**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 March 31, 2005 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 an accelerated filer (as defined in Rule
12b-2 of the Exchange Act).
 
 Yes oNo x
 
 As of
March 31, 2005, there were 9,345,532 shares of the registrant’s common stock
outstanding.
  
  **PART
I - FINANCIAL INFORMATION**
  **ITEM
1.**  **FINANCIAL
STATEMENTS**
 
 **POINT.360**
 
 **CONSOLIDATED
BALANCE SHEETS**
 
 **ASSETS****December
      31,**
      **2004**
    
    **March
      31,**
      **2005**(unaudited)Current
      assets:Cash
      and cash equivalents
    
    $
    668,000
    
    $
    -Accounts
      receivable, net of allowances for doubtful
      accounts
      of $531,000 and $552,000 (unaudited), respectively
    
    
    12,468,000
    
    
    11,600,000Inventories
    
    
    932,000
    
    
    887,000Prepaid
      expenses and other current assets
    
    
    1,788,000
    
    
    1,676,000Deferred
      income taxes
    
    
    1,310,000
    
    
    1,310,000Total
      current assets
    
    
    17,166,000
    
    
    15,473,000Property
      and equipment, net
    
    
    31,451,000
    
    
    31,086,000Other
      assets, net
    
    
    742,000
    
    
    677,000Goodwill
      and other intangibles, net
    
    
    27,288,000
    
    
    27,473,000Total
      assets
    
    $
    76,647,000
    
    $
    74,709,000**LIABILITIES
      AND SHAREHOLDERS’ EQUITY**Current
      liabilities:Bank
      overdraft
    
    $
    -
    
    $
    693,000Accounts
      payable
    
    
    4,898,000
    
    
    4,150,000Accrued
      wages and benefits
    
    
    1,751,000
    
    
    1,435,000Accrued
      earn-out payments
    
    
    1,000,000
    
    
    1,000,000Other
      accrued expenses
    
    
    1,249,000
    
    
    1,074,000Income
      taxes payable
    
    
    1,148,000
    
    
    1,193,000Borrowings
      under revolving line of credit
    
    
    4,323,000
    
    
    3,131,000Current
      portion of borrowings under notes payable
    
    
    2,849,000
    
    
    2,850,000Current
      portion of capital lease and other obligations
    
    
    67,000
    
    
    63,000Total
      current liabilities
    
    
    17,285,000
    
    
    15,589,000Deferred
      income taxes
    
    
    5,788,000
    
    
    5,788,000Bank
      notes payable, less current portion
    
    
    14,494,000
    
    
    13,794,000Capital
      lease and other obligations, less current portion
    
    
    136,000
    
    
    114,000Total
      long-term liabilities
    
    
    20,418,000
    
    
    19,696,000Total
      liabilities
    
    
    37,703,000
    
    
    35,285,000Contingencies
      (Note 4 and 6)
    
    
    -
    
    
    -Shareholders’
      equityPreferred
      stock - no par value; 5,000,000 authorized; none
    outstanding
    
    
    -
    
    
    -Common
      stock - no par value; 50,000,000 authorized;
      9,236,132and
      9,345,532 (unaudited) shares issued and outstanding,
      respectively
    
    
    17,903,000
    
    
    18,314,000Additional
      paid-in capital
    
    
    675,000
    
    
    675,000Retained
      earnings
    
    
    20,366,000
    
    
    20,435,000Total
      shareholders’ equity
    
    
    38,944,000
    
    
    39,424,000Total
      liabilities and shareholders’ equity
    
    $
    76,647,000
    
    $
    74,709,000
 
 See
accompanying notes to consolidated financial statements.
 2
  **POINT.360**
 
 **CONSOLIDATED
STATEMENTS OF INCOME**
 **(Unaudited)**
 
 **Three
      Months Ended**
      **March
      31,****2004**
    
    **2005**Revenues
    
    $
    15,468,000
    
    $
    17,183,000Cost
      of goods sold
    
    
    (9,819,000
    )
    
    (11,402,000
    )Gross
      profit
    
    
    5,649,000
    
    
    5,781,000Selling,
      general and administrative expense
    
    
    (4,593,000
    )
    
    (5,360,000
    )Write-off
      of deferred acquisition,
      financing
      and settlement costs
    
    
    (2,000
    )
    
    -Operating
      income
    
    
    1,054,000
    
    
    421,000Interest
      expense, net
    
    
    (217,000
    )
    
    (307,000
    )Income
      (loss) before income taxes
    
    
    837,000
    
    
    114,000(Provision
      for) benefit from income taxes
    
    
    (344,000
    )
    
    (45,000
    )Net
      income (loss)
    
    $
    493,000
    
    $
    69,000Earnings
      per share:Basic:Net
      income (loss)
    
    $
    0.05
    
    $
    0.01Weighted
      average number of shares
    
    
    9,152,497
    
    
    9,302,596Diluted:Net
      income (loss)
    
    $
    0.05
    
    $
    0.01Weighted
      average number of shares
      including
      the dilutive effect of stock
      options
    
    
    9,890,447
    
    
    9,867,343
  See
accompanying notes to consolidated financial statements.
 3
  **POINT.360**
 
 **CONSOLIDATED
STATEMENTS OF CASH FLOWS**
 **(Unaudited)**
 
 **Three
      Months Ended**
      **March
      31,****2004**
    
    **2005**Cash
      flows from operating activities:Net
      income (loss)
    
    $
    493,000
    
    $
    69,000Adjustments
      to reconcile net income
      to
      net cash provided by operating activities:Depreciation
      and amortization
    
    
    1,391,000
    
    
    1,564,000Provision
      for doubtful accounts
    
    
    26,000
    
    
    24,000Deferred
      income taxes
    
    
    -
    
    
    -Other
      non cash item
    
    
    3,000
    
    
    -Write-off
      of acquisition costs
    
    
    -
    
    
    -Changes
      in assets and liabilities:Decrease
      (increase) in accounts receivable
    
    
    (1,214,000
    )
    
    892,000Decrease
      in inventories
    
    
    35,000
    
    
    45,000Decrease
      in prepaid expenses and
      other
      current assets
    
    
    65,000
    
    
    198,000Decrease
      in other assets
    
    
    18,000
    
    
    65,000(Decrease)
      increase in accounts payable
    
    
    750,000
    
    
    (748,000
    )Decrease
      in accrued expenses
    
    
    (463,000
    )
    
    (466,000
    )Increase
      in income taxes
    
    
    344,000
    
    
    131,000Net
      cash provided by operating activities
    
    
    1,538,000
    
    
    1,774,000Cash
      used in investing activities:Capital
      expenditures
    
    
    (287,000
    )
    
    (804,000
    )Proceeds
      from sale of equipment
    
    
    40,000
    
    
    -Net
      cash paid for acquisitions
    
    
    -
    
    
    (25.000
    )Net
      cash used in investing activities
    
    
    (247,000
    )
    
