<PAGE> 1
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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 SEPTEMBER 30, 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 OCTOBER 31, 1998: 22,286,308
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<PAGE> 2
DIGITAL GENERATION SYSTEMS, INC.
This report 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 September 30, 1998 and
December 31, 1997 ...................................................... 3
Condensed Consolidated Statements of Operations for the three and
nine months ended September 30, 1998 and 1997 .......................... 4
Condensed Consolidated Statements of Cash Flows for the nine months
ended September 30, 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 .................................................. 10
PART II. OTHER INFORMATION
Item 1. Legal Proceedings ...................................................... 25
Item 2. Changes in Securities .................................................. 25
Item 5. Other Information ...................................................... 25
Item 6. Exhibits and Reports on Form 8-K ....................................... 26
SIGNATURES ............................................................. 29
</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>
SEPTEMBER 30, DECEMBER 31,
1998 1997
------------- ------------
(Unaudited)
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 1,601 $ 7,833
Short-term investments -- 987
Accounts receivable, net 9,421 8,053
Prepaid expenses and other 824 649
--------- --------
Total current assets 11,846 17,522
--------- --------
PROPERTY AND EQUIPMENT, at cost:
Network equipment 33,821 30,405
Office furniture and equipment 3,727 2,963
Leasehold improvements 539 506
--------- --------
38,087 33,874
Less - Accumulated depreciation and amortization (24,282) (16,308)
--------- --------
Property and equipment, net 13,805 17,566
--------- --------
GOODWILL AND OTHER ASSETS, net 13,166 25,609
--------- --------
$ 38,817 $ 60,697
========= ========
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 2,752 $ 4,506
Accrued liabilities 4,308 3,501
Line of credit 954 2,834
Current portion of long-term debt 8,019 7,560
--------- --------
Total current liabilities 16,033 18,401
--------- --------
LONG-TERM DEBT, net of current portion 9,348 11,847
--------- --------
SHAREHOLDERS' EQUITY:
Convertible preferred stock, no par value --
Authorized -- 15,000,000 at September 30, 1998;
5,000,000 at December 31, 1997
Outstanding -- none at September 30, 1998 and
4,950,495 at December 31, 1997 -- 31,561
Common stock, no par value --
Authorized -- 40,000,000 shares at September 30, 1998
and 30,000,000 shares at December 31, 1997
Outstanding -- 22,272,197 shares at September 30, 1998
and 12,122,679 shares at December 31, 1997 102,832 57,123
Receivables from issuance of common stock (925) (175)
Accumulated deficit (88,471) (58,060)
--------- --------
Total shareholders' equity 13,436 30,449
--------- --------
$ 38,817 $ 60,697
========= ========
</TABLE>
The accompanying notes are an integral part of these condensed
consolidated financial statements.
3
<PAGE> 4
DIGITAL GENERATION SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1998 AND 1997
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------- -------------------------
1998 1997 1998 1997
-------- -------- -------- --------
(Unaudited) (Unaudited)
<S> <C> <C> <C> <C>
REVENUES $ 9,021 $ 8,798 $ 28,992 $ 18,809
-------- -------- -------- --------
COSTS AND EXPENSES:
Delivery and material costs 3,250 3,886 10,662 7,174
Customer operations 3,460 3,241 10,503 7,480
Sales and marketing 1,156 1,232 3,655 3,373
Research and development 795 688 1,984 1,956
General and administrative 1,097 998 3,141 2,239
Write down of goodwill and fixed assets (Note 4) 17,006 -- 17,006 --
Depreciation and amortization 2,914 2,628 8,627 6,361
-------- -------- -------- --------
Total expenses 29,678 12,673 55,578 28,583
-------- -------- -------- --------
LOSS FROM OPERATIONS (20,657) (3,875) (26,586) (9,774)
-------- -------- -------- --------
OTHER INCOME (EXPENSE):
Interest income 63 138 177 604
Interest expense (831) (762) (2,238) (1,826)
-------- -------- -------- --------
NET LOSS $(21,425) $ (4,499) $(28,647) $(10,996)
======== ======== ======== ========
BASIC AND DILUTED NET LOSS PER SHARE (Note 7) $ (1.33) $ (1.63) $ (2.18) $ (2.21)
======== ======== ======== ========
WEIGHTED AVERAGE COMMON SHARES 17,471 12,035 13,954 11,818
======== ======== ======== ========
</TABLE>
The accompanying notes are an integral part of these condensed
consolidated financial statements.
4
<PAGE> 5
DIGITAL GENERATION SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1998 AND 1997
(IN THOUSANDS)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPT 30, SEPT 30,
1998 1997
-------- --------
(Unaudited)
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $(28,647) $(10,996)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization of property and equipment 7,647 5,897
Amortization of goodwill and intangibles 980 465
Writedown of goodwill and fixed assets (Note 4) 17,006 --
Stock options granted in lieu of professional fees 80 --
Provision for doubtful accounts 130 106
Changes in operating assets and liabilities --
Accounts receivable (367) 446
Prepaid expenses and other assets (117) (424)
Accounts payable and accrued liabilities (947) 351
-------- --------
Net cash used in operating activities (4,235) (4,155)
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of short-term investments (2,013) (7,834)
Maturities of short-term investments 3,000 15,760
Purchase of Mediatech -- (13,921)
Purchase of DCI (Note 3) (9,131)
Acquisition of property and equipment (1,420) (4,083)
-------- --------
Net cash provided by (used in) investing activities (9,564) (10,078)
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock 11,479 74
Proceeds from issuance of preferred stock -- 13,950
Proceeds from line of credit 10,240 3,601
Payments on line of credit (12,120) (4,283)
Proceeds from issuance of long-term debt 4,465 4,355
Payments on long-term debt (6,497) (3,905)
-------- --------
Net cash provided by (used in) financing activities 7,567 13,792
-------- --------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (6,232) (441)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 7,833 9,682
-------- --------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 1,601 $ 9,241
======== ========
SUPPLEMENTAL CASH FLOW INFORMATION
Property and equipment financed with capitalized lease obligations $ -- $ 400
Long term debt used to to finance Mediatech acquisition -- 3,850
Common Stock issued to finance Mediatech acquisition -- 1,906
Preferred Stock deemed dividend 1,764 15,161
</TABLE>
The accompanying notes are an integral part of these
condensed consolidated financial statements.
