<PAGE>
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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 July 3, 1999
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 July 31, 1999: 26,629,746
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<PAGE>
DIGITAL GENERATION SYSTEMS, INC.
The discussion in this Report contains forward-looking statements that involve
risks and uncertainties. The statements contained in this Report that are not
purely historical are forward-looking statements within the meaning of Section
27A of the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended. Words such as "anticipates," "believes,"
"plans," "expects," "future," "intends," and similar expressions are used to
identify forward-looking statements. All forward-looking statements included in
this document are based on information available to the Company on the date
hereof, and we assume no obligation to update any such forward-looking
statements. The Company's actual results could differ materially from those
anticipated in these forward-looking statements as a result of certain factors,
including, but not limited to, those discussed in "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Certain Business
Considerations" as reported in the Company's Report on form 10-K filed on March
31, 1999, as well as those discussed in this section and elsewhere in this
Report, and the risks discussed in the Company's other United States Securities
and Exchange Commission filings.
TABLE OF CONTENTS
<TABLE>
<S> <C> <C>
PART I. FINANCIAL INFORMATION Page
----
Item 1. Financial Statements............................................................................................... 3
Condensed Consolidated Balance Sheets at July 3, 1999 and December 31, 1998........................................ 3
Condensed Consolidated Statements of Operations for the three and six months ended July 3, 1999 and
June 30, 1998, respectively ..................................................................................... 4
Condensed Consolidated Statements of Cash Flows for the six months ended July 3, 1999 and June 30, 1998 ........... 5
Notes to Condensed Consolidated Financial Statements............................................................... 6
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.................................................................................................. 14
Item 2. Changes in Securities.............................................................................................. 14
Item 3. Defaults upon Senior Securities.................................................................................... 14
Item 4. Submission of Matters to a Vote of Security Holders................................................................ 14
Item 5. Other Information.................................................................................................. 14
Item 6. Exhibits and Reports on Form 8-K................................................................................... 14
SIGNATURES......................................................................................................... 17
</TABLE>
2
<PAGE>
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
DIGITAL GENERATION SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts)
<TABLE>
<CAPTION>
July 3, December 31,
1999 1998
-------- -----------
(unaudited)
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 6,387 $ 13,025
Accounts receivable, less allowance for doubtful
accounts of $1,286 in 1999 and $1,895 in 1998 9,922 9,995
Prepaid expenses and other 1,015 933
-------- --------
Total current assets 17,324 23,953
-------- --------
PROPERTY AND EQUIPMENT, at cost:
Network equipment 35,184 33,211
Office furniture and equipment 4,102 3,730
Leasehold improvements 735 542
-------- --------
40,021 37,483
Less -- Accumulated depreciation and amortization (30,224) (25,738)
-------- --------
Property and equipment, net 9,797 11,745
-------- --------
GOODWILL AND OTHER ASSETS, net 14,117 14,094
-------- --------
TOTAL ASSETS $ 41,238 $ 49,792
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 3,854 $ 3,035
Accrued liabilities 4,010 4,081
Line of credit 1,175 1,433
Current portion of long-term debt 7,598 8,226
-------- --------
Total current liabilities 16,637 16,775
LONG-TERM DEBT, net of current portion 5,333 9,307
SHAREHOLDERS' EQUITY:
Convertible preferred stock, no par value --
Authorized -- 15,000,000
Outstanding -- none at July 3, 1999 and
none at December 31, 1998 -- --
Common stock, no par value --
Authorized -- 40,000,000 shares
Outstanding -- 26,613,664 shares at July 3, 1999
and 26,239,520 shares at December 31, 1998 115,375 114,131
Receivable from issuance of common stock (369) (369)
Accumulated other comprehensive income 15 9
Accumulated deficit (95,753) (90,061)
-------- --------
Total shareholders' equity 19,268 23,710
-------- --------
TOTAL LIABILITIES AND SHAREHOLDER'S EQUITY $ 41,238 $ 49,792
======== ========
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
<PAGE>
DIGITAL GENERATION SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
For the Three and Six Months Ended July 3, 1999 and June 30, 1998
(in thousands, except per share amounts)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
July 3, June 30, July 3, June 30,
1999 1998 1999 1998
--------------------- ---------------------