    (829,000
    )Cash
      flows used in financing activities:Exercise
      of stock options
    
    
    203,000
    
    
    11,000Change
      in revolving credit agreement
    
    
    -
    
    
    (498,000
    )Proceeds
      from bank note
    
    
    8,000,000
    
    
    -Shares
      issued for an acquisition
    
    
    -
    
    
    (400,000
    )Repayment
      of notes payable
    
    
    (15,866,000
    )
    
    (700,000
    )Repayment
      of capital lease obligations
    
    
    (19,000
    )
    
    (26,000
    )Net
      cash used in financing activities
    
    
    (7,682,000
    )
    
    (1,613,000
    )Net
      decrease in cash
    
    
    (6,391,000
    )
    
    (668,000
    )Cash
      and cash equivalents at beginning of period
    
    
    7,206,000
    
    
    668,000Cash
      and cash equivalents at end of period
    
    $
    815,000
    
    $
    -Supplemental
      disclosure of cash flow information -
      Cash
      paid for:Interest
    
    $
    241,000
    
    $
    289,000Income
      tax
    
    $
    59,000
    
    $
    86,000
  See
accompanying notes to consolidated financial statements.
 ****
 4
 ****
 **POINT.360**
 
 **NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)**
 
 **March
31, 2005**
 
 **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 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 nine 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-month period ended March 31, 2005
are not necessarily indicative of the results that may be expected for the year
ending December 31, 2005. 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, 2004.
  **NOTE
2**  **-**  **ACCOUNTING
PRONOUNCEMENTS**
  In May
2003, the Financial Accounting Standards Board issued Statement of Financial
Accounting Standards (“SFAS”) No. 150, “ *Accounting
for Certain Financial Instruments with Characteristics of both Liabilities and
Equity* .” SFAS
No. 150 establishes standards for how an issuer classifies and measures in its
statement of financial position certain financial instruments with
characteristics of both liabilities and equity. In accordance with the standard,
financial instruments that embody obligations for the issuer are required to be
classified as liabilities. SFAS No. 150 will be effective for financial
instruments entered into or modified after May 31, 2003 and otherwise will be
effective at the beginning of the first interim period beginning after June 15,
2003. This statement does not affect the Company at this time.
 
 In
November 2004, the FASB issued SFAS No. 151, *“Inventory
Costs* ”. SFAS
No. 151 amends the accounting for abnormal amounts of idle facility expense,
freight, handling costs, and wasted material (spoilage) under the guidance in
ARB No. 43, Chapter 4, *"Inventory
Pricing* ”.
Paragraph 5 of ARB No. 43, Chapter 4, previously stated that “. . . under some
circumstances, items such as idle facility expense, excessive spoilage, double
freight, and rehandling costs may be so abnormal as to require treatment as
current period charges. . . . *”* This
Statement requires that those items be recognized as current-period charges
regardless of whether they meet the criterion of "so abnormal." In addition,
this Statement requires that allocation of fixed production overheads to the
costs of conversion be based on the normal capacity of the production
facilities. This statement is effective for inventory costs incurred during
fiscal years beginning after June 15, 2005. Management does not expect adoption
of SFAS No. 151 to affect the Company’s financial statements.
 
 In
December 2004, the FASB issued SFAS No. 152, *“Accounting
for Real Estate Time-Sharing Transactions* ”. The FASB
issued this Statement as a result of the guidance provided in AICPA Statement of
Position (SOP) 04-2, “ *Accounting
for Real Estate Time-Sharing Transactions* ”. SOP
04-2 applies to all real estate time-sharing transactions. Among other items,
the SOP provides guidance on the recording of credit losses and the treatment of
selling costs, but does not change the revenue recognition guidance in SFAS No.
66,” *Accounting
for Sales of Real Estate* ”, for
real estate time-sharing transactions. SFAS No. 152 amends Statement No. 66 to
reference the guidance provided in SOP 04-2. SFAS No. 152 also amends SFAS No.
67, “ *Accounting
for Costs and Initial Rental Operations of Real Estate Projects* ”, to
state that SOP 04-2 provides the relevant guidance on accounting for incidental
operations and costs related to the sale of real estate time-sharing
transactions. SFAS No. 152 is effective for years beginning after June 15, 2005,
with restatements of previously issued financial statements prohibited. This
statement is not applicable to the Company.
 
 5
 
 In
December 2004, the FASB issued SFAS No. 153, “ *Exchanges
of Nonmonetary Assets* ,” an
amendment to Opinion
No. 29, *“Accounting
for Nonmonetary Transactions* ” . Statement
No. 153 eliminates certain differences in the guidance in Opinion No. 29 as
compared to the guidance contained in standards issued by the International
Accounting Standards Board. The amendment to Opinion No. 29 eliminates the fair
value exception for nonmonetary exchanges of similar productive assets and
replaces it with a general exception for exchanges of nonmonetary assets that do
not have commercial substance. Such an exchange has commercial substance if the
future cash flows of the entity are expected to change significantly as a result
of the exchange. SFAS No. 153 is effective for nonmonetary asset exchanges
occurring in periods beginning after June 15, 2005. Earlier application is
permitted for nonmonetary asset exchanges occuring in periods beginning after
December 16, 2004. Management
does not expect adoption of SFAS No. 153 to have a material impact on the
Company’s financial statements.
  In
December 2004, the FASB issued SFAS No. 123(R), “ *Share-Based
Payment* ”. SFAS
123(R) amends SFAS No. 123, “ *Accounting
for Stock-Based Compensation* ”, and
APB Opinion 25, “ *Accounting
for Stock Issued to Employees* .” SFAS
No.123(R) requires that the cost of share-based payment transactions (including
those with employees and non-employees) be recognized in the financial
statements. SFAS No. 123(R) applies to all share-based payment transactions in
which an entity acquires goods or services by issuing (or offering to issue) its
shares, share options, or other equity instruments (except for those held by an
ESOP) or by incurring liabilities (1) in amounts based (even in part) on the
price of the entity’s shares or other equity instruments, or (2) that require
(or may require) settlement by the issuance of an entity’s shares or other
equity instruments. This statement is effective (1) for public companies
qualifying as SEC small business issuers, as of the first interim period or
fiscal year beginning after December 15, 2005, or (2) for all other public
companies, as of the first fiscal year beginning after June 15, 2005, or (3) for
all nonpublic entities, as of the first fiscal year beginning after December 15,
2005. Management is currently assessing the effect of SFAS No. 123(R) on the
Company’s financial statements.
  **NOTE
3**  **-**  **LONG
TERM DEBT AND NOTES PAYABLE**
  In May
2002, the Company and its banks entered into a term loan agreement amending a
previous credit arrangement and having a maturity date of December 31, 2004.
Pursuant to the agreement, the Company made a $2 million principal payment and
made additional principal payments of $3.5 million and $7.0 million in 2002 and
2003, respectively. The agreement provided for interest at the banks’ reference
rate plus 1.25% and required the Company to maintain certain financial covenant
ratios. The term loan was secured by substantially all of the Company’s assets.
Certain legal and other costs associated with the new term loan, including fees
of $50,000 and $250,000 paid in May 2002 and June 2003, respectively, were
capitalized to be amortized over the remaining life of the loan.
  On March
12, 2004, the Company entered into a new credit agreement which provided up to
$10 million of revolving credit availability for two years and a five-year $8
million term loan. For the first two years of the term loan, the Company can
re-borrow all principal payments to finance up to 80% of capital equipment
purchases. The agreement provides for interest at the banks’ prime rate or LIBOR
plus 2.25% for the revolver, prime rate plus 0.25% or LIBOR plus 2.50% for the
term loan, and requires the Company to maintain certain financial covenant
ratios. The facilities are secured by all of the Company’s assets. The term loan
requires principal payments of $1.6 million annually. The $15,866,000
outstanding term loan as of December 31, 2003 was repaid by $1,000,000 of
scheduled principal payments made in January and February 2004 and, on March 12,
2004, by new term loan borrowings of $8,000,000 and cash payment of $6,866,000.
  In July
and August 2004, the term loan and revolving portions of the Company’s bank
facility were increased by $4.7 million and $1.9 million,
respectively.
  In August
2004, the Company entered into a Standing Loan Agreement and Swap Commitment
with a bank (the “Mortgage”) in order to purchase land and a building (see
below). Pursuant to the Mortgage, the Company borrowed $6,435,000 payable in
monthly installments of principal and interest on a fully amortized basis over
15 years. The mortgage debt is secured by the land and building.
  In
connection with the Mortgage, the Company entered into a one-year interest rate
swap contract to economically hedge the Mortgage debt. Under the terms of the
swap agreement, the amount hedged was $6,435,000 at a fixed 4.35% interest rate
for the first year. Prior to the end of the first year, by August 2005, the
Company was obligated to “fix” the interest rate with respect to the remaining
14 years of the Mortgage debt term based on a fixed rate quoted by the banks or
LIBOR plus 1.85% for that period. In December 2004, the rate was fixed at 6.83%
for the remaining term of the mortgage through a new hedge
agreement.
 6
  **NOTE
4**  **-**  **ISSUANCE
OF WARRANT, POSSIBLE ACQUISITION AND WRITE-OFF OF DEFERRED COSTS, RELATED LEGAL
ACTIONS AND SETTLEMENT**
 
