<PAGE> 1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM __________________ TO____________________.
COMMISSION FILE NUMBER: 0-27644
DIGITAL GENERATION SYSTEMS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
CALIFORNIA 94-3140772
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)
875 BATTERY STREET
SAN FRANCISCO, CALIFORNIA 94111
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE)
(415) 276-6600
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
NOT APPLICABLE
(FORMER NAME, FORMER ADDRESS, 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 SECTIONS 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 [ ]
NUMBER OF SHARES OF REGISTRANT'S COMMON STOCK, WITHOUT PAR VALUE, OUTSTANDING AS
OF APRIL 30, 1998: 12,215,770.
================================================================================
<PAGE> 2
DIGITAL GENERATION SYSTEMS, INC.
This Form 10-Q contains forward-looking statements within the meaning of Section
27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act
of 1934. Actual results could differ materially from those indicated in the
forward-looking statements as a result of certain factors, including those set
forth under "Certain Business Considerations" in "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and elsewhere in this
Form 10-Q.
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PART I. FINANCIAL INFORMATION PAGE
----
<S> <C> <C>
Item 1. Financial Statements................................................3
Condensed Consolidated Balance Sheets at March 31, 1998 and
December 31, 1997 ..................................................3
Condensed Consolidated Statements of Operations for the
three months ended March 31, 1998 and 1997 .........................4
Condensed Consolidated Statements of Cash Flows for the
three months ended March 31, 1998 and 1997 .........................5
Notes to Condensed Consolidated Financial Statements ...............6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations ..........................................8
PART II. OTHER INFORMATION
Item 1. Legal Proceedings ..................................................20
Item 2. Changes in Securities ..............................................20
Item 3. Defaults upon Senior Securities ....................................20
Item 4. Submission of Matters to a Vote of Security Holders ................20
Item 5. Other Information ..................................................20
Item 6. Exhibits and Reports on Form 8-K ...................................21
SIGNATURES..........................................................23
</TABLE>
<PAGE> 3
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
DIGITAL GENERATION SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<TABLE>
<CAPTION>
MARCH 31, DECEMBER 31,
1998 1997
--------- ------------
(Unaudited)
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 3,583 $ 7,833
Short-term investments 1,998 987
Accounts receivable, net 8,422 8,053
Prepaid expenses and other 781 649
-------- --------
Total current assets 14,784 17,522
-------- --------
PROPERTY AND EQUIPMENT, at cost:
Network equipment 30,881 30,405
Office furniture and equipment 3,087 2,963
Leasehold improvements 510 506
-------- --------
34,478 33,874
Less -- Accumulated depreciation and amortization (18,814) (16,308)
-------- --------
Property and equipment, net 15,664 17,566
-------- --------
GOODWILL AND OTHER ASSETS, net 25,367 25,609
-------- --------
$ 55,815 $ 60,697
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 3,705 $ 4,506
Accrued liabilities 3,960 3,501
Line of credit 2,066 2,834
Current portion of long-term debt 7,748 7,560
-------- --------
Total current liabilities 17,479 18,401
-------- --------
LONG-TERM DEBT, net of current portion 11,607 11,847
-------- --------
SHAREHOLDERS' EQUITY:
Convertible preferred stock, no par value --
Authorized -- 5,000,000
Outstanding -- 4,950,495 shares at March 31, 1998
and December 31, 1997 31,561 31,561
Common stock, no par value --
Authorized -- 30,000,000 shares
Outstanding -- 12,212,968 shares at March 31, 1998
and 12,122,679 shares at December 31, 1997 57,206 57,123
Receivable from issuance of common stock (175) (175)
Accumulated deficit (61,863) (58,060)
-------- --------
Total shareholders' equity 26,729 30,449
-------- --------
$ 55,815 $ 60,697
======== ========
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
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DIGITAL GENERATION SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE MONTHS ENDED MARCH 31, 1998 AND 1997
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
------------------------
1998 1997
--------- ---------
(Unaudited)
<S> <C> <C>
REVENUES $ 9,874 $ 4,606
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COSTS AND EXPENSES:
Delivery and material costs 3,746 1,475
Customer operations 3,575 2,135
Sales and marketing 1,264 1,015
Research and development 588 648
General and administrative 1,029 604
Depreciation and amortization 2,833 1,765
------- -------
Total expenses 13,035 7,642
------- -------
LOSS FROM OPERATIONS (3,161) (3,036)
------- -------
OTHER INCOME (EXPENSE):
Interest income 69 251
Interest expense (711) (511)
------- -------
NET LOSS $(3,803) $(3,296)
======= =======
BASIC AND DILUTED NET LOSS PER COMMON SHARE $ (0.31) $ (0.28)
======= =======
WEIGHTED AVERAGE COMMON SHARES 12,176 11,686
======= =======
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
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DIGITAL GENERATION SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE THREE MONTHS ENDED MARCH 31, 1998 AND 1997
(IN THOUSANDS)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
------------------------------
1998 1997
------------- ------------
(Unaudited)
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $(3,803) $(3,296)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization of property and equipment 2,506 1,658
Amortization of goodwill and intangibles 327 107
Provision for doubtful accounts 38 36
Changes in operating assets and liabilities --
Accounts receivable (407) (57)
Prepaid expenses and other assets (218) (523)
Accounts payable and accrued liabilities (342) (279)
------- -------
Net cash used in operating activities (1,899) (2,354)
------- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of short-term investments (1,011) (973)
Maturities of short-term investments -- 2,859
Acquisition of property and equipment (603) (1,701)
------- -------
Net cash provided by (used in) investing
activities (1,614) 185
------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock 83 44
Proceeds from line of credit 3,201 --
Payments on line of credit (3,969) --
Proceeds from issuance of long-term debt 1,890 2,219
Payments on long-term debt (1,942) (1,226)
------- -------
Net cash provided by (used in) financing
activities (737) 1,037
------- -------
NET DECREASE IN CASH AND CASH EQUIVALENTS (4,250) (1,132)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 7,833 9,682
------- -------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 3,583 $ 8,550
======= =======
SUPPLEMENTAL CASH FLOW INFORMATION
Property and equipment financed with capitalized lease obligations $ -- $ 400
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
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DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
The financial statements included herein have been prepared by the Company,
without audit, pursuant to the rules and regulations of the Securities and
Exchange Commission. Certain information and footnote disclosures normally
included in financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted pursuant to such rules and
regulations. However, the Company believes that the disclosures are adequate to
make the information presented not misleading. These condensed consolidated
financial statements should be read in conjunction with the financial statements
and the notes thereto included in the Company's financial statements included in
the Company's Annual Report on Form 10-K for the year ended December 31, 1997.
The unaudited condensed consolidated financial statements included herein
reflect all adjustments (which include only normal, recurring adjustments) which
are, in the opinion of management, necessary to state fairly the results for the
three month period ended March 31, 1998. The results for the three month period
ended March 31, 1998 are not necessarily indicative of the results expected for
the full fiscal year.
2. CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS
The Company has classified all marketable debt securities as
held-to-maturity and has accounted for these investments using the amortized
cost method. Cash and cash equivalents consist of liquid investments with
original maturities of three months or less. Short-term investments are
marketable securities with original maturities greater than three months and
less than one year. As of March 31, 1998, cash and cash equivalents and short
term investments consist principally of U.S. Treasury Bills and various money
market accounts; as a result, the amortized purchase cost approximates the fair
market value.
3. ACQUISITION
On July 18, 1997, the Company acquired 100% of the capital stock of Starcom
Mediatech, Inc. ("Mediatech"), a wholly owned subsidiary of IndeNet, Inc.