(Unaudited) (Unaudited)
<S> <C> <C> <C> <C>
REVENUES $12,120 $10,097 $23,580 $19,971
------- ------- ------- -------
COSTS AND EXPENSES:
Delivery and material cost 4,769 3,666 9,308 7,412
Customer operations 3,971 3,468 7,528 7,043
Sales and marketing 1,414 1,235 2,651 2,499
Research and development 680 601 1,292 1,189
General and administrative 1,102 1,015 2,609 2,044
Depreciation and amortization 2,435 2,880 4,925 5,713
------- ------- ------- -------
Total expenses 14,371 12,865 28,313 25,900
------- ------- ------- -------
LOSS FROM OPERATIONS (2,251) (2,768) (4,733) (5,929)
------- ------- ------- -------
OTHER INCOME (EXPENSE)
Interest income 58 45 153 114
Interest expense (508) (696) (1,112) (1,407)
------- ------- ------- -------
NET LOSS $(2,701) $(3,419) $(5,692) $(7,222)
======= ======= ======= =======
BASIC AND DILUTED NET LOSS PER COMMON SHARE $ (0.10) $ (0.28) $ (0.21) $ (0.59)
======= ======= ======= =======
WEIGHTED AVERAGE COMMON SHARES 26,591 12,216 26,490 12,196
======= ======= ======= =======
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
<PAGE>
DIGITAL GENERATION SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Six Months Ended July 3, 1999 and June 30, 1998
(in thousands)
<TABLE>
<CAPTION>
Six Months Ended
July 3, June 30,
1999 1998
------- --------
(Unaudited)
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $(5,692) $(7,222)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization of property and equipment 4,486 5,059
Amortization of goodwill and intangibles 387 654
Foreign currency translation adjustment 6 --
Provision for doubtful accounts 170 83
Changes in operating assets and liabilities --
Accounts receivable (244) (713)
Prepaid expenses and other assets (306) (51)
Accounts payable and accrued liabilities 790 (1,033)
------- -------
Net cash used in operating activities (403) (3,223)
------- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of short-term investments -- (2,003)
Maturities of short-term investments -- 3,000
Acquisition of property and equipment (2,589) (874)
------- -------
Net cash provided by (used in) investing activities (2,589) 123
------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock 1,244 85
Proceeds from line of credit 1,148 6,985
Payments on line of credit (1,406) (8,147)
Proceeds from issuance of long-term debt -- 4,465
Payments on long-term debt (4,602) (3,933)
------- -------
Net cash provided by (used in) financing activities (3,616) (545)
------- -------
EFFECT OF EXCHANGE RATE CHANGES (30) --
NET DECREASE IN CASH AND CASH EQUIVALENTS (6,638) (3,645)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 13,025 7,833
------- -------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 6,387 $ 4,188
======= =======
SUPPLEMENTAL CASH FLOW INFORMATION
Interest paid 1,391 $ 1,305
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
<PAGE>
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, 1998.
Effective for fiscal year 1999, beginning January 1, the Company elected to
adjust its fiscal quarters so that each quarter is thirteen weeks in length and
ends on the Saturday nearest to March 31, June 30, and September 30. Therefore,
the first fiscal quarter of 1999 ended on April 3, 1999, second quarter ended on
July 3, 1999 and third quarter will end on October 2, 1999. Fiscal fourth
quarter will continue to end on December 31, 1999.
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 six month periods ended July 3, 1999. The results for the three and
six month periods ended July 3, 1999 are not necessarily indicative of the
results expected for the full fiscal year.
Certain reclassifications were made to the previous 1998 condensed
consolidated financial statements to conform to the 1999 presentation. The
reclassifications have no significant effect on previously reported financial
position, results of operations, or cash flows.
2. CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS
Cash and cash equivalents consist of liquid investments with original
maturities of three months or less. As of July 3, 1999 and December 31, 1998,
cash and cash equivalents consists principally of U.S. Treasury Bills and
various money market accounts; as a result, purchase cost approximates the fair
market value.
3. ACQUISITION
DCI
On September 25, 1998, the Company acquired substantially all of the
property and assets, including all accounts receivable, inventories, contracts,
equipment, real property leases and other related assets of Digital Courier
International, Inc. ("DCI"). DCI is in the business of supplying electronic
distribution and communications services for the radio broadcast industry in the
United States and Canada.
The Company paid $13.5 million in Canadian dollars (approximately US $9.06
million) for DCI. The DCI acquisition was accounted for as a purchase. The
excess of purchase price and acquisition costs over the fair value of assets
acquired of approximately $6.2 million has been included in Goodwill and Other
Assets in the accompanying consolidated balance sheet as of July 3, 1999, and is
being amortized over a twenty year period. The operating results 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. Amortization expense
of $81,000 and $165,000 is included in the consolidated statements of operations
for the three and six months periods ended July 3, 1999, respectively.