5
<PAGE> 6
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 and nine month periods ended September 30, 1998. The results for the three
and nine month periods ended September 30, 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 September 30, 1998 and December 31, 1997, cash and
cash equivalents consist principally of U.S. Treasury bills and various money
market accounts; as a result, the amortized purchase cost approximates the fair
market value. As of December 31, 1997, 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. ACQUISITIONS
MEDIATECH 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, had been included in Goodwill and Other Assets
in the accompanying consolidated balance sheet at December 31, 1997, and was
being amortized over a twenty year period. Amortization of approximately
$648,000 is included in the consolidated statement of operations for the nine
months ended September 30, 1998. In September, 1998, the Company wrote off all
of the outstanding goodwill resulting from the Mediatech acquisition and a
portion of the fixed assets of Mediatech, as it was determined that their
carrying
6
<PAGE> 7
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
values were not recoverable (Note 4). 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.
DCI ACQUISITION
On September 25, 1998, the Company, through its wholly owned subsidiary,
17231 Yukon, Inc. ("Yukon") acquired substantially all of the property and
assets, including all accounts receivable, inventories, contracts, equipment,
real property leases and other related assets ("the Assets") of Digital Courier
International, Inc. ("DCI" or "DCI acquisition") from Grant Thornton Limited
("Grant Thornton"), acting in its capacity as Receiver-Manager of Digital
Courier International Corporation ("DCIC") and its wholly-owned subsidiary, DCI.
DCI is in the business of supplying electronic distribution and communications
services for the radio broadcast industry in the United States and Canada.
Grant Thornton was appointed Receiver-Manager of DCIC and DCI pursuant to
an order of the Supreme Court of British Columbia on July 14, 1998. Prior to the
court order appointing Grant Thornton as receiver of DCIC and DCI, DCIC was
listed on the Alberta Stock Exchange and conducted its business through DCI.
Yukon, incorporated under the laws of the Yukon Territory, Canada, subsequently
changed its name to DG Systems North Inc. ("DG North"), effective as of October
5, 1998.
The Company paid $13.5 million in Canadian dollars (approximately US$9.06
million) in consideration for the transfer of the Assets to DG North. The amount
and nature of the consideration was determined by arms-length negotiation among
the parties. The funds used to purchase the Assets were derived from the
Registrant's working capital.
The DCI 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 $5.1 million has been included in Goodwill and Other Assets in
the accompanying consolidated balance sheet and is being amortized over a 20
year period. The operating results and balance sheet of DCI have been included
in the consolidated results and balances of the Company from the date of the
closing of the transaction, September 25, 1998. The operating results of DCI for
the period between the acquisition date and the September 30, 1998 were not
material.
7
<PAGE> 8
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
4. IMPAIRMENT OF LONG-LIVED ASSETS
The Company has adopted Statement of Financial Accounting Standard No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed of" ("Statement 121"). Statement 121 requires that
long-lived assets be reviewed for impairment and written down to fair value
whenever events or changes in circumstances indicated that the carrying value
were not recoverable. In September 1998, the Company wrote off all of the
remaining goodwill of its Mediatech subsidiary, $16.7 million, and wrote down
Mediatech's fixed assets by an additional $340,000 due to management's
evaluation of the appropriate carrying value of Mediatech's assets. Because of
a change in Mediatech's business, it was determined that the value of the
investment had permanently declined. The fair value of the Mediatech assets was
determined by discounting the related expected future cash flows over the
remaining life of the goodwill amortization period of 19 years.
5. PRIVATE PLACEMENT OF COMMON STOCK
In July and August 1998, the Company's Board of Directors authorized the
sale and issuance of up to $ 13.0 million worth of Common Stock in a private
placement transaction. The Company issued 4,589,287 common shares to current
institutional and closely associated investors at a price of $2.80 per share.
Total proceeds to the Company, net of issuance costs, will be approximately
$11.9 million. A portion of a note receivable issued to the Company in
conjunction with the private placement remained outstanding at September 30,
1998. The balance outstanding, $750,000, was included in receivables from
issuance of common stock in the September 30, 1998 condensed consolidated
balance sheet. The proceeds of the note were collected subsequent to the
balance sheet date.
6. CONVERSION OF PREFERRED STOCK TO COMMON STOCK
In July 1998, the Company's Board of Directors authorized conversion of
all of the Company's Series A Preferred Stock to Common Stock. Each Series A
Preferred Shareholder received 1.1 shares of Common Stock for each Preferred
share converted. The Company's Board deemed this action necessary and
appropriate in order to assure conversion by these shareholders which held
certain preferred stock rights which could have delayed the closing of the
Private Placement transaction discussed above. All 4,950,495 shares of Series A
Preferred Stock outstanding at June 30, 1998 were converted to common stock per
the terms of the Series A Preferred Stock Conversion Agreement effective August
14, 1998.
The conversion of the Series A Preferred Stock to Common Stock at a ratio
greater than 1:1 resulted in a deemed dividend of $1,764,000, equal to the value
of the 495,000 additional shares granted to the Preferred Shareholders on the
date of conversion. The amount of the deemed dividend was computed based on the
closing market price on the date of conversion. This deemed dividend is
considered a reduction in earnings in the computation of basic and diluted
earnings per share for the quarter and nine months ended September 30, 1998.
7. NET LOSS PER SHARE
For the three and nine month periods ended September 30, 1998,
respectively, the net loss per share was computed as the net loss of $21,425,000
and $28,647,000, respectively, plus the deemed dividend of $1,764,000 resulting
from the conversion of Series A preferred stock in August 1998, divided by the
weighted average common shares outstanding.
8
<PAGE> 9
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
For the three and nine month periods ended September 30, 1997, the net
loss per share was computed as the net loss of $4,499,000 and $10,996,000,
respectively, plus the deemed dividend of $15,161,000 resulting from the
issuance of Series A preferred stock in 1997, divided by the weighted average
common shares outstanding. The Series A Preferred Stock was issued in 1997 at a
less than the publicly traded price per share and the difference between the
publicly traded price per share and the sales price per share was has been
reflected as a deemed dividend to the preferred shareholders.