("IndeNet"), for consideration totaling approximately $25.8 million ("Mediatech
Acquisition"). The consideration consisted of approximately $14.0 million in
cash, 324,355 shares of the Company's Common Stock, a $2.2 million subordinated
promissory note bearing interest at 9% payable to IndeNet (the "Company Note"),
a $2.2 million secured subordinated promissory note bearing interest at 9%
payable to Thomas H. Baur, a creditor of IndeNet (the "Baur Note"), and the
Company assumed approximately $5.4 million of existing Mediatech debt. Mediatech
is a media duplication and distribution company whose principal offices are
located in Chicago, Illinois. On October 27, 1997, as provided for in the
purchase agreement, the Company and IndeNet agreed to reduce the aggregate
purchase price by $625,000 based on Mediatech's financial position at the
acquisition date.
The Mediatech acquisition was accounted for as a purchase. The excess of
purchase price and acquisition costs over the net book value of assets acquired
of approximately $17.8 million, has been included in Goodwill and Other Assets
in the accompanying consolidated balance sheet and is being amortized over a
twenty year period. Amortization of approximately $216,000 is included in the
consolidated statement of operations for the quarter ended March 31, 1998. The
operating results of Mediatech have been included in the consolidated results of
the Company from the date of the closing of the transaction, July 18, 1997.
6
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DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
PRO FORMA RESULTS
The following table reflects unaudited pro forma combined results of
operations of the Company including Mediatech on the basis that the acquisition
of Mediatech had taken place at the beginning of the first fiscal period
presented:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
----------------------
(in thousands, except
per share data)
1998 1997
---- ----
<S> <C> <C>
Revenues ................................... $ 9,874 $ 10,716
Net Loss ................................... $ (3,803) $ (4,257)
Basic and Diluted Net Loss Per Common Share $ (0.31) $ (0.36)
Number of Shares used in Computation ....... 12,176 11,686
</TABLE>
The unaudited pro forma combined results of operations are not necessarily
indicative of the actual results that would have occurred had the acquisition of
Mediatech been consummated at the beginning of 1997, or of future operations of
the combined companies under the ownership and management of the Company.
7
<PAGE> 8
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following Management's Discussion and Analysis of Financial Condition
and Results of Operations 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 certain factors, including
those set forth under "Certain Business Considerations" in "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
elsewhere in this Form 10-Q.
The following table presents unaudited financial information expressed as a
percentage of total revenues and operating data for the period indicated. The
information and operating data has been prepared by the Company on a basis
consistent with the Company's audited financial statements and includes all
adjustments, consisting only of normal recurring adjustments, that management
considers necessary for a fair presentation for the periods presented. The
operating results for any quarter should not be relied on as indicative of
results for any future period.
STATEMENTS OF OPERATIONS:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
-------------------
1998 1997
<S> <C> <C>
Revenues ............................. 100.0% 100.0%
Costs and Expenses:
Delivery and material costs ...... 37.9 32.0
Customer operations .............. 36.2 46.4
Sales and marketing .............. 12.8 22.0
Research and development ......... 6.0 14.1
General and administrative ....... 10.4 13.1
Depreciation and amortization .... 28.7 38.3
----- -----
Total expenses ................ 132.0 165.9
----- -----
Loss from operations ................. (32.0) (65.9)
Other income (expense):
Interest income .................. 0.7 5.4
Interest expense ................. (7.2) (11.1)
----- -----
Net loss ............................. (38.5)% (71.6)%
===== =====
</TABLE>
ACQUISITION
In July 1997, the Company acquired 100% of the capital stock of Starcom
Mediatech, Inc. ("Mediatech"), a wholly owned subsidiary of IndeNet, Inc. with
operating facilities in Chicago, Los Angeles, New York and Louisville.
Mediatech's primary operations are services typical of a traditional dub and
ship house, including the physical duplication and distribution of audio and
video content on a wide range of tape formats and performance of a variety of
audio and video editing services. Although Mediatech's revenues are generated
primarily from the duplication and distribution of short form content,
consistent with those of DG Systems prior to this acquisition, Mediatech's
revenues also include a significant portion generated from the distribution of
long form syndicated programming of both live and previously broadcast
television shows. Such services include integrating commercials into syndicated
programs and uplinking the completed programs to satellites as well as the
physical duplication and distribution of such programs to those stations which
do not receive a satellite feed. The acquisition was accounted for as a purchase
and the operating results of Mediatech have been included in the consolidated
results of the Company from the date of the closing of the transactions, July
18, 1997.
8
<PAGE> 9
Revenues
<TABLE>
<CAPTION>
THREE MONTHS ENDED MARCH 31,
---------------------------
1998 1997
------- -------
(in thousands)
<S> <C> <C>
Audio Distribution $3,647 $2,665
Video Distribution 3,230 1,283
Ancillary Post-Production Services & Other Services 2,997 658
------ ------
Total Revenues $9,874 $4,606
====== ======
</TABLE>
Revenues were $9,874,000 for the three months ended March 31, 1998, a 114%
increase from $4,606,000 for the three months ended March 31, 1997. The increase
was due to a 63% increase in the combined volume of audio and video deliveries
performed as well as the addition of revenue for other services now offered by
the Company. Of the total volume increase, approximately 64% relates to orders
delivered through the DG Systems Network Operating Center ("NOC") in San
Francisco, primarily as a result of orders received at the former Mediatech
facilities. The Company believes that the increase in delivery volumes is due to
a number of factors, including the increased acceptance of the services offered
by the Company, the increased availability of an expanded network of Company
equipment located in radio and television stations and the increased market
presence resulting from the Mediatech acquisition and the November 1996
acquisition of PDR Productions, Inc. ("PDR").
Average revenue per audio delivery decreased approximately 3% for the three
months ended March 31, 1998 versus the three months ended March 31, 1997. This
decrease is due primarily to the addition of relatively lower priced audio
deliveries dubbed and shipped from the former Mediatech facilities. Such
physical deliveries account for less than 7% of the Company's audio revenue.
Average revenue per audio delivery performed via the NOC increased approximately
2% in the three months ended March 31, 1998 versus the three months ended March
31, 1997. This increase is primarily due to the continued increased utilization
of the Company's premium services.
Average revenue per video delivery decreased approximately 6% for the three
months ended March 31, 1998 from the three months ended ended March 31, 1997.
The average price per delivery for the three months ended March 31, 1998 is
based on the significantly higher revenues resulting from increased digital and
physical delivery volume, including deliveries made directly from the former
Mediatech facilities. The decrease in average revenue per video delivery is due
to changes in the mix of video delivery services provided and the related
customer pricing agreements resulting from the acquisition of Mediatech.
For the three months ended March 31, 1998, revenues included approximately
$3.0 million recorded from other services provided by the Company primarily as a
result of the Mediatech acquisition. This revenue consisted of $1.2 million for
corporate duplication, $.9 million for post-production services, and $.9 million
for satellite distribution services.
9
<PAGE> 10
Delivery and Material Costs
<TABLE>
<CAPTION>
THREE MONTHS ENDED MARCH 31,
---------------------------
1998 1997
------- -------
(in thousands)
<S> <C> <C>
Audio Distribution $ 833 $ 736
Video Distribution 1,513 672
Ancillary Post-Production Services & Other Services 1,401 67
------ ------
Total Delivery and Material Costs $3,747 $1,475
====== ======
</TABLE>
Delivery and material costs for the three months ended March 31, 1998 were
$3,746,000, a 154% increase from $1,475,000 for the three months ended March 31,
1997. The increase in costs is primarily due to the increased delivery volumes,
as well as the addition of the direct costs related to the other services now
provided by the Company. The increased costs include both delivery expenses and
direct materials costs required when physically duplicating and distributing a
video or audio spot as well as the direct materials and fees paid to other
service providers in connection with ancillary post-production services and
other services offered by the Company.