 In July
2002, the Company acquired an option to purchase three subsidiaries (the
“Subsidiaries”) of Alliance Atlantis Communications Inc. (“Alliance”) engaged in
businesses directly related to those of the Company. In consideration for the
option, the Company issued to Alliance a warrant to acquire 500,000 shares of
the Company’s common stock at $2.00 per share. The warrant was to expire five
years from the closing date of the transaction, or July 3, 2005 if the Company
did not purchase the Subsidiaries. In connection therewith, the Company
capitalized the fair value of the warrant ($619,000 determined by using the
Black-Scholes valuation model) as an other asset on the balance
sheet.
 
 In
December 2002, the option was extended to March 10, 2003. In connection with the
extension, the Company made a $300,000 deposit toward the purchase price of the
Subsidiaries, which deposit was nonrefundable except in very limited
circumstances. The deposit was capitalized as an other asset. Additionally, the
Company capitalized approximately $700,000 of due diligence and other expenses
associated with the proposed acquisition during the six months ended June 30,
2003.
 
 The
Company did not exercise its option to purchase the Subsidiaries by the March
10, 2003 termination date; however, Alliance agreed to continue negotiations
with the Company to complete the transaction.
 
 In
connection with the possible acquisition of the Subsidiaries, the Company
entered discussions with several possible lenders to provide financing for the
purchase of the Subsidiaries and to pay off the Company’s then existing term
loan with a group of banks. A provision in the Company’s term loan agreement
prohibited acquisitions unless approved by the banks, which permission had been
denied.
 
 In June
2003, discussions with Alliance and the new lenders were terminated. As a
result, the Company wrote off the above mentioned deposit, due diligence costs
and approximately $400,000 of legal and other costs associated with the proposed
new financing. The $619,000 value of the warrant was reversed against Additional
Paid-in Capital because, in management’s opinion, Alliance had breached certain
provisions of the option agreement resulting in a termination event according to
the provisions of the warrant. In July 2003, Alliance filed a complaint in the
United States District Court, Central District of California, seeking a judicial
determination that Alliance has full right of legal ownership to the warrant as
well as the $300,000 deposit. If the Company was not successful in this defense,
the warrant value would have to be expensed.
 
 On July
18, 2003, Alliance filed a complaint against the Company in the Superior Court
of Justice, Ontario, Canada, alleging that the Company breached a non-disclosure
agreement between Alliance and the Company by issuing a press release with
respect to termination of negotiations to purchase the Subsidiaries without
obtaining the required prior written consent of Alliance. Alliance maintained
that the press release impaired its ability to extract value from the
Subsidiaries and negatively affected its ability to sell the Subsidiaries to a
third party. The complaint sought breach of contract and punitive damages of
approximately $4.4 million, expenses and a permanent order enjoining further
such statements by the Company.
 
 On August
11, 2003, the Company filed a counterclaim in the United States District Court,
Central District of California against Alliance for, among other things,
misrepresentation and breach of contract seeking cancellation of the warrant and
general damages of at least $1.2 million.
 
 Pursuant
to a Settlement and Mutual Release Agreement executed in November 2004, Alliance
and the Company agreed to settle all claims. Pursuant to the agreement, the
Company paid Alliance $575,000 in cash in November 2004. All amounts deferred
prior to the settlement related to possible acquisition of the Subsidiaries have
been expensed. Such amounts have been shown separately in the Consolidated
Statements of Income for clarity of presentation.
 
 **NOTE
5**  **-**  **STOCK-BASED
COMPENSATION**
  The
Company applies Accounting Principles Board (“APB”) Opinion No. 25,
“ *Accounting
for Stock Issued to Employees* ,” and
related interpretations, in accounting for its stock option plans. As such,
compensation expense would be recorded on the date of grant only if the current
market price of the underlying stock exceeded the exercise price. SFAS No. 123
established accounting and disclosure requirements using a fair value-based
method of accounting for stock-based employee compensation plans. As allowed by
SFAS No. 123, the Company has elected to continue to apply the intrinsic
value-based method of accounting described above, and has adopted the disclosure
requirements of SFAS No. 123. Pro forma net income and earnings per share
disclosures, as if the Company recorded compensation expense based on the fair
value for stock-based awards, have been presented in accordance with the
provisions of SFAS No. 148 and are as follows for the three-month periods ended
March 31, 2004 and 2005.
 