9
<PAGE> 10
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 have 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.
STATEMENTS OF OPERATIONS:
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ ------------------
1998 1997 1998 1997
------ ------ ------ ------
<S> <C> <C> <C> <C>
Revenues ............................... 100.0% 100.0% 100.0% 100.0%
Costs and Expenses:
Delivery and material costs ........... 36.0 44.2 36.8 38.1
Customer operations ................... 38.4 36.8 36.2 39.8
Sales and marketing ................... 12.8 14.0 12.6 17.9
Research and development .............. 8.8 7.8 6.8 10.4
General and administrative ............ 12.2 11.3 10.8 12.0
Write down of goodwill and fixed assets 188.5 -- 58.7 --
Depreciation and amortization ......... 32.3 29.9 29.8 33.8
------ ------ ------ ------
Total expenses ..................... 329.0 144.0 191.7% 151.9
------ ------ ------ ------
Loss from operations ................... (229.0%) (44.0%) (91.7%) (51.9%)
Other income (expense):
Interest income ...................... 0.7 1.6 0.6 3.2
Interest expense ..................... (9.2) (8.7) (7.7) (9.7)
------ ------ ------ ------
Net loss ............................... (237.5%) (51.1%) (98.8%) (58.5%)
</TABLE>
ACQUISITIONS
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 the Company 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
10
<PAGE> 11
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.
In September 1998, the Company acquired substantially all of the property
and assets of Digital Courier International, Inc. ("DCI" or "DCI acquisition")
from Grant Thornton Limited, acting in its capacity as Receiver-Manager of
Digital Courier International Corporation ("DCIC") and its wholly-owned
subsidiary, DCI. The operating results of DCI in the period between the
acquisition and September 30, 1998 were not material and therefore are not
referred to in the following analyses.
Revenues
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------- ---------------------
1998 1997 1998 1997
------ ------ ------- -------
(in thousands) (in thousands)
<S> <C> <C> <C> <C>
Audio Distribution $4,197 $3,393 $12,455 $9,421
Video Distribution 3,020 2,547 9,395 5,226
Ancillary Post-Production Services & Other
Services 1,804 2,858 7,142 4,162
------ ------ ------- -------
Total Revenues $9,021 $8,798 $28,992 $18,809
====== ====== ======= =======
</TABLE>
Revenues were $9,021,000 for the three months ended September 30, 1998, a
3% increase from $8,798,000 for the three months ended September 30, 1997, and
$28,992,000 for the nine months ended September 30, 1998, a 54% increase from
$18,809,000 for the nine months ended September 30, 1997. This revenue growth is
due to increases of 24% and 46% in the combined volume of audio and video
deliveries performed for the three and nine months ended September 30, 1998,
respectively, over the same periods last year. Of the total volume increases,
for the three and nine months ended September 30, 1998, 100% and 79%,
respectively, relate to orders delivered through the DG Systems Network
Operating Center ("NOC") in San Francisco. The Company believes that the
increase in delivery volumes are 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 July
1997 Mediatech acquisition and the November 1996 acquisition of PDR Productions,
Inc. ("PDR".)
Average revenue per audio delivery decreased less than 1% for the three
months ended September 30, 1998 and decreased approximately 3% in the nine
months ended September 30, 1998, versus the three and nine months ended
September 30, 1997, respectively. These decreases are due to very small shifts
in the mix of digital audio distribution services provided. The Company
attributes these shifts to increased use of the Company's services for routine
distribution.
Average revenue per video delivery for the three and nine months ended
September 30, 1998 was essentially equal to that for the three and nine months
ended September 30, 1997, and there were no significant shifts in mix versus the
same periods of 1997.
For the three months ended September 30, 1998, revenues from other
services totaled approximately $1.8 million, a 37% decrease versus revenue from
these services for the same period in 1997. This decrease is a result of the
Company's de-emphasis in the less profitable services in order to focus on its
core audio and video distribution businesses. In particular, for the three
months ended September 30, 1998, corporate duplication and satellite services
totaled $1.1 million of revenue versus a combined total of $2.2 million in the
same period of 1997. Post-production services, which are important to audio and
video distribution customers, were approximately $700,000 in the three months
ended September 30, 1998 and 1997. For the nine months ended September 30, 1998,
revenues for other services provided by the Company, primarily as a result of
the Mediatech acquisition, increased 72% versus the same period of the prior
year. Revenues for the nine months ended September 30, 1998 included
approximately $2.4 million for post-production services, $2.4 million for
satellite distribution, and $2.3 million for corporate duplication.
11
<PAGE> 12
Delivery and Material Costs
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------- ---------------------
1998 1997 1998 1997
------ ------ ------- ------
(in thousands) (in thousands)
<S> <C> <C> <C> <C>
Audio Distribution $1,050 $1,018 $3,006 $2,869
Video Distribution 1,553 1,448 4,707 2,618
Ancillary Post-Production Services & Other
Services 647 1,420 2,949 1,687
------ ------ ------- ------
Total Delivery and Materials Costs $3,250 $3,886 $10,662 $7,174
====== ====== ======= ======
</TABLE>
Delivery and material costs were $3,250,000 for the three months ended
September 30, 1998, a 16% decrease from the $3,886,000 for the three months
ended September 30, 1997. This decrease is due primarily to a decrease in the
direct materials and fees paid to other service providers in connection with
ancillary post-production services and other services offered by the Company. As
mentioned above, the Company is focusing its efforts on its core audio and video
distribution businesses. For the nine months ended September 30, 1998, delivery
and materials costs increased 48% over the same period last year. This increase
in costs is due primarily to the increased delivery volumes as well as the
additional direct costs related to the other services being provided as a result
of the Mediatech acquisition.