6
<PAGE>
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Pro forma Results
The following table reflects unaudited pro forma combined results of
operations of the Company on the basis that the acquisition of DCI had occurred
at the beginning of the fiscal 1998:
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
July 3, June 30, July 3, June 30,
------------------------------- -----------------------------------
1999 1998 1999 1998
--------------- --------------- ----------------- -----------------
<S> <C> <C> <C> <C>
(In thousands , except per share data)
Revenues........................................ $12,120 $11,303 $23,580 $ 22,613
Net Loss........................................ (2,701) (5,374) (5,692) (13,279)
Basic and Diluted Net Loss per Common Share..... $ (0.10) $ (0.44) $ (0.21) $ (1.09)
Number of Shares used in Computation............ 26,591 12,216 26,527 12,196
</TABLE>
The unaudited pro forma combined results of operations are not necessarily
indicative of the actual results that would have occurred had the acquisition of
DCI been consummated at the beginning of fiscal 1998, nor of future operations
of the combined companies under the ownership and management of the Company.
4. Segment Information:
In 1998, the Company adopted Statement of Financial Accounting Standard No.
131, "Disclosures about Segments of an Enterprise and Related Information." The
Company operates predominantly in one industry segment: digital and physical
distribution and post-production services for audio and video content, and its
operations are managed primarily by geographic areas. The Company has defined
its reportable segments based on these geographic areas.
The information in the following tables is derived directly from the
segments' internal financial reporting used for corporate management purposes.
The expenses, assets and liabilities attributable to corporate activity are not
allocated to the operating segments. As of July 3, 1999, 5% of operating assets
are located outside of the United States. The balance sheet information for the
Company's Los Angeles segment is maintained as part of the Chicago segment and
is impractical to break out separately.
<TABLE>
<CAPTION>
For the Three Months Ended July 3, 1999
In $000's
-------------------------------------------------------------------------------------------
Adjustments &
San Francisco New York Chicago Los Angeles Vancouver Eliminations Consolidated
------------- -------- ------- ----------- --------- -------------- ------------
<S> <C> <C> <C> <C> <C> <C> <C>
Revenue $ 6,373 $2,961 $3,125 $ 532 $1,361 $ (2,232) $12,120
Net loss $(2,078) $ 358 $ (452) $(173) $ (356) -- $(2,701)
Total identifiable
assets $53,763 $9,938 $6,695 $ -- $9,089 $(38,247) $41,238
</TABLE>
7
<PAGE>
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
<TABLE>
<CAPTION>
For the Three Months Ended June 30, 1998
In $000's
-------------------------------------------------------------------------------------------
Adjustments &
San Francisco New York Chicago Los Angeles Vancouver Eliminations Consolidated
------------- -------- ------- ----------- --------- -------------- ------------
<S> <C> <C> <C> <C> <C> <C> <C>
Revenue $ 5,015 $ 2,473 $ 2,954 $676 $ -- $ (1,021) $10,097
Net loss (2,993) 343 (752) (17) -- -- (3,419)
Total identifiable
assets $44,770 $10,208 $26,046 $ -- $ -- $(29,116) $51,908
</TABLE>
<TABLE>
<CAPTION>
For the Six Months Ended July 3, 1999
In $000's
-------------------------------------------------------------------------------------------
Adjustments &
San Francisco New York Chicago Los Angeles Vancouver Eliminations Consolidated
------------- -------- ------- ----------- --------- -------------- ------------
<S> <C> <C> <C> <C> <C> <C> <C>
Revenue $12,016 $5,901 $6,173 $ 772 $1,497 $ (3,779) $23,580
Net loss (4,292) 798 (777) (539) (882) -- (5,692)
Total identifiable
assets $53,763 $9,938 $6,695 $ -- $9,089 $(38,247) $41,238
</TABLE>
<TABLE>
<CAPTION>
For the Six Months Ended June 30, 1998
In $000's
-------------------------------------------------------------------------------------------
Adjustments &
San Francisco New York Chicago Los Angeles Vancouver Eliminations Consolidated
------------- -------- ------- ----------- --------- -------------- ------------
<S> <C> <C> <C> <C> <C> <C> <C>
Revenue $ 9,227 $ 5,014 $ 6,175 $1,350 $ -- $ (1,795) $19,971
Net loss (6,357) 653 (1,466) (52) -- -- (7,222)
Total identifiable
assets $44,770 $10,208 $26,046 $ -- $ -- $(29,116) $51,908
</TABLE>
8
<PAGE>
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.