 7
 
 **Three
      months ended**
      **March
      31,****2004**
    
    **2005**Net
      income (loss):As
      reported
    
    $
    493,000
    
    $
    69,000Deduct:
      Total stock-based employee
      compensation
      expense determined
      under
      fair value based method for
      all
      awards, net of related tax effects
    
    
    (78,000
    )
    
    (51,000
    )Pro
      forma
    
    
    415,000
    
    
    18,000Basic
      earnings (loss)
      per
      share of common stock:As
      reported
    
    $
    0.05
    
    $
    0.01Pro
      forma
    
    $
    0.05
    
    $
    0.00Diluted
      earnings (loss)
      per
      share of common stock:As
      reported
    
    $
    0.05
    
    $
    0.01Pro
      forma
    
    $
    0.04
    
    $
    0.00
  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:
 
 **Three
      months ended**
      **March
      31,****2004**
    
    **2005**Risk-free
      interest rate
    
    
    1.05
    %
    
    2.50
    %Expected
      term (years)
    
    
    5.00
    
    
    5.00Volatility
    
    
    58
    %
    
    48
    %Expected
      annual dividends
    
    
    0.0
    %
    
    0.0
    %
 
 **NOTE
6**  **-**  **CONTINGENCIES**
 
 In
addition to the legal proceedings the Company had with Alliance (see Note 4)
from time to time the Company may become a party to various legal actions and
complaints arising in the ordinary course of business, although it is not
currently involved in any such material legal proceedings.
 
 **NOTE
7**  **-**  **SHAREHOLDERS’
EQUITY**
 
 During
the three months ended March 31, 2005, the number of outstanding shares of the
Company’s common stock increased by 4,400 shares due to the exercise of employee
stock options for $16,000 in cash, and 105,000 shares issued for the purchase of
the assets of another business (valued at approximately $400,000).
 
 **NOTE
8**  **-**  **ACQUISITION**
 
 On July
1, 2004, the Company acquired all of the outstanding stock of International
Video Conversions, Inc. (“IVC”) for $7 million in cash. The purchase agreement
requires possible additional payments of $1 million, $2 million and $2 million
in 2005, 2006 and 2007, respectively, if earnings before interest, taxes,
depreciation and amortization during the 30 months after the acquisition reach
certain predetermined levels. As part of the transaction, the Company entered
into employment and/or non competition agreements with four senior officers of
IVC which fix responsibilities, salaries and other benefits and set forth
limitations on the individuals’ ability to compete with the Company for the term
of the earn-out period (30 months). IVC is a high definition and standard
definition digital mastering and data conversion entity serving the motion
picture/television production industry. In connection with the acquisition, the
term loan portion of the Company’s bank facility (see Note 3) was increased by
$4.7 million. To pay for the acquisition, the Company used $2.3 million of cash
on hand and borrowed $4.7 million under the term loan portion of the facility.
As of December 31, 2004, the first additional payment of $1 million was accrued
on the balance sheet, which amount was paid on April 1, 2005.
 
 The total
purchase consideration has been allocated to the assets and liabilities acquired
based on their respective estimated fair values as summarized below. The
purchase price allocation is subject to change and will be finalized upon review
and refinement of certain estimates and completion of valuation and appraisals.
 
 8
 
 Cash
      and cash equivalents
    
    $
    1,205,000Inventories
    
    
    120,000Other
      current assets
    
    
    1,000Accounts
      Receivable
    
    
    2,036,000Goodwill
    
    
    242,000Property,
      plant and equipment
    
    
    6,009,000Total
      assets acquired
    
    
    9,613,000Accounts
      payable
    
    
    (442,000
    )Accrued
    
    
    (417,000
    )Income
      tax payable
    
    
    (72,000
    )Deferred
      tax liabilities
    
    
    (1,682,000
    )Current
      and other liabilities assumed
    
    
    (2,613,000
    )Net
      assets acquired over liabilities,and
      purchase price
    
    $
    7,000,000
 The
following table presents unaudited pro forma results of the combined operations
for the three months ended March 31, 2004 as if the acquisition had occurred as
of the beginning of such period rather than as of the acquisition date. The pro
forma information presented below is for illustrative purposes only and is not
indicative of results that would have been achieved or results which may be
achieved in the future:
 
 **Three
      months ended**
      **March
      31, 2004**Revenue
    
    $
    18,293,000Operating
      Income
    
    
    1,215,000Net
      income (loss)
    
    
    564,000Basic
      earnings per share
    
    
    0.06Diluted
      earnings per share
    
    
    0.06
 9
  **POINT.360**
  **MANAGEMENT’S
DISCUSSION AND ANALYSIS**
  **ITEM
2.**  **MANAGEMENT’S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS**
 ****
 **Overview**
  The
following Management’s Discussion and Analysis of Financial Condition and
Results of Operations should be read in conjunction with the Consolidated
Financial Statements and Notes and contains forward-looking statements that
involve risks and uncertainties. Actual results could differ materially from
those indicated in the forward-looking statements as a result of various
factors.
  We are
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 over a long term
(i.e. the next 10 years). 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.
  The
Company has an opportunity to expand its business by establishing closer
relationships with our customers through excellent service at a competitive
price. 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.
  During
2004, we completed the acquisition of International Video Conversions, Inc.
(“IVC”) and settled all disputes related to a proposed acquisition of three
subsidiaries of Alliance Atlantis Communications, Inc. (“Alliance”). The
financial statement comparisons below highlight the effects of these
transactions.
  **Statistical
Analysis**
  The table
below summarizes pro forma results for the three-month periods ended March 31,
2004 and 2005, without the effects of (1) IVC’s results of operations and (2)
the write-off of deferred Alliance acquisition, financing and settlement costs
in 2004. IVC was purchased on July 1, 2004. The Alliance write-off represents
the costs of due diligence, legal, financing and the settlement of all matters
related to the proposed acquisition of three subsidiaries of Alliance, which
matters were finalized in 2004: (in thousands except per share
amounts)
  10
 
 **March
      31, 2004**
    
    **March
      31, 2005****Pro
      forma**
    
    **(2)**
    
    **GAAP**
    
    **Pro
      forma**
    
    **(1)**
    
    **GAAP**Revenues
    
    $
    15,468
    
    $
    -
    
    $
    15,468
    
    $
    14,515
    
    $
    2,668
    
    $
    17,183Cost
      of goods sold
    
    
    (9,819
    )
    
    -
    
    
    (9,819
    )
    
    (9,478
    )
    
    (1,924
    )
    
    (11,402
    )Gross
      profit
    
    
    5,649
    
    
    -
    
    
    5,649
    
    
    5,037
    
    
    744
    
    
    5,781Selling,
      general and
      administrative
      expense(3)
    
    
    (4,593
    )
    
    -
    
    
    (4,593
    )
    
    (4,716
    )
    
    (644
    )
    
    (5,360
    )Write-off
      of deferred
      acquisition,
      financing
      and
      settlement costs(3)
    
    
    -
    
    
    (2
    )
    
    (2
    )
    
    -
    
    
    -
    
    
    -Operating
      income (loss)
    
    
    1,056
    
    
    (2
    )
    
    1,054
    
    
    321
    
    
    100
    
    
    421Interest
      expense, net
    
    
    (217
    )
    
