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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549



FORM 10-K/A



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

For The Fiscal Year Ended December 31, 2002



OR



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

For the Transition Period From  to
.



COMMISSION FILE NUMBER: 0-27644



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Digital Generation Systems, Inc.

(Exact Name of Registrant as Specified in its Charter)



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



750 West John
Carpenter Freeway, Suite 700

Irving, Texas 75039

(Address Of Principal Executive Offices, Including Zip Code)



(972) 581-2000

(Registrants Telephone Number, Including Area Code)



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

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



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



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



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



The aggregate market value of the Common Stock held by non-affiliates of the
registrant, based upon the closing sale price of the Common Stock on June 28, 2002, as reported on the Nasdaq National Market, was approximately $36.4 million. Shares of Common Stock held by each officer and director of the registrant and by each
person who may be deemed to be an affiliate have been excluded. This determination of affiliate status is not necessarily a conclusive determination for other purposes.



As of March 17, 2003, the registrant had 70,815,696 shares of Common Stock outstanding.



DOCUMENTS INCORPORATED BY REFERENCE



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

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Purpose of Amendment



The purpose for this Amendment No. 2 to the Companys Annual Report on Form 10-K is to restate income tax expense for fiscal 2002 in
the Companys financial statements by recording reductions in the Companys valuation allowance for deferred tax assets as a reduction of goodwill rather than as a deferred tax benefit. This Amendment No. 2 reflects only the revisions
necessary for such restatement. However, for the readers convenience, the Company has restated the entire Form 10-K, including Items 10, 11, 12 and 13 which were included in Amendment No. 1. Item 1, 2, 3, 4, 4A, 5, 7A, 9, 10, 11, 12, 13, and
14 remain unchanged from the original filing and Amendment No. 1



DIGITAL GENERATION SYSTEMS, INC.



The discussion in this Report
contains forward-looking statements that involve risks and uncertainties. The statements contained in this Report that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Words such as anticipates, believes, plans, expects, future, intends, and similar expressions are
used to identify forward-looking statements. All forward-looking statements included in this document are based on information available to the Company on the date hereof, and we assume no obligation to update any such forward-looking statements,
except as required by law. The Companys actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those discussed in Managements
Discussion and Analysis of Financial Condition and Results of OperationsCertain Business Considerations as well as those discussed elsewhere in this Report, and the risks discussed in the Companys other United States Securities and
Exchange Commission filings.



TABLE OF CONTENTS



|PART I        
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|PART II       
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|PART III      
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|ITEM 12.      
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|ITEM 13.      
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|ITEM 14.      
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|PART IV       
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|ITEM 15.      
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|SIGNATURES    
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|CERTIFICATIONS





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DIGITAL GENERATION SYSTEMS, INC.



PART I



ITEM 1. BUSINESS



General



Digital Generations Systems, Inc., incorporated in 1991, offers a suite of
digital technology products and services through Digital Generation Systems, Inc. (DGS) and its wholly owned subsidiary StarGuide Digital Networks, Inc. (StarGuide). Through DGS, the Company operates a nationwide digital
network out of its Network Operation Center (NOC) located in Irving, Texas. The network beneficially links hundreds of advertisers and advertising agencies with more than 7,500 radio and 1,000 television stations across the United States
and Canada. Through the NOC, the Company delivers audio, video, image and data content that comprise transactions between the advertising and broadcast industries. Through StarGuide, the Company develops and sells proprietary digital software,
hardware and communications technology, including various bandwidth satellite receivers, audio compression codes and software to operate integrated digital multimedia networks, and offers related engineering consulting services.



In January 2001, the Company completed its merger with StarGuide pursuant to
the Agreement and Plan of Merger by and among DGS, SG Nevada Merger Sub Inc., a wholly owned subsidiary of DGS, and StarGuide. The merger has been accounted for as a reverse acquisition, and accordingly, historical results of the Company prior to
the merger are those of StarGuide, and DGS results of operations have been included subsequent to January 1, 2001. Upon the completion of the merger, each share of StarGuide common stock converted into the right to receive 1.7332 shares of
common stock of the Company. Under the merger agreement, StarGuides options and warrants were assumed by the Company based on the same exchange ratio.



On March 7, 2001, the Company completed its purchase of the 50% interest in Musicam Express L.L.C. (Musicam), previously owned by Westwood
One, Inc. and Infinity Broadcasting Corporation, in exchange for 690,000 shares of common stock plus the assumption of outstanding bank debt and other liabilities of Musicam.



Industry Background



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



While many radio and television broadcasters now embrace digital technology for much of their production processes and in-station media management, current methods for the distribution of audio and video advertising
content are based primarily on the manual duplication and physical delivery of analog tapes. According to industry sources, there are approximately 10,000 commercial radio and 1,100 commercial television stations in the United States. These stations
generate revenue by selling airtime to advertisers. Advertising is most frequently produced under the direction of advertising agencies for large national or regional advertisers or by station personnel for local advertisers. Advertising is
characterized as network or spot, depending on how it is bought and distributed. Network advertising typically is delivered to stations as part of a network feed (bundled with network programming), while spot
advertising is delivered to stations independently of other programming content.



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



The predominant method for distributing spot advertisements to radio and television stations traditionally has been physical
delivery of analog audio or videotapes. The Company estimates that approximately 35% of radio spots and more than 60% of video spots are delivered by air express services. Many companies, commonly known as dub and ship houses, are in the



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business of duplicating audio and video tapes, assembling them according to agency-specified bills of material and
packing them for air express delivery. The Company estimates that it has transitioned approximately 55% of the market for audio spot deliveries and approximately 20% of video spot deliveries, to digital distribution.



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



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



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



Products and Services



The Company
currently markets and provides its products and services through DGS and StarGuide.



DGS provides electronic and physical distribution of and ancillary post-production services for broadcast commercial content to advertising agencies, production studios, and broadcast stations throughout the United
States and Canada. DGS operates a digital network, currently serving approximately 7,500 radio and 1,000 television stations, controlled through its NOC. This network enables the rapid, cost-effective, and reliable electronic transmission of audio
and video spots and other content and provides a high level of quality, accountability, and flexibility to both advertisers and broadcasters. With the DGS network, transmissions are automatically routed to stations through a computerized on-line
transaction and delivery system and arrive, in text format, at stations in as little as one hour after an order is received. Typically, associated traffic instructions are simultaneously transmitted by facsimile to minimize station handling and
scheduling errors. Shortly after a spot is delivered to a station, DGS sends the customer a confirmation specifying the time of delivery. Additionally, DGS digital network delivers close to master quality audio or video to
broadcast stations, which is equal to or superior to that currently delivered on analog tape.



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



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



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



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



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



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



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



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



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



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



The core of the StarGuide transmission system is StarGuides patented MX3 Multiplexer and the StarGuide Receiver. The MX3 Multiplexer can accept up to 120 simultaneous digital, audio, video, or data services in
various digital formats. The MX3 Multiplexer then breaks up these differing digital service streams and re-orders and consolidates the various data streams into a single data stream. The system can then cost-effectively transmit this data stream in
a single transmission signal, via satellites or



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other wired or wireless communications vehicles. The MX3 Multiplexer does so in a highly efficient manner, resulting in
less consumption of costly bandwidth capacity on the satellites than other transmission systems on the market, such as DVB systems.



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



Current StarGuide receiver insertion cards include:



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



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



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



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



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



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



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



Markets and Customers



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



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



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Sales, Marketing and Customer Service



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



Internet/E-Commerce Strategy. In 2002, DGS introduced Open Interface,
an industry first that allows agency traffic systems to interface directly with DGS order management system, reducing duplicate entry of information. In 2001, DGS introduced AdCatalog, a web-based asset management system that allows
geographically dispersed marketing groups the ability to view and request distribution for corporate broadcast commercial content. Additionally, DGS introduced Netclear, a web-based system that allows brand advertisers, advertising agencies and
broadcasters the ability to approve spots for network clearance. DGS estimates that approximately 50% of its orders were entered electronically via the Internet during 2002 compared to 30% during 2001. In addition, DGS also offers its DG Upload
service that allows audio content to be received from clients via the Internet.



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



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



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



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



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



Customer Service. DGS approach to customer service is based on a model designed to provide focused support from key market centered offices, located in Los Angeles, Dallas, Chicago and New York. Clients work with specific,
assigned account coordinators to place production service and distribution orders. National distribution orders are electronically routed to the NOC for electronic distribution or, for off-line destinations, to DGS national duplication center
in Louisville, Kentucky. DGS distributed service approach provides direct support in key market cities enabling DGS to develop closer relationships with clients



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as well as the ability to support client needs for local production services. DGS also maintains a customer service team
dedicated to supporting the needs of radio, television, and network stations. This support is available 7 days a week, 24 hours a day, to respond to station requests for information, traffic instructions or additional media. Providing direct support
alleviates the need for client traffic departments to deal with individual stations or the challenges of staffing for off-hours support. DGS customer service operation centers are linked to DGS order management and media storage systems,
and national distribution network. These resources enable DGS to manage the distribution of client orders to the fulfillment location best suited to meet critical customer requirements as well as providing order status and fulfillment confirmation.
This distributed model also provides DGS with significant redundancy and re-route capability, enabling DGS to meet customer needs when weather or other conditions prevent deliveries using traditional courier services.



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



Competition



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



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



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



The Company expects competition to continue to intensify as existing and new competitors begin to offer products, services, or systems that compete with our products. Our current or future competitors, many of whom,
individually or together with their affiliates, have substantially greater financial resources, research, and development resources, distribution, marketing, and other capabilities than us, may apply these resources and capabilities to compete
successfully against our products and service. A number of the markets in which we sell our products and services are also served by technologies that currently are more widely accepted than ours. Although we believe that our products and services
are less expensive to use and more functional than competing products and services that rely on other technologies, it is uncertain whether our potential customers will be willing to make the initial capital investment that may be necessary to
convert to our products and services. The success of our systems against these competing technologies depends in part upon whether our systems can offer significant improvements in productivity and sound quality in a cost-effective manner. It is
uncertain whether our competitors will be able to develop systems compatible with, or that are alternatives to, our proprietary technology or systems. It is also not certain that we will be able to compete successfully against current or future
competitors or that competitive pressures faced by us will not materially adversely affect our business, operating results, and financial condition.



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Intellectual Property and Proprietary Rights



The Company primarily relies upon a combination of copyright, trademark and trade secret laws and license agreements to establish and protect proprietary rights in its technologies. The Company currently has thirty-one patents issued and
one other allowed and awaiting issuance and more than thirty other patent applications pending domestically and abroad. The Company also has four trademark registrations and seventy-six copyright registrations.



Employees



As of December 31, 2002,
the Company had a total of 333 employees, including 57 in research and development, 30 in sales and marketing, 203 in operations and manufacturing, and 43 in finance and administration. All of these employees were located in the United States. The
Companys employees are not represented by a collective bargaining agreement and the Company has not experienced a work stoppage. The Company considers its relations with its employees to be good.



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



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ITEM 2. PROPERTIES



The
Companys principal executive offices are at 750 West John Carpenter Freeway in Irving, Texas. The Irving offices include 26,000 square feet of leased space, for which the lease expires in June 2006. The Company has a lease obligation for
office space located at 77 OFarrell in San Francisco, California. The Companys lease at this site is for 8,600 square feet and expires in February 2005. In addition, the Company leases approximately 3,000 square feet in Louisville,
Kentucky for its dub and ship facility which expires in 2004; approximately 22,000 square feet in New York City which is occupied by production service and sales personnel and expires in 2006; approximately 13,000 square feet in Los Angeles occupied
by production service and sales personnel which expires in 2006; and 25,000 square feet in Chicago, which is occupied by production service and sales personnel which expires on December 31, 2003. Offices are also located in Reno, Nevada, under a
lease that expired on September 30, 2000 and is on a month-to-month contract. The Reno facility houses some executives and personnel responsible for repair services. The total square footage of this location is 9,300. An additional 11,305 square
feet of space in San Diego is occupied by engineers under a lease that expires on April 30, 2005. In addition, the Company leases an office in Holmdel, New Jersey that is 30,000 square feet and includes audio operations and administrative staff for
StarGuides wholly owned subsidiary, Corporate Computer Systems, Inc. (CCS), which expires on August 31, 2004.



ITEM 3. LEGAL PROCEEDINGS



On
October 12, 2001, StarGuide filed a complaint against Williams Communications Group, Inc. (Williams) in the United States District Court for the District of Nevada alleging that Williams has willfully infringed three StarGuide patents.
StarGuide has requested preliminary and permanent injunctive relief, damages, trebling of damages and costs and expenses. On January 15, 2002, Williams answered the complaint, denying all material allegations in the complaint and asserting, as
affirmative defenses, that the patents-in-suit are invalid and not infringed by Williams. On February 15, 2002, Williams moved for summary judgment of non-infringement of the patents-in-suit. On March 4, 2002, StarGuide opposed Williams motion
for summary judgment and moved to amend its complaint to add Williams Communications, LLC (WCL), a subsidiary of Williams, as a party defendant. On April 22, 2002, Williams filed a Voluntary Petition under Chapter 11 of the United States
Bankruptcy Code in the United States Bankruptcy Court for the Southern District of New York. StarGuides claims against Williams are stayed by virtue of Williams filing for Chapter 11 protection. WCL did not file for Chapter 11
protection. On April 30, 2002, the Nevada Court granted StarGuides motion to add WCL as a party defendant. On June 2, 2002, the Court denied Williams motion for summary judgment of non-infringement. On July 3, 2002, WCL answered
StarGuides complaint and asserted counterclaims seeking a declaratory judgment that the StarGuide patents are invalid and not infringed. The parties are now engaged in discovery.



On February 8, 2002, WCL filed suit against StarGuide and DGS in the Northern District of Oklahoma seeking a declaratory
judgment that the patents involved in the Nevada lawsuit are invalid and not infringed. StarGuide and DGS moved to dismiss, transfer or stay this lawsuit on the basis that the lawsuit brought by StarGuide in Nevada is the first-filed lawsuit between
the parties concerning the patents. After the District of Nevada granted StarGuides motion to add WCL as a party defendant in that action, WCL dismissed the Oklahoma lawsuit on July 11, 2002.



On June 25, 2002, StarGuide filed a second lawsuit against WCL, asserting
infringement of a patent that was issued to StarGuide after the first lawsuit was filed. StarGuide has requested preliminary and permanent injunctive relief, damages, trebling of damages and costs and expenses. On July 16, 2002, WCL answered
StarGuides complaint and asserted counterclaims seeking a declaratory judgment that the StarGuide patent is invalid and not infringed. This lawsuit has been consolidated with the lawsuit filed by StarGuide on October 12, 2001. The parties are
engaged in discovery. On November 5, 2002, the court entered a stay in the case to allow the parties time to engage in settlement negotiations.



On May 17, 2002, WCL filed a petition in the District Court of Tulsa County in the State of Oklahoma against the Company, asserting causes of action for
unfair trade competition, interference with contract, violation of the Oklahoma Deceptive Trade Practices Act, and disparagement of property and trade libel. WCL has requested permanent injunctive relief, damages, punitive damages and costs and
expenses. On July 1, 2002, DGS answered the petition, denying the material allegations of the petition. The parties are now engaged in discovery. The Company believes the allegations of the petition are without merit and intends to defend itself
vigorously against WCLs claims.



On July 17, 2002,
StarGuide filed a complaint against Wegener Communications, Inc. (Wegener) and John Scaggs (collectively the Defendants) in the United States District Court for the District of Nevada alleging that Wegener has willfully
infringed upon



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various StarGuide patents and intentionally interfered with an employment agreement between StarGuide and Mr. Scaggs. The
complaint also alleged breach of contract and breach of contractual covenant of good faith and fair dealings by Mr. Scaggs and trade secret misappropriation by both Defendants.



On December 13, 2002, StarGuide and Wegener settled the complaints noted above pursuant to a settlement agreement, under
which each party agreed to dismiss its claim against the other with prejudice. Management believes the settlement to be favorable to the Company and anticipates no material impact as a result.