Delivery and material costs as a percentage of revenues increased to 38%
from 32% for the three months ended March 31, 1998 and March 31, 1997
respectively. The increase in such costs as a percentage of total revenues is
due to the change in mix of services offered by the Company as a result of the
acquisition of Mediatech and the ramp up of the video distribution service. The
Company's audio distribution services primarily are performed electronically,
which has resulted in lower delivery and material costs as a percentage of
revenues than those of the Company's video distribution and other service
offerings.
Delivery and material costs as a percentage of audio delivery revenues
decreased to approximately 23% from approximately 27% in the three months ended
March 31, 1998 and 1997 respectively. This decrease is primarily the result of
improvements in cost per electronic delivery. Video delivery and material costs
as a percentage of revenues has decreased to approximately 47% from 52% in the
three months ended March 31, 1998 and 1997 respectively. This decrease is due to
changes in mix, specifically the addition of dubbed and shipped video deliveries
resulting from the Mediatech acquisition, as well as improved electronic costs
per delivery. The volume of video deliveries being performed electronically
through the Company's NOC increased by approximately 14 fold resulting in
economies of scale improvements for the related fixed costs. Approximately 46%
of the Company's video deliveries were made through the NOC in the three months
ended March 31, 1998 as opposed to approximately 10% in the same three months of
1997. Delivery and material costs related to the other services provided by the
Company were 47% and 10% of the associated revenue for the three months ended
March 31, 1998 and 1997, respectively. The direct costs as a percentage of
revenues associated with these services vary widely based on the numerous
services performed and the rates negotiated with the customers using these
services. In general, the direct costs of corporate duplication and satellite
services have higher costs as a percentage of revenues than the Company's audio
and video distribution services. The Company is actively reviewing the rates
charged for such services and the potential business impacts of revising these
service offerings
Customer Operations
Customer operations expenses for the three months ended March 31, 1998 were
$3,575,000, a 67% increase from $2,135,000 for the three months ended March 31,
1997. This increase is primarily the result of the consolidation of the costs of
the former Mediatech operations. In addition, expenses increased versus the
prior year due to the addition of the personnel necessary to respond to the
greater volume of orders and deliveries. Additional costs are primarily the
labor and overhead expenses of personnel involved in customer and technical
support and fulfillment of orders for all services offered by the former
Mediatech locations.
Customer operations expenses as a percentage of revenues decreased to 36%
from 46% in the three months ended March 31, 1998 and 1997, respectively. This
decrease is primarily due to the reduced cost of
10
<PAGE> 11
customer operations as a percentage of revenues for orders processed through the
Company's NOC, which serves as the primary support for the digital network.
These improvements in cost as a percentage of revenues, however, were offset
slightly by the impact of the relatively more expensive customer operations
expenses of the Company's other facilities, which have a different cost
structure in order to provide the additional services offered at these
locations.
The Company believes that in order to compete effectively and manage future
growth it will be necessary to continue to implement changes which improve and
increase the efficiency of its customer operations.
Sales and Marketing
Sales and marketing expenses were $1,264,000 for the three months ended
March 31, 1998, a 25% increase from $1,015,000 for the three months ended March
31, 1997. The increase in sales and marketing expenses is due primarily to the
consolidation of the costs of the former Mediatech sales group. However, sales
and marketing expenses as a percentage of revenues was reduced to 13% of
revenues for the three months ended March 31, 1998 from 22% of revenue for the
three months ended March 31, 1997. The Company united its sales forces in 1997
and believes it is now more capable of effectively and efficiently marketing the
Company's complete set of services throughout the country.
The Company expects to continue to expand sales and marketing programs
designed to introduce the Company's services to the marketplace and to attract
new customers for its services.
Research and Development
Research and development expenses decreased 9% to $588,000 for the three
months ended March 31, 1998, from $648,000 for the three months ended March 31,
1997. The decrease is primarily due to a reduction in development and testing
costs, principally frame relay and satellite transmission testing, versus those
incurred in the three months ended March 31, 1997 to prepare the NOC for video
delivery. The decreased testing costs were partially offset by other spending
increases, primarily engineering labor costs.
The Company expects that additional research and development spending will
be necessary to remain competitive and its future success will depend in
significant part upon the technological quality of its products and processes
relative to those of its competitors and its ability both to develop new and
enhanced products and services.
General and Administrative
General and administrative expenses for the three months ended March 31,
1998 were $1,029,000, a 70% increase from $604,000 for the three months ended
March 31, 1997. The increase is primarily due to the consolidation of the costs
of certain former Mediatech staff, as well as system conversion costs for
consolidating and upgrading the Company's order entry and billing systems. The
Company expects to continue to spend on the consolidation and upgrade of the
Company's systems over the course of 1998 to improve reporting and operating
efficiency.
Depreciation and Amortization
Depreciation and amortization expenses increased 61% to $2,833,000 in the
quarter ended March 31, 1998 from $1,765,000 for the quarter ended March 31,
1997. This increase is due to the continued expansion of the Company's network.
The Company's total investment in network equipment has increased 55% to $30.9
million at March 31, 1998 from $20.0 million at March 31, 1997. In particular,
the Company has acquired approximately $7.5 million of equipment as a result of
the acquisition of Mediatech, has made capital additions of approximately $3.3
million between March 31, 1997 and March 31, 1998 in support of its video
delivery service plan and has increased the number of units located at broadcast
stations at March 31, 1998. In addition, amortization expense increased by of
$220,000 in the three months ended March 31, 1998 over the same period last
year, as a result of the goodwill and other intangible assets recorded in
connection with the July 1997 acquisition of Mediatech.
11
<PAGE> 12
The Company expects to continue to invest in the expansion of its network.
In particular, the Company is in the process of expanding its infrastructure
within the television broadcast industry that will require additional DG Video
Transmission Systems and Digital Video Playback Systems to be built and
installed in production studios and television stations. The Company expects
depreciation and amortization to fluctuate in proportion to this growth.
Interest Income and Interest Expense
Interest income decreased 73% to $69,000 in the three months ended March
31, 1998 from $251,000 for the three months ended March 31, 1997. This decrease
is primarily the result of reduced levels of cash and cash equivalents and short
term investments in the first quarter of 1998 versus the first quarter of 1997.
The Company's initial public offering was completed in February 1996 and since
that time the offering's proceeds have been used to fund much of the Company's
operating, investing and financing activities. The Company expects that interest
income will decrease in the future based on the levels of cash used in the
Company's operations.
Interest expense increased 39% to $711,000 in the three months ended March
31, 1998 from $511,000 in the three months ended March 31, 1997. The increase is
primarily due to interest expense totaling $130,000 on the term debt and line of
credit assumed in conjunction with the Mediatech acquisition, as well as $58,000
of interest expense on the promissory notes given as consideration in the July
1997 acquisition of Mediatech. The remaining increase results from interest
expense incurred from leasing and loan agreements used to fund the acquisition
of components and equipment needed to develop the Company's network and to
provide Company personnel with the capital resources necessary to support the
Company's business growth. Debt outstanding under these agreements has increased
to $14.1 million at March 31, 1998 from $13.6 million at March 31, 1997. The
Company expects that interest expense will increase in the future based on the
increased levels of borrowing.
Liquidity and Capital Resources
Net cash used in operating activities, including the adjustment for
depreciation and amortization, decreased to $1.9 million in the three months
ended March 31, 1998 from $2.4 million in the three months ended March 31, 1997.
This change is primarily the result of a reduced net loss, exclusive of
depreciation and amortization. The Company's earnings before interest, taxes and
depreciation has improved from a loss of $1.3 million to a loss of $.2 million
in the three months ended March 31, 1998 and 1997, respectively.
The Company used cash of $603,000 for the purchase of property in the three
months ended March 31, 1998. In the three months ended March 31, 1997 the
Company used cash of $1.7 million for the purchase of property and equipment and
an additional $.4 million of additions had been financed with capital lease
obligations. The capital additions in both periods were a result of the
Company's continued expansion of its network. As the primary video network
infrastructure is now in place, fiscal 1998 capital equipment additions are not
expected to reach the levels of fiscal 1997.