    -
    
    
    (217
    )
    
    (249
    )
    
    (58
    )
    
    (307
    )Income
      (loss) before
      income
      taxes
    
    
    839
    
    
    (2
    )
    
    837
    
    
    72
    
    
    42
    
    
    114(Provision
      for) benefitfrom
      income taxes
    
    
    (344
    )
    
    -
    
    
    (344
    )
    
    (28
    )
    
    (17
    )
    
    (45
    )Net
      income (loss)
    
    $
    495
    
    $
    (2
    )
    $
    493
    
    $
    44
    
    $
    25
    
    
    69Earnings
      (loss) per share:Basic:
    
    $
    0.05
    
    $
    0.00
    
    $
    0.05
    
    $
    0.01
    
    $
    0.00
    
    $
    0.01Diluted:
    
    $
    0.05
    
    $
    0.00
    
    $
    0.05
    
    $
    0.01
    
    $
    0.00
    
    $
    0.01
  (1)
    Contribution
      of IVC. (2)
    Write-off
      of deferred acquisition, financing and settlement
costs. (3)
    Previously
      reported amounts have been adjusted to segregate Alliance-related expenses
      from Selling, General and Administrative expense for consistency of
      presentation among periods.  While the
above presentation of pro forma income statements and adjustments do not
represent the results of operations in accordance with generally accepted
accounting principles (“GAAP”), we believe that this disclosure provides useful
information for readers of the financial statements in analyzing the causes of
operating difference from period to period. Additional comparative data is set
forth below.
  In total,
revenues in the first quarter of 2005 were 11% greater than in the same 2004
period. Without the inclusion of IVC, a company purchased on July 1, 2004,
revenues in the 2005 first quarter would have been $14.5 million, a decrease of
6% from 2004. Pro forma 2004 first quarter revenues if IVC had been purchased at
the beginning of the year would have been $18.3 million.
  The
addition of IVC will not only increase revenues for all of 2005 (twelve months
of operations compared to six months in 2004), but will add to the cost
infrastructure of the Company in both cost of sales and selling, general and
administrative (“SG&A”) areas. With the inclusion of IVC, we expect 2005
sales to be higher than experienced in 2004. We expect SG&A in 2005 to be
higher as a percentage of sales than in 2004 (excluding the special charge) due
to the addition of management and sales personnel and costs associated to
Sarbanes-Oxley process documentation. Interest expense is expected to be higher
in 2005 because of additional debt incurred for the acquisition of IVC and
capital expenditures made in 2004 for the Media Center storage
facility.
  Please
refer to Cautionary Statements and Risk Factors below with respect to these
forward-looking statements.
  **Three
Months Ended March 31, 2005 Compared To Three Months Ended March 31,
2004.**
  *Revenues* .  **** Revenues
were $17.2 million for the three-month period ended March 31, 2005, compared to
$15.5 million for the three-month period ended March 31, 2004. The addition of
IVC as of July 1, 2004 contributed $2.7 million of revenues in the 2005 period,
without which sales would have declined 6% to $14.5 million when compared to the
2004 quarter.
 **
 *Gross
Profit* .  In the
first quarter of 2005, gross margin was 34% of sales, compared to 37% for
quarter ended March 31, 2004. The decline is due principally to lower sales at
facilities other than IVC.
 **
 *Selling,
General And Administrative Expense* .  SG&A
expense was $5.4 million in the first quarter of 2005 as compared to $4.6
million in the same period of 2004. The increase was due to the addition of
IVC.
 **
 *Interest
Expense* .  **** Interest
expense for the three-month period ended March 31, 2005 was $0.3 million, an
increase of $0.1 million over the three-month period ended March 31, 2004
because of higher debt levels due to the acquisition of IVC and real property in
the third quarter of 2004.
  11
 ****
 **LIQUIDITY
AND CAPITAL RESOURCES**
  This
discussion should be read in conjunction with the notes to the financial
statements and the corresponding information more fully described in the
Company’s Form 10-K for the year ended December 31, 2004.
  In May
2002, the Company and its banks entered into a term loan agreement with a
maturity date of December 31, 2004. In January and February 2004, the Company
made $1 million of scheduled principal payments under the term loan. In March
2004, the Company paid off the remaining $14.9 million prior term loan principal
balance with $6.9 of cash and proceeds from the new $8 million term loan
pursuant to a new credit agreement. The new agreement provided up to $10 million
of revolving credit availability for two years and a five-year $8 million
five-year term loan. The agreement was subsequently amended to increase the
revolving credit and term loan availability by $1.9 million and $4.7 million,
respectively. For the first two years of the term loan, the Company can
re-borrow all principal payments on $8 million of the term loan to finance up to
80% of capital equipment purchases. The agreement provides for interest at the
banks’ prime rate or LIBOR plus 2.25% for the revolver, prime rate plus 0.25% or
LIBOR plus 2.50% for the term loan, and requires the Company to maintain certain
financial covenant ratios. The term loan requires principal payments of
approximately $2.5 million annually.
  In
November 2003, the Company leased a new 64,600 square foot building in Los
Angeles, California, for the purpose of consolidating four vault locations then
occupying approximately 71,000 square feet. After the initial build-out of the
new facility and termination of the existing leases during 2004, the resulting
annual lease and operating expense levels are expected to be favorable to the
Company. A provision of the lease provided that in May 2005, the Company had an
option to purchase the building for approximately $8,572,000. We purchased the
building in August 2004 by paying $2,137,000 in cash and borrowing the
$6,435,000 million balance under a mortgage term loan payable over 15 years. We
also spent approximately $3.1 million for improvements to the building during
2004.
  The
acquisition of International Video Conversions, Inc. (“IVC”) was completed in
July 2004. We paid $2.3 million in cash and borrowed the $4.7 million. The IVC
purchase agreement will also require 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.
  The
following table summarizes the March 31, 2005 status of our revolving line of
credit and term loans:
 
 Revolving
      credit (including cash overdraft)
    
    $
    3,824,000Current
      portion of term loans
    
    
    2,850,000Long-term
      portion of term loans
    
    
    13,794,000Total
    
    $
    20,468,000
  Monthly
and annual principal and interest payments due under the term debt are
approximately $260,000 and $3,100,000, respectively, assuming no change in
interest rates. Monthly and annual principal and interest payments due under the
mortgage debt are approximately $57,000 and $700,000, respectively. We expect
that remaining amounts available under the revolving credit and term-loan
re-borrowing arrangements (approximately $3.6 million as of March 31, 2005) 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.
  We will
continue to consider the acquisition of businesses complementary to its 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. Management believes 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:
 