Delivery and material costs as a percentage of revenues decreased to 36%
of revenues from 44% of revenues in the three months ended September 30, 1998
and 1997, respectively, and decreased to 37% of revenues from 38% of revenues in
the nine months ended September 30, 1997 and 1996, respectively. The decreases
in delivery and material costs as a percentage of revenues are due to the change
in the mix of services provided by the Company as well as improvements in
electronic costs of delivery for audio and video distribution.
Audio delivery and material costs as a percentage of audio delivery
revenues decreased to approximately 25% from 30% for the three months ended
September 30, 1998 and 1997, respectively and decreased to approximately 24%
from 31% for the nine months ended September 30, 1998 and 1997, respectively.
This decrease is primarily the result of improvements in cost per electronic
delivery resulting from the increased volume of electronic audio deliveries,
which has resulted in greater efficiencies. In addition, the Company renewed its
contract with its primary telephone service provider in May 1997 which resulted
in improvements in cost per electronic delivery.
Video delivery and material costs as a percentage of video revenues
decreased to approximately 51% from 57% in the three months ended September 30,
1998 and 1997, respectively, due primarily to improvements in the cost of video
deliveries being fulfilled through the NOC. The percentage of video delivery and
material costs as a percentage of video revenues remained approximately the same
at 50% for the nine months ended September 30, 1998 and 1997.
Delivery and material costs related to the other services provided by
the Company were 36% and 31% of the associated revenue for the three and nine
months ended September 30, 1998, and 38% and 40% of the associated revenues for
the three and nine months ended September 30, 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.
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Customer Operations
Customer operations expenses were $3,460,000 and $3,241,000 for the three
months ended September 30, 1998 and 1997, respectively, and $10,503,000 and
$7,480,000 for the nine months ended September 30, 1998 and 1997, respectively.
These expenses have increased in the three months ended September 30, 1998
versus the same period of the prior year due primarily to increased costs
incurred to support the greater volume of deliveries processed through the
Company's NOC. The increase in expenses for the nine months ended September 30,
1998 versus the same period of the prior year is primarily the result of the
consolidation of the costs of the former Mediatech operations as well as the
addition of the personnel necessary to support the greater volume of orders and
deliveries routed through the NOC. The related expenses of the former Mediatech
locations consist principally of personnel costs and related overhead for those
involved in customer and technical support and fulfillment of orders for the
services offered by those locations.
Customer operations expenses as a percentage of revenues increased to 38%
of revenues from 37% of revenues in the three months ended September 30, 1998
and 1997, respectively, and decreased to 36% of revenues from 40% of revenues in
the nine months ended September 30, 1998 and 1997, respectively. Although
customer operations expenses a percentage of revenues continues to decrease for
orders processed through the NOC, the relatively more expensive operations costs
of the other locations offset this improvement in the quarter ended September
30, 1998. For the nine months ended September 30, 1998, the decrease in customer
operations expenses as a percentage of revenues is due primarily to reductions
in cost 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 $1,156,000 for the three months ended
September 30, 1998, a 6% decrease from $1,232,000 for the quarter ended
September 30, 1997, and increased 8% to $3,655,000 for the nine months ended
September 30, 1998 from $3,373,000 in the nine months ended September 30, 1998.
The decrease in sales and marketing expenses in the quarter ended September 30,
1998 is a result of improved efficiency of the consolidated sales and marketing
effort in place since shortly after the Mediatech acquisition. For the nine
months ended September 30, 1998, the increase in sales and marketing expenses is
primarily due to the consolidation of the costs of the former Mediatech sales
group. However, sales and marketing expenses as a percentage of revenues has
been reduced to 13% from 18% of revenues for the nine months ended September 30,
1998 and 1997, respectively. 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 increased 16% to $795,000 for the
quarter ended September 30, 1998 from $688,000, for the quarter ended September
30, 1997, and increased 1% to $1,984,000 from $1,956,000 in the nine months
ended September 30, 1998 and 1997, respectively. These increases are primarily
due to increased personnel costs, in particular the recruiting fees incurred to
hire additional engineers to develop and enhance the Company's digital audio and
video services. These costs more than
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offset reductions in development and testing costs, principally frame relay and
satellite transmission testing, incurred in the same periods in the prior year
to prepare the NOC for video delivery.
The Company expects that research and development expenses 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 increased 10% to $1,097,000 for the
ended September 30, 1998, from $998,000 for the quarter ended September 30,
1997, and increased 40% to $3,141,000 for the nine months ended September 30,
1998 from $2,239,000 in the nine months ended September 30, 1997. The increase
in the three months ended September 30, 1998 versus the same three months of the
prior year is due primarily to expenses incurred to consolidate and upgrade the
Company's order entry, billing and financial reporting systems. The increase in
costs in the nine months ended September 30, 1998 versus the same period of the
prior year is primarily due to the addition of the costs of certain former
Mediatech staff as well as the additional costs of consolidating and upgrading
the Company's order entry, billing and financial reporting systems. The Company
expects to continue to spend on the consolidation and upgrade of the Company's
systems over the remainder of 1998 to improve reporting and operating
efficiency.
Depreciation and Amortization
Depreciation and amortization expenses increased 11% to $2,914,000 in the
three months ended September 30, 1998 from $2,628,000 for the three months ended
September 30, 1997 and increased 36% to $8,627,000 for the nine months ended
September 30, 1998 from $6,361,000 for the nine months ended September 30, 1997.
These increases versus the same periods in the prior year are due to the
continued expansion of the Company's network. The Company's total investment in
network equipment has increased by 16% to $34.2 million at September 30, 1998
from $29.5 million at September 30, 1997. In particular, the Company has
acquired approximately $7.6 million of network equipment as a result of the
acquisition of Mediatech, has made capital additions of approximately $1.7
million between September 30, 1997 and September 30, 1998 in support of its
video delivery service plan, and has increased the number of units located at
broadcast stations at September 30, 1998. In addition, the Company recorded
amortization expense of $216,000 and $648,000, respectively, in the three and
nine months ended September 30, 1998 related to the goodwill and other
intangible assets recorded in connection with the July 1997 acquisition of
Mediatech.
