**UNITED
      STATES SECURITIES AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**


**___________**





**FORM
      10-Q**








(Mark
      One)





xQuarterly
      report
      pursuant to Section 13 or 15(d) of the Securities Exchange Act of
      1934.





For
      the
      quarterly period ended September 30, 2006 or




oTransition
      report pursuant to Section 13
      or 15(d) of the Securities Exchange Act of 1934.





For
      the
      transition period from ___________ to___________





Commission
      file number 0-21917





Point.360


**(Exact
      Name of Registrant as Specified in Its Charter)**





**California**
              (State
                of or other jurisdiction of
              incorporation
                or organization)
            **95-4272619**
              (I.R.S.
                Employer Identification No.)**2777
                North Ontario Street, Burbank, CA**
              (Address
                of principal executive offices)
            **91504**
              (Zip
                Code)





(818)
      565-1400


**(Registrant’s
      Telephone Number, Including Area Code)**








**(Former
      Name, Former Address and Former Fiscal Year,**


**if
      Changed Since Last Report)**








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 (or for such shorter period that the registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days.





Yes x No
o




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





Large
                accelerated filer __________
            Accelerated
                Filer __________
            Non-accelerated
                filer X




Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).





Yes oNo
x





As
      of
      September 30, 2006, there were 9,748,332 shares of the registrant’s common stock
      outstanding.








**PART
      I - FINANCIAL INFORMATION**




**ITEM
      1.**  **FINANCIAL
      STATEMENTS**


**POINT.360**


**CONSOLIDATED
      BALANCE SHEETS**





**ASSETS**
                
                **December
                      31,**
                    **2005**
                
                **September
                      30,**
                    **2006**Current
                    assets:Cash
                    and cash equivalents
                
                $
                595,000
                
                $
                -Accounts
                    receivable, net of allowances for doubtfulaccounts
                    of $563,000 and $708,000 (unaudited), respectively
                
                
                12,662,000
                
                
                13,270,000Inventories
                
                
                796,000
                
                
                717,000Prepaid
                    expenses and other current assets
                
                
                2,432,000
                
                
                2,058,000Deferred
                    income taxes
                
                
                828,000
                
                
                828,000Total
                    current assets
                
                
                17,313,000
                
                
                16,873,000Property
                    and equipment, net
                
                
                28,079,000
                
                
                14,854,000Other
                    assets, net
                
                
                593,000
                
                
                1,456,000Goodwill
                
                
                29,474,000
                
                
                29,474,000Total
                    assets
                
                $
                75,459,000
                
                $
                62,657,000Current
                    liabilities:Accounts
                    payable
                
                $
                3,986,000
                
                $
                3,540,000Accrued
                    wages and benefits
                
                
                1,711,000
                
                
                1,277,000Accrued
                    earn-out payments
                
                
                2,000,000
                
                
                -Other
                    accrued expenses
                
                
                683,000
                
                
                881,000Income
                    taxes payable
                
                
                1,231,000
                
                
                623,000Borrowing
                    under revolving line of credit
                
                
                4,054,000
                
                
                2,439,000Current
                    portion of borrowings under notes payable
                
                
                2,310,000
                
                
                1,158,000Current
                    portion of capital lease and other obligations
                
                
                63,000
                
                
                32,000Current
                    portion of deferred gain on sale of real estate
                
                
                -
                
                
                178,000Total
                    current liabilities
                
                
                16,038,000
                
                
                10,128,000Deferred
                    income taxes
                
                
                6,121,000
                
                
                6,121,000Bank
                    notes payable, less current portion
                
                
                13,744,000
                
                
                3,763,000Capital
                    lease and other oblications, less current portion
                
                
                46,000
                
                
                8,000Deferred
                    gain on sale of real estate, less current portion
                
                
                -
                
                
                2,407,000Total
                    long-term liabilities
                
                
                19,911,000
                
                
                12,299,000Total
                    liabilities
                
                
                35,949,000
                
                
                22,427,000Contingencies
                    (Note 5)
                
                
                -
                
                
                -Shareholder'
                    equityPreferred
                    stock - no par value; 5,000,000 authorized; none
                    outstanding
                
                
                -
                
                
                -Common
                    stock - no par value; 50,000,000 authorized; 9,368,857and
                    9,748,332 (unaudited) shares issued and outstanding,
                    respectively
                
                
                17,971,000
                
                
                18,601,000Additional
                    paid - in capital
                
                
                1,159,000
                
                
                1,159,000Retained
                    earnings
                
                
                20,380,000
                
                
                20,470,000Total
                    shareholders' equity
                
                
                39,510,000
                
                
                40,231,000Total
                    liabilities and shareholders' equity
                
                $
                75,459,000
                
                $
                62,657,000


See
      accompanying notes to consolidated financial statements.





2


**POINT.360**





**CONSOLIDATED
      STATEMENTS OF INCOME (LOSS)**


**(Unaudited)**




**Three
                    Months Ended**
                  **September
                    30,**
              
              **Nine
                    Months Ended**
                  **September
                    30,****2005**
              
              **2006**
              
              **2005**
              
              **2006**Revenues
              
              $
              16,748,000
              
              $
              15,313,000
              
              $
              49,821,000
              
              $
              47,654,000Cost
                  of services sold
              
              
              (10,783,000
              )
              
              (10,335,000
              )
              
              (32,813,000
              )
              
              (31,988,000
              )Gross
                  profit
              
              
              5,965,000
              
              
              4,978,000
              
              
              17,008,000
              
              
              15,666,000Selling,
                  general and administrative expense
              
              
              (5,229,000
              )
              
              (4,694,000
              )
              
              (15,984,000
              )
              
              (14,799,000
              )Operating
                  income (loss)
              
              
              736,000
              
              
              284,000
              
              
              1,024,000
              
              
              867,000Interest
                  expense, net
              
              
              (379,000
              )
              
              (147,000
              )
              
              (999,000
              )
              
              (688,000
              )Income
                  (loss) before income taxes
              
              
              357,000
              
              
              137,000
              
              
              25,000
              
              
              179,000(Provision
                  for) benefit from income taxes
              
              
              (143,000
              )
              
              (72,000
              )
              
              (10,000
              )
              
              (89,000
              )Net
                  income (loss)
              
              $
              214,000
              
              $
              65,000
              
              $
              15,000
              
              $
              90,000Earnings(loss)
                  per share:Basic:Net
                  income (loss)
              
              $
              0.02
              
              $
              0.01
              
              $
              -
              
              $
              0.01Weighted
                  average number of shares
              
              
              9,364,345
              
              
              9,529,316
              
              
              9,338,960
              
              
              9,430,611Diluted:Net
                  income (loss)
              
              $
              0.02
              
              $
              0.01
              
              $
              -
              
              $
              0.01Weighted
                  average number of sharesincluding
                  the dilutive effectof
                  stock options
              
              
              9,709,515
              
              
              9,609,265
              
              
              9,813,250
              
              
              9,573,887





See
      accompanying notes to consolidated financial statements.