 12
 **
 *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,
comprise a significant portion of the Company's total assets. Long-lived assets,
including goodwill and intangibles 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 a comparison of the
carrying amount of an asset to future net cash flows expected to be generated by
that asset. The cash flow projections are based on historical experience,
management’s view of growth rates within the industry and the anticipated future
economic environment.
  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 $58.6 million as of March 31,
2005 .
  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 and 2004 tests performed as of September 30, 2002,
2003 and 2004, respectively, required no goodwill impairment. The discounted
cash flow method used to evaluate goodwill impairment included cash flow
estimates for 2005 and subsequent years. If actual cash flow performance does
not meet these expectations due to factors cited above, any resulting potential
impairment could adversely affect reported goodwill asset values 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 March
31, 2005 was $5.8 million. The Company did not record a valuation allowance
against its deferred tax assets as of March 31, 2005.
  13
 ****
 **RECENT
ACCOUNTING PRONOUNCEMENTS**
  In May
2003, the Financial Accounting Standards Board issued Statement of Financial
Accounting Standards (“SFAS”) No. 150, “ *Accounting
for Certain Financial Instruments with Characteristics of both Liabilities and
Equity* .” SFAS
No. 150 establishes standards for how an issuer classifies and measures in its
statement of financial position certain financial instruments with
characteristics of both liabilities and equity. In accordance with the standard,
financial instruments that embody obligations for the issuer are required to be
classified as liabilities. SFAS No. 150 will be effective for financial
instruments entered into or modified after May 31, 2003 and otherwise will be
effective at the beginning of the first interim period beginning after June 15,
2003. This statement does not affect the Company at this time.
 
 In
November 2004, the FASB issued SFAS No. 151, *“Inventory
Costs* ”. SFAS
No. 151 amends the accounting for abnormal amounts of idle facility expense,
freight, handling costs, and wasted material (spoilage) under the guidance in
ARB No. 43, Chapter 4, *"Inventory
Pricing* ”.
Paragraph 5 of ARB No. 43, Chapter 4, previously stated that “. . . under some
circumstances, items such as idle facility expense, excessive spoilage, double
freight, and rehandling costs may be so abnormal as to require treatment as
current period charges. . . . *”* This
Statement requires that those items be recognized as current-period charges
regardless of whether they meet the criterion of "so abnormal." In addition,
this Statement requires that allocation of fixed production overheads to the
costs of conversion be based on the normal capacity of the production
facilities. This statement is effective for inventory costs incurred during
fiscal years beginning after June 15, 2005. Management does not expect adoption
of SFAS No. 151 to affect the Company’s financial statements.
 
 In
December 2004, the FASB issued SFAS No. 152, *“Accounting
for Real Estate Time-Sharing Transactions* ”. The FASB
issued this Statement as a result of the guidance provided in AICPA Statement of
Position (SOP) 04-2, “ *Accounting
for Real Estate Time-Sharing Transactions* ”. SOP
04-2 applies to all real estate time-sharing transactions. Among other items,
the SOP provides guidance on the recording of credit losses and the treatment of
selling costs, but does not change the revenue recognition guidance in SFAS No.
66,” *Accounting
for Sales of Real Estate* ”, for
real estate time-sharing transactions. SFAS No. 152 amends Statement No. 66 to
reference the guidance provided in SOP 04-2. SFAS No. 152 also amends SFAS No.
67, “ *Accounting
for Costs and Initial Rental Operations of Real Estate Projects* ”, to
state that SOP 04-2 provides the relevant guidance on accounting for incidental
operations and costs related to the sale of real estate time-sharing
transactions. SFAS No. 152 is effective for years beginning after June 15, 2005,
with restatements of previously issued financial statements prohibited. This
statement is not applicable to the Company.
 
 In
December 2004, the FASB issued SFAS No. 153, “ *Exchanges
of Nonmonetary Assets* ,” an
amendment to Opinion
No. 29, *“Accounting
for Nonmonetary Transactions* ” . Statement
No. 153 eliminates certain differences in the guidance in Opinion No. 29 as
compared to the guidance contained in standards issued by the International
Accounting Standards Board. The amendment to Opinion No. 29 eliminates the fair
value exception for nonmonetary exchanges of similar productive assets and
replaces it with a general exception for exchanges of nonmonetary assets that do
not have commercial substance. Such an exchange has commercial substance if the
future cash flows of the entity are expected to change significantly as a result
of the exchange. SFAS No. 153 is effective for nonmonetary asset exchanges
occurring in periods beginning after June 15, 2005. Earlier application is
permitted for nonmonetary asset exchanges occuring in periods beginning after
December 16, 2004. Management
does not expect adoption of SFAS No. 153 to have a material impact on the
Company’s financial statements.
 
 In
December 2004, the FASB issued SFAS No. 123(R), “ *Share-Based
Payment* ”. SFAS
123(R) amends SFAS No. 123, “ *Accounting
for Stock-Based Compensation* ”, and
APB Opinion 25, “ *Accounting
for Stock Issued to Employees* .” SFAS
No.123(R) requires that the cost of share-based payment transactions (including
those with employees and non-employees) be recognized in the financial
statements. SFAS No. 123(R) applies to all share-based payment transactions in
which an entity acquires goods or services by issuing (or offering to issue) its
shares, share options, or other equity instruments (except for those held by an
ESOP) or by incurring liabilities (1) in amounts based (even in part) on the
price of the entity’s shares or other equity instruments, or (2) that require
(or may require) settlement by the issuance of an entity’s shares or other
equity instruments. This statement is effective (1) for public companies
qualifying as SEC small business issuers, as of the first interim period or
fiscal year beginning after December 15, 2005, or (2) for all other public
companies, as of the first fiscal year beginning after June 15, 2005, or (3) for
all nonpublic entities, as of the first fiscal year beginning after December 15,
2005. Management is currently assessing the effect of SFAS No. 123(R) on the
Company’s financial statements.
  14
  **CAUTIONARY
STATEMENTS AND 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. l
    Our
      highly competitive marketplace. l
    The
      risks associated with dependence upon significant
    customers. l
    Our
      ability to execute our expansion strategy. l
    The
      uncertain ability to manage growth. 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.  These
risk factors are discussed further below.
  **Recent
History of Losses** . The
Company reported losses for each of the five fiscal quarters ended December 31,
2001 due, in part, to lower gross margins and lower sales levels and a number of
unusual charges. Although we achieved profitability in Fiscal 2000 and prior
years, as well as in the three fiscal years ended December 31, 2004, there can
be no assurance as to future profitability on a quarterly or annual basis.
 
 **Prior
Breach and Changes in Credit Agreements** **.** Due to
lower operating cash amounts resulting from reduced sales levels in 2001 and the
consequential net losses, the Company breached certain covenants of its credit
facility. The breaches were temporarily cured based on amendments and
forbearance agreements among the Company and the banks which called for, among
other provisions, scheduled payments to reduce amounts owed to the banks to the
permitted borrowing base. In August 2001, the Company failed to meet the
principal repayment schedule and was once again in breach of the credit
facility. The banks ended their formal commitment to the Company in December
2001.
 
 In May
2002, we entered into an agreement with the banks to restructure the credit
facility to a term loan maturing on December 31, 2004. As part of this
restructuring, the banks waived all existing defaults and the Company was
required to make principal payments of $5.5 million, $5.0 million and $18.5
million in 2002, 2003, and 2004, respectively.
 
