  *In recent years, technologicalinnovations in digital media have been driven by increasing demand for reliableand rapid means of information transfer, particularly in the broadcast andtelecommunications industries. Digital distribution technologies areincreasingly used for distributing media in forms such as audio, video, textand data. Digitized information has many advantages including ease andefficiency of storage, manipulation, transmission and reproduction, with lessdegradation and in greater volumes than traditional analog or hard copyformats.

*Governmentmandate to transition to digital broadcasting.**  *On February 1, 2006, the U.S.Congress passed legislation, which was signed by the President on February 8,2006 establishing the deadline for the transition from analog to digitalbroadcasting by February 17, 2009. Most networks currently broadcast and areexpected to continue to broadcast both analog and digital programming until February 17,2009, when 

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all analog broadcastingmust terminate. The shift to digital provides improved picture quality andpreserves network capacity by using various compression technologies. Thisgovernment mandate has created strong momentum in the shift to high definitiontelevision (“HDTV”), broadcasting because of the complementary aspects betweendigital-only and HDTV broadcasting, which we believe will encourage the broadcastindustry to move to an entirely digital work stream, including the electronicdelivery of digital advertising.

*Increasein adoption and popularity of High Definition Television.**  *Consumer demand for superiorquality, declining HDTV set prices and increasing availability of HDTV contentare driving the rapid growth in HDTV adoption, with the United States leadingthe charge. Currently, all major broadcasters are delivering prime time contentvia HD broadcasting and, though advertisements are still mainly delivered instandard definition with the broadcast industry shifting towards HD, we believethat advertising will soon follow. As local television stations work towardsupgrading their infrastructure to enable HDTV signals, advertisers areincreasing the number of HDTV commercials, which we believe will likely requiredigital distribution.

*Emergence of videoadvertising content on the Internet.**  *The confluence of a successfulonline advertising industry and the penetration of personal broadbandconnections creates a strong platform for the Internet to become a significantmedium with respect to video advertisements. The increase in broadband subscribersis fueling the accelerating growth in streaming media. Largely due to thisgrowth in broadband usage, the Internet has become a widely used medium fordistributing and receiving audio and video content. As the volume and qualityof dynamic content progresses, we believe that there will be significant growthin video advertising over the Internet and that advertisers will look toexisting digital content distributors to provide the necessary capabilities tosuccessfully leverage this emerging medium.

**Services**

Our suite of innovative services seek to address theneeds of advertisers at various stages along the value chain of advertisementcreation and delivery. These include idea generation, production andduplication, content distribution, media asset management and broadcastverification products. By offering services that encompass multiple stages ofcontent creation and delivery, we are able to simplify the workflow process foradvertisers. We believe our solutions offer advertisers tools essential to thecreation and strategic distribution of advertisements in a cost effectivemanner. Our services address our clients’ needs for efficient, accurate andreliable solutions for the development and delivery of advertising contentacross a wide spectrum of media, and include the following offerings:

*OnlineCreative Research.**  *Weown and maintain an online database of content and credits of U.S. televisioncommercials for the advertising and TV commercial production industry. Webelieve that this is the most comprehensive online television commercialinformation service available to advertising agencies and production companies.Our SourceEcreative (formerly known as “Source TV”) database includesinformation relating to commercials, individuals and companies. Customers canuse our robust search engine specifically designed for the advertisingindustry. SourceEcreative allows users to find out which director, post house,composer or other production resource worked on specific spots, enablingadvertising agencies to identify creative and production resources, and toaccelerate their creative development process. Information can be provided viafax, phone, e-mail or over the Internet. SourceEcreative services most of themajor U.S. advertising agencies and production companies, as well as televisionnetworks, programs and industry associations.

*MediaProduction and Duplication.**  *Our production and duplication capabilities allow usto provide customers with ancillary services, which are offered in addition toour primary distribution service. Our services include storage of clientmasters or storyboards, editing of materials, tagging content, dubbing, videoduplication and copying of media onto various physical multimedia formats, suchas CD, DVD or 

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tape. We believe theseadd-on service offerings allow us to better service our customers by reducingthe number of vendors necessary to create and distribute advertisements.

*Distribution.**  *We provide primarily electronicand, to a lesser extent, physical distribution of broadcast advertising contentto broadcast stations throughout the United States and Canada. Through our NOC,we operate a digital network, currently connecting more than 5,000 advertisersand advertising agencies with more than 4,500 television, cable and networkbroadcast destinations, over 10,000 radio stations, and over 6,500 printpublishing destinations across the United States and Canada. Our networkenables the rapid, cost-effective and reliable electronic transmission of audioand video spots and other content and provides a high level of quality,accountability and flexibility to both advertisers and broadcasters. Ourtechnologically advanced digital network delivers near master quality audio orvideo to broadcasters, which is equal or superior to the content currentlydelivered on dub and ship analog tapes. Our network routes transmissions tostations through an automated online transaction and delivery system, enablingdelivery in as little as one hour after an order is received.

·       *Video.  *We receive video contentelectronically at our NOC primarily via our proprietary FTP software that isdeployed in video production studios. Video content also can be receivedthrough our various regional customer service locations and collection points throughoutthe United States. When video spots are received, our employees quality assurethe spots and release the video to the NOC, where it is combined with thecustomer’s electronic transaction to transmit the various combinations of videoto designated television stations. Video transmissions are sent via a high-speedfiber link to the digital satellite uplink facility over which they are thendelivered directly to DG FastChannel Spot Boxes that we have placedin television stations and cable interconnects.

·       *Audio.  *Audio content can be uploadedvia the Internet electronically. In addition, audio can be received using ourUpload Internet audio collection system. When audio spots are received, ouremployees quality assure the audio content and then initiate the electronictransaction to transmit various combinations of audio to designated radiostations. Audio transmissions are delivered over broadband connections toservers that we place in each radio station on the network, where the contentwill be available to the station on demand. Alternatively, these transmissionscan be downloaded from our website.

·       *Print.  *Print content can be uploadedvia the Internet electronically into our print media distribution system. Printtransmissions are delivered over the Internet to various newspaper locationsvia proprietary web-based software applications. The print transmissions aremodified to the specific format as required by the individual newspapers.

Video and audio transmissions are received atdesignated television and radio stations on DG FastChannel-owned servers,called DG FastChannel Spot Boxes, Receive Playback Terminals, ClientWorkstations and Digital Media Managers. The servers enable stations to receiveand play back material delivered through our digital distribution network. Theunits are owned by us and typically installed in the master control or productionarea of the stations. Upon receipt, station personnel generally review thecontent and transfer the spot to a standardized internal station and format forsubsequent broadcast. Through our NOC, we monitor the spots stored in each ofour servers and ensure that space is always available for new transmissions. Wecan quickly transmit video or audio at the request of a station or in responseto a customer who wishes to alter an existing order, allowing us to effectivelyadapt to customer needs and to distribute to hundreds of locations in as littleas one hour, which would be impossible for traditional physical dub and shiphouses.

We offer various levels of digital video and audiodistribution services from our NOC to advertisers distributing content to broadcasters.These include the following: DGFC Priority, a service which guarantees arrivalof the first spot on an order within one hour; DGFC Express, which guaranteesarrival within four hours; DGFC Standard, which guarantees arrival by noon thenext day; and DGFC Economy, 

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which guarantees arrivalby noon on the second day. We also offer a set of premium services enablingadvertisers to distribute audio or video spots provided after normal businesshours.

In addition to our standard services, we have developedunique products to service markets with particular time-sensitive deliveryneeds, including the delivery of political advertising during electioncampaigns, providing a rapid response mechanism for candidates and issuegroups.

*MediaAsset Management.**  *Ourdigital media asset management solution simplifies spot management, access,storage and collaboration for our customers. Our media asset managementsolution is integrated with our distribution system, enabling automaticarchiving of trafficked spots, online search, send-for-review andreview-and-approval capabilities, automated digital storyboarding, streamingpreviews, a comprehensive order and market data history for each spot, scriptattachment capability and online search, sort, retrieve and hardcopyfulfillment.

*BroadcastBusiness Intelligence Products.**  *Our broadcast verificationsolution, through various alternative detection networks, allows our customersto monitor and confirm accurate airplay of their broadcast commercials. Thisservice offering relies on remotely controlled tuners and servers operated byothers in secure locations to monitor the stations in each market.

During the fourth quarterof fiscal 2006, the Company’s Board of Directors authorized management to beginmarketing for sale certain assets of two subsidiaries: StarGuide Digital Networks, Inc.and Corporate Computer Systems, Inc. These subsidiaries made up ourpreviously reported Product Sales Segment. The Company determined that thesebusinesses were no longer consistent with our strategic business goals. Theseassets include inventories, property and equipment and certain intangibleassets. The Company completed the sale of the assets of Corporate ComputerSystems for a price of $425,000 in March 2007 and has recorded a loss onsale of $1,163,000 related to this subsidiary. The sale of StarGuide isexpected to result in a gain which will be recognized if the sale is completed.

**Markets andCustomers**

A large portion of DGF’srevenue is derived from the delivery of spot radio and television advertisingto broadcast stations, cable systems and networks. DGF derives revenue frombrand advertisers and advertising agencies, and from its marketing partners,which are typically dub and ship houses that have signed agreements with DGF toconsolidate and forward the deliveries of their advertising agency customers tobroadcast stations, cable systems and networks via DGF’s electronic deliveryservice in exchange for price discounts from DGF. The advertisementsdistributed by DGF are representative of the five leading national advertisingcategories of automotive, retail, business and consumer services, food andrelated products and entertainment. The volume of advertising from thesesegments is subject to seasonal and cyclical variations.

**Sales, Marketingand Customer Service**

*BrandStrategy.**  *DGF’sbrand strategy is to position itself as the standard transaction method for theradio, television, cable, and network broadcast industries. DGF focuses itsmarketing messages and programs at multiple segments within the advertising andbroadcast industries. Each of the segments interacts with DGF for a differentreason. Agencies purchase services from DGF on behalf of their advertisers.Production studios facilitate the transmission of audio and video to DGF’s NOC.Production studios and dub and ship houses resell delivery services toagencies. Stations join the network to receive the content from theircustomers: the agencies and advertisers.

*Internet/E-CommerceStrategy.**  *TheSpotCentral online order entry and management system adds functionality to ouronline management tool that opens up our network so customers can see thestatus of their media asset as it moves from endpoint to endpoint—from the timeit leaves their possession until it 

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arrives at the mediaoutlet. With new system architecture and user-friendly applications,SpotCentral provides advertisers and agencies with an intuitive web portal tovisualize and manage the distribution of their valuable advertising content.Users can upload spots, choose or create new destination groups, attach trafficinstructions, view invoices, distribute media electronically to thousands ofdestinations across DGF’s massive digital network and confirm delivery at thestation level through DGF’s powerful new media server, the DG Spot Box. Usershave immediate access to key statistics, order status and other data, whileworkflow automation tools help user groups save routing instructions anddestination paths for repeat orders. Users can search billing history and viewinvoices from any web-connected location. Customized search features let usersresearch order history by brand, service level or transmission date. Inaddition, spots can be previewed at any time of the day or point in the orderprocess. This design introduces new levels of simplicity, transparency,accountability and customer satisfaction to the spot distribution process.SpotCentral was made available to the entire advertising marketplace in February 2005.

*Sales.**  *DGF employs a direct sales forcethat calls on various departments at advertising agencies to communicate thecapabilities and comparative advantages of DGF’s electronic distribution systemand related products and services. In addition, DGF’s sales force calls oncorporate advertisers who are in a position to either direct or influenceagencies in directing deliveries to DGF. A separate staff sells to and servicesaudio and video dealers, who resell DGF’s distribution services. DGF currentlyhas regional sales offices in New York, Los Angeles and Chicago. DGF’s salesforce includes regional sales, inside sales, and telemarketing personnel.

*Marketing.**  *DGF’s marketing programs aredirected to stimulate demand with an emphasis on popularizing the benefits ofdigital delivery, including fast turnaround (same day services), increasedflexibility, higher quality, and greater reliability and accountability. Thesemarketing 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. DGFalso engages in public relations activities including trade show participation,the stimulation of articles in the trade and business press, press tours andadvertisements in advertising and broadcast oriented trade publications.

DGF markets to broadcast stations to arrange for theplacement of its Digital Media Managers, and DG Spot Boxes for the receipt ofaudio and video advertisements.

*Customer Service.**  *DGF’s approach to customer serviceis based on a model designed to provide focused support from key marketcentered offices, located in Los Angeles, Dallas, Chicago, Detroit, New Yorkand San Francisco. Clients work with specific, assigned account coordinators toplace production service and distribution orders. National distribution ordersare electronically routed to the NOC for electronic distribution or, foroff-line destinations, to DGF’s national duplication center in Louisville,Kentucky. DGF’s distributed service approach provides direct support in keymarket cities enabling DGF to develop closer relationships with clients aswell as the ability to support client needs for local production services. DGFalso maintains a customer service team dedicated to supporting the needs ofradio, television, and network stations. This support is available 7 daysa week, 24 hours a day, to respond to station requests for information,traffic instructions or additional media. Providing direct support alleviatesthe need for client traffic departments to deal with individual stations or thechallenges of staffing for off-hours support. DGF’s customer service operationcenters are linked to DGF’s order management and media storage systems, andnational distribution network. These resources enable DGF to manage thedistribution of client orders to the fulfillment location best suited to meetcritical customer requirements as well as providing order status andfulfillment confirmation. This distribution model also provides DGF withsignificant redundancy and re-route capability, enabling DGF to meet customerneeds when weather or other conditions prevent deliveries using traditionalcourier services.

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**Competition**

DGF competes with a variety of dub and ship houses andproduction studios that have traditionally distributed taped advertising spotsvia physical delivery. As local distributors, these entities have long-standingties with advertising agencies that are often difficult for DGF to replace. Inaddition, these dub and ship houses and production studios often provide anarray of ancillary video services, including archival storage and retrieval,closed captioning and format conversions, enabling them to deliver to theiradvertiser and agency customers a full range of customizable, mediapostproduction, preparation, distribution and trafficking services. DGF plansto continue pursuing potential dub and ship house partners where suchpartnerships make strategic sense.

In the video marketplace, DGF competes with dub and shiphouses across the country but additionally with a satellite-based videodistribution network operated by Vyvx, an operating division of WilltelCommunications, which is a wholly-owned subsidiary of Level 3Communications, Inc. DGF also anticipates that certain common and/orvalue-added telecommunications carriers may develop and deploy high bandwidthnetwork services targeted at the advertising and broadcast industries, althoughDGF believes that no such carriers have yet entered the market for spot distribution.

We are aware of other companies that are focusing ormay in the future focus significant resources on developing and marketingproducts and services that will compete with ours. We believe that our abilityto compete successfully depends on a number of factors, both within and outsideof our control, including: (1) the price, quality and performance of ourproducts and those of our competitors; (2) the timing and success of newproduct introductions; (3) the emergence of new technologies; (4) thenumber and nature of our competitors in a given market; (5) the protectionof intellectual property rights; and (6) general market and economicconditions.

DGF expects competition tocontinue to intensify as existing and new competitors begin to offer products,services, or systems that compete with our products. Our current or futurecompetitors, many of whom, individually or together with their affiliates, havesubstantially greater financial resources, research, and development resources,distribution, marketing, and other capabilities than us, may apply theseresources and capabilities to compete successfully against our products andservice. A number of the markets in which we sell our products and services arealso served by technologies that currently are more widely accepted than ours.Although we believe that our products and services are less expensive to useand more functional than competing products and services that rely on othertechnologies, it is uncertain whether our potential customers will be willingto make the initial capital investment that may be necessary to convert to ourproducts and services. The success of our systems against these competingtechnologies depends in part upon whether our systems can offer significant improvementsin productivity and sound and video quality in a cost-effective manner. It isuncertain whether our competitors will be able to develop systems compatiblewith, or that are alternatives to, our proprietary technology or systems. It isalso not certain that we will be able to compete successfully against currentor future competitors or that competitive pressures faced by us will notmaterially adversely affect our business, operating results, and financialcondition.

**IntellectualProperty and Proprietary Rights**

DGF primarily relies upona combination of copyright, trademark and trade secret laws and licenseagreements to establish and protect proprietary rights in its technologies. DGFcurrently has 27 patents issued with expiration dates ranging from June 2012to September 2022 and eight other patent applications pending. DGF alsohas eleven trademark registrations, eight trademark applications andapproximately 200 copyright registrations.

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**Employees**

As of December 31, 2006, DGF had in itscontinuing operations a total of 376 employees, including 45 in research anddevelopment, 46 in sales and marketing, 242 in operations, and 43 in financeand administration. 372 of these employees are located in the United States and4 are located in the United Kingdom. DGF’s employees are not represented by acollective bargaining agreement and DGF has not experienced a work stoppage. DGFconsiders its relations with its employees to be good.

DGF’s business andprospects depend in significant part upon the continued service of its keymanagement, sales and marketing and administrative personnel. The loss of keymanagement or technical personnel could materially adversely affect DGF’soperating results and financial condition. DGF believes that its prospectsdepend in large part upon its ability to attract and retain highly skilledmanagerial, sales and marketing and administrative personnel. Competition forsuch personnel is intense, and DGF may not be successful in attracting andretaining such personnel. Failure to attract and retain key personnel couldhave a material adverse effect on DGF’s operating results and financialcondition.

**ITEM 1A.**        RISKFACTORS

In evaluating aninvestment in our Company, the following risk factors should be considered.

**Risks Relating tothe Industry**

***The mediadistribution products and services industry is divided into several distinctmarkets, some of which are relatively mature while others are growing rapidly.If the mature markets begin to decline at a time when the developing marketsfail to grow as anticipated, it will be increasingly difficult to achieve and maintainprofitability.***

To date, our design and marketing efforts for ourproducts and services have involved the identification and characterization ofthe broadcast market segments within the media distribution products andservices industry that will be the most receptive to our products and services.We may not have correctly identified and characterized such markets and ourplanned products and services may not address the needs of those markets.Furthermore, our current technologies may not be suitable for specificapplications within a particular market and further design modifications,beyond anticipated changes to accommodate different markets, may be necessary.

While the electronic distribution of media has beenavailable for several years and growth of this market is modest, many of theproducts and services now on the market are relatively new. It is difficult topredict the rate at which the market for these new products and services willgrow, if at all. Even if the market does grow, it will be necessary to quicklyconform our products and services to customer needs and emerging industrystandards in order to be a successful participant in those markets, such as themarket for HD spots. If the market fails to grow, or grows more slowly thananticipated, it will be difficult for any market participant to succeed and itwill be increasingly difficult for us to achieve and maintain profitability.

To achieve andsustain profitability and growth, we must expand our product and serviceofferings beyond the broadcast markets to include additional market segmentswithin the media distribution products and services industry. Potential newapplications for our existing products in new markets include distance learningand training, finance and retail. While our products and services could beamong the first commercial products that may be able to serve the convergenceof several industry segments, including digital networking, telecommunications,compression products and Internet services, our products and services may notbe accepted by that market. In addition, it is possible that:

·       theconvergence of several industry segments may not continue;

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·       themarkets may not develop as a result of such convergence; or

·       ifmarkets develop, such markets may not develop either in a direction beneficialto our products or product positioning or within the time frame in which weexpect to launch new products and product enhancements.

Because the convergence ofdigital networking, telecommunications, compression products and Internetservices is new and evolving, the growth rate, if any, and the size of thepotential market for our products cannot be predicted. If markets for theseproducts fail to develop, develop more slowly than expected or become served bynumerous competitors, or if our products do not achieve the anticipated levelof market acceptance, our future growth could be jeopardized. Broad adoption ofour products and services will require us to overcome significant marketdevelopment hurdles, many of which we cannot predict.

***The industry is in a state of rapid technologicalchange and we may not be able to keep up with that pace.***

The advertisementdistribution and asset management industry is characterized by extremely rapidtechnological change, frequent new products, service introductions and evolvingindustry standards. The introduction of products with new technologies and theemergence of new industry standards can render existing products obsolete andunmarketable. Our future success will depend upon our ability to enhanceexisting products and services, develop and introduce new products and servicesthat keep pace with technological developments and emerging industry standardsand address the increasingly sophisticated needs of our customers, including theneed for HD spots. We may not succeed in developing and marketing productenhancements or new products and services that respond to technological changeor emerging industry standards. We may experience difficulties that could delayor prevent the successful development, introduction and marketing of theseproducts and services. Our products and services may not adequately meet therequirements of the marketplace and achieve market acceptance. If we cannot,for technological or other reasons, develop and introduce products and servicesin a timely manner in response to changing market conditions, industrystandards or other customer requirements, particularly if we have pre-announcedthe product and service releases, our business, financial condition, results ofoperations or cash flows will be harmed.

***The marketing andsale of our products and services involve lengthy sales cycles. This makesbusiness forecasting extremely difficult and can lead to significantfluctuations in quarterly results.***

Due to the complexity and substantial cost associatedwith providing integrated product and services to provide audio, video, dataand other information across a variety of media and platforms, licensing andselling products and services to our potential customers typically involves asignificant technical evaluation. In addition, there are frequently delaysassociated with educating customers as to the productive applications of ourproducts and services, complying with customers’ internal procedures forapproving large expenditures and evaluating and accepting new technologies thataffect key operations. In addition, certain customers have even longerpurchasing cycles that can greatly extend the amount of time it takes to placeour products and services with these customers. Because of the lengthy salescycle and the large size of our potential customers’ average orders, ifrevenues projected from a specific potential customer for a particular quarterare not realized in that quarter, product revenues and operating results forthat quarter could be harmed. Revenues will also vary significantly as a resultof the timing of product and service purchases and introductions, fluctuationsin the rate of development of new markets and new applications, the degree ofmarket acceptance of new and enhanced versions of our products and services,and the level of use of satellite networking and other transmission systems. Inaddition, increased competition and the general strength of domestic andinternational economic conditions also impact revenues.

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Because expense levelssuch as personnel and facilities costs, are based, in part, on expectations offuture revenue levels, if revenue levels are below expectations, our business,financial condition, results of operations or cash flows will be harmed.

***Seasonality inbuying patterns also makes forecasting difficult and can result in widelyfluctuating quarterly results.***

On a historical basis, theindustry has experienced lower sales for services in the first quarter, whichis somewhat offset with higher sales in the fourth quarter due to increasedcustomer advertising volumes for the holiday selling season. In addition,product and service revenues are influenced by political advertising, whichgenerally occurs every two years. Nevertheless, in any single period, productand service revenues and delivery costs are subject to variation based onchanges in the volume and mix of deliveries performed during such period. Inaddition, we have historically operated with little or no backlog. The absenceof backlog and fluctuations in revenues and costs due to seasonality increasesthe difficulty of predicting our operating results.

***The markets inwhich we will operate are highly competitive, and competition may increasefurther as new participants enter the market and more established companieswith greater resource seek to expand their market share.***

Competition within the markets for media distributionis intense. Moreover, these markets have become increasingly concentrated in recentyears as a result of acquisitions. We believe that our ability to competesuccessfully depends on a number of factors, both within and outside of ourcontrol, including: (1) the price, quality and performance of our productsand those of our competitors; (2) the timing and success of new productintroductions; (3) the emergence of new technologies; (4) the numberand nature of our competitors in a given market; (5) the protection ofintellectual property rights; and (6) general market and economic conditions.In addition, the assertion of intellectual property rights by others andgeneral market and economic conditions factor into the ability to competesuccessfully. The competitive environment could result in price reductions thatcould result in lower profits and loss of our market share.

While we offer products and services focused on theelectronic distribution of media, we compete with dub and ship houses andproduction studios. Although many dub and ship houses and production studios,such as Point.360, generally do not offer electronic delivery, they often havelong-standing ties to local distributors that can be difficult to replace. Manyof these dub and ship houses and production studios also have greaterfinancial, distribution and marketing resources than we and have achieved ahigher level of brand recognition. Production studios, advertising agencies andmedia buying firms also could deliver directly through entities with packagedelivery expertise such as Federal Express, United Parcel Service, the UnitedStates Postal Service and DHL.

In addition, we compete with a satellite-based videodistribution network operated by Vyvx, an operating division of WilltelCommunications, which is a wholly-owned subsidiary of Level 3 Communications, Inc.We also anticipate that certain common and/or value-added telecommunicationscarriers and other companies, such as Pathfire, may develop and deploy highbandwidth network services targeted at the advertising and broadcastindustries, although we believe that no such carriers have yet entered themarket for spot distribution in any significant way.

With respect to new markets, such as the delivery ofother forms of content to radio and television stations, competition is likelyto come from companies in related communications markets and/or packagedelivery markets. Some of the companies capable of offering products andservices with superior functionality include telecommunications providers, suchas AT&T, MCI and other fiber and telecommunication companies, each of whichwould enjoy materially lower electronic delivery 

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transportation costs.Radio networks such as ABC Radio Networks or Westwood One could also becomecompetitors by selling and transmitting advertisements as a complement to theircontent programming.

Further, other companies may in the future focussignificant resources on developing and marketing products and services thatwill compete with ours.

We have identified videoadvertising on the Internet as a potential business opportunity. This businessis currently undergoing rapid change with many different companies providinginnovative technology and solutions to advertisers and advertising agencies.Some of these companies capable of providing these services have establishedtechnologies and customer bases. Additionally, there is no assurance we will beable to compete on this level. Additionally, we are unsure of the amount ofinvestment required to enter this new and quickly changing market.

**Risks Related tothe Company**

***We have a history of losses which must be consideredin assessing our future prospects.***

2003 was the first year wereported net income after having been unprofitable since our inception. Whilewe reported profit again in 2004, we experienced a loss in 2005 and 2006. In 2002,we were profitable only after excluding the effect of a change in accountingprinciple. We could continue to generate net losses in the future, which coulddepress our stock price. Decreases in revenues could occur, which could impairour ability to operate profitably in the future. Future success also depends inpart on obtaining reductions in delivery and service costs, particularly ourability to continue to automate order processing and to reducetelecommunications costs. Our prospects must be considered in light of therisks, expenses and difficulties frequently encountered by companies in new andrapidly evolving markets, such as risks that the market might fail to grow,expenses relating to modifying products and services to meet industry standardsas they change over time, and difficulties in gaining and maintaining marketshare. To address these risks, we must, among other things, respond tocompetitive developments, attract, retain and motivate qualified persons,continually upgrade our technologies and begin to commercialize productsincorporating such technologies. We may not be successful in addressing any orall of these risks and may not be able to achieve and sustain profitability.