Revenues
Revenues were $12,120,000 for the three months ended July 3, 1999, a 20%
increase from $10,097,000 for the three months ended June 30, 1998, and revenues
for the six months ended July 3, 1999 were $23,580,000, an 18% increase from
$19,971,000 for the six months ended June 30, 1998.
Revenues increased primarily due to the acquisition of DCI in September 1998.
This acquisition accounted for a substantial potion of the increased combined
revenue for the three months ended July 3, 1999 over the same period in 1998.
In addition to the acquisition, the Company believes that the increase in
delivery volumes is due to a number of other factors, including the increased
acceptance of the services offered by the Company and the increased availability
of an expanded network of Company equipment located in radio and television
stations.
Delivery and Material Costs
Delivery and material costs were $4,769,000 for the three months ended July
3, 1999, a 30% increase from the $3,666,000 for the three months ended June 30,
1998. Delivery and materials costs were $9,308,000 for the six months ended
July 3, 1999, a 26% increase from the $7,412,000 for the six months ended June
30, 1998. The increase in costs in each period versus the same period of the
prior year is primarily due to the increased delivery volume, as well as a
result of the acquisition of DCI. The increased costs include fees paid to
other service providers for charges incurred by the Company for the receipt,
transmission and delivery of information via the Company's distribution NOCs.
Delivery and materials costs also include costs for video and audio tapes and
the related packaging and shipping costs required when physically duplicating
and distributing a video or audio spot. In addition, delivery and materials
costs include the direct materials and fees paid to other service providers in
connection with postproduction services and other services offered by the
Company.
Delivery and material costs related to the other services provided by the
Company were 36% and 40% of their associated revenue for the three and six
months ended July 3, 1999, and 39% and 43% of the associated revenues for the
three and six months ended June 30, 1998, 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.
Total delivery and material costs as a percentage of revenues increased to
39% of revenues from 36% of revenues in the three months ended July 3, 1999 and
June 30, 1998, respectively; and increased to 39% of revenues from 37% of
revenues in the six months ended July 3, 1999 and June 30, 1998, respectively.
The Company expects that delivery costs will increase in absolute dollars and
may fluctuate as a percentage of revenues in future periods, influenced
principally by volumes, average sales price and scale economies as video
deliveries increase in volume.
9
<PAGE>
Customer Operations
Customer operations expenses were $3,971,000 and $3,468,000 for the quarters
ended July 3, 1999 and June 30, 1998, respectively, and $7,528,000 and
$7,043,000 for the six months ended July 3, 1999 and June 30, 1998,
respectively. These increases are primarily due to the addition of the
personnel necessary to respond to the greater volume of orders and deliveries.
Customer operations expenses as a percentage of revenues decreased to 33%
from 34% of revenues in the quarters ended July 3, 1999 and June 30, 1998,
respectively; and decreased to 32% of revenues from 35% of revenues in the six
months ended July 3, 1999 and June 30, 1998, respectively. This decrease is
primarily due to process improvements in orders processed through the Company's
NOC, which serves as the primary support for the digital network. The Company
continually attempts to improve process flows in an effort to gain scale
efficiencies.
The Company expects that customer operations expenses will increase in
absolute dollars and may fluctuate as a percentage of revenues in future
periods. Moreover, the Company believes that in order to compete effectively and
manage future growth, the Company will be required to continue to implement
changes that improve and increase the efficiency of its customer operations.
Sales and Marketing
Sales and marketing expenses were $1,414,000 for the three months ended July
3, 1999, a 14% increase from $1,235,000 for the quarter ended June 30, 1998, and
increased 6% to $2,651,000 from $2,499,000 in the six months ended July 3, 1999
and June 30, 1998, respectively. Sales and marketing expense increased in the
three and six months ended July 3, 1999 from the same periods ended June 30,
1998 primarily due to the consolidation of the sales and marketing departments
of DCI with that of the Company's.
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. The Company expects that sales and marketing
expenses will increase in absolute dollars in future periods and may fluctuate
as a percentage of revenue in future periods.