 In March
2004, we entered into a revised agreement with the banks providing revolving and
term loan facilities. Annual principal payments for the term loan are $1.6
million each for five years. Any principal outstanding under the revolver will
be due in March 2006.
 
 In July
and August 2004, the credit agreement was amended in connection with the
acquisition of IVC to increase the amounts that can be borrowed under the
revolving and term loan portions of the arrangement. Approximately $4.7 million
was borrowed to consummate the transaction. Also in August 2004, we borrowed
$6,435,000 to purchase land and a building to house our Los Angeles area vault
storage facilities. While we believe operating cash flows are sufficient to
service increased total debt levels, reduced future sales levels, if they occur,
could possibly result in a breach of the financial covenants contained in the
credit agreements.
 15
 
 In
November 2004, we began discussion with the banks to amend certain financial
covenants contained in our credit agreement to more closely track our changing
business environment which has contributed to lower sales and profits in recent
quarters. We cannot be sure that we will be successful in achieving such changes
and, if we are not successful, there is a risk that we will be in default of
certain financial covenants in future quarters. If a default condition exists in
the future, all amounts outstanding under the credit agreement will be due and
payable which could materially and adversely affect our business.
  **Competition.** Our post
production, duplication and distribution industry is a highly competitive,
service-oriented business. In general, we do not have long-term or exclusive
service agreements with our customers. Business is acquired on a purchase order
basis and is based primarily on customer satisfaction with reliability,
timeliness, quality and price.
  We
compete with a variety of post production, duplication and distribution firms,
some of which have a national presence, and to a lesser extent, the in-house
post production and distribution operations of our major motion picture studio
and advertising agency customers. Some of these firms, and all of the studios,
have greater financial, distribution and marketing resources and have achieved a
higher level of brand recognition than the Company. In the future, we may not be
able to compete effectively against these competitors merely on the basis of
reliability, timeliness, quality and price or otherwise.
  We may
also face competition from companies in related markets which could offer
similar or superior services to those offered by the Company. We believe that an
increasingly competitive environment as evidenced by recent price pressure and
some related loss of work and the possibility that customers may utilize
in-house capabilities to a greater extent could lead to a loss of market share
or additional price reductions, which could have a material adverse effect on
our financial condition, results of operations and prospects.
  **Customer
and Industry Concentration.** Although
we have an active client list of over 2,500 customers, ten motion picture
studios and advertising agencies accounted for approximately 38% of the
Company’s revenues during the year ended December 31, 2004. If one or more of
these companies were to stop using our services, our business could be adversely
affected. Because we derive substantially all of our revenue from clients in the
entertainment and advertising industries, the financial condition, results of
operations and prospects of the Company could also be adversely affected by an
adverse change in conditions which impact those industries.
  **Expansion
Strategy.** Our
growth strategy involves both internal development and expansion through
acquisitions. We currently have no agreements or commitments to acquire any
company or business. Even though we have completed nine acquisitions in the last
seven fiscal years, the most recent of which was in July 2004, we cannot be sure
additional acceptable acquisitions will be available or that we will be able to
reach mutually agreeable terms to purchase acquisition targets, or that we will
be able to profitably manage additional businesses or successfully integrate
such additional businesses into the Company without substantial costs, delays or
other problems.
 
 Acquisitions
may involve a number of special risks including: adverse effects on our reported
operating results (including the amortization of acquired intangible assets),
diversion of management’s attention and unanticipated problems or legal
liabilities. In addition, we may require additional funding to finance future
acquisitions. We cannot be sure that we will be able to secure acquisition
financing on acceptable terms or at all. We may also use working capital or
equity, or raise financing through equity offerings or the incurrence of debt,
in connection with the funding of any acquisition. Some or all of these risks
could negatively affect our financial condition, results of operations and
prospects or could result in dilution to the Company’s shareholders. In
addition, to the extent that consolidation becomes more prevalent in the
industry, the prices for attractive acquisition candidates could increase
substantially. We may not be able to effect any such transactions. Additionally,
if we are able to complete such transactions they may prove to be
unprofitable.
 
 The
geographic expansion of the Company’s customers may result in increased demand
for services in certain regions where it currently does not have post
production, duplication and distribution facilities. To meet this demand, we may
subcontract. However, we have not entered into any formal negotiations or
definitive agreements for this purpose. Furthermore, we cannot assure you that
we will be able to effect such transactions or that any such transactions will
prove to be profitable.
 
 If we
acquire any entities, we may have to finance a large portion of the anticipated
purchase price and/or refinance our existing credit agreement. The cost of any
new financing may be higher than our existing credit facility. Future earnings
and cash flow may be negatively impacted if any acquired entity does not
generate sufficient earnings and cash flow to offset the increased costs.
 
 **Management
of Growth.** In prior
years, we experienced rapid growth that resulted in new and increased
responsibilities for management personnel and placed, and continues to place,
increased demands on our management, operational and financial systems and
resources. To accommodate this growth, compete effectively and manage future
growth, we will be required to continue to implement and improve our
operational, financial and management information systems, and to expand, train,
motivate and manage our work force. We cannot be sure that the Company’s
personnel, systems, procedures and controls will be adequate to support our
future operations. Any failure to do so could have a material adverse effect on
our financial condition, results of operations and prospects.
 
 **Dependence
on Technological Developments.** Although
we intend to utilize the most efficient and cost-effective technologies
available for telecine, high definition formatting, editing, coloration and
delivery of audio and video content, including digital satellite transmission,
as they develop, we cannot be sure that we will be able to adapt to such
standards in a timely fashion or at all. We believe our future growth will
depend in part, on our ability to add to these services and to add customers in
a timely and cost-effective manner. We cannot be sure we will be successful in
offering such services to existing customers or in obtaining new customers for
these services. We intend to rely on third party vendors for the development of
these technologies and there is no assurance that such vendors will be able to
develop such technologies in a manner that meets the needs of the Company and
its customers. Additionally, in recent years, electronic delivery services have
grown while physical duplication and delivery have been declining. We expect
this trend to continue over a long term (i.e. the next 10 years). 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. Any material interruption in the
supply of such services could materially and adversely affect the Company’s
financial condition, results of operations and prospects.
 
 16
 ****
 **Dependence
on Key Personnel.** The
Company is dependent on the efforts and abilities of certain of its senior
management, particularly those of Haig S. Bagerdjian, Chairman, President and
Chief Executive Officer. The loss or interruption of the services of key members
of management could have a material adverse effect on our financial condition,
results of operations and prospects if a suitable replacement is not promptly
obtained. Mr. Bagerdjian beneficially owns approximately 27% of the Company’s
outstanding stock. Although we have severance agreements with Mr. Bagerdjian and
certain key executives, we cannot be sure that either Mr. Bagerdjian or other
executives will remain with the Company. In addition, our success depends to a
significant degree upon the continuing contributions of, and on our ability to
attract and retain, qualified management, sales, operations, marketing and
technical personnel. The competition for qualified personnel is intense and the
loss of any such persons, as well as the failure to recruit additional key
personnel in a timely manner, could have a material adverse effect on our
financial condition, results of operations and prospects. There is no assurance
that we will be able to continue to attract and retain qualified management and
other personnel for the development of our business.
 