***We may not be able to obtain additional financing tosatisfy our future capital needs.***

We intend to continuemaking capital expenditures to market, develop, produce and deploy at no costto our customer the various equipment required by the customers to receive ourservices and to introduce additional services. In addition, we will need tomake the investments necessary to maintain and improve our network. We alsoexpect to expend capital to consummate any mergers and acquisitions that weundertake in the future. We may require additional capital sooner than currentlyanticipated and may not be able to obtain additional funds adequate for ourcapital needs. We cannot predict any of the factors affecting the revenues andcosts of these activities with any degree of certainty. Accordingly, we cannotpredict the precise amount of future capital that we will require, particularlyif we pursue one or more additional acquisitions.

Furthermore,additional financing may not be available to us, or if it is available, it maynot be available on acceptable terms. Our inability to obtain the necessaryfinancing on acceptable terms may prevent us from deploying our products andservices effectively, maintaining and improving our products and network andcompleting advantageous acquisitions. Our inability to obtain the necessary financingcould seriously harm our business, financial condition, results of operationsand prospects. Consequently, we could be required to:

·       significantlyreduce or suspend our operations;

·       seekan additional merger partner; or

·       sell additional securitieson terms that are highly dilutive to our stockholders.

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***Our business ishighly dependent upon radio and television advertising. If demand for, ormargins from, our radio and television advertising delivery services decline,our business results will decline.***

We expect that asignificant portion of our revenues will continue to be derived from thedelivery of radio and television advertising spots from advertising agencies,production studios and dub and ship houses to radio and television stations inthe United States. A decline in demand for, or average selling prices of, ourradio and television advertising delivery services for any of the followingreasons, or otherwise, would seriously harm our business, financial condition,results of operations and prospects:

·       competitionfrom new advertising media;

·       newproduct introductions or price competition from competitors;

·       ashift in purchases by customers away from our premium services; and

·       achange in the technology used to deliver such services.

Additionally, we aredependent on our relationship with the radio and television stations in whichwe have installed communications equipment. Should a substantial number ofthese stations go out of business, experience a change in ownership ordiscontinue the use of our equipment in any way, our business, financialcondition, results of operations and prospects would be harmed.

***If we are not ableto maintain and improve service quality, our business and results of operationswill be susceptible to decline.***

Our business willdepend on making cost-effective deliveries to broadcast stations within thetime periods requested by our customers. If we are unsuccessful in making thesedeliveries, for whatever reason, a station might be prevented from sellingairtime that it otherwise could have sold. Our ability to make deliveries tostations within the time periods requested by customers depends on a number offactors, some of which will be outside of our control, including:

·       equipmentfailure;

·       interruptionin services by telecommunications service providers; and

·       inabilityto maintain our installed base of audio and video units that will comprise ourdistribution network.

Stations may assert claims for lost air-time in thesecircumstances and dissatisfied advertisers may refuse to make furtherdeliveries through us in the event of a significant occurrence of lostdeliveries, which would result in a decrease in our revenues or an increase inour expenses, either of which could lead to a reduction in net income or anincrease in net loss. Although we expect that we will maintain insuranceagainst business interruption, such insurance may not be adequate to protect usfrom significant loss in these circumstances or from the effects of a majorcatastrophe (such as an earthquake or other natural disaster), which couldresult in a prolonged interruption of our business.

***Our business is highly dependent on electronic videoadvertising delivery service deployment.***

Our inability to maintain units necessary for thereceipt of electronically delivered video advertising content in an adequatenumber of television stations or to capture market share among content deliverycustomers, which may be the result of price competition, new productintroductions from competitors or otherwise, would be detrimental to ourbusiness objectives and deter future growth. We have made a substantialinvestment in upgrading and expanding our NOC and in populating televisionstations with the units necessary for the receipt of electronically deliveredvideo advertising content. However, we cannot assure you that the maintenanceof these units will cause this service to achieve adequate market acceptanceamong customers that require video advertising content delivery.

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In addition, we believe that to more fully address theneeds of video delivery customers we have developed a set of ancillary servicesthat typically are provided by dub and ship houses. These ancillary servicesinclude cataloging, physical archiving, closed-captioning, modification ofslates and format conversions. We will need to provide these services on alocalized basis in each of the major cities in which we provide servicesdirectly to agencies and advertisers. We currently provide certain of such servicesto a portion of our customers through our facilities in New York, Los Angeles,Detroit and Chicago. However, we may not be able to successfully provide theseservices to all customers in those markets or any other major metropolitan areaat competitive prices. Additionally, we may not be able to provide competitivevideo distribution services in other U.S. markets because of the additionalcosts and expenses necessary to do so and because we may not be able to achieveadequate market acceptance among current and potential customers in thosemarkets.

While we are taking the steps we believe are requiredto achieve the network capacity and scalability necessary to deliver videocontent, such as HDTV content, reliably and cost effectively as video advertisingdelivery volume grows, we may not achieve such goals because they are highlydependent on the services provided by our telecommunication providers and thetechnological capabilities of both our customers and the destinations to whichcontent is delivered. If our telecommunication providers are unable orunwilling to provide the services necessary at a rate we are willing to pay orif our customers and/or our delivery destinations do not have the technologicalcapabilities necessary to send and/or receive video content, our goals ofadequate network capacity and scalability could be jeopardized.

In addition, we may beunable to retain current audio delivery customers or attract future audiodelivery customers who may ultimately demand delivery of both media contentunless we can successfully continue to develop and provide video transmissionservices. The failure to retain such customers could result in a reduction ofrevenues, thereby decreasing our ability to achieve and maintain profitability.

***We rely onbandwidth providers or other third parties for key aspects of the process ofproviding products and services to our customers, and any failure orinterruption in the services and products provided by these third parties couldharm our ability to operate our business and damage our reputation.***

We rely on third-partyvendors, including bandwidth providers. Any disruption in the network accessservices provided by these third-party providers or any failure of thesethird-party providers to handle current or higher volumes of use couldsignificantly harm our business. Any financial or other difficulties ourproviders face may have negative effects on our business, the nature and extentof which we cannot predict. We exercise little control over these third partyvendors, which increases our vulnerability to problems with the services theyprovide. We license technology from third parties to facilitate aspects of ourconnectivity operations. We have experienced and expect to continue toexperience interruptions and delays in service and availability for suchelements. Any errors, failures, interruptions or delays experienced inconnection with these third-party technologies could negatively impact ourrelationship with users and adversely affect our business and could expose usto liabilities to third parties.

***If we were nolonger able to rely on our existing providers of transmissions services, ourbusiness and results of operations could be harmed affected.***

We obtain our local accesstransmission services and long distance telephone access through contracts withSprint, which expires in November 2007, and MCI, which expired in March 2007.While our MCI service continues on a month-to-month basis with no contract, weare evaluating which service provider(s) we will select for future needs. Theagreement with Sprint provides for reduced pricing on various services providedin exchange for minimum purchases of $1.0 million for each year of theSprint contract and the MCI contract provided reduced pricing in exchange forminimum purchases of $0.5 million for 2006. The agreements provide forcertain achievement credits once specified purchase levels are met. Any 

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interruptionin the supply or a change in the price of either local access or long distancecarrier service could increase costs or cause a significant decline inrevenues, thereby decreasing our operating results.

***We face various risks associated with purchasingsatellite capacity.***

As part of our strategy ofproviding transmittal of audio, video, data and other information usingsatellite technology, we periodically purchase satellite capacity from thirdparties owning satellite systems. Although our management attempts to matchthese expenditures against anticipated revenues from sales of products tocustomers, they may not be successful at estimating anticipated revenues, andactual revenues from sales of products may fall below expenditures forsatellite capacity. In addition, the purchases of satellite capacity require asignificant amount of capital. Any inability to purchase satellite capacity orto achieve revenues sufficient to offset the capital expended to purchasesatellite capacity may make our business more vulnerable and significantlyaffect financial condition and results of operations.

***If the existingrelationship with Clear Channel Satellite Services is terminated, or if ClearChannel Satellite Services fails to perform as required under its agreementwith us, our business could be interrupted.***

We have designed anddeveloped the necessary software to enable our current video delivery systemsto receive digital satellite transmissions over the AMC-9 satellitesystem. However, the Clear Channel satellite system may not have the capacityto meet our future delivery commitments and broadcast quality requirements on acost-effective basis, if at all. We have a non-exclusive agreement with ClearChannel that expires in June 2010. The agreement provides for fixedpricing on dedicated bandwidth and gives us access to satellite capacity forelectronic delivery of digital audio and video transmissions by satellite.Clear Channel is required to meet performance specifications as outlined in theagreement, and we are given a credit allowance for future fees if Clear Channeldoes not meet these requirements. The agreement states that Clear Channel canterminate the agreement if we do not make timely payments or become insolvent.

***Certain of ourproducts depend on satellites; any satellite failure could result ininterruptions of our service that could negatively impact our business andreputation.***

A reduction in the number of operating satellites oran extended disruption of satellite transmissions would impair the currentutility of the accessible satellite network and the growth of current andadditional market opportunities. Satellites and their ground support systemsare complex electronic systems subject to weather conditions, electronic andmechanical failures and possible sabotage. The satellites have limited designlives and are subject to damage by the hostile space environment in which theyoperate. The repair of damaged or malfunctioning satellites is nearlyimpossible. If a significant number of satellites were to become inoperable,there could be a substantial delay before they are replaced with newsatellites. In addition, satellite transmission can be disrupted by naturalphenomena causing atmospheric interference, such as sunspots.

Certain of our productsrely on signals from satellites, including, but not limited to, satellitereceivers and head-end equipment. Any satellite failure could result ininterruptions of our service, negatively impacting our business. We attempt tomitigate this risk by having our customers procure their own agreements withsatellite providers.

***Interruption orfailure of our information technology and communications systems could impairour ability to effectively provide our products and services, which coulddamage our reputation and harm our operating results.***

Our provision of our products and services depends onthe continuing operation of our information technology and communicationssystems. Any damage to or failure of our systems could result in interruptionsin our service. Interruptions in our service could reduce our revenues andprofits, and our brand could be damaged if people believe our system isunreliable. Our systems are vulnerable to damage 

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or interruption fromearthquakes, terrorist attacks, floods, fires, power loss, telecommunicationsfailures, computer viruses, computer denial of service attacks or otherattempts to harm our systems, and similar events. Some of our systems are notfully redundant, and our disaster recovery planning cannot account for alleventualities. The occurrence of a natural disaster, a decision to close afacility we are using without adequate notice for financial reasons or otherunanticipated problems at our NOC could result in lengthy interruptions in ourservice.

We have experienced systemfailures in the past and may in the future. Any unscheduled interruption in ourservice puts a burden on our entire organization and may result in a loss ofrevenue. If we experience frequent or persistent system failures in our NOC orweb-based management systems, our reputation and brand could be permanentlyharmed. The steps we have taken to increase the reliability and redundancy ofour systems are expensive, reduce our operating margin and may not besuccessful in reducing the frequency or duration of unscheduled downtime.

***The market price of our common stock is likely tocontinue to be volatile.***

Some of the factorsthat may cause the market price of our common stock to fluctuate significantlyinclude:

·       theaddition or departure of key personnel;

·       variationsin our quarterly operating results;

·       announcementsby us or our competitors of significant contracts, new or enhanced products orservice offerings, acquisitions, distribution partnerships, joint ventures orcapital commitments;

·       changesin coverage and financial estimates by securities analysts;

·       changesin market valuations of networking, Internet and telecommunications companies;

·       fluctuationsin stock market prices and trading volumes, particularly fluctuations of stockprices quoted on the Nasdaq Global Market; and

·       sale of a significantnumber of shares of our common stock by us or our significant holders.

***Sales ofsubstantial amounts of our common stock in the public market could harm themarket price of our common stock.***

The sale of substantialamounts of our shares (including shares issuable upon exercise of outstandingoptions and warrants to purchase our common stock) may cause substantialfluctuations in the price of our common stock. Because investors would be morereluctant to purchase shares of our common stock following substantial sales,the sale of these shares also could impair its ability to raise capital throughthe sale of additional stock.

***Our inability toenter into or develop strategic relationships in key market segments could harmour operating results.***

Our strategy depends inpart on the development of strategic relationships with leading companies inkey market segments, including media broadcasters and digital system providers.We may not be able to successfully form or enter into such relationships, whichmay jeopardize our ability to generate sales of our products or services inthose segments. Specific product lines are dependent to a significant degree onstrategic alliances and joint ventures formed with other companies. Variousfactors could limit our ability to enter into or develop strategicrelationships, including, but not limited to, our relatively short operatinghistory, history of losses and the resources available to our competitors.Moreover, the terms of strategic 

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alliancesand joint ventures may vest control in a party other than us. Accordingly, thesuccess of the strategic alliance or joint venture may depend upon the actionsof that party and not us.

***Insiders have substantialcontrol over us which could limit others’ ability to influence the outcome ofkey transactions, including changes in control.***

As of December 31,2006, our executive officers and directors and their respective affiliates ownedapproximately 17% of our common stock. As a result, these stockholders may beable to control or significantly influence all matters requiring stockholderapproval, including the election of directors and the approval of significantcorporate transactions. This concentration of ownership may have the effect ofdelaying or preventing a change in control of us even if a change of control isin the best interest of all stockholders.

***Our business may beharmed if we are not able to protect our intellectual property rights from third-partychallenges.***

We cannot assure that our intellectual property doesnot infringe on the proprietary rights of third parties. The steps taken toprotect our proprietary information may not prevent misappropriation of suchinformation, and such protection may not preclude competitors from developingconfusingly similar brand names or promotional materials or developing productsand services similar to ours. We consider our trademarks, copyrights,advertising and promotion design and artwork to be of value and important toour businesses. We rely on a combination of trade secret, copyright andtrademark laws and nondisclosure and other arrangements to protect ourproprietary rights. We generally enter into confidentiality or licenseagreements with our distributors and customers and limit access to anddistribution of our software, documentation and other proprietary information.Despite our efforts to protect our proprietary rights, unauthorized parties mayattempt to copy or obtain and use information that we regard as proprietary. Inaddition, the laws of some foreign countries do not protect our proprietaryrights to the same extent as do the laws of the United States.

While we believe that ourtrademarks, copyrights, advertising and promotion design and artwork do notinfringe upon the proprietary rights of third parties, we may still receivefuture communications from third parties asserting that we are infringing, ormay be infringing, on the proprietary rights of third parties. Any such claims,with or without merit, could be time-consuming, require us to enter intoroyalty arrangements or result in costly litigation and diversion of managementattention. If such claims are successful, we may not be able to obtain licensesnecessary for the operation of our business, or, if obtainable, such licensesmay not be available on commercially reasonable terms, either of which couldprevent our ability to operate our business.

***We may enter intoor seek to enter into business combinations and acquisitions that may bedifficult to integrate, disrupt our business, dilute stockholder value ordivert management attention.***

We recentlyacquired FastChannel Network Inc., Media DVX, Inc., SourceEcreativeand the Broadcast Division of Applied Graphics Technologies, Inc., each ofwhich became our wholly-owned subsidiary. Our business strategy will includethe acquisition of additional complementary businesses and product lines. Anysuch acquisitions would be accompanied by the risks commonly encountered insuch acquisitions, including:

·       thedifficulty of assimilating the operations and personnel of the acquiredcompanies;

·       thepotential disruption of our business;

·       theinability of our management to maximize our financial and strategic position bythe successful incorporation of acquired technology and rights into our productand service offerings;

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·       difficultymaintaining uniform standards, controls, procedures and policies, with respectto accounting matters and otherwise;

·       thepotential loss of key employees of acquired companies; and

·       theimpairment of relationships with employees and customers as a result of changesin management and operational structure.

We may not be able tosuccessfully complete any acquisition or, if completed, the acquired businessor product line may not be successfully integrated with our operations,personnel or technologies. Any inability to successfully integrate theoperations, personnel and technologies associated with an acquired businessand/or product line may negatively affect our business and results ofoperation. We may dispose of any of our businesses or product lines in theevent that we are unable to successfully integrate them, or in the event thatmanagement determines that any such business or product line is no longer in ourstrategic interests.

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

Our personnel, systems,procedures and controls may not be adequate to support our existing as well asfuture operations. We will need to continue to implement and improve ouroperational, financial and management information systems, procedures andcontrols on a timely basis and to expand, train, motivate and manage our workforce. We must also continue to further develop our products and services whileimplementing effective planning and operating processes, such as continuing toimplement and improve operational, financial and management informationsystems; hiring and training additional qualified personnel; continuing toexpand and upgrade our core technologies; and effectively managing multiplerelationships with various customers, joint venture and technological partnersand other third parties.

***We will depend onkey personnel to manage the business effectively, and if we are unable toretain our key employees or hire additional qualified personnel, our ability tocompete could be harmed.***

Our future success will depend to a significant extentupon the services of Scott K. Ginsburg, Chairman of the Board and ChiefExecutive Officer; and Omar A. Choucair, Chief Financial Officer.Uncontrollable circumstances, such as the death or incapacity of any keyexecutive officer, could have a serious impact on our business.

Our future success willalso depend upon our ability to attract and retain highly qualified management,sales, operations, technical and marketing personnel. At the present time thereis, and will continue to be, intense competition for personnel with experiencein the markets applicable to our products and services. Because of this intensecompetition, we may not be able to retain key personnel or attract, assimilateor retain other highly qualified technical and management personnel in thefuture. The inability to retain or to attract additional qualified personnel asneeded could have a considerable impact on our business.

***Certain provisionsof our bylaws may have anti-takeover effects that could prevent a change incontrol even if the change would be beneficial to its shareholders.***

We have a classified boardwhich might, under certain circumstances, discourage the acquisition of acontrolling interest of its stock because such acquirer would not have theability to replace these directors except as the term of each class expires.The directors are divided into three classes with respect to the time for whichthey hold office. The term of office of one class of directors expires at eachannual meeting of stockholders. At each annual meeting of stockholders,directors elected to succeed those directors whose terms then expire areelected for a term of office to expire at the third succeeding annual meetingof stockholders after their election.

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***Our board ofdirectors may issue, without stockholder approval, preferred stock with rightsand preferences superior to those applicable to the common stock.***

Our certificate ofincorporation includes a provision for the issuance of “blank check” preferredstock. This preferred stock may be issued in one or more series, with eachseries containing such rights and preferences as the board of directors maydetermine from time to time, without prior notice to or approval ofstockholders. Among others, such rights and preferences might include therights to dividends, superior voting rights, liquidation preferences and rightsto convert into common stock. The rights and preferences of any such series ofpreferred stock, if issued, may be superior to the rights and preferencesapplicable to the common stock and might result in a decrease in the price ofthe common stock.

***We depend upon anumber of single or limited-source suppliers, and our ability to produce audioand video distribution equipment could be harmed if those relationships werediscontinued.***

We rely on fewer than fivesingle or limited-source suppliers for integral components used in the assemblyof our audio and video units. If a supplier were to experience financial oroperational difficulties that resulted in a reduction or interruption incomponent supply to us, this would delay our deployment of audio and videounits. We rely on our suppliers to manufacture components for use in ourproducts. Some of our suppliers also sell products to our competitors and mayin the future become our competitors, possibly entering into exclusivearrangements with our existing competitors. In addition, our suppliers may stopselling our products or components to us at commercially reasonable prices orcompletely stop selling our products or components to us. If a reduction orinterruption of supply were to occur, it could take a significant period oftime for us to qualify an alternative subcontractor, redesign our products asnecessary and contract for the manufacture of such products. This would havethe effect of depressing our business until we was able to establish sufficientcomponent supply through an alternative source. We believe that there arecurrently alternative component manufacturers that could supply the componentsrequired to produce our products, but based on the financial condition andservice levels of our current suppliers, we do not feel the need to pursueagreements or understandings with such alternative sources or pursue long-termcontracts with our current suppliers. We have experienced component shortagesin the past, and material component shortages or production or delivery delaysmay occur in the future.

***We determined thatthere was a material weakness in our disclosure controls and procedures relatedsuch that those controls and procedures were not effective as ofDecember 31, 2006 and December 31, 2004. In the event a materialweakness occurs again in the future, our financial statements and results ofoperations could be harmed and you may not be justified in relying on thosefinancial statements.***

For the year endedDecember 31, 2006, we determined that our disclosure controls andprocedures were not effective, and we identified a material weakness in ourinternal controls over financial reporting for business combinations and stockcompensation as of December 31, 2006. For the year ended December 31,2004, we determined that our disclosure controls and procedures were noteffective, and we identified a material weakness in our internal controls overfinancial reporting for income taxes as of December 31, 2004. In the eventthat this or any other material weakness occurs in the future, our financialstatements and results of operations could be harmed and you may not bejustified in relying on those financial statements, either of which couldresult in a decrease in our stock price.

***The Public CompanyAccounting Oversight Board, or PCAOB, is conducting an annual inspection of ourexternal auditors and we cannot assure you that in the course of thisinspection, the PCAOB will not identify additional information in our financialstatements which it believes could have been reported differently.***

The PCAOB is conducting aninspection of our external auditors, KPMG LLP, and their audit of our financialstatements as of and for the year ended December 31, 2005. The PCAOB is aprivate agency established to oversee the auditors of publicly held companies,and the PCAOB conducts annual 

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inspectionson all large public accounting firms that audit the financial statements ofpublicly held companies. As part of this inspection, the PCAOB has selected,among others, to review KPMG LLP’s audit of our financial statements as of andfor the year ended December 31, 2005. The PCAOB’s inspection of KPMG LLPis ongoing and there can be no assurance as to when it will be completed. Inaddition, we cannot assure you that in the course of this inspection, the PCAOBwill not identify additional information contained in our historical financialstatements which it believes could have been reported differently, or theprospective impact of any such items on our financial statements.

***We are required toevaluate our internal control over financial reporting under Section 404of the Sarbanes Oxley Act of 2002, and any adverse results from such evaluationcould result in a loss of investor confidence in our financial reports and harmour stock price.***

Pursuant to Section 404 of the Sarbanes-Oxley Actof 2002, beginning with our Annual Report on Form 10-K for thefiscal year ending December 31, 2007, we will be required to furnish areport by our management on our internal control over financial reporting. Sucha report will contain, among other matters, an assessment of the effectivenessof our internal control over financial reporting as of the end of our fiscalyear, including a statement as to whether or not our internal control overfinancial reporting is effective. This assessment must include disclosure ofany material weaknesses in our internal control over financial reportingidentified by management. Such report must also contain a statement that ourauditors have issued an attestation report on management’s assessment of suchinternal controls.

The Committee of Sponsoring Organizations of theTreadway Commission (COSO) provides a framework for companies to assess andimprove their internal control systems. The Public Company Accounting OversightBoard’s Auditing Standard No. 2, or Standard No. 2 and proposedStandard No. 5, which is expected to replace Standard 2, provides theprofessional standards and related performance guidance for auditors to attestto, and report on, management’s assessment of the effectiveness of internal controlover financial reporting under Section 404. Management’s assessment ofinternal controls over financial reporting requires management to makesubjective judgments and some of the judgments will be in areas that may beopen to interpretation and therefore the report may be uniquely difficult toprepare, and our auditors may not agree with management’s assessments. We arestill performing the system and process documentation and evaluation needed tocomply with Section 404, which is both costly and challenging.

During this process, if our management identifies oneor more material weaknesses in our internal control over financial reporting,we will be unable to assert such internal control is effective. If we areunable to assert that our internal control over financial reporting iseffective as of December 31, 2007 (or if our auditors are unable to attestthat our management’s report is fairly stated or they are unable to express anopinion on the effectiveness of our internal controls), we could lose investorconfidence in the accuracy and completeness of our financial reports, whichwould harm our stock price.

We have in the pastdiscovered, and may in the future discover, areas of our internal controls thatneed improvement. We cannot be certain as to the timing of completion of ourevaluation, testing and any required remediation due in large part to the factthat there is very little precedent available by which to measure compliancewith the new Auditing Standard No. 2. If we are not able to complete ourassessment under Section 404 in a timely manner, we and our auditors wouldbe unable to conclude that our internal control over financial reporting iseffective as of December 31, 2007.

**ITEM 1B.**       UNRESOLVEDSTAFF COMMENTS

None

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**ITEM 2.**                PROPERTIES

The Company’s principalexecutive offices are at 750 West John Carpenter Freeway in Irving, Texas. TheIrving offices include 26,000 square feet of leased space, for which the leaseexpires in 2011. In addition, the Company leases approximately 6,400 squarefeet in Dallas, TX which is occupied by production personnel and expires in2013; approximately 9,100 square feet in Louisville, Kentucky for its dub andship facility which expires in 2010; approximately 15,600 square feet in NewYork which is occupied by production service and sales personnel and expires in2011; approximately 15,300 square feet in Los Angeles occupied by productionservice and sales personnel which expires in 2011; approximately 1,900 squarefeet in San Francisco occupied by sales personnel which expires in 2008; 4,500square feet in Detroit, which is occupied by production service and salespersonnel which expires in July 2007; 19,200 square feet in Wilmington,Ohio that expires in 2009 which is being sublet to a lessee; 18,500 square feetin Chicago, which is occupied by production service and sales personnel whichexpires in 2011; 1,000 square feet near Boston, Massachusetts, which isoccupied by administrative personnel which expires in October 2007; and200 square feet in Austin, Texas, which is occupied by administrative personnelwhich expires in October 2007. In addition, the Company leases an officein Boca Raton, Florida that is approximately 2,600 square feet and includessales, operations and administrative staff for SourceEcreative, which expiresin 2009; and 800 square feet in London, England, which is occupied by salespersonnel which expires in 2009. 

**ITEM 3.**                LEGALPROCEEDINGS

On February 2, 2006, a subsidiary of the Companyinitiated an arbitration proceeding against Pathfire, Inc. Our subsidiary seeksunspecified damages suffered due to Pathfire’s alleged breach and wrongful terminationof a Technology License and Services Agreement between Pathfire and MediaDVX, Inc., which agreement was acquired by our subsidiary inApril 2005. Pathfire has asserted a breach of contract counterclaimagainst our subsidiary and seeks damages in the approximate amount of $387,000.A hearing is scheduled for May 2007, at which the arbitrator isexpected to decide whether Pathfire is liable for breaching an exclusivity andnon-competition clause in the agreement. Discovery is in progress.