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



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



The Company held its annual shareholders meeting on December 4, 2002, at which shareholders were asked (i) to elect four directors, to serve for three-year terms or until their successors have been duly elected and
qualified; (ii) to consider and vote upon a resolution regarding a vote of confidence for Scott K. Ginsburg; and (iii) to ratify the selection of KPMG LLP as the Companys independent accountants for the fiscal year ending December 31, 2002.
The results are as follows:



|Matter                                                                     |  | Votes For  |  | Votes Against/Withheld |  | Abstentions |  | BrokerNon-Votes
|-------------------------------------------------------------------------- |  | ---------- |  | ---------------------- |  | ----------- |  | ---------------
|Election of the following directors for three-year terms expiring in 2005: |  |            |  |                        |  |             |  |                
|Jeffrey A. Dankworth                                                       |  | 57,612,419 |  | 9,290,000              |  | 0           |  | 0              
|Kevin C. Howe                                                              |  | 66,019,071 |  | 883,348                |  | 0           |  | 0              
|Robert J. Schlegel                                                         |  | 66,016,071 |  | 883,348                |  | 0           |  | 0              
|Cappy R. McGarr                                                            |  | 66,016,071 |  | 883,348                |  | 0           |  | 0              
|                                                                           |  |            |  |                       
|Resolution regarding a vote of confidence for Scott K. Ginsburg            |  | 60,672,053 |  | 5,862,952              |  | 367,414     |  | 3,898,583      
|                                                                           |  |            |  |                       
|Ratify the appointment of KPMG LLP                                         |  | 66,212,384 |  | 663,175                |  | 26,860      |  | 3,898,583      



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



ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT



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



|Name                 |  | Age |  | Title(s)                            
|-------------------- |  | --- |  | ------------------------------------
|Matthew E. Devine    |  | 54  |  | Chief Executive Officer and Director
|Omar A. Choucair     |  | 41  |  | Chief Financial Officer and Director
|Jeffrey A. Dankworth |  | 47  |  | President of StarGuide and Director 
|Stephen N. Sparkman  |  | 37  |  | Corporate Controller                



Matthew E. Devinejoined the Company in July 1999 as Chief Executive Officer and Director. Prior to joining the Company, Mr. Devine served as Chief Financial Officer of AMFM Corporation (formerly Chancellor Media) and served as Chief Financial Officer, Executive
Vice President, Treasurer, Secretary and Director for Evergreen Media Corporation. Between 1975 and 1988, Mr. Devine served in various finance positions at AMR Corporation, parent company to American Airlines.



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



Jeffrey A. Dankworth has been President and a director of StarGuide
since 1995 and a director of the Company since February 2001. Prior to co-founding StarGuide in 1994, Mr. Dankworth was an entrepreneur in the entertainment media and professional sports industries where he led the development of various media joint
ventures in professional sports including the NFL Quarterback Club. As an attorney, Mr. Dankworth has extensive experience in various areas of business development, including the negotiation and management of media partnerships, licensing programs,
and joint ventures. Between 1984 and 1994, Mr. Dankworth was Of Counsel with the law firm of Mitchell, Silberberg & Knupp and prior to that was an associate with the law firm of Gibson, Dunn & Crutcher (1981-1984). Mr. Dankworth received
both an undergraduate and a graduate degree from The University of California at Los Angeles.



Stephen N. Sparkman joined the Company as Corporate Controller in January 2000. Prior to joining the Company, Mr. Sparkman was Corporate Controller of Alpha Holdings Inc., a plastics manufacturing concern based
in Dallas. From 1997 to 1999, Mr. Sparkman was Controller and Chief Financial Officer of Group & Pension Administrators, Inc., a third party health and pension administrator based in Richardson, Texas. From 1991 until 1997, Mr. Sparkman served
as Controller of Baker Atlas (formerly Wedge Dia-Log, Inc.), an oil field service company based in Grand Prairie, Texas. From 1988 until 1991, Mr. Sparkman worked at KPMG LLP. Mr. Sparkman received a B.B.A. from The University of Texas at Austin and
is a Certified Public Accountant.



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PART II



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



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



The following table sets forth the high and low closing sales prices of our Common Stock from January 1, 2001 to December 31, 2002. Such prices represent
prices between dealers, do no include retail mark-ups, markdowns or commissions and may not represent actual transactions.



|               |  | Fiscal Year Ended 2002 |      | Fiscal Year Ended 2001
|-------------- |  | ---------------------- | ---- | ----------------------
|               |  | High                   |      | Low                   
|First Quarter  |  | $                      | 1.49 |                       
|Second Quarter |  |                        | 1.46 |                       
|Third Quarter  |  |                        | 1.24 |                       
|Fourth Quarter |  |                        | 1.15 |                       



As of December 31,
2002 the Company had issued 70,833,613 and outstanding 70,810,696 shares of its Common Stock. As of March 17, 2003, the Company had issued 70,838,613 and outstanding 70,815,696 shares of its Common Stock. As of March 17, 2003, the Companys
Common Stock was held by approximately 163 shareholders of record. The Company estimates that there are approximately 4,509 beneficial shareholders.



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



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ITEM 6. SELECTED FINANCIAL DATA



The following selected historical consolidated financial data should be read in conjunction with the Companys consolidated financial statements and related notes and the Companys Managements Discussion and Analysis
of Financial Condition and Results of Operations. The consolidated statement of operations data for each of the years ended December 31, 2000, 1999 and 1998 and the consolidated balance sheet data at December 31, 2000, 1999 and 1998 are
derived from the consolidated financial statements of StarGuide, which have been audited by KPMG LLP, independent public accountants. The consolidated statement of operations data for the years ended December 31, 2002 and 2001 and the consolidated
balance sheet data at December 31, 2002 and 2001 are derived from the consolidated financial statements of the Company, which were audited by KPMG LLP, independent public accountants.



Statement of Operations:



|                                                                                                                |  | For the years ended December 31, |         
|--------------------------------------------------------------------------------------------------------------- |  | -------------------------------- | --------
|                                                                                                                |  | 2002                             |         
|                                                                                                                |  | As Restated(1)                   |         
|Revenues                                                                                                        |  | $                                | 66,294  
|                                                                                                                |  |                                  |         
|Costs and expenses                                                                                              |  |                                  |         
|Cost of revenues                                                                                                |  |                                  | 33,328  
|Sales and marketing                                                                                             |  |                                  | 5,005   
|Research and development                                                                                        |  |                                  | 3,941   
|General and administrative expenses:                                                                            |  |                                  |         
|Noncash stock award charges                                                                                     |  |                                  |        
|Other                                                                                                           |  |                                  | 9,642   
|Restructuring charges                                                                                           |  |                                  | 771     
|Depreciation and amortization                                                                                   |  |                                  | 7,390   
|                                                                                                                |  |                                  |         
|Total expenses                                                                                                  |  |                                  | 60,077  
|                                                                                                                |  |                                  |         
|Income (loss) from operations                                                                                   |  | $                                | 6,217   
|Other (income) expense                                                                                          |  |                                  |         
|Interest and other (income) expense, net                                                                        |  |                                  | 1,520   
|Equity in losses of joint venture                                                                               |  |                                  |        
|                                                                                                                |  |                                  |         
|Net income (loss) before income taxes and cumulative effect of change in accounting principle                   |  |                                  | 4,697   
|Provision for income taxes                                                                                      |  |                                  | 1,848   
|                                                                                                                |  |                                  |         
|Net income (loss) before cumulative effect of change in accounting principle                                    |  |                                  | 2,849   
|Cumulative effect of change in accounting principle                                                             |  |                                  | (130,234
|                                                                                                                |  |                                  |         
|Net loss                                                                                                        |  | $                                | (127,385
|                                                                                                                |  |                                  |         
|Basic and diluted net income (loss) per common share before cumulative effect of change in accounting principle |  | $                                | 0.04    
|                                                                                                                |  |                                  |         
|Basic and diluted net loss per common share                                                                     |  | $                                | (1.80   
|                                                                                                                |  |                                  |         
|Weighted average common shares outstanding                                                                      |  |                                  |         
|Basic                                                                                                           |  |                                  | 70,718  
|                                                                                                                |  |                                  |         
|Diluted                                                                                                         |  |                                  | 70,807  
|                                                                                                                |  |                                  |         

---

|(1) |  | Restated to reflect income tax expense of $1.8 million and a reduction in the cumulative effect of accounting change of $1.1 million.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------







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Balance Sheet Data



|                                          |  | December 31,   |       
|----------------------------------------- |  | -------------- | ------
|                                          |  | 2002           |       
|                                          |  | As Restated(1) |       
|Cash and cash equivalents                 |  | $              | 2,527 
|Working capital                           |  |                | 477   
|Property and equipment, net               |  |                | 12,757
|Total assets                              |  |                | 97,205
|Long-term debt, excluding current portion |  |                | 4,548 
|Shareholders equity (deficit)            |  |                | 69,213

---

|(1) |  | Restated to reflect income tax expense of $1.8 million and a reduction in the cumulative effect of accounting change of $1.1 million.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------



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



Overview



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



DGS was incorporated in 1991. The Company owns a nationwide digital network that beneficially links hundreds of advertisers and advertising agencies with
more than 7,500 radio and 1,000 television stations across the United States and Canada. The Company also owns proprietary digital software, hardware and communications technology, including various bandwidth satellite receivers, audio compression
codes, software to operate integrated digital multimedia networks, software development for satellite applications and engineering consulting services. The Company has a Network Operation Center located in Irving, Texas that delivers audio, video,
image and data content that comprise transactions between the advertising and broadcast industries.



In January 2001, the Company completed its merger with StarGuide pursuant to the Agreement and Plan of Merger by and among DGS, SG Nevada Merger Sub Inc.,
a wholly owned subsidiary of DGS, and StarGuide. The merger has been accounted for as a reverse acquisition, and accordingly, historical results of the combined company prior to the merger are that of StarGuide and DGS results of operations
have been included subsequent to January 1, 2001. Upon the completion of the merger, each share of StarGuide common stock converted into the right to receive 1.7332 shares of common stock of the Company. Under the merger agreement, StarGuides
options and warrants were assumed by the Company based on the same exchange ratio.



Restatement of Financial Information



In
accordance with SFAS No. 109, during 2002, the Company should have recorded reductions in its valuation allowance for deferred tax assets as a reduction in goodwill rather than as a deferred tax benefit. Consequently, income tax expense of $0.8
million should have been recorded during fiscal 2002.



Upon the
adoption of SFAS No. 142 on January 1, 2002, the Company reclassified approximately $3 million of intangible assets with indefinite useful lives to goodwill. The Company should have reclassified the deferred tax liability related to such assets of
approximately $1.1 million to goodwill as well. Such reclassification would have required an increase in the deferred tax asset valuation allowance of approximately $1.1 million, which should have been recorded as additional income tax expense.



Had the $1.1 million deferred tax liability been recorded as a
reduction in goodwill, the cumulative effect of adopting SFAS No. 142 would have been reduced by approximately $1.1 million. See Note 21 in the accompanying financial statements for further discussion.



Critical Accounting Policies



The Securities and Exchange Commission (SEC) recently released Financial Reporting Release No. 60, which requires all companies to include a discussion of critical accounting policies or methods used in the preparation of
financial statements. In addition, Financial Reporting Release No. 61 was recently released by the SEC to require all companies to include a discussion to address, among other matters, liquidity, off-balance sheet arrangements, contractual
obligations and commercial commitments. The Companys significant accounting policies and methods used in the preparation of the Consolidated Financial Statements are discussed in Note 2 of the Notes to Consolidated Financial Statements. The
following is a listing of the Companys critical accounting policies and a brief discussion of each:



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



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



| |  |  | intangible assets and goodwill.
| | - |  | -------------------------------



Allowance for Doubtful Accounts.The Companys allowance for doubtful accounts relates to trade accounts receivable. Financial
Statement Schedule II summarizes the activity in this account. The allowance for doubtful accounts is an estimate prepared by management based on identification of the collectibility of specific accounts and the overall condition of the receivable
portfolios. The Company specifically analyzes trade receivables, historical bad debts, customer credits, customer



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concentrations, customer credit-worthiness, current economic trends and changes in customer payment terms when evaluating
the adequacy of the allowance for doubtful accounts. If the financial condition of the Companys customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Likewise,
should the Company determine that it would be able to realize more of its receivables in the future than previously estimated, an adjustment to the allowance would increase income in the period such determination was made. The allowance for doubtful
accounts is reviewed on a monthly basis and adjustments are recorded as deemed necessary.



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



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



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



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



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



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



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



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



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



If the Company determines that the carrying value of long-lived assets may not be recoverable based upon the existence of one or more of the above
indicators of impairment, the Company assesses the recoverability of the intangibles by determining whether the amortization of the asset balance over its remaining life can be recovered through undiscounted future operating cash flow of the
acquired operations. Any impairment is measured based on a projected discounted cash flow method using a discount rate reflecting the Companys average cost of funds.



In 2002, Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible
Assets became effective, and as a result, the Company ceased amortization of goodwill beginning January 1, 2002 and evaluates goodwill for impairment at least annually. The Company recorded approximately $9.5 million of goodwill amortization
during 2001. SFAS No. 142 requires the Company to test goodwill for impairment at a level referred to as a reporting unit. Goodwill is considered



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impaired and a loss is recognized, when its carrying value exceeds its implied fair value. As an overall check on the
reasonableness of the fair values attributed to the Companys reporting units, the Company is required to compare and contrast the aggregate fair values for all reporting units with the Companys average total market capitalization for a
reasonable period of time. SFAS No.142 states that the fair value may exceed market capitalization due to factors such as control premiums and synergies. The Company completed its impairment review during the first quarter of 2002 and recorded an
impairment of approximately $130.2 million, which is reported as a cumulative effect of change in accounting principle.



Results of Operations



2002 versus 2001



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



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



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



Research and Development. Research and development
expense for the year ended December 31, 2002 decreased $0.7 million, or 14%, as compared to the prior year, due to the capitalization of salaries, benefits and other costs related to the development of new software and cost reductions due to
reductions in personnel.



General and Administrative and
Restructuring Charges. General and administrative expenses decreased $2.5 million, or 21%, as compared to the prior year, primarily due to reductions in headcount and the consolidation of administrative support functions. During the first
quarter 2002, the Company recorded a restructuring charge of $0.8 million related to the consolidation of certain corporate functions and facilities. The charge represents employee termination costs, lease obligations and the write-down of certain
leasehold improvements. During the year ended December 31, 2001, the Company incurred costs of approximately $0.8 million for the move of its Network Operating Center and corporate accounting department from San Francisco, California to Irving,
Texas.



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



Interest and Other Expense. Interest and other
expense decreased $0.5 million for the year ended December 31, 2002, as compared to the prior year, due to lower average outstanding long-term debt and capital lease obligations.



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



2001 versus 2000



Reported operating results for the year ended December 31, 2001 are not comparable with the same prior year periods due to
the merger between DGS and StarGuide, which occurred effective January 1, 2001. The merger was accounted for as a reverse acquisition, thus historical results reflect only StarGuide for the year ended December 31, 2000. In order to enhance
comparability, the following discussion of the Companys results of operations is supplemented by unaudited pro forma financial information that gives effect to the merger as if it had occurred at the beginning of 2000.



15



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|                 |  | Year endedDecember 31,
|---------------- |  | ----------------------
|                 |  | 2001                  
|As reported:     |  |                       
|Revenues         |  | $                     
|Cost of revenues |  | $                     
|                 |  |                       
|Pro Forma:       |  |                       
|Revenues         |  | $                     
|Cost of revenues |  | $                     



Revenues.
Revenues for the year ended December 31, 2001 increased $56.3 million, or 390%, due to the incremental business that was acquired in the merger and incremental revenues related to new radio syndication agreements with major broadcasters.



On a pro forma basis, revenues increased 2% for the year ended December
31, 2001. Revenue from sales of products increased $5.8 million, or 40%, due primarily to sales contracts with major broadcasters. Revenue from services decreased $4.3 million, or 8%, due primarily to a decrease in political revenue from 2000, as
2000 was an election year.



Cost of revenues. Cost of
revenues, which includes delivery and material costs and customer operations, increased $27.6 million for the year ended December 31, 2001 as follows:



| |  |  | $27.8 million increase related to revenues of DGS, which were not included in 2000.
| | - |  | -----------------------------------------------------------------------------------



| |  |  | $0.2 million decrease related to the mix of products sold during 2001 versus 2000.
| | - |  | ----------------------------------------------------------------------------------



On a pro forma basis, cost of revenues decreased 7% for the year ended December 31, 2001 to $37.4 million compared to $40.1
million for the same prior-year period. The decline is primarily a result of lower telecommunications costs as a result of negotiating a lower rate structure with our primary telecommunications provider, MCI WorldCom. In addition, reductions in
headcount due to synergies from the merger and reduced operating expenses as a result of the relocation of the DGS NOC from San Francisco, California to Irving, Texas during 2001 contributed to the lower costs.