3


**POINT.360**





**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**


**(Unaudited)**


**Nine
                    Months Ended****September
                    30,****2005**
                
                **2006**Cash
                    flows from operating activities:Net
                    income (loss)
                
                $
                15,000
                
                $
                90,000Adjustments
                    to reconcile net income to net cashprovided
                    by operating activities:Depreciation
                    and amortization
                
                
                4,652,000
                
                
                4,132,000Provision
                    for doubtful accounts
                
                
                71,000
                
                
                145,000Other
                    non cash items
                
                
                183,000
                
                
                -Changes
                    in assets and liabilities:(Increase)
                    decrease in accounts receivable
                
                
                (766,000
                )
                
                (753,000
                )Decrease
                    in inventories
                
                
                120,000
                
                
                79,000(Increase)
                    decrease in prepaid expenses andother
                    current assets
                
                
                (179,000
                )
                
                375,000(Increase)
                    decrease in other assets
                
                
                (68,000
                )
                
                6,000Increase
                    (decrease) in accounts payable
                
                
                (123,000
                )
                
                (446,000
                )(Decrease)
                    in accrued expenses
                
                
                (1,898,000
                )
                
                (2,236,000
                )Increase
                    (Decrease) in income taxes
                
                
                143,000
                
                
                (608,000
                )(Decrease)
                    in deferred taxes
                
                
                (780,000
                )
                
                (870,000
                )Increase
                    in other current liabilities
                
                
                -
                
                
                33,000Net
                    cash provided by (used in) operating activities
                
                
                1,370,000
                
                
                (53,000
                )Cash
                    used in investing activities:Capital
                    expenditures
                
                
                (1,688,000
                )
                
                (2,248,000
                )Proceeds
                    from sale of Media Center real estate
                
                
                -
                
                
                13,893,000Amount
                    paid for acquisitions
                
                
                (25,000
                )
                
                -Net
                    cash used in investing activities
                
                
                (1,713,000
                )
                
                11,645,000Cash
                    flows provided by (used in) financing activities:Exercise
                    of stock options
                
                
                55,000
                
                
                630,000Change
                    in revolving credit agreement
                
                
                1,666,000
                
                
                (1,615,000
                )Proceeds
                    from bank note
                
                
                1,007,000
                
                
                -Shares
                    issued for an acquisition
                
                
                (400,000
                )
                
                -Repayment
                    of notes payable
                
                
                (2,150,000
                )
                
                (11,133,000
                )Repayment
                    of capital lease and other obligations
                
                
                (72,000
                )
                
                (69,000
                )Net
                    cash provided by (used in) financing activities
                
                
                106,000
                
                
                (12,187,000
                )Net
                    increase (decrease) in cash
                
                
                (237,000
                )
                
                (595,000
                )Cash
                    and cash equivalents at beginning of period
                
                
                668,000
                
                
                595,000Cash
                    and cash equivalents at end of period
                
                $
                431,000
                
                
                -Supplemental
                    disclosure of cash flow information -Cash
                    paid for:Interest
                
                $
                999,000
                
                $
                657,000Income
                    tax
                
                $
                866,000
                
                $
                1,116,000
  See
        accompanying notes to consolidated financial statements.


4


**POINT.360**





**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)**





**September
      30, 2006**





**NOTE
      1**  **-
      THE COMPANY**




Point.360
      (“Point.360” or the “Company”) provides video and film asset management services
      to owners, producers and distributors of entertainment and advertising content.
      The Company provides the services necessary to edit, master, reformat, archive
      and distribute its clients’ video content, including television programming,
      spot advertising and movie trailers. The Company provides worldwide electronic
      distribution, using fiber optics and satellites. The Company delivers
      commercials, movie trailers, electronic press kits, infomercials and syndicated
      programming, by both physical and electronic means, to thousands of broadcast
      outlets worldwide. The Company operates in one reportable segment.




The
      Company seeks to capitalize on growth in demand for the services related to
      the
      distribution of advertising and entertainment content, without assuming the
      production or ownership risk of any specific television program, feature film
      or
      other form of content. The primary users of the Company’s services are
      entertainment studios and advertising agencies that choose to outsource such
      services due to the sporadic demand of any single customer for such services
      and
      the fixed costs of maintaining a high-volume physical plant.




Since
      January 1, 1997, the Company has successfully completed ten acquisitions of
      companies providing similar services. The Company will continue to evaluate
      acquisition opportunities to enhance its operations and profitability. As a
      result of these acquisitions, the Company believes it is one of the largest
      and
      most diversified providers of technical and distribution services to the
      entertainment and advertising industries, and is therefore able to offer its
      customers a single source for such services at prices that reflect the Company’s
      scale economies.




The
      accompanying unaudited financial statements have been prepared in accordance
      with generally accepted accounting principles and the Securities and Exchange
      Commission’s rules and regulations for reporting interim financial statements
      and footnotes. In the opinion of management, all adjustments (consisting of
      normal recurring adjustments) considered necessary for a fair presentation
      have
      been included. Operating results for the three and nine-month periods ended
      September 30, 2006 are not necessarily indicative of the results that may be
      expected for the year ending December 31, 2006. These financial statements
      should be read in conjunction with the financial statements and related notes
      contained in the Company’s Form 10-K for the year ended December 31,
      2005.




**NOTE
      2**  **-
      LONG TERM DEBT AND NOTES PAYABLE**




On
      December 30, 2005, the Company entered into a new $10 million term loan
      agreement. The term loan provides for interest at LIBOR (5.4% as of September
      30, 2006) plus 3.15% and is secured by the Company’s equipment. The term loan
      will be repaid in 60 equal monthly principal payments plus interest. Proceeds
      of
      the term loan were used to repay a previously existing term loan. In March
      2006,
      the Company prepaid $4 million of the term loan with proceeds from the sale
      of
      real estate (see Note 3). Monthly principal payments were subsequently reduced
      pro rata.




In
      January 2006, the due date of the then existing credit facility was extended
      to
      March 31, 2006. As of December 30, 2005, the Company did not meet certain
      financial covenants contained in the credit facility and received a compliance
      waiver from the bank.




In
      March
      2006, the Company entered into a new credit agreement which provides up to
      $10
      million of revolving credit. The two-year agreement provides for interest of
      LIBOR plus 1.85% for the first six months of the agreement, and thereafter
      at
      either (i) prime (8.25% as of September 30, 2006) minus 0% - 1.00% or (ii)
      LIBOR
      plus 1.50% - 2.5%, depending on the level of the Company’s ratio of outstanding
      debt to fixed charges (as defined). The facility is secured by all of the
      Company’s assets, except for equipment securing the term loan. The revolving
      credit agreement requires the Company to comply with various financial and
      business covenants. There are cross default provisions contained in both the
      revolving and term loan agreements.





**NOTE
      3**  **-
      SALE OF REAL ESTATE**




On
      March
      29, 2006, the Company entered into a sale and leaseback transaction with respect
      to its Media Center vaulting real estate. The real estate was sold for
      approximately $14.0 million resulting in a $1.2 million after tax gain.
      Additionally, the Company received $0.5 million from the purchaser for
      improvements. In accordance with SFAS No. 28, *Accounting
      for Sales with Leasebacks* ,
      the
      gain, related deferred taxes of $870,000 and improvement allowance will be
      amortized over the initial 15-year lease term as reduced rent. Such amounts
      are
      included in deferred gain on sale of real estate on the balance sheet. Net
      proceeds at the closing of the sale and the improvement advance (approximately
      $13.9 million) were used to pay off the mortgage and other outstanding debt.
      The
      lease provides for base rental payments during the initial 15-year term of
      $1,111,000 per year (aggregating $16,665,000 over 15 years) plus annual cost
      of
      living increases beginning in year six. There are four five-year renewal
      options. The lease is accounted for as an operating lease.