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

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

Not applicable.

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**PART II**

**ITEM 5.**                MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES

The Common Stock of the Company has been traded on theNasdaq Global Market (formerly known as the Nasdaq National Market) under thesymbol 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 CommonStock or other securities. On May 26, 2006 the Company’s common stock wasreverse split on a 1-for-10 basis.

Thefollowing table sets forth the high and low closing sales prices of our CommonStock from January 1, 2005 to December 31, 2006. Such pricesrepresent prices between dealers, do not include retail mark-ups, markdowns orcommissions and may not represent actual transactions. 

| ** **     | ** ** | **Fiscal Year Ended  2006** | ** ** | **Fiscal Year Ended  2005** | ** ** |
|----------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| ** **     | ** ** | **High**                              | ** ** | **Low**                               | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter  |       | $                                     | 7.40       |                                  | $          | 5.20 |   | $ | 15.80 |   | $ | 10.60 |   |
| Second Quarter |       | 5.75                                  |       | 5.30                                  |       | 13.50 |   | 9.60 |   |
| Third Quarter  |       | 10.64                                 |       | 5.50                                  |       | 9.80 |   | 6.00 |   |
| Fourth Quarter |       | 13.53                                 |       | 10.81                                 |       | 7.10 |   | 4.70 |   |
|                |            |                                       |            |                                       |            |  |  |  |  |  |  |  |  |

 

The prices shown are adjusted to give effect for the1-for-10 reverse split on May 26, 2006.

The following table sets forth the purchases of equitysecurities by the Company during the period January 1, 2005 to December 31,2005. No purchases were made during 2006. All purchases shown below were madeon the open market during the time periods specified. 

| ** **                                      | ** ** | **Total Number  of Shares  Purchased** | ** ** | **Average Price  Paid per Share** | ** ** | **Total Number  of Shares  Purchased as  Part of Publicly  Announced  Plans(1)** | ** ** | **Maximum Dollar  Value of Shares  that May Yet be  Purchased under  the Plan** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------|------------|
| January 1,  2005 to December 31, 2005 |       |                                             | 10,800     |                                             |       |                                                                                                      | $          | 14.60                                                                                                                   |       |   |   | 56,371 |   |   |   | $ | 2,747,827 |   |   |
|                                                 |            |                                                  |            |                                                  |            |                                                                                                           |            |                                                                                                                         |            |  |  |  |  |  |  |  |  |  |  |

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

As of February 28, 2007, the Company had issued15,899,235 and outstanding 15,842,865 shares of its common stock. As of February 28,2007, the Company’s common stock was held by approximately 312 stockholders ofrecord. The Company estimates that there are approximately 5,749 beneficial stockholders.

The Company has neverdeclared or paid cash dividends on its capital stock. The Company currentlyexpects to retain any future earnings for use in the operation and expansion ofits business and does not anticipate paying any cash dividends in theforeseeable future.

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**Stock PerformanceTable**

The table set forth below compares the cumulativetotal stockholder return on the Common Stock between December 31, 2001 andDecember 31, 2006 with the cumulative total return of (i) the NasdaqNon-Financial Stocks Index and (ii) the Nasdaq Computer and DataProcessing Stocks Index, over the same period. This table assumes theinvestment of $100.00 on December 31, 2001 in the Common Stock, the NasdaqNon-Financial Stocks Index and the Nasdaq Computer and Data Processing StocksIndex, and assumes the reinvestment of dividends, if any.

The comparisons shown in the table below are basedupon historical data. The Company cautions that the stock price performanceshown in the table below is not indicative of, nor intended to forecast, thepotential future performance of the Common Stock. Information used in the graphwas obtained from information published by Nasdaq and Research DataGroup, Inc., sources believed to be reliable, but the Company is notresponsible for any errors or omissions in such information.

**COMPARISONOF 5 YEAR CUMULATIVE TOTAL RETURN***Among DG Fastchannel, Inc., The NASDAQComposite IndexAnd The NASDAQ Computer & Data Processing Index

****

* $100 invested on 12/31/01 in stock orindex-including reinvestment of dividends.Fiscal year ending December 31.

| ** **                                               | ** ** | **Cumulative Total Return** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                               | ** ** | **12/01**                             | ** ** | **12/02** | ** ** | **12/03** | ** ** | **12/04** | ** ** | **12/05** | ** ** | **12/06** | ** ** |
| DG FASTCHANNEL, INC.                                     |       | 100.00                                |       | 96.40 |   | 201.80 |   | 112.61 |   | 48.65 |   | 121.44 |   |
| NASDAQ NON-FINANCIAL  STOCKS INDEX                       |       | 100.00                                |       | 71.97 |   | 107.18 |   | 117.07 |   | 120.50 |   | 137.02 |   |
| NASDAQ COMPUTER & DATA PROCESSING STOCKS  INDEX |       | 100.00                                |       | 72.13 |   | 91.67 |   | 104.54 |   | 107.98 |   | 122.16 |   |

 

Notwithstandinganything to the contrary set forth in any of the Company’s previous or futurefilings under the Securities Act or the Exchange Act that might incorporatethis report or future filings made by the Company under those statutes, this StockPerformance Graph shall not be deemed filed with the SEC and shall not bedeemed incorporated by reference into any of those prior filings or into anyfuture filings made by the Company under those statutes.

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**EQUITY COMPENSATIONPLAN INFORMATION**

The following tableprovides information about the securities authorized for issuance under theCompany’s equity compensation plans as of December 31, 2006: 

| ** **                                              | ** ** | **Number of securities to  be issued upon exercise  of outstanding options,  warrants and rights(1)** | ** ** | **Weighted average  exercise price of  outstanding options,  warrants and rights** | ** ** | **Number of securities  remaining available for  future issuance  (excluding securities  reflected in column (a))(2)** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity compensation  plans approved by security holders |       |                                                                                                                                                    | 790,974    |                                                                                                             |       |                                                                                                                                                                | $          | 10.15 |   |   |   | 1,097,500 |   |   |
|                                                         |            |                                                                                                                                                         |            |                                                                                                                  |            |                                                                                                                                                                     |            |  |  |  |  |  |  |  |

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(1)          This table excludes anaggregate of 441,692 shares issuable upon exercise of outstanding options andwarrants assumed by the Company in connection with the Company’s merger withStarGuide Digital Networks, Inc. in January 2001. Theweighted-average exercise price of the excluded options and warrants is $11.95per share.

(2)          Excludes 99,269available for issue under the Employee Stock Purchase Plan.

**ITEM 6.**                SELECTEDFINANCIAL DATA

The following selected historical consolidatedfinancial data should be read in conjunction with the Company’s consolidatedfinancial statements and related notes and “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” contained herein.

The consolidated statement of operations data for theyears ended December 31, 2006, 2005, 2004, 2003, and 2002 and theconsolidated balance sheet data at December 31, 2006, 2005, 2004, 2003,and 2002 are derived from the consolidated financial statements of the Company,which were audited by KPMG LLP, independent registered public accounting firm.

Amounts (except per shareamounts) are shown in thousands:

**Statement of Operations Data (for continuingoperations):**

| ** **                                                                                                                | ** ** | **For years ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                                | ** ** | **2006**                                             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Revenues:                                                                                                                 |       | $                                                    | 68,667     |   | $ | 51,824 |   | $ | 53,570 |   | $ | 47,928 |   | $ | 53,145 |   |
| Costs and  expenses:                                                                                                      |       |                                                 |       |   |   |   |   |   |   |   |   |
| Cost of revenues                                                                                                          |       | 33,322                                               |       | 32,184 |   | 28,941 |   | 23,871 |   | 26,336 |   |
| Sales and marketing                                                                                                       |       | 4,240                                                |       | 3,915 |   | 4,264 |   | 3,970 |   | 4,011 |   |
| Research and development                                                                                                  |       | 1,779                                                |       | 1,107 |   | 1,520 |   | 1,958 |   | 2,449 |   |
| General and administrative                                                                                                |       | 10,462                                               |       | 7,587 |   | 6,328 |   | 4,968 |   | 6,937 |   |
| Restructuring charges                                                                                                     |       | —                                               |       | 434 |   | — |   | — |   | 771 |   |
| Impairment charges                                                                                                        |       | —                                               |       | — |   | 1,048 |   | — |   | — |   |
| Depreciation and amortization                                                                                             |       | 8,563                                                |       | 6,348 |   | 5,143 |   | 5,685 |   | 6,476 |   |
| Total expenses                                                                                                            |       | 58,366                                               |       | 51,575 |   | 47,244 |   | 40,452 |   | 46,980 |   |
| Income from operations                                                                                                    |       | $                                                    | 10,301     |   | $ | 249 |   | $ | 6,326 |   | $ | 7,476 |   | $ | 6,165 |   |
| Other (income)  expense:                                                                                                  |       |                                                 |       |   |   |   |   |   |   |   |   |
| Reduction in fair value of long-term investments                                                                          |       | 4,758                                                |       | — |   | — |   | — |   | — |   |
| Interest income and other (income) expense, net                                                                           |       | (58                                                  | )          | — |   | — |   | — |   | — |   |
| Interest expense                                                                                                          |       | 2,844                                                |       | 2,990 |   | 1,284 |   | 211 |   | 680 |   |
| Net income (loss) before income taxes and cumulative  effect of change in accounting principle from continuing operations |       | $                                                    | 2,757      |   | $ | (2,741 | ) | $ | 5,042 |   | $ | 7,265 |   | $ | 5,485 |   |

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| Provision (benefit) for income taxes                                                                      |   | 2,378  |   | (768   | )      | 1,728  |   | 1,469  |   | 2,114    |   |
|-----------------------------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|----------|--------|
| Net income (loss) before cumulative effect of change  in accounting principle from continuing  operations |   | $      | 379    |   | $      | (1,973 | )      | $      | 3,314  |     | $      | 5,796 |   | $ | 3,371 |   |
| Cumulative effect of change in accounting principle                                                       |   | — |   | — |   | — |   | — |   | (130,234 | )      |
| Net income (loss) after cumulative effect of change  in accounting principle from continuing operations   |   | $      | 379    |   | $      | (1,973 | )      | $      | 3,314  |     | $      | 5,796 |   | $ | (126,863 | ) |
| (Loss) income from operations of discontinued operations                                                  |   | (539   | )      | 1,455  |   | (6,181 | )      | (2,575 | )      | (788     | )      |
| Income tax benefit (expense)                                                                              |   | 209    |   | (572   | )      | 6,071  |   | 978    |   | 266      |   |
| Loss on disposal of discontinued operations, net of  tax benefit                                          |   | (698   | )      | — |   | — |   | — |   | —   |   |
| Net (loss) income from discontinued operations                                                            |   | (1,028 | )      | 883    |   | (110   | )      | (1,597 | )      | (522     | )      |
| Net income (loss) after cumulative effect of change  in accounting principle                              |   | $      | (649   | )      | $      | (1,090 | )      | $      | 3,204  |     | $      | 4,199 |   | $ | (127,385 | ) |
| Basic net income (loss) per common share from  continuing operations                                      |   | $      | 0.04   |   | $      | (0.27  | )      | $      | 0.46   |     | $      | 0.81 |   | $ | (17.94 | ) |
| Basic net income (loss) per common share from  discontinued operations                                    |   | $      | (0.10  | )      | $      | 0.12   |   | $      | (0.02  | )        | $      | (0.22 | ) | $ | (0.07 | ) |
| Basic net income (loss) per common share                                                                  |   | $      | (0.06  | )      | $      | (0.15  | )      | $      | 0.44   |     | $      | 0.59 |   | $ | (18.01 | ) |
| Diluted net income (loss) per common share from  continuing operations                                    |   | $      | 0.04   |   | $      | (0.27  | )      | $      | 0.46   |     | $      | 0.77 |   | $ | (17.92 | ) |
| Diluted net income (loss) per common share from  discontinued operations                                  |   | $      | (0.10  | )      | $      | 0.12   |   | $      | (0.02  | )        | $      | (0.21 | ) | $ | (0.07 | ) |
| Diluted net income (loss) per common share                                                                |   | $      | (0.06  | )      | $      | (0.15  | )      | $      | 0.44   |     | $      | 0.56 |   | $ | (17.99 | ) |
| Basic weighted average common shares outstanding                                                          |   | 10,568 |   | 7,378  |   | 7,277  |   | 7,137  |   | 7,072    |   |
| Diluted weighted average common  shares outstanding                                                       |   | 10,568 |   | 7,378  |   | 7,320  |   | 7,489  |   | 7,081    |   |

 

**Balance Sheet Data (continuing operations):**

| ** **                                           | ** ** | **December 31,** | ** ** |
|------------------------------------------------------|------------|-----------------------|------------|
| ** **                                           | ** ** | **2006**              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Cash and cash  equivalents                           |       | $                     | 24,474     |   | $ | 1,886 |   | $ | 8,059 |   | $ | 7,236 |   | $ | 2,527 |   |
| Working capital                                      |       | 25,106                |       | 1,722 |   | 9,054 |   | 9,206 |   | 2,150 |   |
| Property and  equipment, net                         |       | 12,829                |       | 11,494 |   | 10,692 |   | 9,471 |   | 12,212 |   |
| Total assets                                         |       | 172,996               |       | 110,065 |   | 102,027 |   | 78,357 |   | 80,070 |   |
| Long-term debt,  excluding current portion           |       | 15,650                |       | 20,834 |   | 8,447 |   | 2,400 |   | 4,548 |   |
| Net assets (liabilities)  of discontinued operations |       | 2,441                 |       | 3,242 |   | 1,928 |   | 7,097 |   | (17,495 | ) |
| Shareholders’ equity                            |       | 141,886               |       | 80,207 |   | 79,432 |   | 75,474 |   | 70,004 |   |
|                                                      |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

The following Management’sDiscussion and Analysis of Financial Condition and Results of Operations shouldbe read in conjunction with our Consolidated Financial Statements and Notesthereto contained elsewhere in the Annual Report on Form 10-K.

**Cautionary NoteRegarding Forward-Looking Statements**

The Securities and Exchange Commission encouragescompanies to disclose forward-looking information so that investors can betterunderstand a company’s future prospects and make informed investment decisions.Certain statements contained herein may be deemed to constitute “forward-lookingstatements”.

Words such as “may,” “anticipate,” “estimate,” “expects,”“projects,” “intends,” “plans,” “believes” and words and terms of similarsubstance used in connection with any discussion of future operating orfinancial performance, identify forward-looking statements. All forward-lookingstatements are management’s present expectations of future events and aresubject to a number of risks and uncertainties that could cause actual resultsto differ materially from those described in the forward-looking statements.These risks and uncertainties include, among other things: our need foradditional capital to fund the current level of our technology developmentprograms, our inability to further identify, develop and achieve commercialsuccess for new products; the possibility of delays in product development; ourdependence upon a small number of large customers; the development of competingdistribution products; our ability to protect our proprietary technologies;patent-infringement claims; risks of new, changing and competitivetechnologies; and other factors discussed elsewhere herein under the heading “RiskFactors”.

In light of theseassumptions, risks and uncertainties, the results and events discussed in theforward-looking statements contained herein might not occur. You are cautionednot to place undue reliance on forward-looking statements, which speak only asof the date of this filing. We are not under any obligation, and we expresslydisclaim any obligation, to update or alter any forward-looking statements,whether as a result of new information, future events or otherwise, except asmay be required by applicable law. All subsequent forward-looking statementsattributable to management or to any person authorized to act on our behalf areexpressly qualified in their entirety by the cautionary statements contained orreferred to in this section.

**Critical AccountingPolicies**

Our significantaccounting policies and methods used in the preparation of the ConsolidatedFinancial Statements are discussed in Note 2 of the Notes to ConsolidatedFinancial Statements. The following is a listing of our critical accountingpolicies and a brief discussion of each:

·       allowancefor doubtful accounts;

·       revenuerecognition;

·       long-livedassets and goodwill; and

·       deferredtaxes and the deferred tax valuation allowance.

***Allowance forDoubtful Accounts.******  ***Our allowance for doubtfulaccounts relates to trade accounts receivable. The allowance for doubtfulaccounts is an estimate prepared by management based on identification of thecollectibility of specific accounts and the overall condition of the receivableportfolios. we specifically analyze trade receivables, historical bad debts,customer credits, customer concentrations, customer credit-worthiness, currenteconomic trends and changes in customer payment terms when evaluating theadequacy of the allowance for doubtful accounts. If the financial condition of ourcustomers 

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were to deteriorate,resulting in an impairment of their ability to make payments, additionalallowances may be required. Likewise, should we determine that we would be ableto realize more of our receivables in the future than previously estimated, anadjustment to the allowance would increase income in the period suchdetermination was made. The allowance for doubtful accounts is reviewed on amonthly basis and adjustments are recorded as deemed necessary.

***Revenue Recognition.******  ***We deriverevenue from services which consist primarily of revenue for digital and analogaudio, video, videotape distribution and media research resources.

Our services revenue from digital distribution ofaudio and video advertising content is billed based on a rate per transmission,and we recognize revenue for these services upon notification of successfultransmission of the content at the broadcast destination. Revenue fordistribution of analog audio and video content by tape is recognized whendelivery has occurred, which is at the time the tapes are delivered to a commoncarrier.

DGF recognizes product revenue when persuasiveevidence of an arrangement exists, delivery has occurred, the sales price isfixed and determinable and collectibility is probable. Generally for productsales, 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 estimatedproduct returns, which historically have been immaterial. DGF analyzeshistorical returns, current economic trends, and changes in customer demandwhen evaluating the adequacy of provisions for sales returns. At the time ofthe transaction, DGF assesses whether the fee associated with revenuetransactions is fixed and determinable and whether or not collection isreasonably assured. DGF assesses whether the fee is fixed and determinablebased on the payment terms associated with the transaction. DGF assessescollectibility based on a number of factors, including past transaction historywith the customer and the credit-worthiness of the customer. For all sales, DGFuses either a binding purchase order or signed sales agreement as evidence ofan arrangement. Shipping and handling revenues are included in product revenuesand costs are included in product costs.

***Long-Lived Assets and Goodwill.******  ***DGF assessesthe impairment of long-lived assets whenever events or changes in circumstancesindicate that the carrying value may not be recoverable. Factors that DGFconsiders important which could trigger an impairment review include thefollowing:

·       significantunderperformance relative to expected historical or projected future operatingresults;

·       significantchanges in the manner or use of the acquired assets or the strategy for DGF’soverall business;

·       significantnegative industry or economic trends;

·       significantdecline in its stock price for a sustained period; and

·       DGF’smarket capitalization relative to net book value.

In 2006, DGF engaged a third party to evaluate the amountof goodwill and identifiable intangibles to record as a result of theacquisition of FastChannel Network, Inc. 

If DGF determines that the carrying value oflong-lived or intangible assets may not be recoverable based upon the existenceof one or more of the above indicators of impairment, DGF assesses therecoverability of the long-lived or intangible asset by determining whether theamortization of the asset balance over its remaining life can be recoveredthrough undiscounted future operating cash flow of the acquired operations. Anyimpairment is measured based on a projected discounted cash flow method using adiscount rate reflecting DGF’s average cost of funds. During this evaluationfor the year ended December 31, 2005, DGF determined that the carryingvalue of a portion of its intangible assets was impaired. Accordingly, DGFrecognized a loss of $0.1 million related to this impairment. During 2004,DGF upgraded its distribution network and, during the process, removed selectedfixed assets from 

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operating in the field.Certain of these fixed assets were not yet fully depreciated and, accordingly,their remaining book value became impaired. DGF recognized a loss of $1.0 millionrelated to these assets that have been removed from service.

In 2002, Statement of Financial Accounting Standards (“SFAS”)No. 142, “Goodwill and Other Intangible Assets” became effective, and as aresult, DGF ceased amortization of goodwill beginning January 1, 2002 andevaluates goodwill for impairment at least annually. SFAS No. 142 requiresDGF 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 carryingvalue exceeds its implied fair value. As an overall check on the reasonablenessof the fair values attributed to DGF’s reporting units, DGF is required tocompare and contrast the aggregate fair values for all reporting units with DGF’saverage total market capitalization for a reasonable period of time. SFASNo.142 states that the fair value may exceed market capitalization due tofactors such as control premiums and synergies. DGF completed its initialimpairment review during the first quarter of 2002 and recorded an impairmentof approximately $130.2 million, which is reported as a cumulative effectof change in accounting principle. There have been no further impairments ofeither long-lived assets or goodwill since 2002 other than those describedabove and as incurred when discontinuing operations.

***Deferred Taxes andthe Deferred Tax Valuation Allowance.******  ***DGF hasrecorded both assets and liabilities for deferred taxes that arise as theresult of temporary differences between amounts recorded for federal income taxpurposes versus items recorded in accordance with generally accepted accountingprinciples. DGF offsets deferred tax liabilities against deferred tax assetsfor the purpose of financial statement disclosure.

DGF also has net operating loss carryforwards (NOLs)of approximately $99.8 million which will expire on various dates rangingfrom 2011 to 2025. Generally accepted accounting principles require that DGFrecord a valuation allowance against the deferred tax asset associated withthis NOL if it is “more likely than not” that DGF will not be able to utilize themto offset future taxes. During 2003, DGF concluded that realization of aportion of its tax benefits was more likely than not. As a result,$4.4 million of the valuation allowance for deferred tax assets wasreversed, resulting in a non-cash tax benefit of $1.4 million, whichoffset fiscal 2003 income tax expense of $1.9 million. The remaining$1.6 million reduction in the valuation allowance was due to the reductionin net deferred tax assets attributable to 2003 income.

At December 31, 2004, DGF has concluded that itwas more likely than not that all deferred tax assets would ultimately berealized, so it reversed the remaining valuation allowance of$15.7 million. As a result, $6.7 million was recorded as a non-cashtax benefit, which offset income tax expense of $2.4 million. Theremaining $9.0 million reduction in the valuation allowance related toacquired deferred tax assets and therefore was recorded as a reduction togoodwill. At December 31, 2005, DGF again concluded that it was morelikely than not that all deferred tax assets would ultimately be realized. DGFconsidered several factors in concluding that it was more likely than not that DGFwould fully utilize its deferred tax assets including four consecutive years ofreporting taxable income and utilizing over $20 million of net operatingloss carryforwards and that DGF management expects to continue to generate theearnings necessary to utilize its deferred tax assets in future years. 

During 2006, the Company recorded a valuationallowance of $0.9 million related to the deferred tax asset created as aresult of the impairment charge recorded for its investment in Verance. Additionally,the Company acquired approximately $33.7 million in NOL carryforwards inits acquisition of FastChannel and has maintained a full valuation allowance relatedto those NOL carryforwards. The Company will maintain a full valuationallowance on its acquired NOL carryforwards until the Company’s tax positioncan be completely assessed. In accordance with FAS 109, and any futurereduction in the valuation allowance related to acquired deferred tax assetswill be recorded as a reduction to goodwill.

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***Adoption of Staff Accounting Bulletin No. 108.***   OnSeptember 13, 2006, the SEC issued Staff Accounting Bulletin No. 108(“SAB No. 108”). SAB No. 108 expresses the SEC Staff’s viewsregarding the process of evaluating materiality of financial statementmisstatements. SAB No. 108 addresses the diversity in evaluatingmateriality of financial statement misstatements and the potential undercurrent practice used by the Company for the build up of improper amounts onthe balance sheet. SAB No. 108 is effective for the Company for the yearended December 31, 2006. As allowed by SAB No. 108, the cumulativeeffect of the initial application of SAB No. 108 has been reported in thecarrying amounts of assets and liabilities as of the beginning of fiscal 2006,with the offsetting balance to retained earnings. Upon adoption, the Companyrecorded an increase to accrued liabilities of $0.1 million, an increase indeferred tax liabilities of approximately $0.3 million to record liabilitiesnot previously identified and a decrease in retained earnings of approximately$0.4 million to correct errors in previous years that were consideredimmaterial under the Company’s previous method of evaluating materiality.

**New AccountingPronouncements**

In September 2006, the SEC published SAB No. 108, “Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements.” SAB No. 108 addresses quantifying thefinancial statement effects of misstatements, specifically, how the effects ofprior year uncorrected errors must be considered in quantifying misstatementsin the current year financial statements. SAB No. 108 is effective for fiscalyears ending after November 15, 2006. The adoption of SAB No. 108 by theCompany in the fourth quarter of 2006 is discussed in Note 2 to the financialstatements. 

In December 2004, the FASB issued SFAS No. 123R “ShareBased Payment.” SFAS No. 123R is a revision to SFAS 123 and supersedes APBOpinion No. 25 and amends FASB Statement No. 95, “Statement of Cash Flows.”SFAS No. 123R requires a public entity to expense the cost of employee servicesreceived in exchange for an award of equity instruments. It provides guidanceon valuing and expensing these awards, as well as disclosure requirements ofthese equity arrangements. SFAS No. 123R also requires the benefits of taxdeductions in excess of recognized compensation cost to be reported as afinancing cash flow, rather than as an operating cash flow as required undercurrent literature. This requirement reduces net operating cash flows andincreases net financing cash flows in periods after adoption. SFAS No. 123Rpermits an issuer to use either a prospective or one of two modified versionsof retrospective application under which financial statements for prior periodsare adjusted on a basis consistent with the pro forma disclosures required forthose periods by the original SFAS No. 123. As modified by the SEC on April 15,2005, SFAS No. 123R is effective for the first annual or interim reportingperiod of the registrant’s first fiscal year that begins after June 15, 2005.The Company has implemented this pronouncement effective at the beginning ofthe fiscal year ended December 31, 2006.

In December 2004, the FASB issued SFAS No. 153, “Exchangesof Nonmonetary Assets, an amendment of APB Opinion No. 29.” SFAS No. 153 isbased on the principle that exchanges of nonmonetary assets should be measuredbased on the fair value of the assets exchanged. APB Opinion No. 29, “Accountingfor Nonmonetary Transactions,” provided an exception to its basic measurementprinciple (fair value) for exchanges of similar productive assets. Under APBOpinion No. 29, an exchange of a productive asset for a similar productiveasset was based on the recorded amount of the asset relinquished. SFAS No. 153eliminates this exception and replaces it with an exception for exchanges ofnonmonetary assets that do not have commercial substance. SFAS No. 153 becameeffective for the Company as of July 2, 2005, and did not have a materialimpact on our consolidated financial statements. 