Principal payments on long-term debt were $1,942,000 in the three months
ended March 31, 1998 versus $1,226,000 in the three months ended March 31, 1997.
Such payments increased due primarily to $239,000 of payments on other long-term
debt of Mediatech assumed by the Company in conjunction with the Mediatech
acquisition and principal payments of $200,000 on the promissory notes issued in
connection with the Mediatech acquisition and. In addition, there was an
increase in regularly scheduled repayment of the increased capital lease
liability and term debt incurred to finance equipment and property acquisitions.
At March 31, 1998, the Company's current sources of liquidity included cash
and cash equivalents of $3.5 million; short-term investments of $2.1 million;
and $1.7 million and $504,000 available to finance capital expenditures under
two long-term credit facilities which can be drawn against until December 31,
1998 and June 30, 1998, respectively. The Company also has $2.0 million
available for working capital under a long-term credit agreement which can be
drawn on through December 31, 1998. Mediatech has a revolving line of credit
available to fund the working capital requirements of Mediatech. The maximum
available under the Mediatech line is $3,525,000, dependent upon the level of
qualifying receivables maintained by Mediatech. For the three quarters ended
March 31, 1998, $.8 million of payments were made on the line of credit, with an
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outstanding balance at March 31, 1998 of $2,066,000, which was approximately
equal to the maximum available under the agreement at that time. The Company
expects to fully utilize the funding available under the existing credit
agreements. Based on management's current plans and forecasts, the Company
believes that its existing sources of liquidity will satisfy the Company's
projected working capital, capital lease and term loan commitments and other
cash requirements through December 1998. To provide additional flexibility for
growth and other general corporate purposes, however, the Company plans to raise
additional capital in 1998.
CERTAIN BUSINESS CONSIDERATIONS
The Company's business is subject to the following risks in addition to
those described elsewhere in this Form 10-Q.
History of Losses; Future Operating Results Uncertain. The Company was
founded in 1991 and has been unprofitable since its inception. The Company
expects to continue to generate net losses for a minimum of the next twelve
months. As of March 31, 1998, the Company's accumulated deficit from operations
was $61.9 million. The Company has had difficulty in accurately forecasting its
future sales and operating results due to its limited operating history.
Accordingly, although the Company has recently experienced significant growth, a
significant portion of which is due to acquisitions, such growth rates may not
be sustainable and should not be used as an indication of future sales growth,
if any, or of future operating results. The Company's future success also will
depend in part on obtaining continued reductions in delivery and service costs,
particularly continued automation of order processing and reductions in
telecommunications costs. There can be no assurance that the Company's sales
will grow or be sustained in future periods, that the Company will be able to
reduce delivery and service costs, or that the Company will achieve or sustain
profitability in any future period.
Dependence on Electronic Video Advertising Delivery Service Deployment. The
Company has made a substantial investment in upgrading and expanding its network
operating center and populating television stations with the units necessary for
the receipt of electronically delivered video advertising content. However there
can be no assurance that placement of these units will cause this service to
achieve adequate market acceptance among customers which require video
advertising content delivery. The inability to place units in an adequate number
of stations or the inability to capture market share among content delivery
customers as a result of price competition or new product introductions from
competitors would have a material adverse effect on the Company's business,
operating results and financial position. In addition, the Company believes that
in order to more fully address the
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needs of potential video delivery customers it will need to develop a set
of ancillary services which typically are provided by dub and ship houses. These
ancillary services, which include physical archiving, closed captioning,
modification of slates and format conversions, will need to be provided on a
localized basis in each of the major cities in which the Company provides
services directly to agencies and advertisers. The Company currently has the
capability to provide such services through its facilities in New York, Los
Angeles and Chicago. However, there can be no assurance that the Company will
successfully contract for and provide these services in each major metropolitan
area or that the Company will be able to provide competitive video distribution
services in other U.S. markets. Unless the Company can successfully continue to
develop and provide video transmission services, it may be unable to retain
current or attract future audio delivery customers who may ultimately demand
delivery of both media content.
Uncertainties Relating to Integration of Operations. DG Systems acquired
PDR and Mediatech with the expectation that such strategic acquisitions would
result in enhanced efficiencies for the combined company. To date the Company
has not fully completed the integration of PDR and Mediatech with the Company.
Achieving the anticipated benefits of the PDR and Mediatech acquisitions will
depend in part upon whether the integration of the organizations and businesses
of PDR and Mediatech with those of the Company is achieved in an efficient,
effective and timely manner; however, there can be no assurance that this will
occur. The successful integration and expansion of the Company's business
following its acquisition of PDR and Mediatech requires communication and
cooperation among the senior executives and key technical personnel of DG
Systems, PDR, and Mediatech. Given the inherent difficulties involved in
completing a business combination, there can be no assurance that such
cooperation will occur or that the integration of the respective organizations
will be successful and will not result in disruptions in one or more sectors of
the Company's business. Failure to effectively accomplish the integration of the
operations of PDR and Mediatech with those of the Company could have a material
adverse effect on DG Systems' results of operations and financial condition. In
addition, there can be no assurance that current and potential customers will
favorably view the Company's services as offered through PDR and Mediatech or
that DG Systems will realize any of the other anticipated benefits of the PDR or
Mediatech acquisitions. Moreover, as a result of these acquisitions, certain DG
Systems customers may perceive PDR or Mediatech to be a competitor, and this
could affect such customers' willingness to do business with DG Systems in the
future. The loss of significant customers could have a material adverse effect
on DG Systems' results of operations and financial condition.
Future Capital Needs; Uncertainty of Additional Funding. The Company
intends to continue making capital expenditures to produce and install RSTs,
RPTs, VRTSs and DVPS units and to introduce additional services. The Company
also continually analyzes the costs and benefits of acquiring certain
businesses, products or technologies that it may from time to time identify, and
its related ability to finance such acquisitions. Assuming that the Company does
not pursue one or more additional acquisitions funded by internal cash reserves,
the Company anticipates its existing capital, cash from operations, and funds
available under existing term loan and line of credit agreements should be
adequate to satisfy its capital requirements through December 1998.
There can be no assurance, however, that the net proceeds of the Company's
initial public offering and such other sources of funding will be sufficient to
satisfy the Company's future capital requirements or that the Company will not
require additional capital sooner than currently anticipated.
Based on its current business plan, the Company anticipates that it will
eventually use the entire proceeds of its initial public offering and the Series
A Convertible Preferred Stock financing and there can be no assurance that other
sources of funding will be adequate to fund the Company's capital needs, which
depend upon numerous factors, including the progress of the Company's product
development activities, the cost of increasing the Company's sales and marketing
activities and the amount of revenues generated from operations, none of which
can be predicted with certainty. In addition, the Company is unable to predict
the precise amount of future capital that it will require, particularly if it
were to pursue one or more acquisitions, and there can be no assurance that any
additional financing will be available to the Company on acceptable terms, or at
all. The inability to obtain financing for acquisitions on acceptable terms may
prevent the Company from completing advantageous acquisitions and consequently
may adversely effect the Company's prospects and future rates of growth. The
inability to obtain required financing for continuing operations or an
acquisition would have a material adverse effect on the Company's business,
financial condition and results of operations. Consequently, the Company could
be required to significantly reduce or suspend its operations, seek a merger
partner or sell additional securities on terms that are highly dilutive to
existing investors.