5




The
      following table presents an unaudited pro forma summary balance sheet as of
      December 31, 2005 as if the sale and leaseback had occurred on that date (in
      thousands):




**As
                  Reported**
              
              
              **Adjustments**
              
              
              
              
              **Pro
                  Forma**Current
                  assets
              
              $
              17,313
              
              
              152
              
              (1
              )
              $
              17,465Property
                  and equipment, net
              
              
              28,079
              
              
              (11,249
              )
              (2
              )
              
              16,830Goodwill
                  and other assets
              
              
              30,067
              
              
              870
              
              (3
              )
              
              30,937Total
                  assets
              
              $
              75,459
              
              
              
              
              
              
              $
              65,232Accounts
                  payable and accrued expenses
              
              $
              8,380
              
              
              870
              
              (4
              )
              $
              9,250Deferred
                  income taxes
              
              
              1,231
              
              
              
              
              
              
              
              1,231Short-term
                  debt
              
              
              2,373
              
              
              (310
              )
              (5
              )
              
              2,063Borrowings
                  under revolving credit
              
              
              4,054
              
              
              (3,735
              )
              (5
              )
              
              319Current
                  liabilities
              
              
              16,038
              
              
              
              
              
              
              
              12,863Deferred
                  gain on sale
              
              
              -
              
              
              2,175
              
              (6
              )
              
              2,175Deferred
                  income taxes and other
              
              
              6,121
              
              
              500
              
              (7
              )
              
              6,621Long-term
                  notes payable
              
              
              13,790
              
              
              (9,727
              )
              (5
              )
              
              4,063Shareholders’
                  equity
              
              
              39,510
              
              
              
              
              
              
              
              39,510Total
                  liabilities and shareholders’ equity
              
              $
              75,459
              
              
              
              
              
              
              $
              65,232
 (1)  Prepaid
        rent & property taxes


(2)  Net
      book
      value of assets sold


(3)  Deferred
      taxes associated with gain on sale


(4)  Current
      tax liability


(5)  Pay-down
      of debt with net proceeds


(6)  Deferred
      gain on sale to be amortized over life of lease


(7)  Non-refundable
      advance from purchaser for improvements






**NOTE
      4**  **-
      STOCK-BASED COMPENSATION**




On
      January 1, 2006, we adopted Statements of Financial Accounting Standards
      No. 123 (revised 2004), *Share-Based
      Payment* ,
      (SFAS
      123(R)) which requires the measurement and recognition of compensation expense
      for all share-based payment awards made to employees and directors based on
      estimated fair values. SFAS 123(R) supersedes our previous accounting under
      Accounting Principles Board Opinion No. 25, *Accounting
      for Stock Issued to Employees* (APB 25)
      for periods beginning in fiscal 2006. In March 2005, the Securities and Exchange
      Commission issued Staff Accounting Bulletin No. 107 (SAB 107) relating to
      SFAS 123(R).  We have applied the provisions of SAB 107 in its adoption of
      SFAS 123(R).





SFAS
      123(R) requires companies to estimate the fair value of share-based payment
      awards to employees and directors on the date of grant using an option-pricing
      model. The value of the portion of the award that is ultimately expected to
      vest
      is recognized as expense over the requisite service periods in our Consolidated
      Statements of Operations. Prior to the adoption of SFAS 123(R), we accounted
      for
      stock-based awards to employees and directors using the intrinsic value method
      in accordance with APB 25 as allowed under SFAS No. 123, *Accounting
      for Stock-Based Compensation* .
      Under
      the intrinsic value method, no stock-based compensation expense had been
      recognized in our Consolidated Statements of Operations for awards to employees
      and directors because the exercise price of our stock options equaled the fair
      market value of the underlying stock at the date of grant.





SFAS
      123(R) requires companies to estimate the fair value of share-based payment
      awards to employees and directors on the date of grant using an option-pricing
      model. The value of the portion of the award that is ultimately expected to
      vest
      is recognized as expense over the requisite service periods in the Company’s
      Consolidated Statements of Income (Loss). Stock-based compensation expense
      recognized in the Consolidated Statements of Income (Loss) for the three and
      nine month periods ended September 30, 2006 included compensation expense for
      the share-based payment awards granted subsequent to January 1, 2006 based
      on
      the grant date fair value estimated in accordance with the provisions of SFAS
      123(R). There were no outstanding uninvested share-based payment awards as
      of
      January 1, 2006. For stock-based awards issued to employees and directors,
      stock-based compensation is attributed to expense using the straight-line single
      option method, which is consistent with how the prior-period pro formas were
      provided. As stock-based compensation expense recognized in the Statements
      of
      Consolidated Income (Loss) for 2006 is based on awards expected to vest, SFAS
      123(R) requires forfeitures to be estimated at the time of grant and revised,
      if
      necessary, in subsequent periods if actual forfeitures differ from those
      estimates. For the three and nine months ended September 30, 2006, expected
      forfeitures are immaterial and as such the Company is recognizing forfeitures
      as
      they occur. In the pro-forma information provided under SFAS 123 for the periods
      prior to fiscal 2006, the Company accounted for forfeitures as they
      occurred.




6


We
      adopted SFAS 123(R) using the modified prospective transition method, which
      requires the application of the accounting standard as of January 1, 2006,
      the first day of the Company’s fiscal year 2006. Our consolidated financial
      statements as of and for the three and nine-month periods ended September 30,
      2006 reflect the impact of SFAS 123(R). In accordance with the modified
      prospective transition method, our consolidated financial statements for prior
      periods have not been restated to reflect, and do not include, the impact of
      SFAS 123(R).  Stock-based compensation expense related to employee or
      director stock options recognized for the three and nine-month periods ended
      September 30, 2006 was $23,000 ($16,000 net of tax benefit) and $60,000 ($42,000
      net of tax benefit), respectively.





The
      Company’s determination of fair value of share-based payment awards to employees
      and directors on the date of grant uses the Black-Scholes model, which is
      affected by the Company’s stock price as well as assumptions regarding a number
      of complex and subjective variables. These variables include, but are not
      limited to, the expected stock price volatility over the expected term of the
      awards, and actual and projected employee stock option exercise behaviors.
      The
      Company estimates expected volatility using historical data. The expected term
      is estimated using the “safe harbor" provisions under SAB 107.





The
      following table illustrates the effect on net income (loss) and income (loss)
      per share if we had applied the fair value recognition provisions of SFAS 123
      to
      stock-based awards granted under the company’s stock option plans for the three
      and nine-month periods ended September 30, 2005.  For purposes of this
      pro-forma disclosure, the fair value of the options is estimated using the
      Black-Scholes-Merton option-pricing formula (Black-Scholes model) and amortized
      to expense over the options’ contractual term.




Net
                  income (loss):
              
              **Three
                    Months**
                  **Ended**
                **September
                  30,**
                **2005**
              
              **Nine
                    Months**
                  **Ended**
                  **September
                    30,**
                **2005**As
                  reported
              
              $
              214,000
              
              $
              15,000Deduct:
                  Total stock-based employeecompensation
                  expense determinedunder
                  fair value based method fo rall
                  awards, net of related tax effects
              
              
              (61,000
              )
              
              (158,000
              )Pro
                  forma
              
              
              153,000
              
              
              (143,000
              )Basic
                  earnings (loss) per share ofcommon
                  stock:As
                  reported
              
              $
              0.02
              
              $
              -Pro
                  forma
              
              $
              0.02
              
              $
              (0.02
              )Diluted
                  earnings (loss) per share ofcommon
                  stock:As
                  reported
              
              $
              0.02
              
              
              -Pro
                  forma
              
              $
              0.02
              
              $
              (0.01
              )





During
      the quarter ended September 30, 2006, the Company did not grant any stock-based
      awards to employees or non-employees. During the nine months ended September
      30,
      2006, the Company granted awards of stock options for 400,000 shares at an
      average market price of $2.25 per share. At September 30, 2006, there were
      options outstanding to acquire 2,485,000 shares at an average exercise price
      of
      $2.88 per share. The estimated fair value of all awards granted during the
      nine
      months ended September 30, 2006 was $397,000. The total fair value of options
      vested during 2006 was $60,000. The fair value of each option was estimated
      on
      the date of grant using the Black-Scholes option-pricing model with the
      following weighted average assumptions:





7




**Three
                  months ended**
              
              **Nine
                  months ended****September
                  30**
              
              **September
                  30****2005**
              
              **2006**
              
              **2005**
              
              **2006**Risk-free
                  interest rate
              
              
              3.54
              %
              
              5.23
              %
              
              3.02
              %
              
              4.85
              %Expected
                  term (years)
              
              
              5.00
              
              
              5.00
              
              
              5.00
              
              
              5.00Volatility
              
              
              43
              %
              
              42
              %
              
              43
              %
              
              42
              %Expected
                  annual dividends
              
              
              0.00
              %
              
              0.00
              %
              
              0.00
              %
              
              0.00
              %


At
      September 30, 2006, the Company had outstanding options under three stock
      options plans: the 1996 Stock Incentive Plan, the 2000 Nonqualified Stock Option
      Plan, and the 2005 Equity Incentive Plan. The 1996 and 2000 Plans were
      terminated in May 2005 upon shareholder approval of the 2005 Plan, except that
      outstanding options under the 1996 and 2000 Plans were not terminated. The
      2005
      Plan provides for the award of options to purchase up to 2,000,000 shares of
      common stock, as well as stock appreciation rights and restricted stock
      awards.