In May 2005, the FASB issued SFAS No. 154, “AccountingChanges and Error Corrections, a replacement of Accounting Principles Board (“APB”)Opinion No. 20 and FASB Statement No. 3.” SFAS No. 154 requires retrospectiveapplication to prior periods' financial statements of a voluntary change inaccounting principle unless it is impracticable. APB Opinion No. 20, “AccountingChanges,” previously required that most voluntary changes in accountingprinciple be recognized by including in net income of 

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the period of the changethe cumulative effect of changing to the new accounting principle. SFAS No. 154became effective for the Company on January 1, 2006. The adoption of SFAS No.154 did not have a material impact on our consolidated financial statements. 

In September 2006, theFASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 defines fairvalue, establishes a framework for measuring fair value and expands disclosurerequirements about fair value measurements. SFAS No. 157 is effective for theCompany on January 1, 2008. We believe that the adoption of SFAS No. 157 willnot have a material impact on our consolidated financial statements. 

In February 2007, the FASB issued SFAS No. 159, “TheFair Value Option for Financial Assets and Financial Liabilities—Including anamendment of FASB Statement No. 115.” SFAS No. 159 permits entities to choose tomeasure many financial instruments and certain other items at fair value.Unrealized gains and losses on items for which the fair value option has beenelected will be recognized in earnings at each subsequent reporting date. SFASNo. 159 is effective for the Company on January 1, 2008. The Company isevaluating the impact that the adoption of SFAS No. 159 will have on ourconsolidated financial statements. 

In July 2006, the FASB issued FASB Interpretation No.48, “Accounting for Uncertainty in Income Taxes” (“Interpretation No. 48”).Interpretation No. 48 clarifies the accounting for uncertainty in income taxesrecognized in an enterprise’s financial statements in accordance with SFAS No.109, “Accounting for Income Taxes.” Interpretation No. 48 prescribes arecognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return. Interpretation No. 48 also provides guidance on derecognition,classification, interest and penalties, accounting in interim periods,disclosure and transition. For the Company, Interpretation No. 48 was effectivebeginning January 1, 2007, and the cumulative effect adjustment, if any, willbe recorded in the first quarter of 2007. We believe that the adoption ofInterpretation No. 48 will not have a material impact on our consolidatedfinancial statements. 

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***Results ofOperations***

Thefollowing table sets forth certain financial data for the years ended December 31,2006, 2005, and 2004. Operating results for any period are not necessarilyindicative of results for any future period. Amounts (except per share data)are shown in thousands. 

| ** **                                                               | ** ** | **For years ended December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                               | ** ** | **2006**                                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                                                                |       | $                                                    | 68,667     |   | $ | 51,824 |   | $ | 53,570 |   |
| Costs and  expenses:                                                     |       |                                                 |       |   |   |   |   |
| Cost of revenues                                                         |       | 33,322                                               |       | 32,184 |   | 28,941 |   |
| Sales and marketing                                                      |       | 4,240                                                |       | 3,915 |   | 4,264 |   |
| Research and development                                                 |       | 1,779                                                |       | 1,107 |   | 1,520 |   |
| General and administrative                                               |       | 10,462                                               |       | 7,587 |   | 6,328 |   |
| Restructuring charges                                                    |       | —                                               |       | 434 |   | — |   |
| Impairment charges                                                       |       | —                                               |       | — |   | 1,048 |   |
| Depreciation and amortization                                            |       | 8,563                                                |       | 6,348 |   | 5,143 |   |
| Total expenses                                                           |       | 58,366                                               |       | 51,575 |   | 47,244 |   |
| Income from  operations                                                  |       | $                                                    | 10,301     |   | $ | 249 |   | $ | 6,326 |   |
| Other (income) expense:                                                  |       |                                                 |       |   |   |   |   |
| Reduction in fair value of long-term investments                         |       | 4,758                                                |       | — |   | — |   |
| Interest income and other (income) expense, net                          |       | (58                                                  | )          | — |   | — |   |
| Interest expense                                                         |       | 2,844                                                |       | 2,990 |   | 1,284 |   |
| Net income (loss) before income taxes from  continuing operations        |       | $                                                    | 2,757      |   | $ | (2,741 | ) | $ | 5,042 |   |
| Provision  (benefit) for income taxes                                    |       | 2,378                                                |       | (768 | ) | 1,728 |   |
| Net income (loss)  from continuing operations                            |       | $                                                    | 379        |   | $ | (1,973 | ) | $ | 3,314 |   |
| Discontinued  operations:                                                |       |                                                 |       |   |   |   |   |
| (Loss) income from operations of discontinued operations                 |       | (539                                                 | )          | 1,455 |   | (6,181 | ) |
| Income tax benefit (expense)                                             |       | 209                                                  |       | (572 | ) | 6,071 |   |
| (Loss) on disposal of discontinued operations, net  of tax benefit       |       | (698                                                 | )          | — |   | — |   |
| Net (loss) income  from discontinued operations                          |       | (1,028                                               | )          | 883 |   | (110 | ) |
| Net income (loss)                                                        |       | $                                                    | (649       | ) | $ | (1,090 | ) | $ | 3,204 |   |
| Basic net income (loss) per common share from  continuing operations     |       | $                                                    | 0.04       |   | $ | (0.27 | ) | $ | 0.46 |   |
| Basic net income  (loss) per common share from discontinued   operations |       | $                                                    | (0.10      | ) | $ | 0.12 |   | $ | (0.02 | ) |
| Basic net income  (loss) per common share                                |       | $                                                    | (0.06      | ) | $ | (0.15 | ) | $ | 0.44 |   |
| Diluted net income (loss) per common share from  continuing   operations |       | $                                                    | 0.04       |   | $ | (0.27 | ) | $ | 0.96 |   |
| Diluted net  income (loss) per common share from discontinued operations |       | $                                                    | (0.10      | ) | $ | 0.12 |   | $ | (0.46 | ) |
| Diluted net  income (loss) per common share                              |       | $                                                    | (0.06      | ) | $ | (0.15 | ) | $ | 0.02 |   |
| Basic weighted average common shares outstanding                         |       | 10,568                                               |       | 7,378 |   | 7,277 |   |
| Diluted weighted average  common shares outstanding                      |       | 10,568                                               |       | 7,378 |   | 7,320 |   |

 

***2006 versus 2005***

*Revenues.**  *For the year ended December 31,2006, revenues from continuing operations increased $16.8 million or32.5%, as compared to the prior year period. Revenues increased by$12.6 million due to 

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the acquisition ofFastChannel while the remainder of the increase was primarily from growth inthe existing advertisement distribution operations.

*Costof Revenues.**  *Forthe year ended December 31, 2006, cost of revenues increased$1.1 million, or 3.5%, from the prior year. Increases in cost of revenues occurredat a lower rate than the increases in related revenues due to the eliminationof redundant costs that would have otherwise occurred in FastChannel if it hadnot merged with the Company.

*Salesand Marketing.**  *Salesand marketing expense increased $0.3 million, or 8.3%, for the year ended December 31,2006 primarily due to incremental expenses related to sales support for theabove noted incremental revenues attributable to the operations of FastChannel.

*Researchand Development.**  *Forthe year ended December 31, 2006, research and development expenseincreased $0.7 million, or 60.7%, primarily due to certain costs incurredafter the FastChannel acquisition related to transitioning these duties frompersonnel in the FastChannel division to personnel in the Company’s existingengineering department.

*Generaland Administrative.**  *Forthe year ended December 31, 2006, general and administrative expensesincreased $2.9 million, or 37.9%, from the prior year due to increases inheadcount and office locations resulting from the acquisition of FastChannel.  The FastChannel division incurred $1.1 millionof these costs during the year even as attrition and lease terminationscontinued. Further, during 2005 we benefited from a one-time expense reduction of$0.5 million from the renegotiation of an existing service agreement.

*Depreciationand Amortization.**  *Depreciationand amortization expense increased $2.2 million, or 34.9%, during the yearended December 31, 2006, primarily due to amortization of certainintangible assets of FastChannel which accounts for $1.9 million of theincrease. The remaining portion of the increase is from intangibles acquired inthe 2005 acquisition of MDX that incurred a full year’s amortization in 2006 ascompared to a partial year in 2005.

*Reductionin fair value of investments.*   During the yearended December 31, 2006, a loss from the reduction in fair value ofinvestments of $4.8 million occurred as the Company’s evaluation determinedthat its investment in Verance was other-than-temporarily impaired and theCompany fully impaired the investment value.

*Interest(income) expense and other (income) expense.**  *Interest and other expensedecreased $0.2 million, or 6.8%, for the year ended December 31,2006, as compared to the prior year period due to lower interest during periodslate in 2006 in which the Company paid off portions of the debt with proceedsfrom common stock issued.

*Provisionfor Income Taxes.**  *Forthe year ended December 31, 2006, the Company has recorded a valuationallowance on the deferred tax asset createdas a result of the write down of its investment in Verance. A valuationallowance was deemed necessary since the Company does not have adequate historyof generating capital gains to offset the capital loss when it occurs for taxpurposes, and therefore, ultimate realization of the benefit was not morelikely that not. Other than the aforementioned, the Company has no othervaluation allowance on the remainder of its deferred tax assets.

In the prior year ended December 31, 2005, theCompany’s effective tax rate was 39.4%. This effective tax rate remainedconstant during the current year except as net income was impacted by thevaluation allowance recorded for the Company’s write down of its investment inVerance.

For the year ended December 31,2006, income tax expense related to continuing operations increased$3.1 million also as a result of the increase in net income before taxes fromcontinuing operations. In 2004, the Company recorded a valuation allowance of$0.9 million related to the impairment charge recognized for itsinvestment in Verance. No valuation allowance was recorded in 2005.

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***2005 versus 2004***

*Revenues.**  *For the year ended December 31,2005, revenues decreased $1.7 million or 3.3%, as compared to the prioryear period. $5.2 million in revenue reductions are the result of a morecompetitive rate environment and a decrease in distribution volumes, especiallyby automobile manufacturers and movie studios. In addition, the year ended December 31,2004 contained $3.0 million in political revenues that did not recur in2005. This decrease was partially offset by revenues increases of$0.5 million, $1.7 million, and $1.3 million related theacquisition of MDX, Broadcast, and SourceEcreative, respectively.

*Costof Revenues.**  *Forthe year ended December 31, 2005, cost of revenues increased$3.2 million, or 11.2%, from the prior year period. Increases in cost ofrevenues are attributable to the Company’s acquisition of MDX, Broadcast, andSourceEcreative, which account for increases of $0.7 million,$1.3 million, and $0.5 million, respectively.

*Salesand Marketing.**  *Salesand marketing expense decreased $0.3 million, or 8.2%, for the year ended December 31,2005 primarily due to the elimination of redundant expenses in acquired companies.

*Researchand Development.**  *Forthe year ended December 31, 2005, research and development expensedecreased $0.4 million, or 27.2%, primarily due to increasedcapitalization of expenses related to internally developed software.

*Generaland Administrative.**  *Forthe year ended December 31, 2005, general and administrative expensesincreased $1.3 million, or 19.9%, from the prior year due to increases inheadcount and office locations resulting from the acquisitions of Broadcast andSourceEcreative, each accounting for $0.2 million of increase. Theremaining portion of the increase is due to increased professional fees of $0.5million for audit, tax and legal costs related to acquired companies and highercosts of employee benefit of $0.2 million.

*Depreciationand Amortization.**  *Depreciationand amortization expense increased $1.2 million, or 23.4%, during the yearended December 31, 2005, primarily due to depreciation and amortization ofcertain assets acquired from Broadcast, which accounts for $0.5 million ofthe increase, from SourceEcreative, which accounts for $0.3 million andfrom MDX which accounts for $0.4 million.

*Restructuringcharges.**  *DGFincurred restructuring charges of $0.4 during the year ended December 31,2005. Restructuring charges relate to lease termination costs for redundantfacilities in New York and severance benefits paid or accrued to employeeshired in connection with the Broadcast acquisition, who were subsequentlyterminated.

*Interest(income) expense and other (income) expense.**  *Interest and other expenseincreased $1.7 million, or 132.9%, for the year ended December 31,2005, as compared to the prior year. Interest expense increased$0.7 million, or 56.7%, due to the debt incurred for acquisitions andworking capital, as well as $0.9 million recorded to write off certaindeferred loan fees as a result of DGF’s debt refinancing in April 2005 anddebt covenant violation at December 31, 2005.

*Provision for Income Taxes.**  *For the year ended December 31,2005, as compared to the prior year, income tax benefit decreased $1.0 million,or 55.6%, due primarily to the reversal of DGF’s valuation allowance fordeferred tax assets which occurred in December 2004. At December 31,2005, DGF has no valuation allowance on its deferred tax assets. DGF consideredseveral factors in concluding that it was more likely than not that DGF wouldfully utilize its deferred tax assets including four consecutive years ofreporting taxable income and utilizing over $20 million of net operatingloss carryforwards and that DGF management expects to continue to generate theearnings necessary to utilize its deferred tax assets in future years.Accordingly, DGF has not recorded a valuation allowance on its deferred taxassets.

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**Liquidity andCapital Resources**

On a reported basis, net cash provided by operatingactivities for the year ended December 31, 2006 was $9.6 millioncompared to net cash provided by operating activities of $5.4 million for theyear ended December 31, 2005. The increase of $4.2 million in netcash provided by operating activities is primarily due to net income asincreased by the amounts of non-cash charges such as depreciation of $1.3million, amortization of $1.2 million, deferred taxes of $5.4 million, and thereduction in fair value of long-term investment of $4.8 million partially offsetby a net decrease in net operating assets and liabilities of $8.0 million.

The Company purchased equipment and made capitaladditions of $3.1 million during the year ended December 31, 2006,comparable to the $3.0 million for the year ended December 31, 2005.In the year ended December 31, 2006, the Company used $4.8 million in cashto acquire an investment in the common stock of Point.360, Inc. TheCompany had used $5.1 million in 2005 to acquire an ownership interestinvestment in Verance, Inc.

Net repayments of long-term debt and capital leaseswas $10.4 million for the year ended December 31, 2006 versus ($0.5) millionfor the year ended December 31, 2005. This fluctuation was due to the newcredit facility obtained by the Company in February 2006 which was drawnagainst to payoff the prior credit facility and provide working capital inaddition to the additional funds received at the refinancing of the new creditfacility in May 2006 that was done to facilitate the merger withFastChannel. In 2005, operating activities provided sufficient funds to reducethe line of credit in place at that time.

On February 10, 2006, the Company entered into a$25.0 million Credit Agreement with Wachovia Bank, N.A. This revolving creditfacility replaced the prior senior secured credit facility. On May 31,2006, the Company entered into an Amended and Restated Credit Agreement withWachovia Bank, N.A. The facility, as amended, provides for maximum indebtednessof $35.0 million, made up of a term loan for $20.0 million, and a revolvingline of credit for $15.0 million. None of the revolving line of credit was drawnas of December 31, 2006. Borrowings under the facility will continue tobear interest at various rates, over the applicable base rate or over LIBOR.The facility, as amended, is not subject to any borrowing base, containscustomary debt to EBITDA leverage tests (EBITDA is defined as earnings beforeinterest, taxes, depreciation and amortization) and minimum EBITDA tests,provides for customary events of default, is guaranteed by all of the Company’subsidiaries, including FastChannel, and is secured by substantially all of theassets of the Company and its subsidiaries, including FastChannel, but excludesthe stock and assets of its subsidiary that owns the assets acquired from MediaDVX. The term loan matures on May 31, 2009. The revolving loans mature on June 30,2011. At December 31, 2006, the interest rate on the outstanding term loanwas approximately 7.4%.

At December 31, 2006 the Company’s sources ofliquidity included cash and cash equivalents of $24.5 million while theCompany’s debt consisted of a term loan to Wachovia Bank, N.A. totaling $19.6million, the above referenced $15.0 million undrawn revolving credit facilityand $0.2 million of capital lease obligations. The Company believes it hassufficient capital and capital resources to sustain liquidity in theforeseeable future.

Effective on May 26, 2006, the Company’s commonstock was reverse split on a 1-for-10 basis.

The Company filed a shelf registration statement withthe SEC in October 2006. As a result of the shelf registration, theCompany had the ability to offer, from time to time, up to 3,000,000 shares ofcommon stock and the selling stockholder named therein (the “SellingStockholder”) had the ability to offer up to 659,177 shares. On December 14,2006, the Company entered into an underwriting agreement (the “UnderwritingAgreement”) with Oppenheimer & Co., Inc., as representative ofthe several underwriters named therein (collectively, the “Underwriters”) andthe selling stockholder, related to a public offering of 2,556,000 shares ofcommon stock, par value $0.001 per share, of the Company (the 

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“Common Stock”) and400,000 shares of Common Stock of the Selling Stockholder at a price of $11.40per share. Under the terms of the Underwriting Agreement, the Company grantedthe Underwriters an option, which they excercised in full, to purchase up to anadditional 443,400 shares of Common Stock to cover over-allotments, if any. Theoffering was made pursuant to the Company’s effective shelf registrationstatement on Form S-3, as amended and supplemented (RegistrationStatement No. 333-137958) filed with the Securities and ExchangeCommission. Net proceeds to the Company from the offering was$31.7 million.

Thetable below summarizes the Company’s contractual obligations, includingestimated interest, at December 31, 2006 (in thousands): 

| ** **                          | ** ** | ** ** | ** ** | **Payments Due by Period** | ** ** |
|-------------------------------------|------------|------------|------------|-------------------------------------------|------------|
| **Contractual  Obligation**         | ** ** | ** ** | ** ** | **Total**                                 | ** ** | **Less Than  1 Year** | ** ** | **1-3  Years** | ** ** | **4-5  Years** | ** ** | **After 5  Years** | ** ** |
| Long-Term Debt                      |       | $          | 23,217     |                                      |       | $ | 5,258 |   |   | $ | 15,313 |   | $ | 2,646 |   |   | $ | — |   |   |
| Capital Leases                      |       | 240        |       |                                      | 240        |   |   | — |   | — |   |   |   |   |   |
| Operating Leases                    |       | 11,685     |       |                                      | 2,810      |   |   | 7,300 |   | 1,575 |   |   | — |   |   |
| Employment  contracts               |       | 2,126      |       |                                      | 1,004      |   |   | 1,122 |   | — |   |   | — |   |   |
| Unconditional  Purchase Obligations |       | 5,947      |       |                                      | 2,246      |   |   | 3,701 |   | — |   |   | — |   |   |
| Total Contractual  Cash Obligations |       | $          | 43,215     |                                      |       | $ | 11,558 |   |   | $ | 27,436 |   | $ | 4,221 |   |   | $ | — |   |   |
|                                     |            |            |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**ITEM 7A.**        QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

***Foreign Currency Exchange Risk***

The Company provides verylimited services to entities located outside of the United States and,therefore, believes that the risk that changes in exchange rates will adverselyimpact its results of operations is remote. Historically, our foreign currencyexchange gains and losses have been immaterial.

***Interest Rate Risk***

The Company is exposed to interest rate risk primarilythrough its borrowing activities. See “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—Liquidity and Capital Resources”for additional discussion of the terms of our credit facility.

The Company pays intereston borrowings at a variable rate based on the lender’s Prime Rate or LIBOR,plus an applicable margin. The applicable margin fluctuates based on theCompany’s leverage ratios as defined in the amended long-term credit agreement.As of December 31, 2006, the loan pays interest at a rate of approximately7.4%. A hypothetical 10% increase or decrease in interest rates would increaseor decrease annual interest expense by approximately $0.2 million.

**ITEM 8.**                FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

The information requiredby this Item is set forth in the Company’s Consolidated Financial Statementsand the Notes thereto beginning at Page F-1 of this report.

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

None.

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**ITEM 9A.   CONTROLS AND PROCEDURES**

**Evaluation ofDisclosure Controls and Procedures**

We maintain disclosure controls and procedures thatare designed to ensure that information required to be disclosed in ourExchange Act reports is recorded, processed, summarized and reported withintime periods specified by the SEC’s rules and forms, and that suchinformation is accumulated and communicated to our management team, includingour Chief Executive Officer and Chief Financial Officer, as appropriate, toallow for timely decisions regarding required disclosure. In designing andevaluating the Company’s disclosure controls and procedures, managementrecognizes that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives, and management necessarily was required to apply itsjudgment in evaluating and implementing possible controls and procedures.

We carried out anevaluation, under the supervision and with participation of our management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures as of December 31, 2006. Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded the disclosure controlsand procedures were not effective at a reasonable assurance level as ofDecember 31, 2006 due to a material weakness in our internal control overfinancial reporting described below.

**Internal Controlover Financial Reporting**

Internal controlover financial reporting refers to a process designed by, or under thesupervision of, our Chief Executive Officer and Chief Financial Officer andeffected by our board of directors, management and other personnel, to providereasonable assurance regarding the reliability of financial reporting and thepreparation of financial statements for external purposes in accordance withgenerally accepted accounting principles and includes those policies andprocedures that:

·  pertain to the maintenance of records that inreasonable detail accurately and fairly reflect the transactions anddispositions of our assets;

·  provide reasonable assurance that transactionsare recorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that our receiptsand expenditures are being made only in accordance with authorizations of ourmanagement and members of our board of directors; and

·  provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use, or dispositionof our assets that could have a material effect on our financial statements.

In connection with the preparation of our financialstatements for the year ended December 31, 2006 and the related audit byour independent registered public accounting firm, KPMG LLP, managementidentified a material weakness in our internal control over financialreporting  related to certaindeficiencies in the controls surrounding monitoring and oversight of accountingand financial reporting related to business combinations and stockcompensation. The Public Company Accounting Oversight Board’s Auditing StandardNo. 2 defines a material weakness as a significant deficiency, orcombination of significant deficiencies, that results in a more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected.

Specifically, we did nothave sufficient personnel with adequate knowledge regarding accounting for businesscombinations and stock compensation expense to ensure that these transactionsare accounted for in  accordance withgenerally accepted accounting principles. In addition, we did not have adequatepolicies and procedures regarding our accounting related to completed businesscombinations and stock 

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compensation.These control deficiencies required us to make audit adjustments related ouraccounting for the FastChannel acquisition and related to our recordation ofstock compensation expense.

**Limitations onInternal Control Over Financial Reporting**

Internal control overfinancial reporting cannot provide absolute assurance of achieving financialreporting objectives because of its inherent limitations. Internal control overfinancial reporting is a process that involves human diligence and complianceand is subject to lapses in judgment and breakdowns resulting from humanfailures. Internal control over financial reporting also can be circumvented bycollusion or improper override. Because of such limitations, there is a riskthat material misstatements may not be prevented or detected on a timely basisby internal control over financial reporting. However, these inherentlimitations are known features of the financial reporting process, and it ispossible to design into the process safeguards to reduce, though not eliminate,this risk.

**Plans forRemediation**

To remediate thematerial weakness described above and enhance our internal control overfinancial reporting, we have:

·  required members of our corporate accountingstaff receive training on business combinations and stock compensation on anongoing basis, which we expect will commence immediately;

·  determined to add at least one senior levelcontroller with significant accounting and financial reporting experience tostrengthen the personnel in the corporate accounting department, which weexpect to accomplish in the second quarter of 2007;

·  revised our internal control over financialreporting for non-routine business combinations transactions and stockcompensation to require our accounting staff to take prescribed steps for suchtransactions, including: engaging external accounting advisors, establishingwork groups, action plans, or monitoring meetings based on the nature of theevent, in each case in an effort to ensure that individuals from theappropriate departments are involved, communication is thorough, and actionitems are addressed; and

·  revised our internal control over financialreporting to require the completion of a detailed business combinations checklistwhen acquisitions are completed in order to ensure purchase price considerationis complete and adequately recorded and the performance of ongoing reviews ofexisting acquisition accrual balances and accounting procedures designed toensure proper accounting for business combination activities

Although we are implementing remediation efforts, theexistence of the material weaknesses described above indicates that there is amore than remote likelihood that a material misstatement of our financialstatements will not be prevented or detected in a future period. In addition,we cannot assure you that we will not in the future identify additionalmaterial weaknesses or significant deficiencies in our internal control overfinancial reporting that we have not discovered to date. The remediationefforts we are taking are subject to continued management review supported byconfirmation and testing by management and audit committee oversight. As aresult, additional changes are expected to be made to our internal control overfinancial reporting. Other than the foregoing initiatives we are implementingin response to the material weakness, there has been no change in our internalcontrol over financial reporting during the quarter ended December 31,2006 that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

**ITEM9B.**       OTHER INFORMATION

Not applicable.

39

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**PART III**

**ITEM10.**         Directors, ExecutiveOfficers and Corporate Governance.

Information concerningthis item is incorporated herein by reference to the information under theheadings “Corporate Governance”, “Board of Directors and Committees”, “ExecutiveOfficers” and “Section 16(a) “Beneficial Ownership Reporting Compliance”in the Company’s Proxy Statement or amendment to this Form 10-K to befiled within 120 days of year end as required.

**ITEM11.**         Executive Compensation.

The information concerningthis item is incorporated by reference to the information under the headings“Management Compensation,” “Compensation of Directors,” and “CorporateGovernance,” in the Company’s Proxy Statement or amendment to thisForm 10-K to be filed within 120 days of year end as required. 

**ITEM 12.**         SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters.

The information concerningthis item is incorporated by reference to the information under the heading“Principal Stockholders and Management Ownership” and “Equity Compensation PlanInformation,” in the Company’s Proxy Statement or amendment to thisForm 10-K to be filed within 120 days of year end as required. 

**ITEM 13.**         CertainRelationships and Related Transactions, and Director Independence.

The information concerningthis item is incorporated by reference to the information under the heading“Certain Transactions,” in the Company’s Proxy Statement or amendment to thisForm 10-K to be filed within 120 days of year end as required. 

**ITEM 14.**         PrincipalAccounting Fees and Services.

The information concerningthis item is incorporated by reference to the information under the heading“Independent Registered Public Accounting Firm Fees,” in the Company’s ProxyStatement or amendment to this Form 10-K to be filed within 120 days ofyear end as required.