Sales and marketing. Sales and marketing expense increased $2.9
million, or 105%, for the year due to additional expenses of $4.2 million related to the incremental business acquired in the merger offset by a reduction in expenses of $1.3 million due primarily to a reduction in headcount resulting from synergies
from the merger.



Research and development. Research and
development expense increased $1.5 million, or 48%, of which $2.4 million relates to the incremental business that was acquired in the merger, offset by decreases in research and development activity and the capitalization of salaries and other
costs related to the development of new software.



General
and administrative. General and administrative expenses decreased $12.8 million, or 51%, primarily due to the following:



| |  |  | $8.0 million of expense related to the incremental business that was acquired in the merger.
| | - |  | --------------------------------------------------------------------------------------------



| |  |  | $19.6 million reduction of expense related to noncash stock awards recognized during the year ended December 31, 2000 that was nonrecurring.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | $1.1 million reduction in expenses due to reductions in headcount and savings resulting from synergies from the merger.
| | - |  | -----------------------------------------------------------------------------------------------------------------------



Depreciation and Amortization Depreciation and amortization expense was $17.1
million and $0.8 million in 2001 and 2000, respectively. The increase in depreciation expense from 2000 to 2001 is due to the DGS/StarGuide merger that occurred in January 2001, which added approximately $16 million in property, plant and equipment
and approximately $197 million in goodwill and other intangible assets. Included in depreciation and amortization is goodwill amortization of $9.5 million in 2001.



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Interest Income and Interest Expense



The Company has derived interest income from the short-term investment of
its cash in US money market funds. Fluctuations in interest income are due to differences in the levels of cash used to fund Company operations and interest rates.



Interest expense incurred by the Company was $1.8 million and $0 in 2001 and 2000, respectively. This expense relates
primarily to long-term debt and lease agreements. The significant increase from 2000 to 2001 was a result of the purchase of Musicam Express, upon which the Company refinanced debt of $9.8 million that was assumed as a result of the acquisition.
Total long-term debt and capital lease liabilities outstanding was $16.8 million at December 31, 2001. The Company had no long-term debt outstanding at December 31, 2000.



Liquidity and Capital Resources



The Companys operating activities provided cash of $7.5 million in 2002 compared to $4.9 million in 2001. Cash used in operating activities was $3.6 million in 2000. Cash flows from operating activities improved during 2002 as
compared to 2001 and 2000 primarily due to cost reductions and the $3.2 million reduction in accounts payable and accrued liabilities in 2001 versus a $1.0 million reduction in 2002.



The Company used $0.7 million, $3.2 million and $0.7 million of cash in 2002, 2001 and 2000, respectively, to purchase
property and equipment. In addition, $1.6 million of property and equipment was acquired through capital leases during 2001. The capital additions for each of the three years were a result of the Companys continued expansion of its network and
continued product development.



During June 2001, the Company
signed a new long-term credit agreement with a bank that includes a term loan with an original principal amount of $12.5 million and a revolving credit facility with a borrowing base subject to the Companys eligible accounts receivable
balance. The proceeds from the term loan were used in part to refinance outstanding debt of $9.8 million that was assumed as a result of the acquisition of Musicam during March 2001. Approximately $4.5 million was outstanding under the revolving
credit facility at December 31, 2002 and an additional $4.2 million was available for borrowing. Under the long-term credit agreement, as amended on June 14, 2002, the Company is required to maintain minimum EBITDA, defined as the sum of
consolidated net income plus depreciation, amortization, taxes, interest expense, and other non-cash charges, non-recurring charges and extraordinary charges specifically identified as such as a separate line item on the income statement. In
addition, the Company is required to maintain certain leverage ratios and current ratios on a quarterly basis, and is subject to limitations on capital expenditures for a rolling twelve-month period and capital lease borrowings on an annual basis.
As of December 31, 2002 and for the year then ended, the Company was in compliance with these covenants.



Net principal payments on long-term debt were $6.8 million, $0.6 million and $5.7 million in 2002, 2001 and 2000, respectively.



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



The Company currently has no significant capital commitments other than the commitments under capital leases. The Company also has ongoing commitments with a telephone service provider to spend a minimum of $2.0 million in each of 2003,
2004 and 2005. Based on managements current plans and forecasts, the Company believes that its existing sources of liquidity will satisfy the Companys projected working capital and capital lease commitments and other cash requirements
through the foreseeable future.



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





|                                   |  |                 |       
|---------------------------------- |  | --------------- | ------
|Contractual Obligation             |  | Total           |       
|                                   | 
|                                   |  | Less Than1 Year |       
|Long-Term Debt                     |  | $               | 5,000 
|Line of Credit                     |  |                 | 4,500 
|Capital Leases                     |  |                 | 531   
|Operating Leases                   |  |                 | 6,056 
|Unconditional Purchase Obligations |  |                 | 6,000 
|                                   |  |                 |       
|Total Contractual Cash Obligations |  | $               | 22,087
|                                   |  |                 |       



The present value of
obligations under capital lease was $517, of which $469 is classified as a current liability.



Certain Business Considerations



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



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



We have been unprofitable since our inception, except that we operated at a profit for the year ended December 31, 2002, when excluding the effect of a
change in accounting principle. We could continue to generate net losses in the future, which could depress our stock price. Historical revenue growth rates may not be sustainable and as such, should not be used as an indication of future revenue
growth, if any, or as an indication of future operating results. Future success also depends in part on obtaining continued reductions in delivery and service costs, particularly our ability to continue to automate order processing and to reduce
telecommunications costs. Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in new and rapidly evolving markets, such as risks that the market might fail to grow, expenses relating
to modifying products and services to meet industry standards as they change over time, and difficulties in gaining and maintaining market share. To address these risks, we must, among other things, respond to competitive developments, continue to
attract, retain and motivate qualified persons, continue to upgrade our technologies and begin to commercialize products incorporating such technologies. We may not be successful in addressing any or all of these risks and may not be able to achieve
or sustain profitability.



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



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



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



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



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



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



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



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



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



We cannot predict any of the foregoing factors with certainty. In addition, we cannot predict the precise amount of future capital that we will require,
particularly if we pursue one or more additional acquisitions. Furthermore, additional financing may not be available to us, or if it is available, it may not be available on acceptable terms. Our inability to obtain financing for additional
acquisitions on acceptable terms may prevent us from completing advantageous acquisitions and consequently could seriously harm our prospects and future rates of growth. Our inability to obtain additional funding for continuing operations or an
acquisition would deter the growth of our business and could impair our operations. Consequently, we could be required to significantly reduce or suspend operations, seek an additional merger partner or sell additional securities on terms that are
dilutive to existing investors.



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



Our products and services are relatively new, and alternative technologies are rapidly evolving. It is difficult to predict the rate at which the market
for such products and services will grow, if at all. If the market fails to grow, or grows more slowly than anticipated, we may also fail to grow. Even if the market does grow, our products and services may not achieve commercial success. We may not
be able to conform our products to existing and emerging industry standards in a timely fashion, if at all. We believe that our future growth will depend, in part, on our ability to add these services and additional customers in a timely



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and cost-effective manner. However, we may not be successful in developing such services or in obtaining new customers
for such services. Furthermore, we may not be successful in obtaining a sufficient number of radio and television stations, radio and television networks, advertisers, advertising agencies, production studios and audio and video distributors who are
willing to bear the costs of expanding and increasing the integration of the Companys network, including the Companys field receiving equipment and rooftop satellite antennae.



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



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



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



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



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



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



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



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



We depend on making cost-effective deliveries to broadcast stations within the time periods requested by our customers. If we are unsuccessful, for
whatever reason, a station might be prevented from selling airtime that it otherwise could have sold. Although we disclaim any liability for lost air-time, stations may nevertheless assert claims for lost air-time in these circumstances and
dissatisfied advertisers may refuse to make further deliveries through us in the event of a significant occurrence of lost deliveries, which would result in a decrease in our revenues or an increase in our expenses, either of which could lead to a



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reduction in net income or an increase in net loss. Although we maintain insurance against business interruption, such
insurance may not be adequate to protect us from significant loss in these circumstances or from the effects of a major catastrophe (such as an earthquake or other natural disaster), which could result in a prolonged interruption of our business.
Our ability to make deliveries to stations within the time periods requested by customers depends on a number of factors, some of which are outside of our control, including:



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



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



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



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



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



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



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



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



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



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



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



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



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



While we are taking the steps we believe are required to achieve the network capacity and scalability necessary to deliver video content reliably and cost effectively as video advertising delivery volume grows, we may
not achieve such goals because they are highly dependent on the services provided by our telecommunication providers and the technological capabilities of both



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



We have experienced rapid growth over the past several years that has resulted in new and increased responsibilities for
management personnel and that has placed and continues to place a significant strain on our operating, management and financial systems and resources. Our personnel, systems, procedures and controls may not be adequate to support our existing and
future operations. To accommodate this growth and to compete effectively and manage future growth, if any, we must continue to implement and improve our operational, financial and management information systems, procedures and controls on a timely
basis and to expand, train, motivate and manage our work force. We must continue to further develop our products and services while we manage anticipated growth by implementing effective planning and operating processes, such as continue to
implement and improve our operational, financial and management information systems; hire and train additional qualified personnel; continue to expand



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and upgrade our core technologies; and effectively manage multiple relationships with various customers, joint venture and technological partners and other
third parties.



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



We believe that our future success will depend to a significant extent upon the services of Scott K. Ginsburg, our Chairman of the Board; and certain key
executive officers, particularly Matthew E. Devine, Chief Executive Officer; Omar A. Choucair, Chief Financial Officer; and Jeffrey A. Dankworth, StarGuides President. We do not have employment agreements with any of these key executive
officers, and we do not carry key-man insurance. Uncontrollable circumstances, such as the death or incapacity of any key executive officer, could have a serious impact on our business.



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



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



Our classified board might discourage the acquisition of a controlling interest of our stock because such acquirer would not have the ability to replace
our directors, except as the term of each class expires. Our Board of Directors amended our bylaws so that, commencing with the 2001 annual meeting of stockholders, the directors were divided into three classes with respect to the time for which
they hold office. The term of office of the first class expired at the 2002 annual meeting of stockholders, the term of office of the second class expires at the 2003 annual meeting of stockholders, and the term of office of the third class expires
at the 2004 annual meeting of stockholders. At each annual meeting of stockholders, directors elected to succeed those directors whose terms then expire will be elected for a term of office to expire at the third succeeding annual meeting of
stockholders after their election.



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



Our executive officers and directors and their respective affiliates own
approximately 53% of our common stock, not including options or warrants to purchase additional shares of common stock. As a result, these shareholders are able to control or significantly influence all matters requiring shareholder approval,
including the election of directors and the approval of significant corporate transactions. Such concentration of ownership may have the effect of delaying or preventing a change in control even if a change of control is in the best interest of all
shareholders.



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



We rely on fewer than five single or limited-source suppliers for integral components used in the assembly of our audio and video units. Although these suppliers are generally large, well-financed organizations, in
the event that a supplier were to experience financial or operational difficulties that resulted in a reduction or interruption in component supply to us, it would delay our deployment of audio and video units. We rely on our suppliers to
manufacture components for use in our products. Some of our suppliers also sell products to our competitors and may in the future become our competitors, possibly entering into exclusive arrangements with our existing competitors. In addition, our
suppliers may stop selling their products or components to us at commercially reasonable prices or completely stop selling their products or components to us. If a reduction or interruption of supply were to occur, it could take a significant period
of time for us to qualify an alternative subcontractor, redesign its products as necessary and contract for the manufacture of such products. This would have the effect of depressing our business until we were able to establish sufficient component
supply through an alternative source. We believe that there are currently alternative component manufacturers that could supply the components required to produce our products, but based on the financial condition and service levels of our current
suppliers, we do not feel the need to pursue agreements or understandings with such alternative sources or pursue long-term contracts with our current suppliers. We have experienced component shortages in the past, and material component shortages
or production or delivery delays may occur in the future.



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



We face various risks associated with purchasing satellite capacity.



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



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



We have designed and developed the necessary software to enable our current video delivery systems to receive digital satellite transmissions over the Hughes Network Systems satellite system. However,
the Hughes satellite system may not have the capacity to meet our future delivery commitments and broadcast quality requirements on a cost-effective basis, if at all. We have a



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non-exclusive agreement with Hughes that expires in December 2005. The agreement provides for fixed pricing on dedicated
bandwidth and gives us access to satellite capacity for electronic delivery of digital audio and video transmissions by satellite. Hughes is required to meet performance specifications as outlined in the agreement, and we are given a credit
allowance for future fees if Hughes does not meet these requirements. The agreement states that Hughes can terminate the agreement if we do not make timely payments or become insolvent.



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



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



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



ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



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



The Company is exposed to interest rate risk primarily through its borrowing activities. As of December 31, 2002, the Company had $4.5 million outstanding
under its revolving credit line agreement and other variable rate debt. A one-percentage point increase in the variable interest rate based on debt amounts outstanding would result in approximately $0.1 million reduction in annual pre-tax earnings.
See Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations  Liquidity and Capital Resources for additional discussion of the terms of the Companys credit facility.



ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA



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



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



None.



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PART III



ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT





|Name                         |  | Age |  | Title(s)                              |  | Expiration of Term
|---------------------------- |  | --- |  | ------------------------------------- |  | ------------------
|Scott K. Ginsburg (2)        |  | 50  |  | Chairman of the Board                 |  | 2004              
|Matthew E. Devine            |  | 54  |  | Chief Executive Officer and Director  |  | 2004              
|Omar A. Choucair             |  | 41  |  | Chief Financial Officer and Director  |  | 2003              
|Jeffrey A. Dankworth         |  | 47  |  | President of StarGuide and Director   |  | 2005              
|Robert C. Ryan               |  | 49  |  | General Intellectual Property Counsel |  | N/A               
|Stephen N. Sparkman          |  | 37  |  | Corporate Controller                  |  | N/A               
|Lawrence D. Lenihan, Jr. (2) |  | 38  |  | Director                              |  | 2004              
|David M. Kantor (2)          |  | 46  |  | Director                              |  | 2003              
|Cappy R. McGarr (1)          |  | 51  |  | Director                              |  | 2005              
|Eric L. Bernthal             |  | 56  |  | Director                              |  | 2003              
|Robert J. Schlegel (1)       |  | 53  |  | Director                              |  | 2005              
|Kevin C. Howe (1)            |  | 54  |  | Director                              |  | 2005              

---

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

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



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



Matthew E. Devinejoined the Company in July 1999 as Chief Executive Officer and Director. Prior to joining the Company, Mr. Devine served as Chief
Financial Officer of AMFM Corporation (formerly Chancellor Media) and served as Chief Financial Officer, Executive Vice President, Treasurer, Secretary and Director for Evergreen Media Corporation. Between 1975 and 1988, Mr. Devine served in various
finance positions at AMR Corporation, parent company to American Airlines.



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



Jeffrey A. Dankworth has been President and a director of StarGuide since 1995 and a director of the Company since February 2001. Prior to
co-founding StarGuide in 1994, Mr. Dankworth was an entrepreneur in the entertainment media and professional sports industries where he led the development of various media joint ventures in professional sports including the NFL Quarterback Club. As
an attorney, Mr. Dankworth has extensive experience in various areas of business development, including the negotiation and management of media partnerships, licensing programs, and joint ventures. Between 1984 and 1994, Mr. Dankworth was Of Counsel
with the law firm of Mitchell, Silberberg & Knupp and prior to that was an associate with the law firm of Gibson, Dunn & Crutcher (1981-1984). Mr. Dankworth received both an undergraduate and a graduate degree from The University of
California at Los Angeles.



Robert C. Ryan has been
General Intellectual Property Counsel of StarGuide Digital Networks since 1996. As an attorney, Mr. Ryan has extensive experience in technology and intellectual property law and media partnerships, licensing programs, joint ventures, antitrust law,
and business contracts. Mr. Ryan was a founding equity partner and director at McAndrews, Held & Malloy from 1988 until he joined his then-client, StarGuide, in 1996. Mr. Ryan first became a patent attorney in 1979 and from 1979 through 1988 was
associated with the intellectual property law firm, Banner & Witcoff, where he became a partner in 1983 and an equity partner in 1987. Mr. Ryan also has been an Adjunct Associate Professor at the Northwestern University Technological Institute
and at the John Marshall Law School, where he co-founded and taught from 1990 through 1998 leading post-graduate intellectual property practice classes in conjunction with Judge Paul R. Michel of the United States Court of Appeals for the Federal
Circuit. Mr. Ryan received a B.S. in Industrial Engineering and B.A. in Economics from the University of Illinois at Champaign-Urbana in 1976 and a J.D. from Northwestern University in 1979.