The
      following table summarizes the status of these plans as of September 30,
      2006:


**1996
                  Plan**
              
              **2000
                  Plan**
              
              **2005
                  Plan**Options
                  originally available
              
              
              3,800,000
              
              
              1,500,000
              
              
              2,000,000Stock
                  options outstanding
              
              
              1,314,000
              
              
              632,000
              
              
              539,000Options
                  available for grant
              
              
              -
              
              
              -
              
              
              1,461,000


Under
      all
      plans, the stock option price per share for options granted is determined by
      the
      Board of Directors and is based on the market price of the Company’s common
      stock on the date of grant, and each option is exercisable within the period
      and
      in the increments as determined by the Board, except that no option can be
      exercised later than ten years from the date it was granted. The stock options
      generally vest over one to five years.





A
      summary
      of the status of stock options as of September 30, 2005 and 2006, and changes
      during the three and nine-month periods then ended, is as follows.




**2005**
              
              **2006****Shares**
              
              
              
              **Wtd.
                        Avg.****Exercise**
                  **Price**
              
              **Shares**
              
              
              
              **Wtd.
                      Avg.**
                  **Exercise**
                  **Price**Outstanding
                  at beginning of the year
              
              2,352,947
              
              
              $
              2.82
              
              2,665,797
              
              
              $
              2.79Granted
              
              5,000
              
              
              $
              3.81
              
              20,000
              
              
              $
              2.40Exercised
              
              (4,400
              )
              
              $
              2.47
              
              (3,400
              )
              
              $
              1.35Canceled
              
              (64,447
              )
              
              $
              2.50
              
              (7,303
              )
              
              $
              2.73Outstanding
                  at March 31
              
              2,289,100
              
              
              $
              2.88
              
              2,675,094
              
              
              $
              2.78Granted
              
              501,400
              
              
              $
              2.95
              
              379,950
              
              
              $
              2.25Exercised
              
              (12,000
              )
              
              $
              1.93
              
              (49,725
              )
              
              $
              1.55Canceled
              
              (18,780
              )
              
              $
              2.42
              
              (110,503
              )
              
              $
              3.22Outstanding
                  at June 30
              
              2,759,720
              
              
              $
              2.86
              
              2,894,816
              
              
              $
              2.73Granted
              
              -
              
              
              
              -
              
              -
              
              
              
              -Exercised
              
              (11,325
              )
              
              $
              1.81
              
              (326,350
              )
              
              $
              1.54Canceled
              
              (45,382
              )
              
              $
              2.64
              
              (83,515
              )
              
              $
              2.90Outstanding
                  at September 30
              
              2,703,013
              
              
              $
              2.87
              
              2,484,951
              
              
              $
              2.88





As
      of
      September 30, 2006, the total compensation costs related to non-vested awards
      yet to be expensed was approximately $0.3 million to be amortized over the
      next
      four years.





8


The
      weighted average exercise prices for options granted and exercisable and the
      weighted average remaining contractual life for options outstanding as of
      December 31, 2005 and September 30, 2006 was as follows:




**As
                  of December 31, 2005**
              
              
              **Number
                    of**
                  **Shares**
              
              
              **Weighted
                    Average Exercise Price**
              
              
              **Weighted
                        Average**
                      **Remaining**
                      **Contractual
                        Life**
                      **(Years)**
              
              
              **Intrinsic**
                  **Value**Employees
                  - Outstanding
              
              
              2,300,797
              
              $
              2.69
              
              
              3.33
              
              $
              116,000Employees
                  - Expected to Vest
              
              
              2,300,797
              
              $
              2.69
              
              
              3.33
              
              $
              116,000Employees
                  - Exercisable
              
              
              2,300,797
              
              $
              2.69
              
              
              3.33
              
              $
              116,000Non-Employees
                  - Outstanding
              
              
              365,000
              
              $
              3.44
              
              
              3.87
              
              $
              1,000Non-Employees
                  - Expected to Vest
              
              
              365,000
              
              $
              3.44
              
              
              3.87
              
              $
              1,000Non-Employees
                  - Exercisable
              
              
              365,000
              
              $
              3.44
              
              
              3.87
              
              $
              1,000**As
                  of September 30, 2006**Employees
                  - Outstanding
              
              
              2,119,951
              
              $
              2.79
              
              
              3.35
              
              $
              16,000Employees
                  - Expected to Vest
              
              
              2,082,956
              
              $
              2.80
              
              
              3.33
              
              $
              16,000Employees
                  - Exercisable
              
              
              1,750,501
              
              $
              2.90
              
              
              3.07
              
              $
              16,000Non-Employees
                  - Outstanding
              
              
              365,000
              
              $
              3.44
              
              
              3.52
              
              
              -Non-Employees
                  - Expected to Vest
              
              
              365,000
              
              $
              3.44
              
              
              3.52
              
              
              -Non-Employees
                  - Exercisable
              
              
              365,000
              
              $
              3.44
              
              
              3.52
              
              
              -


Additional
      information with respect to outstanding options as of September 30, 2006 is
      as
      follows (shares in thousands):


**Options
                  Outstanding**
              
              
              **Options
                  Exercisable****Option
                    Exercise**
                  **Price
                    Range**
              
              
              **Number
                  of Shares**
              
              
              **Weighted
                      Average Remaining**
                    **Contractual
                      Life**
              
              
              **Weighted
                      Average Exercise Price**
              
              
              **Number
                  of Shares**
              
              
              **Weighted
                      Average Exercise Price**$
                  1.20 - $5.38
              
              
              2,479,000
              
              
              3.38
                  yrs.
              
              $
              2.87
              
              
              2,110,000
              
              $
              2.98$
                  7.00 - $10.00
              
              
              6,000
              
              
              .41
                  yrs.
              
              $
              7.00
              
              
              6,000
              
              $
              7.00





We
      have
      elected to adopt the detailed method provided in SFAS 123(R) for calculating
      the
      beginning balance of the additional paid-in capital pool (APIC pool) related
      to
      the tax effects of employee stock-based compensation, and to determine the
      subsequent impact on the APIC pool and Consolidated Statements of Cash Flows
      of
      the tax effects of employee stock-based compensation awards that are outstanding
      upon adoption of SFAS 123(R).