As discussed in the Notes to the Condensed Consolidated Financial
Statements, in September 1998, the Company wrote off the remaining goodwill of
its Mediatech subsidiary, approximately $16.7 million, and wrote down
Mediatech's fixed assets by $340,000 because it was determined that the carrying
values of these assets may not be recoverable due to changes affecting their
realization which have occurred since the acquisition.
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 increase in absolute dollars in proportion to
this growth.
Interest Income and Interest Expense
Interest income decreased 54% to $63,000 in the quarter ended September
30, 1998 from $138,000 for the three months ended September 30, 1997 and
decreased 71% to $177,000 in the nine months ended September 30, 1998 from
$604,000 for the nine months ended September 30, 1997. These decreases are
primarily the result of reductions in levels of cash and cash equivalents and
short-term investments versus the same periods of the prior year. The proceeds
from the Company's initial public offering (February
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<PAGE> 15
1996), Series A Preferred Stock Offering (July and August 1997) and private
placement of common stock (August 1998) have been used to fund 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 9% to $831,000 in the three months ended
September 30, 1998 from $762,000 in the three months ended September 30, 1997
and increased 23% to $2,238,000 from for the nine months ended September 30,
1998 from $1,826,000 for the nine months ended September 30, 1997. These
increases are the result of both the scheduled paydown of debt resulting from
leasing and loan agreements used to fund the development and growth of the
Company's network and to provide Company personnel with the capital resources
necessary to support the Company's business growth as well as debt assumed and
incurred as a result of the Mediatech acquisition. Debt outstanding under the
lease and loan agreements used to fund the Company's network has decreased to
$13.0 million at September 30, 1998 from $14.1 million at September 30, 1997.
During the first nine months of 1998, the Company incurred interest expense
totaling $157,000 on the promissory notes given as consideration in the July
1997 acquisition of Mediatech. In addition, the Company incurred $93,000 of
interest expense in the three months ended September 30, 1998 on the Mediatech
debt existing at the time of the acquisition. The Company expects interest
expense will fluctuate in the future based on the levels of borrowing required.
Liquidity and Capital Resources
Net cash used in operating activities, including the adjustment for
depreciation and amortization, increased to $4.7 million in the nine months
ended September 30, 1998 from $4.2 million in the nine months ended September
30, 1997. The net loss, exclusive of depreciation and amortization and the write
down of goodwill, decreased to $3.0 million for the nine months ended September
30, 1998 from $4.6 million for the nine months ended September 30, 1997.
However, changes in working capital balances resulted in cash usage of $1.9
million in the nine months ended September 30, 1998.
The Company used cash of $1.4 million for the purchase of property and
equipment in the nine months ended September 30, 1998. In the nine months ended
September 30, 1997, the Company purchased $4.1 million of property and
equipment. The capital additions for both periods were the 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.
Proceeds from issuance of common stock were $11.5 million and $74,000 for
the nine month periods ended September 30, 1998 and 1997, respectively. Proceeds
in 1998 include $11.9 million net proceeds received from the Company's private
placement of common stock in August 1998. A note receivable issued to the
Company in conjunction with the private placement in the amount of $750,000
remains outstanding at September 30, 1998. The Company expects to collect the
balance prior to the end of the year.
Principal payments on long-term debt were $6.5 million in the nine months
ended September 30, 1998 versus $3.9 million in the nine months ended September
30, 1997, primarily reflecting the increase in regularly scheduled repayment of
the increased capital lease liability and term debt incurred to finance
equipment and property acquisitions. Such payments also include $608,000 paid on
other long-term debt of Mediatech assumed by the Company in conjunction with the
Mediatech acquisition and principal payments of $750,000 on the promissory notes
issued by the Company in connection with the Mediatech acquisition.
As detailed in the Notes to the Condensed Consolidated Financial Statement
and in the Company's Current Report on Form 8-K filed October 13, 1998, the
Company acquired substantially all of the assets of Digital Courier
International, Inc. in September 1998. The Company funded the $13.5 million
Canadian (approximately US $9.1 million) cash purchase from its working capital
balances.
At September 30, 1998, the Company's current sources of liquidity included
cash and cash equivalents of $1.6 million and $1.7 million available to finance
capital expenditures under a long-term
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credit facility which can be drawn on until December 1998. In addition,
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. During the nine months ended September 30, 1998, $1.9 million of net
paydown was made on the line of credit, and the outstanding balance at September
30, 1998 of $954,000 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.
The Company plans to raise additional funds in an amount up to the
purchase price of DCI plus related closing costs in order to replenish its
working capital position. There can be no assurance, however, that additional
funding will be available to the Company on acceptable terms, or at all. In the
event that the Company is unable to raise additional funds, the Company's
business, financial condition and results of operations would be materially
adversely effected. 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.
CERTAIN BUSINESS CONSIDERATIONS
The Company's business is subject to the following risks in addition to
those described elsewhere in this Report.
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 September 30, 1998, the Company's accumulated deficit was $88.5
million. 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.
Future Capital Needs; Uncertainty of Additional Funding. The Company
anticipates that 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, assuming that the
Company does not pursue one or more additional acquisitions funded by internal
cash reserves. There can be no assurance, however, that the Company will not
require additional capital sooner than currently anticipated. The inability to
obtain additional funding for continuing operations would have a material
adverse effect on the Company's business, financial condition and results of
operations.
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 currently plans to raise additional funds in an amount up to the
purchase price of the assets acquired from DCI plus related closing costs in
order to replenish its working capital position, but there can be no assurance
that additional 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 such acquisitions, and there can be no
assurance that any additional financing will be available to the Company on
acceptable terms, or at all. The Company is continually analyzing the costs and
benefits of acquiring certain businesses, products or technologies that it may
from time to time identify, and 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 additional funding
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
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<PAGE> 17
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 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 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. Also,
although the Company is taking the steps it believes are required to achieve the
network capacity and scalability necessary to deliver video content reliably and
cost effectively as video advertising delivery volume grows, there can be no
assurance that such goals will be achieved and failure to do so could have a
material adverse effect on the Company's business, operating results and
financial position. In addition, 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 and the failure to retain such customers could
have a material adverse effect on the Company's results of operations and
financial condition.