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Stephen N. Sparkman joined the Company as Corporate Controller in January 2000. Prior to joining
the Company, Mr. Sparkman was Corporate Controller of Alpha Holdings Inc., a plastics manufacturing concern based in Dallas. From 1997 to 1999, Mr. Sparkman was Controller and Chief Financial Officer of Group & Pension Administrators, Inc., a
third party health and pension administrator based in Richardson, Texas. From 1991 until 1997, Mr. Sparkman served as Controller of Baker Atlas (formerly Wedge Dia-Log, Inc.), an oil field service company based in Grand Prairie, Texas. From 1988
until 1991, Mr. Sparkman worked at KPMG LLP. Mr. Sparkman received a B.B.A. from The University of Texas at Austin and is a Certified Public Accountant.



Lawrence D. Lenihan, Jr. has been a member of the Board of Directors of the Company since July 1997. Mr. Lenihan is a Managing Director of Pequot
Capital Management, Inc. He joined the predecessor to this firm, Dawson-Samberg Capital Management, in 1996. Prior to joining Pequot, Mr. Lenihan was a principal at Broadview Associates, LLC from 1993 to 1996. Prior to joining Broadview, Mr. Lenihan
held several positions at IBM, most recently as the leader of an interactive multimedia software product business. Mr. Lenihan graduated from Duke University with a B.S. in Electrical Engineering and he holds an M.B.A. from the Wharton School of
Business at the University of Pennsylvania. He currently serves as a director of several public and private companies including Accruent, Klocwork, Netegrity, USSearch, Inc., Performaworks, Swingtide and Elance.



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



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



Eric L. Bernthal has been a member of the Board of Directors of the
Company since February 2001. Mr. Bernthal is the Managing Partner of the Washington, DC office of Latham & Watkins, a law firm with more than 1,500 attorneys worldwide. He has practiced corporate and telecommunications law for over 30 years,
specializing in transactional and regulatory matters. Mr. Bernthal has represented companies in the media, communications, health care, consumer products and retail industries. Mr. Bernthal has been a partner in Latham & Watkins since 1986.
Prior to joining Latham, Mr. Bernthal was an associate and then a partner in the Washington, DC law firm of Arent, Fox, Kintner, Plotkin & Kahn, from 1972 to 1986. He served on that law firms Executive Committee for five years. Mr.
Bernthal served as law clerk to the Honorable Ruggero J. Aldisert of the United States Court of Appeals for the Third Circuit in Philadelphia from 1970 to 1972. He earned an undergraduate degree from Columbia University in 1967 and a graduate degree
from George Washington University Law Center.



Robert J.
Schlegel has been a member of the Board of Directors of the Company since February 2001. Mr. Schlegel has been the CEO of The Pavestone Company, a manufacturer of decorative, environmental-friendly concrete landscape products, since 1980. Mr.
Schlegel also built a health care company, PeopleCare Heritage Centers, including 2,200 nursing retirement care beds in 13 Texas facilities. Mr. Schlegel has been actively involved in the Dallas community with the Trinity Christian Academy, the Cox
School of Business at Southern Methodist University, the Salvation Army, Students in Free Enterprise, the Alzheimers Association, the Dallas Symphony, the Young Presidents Organization and his own foundation, the Schlegel Horizons
Foundation. Mr. Schlegel graduated with a B.A. degree in Economics from Wilfrid Laurier University in 1972.



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





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OTHER INFORMATION



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



In April 2002, a jury found that Mr. Ginsburg did make these communications, known as tipping, and therefore
concluded that he had violated Sections 10(b) and 14(e) of the Securities Exchange Act of 1934 and Rules 10b-5 and 14e-3 thereunder. In July 2002, the United States District Court imposed a $1,000,000 civil penalty against Mr. Ginsburg.



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



On February 13, 2003, the Securities and Exchange Commission
filed a Notice of Appeal, seeking to reverse the Courts decision and challenging the Courts earlier refusal to impose an injunction against Mr. Ginsburg.



SECTION 16 (a) BENEFICIAL OWNERSHIP

REPORTING COMPLIANCE



The
members of the Board of Directors, the executive officers of the Company and persons who hold more than 10% of the Companys outstanding common stock are subject to the reporting requirements of Section 16 (a) of the Securities Exchange Act of
1934, as amended, which require them to file reports with respect to their ownership of the Companys common stock and their transactions in such common stock. Based upon (i) the copies of Section 16 (a) reports that the Company received from
such persons for their 2002 fiscal year transactions in the common stock and their common stock holdings and (ii) the written representation received from one or more of such persons that no annual Form 5 reports were required to be filed by them
for the 2002 fiscal year, the Company believes that all reporting requirements under Section 16 (a) for such fiscal year were met in a timely manner by its executive officers, Board members and greater than ten-percent shareholders at all times
during the 2002 fiscal year.



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ITEM 11. EXECUTIVE COMPENSATION



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



|                                                                                         |  |              |  | Annual Compensation (1)    |  |       | Long-TermCompensation Awards Securities UnderlyingOptions
|---------------------------------------------------------------------------------------- |  | ------------ |  | -------------------------- |  | ----- | ---------------------------------------------------------
|Name and Principal Position                                                              |  | Year         |  | Salary                     |  | Bonus |                                                          
|Scott K. Ginsburg Chairman of the Board                                                  |  | 200220012000 |  | $250,000 $250,000 $250,000 |  | $ $ $ |                                                       
|Matthew E. Devine Chief Executive Officer                                                |  | 200220012000 |  | $250,000 $250,000 $250,000 |  | $ $ $ |                                                       
|Omar A. Choucair Chief Financial Officer                                                 |  | 200220012000 |  | $175,000 $175,000 $150,000 |  | $ $ $ | 21,250                                                 
|Jeffrey A. Dankworth President of StarGuide Digital Networks, Inc.                       |  | 200220012000 |  | $250,000 $250,000 $250,000 |  | $ $ $ |                                                       
|Robert C. Ryan General Intellectual Property Counsel of StarGuide Digital Networks, Inc. |  | 200220012000 |  | $275,000 $275,000$203,624  |  | $ $ $ |   20,376                                               

---

|(1) |  | Annual compensation amounts for 2000 represent the combined amounts and awards for services performed by the individuals related to both Digital Generation Systems, Inc. and
StarGuide Digital Networks, Inc.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) |  | For 2002, represents reimbursement of automobile expenses ($32,612), travel expenses incurred during 1999 and 2000 but not reimbursed by the Company until 2002 ($706,305) and
miscellaneous expenses ($16,931). For 2001, represents reimbursement of automobile expenses ($12,000) and travel expenses incurred during 1999 and 2000 ($155,542). Effective January 1, 2001, the Company ceased reimbursement of expenses, related to
Mr. Ginsburgs airplane, incurred after such date. For 2000, represents reimbursement of automobile expenses ($12,000) and travel expenses incurred during 1999 and 2000 ($168,000).
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) |  | Represents reimbursement of automobile expenses.
|--- |  | ------------------------------------------------

|(4) |  | For 2002, includes medical expense reimbursement of $19,895. For 2001, includes forgiveness of loan ($400,000) and medical expense reimbursement ($20,733).
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------



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The following table contains information concerning the stock option grants made to each of the Named
Officers for 2002. No stock appreciation rights were granted to these individuals during such year.



|                     |  | Individual Grant (1)                            |  | Potential Realizable Value at Assumed Annual Rates of Stock Price Appreciation For Option
Term
|-------------------- |  | ----------------------------------------------- |  | ----------------------------------------------------------------------------------------------
|Name                 |  | Number of Securities Underlying Options Granted |  | % Of Total Options Granted to Employees In 2002                                               
|                     |  |                                                 |  |                                                                                               
|Scott K. Ginsburg    |  | 25,000                                          |  | 1.1                                                                                           
|Matthew E. Devine    |  | 25,000 500,000                                  |  | 1.1 22.2                                                                                      
|Omar A. Choucair     |  | 250,000                                         |  | 11.1                                                                                          
|Jeffrey A. Dankworth |  | 25,000                                          |  | 1.1                                                                                           
|Robert C. Ryan       |  | 25,000                                          |  | 1.1                                                                                           

---

|1. |  | Each of the options listed above have a term of 7 years, subject to earlier termination upon termination of employment. In the event of a merger of the Company with or into another
corporation or other legal entity, where vested options have not been assumed or substituted by such successor corporation or other entity, such options will be exercisable for a period for a period of 15 days from the date of notice thereof, and
will terminate upon the expiration of such period. The Companys 1992 Stock Option Plan provides that upon a change in control, the unvested options granted to each of the Companys executive officers will be subject to accelerated vesting
to the extent of 50% of such unvested options. A change in control is defined as (i) merger or acquisition of the Company resulting in a 50% or greater change in the total voting power of the Company immediately following such transaction, or (ii)
certain changes in the majority composition of the Companys Board of Directors during a 24-month period, which changes are not initiated by the Board of Directors.
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The following table sets forth information concerning option exercises during the 2002 fiscal year and option holdings as of
the end of the 2002 fiscal year with respect to each of the Named Officers. No stock appreciation rights were outstanding at the end of the year.



|Name                 |  | Shares Acquired on Exercise |             | Value Realized |               | Number of Securities Underlying Unexercised Options at Fiscal Year End |             | Value of Unexercised in-the-Money Options at Fiscal Year End (1)
|-------------------- |  | --------------------------- | ----------- | -------------- | ------------- | ---------------------------------------------------------------------- | ----------- | ----------------------------------------------------------------
|                     |  |                             | Exercisable |                | Unexercisable |                                                                        | Exercisable |                                                                 
|Scott K. Ginsburg    |  |                            |             | $              |              |                                                                        | 457,258     |                                                                 
|Matthew E. Devine    |  |                            |             | $              |              |                                                                        | 1,399,565   |                                                                 
|Omar A. Choucair     |  |                            |             | $              |              |                                                                        | 444,285     |                                                                 
|Jeffrey A. Dankworth |  |                            |             | $              |              |                                                                        | 197,278     |                                                                 
|Robert C. Ryan       |  |                            |             | $              |              |                                                                        | 395,410     |                                                                 

---

|(1) |  | Based on the fair market value of the Companys common stock at December 31, 2002, of $1.07 per share, less the exercisable price payable for each share.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------



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DIRECTOR COMPENSATION



Except for grants of stock options, directors of the Company generally do not receive compensation for services provided as a director other than
reimbursement for documented reasonable expenses incurred in connection with attendance at meetings of the Companys Board of Directors and the committees thereof. The Company also does not pay compensation for committee participation or
special assignments of the Board of Directors.



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



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



EMPLOYMENT CONTRACTS AND CHANGE IN CONTROL ARRANGEMENTS



None of the Companys current executive officers have employment or severance agreements with the Company, and their employment may be terminated at
any time at the discretion of the Board of Directors.



COMPENSATION COMMITTEE
INTERLOCKS AND INSIDER PARTICIPATION



The members of the
Compensation Committee are Messrs. Ginsburg, Lenihan and Kantor. Other than Mr. Ginsburg, the Companys Chairman of the Board and former Chief Executive Officer, none of these individuals was at any time during 2002, or at any other time, an
officer or employee of the Company.



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



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



Equity Compensation Plan Information:



The following table provides information about the securities authorized for issuance under the Companys equity compensation plans as of December
31, 2002:



|                                                           |  | (a)                                                                                          |  | (b)                                                                         |      | (c)                                                                                                                                        
|---------------------------------------------------------- |  | -------------------------------------------------------------------------------------------- |  | --------------------------------------------------------------------------- | ---- | -------------------------------------------------------------------------------------------------------------------------------------------
|Plan Category                                              |  | Number of securitiesto be issued uponexercise of outstanding options,warrants and rights (1) |  | Weighted-average exercise price of outstanding options, warrants and rights |      | Number of securitiesremaining availablefor future issuanceunder equity compensationplans (excluding securities reflected in column (a)) (2)
|Equity compensation plans approved by security holders     |  | 9,772,338                                                                                    |  | $                                                                           | 2.36 |                                                                                                                                            
|Equity compensation plans not approved by security holders |  |                                                                                             |  | $                                                                           |     |                                                                                                                                            
|                                                           |  |                                                                                              |  |                                                                             |      |                                                                                                                                            
|Total                                                      |  | 9,772,338                                                                                    |  | $                                                                           | 2.36 |                                                                                                                                            
|                                                           |  |                                                                                              |  |                                                                             |      |                                                                                                                                            

---

|(1) |  | This table excludes an aggregate of 7,823,033 shares issuable upon exercise of outstanding options and warrants assumed by the Company in connection with the Companys merger
with StarGuide Digital Networks, Inc. in January 2001. The weighted-average exercise price of the excluded options and warrants is $2.64 per share.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) |  | Includes 68,679 shares issuable under the Companys Employee Stock Purchase Plan, of which approximately 9,399 shares are issuable in connection with the current offering
period, which ends on April 30, 2003.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Beneficial Ownership Information:



The following table sets forth, as of January 31, 2003 (except where otherwise noted), certain information with respect to
shares beneficially owned by (i) each person who is known by the Company to be the beneficial owner of more than five percent of the Companys outstanding shares of common stock, (ii) each of the Companys directors and the executive
officers named in the Summary Compensation Table and (iii) all current directors and executive officers as a group. Beneficial ownership has been determined in accordance with Rule 13d-3 under the Exchange Act. Under this rule, certain shares may be
deemed to be beneficially owned by more than one person (if, for example, persons share the power to vote or the power to dispose of the shares). In addition, shares are deemed to be beneficially owned by a person if the person has the right to
acquire shares (for example, upon exercise of an option or warrant) within sixty (60) days of the date as of which the information is provided; in computing the percentage ownership of any person, the amount of shares is deemed to include the amount
of shares beneficially owned by such person (and only such person) by reason of such acquisition rights. As a result, the percentage of outstanding shares of any person as shown in the following table does not necessarily reflect the persons
actual voting power at any particular date.



|                                                                                                                            |  | Shares Beneficially Ownedas of January 31, 2003 (1) (2) | 
|--------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------------------------- | 
|Beneficial Owner                                                                                                            |  | Number ofShares                                         | 
|Scott Ginsburg (3) Moon Doggie Family Partnership 4707 Park Lane Dallas, Texas 75220                                        |  | 31,934,139                                              | 
|                                                                                                                            |  |                                                        
|Entities and individuals associated with Pequot Capital Management, Inc. (4) 354 Pequot Avenue Southport, Connecticut 06490 |  | 5,195,603                                               | 
|                                                                                                                            |  |                                                        
|C.D.A.S., Inc. (5) 2897 Granite Pointe Court Reno, NV 89511                                                                 |  | 2,858,575                                               | 
|                                                                                                                            |  |                                                        
|Matthew E. Devine (6)                                                                                                       |  | 2,706,273                                               | 
|Omar A. Choucair (7)                                                                                                        |  | 634,069                                                 | 
|Lawrence D. Lenihan, Jr (8)                                                                                                 |  | 5,236,992                                               | 
|David M. Kantor (9)                                                                                                         |  | 46,389                                                  | 
|Cappy R. McGarr (10)                                                                                                        |  | 169,445                                                 | 
|Jeffrey A. Dankworth (11)                                                                                                   |  | 5,598,320                                               | 
|Eric L. Bernthal (10)                                                                                                       |  | 744,669                                                 | 
|Robert J. Schlegel (10)                                                                                                     |  | 299,709                                                 | 
|Kevin Howe (10)                                                                                                             |  | 173,049                                                 | 
|Robert Ryan (12)                                                                                                            |  | 753,132                                                 | 
|All current directors and executive officers as a group                                                                     |  | 48,296,188                                              | 

---

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



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



|(2) |  | The number of shares of common stock deemed outstanding as of January 31, 2003 was 70,810,696. The number of beneficially owned shares includes shares issuable pursuant to stock
options and warrants that may be exercised within sixty days after January 31, 2003.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