**NOTE
      5**  **-
      CONTINGENCIES**




On
      July
      10, 2006, Digital Generation Systems, Inc. (“DG”) filed a claim in the District
      Court of Dallas County, Texas, alleging that the Company interfered with a
      contract between DG and Pathfire, Inc. (Pathfire), which contract provided
      that
      DG was granted exclusive use of Pathfire’s network for the distribution of
      advertising content. The DG/Pathfire exclusivity excluded the distribution
      of
      certain other types of content (other than advertising content) to be
      distributed by Pathfire for CBS/Viacom. The claim alleges that the Company
      was
      aware of the exclusivity provision during its negotiations with CBS Worldwide
      Distribution, CBS Broadcasting, Inc. (“CBS”), which resulted in a January 2006
      contract between the Company and CBS (“CBS Contract”). Under the CBS Contract,
      the Company licensed advertising content distribution services from CBS, which
      services were to be performed utilizing Pathfire’s IP-Multicast Format Store
& Forward technology. DG alleges that the Company’s knowledge of the
      exclusivity provision during the Company’s negotiations with CBS and the
      resulting use of Pathfire’s technology for distribution of ads caused damage to
      DG. The claim seeks unspecified actual and punitive damages and other costs
      of
      prosecution.




9


If
      DG is
      successful in its claim, the possibility exists that the Pathfire distribution
      technology will become unavailable to the Company, through which the Company
      currently distributes a portion of its commercial spots. If that occurs, the
      Company believes it has alternative means to fulfill customer
      needs.




The
      Company believes the complaint is without merit and will not have a material
      effect on the Company’s financial position. Regardless, CBS has agreed to
      indemnify the Company pursuant to the CBS Contract to the extent permitted
      by
      law or otherwise.





From
      time
      to time the Company may become a party to other legal actions and complaints
      arising in the ordinary course of business, although it is not currently
      involved in any such material legal proceedings.











**NOTE
      6**  **-
      SHAREHOLDERS’ EQUITY**





During
      the nine-month period ended September 30, 2006, the number of outstanding shares
      of the Company’s common stock increased by 379,475 shares due to the exercise of
      employee stock options for $571,000 in cash.





10


**POINT.360**




**MANAGEMENT’S
      DISCUSSION AND ANALYSIS**




**ITEM
      2.**  **MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS**




*Except
      for the historical information contained herein, certain statements in this
      quarterly report are "forward-looking statements" as defined in the Private
      Securities Litigation Reform Act of 1995, which involve certain risks and
      uncertainties, which could cause actual results to differ materially from those
      discussed herein, including but not limited to competition, customer and
      industry concentration, dependence on technological developments, risks related
      to expansion, dependence on key personnel, fluctuating results and seasonality
      and control by management. See the relevant portions of the Company's documents
      filed with the Securities and Exchange Commission and Risk Factors in Item
      1A of
      Part II of this Form 10-Q, for a further discussion of these and other risks
      and
      uncertainties applicable to the Company's business.*




**Overview**




We
      are
      one of the largest providers of video and film asset management services to
      owners, producers and distributors of entertainment and advertising content.
      We
      provide the services necessary to edit, master, reformat, archive and ultimately
      distribute our clients’ film and video content, including television
      programming, spot advertising, feature films and movie trailers using electronic
      and physical means. We deliver commercials, movie trailers, electronic press
      kits, infomercials and syndicated programming to hundreds of broadcast outlets
      worldwide. Our interconnected facilities in Los Angeles, New York, Chicago,
      Dallas and San Francisco provide service coverage in each of the major U.S.
      media centers. Clients include major motion picture studios, advertising
      agencies and corporations.




We
      operate in a highly competitive environment in which customers desire a broad
      range of service at a reasonable price. There are many competitors offering
      some
      or all of the services provided by the Company. Additionally, some of our
      customers are large studios, which also have in-house capabilities that may
      influence the amount of work outsourced to companies like Point.360. We attract
      and retain customers by maintaining a high service level at reasonable
      prices.




In
      recent
      years, electronic delivery services have grown while physical duplication and
      delivery have been declining. We expect this trend to continue for the
      foreseeable future. All of our electronic, fiber optics, satellite and Internet
      deliveries are made using third party vendors, which eliminates our need to
      invest in such capability. However, the use of others to deliver our services
      poses the risk that costs may rise in certain situations that cannot be passed
      on to customers, thereby lowering gross margins. There is also the risk that
      third party vendors who directly compete with us will succeed in taking away
      business or refuse to allow us to use their distribution channels. In fact,
      in
      June 2005, one such vendor/competitor notified us that its electronic
      distribution channel would not be available to us except in very limited
      circumstances, or unless we entered certain “preferred vendor” arrangements that
      we believed would not be in the best long-term interests of Point.360. While
      curtailment of these services has not materially affected our ability to deliver
      commercial spots, we have not been able to pass on increased alternative
      delivery costs to our customers since June 2005. While we are exploring other
      lower cost alternatives, gross margins related to spot delivery revenues will
      be
      lower until such alternatives become available.




The
      Company has an opportunity to expand its business by establishing closer
      relationships with our customers through excellent service at a competitive
      price and maintaining adequate third party distribution channels. Our success
      is
      also dependent on attracting and maintaining employees capable of maintaining
      such relationships. Also, growth can be achieved by acquiring similar businesses
      (for example, the acquisition of International Video Conversions, Inc. (“IVC”)
      in July 2004) which can increase revenues by adding new customers, or expanding
      services provided to existing customers.




Our
      business generally involves the immediate servicing needs of our customers.
      Most
      orders are fulfilled within several days, with occasional larger orders spanning
      weeks or months. At any particular time, we have little firm
      backlog.




We
      believe that our nationwide interconnected facilities provide the ability to
      better service national customers than single-location competitors. We will
      look
      to expand both our service offering and geographical presence through
      acquisition of other businesses or opening additional facilities.




**Statistical
      Analysis**




The
      table
      below summarizes pro forma results for the three and nine-month periods ended
      September 30, 2005 and 2006, isolating the effects of the March 29, 2006
      sale/leaseback transaction for the 2006 periods: (in thousands except per share
      amounts)




11




****Quarter
                  Ended******September
                  30,
                  2005**
              
              **September
                  30, 2006****GAAP**
              
              **Pro
                  forma**
              
              **(1)**
              
              **GAAP**Revenues
              
              $
              16,748
              
              $
              15,313
              
              $
              -
              
              $
              15,313Cost
                  of services
              
              
              (10,783
              )
              
              (10,162
              )
              
              (173
              )
              
              (10,335
              )Gross
                  profit
              
              
              5,965
              
              
              5,151
              
              
              (173
              )
              
              4,978Selling,
                  general andadministrative
                  expense
              
              
              (5,229
              )
              
              (4,680
              )
              
              (14
              )
              
              (4,694
              )Operating
                  income
              
              
              736
              
              
              471
              
              
              (187
              )
              
              284Interest
                  expense, net
              
              
              (379
              )
              
              (413
              )
              
              266
              
              
              (147
              )Incomebefore
                  income taxes
              
              
              357
              
              
              58
              
              
              79
              
              
              137Provision
                  forincome
                  taxes
              
              
              (143
              )
              
              (31
              )
              
              (41
              )
              
              (72
              )Net
                  income
              
              $
              214
              
              $
              27
              
              $
              38
              
              $
              65Earnings
                  per share:Basic:
              
              $
              0.02
              
              $
              -
              
              $
              0.01
              
              $
              0.01Diluted:
              
              $
              0.02
              
              $
              -
              
              $
              0.01
              
              $
              0.01
  **Nine
                  Months
                  Ended****September
                  30,
                  2005**
              
              **September
                  30,
                  2006****GAAP**
              
              **Pro
                  forma**
              
              **(1)**
              
              **GAAP**Revenues
              
              $
              49,821
              
              $
              47,654
              
              $
              -
              
              $
              47,654Cost
                  of services
              
              
              (32,813
              )
              
              (31,642
              )
              
              (346
              )
              
              (31,988
              )Gross
                  profit
              
              
              17,008
              
              
              16,012
              
              
              (346
              )
              