Uncertainties Relating to Integration of Operations. DG Systems acquired
PDR, Mediatech and DCI 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, Mediatech and DCI with
the Company. Achieving the anticipated benefits of these acquisitions will
depend in part upon whether the integration of the organizations and businesses
of PDR, Mediatech and DCI 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, Mediatech and DCI requires communication and
cooperation among the senior executives and key technical personnel of The
Company, PDR, Mediatech and DCI. 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, Mediatech and DCI 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 all current and potential
customers will favorably view the Company's services as offered through PDR,
Mediatech and DCI or that the Company will realize any of the other anticipated
benefits of the acquisitions. Moreover, as a result of these acquisitions,
certain customers of the Company may perceive PDR, Mediatech or DCI to be a
competitor, and this could affect such customers' willingness to do business
with the Company in the future. The loss of significant customers would have a
material adverse effect on the Company's results of operations and financial
condition.
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 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,
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or grows more slowly than anticipated, the Company's business, operating results
and financial condition would 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 systems
interfaces, and work on reliability and throughput enhancements to the network.
The growth of the Company's electronic video delivery services is also dependent
on its ability to obtain reliable and cost-effective 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 improves
picture quality while maintaining compliance with industry standards, within the
Company's existing network. TV station system interface implementation includes
various system control protocols and improvements of the 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 the 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
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enhancements of existing products and services in a timely 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 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. As a result of the Company's September 1998
acquisition of substantially all of the assets of DCI, the Company has expanded
its customer base, increased the number of radio stations included in its
network and improved its ability to provide a point to point delivery service
between the radio stations and groups. The Company believes it now offers the
only nationwide electronic delivery option for audio spot distribution.
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In the market for the distribution of video content to television
stations, the Company encounters competition from VDI Media, Vyvx Advertising
Distribution Services ("VADS"), a subsidiary of The Williams Companies which
includes CycleSat, Inc., and Applied Graphics Technologies, Inc., a provider of
digital pre-press services which also owns the dub and ship house Spotlink, as
well as 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
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.
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, Mediatech and DCI.
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.
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 14 months, 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. The Company has done a
preliminary internal assessment of the components and applications of its
network and has determined that a number of these components are year 2000
compliant. To further identify potential
20
<PAGE> 21
issues, the Company has hired a third party consulting firm to inventory the
various internal and external systems and related applications upon which the
Company may be dependent and to assess both the level of dependence and the
exposure in each area to year 2000 risks. This study is not yet complete and the
Company has not yet fully completed the assessment of the full range of risks. A
complete action plan awaits the completion of this report and is expected to be
in place early in 1999.
In the interim, the Company is continuing to take the steps it believes
are necessary to address the network and related applications it has identified
that are not year 2000 compliant, primarily through internal development
efforts. Although Company has direct programming control over its network
applications and believes 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 is also dependent upon other third parties, in
particular it's telephone and satellite transmission suppliers, in order to
provide its electronic distribution services. (See Dependence on Certain
Suppliers.) The Company is in the process of obtaining relevant information from
these suppliers in order to increase awareness of potential issues. If such
vendors systems are not year 2000 compliant it could have a material adverse
affect on the Company's operations. At this time the Company has not fully
quantified the potential impact of third party vendor year 2000 issues. The
Company currently does not anticipate that the direct resource requirements or
expenses of the Company related to resolving year 2000 issues will have a
material affect on its operating results or financial position.
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 effect on the Company's
business, financial condition and results of operations. At this time, the
Company has not fully developed detailed contingency plans for the possibility
of significant disruption due to year 2000 issues. Preliminary discussions have
been held but timing of the development of such a contingency plan will be
dependent upon the findings and resulting actions taken based on the risk
assessment studies discussed above.
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
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<PAGE> 22
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 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 have a material and adverse effect on 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
22
<PAGE> 23
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.
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.
Potential for Nasdaq Review. The holders of the registered Common Stock of
the Company currently enjoy a substantial benefit in terms of liquidity by
having such Common Stock listed on the Nasdaq National Market trading system
which would be lost if the Company were to be delisted. For the three months
ended September 30, 1998, the Company's net tangible assets fell below the level
required for continued inclusion of the Company's Common Stock on the Nasdaq
National Market System and, therefore, there can be no assurance that the
Company's Common Stock will be able to continue to be listed on the Nasdaq
National Market. The Company fully expects to be able to return to compliance
with all requirements for continued listing on the Nasdaq National Market, in
particular, the Company is in the process of raising additional capital. (See
Liquidity and Capital Resources). There can be no assurance however, that the
Company will be able to continue to have its registered Common Stock listed on
the Nasdaq National Market or similar public securities exchange.
Concentration of Stock Ownership; Antitakeover Provisions. The present
executive officers and directors of the Company and their respective affiliates
own approximately 34% of the Company's Common Stock. 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.
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<PAGE> 24
Preferential Rights of Preferred Stock. The Company presently has
15,000,000 shares of Preferred Stock authorized. On August 12, 1998 holders of
4,950,495 shares of Series A Convertible Preferred Stock, constituting all of
the outstanding shares of the Series A Convertible Preferred Stock, elected to
convert such shares into shares of the Company's Common Stock. Accordingly,
pursuant to the Company's Articles of Incorporation, the Company's Board of
Directors has the authority to issue up to 10,049,505 additional shares of
Preferred Stock and may divide such 10,049,505 remaining authorized shares of
Preferred Stock into any number of series, to fix the number of and determine
the rights, preferences, privileges and restrictions granted to or imposed upon,
any such series.
Registration Rights. In connection with the private placement of shares
of the Company's Common Stock which occurred on August 14, 1998, as further
described in "Part II. Item 2. Changes in Securities," the Company has agreed to
file a registration statement on Form S-3 with the SEC for the purposes of
registering the resale of such shares and to list such shares on the Nasdaq
National Market. In addition, certain other holders of the Company's Common
Stock, including former holders of the Company's Series A Convertible Preferred
Stock, previously have been granted similar demand and piggy-back registration
rights, such that the holders will be entitled to include their shares in the
registration process. The Company presently intends to prepare and file such
registration statement prior to the end of 1998. Following the successful
completion of such registration and listing processes, such additional shares of
the Company's Common Stock will be freely tradable in the public market, subject
to volume limitations applicable to affiliates of the Company. Approximately 12
million shares of the Company's Common Stock and former Series A Preferred Stock
will be registered in the Form S registration. Sales of a substantial number of
additional shares in the public market could adversely affect the market price
of the Company's Common Stock and could impair the Company's future ability to
raise capital through the sale of its equity securities.