34



---

##### Table of Contents

|(3) |  | Based on a filing with the Securities and Exchange Commission, dated January 22, 2001, indicating beneficial ownership as of such date. Includes 22,028,594 shares held in the name
of Scott K. Ginsburg and 2,920,134 shares held in the name of Moon Doggie Family Partnership, L.P. Scott K. Ginsburg, the Companys Chairman of the Board, is the sole general partner of Moon Doggie Family Partnership, L.P. Includes options
exercisable into 467,154 shares of common stock, warrants issued to Moon Doggie Family Partnership, L.P. exercisable into 3,008,527 shares of common stock and warrants issued to Scott K. Ginsburg exercisable into 3,509,730 shares of common stock.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(4) |  | Includes 375,367 shares held in the name of Pequot Offshore Private Equity Fund, Inc., 2,964,740 shares held in the name of Pequot Private Equity Fund, L.P., 823,902 shares held in
the name of Pequot International Fund, Inc. and 823,902 shares held in the name of Pequot Partners Fund, L.P. Pequot Capital Management, Inc. is the investment advisor to Pequot Offshore Private Equity Fund, Inc., Pequot Private Equity Fund, L.P.,
Pequot International Fund, Inc. and Pequot Partners Fund, L.P. (the Pequot Funds) and may be deemed to beneficially own all of such shares. Pequot Capital Management, Inc. acquired beneficial ownership of such shares from Dawson-Samberg
Capital Management, Inc., the former investment advisor to the Pequot Funds. On January 1, 1999, Dawson-Samberg Capital Management, Inc. spun-off a portion of its investment management business to Pequot Capital Management, Inc., including the
beneficial ownership of all of such shares formerly held by Dawson-Samberg Capital Management, Inc. Lawrence D. Lenihan, Jr., a member of the Companys Board of Directors, is a principal and minority shareholder of Pequot Capital Management,
Inc. Mr. Lenihan disclaims beneficial ownership of all shares held or beneficially owned by or through such entity. Includes warrants exercisable into 207,692 shares of common stock.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(5) |  | Based on most recent information received from C.D.A.S., Inc.
|--- |  | -------------------------------------------------------------



|(6) |  | Includes options exercisable into 1,441,330 shares of common stock and warrants exercisable into 303,310 shares of common stock.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------



|(7) |  | Includes options exercisable into 523,544 shares of common stock and warrants exercisable into 86,660 shares of common stock.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------



|(8) |  | Includes 5,195,603 shares beneficially owned by affiliated entities of Pequot Capital Management, Inc., of which Mr. Lenihan disclaims beneficial ownership as set forth in footnote
4 above. Includes options exercisable into 41,389 shares of common stock.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(9) |  | Includes options exercisable into 36,389 shares of common stock.
|--- |  | ----------------------------------------------------------------



|(10) |  | Includes options exercisable into 26,389 shares of common stock.
|---- |  | ----------------------------------------------------------------



|(11) |  | Includes options exercisable into 207,174 shares of common stock.
|---- |  | -----------------------------------------------------------------



|(12) |  | Includes options exercisable into 405,306 shares of common stock.
|---- |  | -----------------------------------------------------------------



ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS



During 2002 and 2001, the Company paid approximately $1,435,000 and $424,000 in legal fees, respectively to Latham & Watkins, a law firm for which Eric L. Bernthal is a partner.



During 2002, the Company paid approximately $105,000 in federal income taxes
on behalf of Robert Ryan in relation to stock options exercised.



ITEM 14. CONTROLS AND PROCEDURES



Our principal executive and financial officers have concluded, based on their evaluation as of a date within 90 days before the filing of this Form 10-K, that our disclosure controls and procedures under Rule 13a-14 of the Securities
Exchange Act of 1934 are effective to ensure that information we are required to disclose in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SECs
rules and forms, and include controls and procedures designed to ensure that information we are required to disclose in such reports is accumulated and communicated to management, including our principle executive and financial officers, as
appropriate to allow timely decisions regarding required disclosure.



Subsequent to our evaluation, there were no significant changes in internal controls or other factors that could significantly affect these internal controls.



35



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##### Table of Contents

PART IV



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



|(a) |  | 1. FINANCIAL STATEMENTS
|--- |  | -----------------------



The following financial statements are filed as part of this Report:



|                                                                                                      |  | Page
|----------------------------------------------------------------------------------------------------- |  | ----
|Independent Auditors Report                                                                          |  | F-2 
|Consolidated Balance Sheets as of December 31, 2002 and 2001                                          |  | F-3 
|Consolidated Statements of Operations for the three years ended December 31, 2002                     |  | F-4 
|Consolidated Statements of Stockholders Equity (Deficit) for the three years ended December 31, 2002 |  | F-5 
|Consolidated Statements of Cash Flows for the three years ended December 31, 2002                     |  | F-6 
|Notes to Consolidated Financial Statements                                                            |  | F-7 



2. FINANCIAL STATEMENT SCHEDULES



|IIValuation and Qualifying Accounts |  | S-1
|------------------------------------ |  | ---



3. EXHIBITS



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



36



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##### Table of Contents

|ExhibitNumber |     |  | Exhibit Title                                                                                                                                 
|------------- | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------
|              |    
|10.15         | (g) |  | Warrant No. 1 to Purchase Common Stock dated December 9, 1998 by and among Registrant and Scott K. Ginsburg.                                  
|              |    
|10.16         | (g) |  | Warrant No. 2 to Purchase Common Stock dated December 9, 1998 by and among Registrant and Scott K. Ginsburg                                   
|              |    
|10.17         | (h) |  | Registration Rights Agreement, dated December 17, 1999, by and among the Registrant and certain of its security holders.                      
|              |    
|10.18         | (h) |  | Common Stock Purchase Agreement dated December 17, 1999 by and among the Registrant and investors listed in Schedule A thereto.               
|              |    
|10.19         | (i) |  | Credit agreement, dated as of June 1, 2001 between Digital Generation Systems, Inc. as borrower and JP Morgan and Bank of New York as Lenders.
|              |    
|10.20         | (j) |  | Customer Service Agreement, dated September 12, 2002 between Digital Generation Systems, Inc. and Sprint Communications Company L.P.          
|              |    
|21.1          | (a) |  | Subsidiaries of the Registrant.                                                                                                               
|              |    
|23.1          | **  |  | Consent of KPMG LLP.                                                                                                                          
|              |    
|31.1          | **  |  | Rule 13a-14(a)/15d-14(a) Certifications                                                                                                       
|              |    
|31.2          | **  |  | Rule 13a-14(a)/15d-14(a) Certifications                                                                                                       
|              |    
|32.1          | **  |  | Section 1350 Certifications                                                                                                                   



37



---

##### Table of Contents

|(a) |  | Previously filed.
|--- |  | -----------------



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



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



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



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



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



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



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



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



|(j) |  | Previously filed. The registrant has requested confidential treatment with respect to certain portions of this exhibit.
|--- |  | -----------------------------------------------------------------------------------------------------------------------



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

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



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



Not applicable.



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



See Item 15 (a) (3) above.



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



See Item 15(a) (2) above.



38



---

##### Table of Contents

SIGNATURES



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



|                          |  |  |  | DIGITAL GENERATION SYSTEMS, INC.
|------------------------- |  |  |  | --------------------------------
|                          |  |  | 
|Dated:  November 19, 2003 |  |  |  | By:                             
|                          |  |  |  |                                 



POWER OF ATTORNEY



KNOW ALL PERSONS BY THESE PRESENTS, that each
person whose signature appears below hereby constitutes and appoints Matthew E. Devine or Omar A. Choucair as his attorney-in-fact, with full power of substitution for him in any and all capacities, to sign any and all amendments to this report on
Form 10-K, and to file the same, with exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission.



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



|Signature                                                     |  | Title                                                                             |  | Date             
|------------------------------------------------------------- |  | --------------------------------------------------------------------------------- |  | -----------------
|                                                              |  |                                                                                  
|*Scott K. Ginsburg                                            |  | Chairman of the Board and Director                                                |  | November 19, 2003
|                                                              |  |                                                                                  
|/s/ MATTHEW E. DEVINEMatthew E. Devine                        |  | Chief Executive Officer and Director                                              |  | November 19, 2003
|                                                              |  |                                                                                  
|/s/ OMAR A. CHOUCAIROmar A. Choucair                          |  | Chief Financial Officer and Director (Principal Financial and Accounting Officer) |  | November 19, 2003
|                                                              |  |                                                                                  
|*David M. Kantor                                              |  | Director                                                                          |  | November 19, 2003
|                                                              |  |                                                                                  
|*Lawrence D. Lenihan, Jr.                                     |  | Director                                                                          |  | November 19, 2003
|                                                              |  |                                                                                  
|*Cappy McGarr                                                 |  | Director                                                                          |  | November 19, 2003
|                                                              |  |                                                                                  
|*Robert J. Schlegel                                           |  | Director                                                                          |  | November 19, 2003
|                                                              |  |                                                                                  
|*Kevin C. Howe                                                |  | Director                                                                          |  | November 19, 2003
|                                                              |  |                                                                                  
|*/s/  MATTHEW E. DEVINEMatthew E. Devine, as Attorney-in-Fact |  |                                                                                   |  |                  



39



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##### Table of Contents

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



|                                                                                                      |  | Page
|----------------------------------------------------------------------------------------------------- |  | ----
|Independent Auditors Report                                                                          |  | F-2 
|Consolidated Balance Sheets as of December 31, 2002 and 2001                                          |  | F-3 
|Consolidated Statements of Operations for the three years ended December 31, 2002                     |  | F-4 
|Consolidated Statements of Stockholders Equity (Deficit) for the three years ended December 31, 2002 |  | F-5 
|Consolidated Statements of Cash Flows for the three years ended December 31, 2002                     |  | F-6 
|Notes to Consolidated Financial Statements                                                            |  | F-7 



F-1



---

##### Table of Contents

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

INDEPENDENT AUDITORS REPORT



The Board of
Directors

Digital Generation Systems, Inc.:



We have audited the accompanying consolidated balance sheets of Digital Generation Systems, Inc. and subsidiaries as of December 31, 2002 and 2001, and
the related consolidated statements of operations, stockholders equity (deficit) and cash flows for each of the years in the three-year period ended December 31, 2002. In connection with our audits of the consolidated financial statements, we
have also audited the financial statement schedule as listed at Item 15(a) 2 for each of the years in the three-year period ended December 31, 2002. These consolidated financial statements and financial statement schedule are the responsibility of
the Companys management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.



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



In our opinion, the consolidated financial
statementsreferred to above present fairly, in all material respects, the financial position of Digital Generation
Systems, Inc. and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002, in conformity with accounting principles generally
accepted in the United States of America. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the
information set forth therein.



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



As discussed in Note 21 to the consolidated financial
statements, the accompanying consolidated balance sheet as of December 31, 2002 and the related consolidated statements of operations, stockholders equity (deficit) and cash flows for the year ended December 31, 2002, have been restated.



KPMG LLP



Dallas, Texas

February 12, 2003 (except for the

matter discussed in Note 21,

as to which the date is

November 18, 2003)



F-2



---

##### Table of Contents

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands, except per share amounts)



|                                                                                                                                                                        |  | December 31,2002 |          |   | December 31,2001 |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | -------- | - | ---------------- | -
|                                                                                                                                                                        |  | As Restated      |          |   |                  |  
|Assets                                                                                                                                                                  |  |                  |          |   |                  |  
|                                                                                                                                                                        |  |                 
|CURRENT ASSETS:                                                                                                                                                         |  |                  |          |   |                  |  
|Cash and cash equivalents                                                                                                                                               |  | $                | 2,527    |   |                  | $
|Accounts receivable (less allowance for doubtful accounts of $1,114 in 2002 and $2,883 in 2001)                                                                         |  |                  | 12,971   |   |                  |  
|Inventories                                                                                                                                                             |  |                  | 2,195    |   |                  |  
|Deferred income taxes                                                                                                                                                   |  |                  | 239      |   |                  |  
|Other current assets                                                                                                                                                    |  |                  | 605      |   |                  |  
|                                                                                                                                                                        |  |                  |          |   |                  |  
|Total current assets                                                                                                                                                    |  |                  | 18,537   |   |                  |  
|                                                                                                                                                                        |  |                  |          |   |                  |  
|                                                                                                                                                                        |  |                 
|Property and equipment, net                                                                                                                                             |  |                  | 12,757   |   |                  |  
|Goodwill, net                                                                                                                                                           |  |                  | 53,306   |   |                  |  
|Intangible and other assets, net                                                                                                                                        |  |                  | 12,605   |   |                  |  
|                                                                                                                                                                        |  |                  |          |   |                  |  
|TOTAL ASSETS                                                                                                                                                            |  | $                | 97,205   |   |                  | $
|                                                                                                                                                                        |  |                  |          |   |                  |  
|                                                                                                                                                                        |  |                 
|Liabilities and Stockholders Equity                                                                                                                                    |  |                  |          |   |                  |  
|                                                                                                                                                                        |  |                 
|CURRENT LIABILITIES:                                                                                                                                                    |  |                  |          |   |                  |  
|Accounts payable                                                                                                                                                        |  | $                | 4,362    |   |                  | $
|Accrued liabilities                                                                                                                                                     |  |                  | 4,915    |   |                  |  
|Deferred revenue, net                                                                                                                                                   |  |                  | 3,314    |   |                  |  
|Current portion of long-term debt and capital leases                                                                                                                    |  |                  | 5,469    |   |                  |  
|                                                                                                                                                                        |  |                  |          |   |                  |  
|Total current liabilities                                                                                                                                               |  |                  | 18,060   |   |                  |  
|                                                                                                                                                                        |  |                  |          |   |                  |  
|                                                                                                                                                                        |  |                 
|Deferred revenue, net                                                                                                                                                   |  |                  | 5,145    |   |                  |  
|Long-term debt and capital leases, net of current portion                                                                                                               |  |                  | 4,548    |   |                  |  
|Deferred income taxes                                                                                                                                                   |  |                  | 239      |   |                  |  
|                                                                                                                                                                        |  |                  |          |   |                  |  
|TOTAL LIABILITIES                                                                                                                                                       |  |                  | 27,992   |   |                  |  
|                                                                                                                                                                        |  |                  |          |   |                  |  
|                                                                                                                                                                        |  |                 
|STOCKHOLDERS EQUITY:                                                                                                                                                   |  |                  |          |   |                  |  
|Preferred stock, $0.001 par value                                                                                                                                      |  |                  |          |   |                  |  
|Authorized 15,000 shares; Issued and outstanding  none                                                                                                                 |  |                  |         |   |                  |  
|Common stock, $0.001 par value                                                                                                                                         |  |                  |          |   |                  |  
|Authorized 200,000 shares at December 31, 2002; 70,834 issued and 70,811 outstanding at December 31, 2002 and 70,807 issued and 70,784 outstanding at
December 31, 2001 |  |                  | 72       |   |                  |  
|Additional paid-in capital                                                                                                                                              |  |                  | 265,928  |   |                  |  
|Accumulated deficit                                                                                                                                                     |  |                  | (196,581 | ) |                  |  
|Receivables from issuance of common stock                                                                                                                               |  |                  | (105     | ) |                  |  
|Treasury stock, at cost                                                                                                                                                 |  |                  | (101     | ) |                  |  
|                                                                                                                                                                        |  |                  |          |   |                  |  
|TOTAL STOCKHOLDERS EQUITY                                                                                                                                              |  |                  | 69,213   |   |                  |  
|                                                                                                                                                                        |  |                  |          |   |                  |  
|TOTAL LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                              |  | $                | 97,205   |   |                  | $
|                                                                                                                                                                        |  |                  |          |   |                  |  