Dependence on Emerging Markets. The market for the electronic delivery of
digital audio and video transmissions by advertisers, advertising agencies,
production studios, and video and music distributors to radio and
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television stations, is relatively new and alternative technologies are
rapidly evolving. The Company's marketing task requires it to overcome buyer
inertia related to the diffuse and relatively low level decision making
regarding an agency's choice of delivery services and long standing
relationships with existing dub and ship vendors. Therefore, it is difficult to
predict the rate at which the market for the electronic delivery of digital
audio and video transmissions will grow, if at all. If the market fails to grow,
or grows more slowly than anticipated, the Company's business, operating results
and financial condition will be materially adversely affected. Even if the
market does grow, there can be no assurance that the Company's products and
services will achieve commercial success. Although the Company intends to
conform its products and services to meet existing and emerging standards in the
market for the electronic delivery of digital audio and video transmissions,
there can be no assurance that the Company will be able to conform its products
to such standards in a timely fashion, or at all. The Company believes that its
future growth will depend, in part, on its ability to add these services and
additional customers in a timely and cost-effective manner, and there can be no
assurance that the Company will be successful in developing such services, and
in obtaining new customers for such services. See "Dependence on New Product
Introductions." There can also be no assurance that the Company will be
successful in obtaining a sufficient number of radio and television stations,
radio and television networks, advertisers, advertising agencies, production
studios, and audio and video distributors who are willing to bear the costs of
expanding and increasing the integration of the Company's network, including the
Company's field receiving equipment and rooftop satellite antennae.
The Company's marketing efforts to date with regard to the Company's
products and services have involved identification and characterization of
specific market segments for these products and services with a view to
determining the target markets that will be the most receptive to such products
and services. There can be no assurance that the Company has correctly
identified such markets or that its planned products and services will address
the needs of such markets. Furthermore, there can be no assurance that the
Company's technologies, in their current form, will be suitable for specific
applications or that further design modifications, beyond anticipated changes to
accommodate different markets, will not be necessary. Broad commercialization of
the Company's products and services will require the Company to overcome
significant market development hurdles, many of which may not currently be
foreseen.
Dependence on Technological Developments. The market for the distribution
of digital audio and video transmissions is characterized by rapidly changing
technology. The Company's ability to remain competitive and its future success
will depend in significant part upon the technological quality of its products
and processes relative to those of its competitors and its ability both to
develop new and enhanced products and services and to introduce such products
and services at competitive prices and in a timely and cost-effective fashion.
The Company's development efforts have been focused on the areas of satellite
transmission technology, video compression technology, TV station system
interface, and work on reliability and throughput enhancement of the network.
The Company's ability to successfully grow electronic video delivery services
depends on its ability to obtain satellite delivery capability. Work in
satellite technology is oriented to development and deployment of software to
lower transmission costs and increase delivery reliability. Work in video
compression technology is directed toward integration of emerging broadcast
quality compression systems, which further improve picture quality while
maintaining compliance with industry standards, with the Company's existing
network. Work in TV station system interface includes implementation of various
system control protocols and improvement of system throughput and reliability.
The Company has an agreement with Hughes Network Systems, Inc. ("Hughes") which
allows the Company to use Hughes' satellite capacity for electronic delivery of
digital audio and video transmissions by that media. The Company has developed
and incorporated software designed to enable the current DVPSs to receive
digital satellite transmissions over the Hughes satellite system. There can be
no assurance that the Hughes satellite system will have the capacity to meet the
Company's future delivery commitments and broadcast quality requirements and to
do so on a cost-effective basis. See "Dependence on Certain Suppliers."
The introduction of products embodying new technologies can render existing
products obsolete or unmarketable. There can be no assurance that the Company
will be successful in identifying, developing, contracting for the manufacture
of, and marketing product enhancements or new products that respond to
technological change, that the Company will not experience difficulties that
could delay or prevent the successful development, introduction and marketing of
these products, or that its new products and product enhancements will
adequately meet the requirements of the marketplace and achieve market
acceptance. Delays in the commencement of commercial availability of new
products and services and enhancements to existing products and services may
result in customer dissatisfaction and delay or loss of revenue. If the Company
is unable, for other reasons, to develop and introduce new products and services
or enhancements of existing products and services in a timely
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manner or if new versions of existing products do not achieve a significant
degree of market acceptance, there could be a material adverse effect on the
Company's business, financial condition and results of operations.
Dependence on Radio Advertising. Prior to the Company's acquisitions of PDR
and Mediatech, the Company's revenues were derived principally from a single
line of business, the delivery of radio advertising spots from advertising
agencies, production studios and dub and ship houses to radio stations in the
United States, and such services are expected to continue to account for a
significant portion of the Company's revenues for some time. A decline in demand
for, or average selling prices of, the Company's radio advertising delivery
services, whether as a result of competition from new advertising media, new
product introductions or price competition from competitors, a shift in
purchases by customers away from the Company's premium services such as DG
Priority or DG Express, technological change or otherwise, would have a material
adverse effect on the Company's business, operating results and financial
condition. Additionally, the Company is dependent upon its relationship with and
continued support of the radio stations in which it has installed communications
equipment. Should a substantial number of these stations go out of business,
experience a change in ownership, or discontinue the use of the Company's
equipment in any way, it could materially adversely affect the Company's
business, operating results and financial condition.
Ability to Maintain and Improve Service Quality. The Company's business is
dependent on its ability to make cost-effective deliveries to broadcast stations
within the time periods requested by customers. Any failure to do so, whether or
not within the control of the Company, could result in an advertisement not
being run and in the station losing air-time which it could have otherwise sold.
Although the Company disclaims any liability for lost air-time, there can be no
assurance that claims by stations for lost air-time would not be asserted in
these circumstances or that dissatisfied advertisers would refuse to make
further deliveries through the Company in the event of a significant occurrence
of lost deliveries, either of which would have a material adverse that effect on
the Company's business, results of operations and financial condition. Although
the Company maintains insurance against business interruption, there can be no
assurance that such insurance will be adequate to protect the Company from
significant loss in these circumstances or that a major catastrophe (such as an
earthquake or other natural disaster) would not result in a prolonged
interruption of the Company's business. In particular, the Company's network
operating center is located in the San Francisco Bay area, which has in the past
and may in the future experience significant, destructive seismic activity that
could damage or destroy the Company's network operating center. In addition, the
Company's ability to make deliveries to stations within the time periods
requested by customers depends on a number of factors, some of which are outside
of its control, including equipment failure, interruption in services by
telecommunications service providers, and the Company's inability to maintain
its installed base of RSTs, RPTs, VRTSs and DVPS video units that comprise its
distribution network. The result of the Company's failure to make timely
deliveries for whatever reason could be that dissatisfied advertisers would
refuse to make further deliveries through the Company which would have a
material adverse effect on the Company's business, results of operations and
financial condition.
Competition. The Company currently competes in the market for the
distribution of audio advertising spots to radio stations and the distribution
of video advertising spots to television stations. The principal competitive
factors affecting these markets are ease of use, price, timeliness and accuracy
of delivery. The Company competes with a variety of dub and ship houses and
production studios that have traditionally distributed taped advertising spots
via physical delivery. Although such dub and ship houses and production studios
do not currently offer electronic delivery, they have long-standing ties to
local distributors that will be difficult for the Company to replace. Some of
these dub and ship houses and production studios have greater financial,
distribution and marketing resources and have achieved a higher level of brand
recognition than the Company. Moreover, Digital Courier International
Corporation has deployed a system to electronically deliver audio content in
Canada and the United States and several other companies have announced such
systems. As a result, there can be no assurance that the Company will be able to
compete effectively against these competitors merely on the basis of ease of
use, timeliness and accuracy of delivery.
In the market for the distribution of video content to television stations,
the Company encounters competition from VDI Media and Vyvx Advertising
Distribution Services ("VADS"), a subsidiary of The Williams Companies which
includes CycleSat, Inc., in addition to dub and ship houses and production
studios, certain of which currently function as marketing partners with the
Company in the audio distribution market. To the extent that the Company is
successful in entering new markets, such as the delivery of other forms of
content to radio and television stations
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and content delivery to radio and television stations, it would expect to face
competition from companies in related communications markets and/or package
delivery markets which could offer products and services with functionality
similar or superior to that offered by the Company's products and services.