              15,666Selling,
                  general andadministrative
                  expense
              
              
              (15,984
              )
              
              (14,771
              )
              
              (28
              )
              
              (14,799
              )Operating
                  income
              
              
              1,024
              
              
              1,241
              
              
              (374
              )
              
              867Interest
                  expense, net
              
              
              (999
              )
              
              (1,212
              )
              
              524
              
              
              (688
              )Incomebefore
                  income
              
              
              25
              
              
              29
              
              
              150
              
              
              179Provision
                  forfrom
                  income taxes
              
              
              (10
              )
              
              (14
              )
              
              (75
              )
              
              (89
              )Net
                  income
              
              $
              15
              
              $
              15
              
              $
              75
              
              $
              90Earnings
                  per share:Basic:
              
              $
              -
              
              $
              -
              
              $
              0.01
              
              $
              0.01Diluted:
              
              $
              -
              
              $
              -
              
              $
              0.01
              
              $
              0.01






(1)
            Effect
                of sale/leaseback transaction. The adjustments reflect the decrease
                in
                depreciation and the increase in rent associated with the real estate
                and
                lower interest expense resulting from the pay off of approximately
                $13.9
                million of mortgage and other debt with the sale
                proceeds.




**Three
      Months Ended September 30, 2006 Compared To Three Months Ended September 30,
      2005.**




*Revenues* .
      Revenues were $15.3 million for the three-month period ended September 30,
      2006,
      compared to $16.7 million for the three-month period ended September 30, 2005.
      Revenues declined in 2006 due to a number of factors including: (i) price
      compression due to competition in post production and spot advertising
      distribution, (ii) consolidation among some customers that has resulted in
      less
      business being available to Point.360, and (iii) the continuing trend toward
      electronic distribution of commercial spots as opposed to physical duplication
      and distribution which results in lower revenues. Billings to customers for
      sending commercial spots physically, has declined to about 4.6% of sales in
      the
      third quarter of 2006 from 5.1% in the prior year period. These factors have
      been somewhat offset by acquiring new customers and adding new service
      offerings. We expect the negative trends to continue at a slower pace in the
      future, and we will continue to invest in high definition capabilities where
      demand is expected to grow. We believe our high definition service platform
      will
      attract additional business in the future.




12


*Gross
      Profit* .
      In the
      third quarter of 2006, gross margin was 33 % of sales, compared to 36% for
      the
      quarter ended September 30, 2005. The sale/leaseback penalized third quarter
      gross margin by 1% of sales (i.e., lease costs increased $0.2 million in the
      2006 quarter net of depreciation associated with the previously-owned facility).
      The impact of the sale/leaseback will be continuing. The remaining decrease
      in
      gross profit percentage is due to lower sales offset by declining wages and
      benefits. Gross margins have been historically higher as a percentage of sales
      for advertising related revenue as compared to post production, the latter
      requiring a larger investment in equipment (greater depreciation) and higher
      personnel costs when compared to duplication and distribution of advertising
      content. We expect gross margins to fluctuate in the future as the sales mix
      changes.




*Selling,
      General and Administrative Expense* .  SG&A
      expense was $4.7 million (31% of sales) in the third quarter of 2006 as compared
      to $5.2 million (31% of sales) in the same period of 2005.




*Interest
      Expense* .  **** Interest
      expense for the three-month period ended September 30, 2006 was $0.1 million,
      a
      decrease of $0.2 million over the three-month period ended September 30, 2005.
      The decrease was due to lower debt levels resulting from the sale/leaseback
      transaction offset partially by higher rates on remaining variable interest
      debt.




**Nine
      Months Ended September 30, 2006 Compared to Nine Months Ended September 30,
      2005.**




*Revenues* .
      Revenues were $47.7 million for the nine-month period ended September 30, 2006,
      compared to $49.8 million for the nine-month period ended September 30, 2005.
      Revenues declined in 2006 due to a number of factors including: (i) price
      compression due to competition in post production and spot advertising
      distribution, (ii) consolidation among some customers that has resulted in
      less
      business being available to Point.360, and (iii) the continuing trend toward
      electronic distribution of commercial spots as opposed to physical duplication
      and distribution which results in lower revenues. Revenue from freight, the
      charge to customers for sending commercial spots physically, has declined to
      about 4.6% of sales in the third quarter of 2006 from 5.2% in the prior year
      period. These factors have been somewhat offset by acquiring new customers
      and
      adding new service offerings. We expect the negative trends to continue at
      a
      slower pace in the future, and we will continue to invest in high definition
      capabilities where demand is expected to grow. We believe our high definition
      service platform will attract additional business in the future.




*Gross
      Profit* .
      In the
      first nine months of 2006, gross margin was 33 % of sales, compared to 34%
      for
      the same period last year. The sale/leaseback penalized third quarter gross
      margin by 1% of sales (i.e., lease costs increased $0.4 million in the 2006
      period net of depreciation associated with the previously-owned facility).
      The
      impact of the sale/leaseback will be continuing. The remaining decrease in
      gross
      profit percentage is due to lower sales offset by declining wages and benefits.
      Gross margins have been historically higher as a percentage of sales for
      advertising related revenue as compared to post production, the latter requiring
      a greater investment in equipment (greater depreciation) and higher personnel
      costs when compared to duplication and distribution of advertising content.
      We
      expect gross margins to fluctuate in the future as the sales mix
      changes.




*Selling,
      General and Administrative Expense* .  SG&A
      expense was $14.8 million (31% of sales) in the first nine months of 2006 as
      compared to $16.0 million (32% of sales) in the same period of 2005.




*Interest
      Expense* .  **** Interest
      expense for the nine-month period ended September 30, 2006 was $0.7 million,
      a
      decrease of $0.3 million over the nine-month period ended September 30, 2005.
      The decrease was due to lower debt levels resulting from the sale/leaseback
      transaction offset partially by higher rates on remaining variable interest
      debt.




**LIQUIDITY
      AND CAPITAL RESOURCES**




On
      December 30, 2005, the Company entered a new $10 million term loan agreement.
      The term loan provides for interest at LIBOR (5.4% at September 30, 2006) plus
      3.15% and is secured by the Company’s equipment. The term loan will be repaid in
      60 equal principal payments plus interest. Proceeds of the loan were used to
      pay
      off our previously existing term loan.




In
      March
      2006, the Company entered into a new credit agreement which provides up to
      $10
      million of revolving credit. The two-year agreement provides for interest of
      LIBOR plus 1.85% for the first six months of the agreement, and thereafter
      either (i) prime (8.25% at September 30, 2006) minus 0% - 1.00% or (ii) LIBOR
      plus 1.50% - 2.50%, depending on the level of the Company’s ratio of outstanding
      debt to fixed charges (as defined). The facility is secured by all of the
      Company’s assets, except for equipment securing a new term loan as described
      above.




In
      March
      2006, the Company entered into a sale and leaseback transaction with respect
      to
      its Media Center vaulting real estate. The real estate was sold for $13,946,000
      resulting in a $1.2 million after tax gain. Additionally, we received $500,000
      from the purchaser for improvements. In accordance with SFAS No. 28, *Accounting
      for Sales with Leasebacks* (“SFAS
      28”), the gain and the improvement allowance will be amortized over the initial
      15-year lease term as reduced rent. Net proceeds at the closing of the sale
      and
      the improvement advance (approximately $13.9 million) were used to pay off
      the
      mortgage and other outstanding debt. In accordance with our agreement with
      the
      revolving credit lender, we prepaid $4 million of the term loan. As a result
      of
      the prepayment, monthly principal payments on the term loan were reduced by
      approximately $70,000 per month ($840,000 per year).