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



F-3



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##### Table of Contents

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)



|                                                                                                      |  | For years ended December 31, |         
|----------------------------------------------------------------------------------------------------- |  | ---------------------------- | --------
|                                                                                                      |  | 2002                         |         
|                                                                                                      |  | As Restated                  |         
|Revenues:                                                                                             |  |                              |         
|Audio and video content distribution                                                                  |  | $                            | 53,144  
|Product sales                                                                                         |  |                              | 8,045   
|Other                                                                                                 |  |                              | 5,105   
|                                                                                                      |  |                              |         
|Total revenues                                                                                        |  |                              | 66,294  
|                                                                                                      |  |                              |         
|                                                                                                      |  |                              |         
|Cost of revenues:                                                                                     |  |                              |         
|Audio and video content distribution                                                                  |  |                              | 26,336  
|Product sales                                                                                         |  |                              | 4,673   
|Other                                                                                                 |  |                              | 2,319   
|                                                                                                      |  |                              |         
|Total cost of revenues                                                                                |  |                              | 33,328  
|                                                                                                      |  |                              |         
|Operating expenses:                                                                                   |  |                              |         
|Sales and marketing                                                                                   |  |                              | 5,005   
|Research and development                                                                              |  |                              | 3,941   
|General and administrative expenses:                                                                  |  |                              |         
|Noncash stock award charges                                                                           |  |                              |        
|Other                                                                                                 |  |                              | 9,642   
|Restructuring charges                                                                                 |  |                              | 771     
|Depreciation and amortization                                                                         |  |                              | 7,390   
|                                                                                                      |  |                              |         
|Total operating expenses                                                                              |  |                              | 60,077  
|                                                                                                      |  |                              |         
|Income (loss) from operations                                                                         |  | $                            | 6,217   
|Other (income) expense:                                                                               |  |                              |         
|Interest and other (income) expense, net                                                              |  |                              | (20     
|Interest expense                                                                                      |  |                              | 1,540   
|Equity in losses of joint venture                                                                     |  |                              |        
|                                                                                                      |  |                              |         
|Net income (loss) before income taxes and cumulative effect of change in accounting principle         |  | $                            | 4,697   
|Provision for income taxes                                                                            |  |                              | 1,848   
|                                                                                                      |  |                              |         
|Net income (loss) before cumulative effect of change in accounting principle                          |  |                              | 2,849   
|                                                                                                      |  |                              |         
|Cumulative effect of change in accounting principle                                                   |  |                              | (130,234
|                                                                                                      |  |                              |         
|Net loss                                                                                              |  | $                            | (127,385
|                                                                                                      |  |                              |         
|                                                                                                      |  |                              |         
|Basic net income (loss) per common share before cumulative effect of change in accounting principle   |  | $                            | 0.04    
|                                                                                                      |  |                              |         
|Diluted net income (loss) per common share before cumulative effect of change in accounting principle |  | $                            | 0.04    
|                                                                                                      |  |                              |         
|Basic net loss per common share                                                                       |  | $                            | (1.80   
|                                                                                                      |  |                              |         
|Diluted net loss per common share                                                                     |  | $                            | (1.80   
|                                                                                                      |  |                              |         
|Basic weighted average common shares outstanding                                                      |  |                              | 70,718  
|                                                                                                      |  |                              |         
|Diluted weighted average common shares outstanding                                                    |  |                              | 70,807  
|                                                                                                      |  |                              |         



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



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##### Table of Contents

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (DEFICIT)

(In thousands)



|                                                                 |  | Common Stock |  | Treasury Stock |    |        | Additional Paid-inCapital |   |        | NotesReceivable |      |   | AccumulatedDeficit |   |         | TotalStockholdersEquity(Deficit) | 
|---------------------------------------------------------------- |  | ------------ |  | -------------- | -- | ------ | ------------------------- | - | ------ | --------------- | ---- | - | ------------------ | - | ------- | --------------------------------- | 
|                                                                 |  | Shares       |  | Amount         |    | Shares |                           |   | Amount |                 |      |   |                    |  
|Balance at December 31, 1999                                     |  | 39,525       |  | $              | 40 |        | (139                      | ) |        | $               | (270 | ) |                    | $ | 17,855  |                                   | 
|                                                                 |  |              |  |                |    |        |                           |   |        |                 |      |   |                    |   |         |                                   | 
|Issuance of common stock                                         |  | 2,110        |  |                | 2  |        |                          |   |        |                 |     |   |                    |   | 12,083  |                                   | 
|Exercise of stock options                                        |  | 25           |  |                |   |        |                          |   |        |                 |     |   |                    |   | 30      |                                   | 
|Purchase of treasury stock                                       |  |             |  |                |   |        | (324                      | ) |        |                 | (701 | ) |                    |   |        |                                   | 
|Issuance of common stock warrants and options                    |  |             |  |                |   |        |                          |   |        |                 |     |   |                    |   | 19,630  |                                   | 
|Net loss                                                         |  |             |  |                |   |        |                          |   |        |                 |     |   |                    |   |        |                                   | 
|                                                                 |  |              |  |                |    |        |                           |   |        |                 |      |   |                    |   |         |                                   | 
|Balance at December 31, 2000                                     |  | 41,660       |  |                | 42 |        | (463                      | ) |        |                 | (971 | ) |                    |   | 49,598  |                                   | 
|                                                                 |  |              |  |                |    |        |                           |   |        |                 |      |   |                    |   |         |                                   | 
|Shares issued to effect DGS/StarGuide merger                     |  | 27,796       |  |                | 28 |        | 440                       |   |        |                 | 870  |   |                    |   | 211,591 |                                   | 
|Musicam Express acquisition                                      |  | 693          |  |                | 1  |        |                          |   |        |                 |     |   |                    |   | 3,999   |                                   | 
|Exercise of stock options                                        |  | 611          |  |                | 1  |        |                          |   |        |                 |     |   |                    |   | 367     |                                   | 
|Issuance of common stock under employee stock purchase plan      |  | 47           |  |                |   |        |                          |   |        |                 |     |   |                    |   | 74      |                                   | 
|Noncash stock compensation                                       |  |             |  |                |   |        |                          |   |        |                 |     |   |                    |   | 371     |                                   | 
|Net loss                                                         |  |             |  |                |   |        |                          |   |        |                 |     |   |                    |   |        |                                   | 
|                                                                 |  |              |  |                |    |        |                           |   |        |                 |      |   |                    |   |         |                                   | 
|Balance at December 31, 2001                                     |  | 70,807       |  | $              | 72 |        | (23                       | ) |        | $               | (101 | ) |                    | $ | 266,000 |                                   | 
|                                                                 |  |              |  |                |    |        |                           |   |        |                 |      |   |                    |   |         |                                   | 
|Exercise of stock options                                        |  | 1            |  |                |   |        |                          |   |        |                 |     |   |                    |   |        |                                   | 
|Issuance of common stock under employee stock purchase plan      |  | 26           |  |                |   |        |                          |   |        |                 |     |   |                    |   | 21      |                                   | 
|Note receivable issued to employee for exercise of stock options |  |             |  |                |   |        |                          |   |        |                 |     |   |                    |   |        |                                   | 
|Collection of note receivable from former employee               |  |             |  |                |   |        |                          |   |        |                 |     |   |                    |   | (93     | )                                 | 
|Net loss, as restated                                            |  |             |  |                |   |        |                          |   |        |                 |     |   |                    |   |        |                                   | 
|                                                                 |  |              |  |                |    |        |                           |   |        |                 |      |   |                    |   |         |                                   | 
|Balance at December 31, 2002, as restated                        |  | 70,834       |  | $              | 72 |        | (23                       | ) |        | $               | (101 | ) |                    | $ | 265,928 |                                   | 
|                                                                 |  |              |  |                |    |        |                           |   |        |                 |      |   |                    |   |         |                                   | 



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



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##### Table of Contents

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)



|                                                                                          |  | Years ended December 31, |         
|----------------------------------------------------------------------------------------- |  | ------------------------ | --------
|                                                                                          |  | 2002                     |         
|                                                                                          |  | As Restated              |         
|Cash flows from operating activities:                                                     |  |                          |         
|Net loss                                                                                  |  | $                        | (127,385
|Adjustments to reconcile net loss to net cash provided by (used in) operating activities: |  |                          |         
|Depreciation of property and equipment                                                    |  |                          | 5,312   
|Amortization of goodwill and other intangibles                                            |  |                          | 2,078   
|Impairment of goodwill                                                                    |  |                          | 130,234 
|Noncash stock award charges                                                               |  |                          |        
|Provision for income taxes                                                                |  |                          | 1,848   
|Provision for doubtful accounts                                                           |  |                          | 715     
|Equity in losses of joint venture                                                         |  |                          |        
|Changes in operating assets and liabilities, net of working capital from acquisitions:    |  |                          |         
|Accounts receivable                                                                       |  |                          | 156     
|Inventories                                                                               |  |                          | (68     
|Other assets                                                                              |  |                          | (1,910  
|Accounts payable and accrued liabilities                                                  |  |                          | (201    
|Deferred revenue, net                                                                     |  |                          | (3,284  
|                                                                                          |  |                          |         
|Net cash provided by (used in) operating activities                                       |  |                          | 7,495   
|                                                                                          |  |                          |         
|Cash flows from investing activities:                                                     |  |                          |         
|Purchases of property and equipment                                                       |  |                          | (723    
|Acquisitions, net of cash acquired                                                        |  |                          |        
|Investment in and advances to joint venture                                               |  |                          |        
|Loan to employee for issuance of common stock                                             |  |                          | (105    
|                                                                                          |  |                          |         
|Net cash used in investing activities                                                     |  |                          | (828    
|                                                                                          |  |                          |         
|Cash flows from financing activities:                                                     |  |                          |         
|Proceeds from issuance of common stock                                                    |  |                          | 21      
|Payments to acquire financing                                                             |  |                          | (112    
|Borrowings under long-term debt                                                           |  |                          | 6,500   
|Payments on long-term debt                                                                |  |                          | (13,273 
|Purchase of treasury stock                                                                |  |                          |        
|                                                                                          |  |                          |         
|Net cash provided by (used in) financing activities                                       |  |                          | (6,864  
|                                                                                          |  |                          |         
|Net increase (decrease) in cash and cash equivalents                                      |  |                          | (197    
|Cash and cash equivalents at beginning of year                                            |  |                          | 2,724   
|                                                                                          |  |                          |         
|Cash and cash equivalents at end of year                                                  |  | $                        | 2,527   
|                                                                                          |  |                          |         
|Interest paid                                                                             |  | $                        | 1,181   
|                                                                                          |  |                          |         
|Noncash financing activities:                                                             |  |                          |         
|Property and equipment acquired through capital lease                                     |  | $                        |        
|                                                                                          |  |                          |         



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



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##### Table of Contents

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



1.
The Company:



Digital Generations Systems, Inc. (the
Company) owns a nationwide digital network that beneficially links hundreds of advertisers and advertising agencies with more than 7,500 radio and 1,000 television stations across the United States and Canada. The Company also owns
proprietary digital software, hardware and communications technology, including various bandwidth satellite receivers, audio compression codes, software to operate integrated digital multimedia networks, software development for satellite
applications and engineering consulting services. The Company has a Network Operation Center located in Irving, Texas that delivers audio, video, image and data content that comprise transactions between the advertising and broadcast industries.



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



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



2. Summary of Significant Accounting Policies:



Consolidation



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



Cash and Cash Equivalents



Cash and cash equivalents consist of liquid investments
with original maturities of three months or less. The Company maintains substantially all of its cash and cash equivalents within a few major financial institutions in the United States. As of December 31, 2002 and 2001, cash equivalents consisted
primarily of investments in U.S. money market funds.



Allowance for Doubtful
Accounts



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



Inventories



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



Property and Equipment



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



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##### Table of Contents

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Impairment of Long-Lived Assets



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



Goodwill



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



Intellectual Property Rights



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



Investment in Joint Venture



The Companys investment in a joint venture was accounted for using the equity method during 2000. Losses in excess of the Companys investment
and its guaranteed minimum contribution were recognized in full based on the Companys intent to fund excess losses of the joint venture. The Company acquired the remaining interest in the joint venture during 2001 (see Note 3).



Use of Estimates



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



Revenue Recognition



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



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



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##### Table of Contents

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Research and Development and Software Development Costs



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



Income Taxes



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



Foreign Currencies



The Company provides services to certain entities located
outside of the United States of America. Losses on foreign currency transactions of $3 and $28 were recognized for the years ended December 31, 2002 and 2001, respectively (none in 2000) and are included in interest and other (income) expense in the
consolidated statements of operations.



Stock Option Plans



The Company applies the intrinsic value-based method of accounting
prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, in accounting for its fixed plan stock options. As such, compensation expense would be
recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation,
established accounting and disclosure requirements using a fair value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to continue to apply the intrinsic value-based method
of accounting described above, and has adopted the disclosure requirements of SFAS No. 123. Pro forma net income and earnings per share disclosures, as if the Company recorded compensation expense based on the fair value for stock-based awards, have
been restated in accordance with the provisions of SFAS No. 148, Accounting for



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##### Table of Contents

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Stock-based Compensation  Transition and Disclosure, and are as follows for the three years ended
December 31, 2002, 2001and 2000 (in thousands, except per share amounts).



|                                                                                                                                    |  | 2002        |          |   | 2001 |   |         | 2000 | 
|----------------------------------------------------------------------------------------------------------------------------------- |  | ----------- | -------- | - | ---- | - | ------- | ---- | 
|                                                                                                                                    |  | As Restated |          |   |      |   |         |      | 
|Net loss:                                                                                                                           |  |             |          |   |      |   |         |      | 
|As reported                                                                                                                         |  | $           | (127,385 | ) |      | $ | (9,029  | )    | 
|Stock-based employee compensation cost included in reported net income, net of related tax effects                                  |  |             |         |   |      |   | 156     |      | 
|Total stock-based employee compensation expense determined under fair value-based method for all awards, net of related tax
effects |  |             | (1,456   | ) |      |   | (3,296  | )    | 
|                                                                                                                                    |  |             |          |   |      |   |         |      | 
|Pro forma                                                                                                                           |  | $           | (128,841 | ) |      | $ | (12,169 | )    | 
|                                                                                                                                    |  |             |          |   |      |   |         |      | 
|                                                                                                                                    |  |             |         
|Basic earnings per share of common stock:                                                                                           |  |             |          |   |      |   |         |      | 
|As reported                                                                                                                         |  | $           | (1.80    | ) |      | $ | (0.13   | )    | 
|Pro forma                                                                                                                           |  | $           | (1.82    | ) |      | $ | (0.17   | )    | 
|                                                                                                                                    |  |             |         
|Diluted earnings per share of common stock:                                                                                         |  |             |          |   |      |   |         |      | 
|As reported                                                                                                                         |  | $           | (1.80    | ) |      | $ | (0.13   | )    | 
|Pro forma                                                                                                                           |  | $           | (1.82    | ) |      | $ | (0.17   | )    | 



The fair value of each
option grant is estimated on the date of grant using the multiple option approach of the Black-Scholes option pricing model with the following assumptions used for grants in 2002, 2001 and 2000, respectively; risk-free interest rates of 4.1%, 5.1%
and 6.4%; a dividend yield of 0%; expected life of five years; and volatility factors of the expected market price of the Companys common stock of 100%, 136% and 113%.



Financial Instruments and Concentration of Credit Risk



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



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



During the year ended December 31, 2002, the Company had one customer, BBDO, that accounted for $7.8 million (12%) of its
revenue. No single customer accounted for more than 10% of the Companys revenue during the years ended December 31, 2001 and 2000.



3. Acquisitions:



During January 2001, the Company completed its merger with StarGuide, which was accounted for under the purchase method of accounting. In this merger, the
holders of StarGuide common stock received approximately 1.7332 shares of the Companys common stock for each StarGuide share held, and the holders of Company common stock continued to hold their shares. StarGuide effectively issued
approximately 27,796,000 shares of common stock as a result of the merger. StarGuide was the acquirer for financial reporting purposes. The total purchase



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##### Table of Contents

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



consideration of $217.2 million included $212.6 million related to the fair value of the Companys common stock
(at $6.50 per share), options and warrants and merger transaction costs of $4.6 million. The purchase price was allocated to working capital ($6.0 million), property and equipment ($15.0 million), other assets ($0.4 million), long-term debt ($1.7
million) and identifiable intangible assets ($16.0 million) based on their fair values. During the third quarter of 2002, the Company recorded certain adjustments to the original purchase price allocation related to the components of property and
equipment. The net impact of these adjustments was insignificant to the Companys results of operations and financial position for all periods subsequent to the acquisition. The excess of purchase price over fair value of net assets acquired of
$181.5 million was allocated to goodwill and was being amortized over a 20-year period during the year ended December 31, 2001. For the year ended December 31, 2002, goodwill amortization was discontinued in accordance with SFAS No. 142,
Goodwill and Other Intangible Assets, with $130.2 million being recorded as a change in accounting principle.