Telecommunications providers such as AT&T, MCI and Regional Bell Operating
Companies could also enter the market as competitors with materially lower
electronic delivery transportation costs. The Company could also face
competition from entities with package delivery expertise such as Federal
Express, United Parcel Service, DHL and Airborne if any such companies enter the
electronic data delivery market. Radio networks such as ABC or Westwood One
could also become competitors by selling and transmitting advertisements as a
complement to their content programming. In addition, Applied Graphics
Technologies, Inc., a provider of digital pre-press services, has indicated its
intention to provide electronic distribution services and acquired Spotlink, a
dub and ship house and current customer of the Company, in December 1996 as an
entry to this market. In 1997, Applied Graphics is reported to have acquired
additional dub and ship operations.
Many of the Company's current and potential competitors in the markets for
audio and video transmissions have substantially greater financial, technical,
marketing and other resources and larger installed customer bases than the
Company. There can be no assurance that the Company will be able to compete
successfully against current and future competitors based on these and other
factors. The Company expects that an increasingly competitive environment will
result in price reductions that could result in reduced unit profit margins and
loss of market share, all of which would have a material adverse effect on the
Company's business, results of operations and financial condition. Moreover, the
market for the distribution of audio and video transmissions has become
increasingly concentrated in recent years as a result of acquisitions, which are
likely to permit many of the Company's competitors to devote significantly
greater resources to the development and marketing of new competitive products
and services. The Company expects that competition will increase substantially
as a result of these and other industry consolidations and alliances, as well as
the emergence of new competitors. There can be no assurance that the Company
will be able to compete successfully with new or existing competitors or that
competitive pressures faced by the Company will not materially and adversely
affect its business, operating results and financial condition.
Ability to Manage Growth. The Company has recently experienced a period of
rapid growth that has resulted in new and increased responsibilities for
management personnel and has placed and continues to place a significant strain
on the Company's management, operating and financial systems and resources. To
accommodate this recent growth and to compete effectively and manage future
growth, if any, the Company will be required to continue to implement and
improve its operational, financial and management information systems,
procedures and controls on a timely basis and to expand, train, motivate and
manage its work force. In particular, the Company believes that to achieve these
objectives it must complete the automation of the customer order entry process
and the integration of the delivery fulfillment process into the customer
billing system and integrate these systems with those of PDR and Mediatech.
There can be no assurance that the Company's personnel, systems, procedures and
controls will be adequate to support the Company's existing and future
operations. Any failure to implement and improve the Company's operational,
financial and management systems or to expand, train, motivate or manage
employees could have a material adverse effect on the Company's business,
operating results and financial condition.
Potential Fluctuations in Quarterly Results; Seasonality. The Company's
quarterly operating results have in the past and may in the future vary
significantly depending on factors such as the volume of advertising in response
to seasonal buying patterns, the timing of new product and service
introductions, increased competition, the timing of the Company's promotional
efforts, general economic factors, and other factors. For example, the Company
has historically experienced lower sales in the first quarter and higher sales
in the fourth quarter, due to increased customer advertising volumes for the
Christmas selling season. As a result, the Company believes that period to
period comparisons of its results of operations are not necessarily meaningful
and should not be relied upon as an indication of future performance. In any
period, the Company's revenues and delivery costs are subject to variation based
on changes in the volume and mix of deliveries performed during the period. In
particular, the Company's operating results have historically been significantly
influenced by the volume of deliveries ordered by television stations during the
"Sweeps" rating periods that currently take place in February, May, August and
November. The increased volume of these deliveries during such periods and the
Company's pricing for "Sweeps" advertisements have historically increased the
total revenues and revenues per delivery of the Company and tended to reduce
delivery costs as a percentage of revenues. The Company's expense levels are
based, in part, on its expectations of future sales levels. If sales levels are
below expectations, operating results are likely to be materially adversely
affected. In addition, the Company has historically operated with little or no
backlog. The absence of backlog
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increases the difficulty of predicting sales and operating results. Fluctuations
in sales due to seasonality may become more pronounced as the growth rate of the
Company's sales slows. Due to the unique nature of the Company's products and
services, the Company believes that it will incur significant expenses for sales
and marketing, including advertising, to educate potential customers about such
products and services.
Dependence on Key Personnel. The Company's success depends to a significant
degree upon the continuing contributions of, and on its ability to attract and
retain, qualified management, sales, operations, marketing and technical
personnel. The competition for qualified personnel, particularly engineering
staff, is intense and the loss of any of such persons, as well as the failure to
recruit additional key personnel in a timely manner, could adversely affect the
Company. There can be no assurance that the Company will be able to continue to
attract and retain qualified management, sales and technical personnel for the
development of its business. The Company generally has not entered into
employment or noncompetition agreements with any of its employees. The Company
does not maintain key man life insurance on the lives of any of its key
personnel. The Company's failure to attract and retain key personnel could have
a material adverse effect on its business, operating results and financial
condition.
Dependence on Certain Suppliers. The Company relies on certain single or
limited-source suppliers for certain integral components used for the assembly
of the Company's audio and video units. Although the Company's suppliers are
generally large, well-financed organizations, in the event that a supplier were
to experience financial or operational difficulties that resulted in a reduction
or interruption in component supply to the Company, it would delay the Company's
deployment of audio and video units which would have the effect of depressing
the Company's business until the Company established sufficient component supply
through an alternative source. The Company believes that there are alternative
component manufacturers that could supply the components required to produce the
Company's products, but the Company is not currently pursuing agreements or
understandings with such alternative sources. If a reduction or interruption of
supply were to occur, it could take a significant period of time for the Company
to qualify an alternative subcontractor, redesign its products as necessary and
contract for the manufacture of such products. The Company does not have
long-term supply contracts with its sole- or limited-source vendors and
purchases its components on a purchase order basis. The Company has experienced
component shortages in the past and there can be no assurance that material
component shortages or production or delivery delays will not occur in the
future. The inability in the future to obtain sufficient quantities of
components in a timely manner as required, or to develop alternative sources as
required, could result in delays or reductions in product shipments or product
redesigns, which would materially and adversely affect the Company's business,
operating results and financial condition.
Pursuant to its development efforts in the area of satellite transmission
technology, the Company has successfully completed live field trials of software
designed to enhance and enable the current RPTs to receive digital satellite
transmissions over the Hughes satellite system. The Company's dependence on
Hughes entails a number of significant risks. The Company's business, results of
operations and financial condition would be materially adversely affected if
Hughes were unable for any reason to continue meeting the Company's delivery
commitments on a cost-effective basis or if any transmissions failed to satisfy
the Company's quality requirements. In the event that the Company were unable to
continue to use Hughes' satellite capacity, the Company would have to identify,
qualify and transition deliveries to an acceptable alternative satellite
transmission vendor. This identification, qualification and transition process
could take nine months or longer, and no assurance can be given that an
alternative satellite transmission vendor would be available to the Company or
be in a position to satisfy the Company's delivery requirements on a timely and
cost-effective basis.
The Company obtains its local access telephone transmission services
through Teleport Communications Group. The Company obtains its long distance
telephone access through an exclusive contract with MCI. During 1997, the
Company renegotiated its agreement, which now expires in 2001. Any material
interruption in the supply or a material adverse change in the price of either
local access or long distance carrier service could have a material adverse
effect on the Company's business, results of operations and financial condition.
Dependence on New Product Introductions. The Company's future growth
depends on its successful and timely introduction of new products and services
in markets that do not currently exist or are just emerging. The Company's goals
are to introduce new services, such as media archiving and the ability to
quickly and reliably give an agency the ability to preview and authorize
electronic delivery of video advertising spots. There can be no assurance that
the Company will successfully complete development of such products and
services, or that if any such development is completed, that the Company's
planned introduction of these products and services will realize market
acceptance or will meet the technical or other requirements of potential
customers.