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.
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.
24
<PAGE> 25
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
(b) On August 14, 1998, the Company issued 4,589,287 shares of the
Company's Common Stock to current institutional and closely associated investors
in a private placement transaction. These shares were issued at $2.80 per share.
The offer and sale of the shares is exempt from registration under Section 4(2)
of the Securities Act of 1933.
On August 12, 1998, 4,950,495 shares of the Company's Series A
Preferred Stock, constituting all of the shares then outstanding, were converted
to Common Stock pursuant to the terms of the Series A Preferred Stock Conversion
Agreement dated August 12, 1998, by and between the Company and the holders of
the Series A Convertible Preferred Stock. Each holder of Series A Convertible
Preferred Stock received 1.1 shares of Common Stock for each share of Series A
Convertible Preferred Stock so converted. The Company's Board deemed this action
necessary and appropriate in order to assure conversion by these shareholders
which held certain preferred stock rights which could have delayed the closing
of the Private Placement transaction discussed above. The issuance of such
shares of Common Stock upon conversion of the Series A Convertible Preferred
Stock is exempt from registration under Section 3(a)(9) of the Act.
ITEM 5. OTHER INFORMATION
DEADLINE FOR RECEIPT OF SHAREHOLDER PROPOSALS FOR 1999 ANNUAL MEETING
Shareholders are entitled to present proposals for action at forthcoming
shareholder meetings of the Company if they comply with the requirements of the
appropriate proxy rules promulgated by the Securities and Exchange Commission.
According to the Securities and Exchange Commission rules, proposals of
shareholders of the Company intended to be presented for consideration at the
Company's 1999 Annual Meeting of Shareholders must be received at the Company's
principal executive offices not less than 120 calendar days before the date of
the Company's proxy statement from the previous year. Therefore, as the Company
held its 1998 Annual Meeting of Shareholders on April 29, 1998, the deadline for
shareholders to submit proposals to be presented for consideration at the
Company's 1999 Annual Meeting of Shareholders is December 28, 1998, in order
that they may be included in the proxy statement and form of proxy related to
that meeting.
The proxy card used in connection with the Company's 1998 Annual Meeting
of Shareholders granted the proxy holders discretionary authority to vote on any
matter properly raised at the 1998 Annual Meeting of Shareholders and the
Company presently intends to use a similar form of proxy card for its 1999
Annual Meeting of Shareholders. Pursuant to new amendments to Rule 14a-4(c) of
the Securities Exchange Act of 1934, if a shareholder intends to submit a
proposal at the Company's 1999 Annual Meeting which is not eligible for
inclusion in the proxy statement and form of proxy relating to that shareholder
meeting, such proposal must be received by the Company no later than 45 calendar
days before the mailing date of the prior year's notice of Annual Meeting of
Shareholders. As the mailing date of the 1998 Annual Meeting of Shareholders was
April 3, 1998, the
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<PAGE> 26
deadline for submitting proposals which are not eligible for inclusion in the
proxy statement is February 17, 1999. If such a shareholder fails to comply with
the foregoing notice provision for proposals not included in the proxy statement
and related form of proxy, the proxy holders will be allowed to use their
discretionary voting authority if such a proposal is properly raised at the
Company's 1999 Annual Meeting of Shareholders. The Company currently believes
that its Annual Meeting of Shareholders will be held during the third week of
April, 1999.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
EXHIBIT
NUMBER EXHIBIT TITLE
----- -------------
3.1(d) Restated Articles of Incorporation of registrant.
3.2(b) Bylaws of registrant, as amended to date.
3.3(l) Certificate of Amendment of The Articles of Incorporation
filed with California Secretary of State on July 3, 1998.
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.
10.6(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.
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<PAGE> 27
10.24(e) Digital Generation Systems, Inc. Supplemental Stock
Option Plan.
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(k) 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.
10.33(l) Common Stock Subscription Agreement for private
placement of Company's common stock at $2.80 per share.
10.34(m) Sale and Purchase Agreement, dated September 10,
1998, by and between Grant Thornton Limited, in its
capacity as Receiver-Manager of Digital Courier
International Corporation and Digital Courier
International, Inc. and Digital Generation Systems, Inc.
and exhibits thereto.
10.35(a) Series A Preferred Stock Conversion Agreement dated as
of August 12, 1998.
21.1(g) Subsidiaries of the Registrant.
27(a) Financial Data Schedule.
- ----------
(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
27
<PAGE> 28
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.
(k) Incorporated by reference to the exhibit bearing the same title
filed with registrant's Quarterly report on Form 10-Q filed May
15, 1998.
(l) Incorporated by reference to the exhibit bearing the same title
filed with registrant's Quarterly report on Form 10-Q filed August
14, 1998.
(m) Incorporated by reference to the exhibit bearing the same title
filed with registrant's Current Report on Form 8-K filed October
13, 1998.
(b) Reports on Form 8-K.
(1) Current Report on Form 8-K filed on October 13, 1998 reporting
that effective September 25, 1998, the Registrant had acquired
substantially all of the assets of DCI, pursuant to a Sale and
Purchase Agreement between the Registrant and Grant-Thornton
acting in its capacity as receiver-manager of DCIC and its
wholly-owned subsidiary, DCI.
(2) Current Report on Form 8-K/A filed on November 12, 1998 providing
audited consolidated financial statements of DCIC for the twelve
months ended September 30, 1997 and 1996, unaudited consolidated
financial statements of DCIC for the six months ended March 31,
1998 and 1997 and the unaudited condensed pro forma combined
financial statements of Digital Generation Systems, Inc.,
Mediatech, Inc. and DCIC.