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



4. Inventories:



Inventories as of December 31, 2002 and 2001 are summarized as follows (in thousands) :



|                  |  | 2002 |       | 2001
|----------------- |  | ---- | ----- | ----
|Raw materials     |  | $    | 724   |     
|Work-in-process   |  |      | 677   |     
|Finished goods    |  |      | 794   |     
|                  |  |      |       |     
|Total inventories |  | $    | 2,195 |     
|                  |  |      |       |     



5. Property and Equipment:



Property and equipment as of December 31, 2002 and 2001
are summarized as follows (in thousands):



|                                               |  | 2002 |         |   | 2001 |  
|---------------------------------------------- |  | ---- | ------- | - | ---- | -
|Network equipment                              |  | $    | 17,841  |   |      | $
|Office furniture and equipment                 |  |      | 5,620   |   |      |  
|Leasehold improvements                         |  |      | 624     |   |      |  
|                                               |  |      |         |   |      |  
|                                               |  |      | 24,085  |   |      |  
|Less accumulated depreciation and amortization |  |      | (11,328 | ) |      |  
|                                               |  |      |         |   |      |  
|                                               |  | $    | 12,757  |   |      | $
|                                               |  |      |         |   |      |  



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##### Table of Contents

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



6. Intangible and Other Assets:



Other assets as of December 31, 2002 and 2001 are summarized as follows (in thousands):



|                               |  | 2002 |        |   | 2001 |  
|------------------------------ |  | ---- | ------ | - | ---- | -
|Brand name                     |  | $    | 8,804  |   |      | $
|Employee workforce             |  |      |       |   |      |  
|Customer relationships         |  |      | 3,044  |   |      |  
|Other assets                   |  |      | 4,685  |   |      |  
|                               |  |      |        |   |      |  
|                               |  |      | 16,533 |   |      |  
|Less: accumulated amortization |  |      | (3,928 | ) |      |  
|                               |  |      |        |   |      |  
|                               |  | $    | 12,605 |   |      | $
|                               |  |      |        |   |      |  



During the year ended
December 31, 2002, the Company deferred approximately $1.6 million in legal expenses related to the defense of certain patents. During October 2002 and December 2002, the Company settled two of the cases and management believes both settlements to
be favorable to the Company. As a result of the settlements, the Company recorded approximately $0.2 million in amortization expense during the year ended December 31, 2002 related to these cases. The Company will continue to defer costs for the
pending cases that have not yet been settled ($0.9 million at December 31, 2002). If the Company is unsuccessful in defending its patents, all deferred patent costs will be expensed in the period in which the determination is made. If the results of
the cases are favorable to the Company, these costs will be amortized in proportion to the future incremental economic benefit that the Company expects to receive.



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



In accordance with SFAS No. 142, goodwill amortization was discontinued as of January 1, 2002. The Company identified two reporting units, as defined in SFAS No. 142, with goodwill, a Services unit and a Products
unit, which are included in the Audio and Video Content Distribution Segment. The Company recorded goodwill impairment of $130.2 million in the Services reporting unit, or $1.84 per diluted share, as a cumulative effect of change in accounting
principle in the first quarter of 2002. The assessment was performed primarily due to changes in the economy and the decline in our stock price since the valuation date of the shares issued in the DG/StarGuide merger. The fair value of the Services
reporting unit was determined by estimating the present value of future cash flows expected to be generated by this reporting unit.



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



|                                                     |  | Year Ended December 31, |         
|---------------------------------------------------- |  | ----------------------- | --------
|                                                     |  | 2002                    |         
|                                                     |  | As Restated             |         
|Reported net income (loss)                           |  | $                       | (127,385
|Goodwill amortization                                |  |                         |        
|Employee workforce amortization                      |  |                         |        
|                                                     |  |                         |         
|Adjusted net income                                  |  | $                       | (127,385
|                                                     |  |                         |         
|Reported basic and diluted earnings (loss) per share |  | $                       | (1.80   
|Goodwill amortization per share                      |  |                         |        
|                                                     |  |                         |         
|Adjusted basic and diluted earnings (loss) per share |  | $                       | (1.80   
|                                                     |  |                         |         



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DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Goodwill totaled $53.3 million at December 31, 2002 and $183.2 million at December 31, 2001. The changes in the
carrying value of goodwill by segment for the twelve months ended December 30, 2002 are as follows (in thousands):



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



Intangible assets as
of December 31, 2002 and December 31, 2001 are as follows (in thousands):



|                       |  | AmortizationPeriod |  | GrossIntangible Assets |        | AccumulatedAmortization |   |        | NetIntangible Assets
|---------------------- |  | ------------------ |  | ---------------------- | ------ | ----------------------- | - | ------ | --------------------
|December 31, 2002      |  |                    |  |                        |        |                         |   |        |                     
|Customer relationships |  | 3 years            |  | $                      | 3,044  |                         | $ | (2,029 | )                   
|Brand name             |  | 20 years           |  |                        | 8,804  |                         |   | (881   | )                   
|                       |  |                    |  |                        |        |                         |   |        |                     
|                       |  |                    |  | $                      | 11,848 |                         | $ | (2,910 | )                   
|                       |  |                    |  |                        |        |                         |   |        |                     
|December 31, 2001      |  |                    |  |                        |        |                         |   |        |                     
|Customer relationships |  | 3 years            |  | $                      | 3,044  |                         | $ | (1,015 | )                   
|Brand name             |  | 20 years           |  |                        | 8,804  |                         |   | (440   | )                   
|Employee workforce     |  | 3 years            |  |                        | 4,174  |                         |   | (1,391 | )                   
|                       |  |                    |  |                        |        |                         |   |        |                     
|                       |  |                    |  | $                      | 16,022 |                         | $ | (2,846 | )                   
|                       |  |                    |  |                        |        |                         |   |        |                     



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



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



|2003       |  | $ | 1,455
|---------- |  | - | -----
|2004       |  |   | 440  
|2005       |  |   | 440  
|2006       |  |   | 440  
|2007       |  |   | 440  
|Thereafter |  |   | 5,723
|           |  |   |      
|           |  | $ | 8,938
|           |  |   |      



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DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



7. Investment in Joint Venture



During 2000, the Company owned a 50% interest in Musicam, which serves the radio industry by enabling the transmission,
exchange, storage and retrieval of programming, commercials, music releases, affidavits of performance and other information over high-speed digital telecommunications circuits on an on-demand basis. The Company recognized losses in excess of its
investment and its guaranteed minimum contribution based on its intent to fund these excess losses. In addition, the Company made noninterest-bearing advances to Musicam to fund operations. The remaining 50% interest in Musicam was acquired in 2001.
(See Note 3.)



Included in revenues in the consolidated
statements of operations for 2000 is $104 of product sales to Musicam. The amounts deferred are recognized as equity in earnings (loss) of the joint venture on a straight-line basis over the period that Musicam depreciates the related equipment sold
by the Company



Summarized financial information for Musicam as
of December 31, 2000 and for the year ended December 31, 2000 is as follows (in thousands):



|                       |  | 2000 |       
|---------------------- |  | ---- | ------
|Results of operations: |  |      |       
|Sales                  |  | $    | 1,289 
|Gross profit           |  |      | 297   
|Net loss               |  |      | (2,542



8. Accrued Liabilities:



Accrued liabilities consist of the following (in
thousands) :



|                         |  | 2002 |       | 2001
|------------------------ |  | ---- | ----- | ----
|Telecommunications costs |  | $    | 479   |     
|Employee compensation    |  |      | 707   |     
|Merger liabilities       |  |      | 1,020 |     
|Property tax liabilities |  |      | 439   |     
|Lease obligations        |  |      | 251   |     
|Other                    |  |      | 2,019 |     
|                         |  |      |       |     
|                         |  | $    | 4,915 |     
|                         |  |      |       |     



9. Deferred Revenue, net:



During 1999, the Company entered into contracts with two
major radio broadcasting companies to produce and supply the Companys receivers, hubs and other items. The terms of the contracts are five and seven years and cover the related equipment and software, future software enhancements, technical
support, development work and training. As the equipment to be sold under the contracts includes software components that are more than incidental to the functionality of the equipment, the entire arrangement has been accounted for under AICPA
Statement of Position 97-2, Software Revenue Recognition. Cash received related to these contracts is recorded as deferred revenue, with revenue and cost of revenue being recognized on a straight-line basis over the respective contract
terms.



Revenues and cost of revenues under these two contracts
were (in thousands) $5,109 and $1,827, respectively during 2002 and $5,025 and $1,783, respectively, during 2001, and $3,462 and $1,177, respectively, during 2000.



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DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



The components of deferred revenue at December 31, 2002 and 2001 are as follows (in thousands):



|                         |  | 2002 |        |   | 2001 |  
|------------------------ |  | ---- | ------ | - | ---- | -
|Deferred revenue         |  | $    | 12,903 |   |      | $
|Deferred cost of revenue |  |      | (4,474 | ) |      |  
|Customer deposits        |  |      | 30     |   |      |  
|                         |  |      |        |   |      |  
|                         |  |      | 8,459  |   |      |  
|Less current portion     |  |      | (3,314 | ) |      |  
|                         |  |      |        |   |      |  
|                         |  | $    | 5,145  |   |      | $
|                         |  |      |        |   |      |  



10. Long-Term Debt:



Long-term debt as of December 31, 2002 is summarized as follows (in
thousands):



|Term loan                 |  | $ | 5,000  |  
|------------------------- |  | - | ------ | -
|Revolving line of credit  |  |   | 4,500  |  
|Capital lease obligations |  |   | 517    |  
|                          |  |   |        |  
|                          |  |   | 10,017 |  
|Less current portion      |  |   | (5,469 | )
|                          |  |   |        |  
|                          |  | $ | 4,548  |  
|                          |  |   |        |  



During June 2001, the
Company signed a long-term credit agreement with a bank that includes a term loan with an original principal amount of $12.5 million and a revolving credit facility with a borrowing base subject to the Companys eligible accounts receivable
balance. The agreement expires on May 31, 2004. The proceeds from the term loan were used in part to refinance outstanding debt of $9.8 million that was assumed as a result of the acquisition of Musicam during March 2001. Approximately $4.5 million
was outstanding under the revolving credit facility at December 31, 2002 and an additional $4.2 million was available for borrowing. The Company pays interest on borrowings at a variable rate. At December 31, 2002, the weighted average interest rate
on outstanding borrowings was 5.6%. The credit facility requires the Company to pay a quarterly facility fee of 0.50% of the average unused portion of the revolving line of credit and a commission fee on outstanding letters of credit. At December
31, 2002, the Company had $0.3 million outstanding in letters of credit.



Under the long-term credit agreement, as amended on June 14, 2002, the Company is required to maintain minimum EBITDA, as defined. In addition, the Company is required to maintain certain leverage ratios and current
ratios on a quarterly basis, and is subject to limitations on capital expenditures for a rolling twelve-month period and capital lease borrowings on an annual basis. As of December 31, 2002 and for the year then ended, the Company was in compliance
with these covenants.



At December 31, 2002, the long-term debt
outstanding under this facility matures as follows: $5.0 million in 2003 and $4.5 million in 2004.



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DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



11. Income Taxes:



Components of deferred tax assets at December 31, 2002 and 2001 are as follows (in thousands):



|Deferred Tax Assets                               |  | 2002 As Restated |         |   | 2001 |  
|------------------------------------------------- |  | ---------------- | ------- | - | ---- | -
|Net operating loss carryforwards                  |  | $                | 26,512  |   |      | $
|Current temporary differences                     |  |                  | 2,063   |   |      |  
|Other                                             |  |                  | 690     |   |      |  
|                                                  |  |                  |         |   |      |  
|Total gross deferred tax assets                   |  |                  | 29,265  |   |      |  
|Less valuation allowance                          |  |                  | (25,869 | ) |      |  
|                                                  |  |                  |         |   |      |  
|Net deferred tax assets after valuation allowance |  | $                | 3,396   |   |      | $
|                                                  |  |                  |         |   |      |  
|Deferred Tax Liabilities                          |  |                  |         |   |      |  
|Non-Deductible intangible assets                  |  |                  | (3,396  | ) |      |  
|                                                  |  |                  |         |   |      |  
|Net deferred tax assets                           |  |                  |        |   |      |  



Income tax expense
(benefit) differs from the amounts that would result from applying the federal statutory rate of 34% to the Companys net income (loss) before income taxes and cumulative effect of change in accounting principle as follows:



|                                                              |  | 2002 |       | 2001 |   |        | 2000 | 
|------------------------------------------------------------- |  | ---- | ----- | ---- | - | ------ | ---- | 
|Expected tax expense (benefit)                                |  | $    | 1,597 |      | $ | (3,070 | )    | 
|State income taxes, net of federal benefit                    |  |      | 251   |      |   |       |      | 
|Non-deductible amortization of goodwill and other intangibles |  |      |      |      |   | 3,070  |      | 
|Valuation allowance                                           |  |      |      |      |   |       |      | 
|                                                              |  |      |       |      |   |        |      | 
|                                                              |  | $    | 1,848 |      | $ |       |      | 
|                                                              |  |      |       |      |   |        |      | 



The net operating
losses (NOL) and research and development credit carryforwards of approximately $71.0 million and $0.2 million, respectively, will expire on various dates ranging from 2007 to 2020. Utilization of approximately $30.0 million of these carryforwards
will be limited on an annual basis as a result of the merger, pursuant to Section 382 of the Internal Revenue Code.



In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred
tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Based upon the level of historical
taxable income and projections for future taxable income over the periods that the deferred tax assets are deductible, management believes it is more likely than not that the Company will not realize the benefits of those deductible differences.
Accordingly, a valuation allowance has been recorded for the deferred tax assets which exceed the Companys deferred tax liabilities.



12. Employee Benefit Plan:



The Company has a 401(k) retirement plan for full-time U.S. based employees. Employees who are at least 21 years of age and have completed at least 90
days of service are eligible to participate in the plan. Employees may contribute up to 20% of gross pay with a maximum dollar limit for 2002 of $11,000. The employer contribution is made at the end of the plan year in an amount set by corporate
resolution, based on participants compensation. The Company made no contributions to the plan in 2002, 2001 or 2000.



13. Stockholders Equity (Deficit):



(a) Stock Options



In March 2000, the Company issued an award of stock purchase rights to a third party for 346,640 shares at $1.44 per share, resulting in a noncash charge
of $1,500. The stock purchase rights expired in March 2001. In addition, $1,255 of noncash stock compensation expense was recorded in the fourth quarter of 2000 related to the issuance of stock options to employees with exercise prices less than the
fair value of the stock on the date of grant.



(b) Warrants



The Company has issued warrants in connection with certain financing and
leasing transactions and common stock offerings. In February 2000, the Company issued warrants to its Chairman to purchase up to 3,899,700 shares of common stock at $1.44 per share, resulting in a noncash compensation charge of $16,875. The warrant
expires in February 2005. All of the outstanding warrants are convertible into common stock. The warrants outstanding at December 31, 2002 expire on various dates from 2003 through 2008. A summary of outstanding warrants at December 31, 2002, 2001
and 2000 and changes during the years then ended follows:



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DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



|                                     |  | 2002      |  | 2001                    |      | 2000    
|------------------------------------ |  | --------- |  | ----------------------- | ---- | --------
|                                     |  | Warrants  |  | Wtd. Avg.Exercise Price |      | Warrants
|Outstanding at beginning of the year |  | 8,544,870 |  | $                       | 2.48 |         
|Issued as a result of merger         |  |          |  |                         |     |         
|Granted                              |  |          |  |                         |     |         
|Canceled                             |  |          |  |                         |     |         
|Exercised                            |  |          |  |                         |     |         
|                                     |  |           |  |                         |      |         
|Outstanding at end of the year       |  | 8,544,870 |  | $                       | 2.48 |         
|                                     |  |           |  |                         |      |         



14. Stock Plans:



The Company has three Stock Option Plans:



1992 Stock Option Plan



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



1996 Supplemental Option Plan



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



1995 Director Option Plan



Under the Companys 1995 Director Option Plan (the Director
Plan), the Company may issue up to 800,000 shares of common stock to non-employee directors. The Director Plan provides that each future non-employee director of the Company will be automatically granted an option to purchase 10,000 shares of
common stock (the First Option) on the date on which the optionee first becomes a non-employee director of the Company and an additional option to purchase 2,500 shares of common stock (the Subsequent Option) on each
anniversary date thereafter. The exercise price per share of all options granted under the Director Plan shall be equal to the fair market value of a share of the Companys common stock on the date of grant. Shares subject to the First Option
vest over 36 months, and the Subsequent Option shares vest over 12 months beginning with the month following the second anniversary of its date of grant. The term of the options granted is ten years.



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DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



A summary of the Companys fixed plan stock options at December 31, 2002, 2001 and 2000 and
changes during the years then ended is presented below:



|                                               |  | 2002       |   | 2001 |                         | 2000
|---------------------------------------------- |  | ---------- | - | ---- | ----------------------- | ----
|                                               |  | Shares     |   |      | Wtd. Avg.Exercise Price |     
|Outstanding at beginning of the year           |  | 8,055,828  |   |      | $                       | 2.92
|Issued as a result of the merger               |  |           |   |      |                         |    
|Granted                                        |  | 2,747,724  |   |      | $                       | 1.15
|Exercised                                      |  | (500       | ) |      | $                       | 0.30
|Canceled                                       |  | (1,752,551 | ) |      | $                       | 2.38
|                                               |  |            |   |      |                         |     
|Outstanding at end of the year                 |  | 9,050,501  |   |      | $                       | 2.49
|                                               |  |            |   |      |                         |     
|Exercisable at end of the year                 |  | 6,341,868  |   |      | $                       | 2.79
|Weighted average fair value of options granted |  |            |   |      | $                       | 0.76



The following table
summarizes information about stock options outstanding at December 31, 2002:



|Options Outstanding      |  | Options Exercisable
|------------------------ |  | -------------------
|Range of Exercise Prices |  | Number Outstanding 
|$0.20$ 2.65             |  | 5,985,034          
|$2.75$5.00              |  | 1,465,509          
|$5.125$10.125           |  | 1,599,958          
|                         |  |                    
|$0.20$10.125            |  | 9,050,501          
|                         |  |                    



As of December 31,
2002, there were 9,703,157 shares available for future grant under the stock option plans.