40

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**PART IV**

**ITEM 15.**         EXHIBITS, FINANCIALSTATEMENT SCHEDULES 

**(a)**

**1.   FINANCIALSTATEMENTS**

Thefollowing financial statements are filed as part of this Report: 
|                                                                                                                                  | ** ** | **Page** |
|----------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| Independent Auditors’ Report                                                                                                |       | F-2      |   |
| Consolidated Balance Sheets  as of December 31, 2006 and 2005                                                               |       | F-3      |   |
| Consolidated Statements of  Operations for the three years ended December 31, 2006                                          |       | F-4      |   |
| Consolidated Statements of  Stockholders’ Equity and Comprehensive Income for the three years ended  December 31, 2006 |       | F-5      |   |
| Consolidated Statements of  Cash Flows for the three years ended December 31, 2006                                          |       | F-6      |   |
| Notes  to Consolidated Financial Statements                                                                                      |       | F-7      |   |

 

**2.   FINANCIALSTATEMENT SCHEDULES**
| II—Valuation and Qualifying  Accounts |   | S-1 |
|--------------------------------------------|--------|-----|

 

**3.****   EXHIBITS**
| Exhibit   Number | ** ** | **Exhibit Title**                                                                                                                                                       |
|------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1(a)           |       | Certificate of Incorporation of registrant.                                                                                                                             |
| 3.2(b)           |       | Certificate of Amendment to the Certificate of Incorporation  of registrant.                                                                                            |
| 3.3(b)           |       | Certificate of Amendment to the Certificate of Incorporation  of registrant                                                                                             |
| 3.4(a)           |       | Bylaws of registrant, as amended to date.                                                                                                                               |
| 4.1(c)           |       | Form of Common Stock Certificate.                                                                                                                                       |
| 10.1(c)          |       | 1992 Stock Option Plan (as amended) and forms of  Incentive Stock Option Agreement and Non-statutory Stock Option Agreement. *                                          |
| 10.2(c)          |       | Form of Directors’ and Officers’ Indemnification  Agreement.                                                                                                  |
| 10.3(c)          |       | 1995 Director Option Plan and form of Incentive  Stock Option Agreement thereto. *                                                                                      |
| 10.4(c)          |       | Form of Restricted Stock Agreement. *                                                                                                                                   |
| 10.5(d)          |       | Content Delivery Agreement between the Company and  Hughes Network Systems, Inc., dated November 28, 1995.                                                    |
| 10.6(d)          |       | Equipment Reseller Agreement between the Company and  Hughes Network Systems, Inc., dated November 28, 1995.                                                  |
| 10.7(f)          |       | Special Customer Agreement between the Company and  MCI Telecommunications Corporation, dated May 5, 1997.                                                         |
| 10.8(g)          |       | 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. |
| 10.9(g)          |       | Amended and Restated Registration Rights Agreement,  dated December 9, 1998, by and among the Registrant and certain of its  security holders                      |
| 10.10(g)         |       | Registration Rights Agreement, dated  December 9, 1998, by and among the Registrant and certain of its  security holders.                                          |
| 10.11(h)         |       | Common Stock and Warrant Purchase Agreement dated  December 9, 1998 by and among the Registrant and investors listed in  Schedule A thereto.                       |
| 10.12(h)         |       | Common Stock Subscription Agreement dated  December 9, 1998 by and among the Registrant and Scott Ginsburg.                                                        |

41

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| 10.13(h) |   | Warrant Purchase Agreement dated December 9,  1998 by and among the Registrant and Scott Ginsburg.                                                                                                                |
|----------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.14(h) |   | Warrant No. 1 to Purchase Common Stock dated  December 9, 1998 by and among Registrant and Scott K. Ginsburg.                                                                                           |
| 10.15(h) |   | Warrant No. 2 to Purchase Common Stock dated  December 9, 1998 by and among Registrant and Scott K. Ginsburg                                                                                            |
| 10.16(i) |   | Registration Rights Agreement, dated  December 17, 1999, by and among the Registrant and certain of its  security holders.                                                                                        |
| 10.17(i) |   | Common Stock Purchase Agreement dated  December 17, 1999 by and among the Registrant and investors listed in  Schedule A thereto.                                                                            |
| 10.18(j) |   | Customer Service Agreement, dated September 12,  2002 between Digital Generation Systems, Inc. and Sprint Communications  Company L.P.                                                                  |
| 10.19(k) |   | Employment Agreement, dated December 10, 2003,  between Digital Generation Systems, Inc. and Omar Choucair, Chief  Financial Officer.*                                                                       |
| 10.20(l) |   | Amendment to Employment Agreement between Digital  Generation Systems and Omar Choucair dated March 24, 2005.*                                                                                                    |
| 10.21(m) |   | First Amended and Restated Agreement and Plan of  Merger by and among Digital Generation Systems, Inc.,  DG Acquisition Corp. IV and FastChannel Network, Inc. Dated as  of January 13, 2006. |
| 10.22(m) |   | Credit Agreement dated as of February 10, 2006  by and among Digital Generation Systems, Inc. and Wachovia Bank, NA  as Administrative Agent and Issuing Lender.                                        |
| 10.23(m) |   | Amendment No. 1 to Common Stock Purchase  Warrant by and among Registrant and Scott K. Ginsburg.*                                                                                                            |
| 10.24(m) |   | Amendment No. 2 to Warrant No. 1 by and  among Registrant and Scott K. Ginsburg.*                                                                                                                       |
| 10.25(m) |   | Amendment No. 2 to Warrant No. 2 by and  among Registrant and Scott K. Ginsburg.*                                                                                                                       |
| 10.26(m) |   | Amendment No. 1 to Common Stock Purchase  Warrant by and among Registrant and Omar A. Choucair.*                                                                                                             |
| 10.27(m) |   | Amendment No. 2 to Warrant by and among  Registrant and Omar A. Choucair.*                                                                                                                                   |
| 10.28(n) |   | Employment Agreement, dated June 22, 2006,  between the Company and Scott K. Ginsburg*                                                                                                                            |
| 10.29(n) |   | Amended and Restated Employment Agreement, dated  June 22, 2006, between the Company and Omar A. Choucair*                                                                                                   |
| 10.30(o) |   | Form of DG FastChannel,  Inc. 2006 Employee Stock Purchase Plan*                                                                                                                                                       |
| 10.31(o) |   | Form of DG FastChannel,  Inc. 2006 Long-term Stock Incentive Plan*                                                                                                                                                     |
| 10.32(p) |   | Amended and Restated Credit Agreement dated as of  May 31, 2006 by and among DG  FastChannel, Inc. and Wachovia Bank, NA as Administrative  Agent and Issuing Lender                                         |
| 10.33(q) |   | Debt Settlement and Exchange Agreement dated  November 20, 2006 by and among DG FastChannel, Inc., DG Systems Acquisition  III Corporation and MDVX, Inc.                                                              |
| 10.34(r) |   | Underwriting Agreement, dated December 14, 2006 by  and among DG FastChannel, Inc., a selling stockholder and Oppenheimer &  Co., Inc., as representative of the several underwriters named therein.               |
| 10.35(s) |   | Securities Purchase Agreement dated  December 22, 2006, between DG FastChannel, Inc. and Midwood Capital  Management, LLC, Midwood Capital Partners, L.P., and Midwood Capital Partners  QP, L.P.                 |
| 21.1**   |   | Subsidiaries of the Registrant.                                                                                                                                                                                        |
| 23.1**   |   | Consent of Independent Registered Public Accounting  Firm                                                                                                                                                              |
| 24.1**   |   | Power of Attorney (included on signature page)                                                                                                                                                                         |
| 31.1**   |   | Rule 13a-14(a)/15d-14(a) Certifications                                                                                                                                                                                |
| 31.2**   |   | Rule 13a-14(a)/15d-14(a) Certifications                                                                                                                                                                                |

42

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| 32.1** |   | Section 1350 Certifications |
|--------|--------|-----------------------------|

 

----

(a)    Incorporatedby reference to exhibit bearing the same title filed with registrant’s AnnualReport on Form 10-K filed March 27, 2003. 

(b)   Incorporatedby reference to the exhibit bearing the same title filed with registrant’sQuarterly Report on Form 10-Q filed November 14, 2006.

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

(d)   Incorporatedby reference to the exhibit bearing the same title filed with registrant’sRegistration Statement on Form S-1 (Registration No. 33-80203). Theregistrant has received confidential treatment with respect to certain portionsof this exhibit. Such portions have been omitted from this exhibit and havebeen filed separately with the SEC. 

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

(f)    Incorporatedby reference to the exhibit bearing the same title filed with registrant’sQuarterly report on Form 10-Q filed August 14, 1997. Confidentialtreatment has been requested with respect to certain portions of this exhibitpursuant to a request for confidential treatment filed with the SEC, whichrequest was granted. Omitted portions have been filed separately with theSEC.  

(g)    Incorporatedby reference to the exhibit bearing the same title filed with registrant’sRegistration Statement on Form S-3 filed on December 31, 1998. 

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

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

(j)     Incorporatedby reference to the exhibits bearing the same title filed with registrant’sAnnual Report on Form 10-K filed on March 27, 2003. The registranthas requested confidential treatment with respect to certain portions of thisexhibit. 

(k)   Incorporatedby reference to the exhibit bearing the same title filed with registrant’sAnnual Report on Form 10-K filed on March 12, 2004.

(l)    Incorporatedby reference to the exhibit bearing the same title filed with registrant’sCurrent Report on Form 8-K filed March 29, 2005. 

(m)  Incorporatedby reference to the exhibit bearing the same title filed with registrant’sAnnual Report on Form 10-K filed on March 28, 2006.

(n)   Incorporatedby reference to the exhibit bearing the same title filed with registrant’sCurrent Report on Form 8-K filed June 27, 2006. 

(o)   Incorporatedby reference to the exhibit bearing the same title filed with registrant’sDefinitive Proxy filed July 24, 1996

(p)   Incorporatedby reference to the exhibit bearing the same title filed with registrant’sQuarterly Report on Form 10-Q filed August 14, 1996.

43

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(q)   Incorporatedby reference to the exhibit bearing the same title filed with registrant’sCurrent Report on Form 8-K filed November 22, 2006.

(r)    Incorporatedby reference to the exhibit bearing the same title filed with registrant’sCurrent Report on Form 8-K filed December 19, 2006

(s)    Incorporatedby reference to the exhibit bearing the same title filed with registrant’sCurrent Report on Form 8-K filed December 28, 2006

*       Managementcontract or compensatory plan or arrangement. 

**    Filedherewith.

44

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned thereunto duly authorized. 
|                            | DG FASTCHANNEL, INC. |
|----------------------------|----------------------|
| Dated: April 2,  2007 | 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 whosesignature 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, placeand stead, in any and all capacities, to sign any or all amendments to this Form 10-Kand to file the same, with all exhibits thereto, and all other documents inconnection therewith, with the Securities and Exchange Commission, grantingunto said attorneys-in-fact and agents, and each of them, full power andauthority to do and perform each and every act and thing requisite andnecessary to be done in and about the premises, as fully to all intents andpurposes as he might or could do in person, hereby ratifying and confirming allthat said attorneys-in-fact and agents, or any of them, or its or hissubstitute or substitutes, may lawfully do or cause to be done by virtuethereof.

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated. 

|                                      | **Signature** | ** **                                    | ** ** | ** **         | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|--------------------------------------|---------------|-----------------------------------------------|------------|--------------------|-----------|------------|------------|------------|----------|------------|
| /s/  SCOTT  K. GINSBURG    |          | Chairman of the Board of Directors            |       | April 2, 2007 |
| Scott  K. Ginsburg                   |          | and  Chief Executive Officer             |       |               |
| /s/  OMAR  A. CHOUCAIR     |          | Chief Financial Officer and Director          |       | April 2, 2007 |
| Omar  A. Choucair                    |          | (Principal  Financial and Accounting Officer) |       |               |
| /s/  WILLIAM  DONNER       |          | Director                                      |       | April 2, 2007 |
| William  Donner                      |          |                                          |       |               |
| /s/  DAVID  M. KANTOR      |          | Director                                      |       | April 2, 2007 |
| David  M. Kantor                     |          |                                          |       |               |
| /s/  LISA  GALLEGHER       |          | Director                                      |       | April 2, 2007 |
| Lisa  Gallegher                      |          |                                          |       |               |
| /s/  KEVIN  C. HOWE        |          | Director                                      |       | April 2, 2007 |
| Kevin  C. Howe                       |          |                                          |       |               |
| /s/  ANTHONY  J. LEVECCHIO |          | Director                                      |       | April 2, 2007 |
| Anthony J.  LeVecchio                |          |                                          |       |               |

 

45

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**INDEXTO FINANCIAL STATEMENTS**

|                                                                                                                                  | ** ** | **Page** |
|----------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| Report of Independent  Registered Public Accounting Firm                                                                         |       | F-2      |   |
| Consolidated Balance Sheets  as of December 31, 2006 and 2005                                                               |       | F-3      |   |
| Consolidated Statements of  Operations for the Three Years Ended December 31, 2006                                          |       | F-4      |   |
| Consolidated Statements of  Stockholders’ Equity and Comprehensive Income for the Three Years Ended  December 31, 2006 |       | F-5      |   |
| Consolidated Statements of  Cash Flows for the Three Years Ended December 31, 2006                                          |       | F-6      |   |
| Notes  to Consolidated Financial Statements                                                                                      |       | F-7      |   |

 

F-1

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**DGFASTCHANNEL, INC. AND SUBSIDIARIES**

**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

The Board of Directors and StockholdersDG FastChannel, Inc. f/k/a Digital Generation Systems, Inc.:

We have audited the accompanying consolidated balance sheets of DGFastChannel, Inc. and subsidiaries (f/k/a Digital Generation Systems, Inc.) asof December 31, 2006 and 2005, and the related consolidated statements of operations,stockholders’ equity and comprehensive income, and cash flows for each of the years in thethree-year period ended December 31, 2006. In connection with our audits of theconsolidated financial statements, we also have audited financial statement scheduleII.  These consolidated financialstatements and financial statement schedule are the responsibility of theCompany’s management. Our responsibility is to express an opinion on theseconsolidated financial statements and financial statement schedule based on ouraudits.

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

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of DG FastChannel, Inc. and subsidiaries (f/k/a Digital Generation Systems, Inc.) asof December 31, 2006 and 2005, and the results of their operations and theircash flows for each of the years in the three-year period ended December 31,2006, in conformity with U.S. generally accepted accounting principles.  Also in our opinion, the related financialstatement schedule, when considered in relation to the basic consolidatedfinancial statements taken as a whole, present fairly, in all materialrespects, the information set forth therein.

As discussed in Note 2 to the consolidated financialstatements, effective January 1, 2006, the Company adopted Statement ofFinancial Accounting Standards No. 123 (revised 2004), *Share-Based Payment*, and effectiveJanuary 1, 2006, the Company adopted the provision of Securities andExchange Commission Staff Accounting Bulletin No. 108, *Considering the Effects of Prior Year Misstatementswhen Quantifying Misstatements in the Current Year Financial Statements*.

KPMG LLP

Dallas, TexasMarch 30, 2007

F-2

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**DG FASTCHANNEL, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(In thousands, except per share amounts)**

| ** **                                                                                                                                                                                          | ** ** | **December 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ***Assets***                                                                                                                                                                                        |       |                        |       |                        |       |   |   |   |   |
| CURRENT ASSETS:                                                                                                                                                                                     |       |                        |       |                        |       |   |   |   |   |
| Cash and cash  equivalents                                                                                                                                                                          |       |                        | $          | 24,474                      |       |   |   | $ | 1,886 |   |   |
| Accounts receivable  (less allowance for doubtful accounts of $1,046 in 2006 and $491 in 2005)                                                                                                      |       |                        | 15,433     |                        |       |   | 10,363 |   |   |
| Current deferred income  taxes                                                                                                                                                                      |       |                        | 2,290      |                        |       |   | 829 |   |   |
| Other current assets                                                                                                                                                                                |       |                        | 811        |                        |       |   | 910 |   |   |
| Current assets held for  sale from discontinued operations                                                                                                                                          |       |                        | 711        |                        |       |   | 1,928 |   |   |
| Total current assets                                                                                                                                                                                |       |                        | 43,719     |                        |       |   | 15,916 |   |   |
| Property and equipment  (net of accumulated depreciation of $20,163 in 2006 and $16,245 in 2005)                                                                                                    |       |                        | 12,829     |                        |       |   | 11,494 |   |   |
| Long term investments                                                                                                                                                                               |       |                        | 5,180      |                        |       |   | 4,758 |   |   |
| Goodwill                                                                                                                                                                                            |       |                        | 65,545     |                        |       |   | 43,397 |   |   |
| Deferred income taxes,  net                                                                                                                                                                         |       |                        | 10,244     |                        |       |   | 17,371 |   |   |
| Intangible assets (net  of accumulated amortization of $9,210 in 2006 and $5,638 in 2005)                                                                                                           |       |                        | 35,112     |                        |       |   | 18,242 |   |   |
| Restricted cash                                                                                                                                                                                     |       |                        | 425        |                        |       |   | — |   |   |
| Other noncurrent assets                                                                                                                                                                             |       |                        | 654        |                        |       |   | 815 |   |   |
| Noncurrent assets held  for sale from discontinued operations                                                                                                                                       |       |                        | 1,875      |                        |       |   | 2,340 |   |   |
| TOTAL ASSETS                                                                                                                                                                                        |       |                        | $          | 175,583                     |       |   |   | $ | 114,333 |   |   |
| ***Liabilities and Stockholders’  Equity***                                                                                                                                                    |       |                        |       |                        |       |   |   |   |   |
| CURRENT LIABILITIES                                                                                                                                                                                 |       |                        |       |                        |       |   |   |   |   |
| Accounts payable                                                                                                                                                                                    |       |                        | $          | 4,112                       |       |   |   | $ | 4,870 |   |   |
| Accrued liabilities  (includes amounts owed to related party of $332 in 2006, and $103 in 2005—see  Notes 7 and 19)                                                                       |       |                        | 8,500      |                        |       |   | 3,240 |   |   |
| Deferred revenue, net                                                                                                                                                                               |       |                        | 1,100      |                        |       |   | 458 |   |   |
| Current portion of  long-term debt and capital leases                                                                                                                                               |       |                        | 4,190      |                        |       |   | 3,698 |   |   |
| Short-term obligations  of discontinued operations                                                                                                                                                  |       |                        | 145        |                        |       |   | 1,026 |   |   |
| Total current  liabilities                                                                                                                                                                          |       |                        | 18,047     |                        |       |   | 13,292 |   |   |
| Long-term debt and  capital leases, net of current portion                                                                                                                                          |       |                        | 15,650     |                        |       |   | 20,834 |   |   |
| TOTAL LIABILITIES                                                                                                                                                                                   |       |                        | 33,697     |                        |       |   | 34,126 |   |   |
| Commitments and contingencies (see Note 14)                                                                                                                                                         |       |                        |       |                        |       |   |   |   |   |
| 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; 15,900 issued and 15,844 outstanding at  December 31, 2006; 7,479 issued and 7,423 outstanding at  December 31, 2005 |       |                        | 16         |                        |       |   | 8 |   |   |
| Additional paid-in  capital                                                                                                                                                                         |       |                        | 333,821    |                        |       |   | 271,320 |   |   |
| Accumulated deficit                                                                                                                                                                                 |       |                        | (191,358   | )                           |       |   | (190,268 | ) |   |
| Other comprehensive  income                                                                                                                                                                         |       |                        | 260        |                        |       |   | — |   |   |
| Treasury stock, at cost                                                                                                                                                                             |       |                        | (853       | )                           |       |   | (853 | ) |   |
| TOTAL STOCKHOLDERS’  EQUITY                                                                                                                                                                    |       |                        | 141,886    |                        |       |   | 80,207 |   |   |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                     |       |                        | $          | 175,583                     |       |   |   | $ | 114,333 |   |   |

 

The accompanying notes are an integral part of these financial statements.

F-3

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share amounts)**

| ** **                                                                | ** ** | **For years ended December 31,** | ** ** |
|---------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                | ** ** | **2006**                                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                                                                 |       |                                                 |       |   |   |   |   |
| Audio and video content distribution                                      |       | $                                                    | 64,911     |   | $ | 49,971 |   | $ | 52,970 |   |
| Other                                                                     |       | 3,756                                                |       | 1,853 |   | 600 |   |
| Total revenues                                                            |       | 68,667                                               |       | 51,824 |   | 53,570 |   |
| Cost of revenues:                                                         |       |                                                 |       |   |   |   |   |
| Audio and video content distribution                                      |       | 32,919                                               |       | 31,578 |   | 28,806 |   |
| Other                                                                     |       | 403                                                  |       | 606 |   | 135 |   |
| Total cost of revenues                                                    |       | 33,322                                               |       | 32,184 |   | 28,941 |   |
| Operating  expenses:                                                      |       |                                                 |       |   |   |   |   |
| Sales and marketing                                                       |       | 4,240                                                |       | 3,915 |   | 4,264 |   |
| Research and development                                                  |       | 1,779                                                |       | 1,107 |   | 1,520 |   |
| General and administrative                                                |       | 10,462                                               |       | 7,587 |   | 6,328 |   |
| Restructuring charges                                                     |       | —                                               |       | 434 |   | — |   |
| Impairment charges                                                        |       | —                                               |       | — |   | 1,048 |   |
| Depreciation and amortization                                             |       | 8,563                                                |       | 6,348 |   | 5,143 |   |
| Total operating  expenses                                                 |       | 25,044                                               |       | 19,391 |   | 18,303 |   |
| Income from  operations                                                   |       | $                                                    | 10,301     |   | $ | 249 |   | $ | 6,326 |   |
| Other (income) expense:                                                   |       |                                                 |       |   |   |   |   |
| Reduction in fair value of long-term investments                          |       | 4,758                                                |       | — |   | — |   |
| Interest income and other (income) expense, net                           |       | (58                                                  | )          | — |   | — |   |
| Interest expense                                                          |       | 2,844                                                |       | 2,990 |   | 1,284 |   |
| Net income (loss)  before income taxes from continuing operations         |       | $                                                    | 2,757      |   | $ | (2,741 | ) | $ | 5,042 |   |
| Provision  (benefit) for income taxes                                     |       | 2,378                                                |       | (768 | ) | 1,728 |   |
| Net income (loss)  from continuing operations                             |       | $                                                    | 379        |   | $ | (1,973 | ) | $ | 3,314 |   |
| Discontinued  operations:                                                 |       |                                                 |       |   |   |   |   |
| (Loss) income from operations of discontinued operations                  |       | (539                                                 | )          | 1,455 |   | (6,181 | ) |
| Income tax benefit (expense)                                              |       | 209                                                  |       | (572 | ) | 6,071 |   |
| (Loss) on disposal of discontinued operations, net  of tax benefit        |       | (698                                                 | )          | — |   | — |   |
| Net (loss) income  from discontinued operations                           |       | (1,028                                               | )          | 883 |   | (110 | ) |
| Net income (loss)                                                         |       | (649                                                 | )          | (1,090 | ) | 3,204 |   |
| Basic net income (loss) per common share from  continuing operations      |       | $                                                    | 0.04       |   | $ | (0.27 | ) | $ | 0.46 |   |
| Basic net income  (loss) per common share from discontinued operations    |       | $                                                    | (0.10      | ) | $ | 0.12 |   | $ | (0.02 | ) |
| Basic net income  (loss) per common share                                 |       | $                                                    | (0.06      | ) | $ | (0.15 | ) | $ | 0.44 |   |
| Diluted net income (loss) per common share from continuing  operations    |       | $                                                    | 0.04       |   | $ | (0.27 | ) | $ | 0.46 |   |
| Diluted net  income (loss) per common share from discontinued  operations |       | $                                                    | (0.10      | ) | $ | 0.12 |   | $ | (0.02 | ) |
| Diluted net  income (loss) per common share                               |       | $                                                    | (0.06      | ) | $ | (0.15 | ) | $ | 0.44 |   |
| Basic weighted average common shares outstanding                          |       | 10,568                                               |       | 7,378 |   | 7,277 |   |
| Diluted weighted average  common shares outstanding                       |       | 10,568                                               |       | 7,378 |   | 7,330 |   |

 

The accompanying notes are an integral part of these financial statements.