 **Ability
to Maintain and Improve Service Quality.** Our
business is dependent on our ability to meet the current and future demands of
our customers, which demands include reliability, timeliness, quality and price.
Any failure to do so, whether or not caused by factors within our control could
result in losses to such clients. Although we disclaim any liability for such
losses, there is no assurance that claims would not be asserted or that
dissatisfied customers would refuse to make further deliveries through the
Company in the event of a significant occurrence of lost deliveries, either of
which could have a material adverse effect on our financial condition, results
of operations and prospects. Although we maintain insurance against business
interruption, such insurance may not be adequate to protect the Company from
significant loss in these circumstances and there is no assurance that a major
catastrophe (such as an earthquake or other natural disaster) would not result
in a prolonged interruption of our business. In addition, our ability to make
deliveries within the time periods requested by customers depends on a number of
factors, some of which are outside of our control, including equipment failure,
work stoppages by package delivery vendors or interruption in services by
telephone or satellite service providers.
 
 **Fluctuating
Results, Seasonality.** Our
operating results have varied in the past, and may vary in the future, depending
on factors such as the volume of advertising in response to seasonal buying
patterns, the timing of new product and service introductions, the timing of
revenue recognition upon the completion of longer term projects, increased
competition, timing of acquisitions, general economic factors and other factors.
As a result, we believe that period-to-period comparisons of our results of
operations are not necessarily meaningful and should not be relied upon as an
indication of future performance. For example, our operating results have
historically been significantly influenced by the volume of business from the
motion picture industry, which is an industry that is subject to seasonal and
cyclical downturns, and, occasionally, work stoppages by actors, writers and
others. In addition, as our business from advertising agencies tends to be
seasonal, our operating results may be subject to increased seasonality as the
percentage of business from advertising agencies increases. In any period our
revenues are subject to variation based on changes in the volume and mix of
services performed during the period. It is possible that in some future quarter
the Company’s operating results will be below the expectations of equity
research analysts and investors. In such event, the price of the Company’s
Common Stock would likely be materially adversely affected. Fluctuations in
sales due to seasonality may become more pronounced if the growth rate of the
Company’s sales slows.
 
 **Control
by Principal Shareholder; Potential Issuance of Preferred Stock; Anti-Takeover
Provisions.** The
Company’s Chairman, President and Chief Executive Officer, Haig S. Bagerdjian,
beneficially owned approximately 27% of the outstanding common stock as of March
31, 2005. The ex-spouse of R. Luke Stefanko, the Company’s former President and
Chief Executive Officer, owned approximately 19% of the common stock on that
date. Together, they owned approximately 46%. By virtue of their stock
ownership, Ms. Stefanko and Mr. Bagerdjian individually or together may be able
to significantly influence the outcome of matters required to be submitted to a
vote of shareholders, including (i) the election of the board of directors, (ii)
amendments to the Company’s Restated Articles of Incorporation and (iii)
approval of mergers and other significant corporate transactions. The foregoing
may have the effect of discouraging, delaying or preventing certain types of
transactions involving an actual or potential change of control of the Company,
including transactions in which the holders of common stock might otherwise
receive a premium for their shares over current market prices.
 
 Our Board
of Directors also has the authority to issue up to 5,000,000 shares of preferred
stock without par value (the “Preferred Stock”) and to determine the price,
rights, preferences, privileges and restrictions thereof, including voting
rights, without any further vote or action by the Company’s shareholders. On
November 17, 2004, the Compay declared a dividend distribution of one Preferred
Share Purchase Right on each outstanding share of its common stock. The Rights
will be attached to the Company’s Common Stock and will trade separately and be
exercisable only in the event that a person or group acquires or announces the
intent to acquire 20% or more of Point.360’s Common Stock. Each Right will
entitle shareholders to buy one one-hundredth of a share of a new series of
junior participating preferred stock at an exercise price of $10. If the Company
is acquired in a merger or other business combination transaction after a person
has acquired 20% or more of the Company’s outstanding Common Stock, each Right
will entitle its holder to purchase, at the Right’s then-current exercise price,
a number of the acquiring company’s common shares having a market value of twice
such price. In addition, if a person or group acquires 20% or more of
Point.360’s outstanding Common Stock, each Right will entitle its holder (other
than such person or members of such group) to purchase, at the Right’s
then-current exercise price, a number of the Company’s common shares having a
market value of twice such price. Following an acquisition by a person or group
of beneficial ownership of 20% of more of the Company’s Common Stock and before
an acquisition of 50% or more of the Common Stock, Point.360’s Board of
Directors may exchange the Rights (other than Rights owned by such person or
group), in whole or in part, at an exchange ratio of one one-hundredth of a
share of the new series of junior participating preferred stock per Right.
Before a person or group acquires beneficial ownership of 20% or more of the
Company’s Common Stock, the Rights are redeemable for $.0001 per Right at the
option of the Board of Directors. The Rights are intended to enable Point.360’s
shareholders to realize the long-term value of their investment in the Company.
They will not prevent a takeover, but should encourage anyone seeking to acquire
the Company to negotiate with the Board prior to attempting a
takeover.
  17
 
 Although
we have no current plans to issue any other shares of Preferred Stock, the
rights of the holders of common stock would be subject to, and may be adversely
affected by, the rights of the holders of any Preferred Stock that may be issued
in the future. Issuance of Preferred Stock could have the effect of
discouraging, delaying, or preventing a change in control of the Company.
Furthermore, certain provisions of the Company’s Restated Articles of
Incorporation and By-Laws and of California law also could have the effect of
discouraging, delaying or preventing a change in control of the
Company.
 18
   **ITEM
3.**  **QUANTITATIVE
AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**
  *Market
Risk* . The
Company had borrowings of $3.1 million at March 31, 2005 under a term loan and
revolving credit agreement, and $6.2 million outstanding under a mortgage.
Amounts outstanding under the term loan and revolving credit facility and the
mortgage debt provide for interest at the banks’ prime rate or LIBOR plus 2.25%
for the revolver, prime plus 0.25% or LIBOR plus 2.50% for the term loan and
6.83% for the mortgage debt. The Company’s market risk exposure with respect to
financial instruments is to changes in prime or LIBOR rates.
  **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**
  F rom **** time to
time, the Company may become a party to various legal actions and complaints
arising in the ordinary course of business, although it is not currently
involved in any such material legal proceedings.
  **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: May 12, 2005
    BY:
    /s/ Alan R. SteelAlan R. Steel
      Executive
      Vice President,
      Finance
      and Administration
      (duly
      authorized officer and principal financial officer)
  19