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Dependence on Proprietary Technology, Protection of Trademarks, Copyrights,
and Other Proprietary Information; Risk of Third Party Claims of Infringement.
The Company considers its trademarks, copyrights, advertising, and promotion
design and artwork to be of value and important to its business. The Company
relies on a combination of trade secret, copyright and trademark laws and
nondisclosure and other arrangements to protect its proprietary rights. The
Company does not have any patents or patent applications pending. Despite the
Company's efforts to protect its proprietary rights, unauthorized parties may
attempt to copy or obtain and use information that the Company regards as
proprietary. There can be no assurance that the steps taken by the Company to
protect its proprietary information will prevent misappropriation of such
information and such protection may not preclude competitors from developing
confusingly similar brand names or promotional materials or developing products
and services similar to those of the Company. In addition, the laws of some
foreign countries do not protect the Company's proprietary rights to the same
extent as do the laws of the United States. While the Company believes that its
trademarks, copyrights, advertising and promotion design and artwork do not
infringe upon the proprietary rights of third parties, there can be no assurance
that the Company will not receive future communications from third parties
asserting that the Company's trademarks, copyrights, advertising and promotion
design and artwork infringe, or may infringe, on the proprietary rights of third
parties. Any such claims, with or without merit, could be time-consuming,
require the Company to enter into royalty arrangements or result in costly
litigation and diversion of management personnel. No assurance can be given that
any necessary licenses can be obtained or that, if obtainable, such licenses can
be obtained on commercially reasonable terms. In the event of a successful claim
of infringement against the Company and failure or inability of the Company to
license the infringed or similar proprietary information, the Company's
business, operating results and financial condition could be materially
adversely affected.
Year 2000 Risk Compliance. Many currently installed computer systems and
software products are coded to accept only two digit entries in the date code
field. Beginning in the year 2000, these date codes fields will need to accept
four digit entries to distinguish 21st century dates from 20th century dates. As
a result, in less than two years, many such currently installed computer systems
and software products used by many companies will need to be upgraded to enable
such systems and computer hardware and software products to avoid the potential
effects associated with this year 2000 coding problem. Although the Company has
begun taking the steps it believes are necessary to make its network and other
systems year 2000 compliant and despite the Company's belief that it utilizes
the most recently available hardware and software products of leading industry
providers, whom the Company believes are allocating significant resources to
address and resolve these issues, there can be no assurance that the Company's
computer hardware and software products will contain all necessary code changes
in their date code fields to avoid any or all damaging interruptions and other
problems associated with date entry limitations.
The Company believes that the purchasing pattern of its current and
potential customers may be affected by the year 2000 problem described above in
a variety of ways. For example, as the year 2000 approaches, some of the
Company's current customers may develop concerns about the reliability of the
Company's electronic delivery services and, as a result, shift their delivery
work to less technical dub and ship operations. Likewise, some potential
customers of the Company with the same concern may elect not to utilize the
Company's electronic delivery services until after year 2000 and beyond. If any
current customers of the Company shift some or all of their delivery work to
other delivery providers, the Company's business, financial condition and
results of operations will be adversely affected, and if any potential customers
elect to not utilize the Company's delivery services for any period of time on
the basis of year 2000 concerns, the Company's business and financial prospects
for growth could be adversely affected. In addition to the foregoing, in the
event that the Company does experience interruptions and problems with its
computer hardware and software products due to year 2000 limitations of such
products, some or all of the Company's current customers may shift some or all
of their delivery work to other delivery providers without year 2000 problems.
Moreover, potential customers of the Company may elect not to utilize the
Company's delivery services in the event of any such interruptions and problems.
Any of the foregoing could have a material adverse affect on the Company's
business, financial condition and results of operations.
Expansion into International Markets. Although the Company's long-term
plans include expansion of its operations to Europe and Asia, it does not at
present have network operating center personnel experienced in operating in
these locations. Telecommunications standards in foreign countries differ from
those in the United States and may work require the Company to incur substantial
costs and expend significant managerial resources to obtain any necessary
regulatory approvals and comply with differing equipment interface and
installation standards promulgated by regulatory authorities of those countries.
Changes in government policies, regulations and telecommunications systems in
foreign countries could require the Company's products and services to be
redesigned, causing product and service delivery delays that could materially
adversely affect the Company's operating results. The Company's ability to
successfully enter these new markets will depend, in part, on its ability to
attract personnel with experience in these locations and to attract partners
with the necessary local business relationships. There can be no assurance,
however, that the Company's products and services will achieve market acceptance
in foreign countries. The inability of the Company to successfully establish and
expand its international operations may also limit its ability to obtain
significant international revenues and could materially adversely affect the
business, operating results and financial condition of the Company. Furthermore,
international business is subject to a number of country-specific risks and
circumstances, including different tax laws, difficulties in expatriating
profits, currency exchange rate fluctuations, and the complexities of
administering business abroad. Moreover, to the extent the Company increases its
international sales, the Company's business, operating results and financial
condition could be materially adversely affected by these risks and
circumstances, as well as by increases in duties, price controls or other
restrictions on foreign currencies, and trade barriers imposed by foreign
governments, among other factors.
Concentration of Stock Ownership; Antitakeover Provisions. The present
executive officers and directors of the Company and their respective affiliates
own approximately 44% of the Company's Common Stock and recently-issued Series A
Convertible Preferred Stock, which votes together with Common Stock on all
matters submitted to the shareholders of the Company. As a result, these
shareholders will be able to control or significantly influence all matters
requiring shareholder approval, including the election of directors and the
approval of significant corporate transactions. Such concentration of ownership
may have the effect of delaying or preventing a change in control of the
Company. Furthermore, certain provisions of the Company's Amended and Restated
Articles of Incorporation and Bylaws, and of California law, could have the
effect of delaying, deferring or preventing a change in control of the Company.
Preferential Rights of Outstanding Preferred Stock. The Company has
issued and outstanding 4,950,495
19
<PAGE> 20
shares of its Series A Convertible Preferred Stock (the "Series A Preferred").
The rights of the Series A Preferred include certain rights and preferences set
forth in the Company's Certificate of Determination of Rights of Series A
Convertible Preferred Stock, which rights could materially limit or qualify the
rights of holders of the Company's Common Stock and have a material adverse
effect on the prevailing market price of the Common Stock. Such rights include,
without limitation, the right to participate, on an as converted basis, in any
and all dividends declared or paid, or set aside for payment, in respect of
outstanding shares of the Company's Common Stock. The rights of the Series A
Preferred also include the right to receive payment prior to any payment to the
holders of the Company's Common Stock, in a per share amount equal to the
purchase price paid per share of the Series A Preferred in the event of any
voluntary or involuntary liquidation, distribution of assets (other than payment
of dividends), dissolution or winding up of the affairs of the Company. In
addition, the Series A Preferred have special voting rights which enable the
holders thereof to designate one member of the Board of Directors of the Company
for election by the holders of the Series A Preferred. The rights of the holders
of Common Stock are subject to, and may be adversely affected by, the rights of
the holders of Series A Preferred, which in turn could adversely affect the
prevailing market price for the Company's Common Stock.
The Series A Preferred is convertible, at the option of the holder, into
shares of the Company's Common Stock. The Series A Preferred also will
automatically convert into shares of the Company's Common Stock upon the
satisfaction of certain conditions. The Series A Preferred, and the shares of
Common Stock issuable upon the conversion of such shares of Series A Preferred,
are "restricted securities" as that term is defined in Rule 144 promulgated by
the Securities and Exchange Commission under the Securities Act of 1933, as
amended. Accordingly, such shares, if sold pursuant to Rule 144, will be subject
to the resale provisions applicable to restricted securities under Rule 144. The
availability for sale, as well as actual sales, of the Company's Common Stock
issuable or issued upon the conversion of the Series A Preferred may depress the
prevailing market price for the Common Stock and could adversely affect the
terms upon which the Company would be able to obtain additional equity
financing.