F-4

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME(In thousands)**

| ** **                                                                 | ** ** | ** **            | ** ** | ** **              | ** ** | ** **  | ** ** | ** **        | ** ** | **Additional**  | ** ** | **Other**              | ** ** | ** **  | ** ** | **Total**  | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|-------------|------------|-------------------|------------|-----------------|------------|------------------------|------------|-------------|------------|------------|------------|
| ** **                                                                 | ** ** | **Common Stock** | ** ** | **Treasury Stock** | ** ** | **Paid-in** | ** ** | **Comprehensive** | ** ** | **Accumulated** | ** ** | **Stockholders’** | ** ** |
| ** **                                                                 | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Shares**  | ** ** | **Amount**        | ** ** | **Capital**     | ** ** | **Income**             | ** ** | **Deficit** | ** ** | **Equity** | ** ** |
| Balance at December 31, 2003                                          |       |                  | 7,209      |                    |       |        | $          | 7                 |       |            |       | (1                     | )          |        |       | $          | (101       | ) |   |   | $ | 267,950 |   |   |   | $ | — |   |   |   | $ | (192,382 | ) |   |   | $ | 75,474 |   |   |
| Exercise of stock options                                                  |       |                  | 109        |                    |       |        | 0          |              |       |            | —     |                   |       |        | —     |       |       |   | 1,254 |   |   |   | — |   |   |   | — |   |   |   | 1,254 |   |   |
| Issuance of common stock under employee stock  purchase plan               |       |                  | 2          |                    |       |        | —     |              |       |            | —     |                   |       |        | —     |       |       |   | 19 |   |   |   | — |   |   |   | — |   |   |   | 19 |   |   |
| Tax benefits from employee stock option plans                              |       |                  | —     |                    |       |        | —     |              |       |            | —     |                   |       |        | —     |       |       |   | 75 |   |   |   | — |   |   |   | — |   |   |   | 75 |   |   |
| Repurchase of common stock                                                 |       |                  | —     |                    |       |        | —     |              |       |            | (45        | )                      |       |        | (594       | )          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | (594 | ) |   |
| Net income                                                                 |       |                  | —     |                    |       |        | —     |              |       |            | —     |                   |       |        | —     |       |       |   | — |   |   |   | — |   |   |   | 3,204 |   |   |   | 3,204 |   |   |
| Balance at December 31, 2004                                          |       |                  | 7,320      |                    |       |        | $          | 7                 |       |            |       | (46                    | )          |        |       | $          | (695       | ) |   |   | $ | 269,298 |   |   |   | $ | — |   |   |   | $ | (189,178 | ) |   |   | $ | 79,432 |   |   |
| Exercise of stock options                                                  |       |                  | 1          |                    |       |        | —     |              |       |            | —     |                   |       |        | —     |       |       |   | 5 |   |   |   | — |   |   |   | — |   |   |   | 5 |   |   |
| Issuance of common stock for acquisition                                   |       |                  | 155        |                    |       |        | 1          |              |       |            | —     |                   |       |        | —     |       |       |   | 1,999 |   |   |   | — |   |   |   | — |   |   |   | 2,000 |   |   |
| Issuance of common stock under employee stock  purchase plan               |       |                  | 3          |                    |       |        | —     |              |       |            | —     |                   |       |        | —     |       |       |   | 18 |   |   |   | — |   |   |   | — |   |   |   | 18 |   |   |
| Repurchase of common stock                                                 |       |                  | —     |                    |       |        | —     |              |       |            | (10        | )                      |       |        | (158       | )          |       |   | — |   |   |   | — |   |   |   | — |   |   |   | (158 | ) |   |
| Net loss                                                                   |       |                  | —     |                    |       |        | —     |              |       |            | —     |                   |       |        | —     |       |       |   | — |   |   |   | — |   |   |   | (1,090 | ) |   |   | (1,090 | ) |   |
| Balance at December 31, 2005                                          |       |                  | 7,479      |                    |       |        | $          | 8                 |       |            |       | (56                    | )          |        |       | $          | (853       | ) |   |   | $ | 271,320 |   |   |   | $ | — |   |   |   | $ | (190,268 | ) |   |   | $ | 80,207 |   |   |
| SAB 108 adoption                                                           |       |                  | —     |                    |       |        | —     |              |       |            | —     |                   |       |        | —     |       |       |   | — |   |   |   | — |   |   |   | (441 | ) |   |   | (441 | ) |   |
| Exercise of stock options                                                  |       |                  | 2          |                    |       |        | —     |              |       |            | —     |                   |       |        | —     |       |       |   | 23 |   |   |   | — |   |   |   | — |   |   |   | 23 |   |   |
| Common stock issued to acquire FastChannel  Networks, Inc.            |       |                  | 5,160      |                    |       |        | 5          |              |       |            | —     |                   |       |        | —     |       |       |   | 27,444 |   |   |   | — |   |   |   | — |   |   |   | 27,449 |   |   |
| Issuance of common stock to retire debt                                    |       |                  | 259        |                    |       |        | —     |              |       |            | —     |                   |       |        | —     |       |       |   | 3,000 |   |   |   | — |   |   |   | — |   |   |   | 3,000 |   |   |
| Issuance of common stock under employee stock  purchase plan               |       |                  | 1          |                    |       |        | —     |              |       |            | —     |                   |       |        | —     |       |       |   | 9 |   |   |   | — |   |   |   | — |   |   |   | 9 |   |   |
| Proceeds from issuance of common stock                                     |       |                  | 2,999      |                    |       |        | 3          |              |       |            | —     |                   |       |        | —     |       |       |   | 31,717 |   |   |   | — |   |   |   | — |   |   |   | 31,720 |   |   |
| Share based compensation                                                   |       |                  | —     |                    |       |        | —     |              |       |            | —     |                   |       |        | —     |       |       |   | 308 |   |   |   | — |   |   |   | — |   |   |   | 308 |   |   |
| Comprehensive  income:                                                     |       |                  |       |                    |       |        |       |              |       |            |       |                   |       |        |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Currency translation adjustment                                            |       |                  | —     |                    |       |        | —     |              |       |            | —     |                   |       |        | —     |       |       |   | — |   |   |   | (2 | ) |   |   | — |   |   |   | (2 | ) |   |
| Unrealized gain on long-term investment (net of tax  expense of $166) |       |                  | —     |                    |       |        | —     |              |       |            | —     |                   |       |        | —     |       |       |   | — |   |   |   | 262 |   |   |   | — |   |   |   | 262 |   |   |
| Net loss                                                                   |       |                  | —     |                    |       |        | —     |              |       |            | —     |                   |       |        | —     |       |       |   | — |   |   |   | — |   |   |   | (649 | ) |   |   | (649 | ) |   |
| Total comprehensive income                                                 |       |                  |       |                    |       |        |       |              |       |            |       |                   |       |        |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |   | (389 | ) |   |
| Balance at  December 31, 2006                                         |       |                  | 15,900     |                    |       |        | $          | 16                |       |            |       | (56                    | )          |        |       | $          | (853       | ) |   |   | $ | 333,821 |   |   |   | $ | 260 |   |   |   | $ | (191,358 | ) |   |   | $ | 141,886 |   |   |

 

The accompanying notes are an integral part of these financial statements.

F-5

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands)**

| ** **                                                                                | ** ** | **Years ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Cash flows from operating activities:                                                     |       |                                        |       |   |   |   |   |
| Net income (loss)                                                                         |       | $                                           | (649       | ) | $ | (1,090 | ) | $ | 3,204 |   |
| Adjustments to reconcile  net income (loss) to net cash provided by operating activities: |       |                                        |       |   |   |   |   |
| Depreciation of  property and equipment                                                   |       | 4,861                                       |       | 3,594 |   | 3,864 |   |
| Amortization of  intangibles                                                              |       | 4,285                                       |       | 3,052 |   | 1,933 |   |
| Impairment of  fixed assets                                                               |       | —                                      |       | — |   | 1,048 |   |
| Impairment of  goodwill                                                                   |       | —                                      |       | 655 |   | 8,083 |   |
| Deferred income  taxes                                                                    |       | 5,153                                       |       | (226 | ) | (4,678 | ) |
| Tax benefits from  employee stock options                                                 |       | —                                      |       | — |   | 75 |   |
| Loss on  extinguishment of debt                                                           |       | —                                      |       | 949 |   | — |   |
| Reduction in fair  value of long-term investment                                          |       | 4,758                                       |       | — |   | — |   |
| Provision for  doubtful accounts                                                          |       | 806                                         |       | 330 |   | 275 |   |
| Loss on disposal  of fixed assets                                                         |       | —                                      |       | 8 |   | — |   |
| Share based  compensation                                                                 |       | 308                                         |       | — |   | — |   |
| Changes in operating  assets and liabilities, net of working capital from acquisitions:   |       |                                        |       |   |   |   |   |
| Accounts  receivable                                                                      |       | (1,769                                      | )          | 1,510 |   | 1,051 |   |
| Other assets                                                                              |       | 874                                         |       | (2,310 | ) | (380 | ) |
| Accounts payable  and accrued liabilities                                                 |       | (8,044                                      | )          | 517 |   | (568 | ) |
| Deferred revenue,  net                                                                    |       | (938                                        | )          | (1,635 | ) | (2,537 | ) |
| Net cash provided  by operating activities                                                |       | 9,645                                       |       | 5,354 |   | 11,370 |   |
| Cash flows from investing  activities:                                                    |       |                                        |       |   |   |   |   |
| Purchases of  property and equipment                                                      |       | (3,054                                      | )          | (3,044 | ) | (3,342 | ) |
| Long-term  investments                                                                    |       | (4,752                                      | )          | (5,116 | ) | — |   |
| Acquisitions, net  of cash acquired                                                       |       | (257                                        | )          | (1,809 | ) | (18,251 | ) |
| Net cash used in  investing activities                                                    |       | (8,063                                      | )          | (9,969 | ) | (21,593 | ) |
| Cash flows from financing  activities:                                                    |       |                                        |       |   |   |   |   |
| Proceeds from  issuance of common stock                                                   |       | 31,753                                      |       | 23 |   | 1,273 |   |
| Purchases of  treasury stock                                                              |       | —                                      |       | (158 | ) | (594 | ) |
| Payments to secure  financing                                                             |       | (341                                        | )          | (885 | ) | (78 | ) |
| Borrowings under  long-term debt                                                          |       | 51,850                                      |       | 19,500 |   | 16,500 |   |
| Payments on  long-term debt                                                               |       | (62,254                                     | )          | (20,038 | ) | (6,055 | ) |
| Net cash provided  by (used in) financing activities                                      |       | 21,008                                      |       | (1,558 | ) | 11,046 |   |
| Effect of exchange  rate changes on cash and cash equivalents                             |       | (2                                          | )          | — |   | — |   |
| Net increase  (decrease) in cash and cash equivalents                                     |       | 22,588                                      |       | (6,173 | ) | 823 |   |
| Cash and cash  equivalents at beginning of year including discontinued operations         |       | 1,886                                       |       | 8,059 |   | 7,236 |   |
| Cash and cash  equivalents at end of year including discontinued operations               |       | $                                           | 24,474     |   | $ | 1,886 |   | $ | 8,059 |   |
| Cash paid for  interest                                                                   |       | $                                           | 2,349      |   | $ | 1,209 |   | $ | 991 |   |
| Cash paid for  income taxes                                                               |       | $                                           | 264        |   | $ | 195 |   | $ | 183 |   |
| Noncash financing  activities:                                                            |       |                                        |       |   |   |   |   |
| Vendor financed  acquisition of software                                                  |       | $                                           | —     |   | $ | 468 |   | $ | 1,544 |   |
| Equipment  purchased under capital lease                                                  |       | $                                           | —     |   | $ | — |   | $ | 757 |   |
| Non-cash component  of purchase price to acquire a business                               |       | $                                           | 49,048     |   | $ | 8,500 |   | $ | — |   |
| Debt extinguished  with the issuance of common stock                                      |       | $                                           | 3,000      |   | $ | — |   | $ | — |   |

 

The accompanying notes are an integral part of these financial statements.

F-6

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**1.   The Company:**

DG FastChannel, Inc.(the “Company”) owns a nationwide digital network that beneficially links morethan 5,000 advertisers and advertising agencies with more than 21,000 radio,television, cable, network and print publishing destinations electronicallythroughout the United States and Canada. The Company has a Network OperationCenter located in Irving, Texas that delivers audio, video, image and datacontent that comprise transactions among advertisers and various media outlets,including those in the broadcast industries.

**2.   Summary of Significant Accounting Policies:**

**Consolidation**

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

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

**Cash and Cash Equivalents**

Cash and cash equivalentsconsist of liquid investments with original maturities of three months or less.The Company maintains substantially all of its cash and cash equivalents withina few major financial institutions in the United States. As of December 31,2006 and 2005, cash equivalents consisted primarily of investments in U.S.money market funds and/or certificates of deposit at U.S. financialinstitutions.

**Allowance for Doubtful Accounts**

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

**Property and Equipment**

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

**Impairment of Long-Lived Assets**

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

F-7

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**Goodwill**

Goodwill, which representsthe excess of purchase price over the fair value of net identifiable assetsacquired, is assessed annually for recoverability based on the fair value ofthe reporting unit to which it relates.

**Identifiable Intangible Assets**

TheCompany assesses the impairment of long-lived assets whenever events or changesin circumstances indicate that the carrying value may not be recoverable.Factors that the Company considers important which could trigger an impairmentreview include the following:

·       significantunderperformance relative to expected historical or projected future operatingresults;

·       significantchanges in the manner or use of the acquired assets or the strategy for theCompany’s overall business;

·       significantnegative industry or economic trends;

·       significantdecline in its stock price for a sustained period; and

·       theCompany’s market capitalization relative to net book value.

If the Company determinesthat the carrying value of long-lived or intangible assets may not berecoverable based upon the existence of one or more of the above indicators ofimpairment, the Company assesses the recoverability of the long-lived orintangible asset by determining whether the amortization of the asset balanceover its remaining life can be recovered through undiscounted future operatingcash flow of the acquired operations. Any impairment is measured based on aprojected discounted cash flow method using a discount rate reflecting theCompany’s average cost of funds.

The Company determines theuseful lives of identifiable intangible assets after considering the specificfacts and circumstances related to each intangible asset. Factors consideredwhen determining useful lives include the contractual term of any agreement,the history of the asset, the Company’s long-term strategy for the use of theasset, any laws or other local regulations which could impact the useful lifeof the asset, and other economic factors, including competition and specificmarket conditions. Intangible assets that are deemed to have definite lives areamortized, generally on a straight-line basis, over their useful lives, rangingfrom 3 to 20 years. Refer to Note 6.

**Restricted Cash**

Restricted cash consistsof real estate security deposits totaling $0.4 million at December 31,2006. These security deposits are carried at fair value and are restricted asto withdrawal. The security deposits are held in the name of one of the Company’ssubsidiaries with major financial institutions to collateralize certain of theCompany’s office leases. Deposits expected to be returned beyond one year areclassified as non-current on the accompanying consolidated balance sheets.

**Use of Estimates**

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period. On an ongoing basis, the Company evaluates its estimates,including those related to the allowance for 

F-8

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

doubtfulaccounts, inventories, intangible assets and income taxes. The Company basesits estimates on historical experience and on other relevant assumptions thatare believed to be reasonable under the circumstances, the results of whichform the basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources. Actual resultscould differ from those estimates.

**Revenue Recognition**

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

The Company recognizesproduct revenue when persuasive evidence of an arrangement exists, delivery hasoccurred, the sales price is fixed and determinable and collectibility isprobable. Generally for product sales, these criteria are met at the time ofdelivery to a common carrier. Provision is made at the time the related revenueis recognized for estimated product returns, which historically have beenimmaterial. The Company analyzes historical returns, current economic trends,and changes in customer demand when evaluating the adequacy of provisions forsales returns. At the time of the transaction, the Company assesses whether thefee associated with revenue transactions is fixed and determinable and whetheror not collection is reasonably assured. The Company assesses whether the feeis fixed and determinable based on the payment terms associated with thetransaction. The Company assesses collectibility based on a number of factors,including past transaction history with the customer and the credit-worthinessof the customer. For all sales, the Company uses either a binding purchase orderor signed sales agreement as evidence of an arrangement. Shipping and handlingrevenues are included in product revenues and costs are included in productcosts.

**Operating Leases**

***The Company leases certain properties under terms thatinclude both rent holidays and escalations of rent. Rent expense on all leasesis recorded on a straight-line basis over the term of the lease.***

**Research and Development and Software DevelopmentCosts**

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

Research and developmentand other costs incurred for the creation of internal use software arecapitalized when the preliminary project stage is completed and only costs incurredduring the application development stage are capitalized. Upon completion ofthe project, amortization is initiated and capitalized software developmentcosts are amortized over their estimated useful lives, generally expected to be3 years.

F-9

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**Income Taxes**

Income taxes are accountedfor under the asset and liability method. Deferred tax assets and liabilitiesare recognized for the future tax consequences attributable to differencesbetween financial statement carrying amounts of existing assets and liabilitiesand its respective tax basis and operating loss and tax credit carryforwards.Deferred tax assets and liabilities are measured using enacted tax ratesexpected to apply to taxable income in the years in which those temporarydifferences are expected to be recovered or settled. The effect on deferred taxassets and liabilities of a change in tax rates is recognized in income in theperiod that includes the enactment date.

**Foreign Currencies**

The Company providesservices to certain entities located outside of the United States of America.Gains or losses on foreign currency transactions for the years ended December 31,2006, 2005 and 2004, were not material.

**Stock Option Plans**

Effective for the firstquarter of 2006, the Company adopted SFAS No. 123R, “Share-BasedPayment,” which is a revision to SFAS No. 123, “Accounting forStock-Based Compensation.” SFAS No. 123R focuses primarily onaccounting for transactions in which an entity obtains employee services inexchange for share-based payments. Under SFAS No. 123R, share-basedawards that do not require future service (i.e., vested awards) are expensedimmediately. Share-based employee awards that require future service areamortized over the relevant service period. The Company adopted SFAS No. 123Runder the modified prospective adoption method. Accordingly, beginning January 1,2006, the Company recognizes compensation cost from share-based paymentarrangements based on grant date fair value. Under the modified prospectivetransition method, compensation cost recognized in 2006 includes: (i) compensationcost for all share-based payments granted prior to, but not vested as of, January 1,2006, based on the grant date fair value estimated in accordance with theoriginal provisions of SFAS No.123, and (ii) compensation cost for allshare-based payments granted subsequent to January 1, 2006, based on thegrant date fair value estimated in accordance with the provisions of SFAS No.123R.The Company recognized approximately $308,000 in share-based compensationexpense related to employee stock options in the year ended December 31,2006.

F-10

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Share-basedemployee awards granted for the year ended December 31, 2005 and prioryears were accounted for under the intrinsic-value-based method prescribed byAPB Opinion No. 25, “Accounting for Stock Issued to Employees,” aspermitted by SFAS No. 123. Therefore, no compensation expense wasrecognized for unmodified stock options issued for years prior to fiscal 2003that had no intrinsic value on the date of grant. If the Company were torecognize compensation expense over the relevant service period, generally fouryears, under the fair value method per SFAS No. 123 with respect tostock options granted for the years ended December 31, 2005 and 2004, netearnings would have decreased, resulting in proforma net gain (loss) andearning (loss) per common share (EPS) as set forth below (in thousands,except per share amounts):

| ** **                                                                                                                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Net income (loss):                                                                                                                         |       |     |       |     |       |
| As reported                                                                                                                                |       | $        | (1,090     | )        | $          | 3,204 |   |
| Total stock-based employee  compensation expense determined under fair value-based method for all  awards, net of related tax effects |       | (1,528   | )          | (2,999   | )          |
| Pro forma                                                                                                                                  |       | $        | (2,618     | )        | $          | 205 |   |
| Basic earnings per share of common stock:                                                                                                  |       |     |       |     |       |
| As reported                                                                                                                                |       | $        | (0.15      | )        | $          | 0.44 |   |
| Pro forma                                                                                                                                  |       | $        | (0.35      | )        | $          | 0.03 |   |
| Diluted earnings per share of common stock:                                                                                                |       |     |       |     |       |
| As reported                                                                                                                                |       | $        | (0.15      | )        | $          | 0.44 |   |
| Pro forma                                                                                                                                  |       | $        | (0.35      | )        | $          | 0.03 |   |

 

On January 17, 2006, the Company amended thetotal stock-based employee compensation expense determined under fairvalue-based method for all awards, net of related tax effects, pro forma netincome, and pro forma basic and diluted earnings per share of common stock forthe year ended December 31, 2004 to reflect the fair value of themodification of certain warrants during 2004.

**Financial Instruments and Concentration of Credit Risk**

Financial instruments thatpotentially subject the Company to a concentration of credit risk consistprimarily of cash and cash equivalents and accounts receivable. The Companyperforms ongoing credit evaluations of its customers, generally does notrequire collateral from its customers and maintains a reserve for potentialcredit losses. The Company believes that a concentration of credit risk withrespect to accounts receivable related to audio and video content distribution(the primary source of revenues and related accounts receivable) is limitedbecause its customers are geographically dispersed and the end users (thecustomers’ clients) are diversified across industries. The Company’sreceivables are principally from advertising agencies, dub and ship houses, andsyndicated programmers. The Company’s revenues are not contingent on itscustomers’ sales or collections. However, the timing of collections from itscustomers is affected by the billing cycle in which the customer bills itsend-users (the customers’ clients). The Company provides reserves for creditlosses.

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

F-11

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

During the years ended December 31,2006, 2005 and 2004, the Company had no customers that accounted for more than10% of the Company’s total revenue.

**Adoption of SAB 108**

On September 13,2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”). SAB108 expresses the SEC Staff’s views regarding the process of evaluatingmateriality of financial statement misstatements. SAB 108 addresses thediversity in evaluating materiality of financial statement misstatements andthe potential under current practice used by the Company for the build up ofimproper amounts on the balance sheet. SAB 108 is effective for the Company forthe year ended December 31, 2006. As allowed by SAB 108, the cumulativeeffect of the initial application of SAB 108 has been reported in the carryingamounts of assets and liabilities as of the beginning of fiscal 2006, with theoffsetting balance to retained earnings. Upon adoption, the Company recorded anincrease to accrued liabilities of $0.1 million, originally related to2005, and an increase in deferred tax liabilities of approximately $0.3 millionoriginally related to 2001 or earlier to record liabilities not previouslyidentified and a decrease in retained earnings of approximately $0.4 millionto correct errors in previous years that were considered immaterial under theCompany’s previous method of evaluating materiality.

**3.   Investments and Acquisitions:**

*Investment in Point.360*

On December 22, 2006,the Company entered into a Securities Purchase Agreement (the “Agreement”)with Midwood Capital Management LLC, Midwood Capital Partners, L.P. andMidwood Capital Partners QP, L.P., related to the purchase by the Companyof 1,108,674 shares (the “Shares”) of common stock, no par value, ofPoint.360 (symbol “PTSX” on the NASDAQ Global Market), a Californiacorporation, which were held by such entities.

At December 31, 2006the Company owned 1,442,974 shares of common stock or approximately 14.8% ofPoint.360 and accounts for the long-term investment as an ‘available for sale’equity security in accordance with SFAS 115. Other than a nondisclosureagreement and the Securities Purchase Agreement, the Company and its affiliatesdo not have a material relationship with Point.360. The Company has determinedthat these agreements are not “material contracts” for purposes ofItem 601(b)(10) of Regulation S-K.

*Merger with FastChannel Network*

On December 15, 2005,the Company and privately-held FastChannel Network, Inc. (“FastChannel”)entered into a definitive agreement to merge in a tax-free, stock-for-stocktransaction. The purpose of the merger was to expand the Company’s electronicdistribution network and customer base. On May 31, 2006, the merger wasconsummated, pursuant to which FastChannel became a wholly owned subsidiary ofthe Company. As consideration for the transaction, the Company issued toholders of FastChannel common and preferred stock approximately 5.2 millionshares of the Company’s common stock (giving effect to the 1-for-10share reverse stock split that was effective as of May 30, 2006) valued at$27.4 million. Additionally, the Company refinanced approximately $8.0 millionof FastChannel debt. The net purchase price was allocated based on thecurrent estimated fair values of the assets deemed acquired and liabilities deemedassumed at the date of acquisition, $14.6 million to customer relationships and$4.4 million to the trade name. Both intangibles are being amortized over 10years. The remaining excess of the purchase 

F-12

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

priceover the net assets deemed acquired was allocated to Goodwill. Goodwill createdas a result of the acquisition totaled $22.0 million, none of which willbe deductible for tax purposes.

*Investment in Verance Corporation*

Effective March 21,2005, the Company purchased 6,286,146 shares of Series B ConvertiblePreferred Stock, $0.0001 par value per share (the “Series B PreferredStock”), from Verance Corporation, a Delaware corporation (“Verance”), for$2.5 million pursuant to that certain Series B Convertible PreferredStock Purchase Agreement, dated March 16, 2005 (the “Verance Agreement”)between Verance and the Company. As required by the Verance Agreement, theCompany purchased an additional 6,286,146 shares of Series B PreferredStock from Verance for $2.5 million in July 2005. The Series BPreferred Stock is convertible into common stock, $0.0001 par value per share(the “Common Stock”), and will be automatically converted into Common Stock (1) uponthe election of the holders of 662¤3% of the Series A Preferred Stockand Series B Preferred Stock acting together, or (2) immediatelyprior to a qualified public offering by Verance. The holders of Series BPreferred Stock are entitled to cumulative cash dividends of 7% per annum pershare. Verance has the option to pay such dividends in kind with shares of Series BPreferred Stock. For purposes of liquidation or in connection with a sale ormerger by Verance, the Series B Preferred Stock is senior to the Series APreferred Stock and Common Stock of Verance, but is junior to the Series CPreferred Stock of Verance. Holders of Verance’s preferred stock vote togetherwith holders of its Common Stock on an as-converted basis.

The Company owns approximately 8% of Verance on anas-converted basis and accounts for the long-term investment using the costmethod of accounting. Other than the Verance Agreement, the Company and itsaffiliates do not have a material relationship with Verance. However, theCompany and Verance have simultaneously entered into other agreements thatenable the Company to add certain services provided by Verance to its products.The Company has determined that these other existing agreements are not “materialcontracts” for purposes of Item 601(b)(10) of Regulation S-K.

TheCompany regularly evaluates the carrying value of its investments. When thecarrying value of an investment exceeds the fair value and the decline in fairvalue is deemed to be other-than-temporary, the Company writes down the valueof the investment to its fair value. As of September 30, 2006, the Company’sevaluation of its investment in Verance determined that it had sustained another-than-temporary reduction in fair value and reduced the carrying value ofthe investment down to zero. A license related to this investment was alsodeemed to have no further value and the Company recorded additionalamortization expense to reduce the carrying value to zero. Details of theother-than-temporary reduction are as follows (in thousands):

| ** **                             | ** ** | **Year ended**             | ** ** |
|----------------------------------------|------------|---------------------------------|------------|
| ** **                             | ** ** | **December 31, 2006** | ** ** |
| Long-term investments:                 |       |                            |       |   |   |
| Verance Series B  Preferred Stock |       |                            | $          | 4,758 |   |   |
| Intangible assets:                     |       |                            |       |   |   |
| Verance license                        |       |                            | 329        |   |   |
|                                   |       |                            | $          | 5,087 |   |   |

 

*Media DVX*

On April 15, 2005, the Company completed theacquisition of substantially all of the assets of Media DVX, Inc. (“MDX”).Accordingly, the results of MDX’s operations have been included in the 

F-13

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

consolidated financialstatements since that date. Based in Pennsylvania, MDX’s core services are thedistribution of program and/or advertising content to television stationsthroughout the country utilizing conventional and electronic duplicationtechnology. The purpose of the acquisition was to expand the Company’selectronic distribution network. The Company paid $1.5 million in cash, issueda $6.5 million promissory note and issued 155,039 shares of its commonstock, worth approximately $2.0 million at the time of issuance, asconsideration for the assets of MDX. The net purchase price was allocated basedon the current estimated fair values of the assets acquired and liabilitiesassumed at the date of acquisition. Subsequent to the acquisition date, theCompany obtained a third-party valuation of certain intangible assets of MDXand, accordingly, allocated $1.0 million to customer relationships and$0.1 million to the trade name. Both intangible assets are being amortizedover 10 years. The remaining excess of the purchase price over the net assetsacquired was allocated to Goodwill. Goodwill created as a result of theacquisition totaled $8.9 million, all of which is deductible for taxpurposes.