28
<PAGE> 29
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: NOVEMBER 16, 1998 BY: /s/ PAUL W. EMERY, II
--------------------------------
PAUL W. EMERY, II
VICE PRESIDENT & CHIEF FINANCIAL
OFFICER (PRINCIPAL FINANCIAL AND
CHIEF ACCOUNTING OFFICER)
29
<PAGE> 30
EXHIBIT INDEX
EXHIBIT
NUMBER EXHIBIT TITLE
----- -------------
3.1(d) Restated Articles of Incorporation of registrant.
3.2(b) Bylaws of registrant, as amended to date.
3.3(l) Certificate of Amendment of The Articles of Incorporation
filed with California Secretary of State on July 3, 1998.
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.
10.6(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.
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(k) 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.
<PAGE> 31
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.
10.33(l) Common Stock Subscription Agreement for private
placement of Company's common stock at $2.80 per share.
10.34(m) Sale and Purchase Agreement, dated September 10,
1998, by and between Grant Thornton Limited, in its
capacity as Receiver-Manager of Digital Courier
International Corporation and Digital Courier
International, Inc. and Digital Generation Systems, Inc.
and exhibits thereto.
10.35(a) Series A Preferred Stock Conversion Agreement dated as
of August 12, 1998.
21.1(g) Subsidiaries of the Registrant.
27(a) Financial Data Schedule.
- ----------
(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.
(k) Incorporated by reference to the exhibit bearing the same title
filed with registrant's Quarterly report on Form 10-Q filed May
15, 1998.
(l) Incorporated by reference to the exhibit bearing the same title
filed with registrant's Quarterly report on Form 10-Q filed August
14, 1998.
(m) Incorporated by reference to the exhibit bearing the same title
filed with registrant's Current Report on Form 8-K filed October
13, 1998.
<PAGE> 1
EXHIBIT 10.35
DIGITAL GENERATION SYSTEMS, INC.
SERIES A PREFERRED STOCK
CONVERSION AGREEMENT
Effective as of August 12, 1998
AGREEMENT, by and between Digital Generation Systems, Inc., a
California corporation (the "Company"), and _____________ ("Holder") of the
Company's Series A Preferred Stock ("Preferred Stock").
WHEREAS, Nasdaq has formally advised the Company, based in part upon
its position that the outstanding convertible voting Series A Preferred Stock is
not included in Nasadaq's calculation of the Company's market capitalization,
that the Company no longer meets certain maintenance criteria for the continued
inclusion of its Common Stock ("Common Stock") on the Nasdaq National Market
System ("Nasdaq National Market"), including the market capitalization
requirement under Maintenance Standard 2 as set forth in NASD Marketplace Rule
4450(b)(1);
WHEREAS, the Company has been formally advised that its request for
continued listing on the Nasdaq National Market will be considered at an oral
hearing on August 7, 1998 (the "Hearing");
WHEREAS, in order to prevent the delisting of its Common Stock, at the
Hearing, the Company's Common Stock must demonstrate its ability to regain
compliance with such maintenance criteria, as well as its ability to sustain
long-term compliance therewith;
WHEREAS, the board of directors of the Company has determined that it
is advisable and in the best interests of the Company and its shareholders that
the Company continue to be listed on the Nasdaq National Market;
WHEREAS, the Company's board of directors has authorized the
appropriate officers of the Company to take all actions they deem necessary or
advisable to regain and maintain compliance with the requirements for continued
listing on the Nasdaq National Market, including, but not limited to, the
issuance to Holder of one additional share of Common Stock for each ten shares
of Preferred Stock it might agree immediately to convert; and
WHEREAS, as part of the Company's plan to regain and sustain long-term
compliance with the Nasdaq National Market maintenance criteria, and, in
particular, the market capitalization requirement mentioned above, the officers
of the Company have urgently requested Holder to convert its Preferred Stock
into Common Stock, and Holder has expressed its willingness so to convert under
certain conditions;
NOW, THEREFORE, for good and valuable consideration, the receipt of
which is hereby acknowledged, the parties hereto agree as follows:
<PAGE> 2
1. Conversion of Series A Preferred. Effective immediately and without
further documentation, Holder hereby converts the number of shares of Preferred
Stock listed below its signature into the identical number of fully-paid and
non-assessable shares of Common Stock of the Company.
2. Issuance of Common Stock. In light of the exigencies described in
the Recitals to this agreement and in consideration of Holder's election in
Section 1 to convert, and, thereby, to lose the preferences set forth in the
Company's Certificate of Determination of Rights relating to the Preferred
Stock, the Company hereby agrees to issue one additional fully-paid and
non-assessable share of Common Stock for each ten shares of Preferred Stock
converted hereunder by Holder, in addition to such number of shares of Common
Stock otherwise issuable upon such conversion.
IN WITNESS WHEREOF, the parties hereto have duly executed this
agreement as of the date first above written.
"COMPANY" DIGITAL GENERATION SYSTEMS, INC.
By:
Name:
Title:
"HOLDER" By:
Name:
Title:
Number of Shares of Series A
Preferred Stock Converted Hereby:
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 1,601
<SECURITIES> 0
<RECEIVABLES> 9,421
<ALLOWANCES> (715)
<INVENTORY> 296
<CURRENT-ASSETS> 11,845
<PP&E> 38,087
<DEPRECIATION> (24,282)
<TOTAL-ASSETS> 38,817
<CURRENT-LIABILITIES> 16,032
<BONDS> 9,348
0
0
<COMMON> 102,832
<OTHER-SE> (89,396)
<TOTAL-LIABILITY-AND-EQUITY> 38,817
<SALES> 0
<TOTAL-REVENUES> 28,992
<CGS> 0
<TOTAL-COSTS> 55,578
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 130
<INTEREST-EXPENSE> 2,238
<INCOME-PRETAX> (28,647)
<INCOME-TAX> 0
<INCOME-CONTINUING> (28,647)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (28,647)
<EPS-PRIMARY> (2.18)<F1>
<EPS-DILUTED> (2.18)
<FN>
<F1>FOR PURPOSES OF THIS EXHIBIT, PRIMARY MEANS BASIC.
</FN>
</TABLE>