Possible Volatility of Share Price. The trading prices of the Company's
Common Stock may be subject to wide fluctuations in response to a number of
factors, including variations in operating results, changes in earnings
estimates by securities analysts, announcements of extraordinary events such as
litigation or acquisitions, announcements of technological innovations or new
products or services by the Company or its competitors, as well as general
economic, political and market conditions. In addition, stock markets have
experienced extreme price and volume trading volatility in recent years. This
volatility has had a substantial effect on the market prices of the securities
of many high technology companies for reasons frequently unrelated to the
operating performance of specific companies. These broad market fluctuations may
adversely affect the market price of the Company's Common Stock.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
From time to time the Company has been, or may become, involved in
litigation proceedings incidental to the conduct of its business. The Company
does not believe that any such proceedings presently pending will have a
material adverse affect on the Company's financial position or its results of
operations.
ITEM 2. CHANGES IN SECURITIES
Not applicable.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
20
<PAGE> 21
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
<TABLE>
<CAPTION>
EXHIBIT
NUMBER EXHIBIT TITLE
------ -------------
<S> <C>
3.1(d) Restated Articles of Incorporation of registrant.
3.2(b) Bylaws of registrant, as amended to date.
4.2(b) Form of Common Stock Certificate.
10.1(b) 1992 Stock Option Plan (as amended) and forms of
Incentive Stock Option Agreement and Nonstatutory Stock
Option Agreement.
10.2(b) Form of Directors' and Officers' Indemnification
Agreement.
10.3(b) 1995 Director Option Plan and form of Incentive Stock
Option Agreement thereto.
10.4(b) Form of Restricted Stock Agreement.
10.5.1(c) Content Delivery Agreement between the Company and
Hughes Network Systems, Inc., dated November 28, 1995.
10.5.2(c) Equipment Reseller Agreement between the Company and
Hughes Network Systems, Inc., dated November 28, 1995.
10.6(b) Amendment to Warrant Agreement between the Company and
Comdisco, Inc., dated January 31, 1996.
10.7.1(c) Corporate Service Plan Agreement between the Company and
MCI Telecommunications Corporation, dated March 23,
1994.
10.7.2(c) First Amendment to Corporate Service Plan Agreement
between the Company and MCI Telecommunications
Corporation, dated November 2, 1995.
10.8(b) Master Lease Agreement between the Company and Comdisco,
Inc., dated October 20, 1994, and Exhibits thereto.
10.9(b) Loan and Security Agreement between the Company and
Comdisco, Inc., dated October 20, 1994, and Exhibits
thereto.
10.10(b) Master Equipment Lease between the Company and Phoenix
Leasing, Inc., dated January 7, 1993.
10.15(c) Audio Server Network Prototype Vendor Agreement and
Satellite Vendor Agreement between the Company and ABC
Radio Networks, dated December 15, 1995.
10.17(b) Promissory Note between the Company and Henry W.
Donaldson, dated March 18, 1994, December 5, 1994,
December 5, 1994, and March 14, 1995.
10.18(b) Warrant Agreement to purchase Series B Preferred Stock
between the Company and Comdisco, Inc., dated as of
October 20, 1994.
10.19(b) Warrant Agreement to purchase Series C Preferred Stock
between the Company and Comdisco, Inc., dated as of June
13, 1995.
10.20(b) Warrant Agreement to purchase Series D Preferred Stock
between the Company and Comdisco, Inc., dated as of
January 11, 1996.
10.22(d) Agreement of Sublease for 9,434 rentable square feet at
855 Battery Street, San Francisco, California between
the Company and T.Y. Lin International dated September
8, 1995 and exhibits thereto.
10.23(d) Agreement of Sublease for 5,613 rentable square feet at
855 Battery Street, San Francisco, California between
the Company and Law/Crandall, Inc. dated September 29,
1995 and exhibits thereto.
10.24(e) Digital Generation Systems, Inc. Supplemental Stock
Option Plan.
</TABLE>
21
<PAGE> 22
<TABLE>
<CAPTION>
EXHIBIT
NUMBER EXHIBIT TITLE
------ -------------
<S> <C>
10.25(e) Stock Purchase Agreement by and among Digital Generation
Systems, Inc. and PDR Productions, Inc. and Pat DeRosa
dated as of October 15, 1996 and exhibits thereto.
10.26(f) Amendment to Stock Purchase Agreement dated November 8,
1996, among Digital Generation Systems, Inc., and Pat
DeRosa.
10.27(a) Loan Agreement dated as of January 28, 1997 between
Digital Generation Systems, Inc. as Borrower, and
Venture Lending and Leasing, Inc. as Lender and exhibits
thereto.
10.29(i) Preferred Stock Purchase Agreement, dated as of July 14,
1997, by and among Digital Generation Systems, Inc. and
the parties listed on the Schedule of Purchasers
attached, as Exhibit A thereto.
10.30(i) Amendment to Preferred Stock Purchase Agreement, dated
as of July 23, 1997, by and among Digital Generation
Systems, Inc. and the purchasers listed on the Exhibit A
thereto.
10.31(g) Loan Agreement dated as of December 1, 1997 between
Digital Generation Systems, Inc. as Borrower, and
Venture Lending and Leasing, Inc. as Lender and exhibits
thereto.
10.32(g) First Amendment to Loan Agreement dated as of January
28, 1997 between Digital Generation Systems, Inc. as
Borrower, and Venture Lending and Leasing, Inc. as
Lender and exhibits thereto.
21.1(g) Subsidiaries of the Registrant.
27(a) Financial Data Schedule.
</TABLE>
- ----------
(a) Filed herewith.
(b) Incorporated by reference to the exhibit bearing the same number
filed with registrant's Registration Statement on Form S-1
(Registration No. 33-80203).
(c) Incorporated by reference to the exhibit bearing the same number
filed with registrant's Registration Statement on Form S-1
(Registration No. 33-80203). The registrant has received confidential
treatment with respect to certain portions of this exhibit. Such
portions have been omitted from this exhibit and have been filed
separately with the Securities and Exchange Commission.
(d) Incorporated by reference to the exhibit bearing the same number
filed with registrant's Quarterly Report on Form 10-Q filed May 3,
1996, as amended.
(e) Incorporated by reference to the exhibit bearing the same number
filed with registrant's Quarterly report on Form 10-Q filed November
13, 1996.
(f) Incorporated by reference to the exhibit bearing the same number
filed with registrant's Current Report on Form 8-K/A filed January
21, 1997.
(g) Incorporated by reference to the exhibit bearing the same number
filed with registrant's Annual Report on Form 10-K filed March 31,
1998.
(h) Incorporated by reference to the exhibit bearing the same number
filed with registrant's quarterly report on Form 10-Q filed May 15,
1997.
(i) Incorporated by reference to the exhibit bearing the same title filed
with registrant's Form 8-K filed August 1, 1997.
(j) Incorporated by reference to the exhibit bearing the same title filed
with registrant's Quarterly report on Form 10-Q filed August 14,
1997. Confidential treatment has been requested with respect to
certain portions of this exhibit pursuant to a request for
confidential treatment filed with the Securities and Exchange
Commission. Omitted portions have been filed separately with the
Commission.
22
<PAGE> 23
(b) REPORTS ON FORM 8-K.
Current Report on Form 8-K/A-4 filed on January 8, 1998, reporting the
release of Series A proceeds held in escrow to the registrant.
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.
DIGITAL GENERATION SYSTEMS, INC.
Dated: MAY 15, 1998 BY: /S/ PAUL W. EMERY, II
---------------------------
PAUL W. EMERY, II
VICE PRESIDENT & CHIEF FINANCIAL
OFFICER (PRINCIPAL FINANCIAL AND
CHIEF ACCOUNTING OFFICER)
23
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