Thefollowing table summarizes the estimated fair values of the assets acquired andthe liabilities assumed at the date of the acquisition for each of theaforementioned acquisitions other than Point.360 and Verance. The table alsosummarizes the preliminary fair values of the assets acquired and liabilitiesassumed of these companies adjusted to incorporate the results of a third partyvaluation analysis. The Company is in the process of finalizing the fair valuesof the assets required and liabilities assumed and will complete the process inthe first quarter of 2007. The purchase price allocations for the acquisitionsare currently as follows (in thousands): 

| ** **                      | ** ** | **FastChannel** | ** ** | **MDX** | ** ** |
|---------------------------------|------------|-----------------|------------|---------|------------|
| Current assets                  |       |            | $          | 5,303   |       |   | $ | — |   |
| Property, plant and  equipment  |       |            | 2,950      |    |       | 1,004 |   |
| Other non-current assets        |       |            | 1,052      |    |       | — |   |
| Identifiable intangible  assets |       |            | 19,010     |    |       | 1,103 |   |
| Goodwill                        |       |            | 22,038     |    |       | 8,940 |   |
| Total assets acquired           |       |            | $          | 50,353  |       |   | $ | 11,047 |   |
| Liabilities assumed             |       |            | 21,597     |    |       | 890 |   |
| Net assets acquired             |       |            | $          | 28,756  |       |   | $ | 10,157 |   |

 

Thefollowing pro forma information details the results of continuing operations asif the acquisitions of MDX and FastChannel had taken place on January 1,2005 (in thousands). A table of actual amounts is provided for reference:

| ** **                                                  | ** ** | **As Reported**  | ** ** | **Proforma**          | ** ** |
|-------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                  | ** ** | **Year ended**   | ** ** | **Year ended**   | ** ** |
| ** **                                                  | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                                  | ** ** | **2006**              | ** ** | **2005**              | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenue                                                     |       | $                     | 68,667     |                  | $          | 51,824 |   | $ | 78,148 |   | $ | 77,194 |   |
| Income (loss) from  operations                              |       | $                     | 10,301     |                  | $          | (249 | ) | $ | 7,175 |   | $ | (12,415 | ) |
| Net income (loss) from  continuing operations:              |       | $                     | 379        |                  | $          | (1,973 | ) | $ | (3,585 | ) | $ | (15,567 | ) |
| Basic and Diluted income (loss) per share of common  stock: |       | $                     | 0.04       |                  | $          | (0.27 | ) | $ | (0.28 | ) | $ | (1.23 | ) |

 

F-14

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**4.   Discontinued Operations**

During the fourth quarterof fiscal 2006, the Company’s Board of Directors authorized management to beginmarketing for sale certain assets of two subsidiaries: StarGuide DigitalNetworks, Inc. and Corporate Computer Systems, Inc. Thesesubsidiaries made up our previously reported Product Sales Segment. The Companydetermined that these businesses were no longer consistent with our strategicbusiness goals. These assets include inventories, property and equipment andcertain intangible assets. The Company completed the sale of the assets of CorporateComputer Systems for a price of $425,000 in March 2007 and as ofDecember 31, 2006 has recorded a loss on sale of $1,163,000 ($698,000 netof tax benefit) related to this subsidiary. The sale of StarGuide is expectedto result in a gain which will be recognized if the sale is completed.

In accordance with the provisions of SFAS No. 144“Accounting for the Impairment or Disposal of Long-Lived Assets,” the financialdata for these businesses have been presented as discontinued operations. Theassets and liabilities of the discontinued operations are presented in theconsolidated balance sheet under the captions “Assets held for sale fromdiscontinued operations” and “Obligations of Discontinued Operations.”

Theunderlying assets and liabilities of the discontinued operations as ofDecember 31, 2006 and 2005 are as follows:

| ** **                        | ** ** | **December 31,**   | ** ** |
|-----------------------------------|------------|-------------------------|------------|
| ** **                        | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                        | ** ** | **(In thousands)** | ** ** |
| **Assets**                        |       |                    |       |   |   |
| Accounts receivable               |       | $                       | 376        |   | $ | 357 |   |
| Inventories                       |       | 316                     |       | 1,548 |   |
| Other current assets              |       | 19                      |       | 23 |   |
| Total current assets              |       | 711                     |       | 1,928 |   |
| Property and equipment,  net      |       | 7                       |       | 147 |   |
| Goodwill, net                     |       | 1,750                   |       | 1,750 |   |
| Intangible and other  assets, net |       | 118                     |       | 443 |   |
| Total noncurrent assets           |       | 1,875                   |       | 2,340 |   |
| **Liabilities**                   |       |                    |       |   |   |
| Accounts payable                  |       | $                       | 102        |   | $ | 197 |   |
| Accrued liabilities               |       | 43                      |       | 100 |   |
| Deferred revenue, net             |       | —                  |       | 729 |   |
| Total current liabilities         |       | 145                     |       | 1,026 |   |

 

F-15

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Operatingresults of the discontinued operations for the years ended December 31,2006, 2005 and 2004 were as follows:

| ** **                                                | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                | ** ** | **(in Thousands)**                     | ** ** |
| Revenues                                                  |       | $                                           | 3,983      |   | $ | 6,528 |   | $ | 8,796 |   |
| Cost of revenues                                          |       | (2,448                                      | )          | (3,159 | ) | (4,414 | ) |
| Operating expenses                                        |       | (2,074                                      | )          | (1,914 | ) | (10,563 | ) |
| Income/(loss) from  operations of discontinued operations |       | (539                                        | )          | 1,455 |   | (6,181 | ) |
| Income taxes (benefit)                                    |       | 209                                         |       | (572 | ) | 6,071 |   |
| Loss from disposition  net of tax benefit                 |       | (698                                        | )          | — |   | — |   |
| Income/(loss) on discontinued operations                  |       | $                                           | (1,028     | ) | $ | 883 |   | $ | 110 |   |

 

F-16

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**5.   Propertyand Equipment:**

Propertyand equipment as of December 31, 2006 and 2005 are summarized as follows(in thousands): 

| ** **                                      | ** ** | **December 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Network equipment                               |       |                        | $          | 25,862                      |       |   |   | $ | 20,397 |   |   |
| Office furniture  and equipment                 |       |                        | 6,581      |                        |       |   | 6,352 |   |   |
| Leasehold  improvements                         |       |                        | 549        |                        |       |   | 990 |   |   |
|                                            |       |                        | 32,992     |                        |       |   | 27,739 |   |   |
| Less accumulated  depreciation and amortization |       |                        | (20,163    | )                           |       |   | (16,245 | ) |   |
|                                            |       |                        | $          | 12,829                      |       |   |   | $ | 11,494 |   |   |

 

The Company incurredrestructuring charges of $0.4 million during the year ended December 31,2005. Restructuring charges relate to lease termination costs for redundantfacilities in New York and severance benefits paid or accrued to employeeshired in connection with the Broadcast acquisition, who were subsequentlyterminated.

**6.   Intangibleand Other Assets:**

In accordance with SFAS No. 142, the Companyperforms an annual impairment test of its goodwill. A two-step impairment testis used to first identify potential goodwill impairment and then measure theamount of goodwill impairment loss, if any.

In 2006, the Company engaged a third party to evaluatethe amount of goodwill and identifiable intangibles to record as a result ofthe acquisition of FastChannel Network, Inc. 

The Company has identified two reporting units, asdefined in SFAS No. 142, with goodwill, a digital distribution unit andSourceEcreative.

Goodwill totaled $65.5 million at December 31,2006 and $43.4 million at December 31, 2005. The changes in thecarrying value of goodwill by segment for the years ended December 31,2006 and 2005 are as follows (in thousands): 

| ** **                                      | ** ** | **Digital  Distribution** | ** ** | **SourceEcreative** | ** ** | **Total** | ** ** |
|-------------------------------------------------|------------|---------------------------|------------|---------------------|------------|-----------|------------|
| Balance at  December 31, 2004              |       |                      | $          | 32,569              |       |      |       | $ | — |   |   | $ | 32,569 |   |
| Finalization of  SourceEcreative acquisition    |       |                      | —     |                |       |      | 1,998      |   |   | 1,998 |   |
| Goodwill created by  acquisition of MDX         |       |                      | 8,830      |                |       |      | —     |   |   | 8,830 |   |
| Balance at  December 31, 2005              |       |                      | $          | 41,399              |       |      |       | $ | 1,998 |   |   | $ | 43,397 |   |
| Finalization of MDX  acquisition                |       |                      | 110        |                |       |      | —     |   |   | 110 |   |
| Goodwill created  by acquisition of FastChannel |       |                      | 22,038     |                |       |      | —     |   |   | 22,038 |   |
| Balance at  December 31, 2006              |       |                      | $          | 63,547              |       |      |       | $ | 1,998 |   |   | $ | 65,545 |   |

 

F-16

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Intangible assets as of December 31,2006, and December 31, 2005 are as follows (in thousands): 

| ** **                         | ** ** | **Amortization  Period** | ** ** | **Gross  Assets** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Assets** | ** ** |
|------------------------------------|------------|--------------------------|------------|-------------------|------------|-------------------------------|------------|-----------------|------------|
| ***December 31, 2006***       |       |                     |       |              |       |                          |       |            |       |   |   |   |   |
| Customer relationships             |       |                     | 10 years   |              |       | $                             | 21,902     |            |       | $ | (2,596 | ) |   | $ | 19,306 |   |
| Brand name                         |       |                     | 20 years   |              |       | 13,304                        |       |            | (2,907     | ) |   | 10,397 |   |
| On-line resource and  database     |       |                     | 3 years    |              |       | 724                           |       |            | (560       | ) |   | 164 |   |
| Software development  costs        |       |                     | 3-5 years  |              |       | 8,392                         |       |            | (3,147     | ) |   | 5,245 |   |
| Total Intangible Assets            |       |                     |       |              |       | 44,322                        |       |            | (9,210     | ) |   | 35,112 |   |
| Other assets                       |       |                     |       |              |       | 654                           |       |            | —     |   |   | 654 |   |
| Total Intangible and  Other Assets |       |                     |       |              |       | $                             | 44,976     |            |       | $ | (9,210 | ) |   | $ | 35,766 |   |
| ***December 31, 2005***       |       |                     |       |              |       |                          |       |            |       |   |   |   |   |
| Customer relationships             |       |                     | 10 years   |              |       | $                             | 7,393      |            |       | $ | (979 | ) |   | $ | 6,414 |   |
| Brand name                         |       |                     | 20 years   |              |       | 8,954                         |       |            | (2,351     | ) |   | 6,603 |   |
| On-line resource and  database     |       |                     | 3 years    |              |       | 724                           |       |            | (315       | ) |   | 409 |   |
| Software development  costs        |       |                     | 3-5 years  |              |       | 6,450                         |       |            | (1,993     | ) |   | 4,457 |   |
| Other licenses                     |       |                     | 9 years    |              |       | 359                           |       |            | —     |   |   | 359 |   |
| Total Intangible Assets            |       |                     |       |              |       | 23,880                        |       |            | (5,638     | ) |   | 18,242 |   |
| Other assets                       |       |                     |       |              |       | 815                           |       |            | —     |   |   | 815 |   |
| Total Intangible and Other Assets  |       |                     |       |              |       | $                             | 24,695     |            |       | $ | (5,638 | ) |   | $ | 19,057 |   |

 

Intangibleassets are amortized using the straight line method over the periods shownabove. Amortization expense related to intangible assets totaled $3.8, $2.3,and $1.0 million during the years ended December 31, 2006, 2005 and2004, respectively. The estimated aggregate future amortization expense forintangible assets remaining as of December 31, 2006 is as follows (inthousands): 

| 2007       |   | 4,860  |   |
|------------|--------|--------|--------|
| 2008       |   | 4,582  |   |
| 2009       |   | 4,284  |   |
| 2010       |   | 3,682  |   |
| 2011       |   | 3,575  |   |
| Thereafter |   | 14,129 |   |
|       |   | $      | 35,112 |   |
|            |        |        |        |  |

 

F-17

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**7.   AccruedLiabilities:**

Accruedliabilities consist of the following (in thousands): 

| ** **                                                            | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                            | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Interest payable                                                      |       | $                     | 507        |   | $ | 220 |   |
| Interest payable  to guarantor of MDX note payable (see Note 19) |       | 332                   |       | 103 |   |
| Lease obligations                                                     |       | 615                   |       | 147 |   |
| Telecommunications  liabilities                                       |       | 78                    |       | 109 |   |
| Employee  compensation                                                |       | 432                   |       | 329 |   |
| Royalties  obligations                                                |       | 935                   |       | 823 |   |
| Property tax  liabilities                                             |       | 148                   |       | 363 |   |
| Merger  liabilities                                                   |       | 2,220                 |       | — |   |
| Due to broker for  unsettled Point.360 trades                         |       | 1,149                 |       | — |   |
| Other                                                                 |       | 2,084                 |       | 1,146 |   |
|                                                                  |       | $                     | 8,500      |   | $ | 3,240 |   |

 

**8.   DeferredRevenue:**

Deferred revenue isprimarily from payments received for subscriptions and memberships withinSourceEcreative for which revenue is recognized ratably over the membership orsubscription period, generally less than one year. Deferred revenue was $1.1million and $0.5 at December 31, 2006 and 2005, respectively all of whichwas classified as current. Cash received from customers in 2006 forsubscriptions and memberships was $3.5 million. Amounts recognized asrevenue during 2006 was $3.7 million. The Company acquired $0.9 millionin deferred revenue from FastChannel.

**9.   Long-TermDebt:**

Long-termdebt as of December 31, 2006 and 2005 is summarized as follows (inthousands): 

| ** **                                         | ** ** | **December 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Term loan                                          |       |                        | $          | 19,600                      |       |   |   | $ | 12,500 |   |   |
| Revolving credit  facility                         |       |                        | —     |                        |       |   | 4,276 |   |   |
| Note Payable  issued to Seller for MDX acquisition |       |                        | —     |                        |       |   | 6,500 |   |   |
| Capital lease  obligations                         |       |                        | 240        |                        |       |   | 1,256 |   |   |
|                                               |       |                        | 19,840     |                        |       |   | 24,532 |   |   |
| Less current  portion                              |       |                        | (4,190     | )                           |       |   | (3,698 | ) |   |
|                                               |       |                        | $          | 15,650                      |       |   |   | $ | 20,834 |   |   |

 

In conjunction with the purchase of MDX, on April 15,2005, the Company amended its credit facility. As a result of this amendment,the Company wrote off approximately $0.3 million in previously deferredloan origination fees incurred during the three months ended June 30,2005. The amended credit facility provided for a $15.0 million revolvingline of credit as well as a $15.0 million term loan. All previousoutstanding debt was consolidated into the term loan effective as of theclosing date of the transaction. The amended term loan was scheduled to matureon March 31, 2008 and required quarterly principal payments of$1.25 million. The Company paid interest on borrowings at a variable ratebased on the lender’s 

F-18

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Prime Rate or LIBOR,plus an applicable margin. The applicable margin fluctuated based on theCompany’s leverage ratios as defined in the amended long-term credit agreement.At December 31, 2005, the loan interest rate was approximately 8.6%.

Under the amended long-term credit agreement, theCompany was required to maintain certain fixed charge coverage ratios, certainleverage ratios and minimum tangible net worth on a quarterly basis and wassubject to limitations on capital expenditures for a rolling twelve-monthperiod and limitations on capital lease borrowings on an annual basis. Otherthan its fixed charge coverage ratio, the Company was in compliance with thesecovenants for the period ended June 30, 2005. As of September 30,2005, the Company was not in compliance with one of its covenants related toits leverage ratio. On November 9, 2005, the Company received a waiverfrom its lenders as of September 30, 2005. In connection with securingthis waiver, certain other changes were made to the credit facility which,among other things, reduced the amount that could be borrowed under the Company’srevolving line of credit from $15.0 million to $4.5 million. As such,no additional amounts were available to be borrowed under the revolving line ofcredit at December 31, 2005. As of December 31, 2005, the Company wasnot in compliance with its loan covenants. Upon making this determination, theCompany agreed to seek a new lender.

On February 10, 2006, the Company entered into a$25.0 million Credit Agreement with Wachovia Bank, N.A. This revolving creditfacility replaced the Company’s prior senior secured credit facility. The newfacility provides that borrowings under the facility will bear interest atvarious rates, over the applicable base rate or over LIBOR. The new facility isnot subject to any borrowing base, contains customary debt to EBITDA leveragetests (EBITDA is defined as earnings before interest, taxes, depreciation andamortization) and minimum EBITDA tests, provides for customary events ofdefault, is guaranteed by all of the Company’s subsidiaries and is secured bysubstantially all of the assets of the Company and its subsidiaries other thanthe stock and assets of its subsidiary that owns the assets acquired from MDX.This loan was originally set to mature on February 10, 2008. In addition,in 2005, the Company wrote off approximately $0.7 million in previouslydeferred loan origination fees incurred for the prior credit facility.

On May 31, 2006, theCompany entered into an Amended and Restated Credit Agreement with WachoviaBank, N.A. The facility, as amended, provides for maximum indebtedness of $35.0million made up of a term loan for $20.0 million, and a revolving line ofcredit for $15.0 million, of which none is drawn as of December 31, 2006.Borrowings under the facility will continue to bear interest at various rates,over the applicable base rate or over LIBOR. The facility, as amended, is notsubject to any borrowing base, contains customary debt to EBITDA leverage testsand minimum EBITDA tests, provides for customary events of default, isguaranteed by all of the Company’s subsidiaries, including FastChannel, and issecured by substantially all of the assets of the Company and its subsidiaries,including FastChannel, but other than the stock and assets of its subsidiarythat owns the assets acquired from MDX. At December 31, 2006, the loan interestrate was approximately 7.4%. The Company pays quarterly a nominal commitmentfee for the unused portion of the revolving line of credit. The Company iscurrently in compliance with its covenants as of December 31, 2006.

F-19

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**10.   IncomeTaxes:**

Thecomponents of income from continuing operations before income taxes were: 

| ** **             | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------|------------|----------|------------|----------|------------|----------|------------|
| United States          |       | 2,040    |       | (2,741   | )          | 5,042    |       |
| Outside United  States |       | 717      |       | —   |       | —   |       |
| Total                  |       | 2,757    |       | (2,741   | )          | 5,042    |       |

 

Componentsof deferred tax assets at December 31, 2006 and 2005 are as follows (inthousands): 

| ** **                                         | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred Tax Assets                                |       |     |       |     |       |
| Net operating  loss carryforwards                  |       | $        | 29,818     |     | $          | 21,927 |   |
| Current temporary  differences                     |       | 2,290    |       | 829      |       |
| Other                                              |       | 5,397    |       | 294      |       |
| Total gross  deferred tax assets                   |       | 37,505   |       | 23,050   |       |
| Less valuation  allowance                          |       | (13,051  | )          | —   |       |
| Net deferred tax  assets after valuation allowance |       | $        | 24,454     |     | $          | 23,050 |   |
| Deferred Tax  Liabilities                          |       |     |       |     |       |
| Non-deductible  intangibles and fixed asset basis  |       | $        | (11,920    | )        | (4,850     | ) |
| Net deferred tax assets                            |       | $        | 12,534     |     | $          | 18,200 |   |

 

Componentsof the provision for income taxes are as follows (in thousands): 

| ** **           | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------|------------|----------|------------|----------|------------|----------|------------|
| Current:             |       |     |       |     |       |     |       |
| US Federal           |       | $        | 92         |     | $          | 18       |       | $ | 138 |   |
| State                |       | 197      |       | 11       |       | 85       |       |
| Foreign              |       | 82       |       |     |       |     |       |
|                 |       | 371      |       | 29       |       | 223      |       |
| Deferred:            |       |     |       |     |       |     |       |
| US Federal           |       | 1,063    |       | (697     | )          | 1,336    |       |
| State                |       | 68       |       | (100     | )          | 170      |       |
|                 |       | 1,131    |       | (797     | )          | 1,506    |       |
| Valuation  allowance |       | 876      |       | —   |       | —   |       |
|                 |       | $        | 2,378      |     | $          | (768     | )          | $ | 1,729 |   |

 

As of December 31, 2006, the Company’s currenttax liability was $0.1 million, primarily related to amounts due inforeign jurisdictions.

F-20

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

Incometax expense (benefit) differs from the amounts that would result from applyingthe federal statutory rate of 34% to the Company’s net income (loss) beforeincome taxes from continuing operations as follows (in thousands): 

| ** **                                                                     | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected tax  expense (benefit)                                                |       | $        | 937        |     | $          | (932     | )          | $ | 1,714 |   |
| State and foreign  income taxes, net of federal benefit                        |       | 207      |       | (88      | )          | 227      |       |
| Other  non-deductible items                                                    |       | 358      |       | 252      |       | (212     | )          |
| Utilization of  acquired deferred tax assets recorded as reduction to goodwill |       | —   |       | —   |       | 8,971    |       |
| Valuation allowance                                                            |       | 876      |       | —   |       | (8,971   | )          |
| Provision  (benefit) for income taxes                                          |       | $        | 2,378      |     | $          | (768     | )          | $ | 1,729 |   |

 

Net operating loss (NOL) carryforwards ofapproximately $88.0 million will expire on various dates ranging from 2011to 2025. Utilization of these carryforwards will be limited on an annual basisas a result of previous business combinations, pursuant to Section 382 ofthe Internal Revenue Code.

Generally accepted accounting principles require theCompany to record a valuation allowance against its deferred tax assets if itis “more likely than not” that the Company will not be able to utilize them inthe future. For the period from 2001 through 2004, the Company has utilized $20.0 millionin NOL carryforwards to offset its current tax liability. During 2004, theCompany concluded that realization of all tax benefits from NOL carryforwardsand other deferred tax assets was more likely than not. As a result, $9.0 millionof the valuation allowance for deferred tax assets was reversed related toacquired deferred tax assets and was recorded as a reduction to goodwill.

During 2006, the Companyhas recorded a valuation allowance of $0.9 million related to the deferred taxasset created as a result of the impairment charge recorded for its investmentin Verance. Additionally, the Company acquired approximately $33.7 million inNOL carryforwards in its acquisition of FastChannel and has maintained a full valuationallowance related to those NOL carryforwards. The Company will maintain a fullvaluation allowance on its acquired NOL carryforward until the Company’s taxposition can be completely assessed. In accordance with FAS 109, any futurereduction in the valuation allowance related to acquired deferred tax assetswill be recorded as a reduction to goodwill. Management believes that theresults of future operations will generate sufficient taxable income to realizethe benefits of all of its net deferred tax assets.

**11.   EmployeeBenefit Plan:**

The Company has a401(k) retirement plan for all U.S. based employees. Employees maycontribute up to a maximum dollar limit for 2006 of $15,000. In September 2006,the Company began matching 1% of gross pay for those employees contributing atleast 3% of their gross pay into the plan. Employees vest in the matchedcontribution after two years of employment. Employer contributions are fundedconcurrent with the employee contributions they matched. The Company madeapproximately$27,500 in matching contributions in 2006 to the plan and nomatching contributions in 2005 or 2004.

**12.   Stockholders’Equity:**

On May 26, 2006 the Company’s common stock was reversesplit on a 1-for-10 basis.

F-21

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**Warrants**

The Company hasissued warrants in connection with certain financing and leasing transactionsas well as through common stock offerings. All outstanding warrants areconvertible into common stock. The warrants outstanding at December 31,2006 expire on December 31, 2010. A summary of outstanding warrants at December 31,2006, 2005 and 2004 and changes during the years then ended follows (inthousands, except per share amounts): 

| ** **                            | ** ** | **2006**     | ** ** | **2005**                            | ** ** | **2004**     | ** ** |
|---------------------------------------|------------|--------------|------------|-------------------------------------|------------|--------------|------------|
| ** **                            | ** ** | **Warrants** | ** ** | **Wtd. Avg.  Exercise  Price** | ** ** | **Warrants** | ** ** | **Wtd. Avg.  Exercise  Price** | ** ** | **Warrants** | ** ** | **Wtd. Avg.  Exercise  Price** | ** ** |
| Outstanding at beginning  of the year |       |         | 708        |                                |       |         | $          | 11.56 |   |   |   | 738 |   |   |   | $ | 23.00 |   |   |   | 738 |   |   |   | $ | 23.00 |   |   |
| Canceled                              |       |         | (47        | )                                   |       |         | 33.45      |   |   |   | (30 | ) |   |   | 14.40 |   |   |   | — |   |   |   | — |   |   |
| Outstanding at end of the year        |       |         | 661        |                                |       |         | $          | 10.00 |   |   |   | 708 |   |   |   | $ | 11.56 |   |   |   | 738 |   |   |   | $ | 23.00 |   |   |

 

On June 24, 2004, the Company approved a proposalto extend the expiration date of certain fully-vested, outstanding warrants topurchase Common Stock of the Company held by Scott K. Ginsburg, Chairman andChief Executive Officer, and Omar A. Choucair, Chief Financial Officer, from March 31,2005 until March 20, 2008. The modification had no effect on the Company’sconsolidated financial statements but was included in the Company’s disclosureof pro forma net income (loss) and earnings (loss) per share under SFAS No. 123in Note 2 to these financial statements.

On December 21, 2005,Company approved a proposal to (i) extend the expiration date of certainfully-vested, outstanding warrants to purchase Common Stock of the Company heldby Scott K. Ginsburg, Chairman and Chief Executive Officer, and Omar A.Choucair, Chief Financial Officer, until December 31, 2010, and (ii) reducethe strike price of the warrants to $10.00 per share (split adjusted). Prior tothese modifications, Mr. Ginsburg held fully vested warrants as follows: (i) warrantto purchase 146,007 shares of Common Stock, strike price $32.50, with anexpiration date of December 20, 2006; (ii) warrant to purchase154,846 shares of Common Stock, strike price $32.50, with an expiration date ofFebruary 20, 2008: and (iii) warrant to purchase 350,973 shares ofCommon Stock, strike price $14.40, with an expiration date of March 20,2008. Prior to the approved modifications, Mr. Choucair held a fullyvested warrant to purchase 8,666 shares of Common Stock, strike price $14.40and an expiration date of March 20, 2008. The modification had no effecton the Company’s consolidated financial statements but was included in theCompany’s disclosure of pro forma net income (loss) and earnings (loss) pershare under SFAS No. 123 in Note 2 to these financial statements.