13


The
      following table summarizes the September 30, 2006 status of our revolving line
      of credit and term loans:


Revolving
                  credit
              
              $
              2,439,000Current
                  portion of term loan
              
              
              1,158,000Long-term
                  portion of term loan
              
              
              3,763,000Total
              
              $
              7,360,000




Monthly
      and annual principal and interest payments due under the term debt are
      approximately $94,000 and $1.1 million, respectively, assuming no change in
      interest rates, down from $260,000 and $3,100,000, respectively, from the term
      loan in existence in 2005. Simultaneously, monthly and annual cash lease costs
      have increased by $93,000 and $1,111,000, respectively.




Cash
      generated by operating activities is directly dependent upon sales levels and
      gross margins achieved. We generally receive payments from customers in 50-90
      days after services are performed. The larger payroll and freight components
      of
      cost of sales must be paid currently and within 30 days, respectively. Payment
      terms of other liabilities vary by vendor and type. Income taxes must be paid
      quarterly. Fluctuations in sales levels will generally affect cash flow
      negatively or positively in early periods of growth or contraction,
      respectively, because of operating cash receipt/payment timing. Other investing
      and financing cash flows also affect cash availability.




We
      expect
      that remaining amounts available under the new revolving credit arrangement,
      the
      availability of bank or institutional credit from new sources and cash generated
      from operations will be sufficient to fund debt service, operating needs and
      about $2.5 - 3.5 million of capital expenditures for the next twelve
      months.




The
      acquisition of IVC was completed in July 2004 for $2.3 million in cash and
      $4.7
      million in borrowings. The IVC purchase agreement also required payments of
      $1
      million, $2 million and $2 million in 2005, 2006 and 2007, respectively, if
      certain predetermined earnings levels (as defined) are met. In April 2005,
      $1
      million was paid. $2 million was paid in 2006.




During
      the past year, the Company has generated sufficient cash to meet operating,
      capital expenditure and debt service needs and obligations, as well as to
      provide sufficient cash reserves to address contingencies. When preparing
      estimates of future cash flows, we consider historical performance,
      technological changes, market factors, industry trends and other criteria.
      In
      our opinion, the Company will continue to be able to fund its needs for the
      foreseeable future.




We
      will
      continue to consider the acquisition of businesses complementary to our current
      operations. Consummation of any such acquisition or other expansion of the
      business conducted by the Company may be subject to the Company securing
      additional financing, perhaps at a cost higher than our existing term loans.
      Future earnings and cash flow may be negatively impacted to the extent that
      any
      acquired entities do not generate sufficient earnings and cash flow to offset
      the increased financing costs.




**CRITICAL
      ACCOUNTING POLICIES AND ESTIMATES**




Our
      discussion and analysis of our financial condition and results of operations
      are
      based upon our consolidated financial statements, which have been prepared
      in
      accordance with accounting principles generally accepted in the United States
      of
      America. The preparation of these financial statements requires us to make
      estimates and judgments that affect the reported amounts of assets, liabilities,
      revenues and expenses, and related disclosure of contingent assets and
      liabilities. On an on-going basis, we evaluate our estimates and judgments,
      including those related to allowance for doubtful accounts, valuation of
      long-lived assets, and accounting for income taxes. We base our estimates on
      historical experience and on various other assumptions that we believe 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 may differ from these
      estimates under different assumptions or conditions. We believe the following
      critical accounting policies affect our more significant judgments and estimates
      used in the preparation of our consolidated financial statements.




Critical
      accounting policies are those that are important to the portrayal of the
      Company's financial condition and results, and which require management to
      make
      difficult, subjective and/or complex judgements. Critical accounting policies
      cover accounting matters that are inherently uncertain because the future
      resolution of such matters is unknown. We have made critical estimates in the
      following areas:




14


*Revenues.* We
        perform a multitude of services for our clients, including film-to-tape
        transfer, video and audio editing, standards conversions, adding effects,
        duplication, distribution, etc. A customer orders one or more of these services
        with respect to an element (commercial
        spot, movie, trailer, electronic press kit, etc.). The sum total of services
        performed on a particular element (a “package”) becomes the deliverable (i.e.,
        the customer will pay for the services ordered in total when the entire job
        is
        completed). Occasionally, a major studio will request that package services
        be
        performed on multiple elements. Each element creates a separate revenue stream
        which is recognized only when all requested services have been performed
        on that
        element.




*Allowance
      for doubtful accounts* .
      We are
      required to make judgments, based on historical experience and future
      expectations, as to the collectibility of accounts receivable. The allowances
      for doubtful accounts and sales returns represent allowances for customer trade
      accounts receivable that are estimated to be partially or entirely
      uncollectible. These allowances are used to reduce gross trade receivables
      to
      their net realizable value. The Company records these allowances as a charge
      to
      selling, general and administrative expenses based on estimates related to
      the
      following factors: i) customer specific allowances; ii) amounts based upon
      an
      aging schedule and iii) an estimated amount, based on the Company's historical
      experience, for issues not yet identified.




*Valuation
      of long-lived and intangible assets* . Long-lived
      assets, consisting primarily of property, plant and equipment and intangibles
      (consisting only of goodwill), comprise a significant portion of the Company's
      total assets. Long-lived assets, including goodwill are reviewed for impairment
      whenever events or changes in circumstances have indicated that their carrying
      amounts may not be recoverable. Recoverability of assets is measured by
      comparing the carrying amount of an asset to its fair value in a current
      transaction between willing parties, other than in a forced liquidation sale.
      Fair value was estimated by independent appraisals and other valuation
      techniques.




Factors
      we consider important which could trigger an impairment review include the
      following:




l
            significant
                underperformance relative to expected historical or projected future
                operating results;


l
            significant
                changes in the manner of our use of the acquired assets or the strategy
                for our overall business;


l
            significant
                negative industry or economic
                trends;


l
            significant
                decline in our stock price for a sustained period;
                and


l
            our
                market capitalization relative to net book value.




When
      we
      determine that the carrying value of intangibles, long-lived assets and related
      goodwill and enterprise level goodwill may not be recoverable based upon the
      existence of one or more of the above indicators of impairment, we measure
      any
      impairment based on a projected discounted cash flow method using a discount
      rate determined by our management to be commensurate with the risk inherent
      in
      our current business model. Any amount of impairment so determined would be
      written off as a charge to the income statement, together with an equal
      reduction of the related asset. Net intangible assets, long-lived assets, and
      goodwill amounted to approximately $45.8 million as of September
      30, 2006 .




In
      2002,
      Statement of Financial Accounting Standards (“SFAS”) No. 142, “ *Goodwill
      and Other Intangible Assets* ”
(“SFAS
      142”) became effective and as a result, we ceased to amortize approximately
      $26.3 million of goodwill beginning in 2002. In lieu of amortization, we
      were required to perform an initial impairment review of our goodwill in 2002
      and an annual impairment review thereafter. The initial test on January 1,
      2002,
      and the Fiscal 2002, 2003, 2004 and 2005 tests performed as of September 30,
      2002, 2003, 2004 and 2005, respectively, required no goodwill impairment. An
      additional test was performed as of December 31, 2005 which required no
      impairment. The discounted cash flow method used to evaluate goodwill impairment
      included cash flow estimates for 2006 and subsequent years. In the 2006 test
      performed as of September 30, 2006, we determined the fair value of the
      enterprise using independent appraisals and other valuation techniques, and
      there was no impairment indicated. If future appraisals or future performance
      are affected by the factors cited above, resulting potential impairment could
      adversely affect the reported goodwill asset value and earnings.