15. Commitments and Contingencies:



(a) Leases



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



At December 31, 2002, future minimum annual payments under capital leases and non-cancelable operating leases are as follows (in thousands):



|                       |  |       |      
|---------------------- |  | ----- | -----
|Contractual Obligation |  | Total |      
|                       | 
|                       |  | 2003  |      
|Capital Leases         |  | $     | 531  
|Operating Leases       |  | $     | 6,056



The present value of
obligations under capital lease was $517, of which $469 is classified as a current liability.



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DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Rent expense totaled $2,603, $2,908 and $980 in 2002, 2001 and 2000, respectively.



As of December 31, 2002, the Company has non-cancelable future minimum
purchase commitments with its primary telephone service provider of $2.0 million for each of 2003, 2004 and 2005.



(b) Litigation



On October 12, 2001, StarGuide filed a complaint against Williams Communications Group, Inc. (Williams) in the United States District Court
for the District of Nevada alleging that Williams has willfully infringed three StarGuide patents. StarGuide has requested preliminary and permanent injunctive relief, damages, trebling of damages and costs and expenses. On January 15, 2002,
Williams answered the complaint, denying all material allegations in the complaint and asserting, as affirmative defenses, that the patents-in-suit are invalid and not infringed by Williams. On February 15, 2002, Williams moved for summary judgment
of non-infringement of the patents-in-suit. On March 4, 2002, StarGuide opposed Williams motion for summary judgment and moved to amend its complaint to add Williams Communications, LLC (WCL), a subsidiary of Williams, as a party
defendant. On April 22, 2002, Williams filed a Voluntary Petition under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the Southern District of New York. StarGuides claims against Williams are stayed
by virtue of Williams filing for Chapter 11 protection. WCL did not file for Chapter 11 protection. On April 30, 2002, the Nevada Court granted StarGuides motion to add WCL as a party defendant. On June 2, 2002, the Court denied
Williams motion for summary judgment of non-infringement. On July 3, 2002, WCL answered StarGuides complaint and asserted counterclaims seeking a declaratory judgment that the StarGuide patents are invalid and not infringed. The parties
are now engaged in discovery.



On February 8, 2002, WCL filed
suit against StarGuide and the Company in the Northern District of Oklahoma seeking a declaratory judgment that the patents involved in the Nevada lawsuit are invalid and not infringed. StarGuide and the Company moved to dismiss, transfer or stay
this lawsuit on the basis that the lawsuit brought by StarGuide in Nevada is the first-filed lawsuit between the parties concerning the patents. After the District of Nevada granted StarGuides motion to add WCL as a party defendant in that
action, WCL dismissed the Oklahoma lawsuit on July 11, 2002.



On June 25, 2002, StarGuide filed a second lawsuit against WCL, asserting infringement of a patent that was issued to StarGuide after the first lawsuit was filed. StarGuide has requested preliminary and permanent injunctive relief, damages,
trebling of damages and costs and expenses. On July 16, 2002, WCL answered StarGuides complaint and asserted counterclaims seeking a declaratory judgment that the StarGuide patent is invalid and not infringed. This lawsuit has been
consolidated with the lawsuit filed by StarGuide on October 12, 2001. The parties are engaged in discovery. On November 5, 2002, the court entered a stay in the case to allow the parties time to engage in settlement negotiations.



On May 17, 2002, WCL filed a petition in the District Court of Tulsa County
in the State of Oklahoma against the Company, asserting causes of action for unfair trade competition, interference with contract, violation of the Oklahoma Deceptive Trade Practices Act, and disparagement of property and trade libel. WCL has
requested permanent injunctive relief, damages, punitive damages and costs and expenses. On July 1, 2002, DGS answered the petition, denying the material allegations of the petition. The parties are now engaged in fact discovery. The Company
believes the allegations of the petition are without merit and intends to defend itself vigorously against WCLs claims.



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DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



The Company believes that any adverse outcome of the above litigation will be insignificant.



16. Net Income (Loss) Per Share:



Under SFAS No. 128 Earnings per Share. the Company is required
to compute earnings per share under two different methods (basic and diluted). Basic earnings per share is calculated by dividing net income (loss) attributable to common shareholders by the weighted average shares of common stock outstanding during
the period. Diluted earnings per share is calculated by dividing net income attributable to common shareholders by the weighted average shares of outstanding common stock and common stock equivalents during the period. Due to losses for fiscal years
2001 and 2000, inclusion of common stock equivalents would be anti-dilutive. Therefore, basic and diluted loss per share for the Company are the same.



A reconciliation of net loss per basic and diluted share for the three years ended December 31, 2002 follows (in thousands, except per share amounts):



|                                               |  | 2002        |          |   | 2001 |   |        | 2000 | 
|---------------------------------------------- |  | ----------- | -------- | - | ---- | - | ------ | ---- | 
|                                               |  | As Restated |          |   |      |   |        |      | 
|Basic:                                         |  |             |          |   |      |   |        |      | 
|Net loss applicable to common shareholders     |  | $           | (127,385 | ) |      | $ | (9,029 | )    | 
|Weighted average shares outstanding            |  |             | 70,718   |   |      |   | 70,443 |      | 
|                                               |  |             |          |   |      |   |        |      | 
|Net loss per share                             |  | $           | (1.80    | ) |      | $ | (0.13  | )    | 
|                                               |  |             |          |   |      |   |        |      | 
|Diluted:                                       |  |             |          |   |      |   |        |      | 
|Net loss applicable to common shareholders     |  | $           | (127,385 | ) |      | $ | (9,029 | )    | 
|                                               |  |             |          |   |      |   |        |      | 
|Weighted average shares outstanding            |  |             | 70,718   |   |      |   | 70,443 |      | 
|Add: Net effect of potentially dilutive shares |  |             | 89       |   |      |   |       |      | 
|                                               |  |             |          |   |      |   |        |      | 
|Total shares                                   |  |             | 70,807   |   |      |   | 70,443 |      | 
|                                               |  |             |          |   |      |   |        |      | 
|Net loss per share                             |  | $           | (1.80    | ) |      | $ | (0.13  | )    | 
|                                               |  |             |          |   |      |   |        |      | 



17. Related Party Transactions:



Prior to the merger between StarGuide and the Company,
the companies shared certain management personnel and had certain common shareholders, thus the two companies were related parties. During 2000, StarGuide charged approximately $658 to the Company for payroll, insurance and travel costs related to
shared employees and was charged $342 by DG Systems for shared office space, commons utilities and equipment. At December 31, 2002 and 2001, all intercompany balances and transactions for 2002 and 2001 have been eliminated.



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



|                              |  | Quarter Ended 
|----------------------------- |  | --------------
|                              |  | March 31, 2002
|Revenues                      |  | $             
|                              |  |               
|Gross profit                  |  |               
|                              |  |               
|Net income (loss) (restated)  |  |               
|                              |  |               
|Earnings per share (restated) |  | $             



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DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



|                                   |  | Quarter Ended  |       
|---------------------------------- |  | -------------- | ------
|                                   |  | March 31, 2001 |       
|Revenues                           |  | $              | 18,931
|                                   |  |                |       
|Gross profit                       |  |                | 8,904 
|                                   |  |                |       
|Net loss                           |  |                | (1,430
|                                   |  |                |       
|Earnings per share as reported     |  | $              | (0.02 
|                                   |  |                |       
|Earnings per share as adjusted (2) |  | $              | 0.03  



|(1) |  | Includes cumulative effect of implementation of FAS 142 of $130.2 million.
|--- |  | --------------------------------------------------------------------------

|(2) |  | Adjusts reported loss per share before cumulative effect of change in accounting principle to exclude goodwill amortization.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------



19. Segment Information:



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



|                                      |  | Year ended December 31, 2002        |         
|------------------------------------- |  | ----------------------------------- | --------
|                                      |  | Audio and VideoContent Distribution |         
|Revenues                              |  | $                                   | 62,728  
|Interest income                       |  |                                     | 20      
|Interest expense                      |  |                                     | (1,539  
|Depreciation and amortization expense |  |                                     | (7,375  
|Impairment loss                       |  |                                     | (130,234
|Net income (loss), as restated        |  | $                                   | (127,552
|                                      |  |                                     |         
|Purchases of property and equipment   |  | $                                   | 706     
|                                      |  |                                     |         
|Total assets (as restated)            |  | $                                   | 130,791 
|                                      |  |                                     |         



|                                      |  | Year ended December 31, 2001        |        
|------------------------------------- |  | ----------------------------------- | -------
|                                      |  | Audio and VideoContent Distribution |        
|Revenues                              |  | $                                   | 65,228 
|Interest income                       |  |                                     | 130    
|Interest expense                      |  |                                     | (1,772 
|Depreciation and amortization expense |  |                                     | (16,984
|Net income (loss)                     |  | $                                   | (9,175 
|                                      |  |                                     |        
|Purchases of property and equipment   |  | $                                   | 3,191  
|                                      |  |                                     |        
|Total assets                          |  | $                                   | 244,207
|                                      |  |                                     |        



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DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



|                                    |  | Year ended December 31, 2000        |        
|----------------------------------- |  | ----------------------------------- | -------
|                                    |  | Audio and VideoContent Distribution |        
|Revenues                            |  | $                                   | 6,924  
|Interest income                     |  |                                     | 300    
|Interest expense                    |  |                                     | (11    
|Depreciation expense                |  |                                     | (763   
|Equity in losses of joint venture   |  |                                     | (1,125 
|Noncash stock awards and charges    |  |                                     | (19,630
|Net income (loss)                   |  | $                                   | (27,960
|                                    |  |                                     |        
|Investment in joint venture         |  | $                                   | (2,586 
|                                    |  |                                     |        
|Purchases of property and equipment |  | $                                   | 647    
|                                    |  |                                     |        
|Total assets                        |  | $                                   | 22,165 
|                                    |  |                                     |        



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

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



20. New Accounting Pronouncements:



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



In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which replaces SFAS No. 121,
Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. The Company has adopted SFAS No. 144 for 2002, which did not have a significant impact on its financial condition or results of operations.



In July 2002, the FASB issued SFAS No. 146, Accounting
for Costs Associated with Exit or Disposal Activities. SFAS No. 146 applies to costs associated with an exit activity (including restructuring) or with a disposal of long-lived assets. SFAS No. 146 is effective prospectively for exit or
disposal activities initiated subsequent to December 31, 2002.





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DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



21. Restatement of Financial Information



In accordance with SFAS No. 109, during 2002, the Company should have recorded reductions in its valuation allowance for
deferred tax assets as a reduction in goodwill rather than as a deferred tax benefit. Consequently, income tax expense of $0.8 million should have been recorded during fiscal 2002.



Upon the adoption of SFAS No. 142 on January 1, 2002, the Company reclassified approximately $3 million of intangible assets
with indefinite useful lives to goodwill. The Company should have reclassified the deferred tax liability related to such assets of approximately $1.1 million to goodwill and recorded additional income tax expense of $1.1 million.



Had goodwill been reduced by the $1.1 million deferred tax liability, the
cumulative effect of adopting SFAS No. 142 would have been reduced by approximately $1.1 million. The following table summarizes the accounts that have been restated as a result of the adjustments described above (in thousands):



|                                                                                                         |  | Year ended December 31, 2002          |         
|-------------------------------------------------------------------------------------------------------- |  | ------------------------------------- | --------
|                                                                                                         |  | As Reported                           |         
|Provision for Income Taxes                                                                               |  | $                                     |        
|                                                                                                         |  |                                       |         
|Net income before cumulative effect of change in accounting principle                                    |  |                                       | 4,697   
|Cumulative effect of change in accounting principle                                                      |  |                                       | (131,291
|                                                                                                         |  |                                       |         
|Net Loss                                                                                                 |  | $                                     | (126,594
|                                                                                                         |  |                                       |         
|                                                                                                         |  |                                      
|Basic and diluted net income per common share before cumulative effect of change in accounting principle |  | $                                     | 0.07    
|Basic and diluted net loss per common share                                                              |  | $                                     | (1.79   
|                                                                                                         | 
|                                                                                                         |  | Three months ended March 31, 2002     |         
|                                                                                                         |  | As Reported                           |         
|Provision (Benefit) for Income Taxes                                                                     |  | $                                     |        
|                                                                                                         |  |                                       |         
|                                                                                                         |  |                                       |         
|Net loss before cumulative effect of change in accounting principle                                      |  |                                       | (857    
|Cumulative effect of change in accounting principle                                                      |  |                                       | (131,291
|                                                                                                         |  |                                       |         
|Net Loss                                                                                                 |  | $                                     | (132,148
|                                                                                                         |  |                                       |         
|                                                                                                         |  |                                      
|Basic and diluted net loss per common share before cumulative effect of change in accounting principle   |  | $                                     | (0.01   
|Basic and diluted net loss per common share                                                              |  | $                                     | (1.87   
|                                                                                                         | 
|                                                                                                         |  | Three months ended June 30, 2002      |         
|                                                                                                         |  | As Reported                           |         
|Provision for Income Taxes                                                                               |  | $                                     |        
|                                                                                                         |  |                                       |         
|Net Income                                                                                               |  | $                                     | 1,176   
|                                                                                                         |  |                                       |         
|Basic and diluted net income per common share                                                            |  | $                                     | 0.02    
|                                                                                                         | 
|                                                                                                         |  | Three months ended September 30, 2002 |         
|                                                                                                         |  | As Reported                           |         
|Provision for Income Taxes                                                                               |  | $                                     |        
|                                                                                                         |  |                                       |         
|Net Income                                                                                               |  | $                                     | 1,182   
|                                                                                                         |  |                                       |         
|Basic and diluted net income per common share                                                            |  | $                                     | 0.02    
|                                                                                                         | 
|                                                                                                         |  | Three months ended December 31, 2002  |         
|                                                                                                         |  | As Reported                           |         
|Provision for Income Taxes                                                                               |  | $                                     |        
|                                                                                                         |  |                                       |         
|Net Income                                                                                               |  | $                                     | 3,196   
|                                                                                                         |  |                                       |         
|Basic and diluted net income per common share                                                            |  | $                                     | 0.05    
|                                                                                                         | 
|                                                                                                         |  | As of December 31, 2002               |         
|                                                                                                         |  | As Reported                           |         
|Current deferred tax assets                                                                              |  | $                                     |        
|Total current assets                                                                                     |  |                                       | 18,298  
|Goodwill                                                                                                 |  |                                       | 54,097  
|Total assets                                                                                             |  |                                       | 97,757  
|Deferred tax liabilities                                                                                 |  |                                       |        
|Total liabilities                                                                                        |  |                                       | 27,753  
|Accumulated deficit                                                                                      |  |                                       | (195,790
|Total stockholders equity                                                                               |  |                                       | 70,004  
|Total liabilities and stockholders equity                                                               |  |                                       | 97,757  



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DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

SCHEDULE IIVALUATION AND QUALIFYING ACCOUNTS

(in thousands)



|Classification                  |  | Balance atBeginning of Period |       | AdditionsCharged toOperations |       | Other |       |     | Write-offs |        |   | Balance at End of Period
|------------------------------- |  | ----------------------------- | ----- | ----------------------------- | ----- | ----- | ----- | --- | ---------- | ------ | - | ------------------------
|                                |  |                               |       |                              
|Allowance for Doubtful Accounts |  |                               |       |                               |       |       |       |     |            |        |  
|Year Ended:                     |  |                               |       |                               |       |       |       |     |            |        |   |                         
|                                |  |                               |       |                               |      
|December 31, 2000               |  | $                             | 235   |                               | 531   |       | 81    |     |            |        |   |                         
|                                |  |                               |       |                               |      
|December 31, 2001               |  | $                             | 847   |                               | 1,954 |       | 2,907 | (a) |            | (2,825 | ) |                         
|                                |  |                               |       |                               |      
|December 31, 2002               |  | $                             | 2,883 |                               | 715   |       |      |     |            | (2,484 | ) |                         



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



S-1