**13.   StockPlans:**

The Company has three stockincentive plans:

**1992 Stock OptionPlan**

Under the Company’s 1992Stock Option Plan, (the “1992 Plan”), the Company was permitted to issue up to14,950,000 shares of common stock to employees, officers, directors andconsultants. The exercise price and terms of the options granted were determinedby the Board of Directors, provided that such price could not be less than thefair value of the common stock on the date of grant for incentive stock optionsor, in the case of non-statutory options, less than 85 percent of the fairvalue of the common stock on the date of grant. The options generally vest overfour years. The 1992 Plan provided that, in the event of a change in control ofthe Company, executive officers of the Company would receive acceleratedvesting for a portion of its unvested option shares. The term of the optionsgranted is seven years. No options have been granted at less than fair valueunder this plan.  As of December 31,2006, the 1992 Plan has expired. As such, no shares are available for future grants.

F-22

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**1996 SupplementalOption Plan**

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

**1995 DirectorOption Plan**

Under the Company’s 1995Director Option Plan (the “Director Plan”), the Company could issue up to 800,000shares of common stock to non-employee directors. The Director Plan provided thateach future non-employee director of the Company would be automatically grantedan option to purchase 10,000 shares of common stock (the “First Option”) on thedate on which the optionee first became a non-employee director of the Companyand an additional option to purchase 2,500 shares of common stock (the “SubsequentOption”) on each anniversary date thereafter. The exercise price per share of alloptions granted under the Director Plan would be equal to the fair market valueof a share of the Company’s common stock on the date of grant. Shares subjectto the First Option vest over 36 months, and the Subsequent Option sharesvest over 12 months beginning with the month following the secondanniversary of its date of grant. The term of the options granted is ten years. As of December 31, 2006, theDirector Plan has expired and no shares are available for future grants.

**2006 Long-TermStock Incentive Plan**

The 2006 Long-Term Stock Incentive Plan (the “2006Plan”) has been adopted to replace the Company’s 1992 Stock Option Plan. Inaddition, because the Director Plan has expired recently, the 2006 Plan hasbeen prepared in a manner to enable stock awards to be granted to members ofour Board of Directors. When the 2006 Plan was approved by our stockholders,the 1992 Plan terminated and the shares identified above as remaining forfuture grants under the 1992 Plan ceased to be available for grants under the1992 Plan. The number of shares subject to the 2006 Plan is 1,100,000 shares.

A summary of theCompany’s fixed plan stock options at December 31, 2006 and the year thenended is presented below: 

| ** **                               | ** ** | **2006**   | ** ** |
|------------------------------------------|------------|------------|------------|
| ** **                               | ** ** | **Shares** | ** ** | **Wtd. Avg.  Exercise  Price** | ** ** |
| Outstanding at  beginning of the year    |       | 318,216    |       |   | $ | 22.46 |   |   |
| Granted                                  |       | 306,000    |       |   | $ | 5.82 |   |   |
| Exercised                                |       | (2,404     | )          |   | $ | 9.67 |   |   |
| Canceled                                 |       | (49,636    | )          |   | $ | 43.75 |   |   |
| Outstanding at end  of the year          |       | 572,176    |       |   | $ | 11.71 |   |   |
| Exercisable at end  of the year (vested) |       | 268,488    |       |   | $ | 17.93 |   |   |

 

The following tablesummarizes information about stock options outstanding at December 31,2006: 

| **Options Outstanding**                | ** ** | **Options Exercisable** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|
| **Range of Exercise Prices** | ** ** | ** **                   | ** ** | **Number  Outstanding** | ** ** | **Weighted-  Average  Remaining  Contractual Life** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
| $5.00   -  $9.99                  |       |                         | 326,755    |   |   |   | 3.10 years |   |   |   | $ | 6.01 |   |   |   | 34,922 |   |   |   | $ | 7.34 |   |   |
| $10.00 - $12.49                             |       |                         | 61,853     |   |   |   | 2.87 years |   |   |   | $ | 11.33 |   |   |   | 56,175 |   |   |   | $ | 11.24 |   |   |
| $12.50 - $15.00                             |       |                         | 48,500     |   |   |   | 2.36 years |   |   |   | $ | 12.92 |   |   |   | 45,255 |   |   |   | $ | 12.92 |   |   |
| $20.00 - $50.00                             |       |                         | 135,068    |   |   |   | 2.44 years |   |   |   | $ | 25.26 |   |   |   | 132,136 |   |   |   | $ | 25.28 |   |   |
| $5.30   - $43.80                  |       |                         | 572,176    |   |   |   |   |   |   |   |   |   |   |   | 268,488 |   |   |   |   |   |   |

 

As of December 31, 2006, there were 1,097,500shares available for future grant under the stock option plans.

F-23

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

The weightedaverage fair value per share of options granted during the year was $4.03,$5.10 and $6.40 for the years ended December 31, 2006, 2005 and 2004, respectively.

The total intrinsicvalue of options exercised was approximately $7,000, $1,000, and $407,000during the years ended December 31, 2006, 2005 and 2004, respectively.

The aggregateintrinsic value of options outstanding at December 31, 2006 wasapproximately $2,600,000. The aggregate intrinsic value of options vested atDecember 31, 2006 was approximately $366,000.

The fair value ofeach option was estimated on the date of grant using the Black-Scholes optionpricing model with the following weighted average assumptions:

| ** **                                          | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Number of options  granted                          |       | 306,000  |       | 9,000    |       | 22,250   |       |
| Weighted average  exercise price of options granted |       | $        | 5.82       |     | $          | 10.87    |       | $ | 12.79 |   |
| Volatility(1)                                       |       | 86       | %          | 76       | %          | 83       | %          |
| Risk free interest  rate(2)                         |       | 4.4      | %          | 4.0      | %          | 3.5      | %          |
| Expected term (years)(3)(4)                         |       | 4.8      |       | 5.5      |       | 4.8      |       |
| Expected annual dividends                           |       | None     |       | None     |       | None     |       |
|                                                     |            |          |            |          |            |          |            |  |  |  |

----

(1)   Expectedvolatility is based on historical volatility of our stock over a precedingperiod commensurate with the expected term of the award.

(2)   The riskfree rate for periods within the contractual term of the stock is based on theU.S. Treasury yield curve in effect at the time of grant.

(3)   Theexpected term for 2006 is calculated as the average between the vesting termand the contractual term, weighted by tranche, pursuant to SAB No. 107.

(4)   The Company assumes a forfeiture rate of zero in its fair valuecalculations due to minimal turnover in holders of options in its workforce.

**14.   Commitmentsand Contingencies:**

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

The table belowsummarizes the Company’s contractual obligations, including estimated interest,at December 31, 2006 (in thousands): 

| ** **                          | ** ** | ** ** | ** ** | **Payments Due by Period** | ** ** |
|-------------------------------------|------------|------------|------------|-------------------------------------------|------------|
| **Contractual Obligation**     | ** ** | **Total**  | ** ** | **Less Than  1 Year**           | ** ** | **1-3  Years** | ** ** | **4-5  Years** | ** ** | **After 5  Years** | ** ** |
| Long-Term Debt                      |       | $          | 23,217     |                                      |       | $ | 5,258 |   |   | $ | 15,313 |   | $ | 2,646 |   |   | $ | — |   |   |
| Capital Leases                      |       | 240        |       |                                      | 240        |   |   | — |   | — |   |   | — |   |   |
| Operating Leases                    |       | 11,685     |       |                                      | 2,810      |   |   | 7,300 |   | 1,575 |   |   | — |   |   |
| Employment contracts                |       | 2,126      |       |                                      | 1,004      |   |   | 1,122 |   | — |   |   | — |   |   |
| Unconditional Purchase  Obligations |       | 5,947      |       |                                      | 2,246      |   |   | 3,701 |   | — |   |   | — |   |   |
| Total Contractual Cash Obligations  |       | $          | 43,215     |                                      |       | $ | 11,558 |   |   | $ | 27,436 |   | $ | 4,221 |   |   | $ | — |   |   |

 

The present value of obligations under capital leasewas $227 of which $240 is classified as a current liability.

Rent expense totaled $3,411, $2,675 and $2,422 in2006, 2005 and 2004, respectively.

As of December 31,2006, the Company has non-cancelable future minimum purchase commitments withits telephone and satellite service providers of approximately $2,246 for 2007,$1,247 for 2008, $1,534 for 2009, and $920 for 2010.

F-24

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

On February 2, 2006, a subsidiary of the Companyinitiated an arbitration proceeding against Pathfire, Inc. Our subsidiaryseeks unspecified damages suffered due to Pathfire’s alleged breach andwrongful termination of a Technology License and Services Agreement betweenPathfire and Media DVX, Inc., which agreement was acquired by oursubsidiary in April 2005. Pathfire has asserted a breach of contractcounterclaim against our subsidiary and seeks damages in the approximate amountof $387,000. A hearing is scheduled for May 2007, at which the arbitrator isexpected to decide whether Pathfire is liable for breaching an exclusivity andnon-competition clause in the agreement. Discovery is in progress.

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

**15.   NetIncome (Loss) Per Share:**

Under SFAS No. 128, “Earnings per Share,” theCompany is required to compute earnings per share under two different methods(basic and diluted). Basic earnings per share is calculated by dividing netincome (loss) attributable to common shareholders by the weighted averageshares of common stock outstanding during the period. Diluted earnings pershare is calculated by dividing net income attributable to common shareholdersby the weighted average shares of outstanding common stock and common stockequivalents during the period.

A reconciliation ofnet income (loss) per basic and diluted share for the three years ended December 31,2006 follows (in thousands, except per share amounts): 

| ** **                                                               | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                               | ** ** | **2006**              | ** ** | **2005** | ** ** | **2004** | ** ** |
| Basic:                                                                   |       |                  |       |   |   |   |   |
| Net income (loss) from  continuing operations                            |       | $                     | 379        |   | $ | (1,973 | ) | $ | 3,314 |   |
| Net income (loss) from  discontinued operations                          |       | $                     | (1,028     | ) | $ | 883 |   | $ | (110 | ) |
| Net income (loss)                                                        |       | $                     | (649       | ) | $ | (1,090 | ) | $ | 3,204 |   |
| Weighted average shares  outstanding                                     |       | 10,568                |       | 7,378 |   | 7,277 |   |
| Basic net income (loss)  from continuing operations per   common share   |       | $                     | 0.04       |   | $ | (0.27 | ) | $ | .46 |   |
| Basic net income (loss)  from discontinued operations per common share   |       | $                     | (0.10      | ) | $ | 0.12 |   | $ | (0.02 | ) |
| Basic net income (loss)  per common share                                |       | $                     | (0.06      | ) | $ | (0.15 | ) | $ | 0.44 |   |
| Diluted:                                                                 |       |                  |       |   |   |   |   |
| Weighted average shares  outstanding                                     |       | 10,568                |       | 7,378 |   | 7,277 |   |
| Add: Net effect of  potentially dilutive shares                          |       | —                |       | — |   | 53 |   |
| Total shares                                                             |       | 10,568                |       | 7,378 |   | 7,330 |   |
| Diluted net income  (loss) from continuing operations per common share   |       | $                     | 0.04       |   | $ | (0.27 | ) | $ | 0.46 |   |
| Diluted net income  (loss) from discontinued operations per common share |       | $                     | (0.10      | ) | $ | 0.12 |   | $ | (0.02 | ) |
| Diluted net income (loss) per common share                               |       | $                     | (0.06      | ) | $ | (0.15 | ) | $ | 0.44 |   |

 

F-25

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

**16.   UnauditedQuarterly Financial Information (in thousands, expect per share amounts)**

| ** **                                                      | ** ** | **Quarter Ended**   | ** ** |
|-----------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                      | ** ** | **March 31,  2006** | ** ** | **June 30,  2006** | ** ** | **September 30,  2006** | ** ** | **December 31,  2006** | ** ** |
| Revenues                                                        |       |                     | $          | 13,034 |   |   | $ | 15,124 |   |   | $ | 18,769 |   |   |   | $ | 21,740 |   |   |
| Gross profit                                                    |       |                     | 6,312      |   |   | 7,578 |   |   | 9,394 |   |   |   | 12,061 |   |   |
| Net income (loss) from  continuing operations                   |       |                     | 632        |   |   | 1,060 |   |   | (4,426 | ) |   |   | 3,113 |   |   |
| Net income (loss) from  discontinued operations                 |       |                     | 118        |   |   | 32 |   |   | (54 | ) |   |   | (1,124 | ) |   |
| Net income (loss)                                               |       |                     | $          | 750 |   |   | $ | 1,092 |   |   | $ | (4,480 | ) |   |   | $ | 1,989 |   |   |
| Basic earnings (loss)  per share from continuing operations     |       |                     | $          | 0.08 |   |   | $ | 0.12 |   |   | $ | (0.35 | ) |   |   | $ | 0.24 |   |   |
| Basic earnings (loss)  per share from discontinued operations   |       |                     | $          | 0.02 |   |   | $ | 0.00 |   |   | $ | (0.00 | ) |   |   | $ | (0.09 | ) |   |
| Basic earnings (loss)  per share                                |       |                     | $          | 0.10 |   |   | $ | 0.12 |   |   | $ | (0.35 | ) |   |   | $ | 0.15 |   |   |
| Diluted earnings (loss)  per share from continuing operations   |       |                     | $          | 0.08 |   |   | $ | 0.12 |   |   | $ | (0.35 | ) |   |   | $ | 0.24 |   |   |
| Diluted earnings (loss)  per share from discontinued operations |       |                     | $          | 0.02 |   |   | $ | 0.00 |   |   | $ | (0.00 | ) |   |   | $ | (0.09 | ) |   |
| Diluted earnings (loss) per share                               |       |                     | $          | 0.10 |   |   | $ | 0.12 |   |   | $ | (0.35 | ) |   |   | $ | 0.15 |   |   |

 

| ** **                                                      | ** ** | **Quarter Ended**   | ** ** |
|-----------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                      | ** ** | **March 31,  2005** | ** ** | **June 30,  2005** | ** ** | **September 30,  2005** | ** ** | **December 31,  2005** | ** ** |
| Revenues                                                        |       |                     | $          | 13,638 |   |   | $ | 13,555 |   |   | $ | 11,591 |   |   |   | $ | 13,040 |   |   |
| Gross profit                                                    |       |                     | 5,611      |   |   | 5,018 |   |   | 3,648 |   |   |   | 5,363 |   |   |
| Net income (loss) from  continuing operations                   |       |                     | 471        |   |   | (577 | ) |   | (1,054 | ) |   |   | (808 | ) |   |
| Net income (loss) from  discontinued operations                 |       |                     | 652        |   |   | (227 | ) |   | (218 | ) |   |   | (216 | ) |   |
| Net income (loss)                                               |       |                     | $          | 1,125 |   |   | $ | (350 | ) |   | $ | (841 | ) |   |   | $ | (1,024 | ) |   |
| Basic earnings (loss)  per share from continuing operations     |       |                     | $          | 0.06 |   |   | $ | (0.08 | ) |   | $ | (0.14 | ) |   |   | $ | (0.11 | ) |   |
| Basic earnings (loss)  per share from discontinued operations   |       |                     | $          | 0.09 |   |   | $ | 0.03 |   |   | $ | 0.03 |   |   |   | $ | (0.03 | ) |   |
| Basic earnings (loss)  per share                                |       |                     | $          | 0.15 |   |   | $ | (0.05 | ) |   | $ | (0.11 | ) |   |   | $ | (0.14 | ) |   |
| Diluted earnings (loss)  per share from continuing operations   |       |                     | $          | 0.06 |   |   | $ | (0.08 | ) |   | $ | (0.14 | ) |   |   | $ | (0.11 | ) |   |
| Diluted earnings (loss)  per share from discontinued operations |       |                     | $          | 0.09 |   |   | $ | 0.03 |   |   | $ | 0.03 |   |   |   | $ | (0.03 | ) |   |
| Diluted earnings (loss) per share                               |       |                     | $          | 0.15 |   |   | $ | (0.05 | ) |   | $ | (0.11 | ) |   |   | $ | (0.14 | ) |   |

 

**17.   Segment Information:**

The Companyoperates predominantly in two industry segments: digital and physicaldistribution of audio and video content and broadcast business intelligence andcreative research services (“SourceEcreative”). The Company has defined itsreportable segments based on internal financial reporting used for corporatemanagement and decision-making purposes. The information in the followingtables is derived directly from the segments’ internal financial reporting usedfor corporate management purposes (in thousands). 

| ** **                             | ** ** | **Year ended December 31, 2006** | ** ** |
|----------------------------------------|------------|------------------------------------------------------|------------|
| ** **                             | ** ** | **Audio and Video**                        | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Content  Distribution**                            | ** ** | **SourceEcreative** | ** ** | **Consolidated  Totals** | ** ** |
| Revenues                               |       |                                                 | $          | 64,911 |   |   |   | $ | 3,756 |   |   |   | $ | 68,667 |   |   |
| Depreciation and  amortization expense |       |                                                 | 8,162      |   |   |   | 401 |   |   |   | 8,563 |   |   |
| Operating income                       |       |                                                 | $          | 8,624 |   |   |   | $ | 1,677 |   |   |   | $ | 10,301 |   |   |
| Total assets                           |       |                                                 | $          | 171,091 | (a) |   |   | $ | 4,492 |   |   |   | $ | 175,583 |   |   |

 

F-26

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

 

| ** **                             | ** ** | **Year ended December 31, 2005** | ** ** |
|----------------------------------------|------------|------------------------------------------------------|------------|
| ** **                             | ** ** | **Audio and Video **                  | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Content   Distribution**                      | ** ** | **SourceEcreative** | ** ** | **Consolidated  Totals** | ** ** |
| Revenues                               |       |                                                 | $          | 49,971 |   |   |   | $ | 1,853 |   |   |   | $ | 51,824 |   |   |
| Depreciation and  amortization expense |       |                                                 | 5,954      |   |   |   | 394 |   |   |   | 6,348 |   |   |
| Operating income (loss)                |       |                                                 | $          | (37 | ) |   |   | $ | 286 |   |   |   | $ | 249 |   |   |
| Total assets                           |       |                                                 | $          | 110,643 | (a) |   |   | $ | 3,690 |   |   |   | $ | 114,333 |   |   |

 

| ** **                             | ** ** | **Year ended December 31, 2004** | ** ** |
|----------------------------------------|------------|------------------------------------------------------|------------|
| ** **                             | ** ** | **Audio and Video**                        | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Content   Distribution**                      | ** ** | **SourceEcreative** | ** ** | **Consolidated   Totals** | ** ** |
| Revenues                               |       |                                                 | $          | 52,970 |   |   |   | $ | 600 |   |   |   | $ | 53,570 |   |   |
| Depreciation and  amortization expense |       |                                                 | 5,019      |   |   |   | 124 |   |   |   | 5,143 |   |   |
| Operating income (loss)                |       |                                                 | $          | 6,245 |   |   |   | $ | 81 |   |   |   | $ | 6,326 |   |   |
| Total assets                           |       |                                                 | $          | 102,694 | (a) |   |   | $ | 4,533 |   |   |   | $ | 107,227 |   |   |

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(a)    Net of intersegment elimination which relateto intercompany receivables and payables that occur when one operating segmentpays costs that are related to another operating segment.

**18.   New Accounting Pronouncements:**

In September 2006,the SEC staff published Staff Accounting Bulletin (“SAB”) No. 108, *“*Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements.” SAB No. 108 addresses quantifying the financial statementeffects of misstatements, specifically, how the effects of prior yearuncorrected errors must be considered in quantifying misstatements in thecurrent year financial statements. SAB No. 108 is effective for fiscalyears ending after November 15, 2006. The adoption of SAB No. 108 bythe Company in the fourth quarter of 2006 is discussed in Note 2 to thefinancial statements.

In December 2004, theFASB issued SFAS No. 123R “Share Based Payment.” SFAS No. 123R is arevision to SFAS 123 and supersedes APB Opinion No. 25 and amends FASBStatement No. 95, “Statement of Cash Flows.” SFAS No. 123R requires apublic entity to expense the cost of employee services received in exchange foran award of equity instruments. It provides guidance on valuing and expensingthese awards, as well as disclosure requirements of these equity arrangements.SFAS No. 123R also requires the benefits of tax deductions in excess ofrecognized compensation cost to be reported as a financing cash flow, rather thanas an operating cash flow as required under current literature. Thisrequirement reduces net operating cash flows and increases net financing cashflows in periods after adoption. SFAS No. 123R permits an issuer to useeither a prospective or one of two modified versions of retrospectiveapplication under which financial statements for prior periods are adjusted ona basis consistent with the pro forma disclosures required for those periods bythe original SFAS No. 123. As modified by the SEC on April 15, 2005,SFAS No. 123R is effective for the first annual or interim reportingperiod of the registrant’s first fiscal year that begins after June 15,2005. The Company has implemented this pronouncement effective at the beginningof the fiscal year ended December 31, 2006.

In December 2004, theFASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets, an amendmentof APB Opinion No. 29.” SFAS No. 153 is based on the principle thatexchanges of nonmonetary assets should be measured based on the fair value ofthe assets exchanged. APB Opinion No. 29, “Accounting for NonmonetaryTransactions,” provided an exception to its basic measurement principle (fairvalue) for exchanges of similar productive assets. Under APB OpinionNo. 29, an exchange of a productive asset for a similar productive assetwas based on the recorded amount of the asset relinquished. SFAS No. 153eliminates this exception and replaces it with an exception for exchanges ofnonmonetary assets that do not have commercial substance. SFAS No. 153became effective for the Company as of July 2, 2005, and did not have amaterial impact on our consolidated financial statements.

In May 2005, the FASBissued SFAS No. 154, “Accounting Changes and Error Corrections, areplacement of Accounting Principles Board (“APB”) Opinion No. 20 and FASBStatement No. 3.” SFAS 

F-27

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)**

No. 154requires retrospective application to prior periods’ financial statements of avoluntary change in accounting principle unless it is impracticable. APBOpinion No. 20, “Accounting Changes,” previously required that mostvoluntary changes in accounting principle be recognized by including in netincome of the period of the change the cumulative effect of changing to the newaccounting principle. SFAS No. 154 became effective for the Company on January 1,2006. The adoption of SFAS No. 154 did not have a material impact on ourconsolidated financial statements.

In September 2006,the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157defines fair value, establishes a framework for measuring fair value andexpands disclosure requirements about fair value measurements. SFASNo. 157 is effective for the Company on January 1, 2008. We believethat the adoption of SFAS No. 157 will not have a material impact on ourconsolidated financial statements.

In February 2007, theFASB issued SFAS No. 159, “The Fair Value Option for Financial Assets andFinancial Liabilities—Including an amendment of FASB Statement No. 115.”SFAS No. 159 permits entities to choose to measure many financialinstruments and certain other items at fair value. Unrealized gains and losseson items for which the fair value option has been elected will be recognized inearnings at each subsequent reporting date. SFAS No. 159 is effective forthe Company on January 1, 2008. The Company is evaluating the impact thatthe adoption of SFAS No. 159 will have on our consolidated financialstatements.

In July 2006, theFASB issued FASB Interpretation No. 48, “Accounting for Uncertainty inIncome Taxes” (“Interpretation No. 48”). Interpretation No. 48clarifies the accounting for uncertainty in income taxes recognized in anenterprise’s financial statements in accordance with SFAS No. 109,“Accounting for Income Taxes.” Interpretation No. 48 prescribes arecognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return. Interpretation No. 48 also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition. For the Company, Interpretation No. 48was effective beginning January 1, 2007, and the cumulative effectadjustment, if any, will be recorded in the first quarter of 2007. We believethat the adoption of Interpretation No. 48 will not have a material impacton our consolidated financial statements.

**19.   Related Party Transaction**

In connection with theCompany’s acquisition of MDX, a $6.5 million promissory note was issued tothe seller of Media DVX and was payable over three years with an interest rateof the one month LIBOR rate for the applicable period with principal and thenaccrued interest due as follows: $1.5 million due on April 15, 2006,$2.0 million due on April 15, 2007, and $3.0 million due on April 15,2008. However, during the fourth quarter of 2006, the Company retired theentire remaining balance of this obligation through a combination of issuingcommon stock and cash. The Company paid accrued interest on the promissory noteon a quarterly basis. The promissory note was personally guaranteed byScott K. Ginsburg, the Company’s Chief Executive Officer and Chairman ofthe Board. Mr. Ginsburg’s personal guarantee of the Company’s debt wasevaluated for the purpose of determining an amount to compensate him for suchguarantee. The Company obtained an independent valuation which determined thatthe improved interest rate obtained by the Company as a direct result of thepersonal guarantee was worth approximately $0.6 million over the term ofthe loan. For the years ended December 31, 2006 and 2005 respectively, theCompany has recognized additional interest expense of $0.3 million and $0.1 millionassociated with the guarantee.

**20.   Subsequent Event**

On March 1, 2007, the Company completed its saleof Corporate Computer Systems, Inc. and proceeds of $425,000 were receivedin cash. Note 4 describes how this subsidiary is reflected in these financialstatements as discontinued operations.

F-28

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**DG FASTCHANNEL, INC. AND SUBSIDIARIES SCHEDULE II—VALUATION AND QUALIFYING ACCOUNTS(in thousands)**

| **Classification**               | ** ** | ** ** | ** ** | **Balance at  Beginning of  Period** | ** ** | **Additions  Charged to  Operations** | ** ** | **Acquired** | ** ** | **Write-offs** | ** ** | **Balance at  End of Period** | ** ** |
|----------------------------------|------------|------------|------------|------------------------------------------------|------------|--------------------------------------------|------------|--------------|------------|----------------|------------|----------------------------------------------|------------|
| *Allowance for Doubful Accounts* |       |       |       |                                           |       |                                       |       |         |       |           |       |                                         |       |   |   |   |   |   |   |   |   |
| Year Ended:                      |       |       |       |                                           |       |                                       |       |         |       |           |       |                                         |       |   |   |   |   |   |   |   |   |
| December 31,  2004          |       |       | $          | 507                                            |       |                                       |       | 262          |       |           |       | 157                                          |       |   |   | (504 | ) |   |   | $ | 422 |   |   |
| December 31,  2005          |       |       | $          | 422                                            |       |                                       |       | 343          |       |           |       | —                                       |       |   |   | (274 | ) |   |   | $ | 491 |   |   |
| December 31, 2006           |       |       | $          | 491                                            |       |                                       |       | 789          |       |           |       | 199                                          |       |   |   | (433 | ) |   |   | $ | 1,046 |   |   |

 

S-1

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