*Accounting
      for income taxes* .
      As part
      of the process of preparing our consolidated financial statements, we are
      required to estimate our income taxes in each of the jurisdictions in which
      we
      operate. This process involves us estimating our actual current tax exposure
      together with assessing temporary differences resulting from differing treatment
      of items, such as deferred revenue, for tax and accounting purposes. These
      differences result in deferred tax assets and liabilities, which are included
      within our consolidated balance sheet. We must then assess the likelihood that
      our deferred tax assets will be recovered from future taxable income and to
      the
      extent we believe that recovery is not likely, we must establish a valuation
      allowance. To the extent we establish a valuation allowance or increase this
      allowance in a period, we must include an expense within the tax provision
      in
      the statement of operations.




Significant
      management judgment is required in determining our provision for income taxes,
      our deferred tax assets and liabilities and any valuation allowance recorded
      against our net deferred tax assets. The net deferred tax liability as of
      September 30, 2006 was $6.1 million. The Company did not record a valuation
      allowance against its deferred tax assets as of September 30, 2006.




**ITEM
      3.**  **QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**




*Market
      Risk* .
      The
      Company had borrowings of $7.4 million at September 30, 2006 under a term loan
      and revolving credit agreements. All debt was subject to a variable interest
      rate. The weighted average interest rate paid during the first nine months
      of
      2006 was 7.7%. For variable rate debt outstanding at September 30, 2006, a
      .25%
      increase in interest rates will increase annual interest expense by
      approximately $18,000. Amounts outstanding under the revolving credit facility
      provide for interest at the banks’ prime rate minus 0%- 1.00% assuming the same
      amount of outstanding debt or LIBOR plus 1.5% to 2.5%, and LIBOR plus 3.15%
      for
      the term loan. The Company’s market risk exposure with respect to financial
      instruments is to changes in prime or LIBOR rates.




15


**ITEM
      4.**  **CONTROLS AND PROCEDURES**




Pursuant
      to Rule 13a-15(b) under the Securities Exchange Act of 1934 (the “Exchange
      Act”), the Company’s management, with the participation of the Chief Executive
      Officer and Chief Financial Officer, evaluated the effectiveness of the
      Company’s disclosure controls and procedures, as of the end of the period
      covered by this report. Based on that evaluation, the Chief Executive Officer
      and Chief Financial Officer concluded that the Company’s disclosure controls and
      procedures are effective in ensuring that information required to be disclosed
      in reports that the Company files or submits under the Exchange Act is recorded,
      processed, summarized and reported within the time periods specified in the
      SEC’s rules and forms. No change in the Company’s internal control over
      financial reporting occurred during the Company’s most recent fiscal quarter
      that materially affected, or is reasonably likely to materially affect, the
      Company’s internal control over financial reporting.





**PART
      II - OTHER INFORMATION**




**ITEM
      1. LEGAL PROCEEDINGS**




On
      July
      10, 2006, Digital Generation Systems, Inc. (“DG”) filed a claim in the District
      Court of Dallas County, Texas, alleging that the Company interfered with a
      contract between DG and Pathfire, Inc. (Pathfire), which contract provided
      that
      DG was granted exclusive use of Pathfire’s network for the distribution of
      advertising content. The DG/Pathfire exclusivity excluded the distribution
      of
      certain other types of content (other than advertising content) to be
      distributed by Pathfire for CBS/Viacom. The claim alleges that the Company
      was
      aware of the exclusivity provision during its negotiations with CBS Worldwide
      Distribution, CBS Broadcasting, Inc. (“CBS”), which resulted in a January 2006
      contract between the Company and CBS (“CBS Contract”). Under the CBS Contract,
      the Company licensed advertising content distribution services from CBS, which
      services were to be performed utilizing Pathfire’s IP-Multicast Format Store
& Forward technology. DG alleges that the Company’s knowledge of the
      exclusivity provision during the Company’s negotiations with CBS and the
      resulting use of Pathfire’s technology for distribution of ads caused damage to
      DG. The claim seeks unspecified actual and punitive damages and other costs
      of
      prosecution.




If
      DG is
      successful in its claim, the possibility exists that the Pathfire distribution
      technology will become unavailable to the Company, through which the Company
      currently distributes a portion of its commercial spots. If that occurs, the
      Company believes it has alternative means to fulfill customer
      needs.




The
      Company believes the complaint is without merit and will not have a material
      effect on the Company’s financial position. Regardless, CBS has agreed to
      indemnify the Company pursuant to the CBS Contract to the extent permitted
      by
      law or otherwise.




**ITEM
      1A. RISK FACTORS**




In
      our
      capacity as Company management, we may from time to time make written or oral
      forward-looking statements with respect to our long-term objectives or
      expectations which may be included in our filings with the Securities and
      Exchange Commission (the “SEC”), reports to stockholders and information
      provided in our
      web
      site.




The
      words
      or phrases “will likely,” “are expected to,” “is anticipated,” “is predicted,”
“forecast,” “estimate,” “project,” “plans to continue,” “believes,” or similar
      expressions identify “forward-looking statements” within the meaning of the
      Private Securities Litigation Reform Act of 1995. Such forward-looking
      statements are subject to certain risks and uncertainties that could cause
      actual results to differ materially from historical earnings and those presently
      anticipated or projected. We wish to caution you not to place undue reliance
      on
      any such forward-looking statements, which speak only as of the date made.
      In
      connection with the “Safe Harbor” provisions of the Private Securities
      Litigation Reform Act of 1995, we are calling to your attention important
      factors that could affect our financial performance and could cause actual
      results for future periods to differ materially from any opinions or statements
      expressed with respect to future periods in any current statements.




The
      following list of important factors may not be all-inclusive, and we
      specifically decline to undertake an obligation to publicly revise any
      forward-looking statements that have been made to reflect events or
      circumstances after the date of such statements or to reflect the occurrence
      of
      anticipated or unanticipated events. Among the factors that could have an impact
      on our ability to achieve expected operating results and growth plan goals
      and/or affect the market price of our stock are:




l
            Recent
                history of losses.


l
            Prior
                breach and changes in credit agreements and ongoing
                liquidity.


l
            Our
                highly competitive marketplace.




16




l
            The
                risks associated with dependence upon significant
                customers.


l
            Our
                ability to execute our expansion
                strategy.


l
            The
                uncertain ability to manage in a changing
                environment.


l
            Our
                dependence upon and our ability to adapt to technological
                developments.


l
            Dependence
                on key personnel.


l
            Our
                ability to maintain and improve service
                quality.


l
            Fluctuation
                in quarterly operating results and seasonality in certain of our
                markets.


l
            Possible
                significant influence over corporate affairs by significant
                shareholders.





Investors
      are encouraged to examine the Company’s 2005 Form 10-K, which more fully
      describes the risks and uncertainties associated with the Company’s
      business.




**ITEM
      6. EXHIBITS**




**(a)**
            **Exhibits**





31.1  Certification
      of Chief Executive Officer Pursuant to 15 U.S.C. § 7241, as Adopted Pursuant to
      Section 302 of the Sarbanes-Oxley Act of 2002.





31.2  Certification
      of Chief Financial Officer Pursuant to 15 U.S.C. § 7241, as Adopted Pursuant to
      Section 302 of the Sarbanes-Oxley Act of 2002.





32.1  Certification
      of Chief Executive Officer Pursuant to 18 U.S.C. § 1350, as Adopted Pursuant to
      Section 906 of the Sarbanes-Oxley Act of 2002.





32.2  Certification
      of Chief Financial Officer Pursuant to 18 U.S.C. § 1350, as Adopted Pursuant to
      Section 906 of the Sarbanes-Oxley Act of 2002.




**SIGNATURES**




Pursuant
      to the requirements 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.




POINT.360DATE:
              November 14, 2006
            By:
            /s/ Alan
              R.
              SteelAlan R. Steel
              Executive
                Vice President,
              Finance
                and Administration
              (duly
                authorized officer and principal financial officer)






17