Research and Development
Research and development expenses increased 13% to $680,000 for the quarter
ended July 3, 1999 from $601,000 for the quarter ended June 30, 1998, and
increased 9% to $1,292,000 from $1,189,000 for the six months ended July 3, 1999
and June 30, 1998 respectively. The increase reflects the costs incurred for
various Year 2000 compliance issues, as well the addition of key personnel to
address the future delivery capacity of the Company's network.
The Company expects that additional research and development spending will be
necessary to remain competitive and its future success will depend in
significant part upon the technological quality of its products and processes
relative to those of its competitors and its ability both to develop new and
enhanced products and services.
General and Administrative
General and administrative expenses increased 9% to $1,102,000 for the
quarter ended July 3, 1999, from $1,015,000 for the quarter ended June 30, 1998;
and increased 28% to $2,609,000 from $2,044,000 in the six months ended June 30,
1998. The increase is primarily due to the costs incurred to consolidate and
upgrade the Company's order entry, billing, and financial reporting systems and
the increase in staff as a result of the acquisition of DCI. General and
administrative expenses have decreased to 9% and 11% of revenues for the
quarter and six months ended July 3, 1999 from 10% for both the quarter and six
months ended June 30, 1998.
10
<PAGE>
Depreciation and Amortization
Depreciation and amortization expenses decreased 17% to $2,402,000 in the
quarter ended July 3, 1999 from $2,880,000 in the quarter ended June 30, 1998;
and decreased 15% to $4,866,000 for the six months ended July 3, 1999 from
$5,713,000 for the six months ended June 30, 1998. The Company acquired the bulk
of its assets prior to December 31, 1996; therefore, beginning in fiscal year
1998, there has been a higher percentage of fixed assets which are reaching or
have already reached the end of their depreciable life. The decline of
depreciation expense in the first and second quarter of 1999 reflects this. As
of July 3, 1999, the Company's total investment in network equipment has
increased 13% to $35.2 million, from $31.1 million at June 30, 1998.
The Company recorded amortization expense of $192,000 and $387,000 for the
quarter and the six months ended July 3, 1999, and $327,000 and $653,000 for the
quarter and six months ended June 30, 1998, respectively. The increase in
amortization expense from the acquisition of DCI in September 1998 was offset by
the reduction in amortization expense due to the write down of the Mediatech
subsidiary's net assets in the quarter ended September 30, 1998.
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 ("DVPSs") to be built
and installed in production studios and television stations. The Company expects
depreciation and amortization to fluctuate in proportion to this growth.
However, there can be no assurance that the Company will make such investments
or that such investments will result in future revenue growth.
Interest Income and Interest Expense
Interest income increased 29% to $58,000 in the quarter ended July 3, 1999
from $45,000 for the quarter ended June 30, 1998 and increased 34% to $153,000
for the six months ended July 3, 1999, from $114,000 in the six months ended
June 30, 1998. This increase is primarily the result of an increased level of
cash and cash equivalents and short term investments in the first quarter and
six months of 1999 over the first quarter and first six months of 1998. The
Company expects that interest income will fluctuate in the future based on the
levels of cash used in the Company's operations.
Interest expense decreased 27% to $509,000 for the quarter ended July 3,
1999, from $696,000 in the quarter ended June 30, 1998 and decreased 21% to
$1,113,000 for the six months ended July 3, 1999, from $1,407,000 for the six
months ended June 30, 1998. The decrease is due primarily to a decrease in the
Company's outstanding debt, particularly its leasing and loan agreements used to
fund the acquisition of components and equipment needed to develop the Company's
network and to provide Company personnel with the capital resources necessary to
support the Company's business growth. Debt outstanding under these agreements
has decreased to $9.6 million at July 3, 1999 from $14.9 million at June 30,
1998. The Company expects that interest expense will fluctuate in the future
based on the levels of borrowing.
Liquidity and Capital Resources
Net cash used in operating activities decreased to $0.4 million in the six
months ended July 3, 1999 from $3.2 million in the six months ended June 30,
1998.
The Company made capital additions of $2.6 million during the six months
ended July 3, 1999 versus $0.9 million in the six months ended June 30, 1998.
The capital additions in both periods were a result of the Company's continued
expansion of its network. Principal payments on long-term debt were $4.6
million for the six months ended July 3, 1999 versus $3.9 million for the six
months ended June 30, 1998.
At July 3, 1999, the Company's current sources of liquidity included cash and
cash equivalents of $6.4 million. Based on management's current plans and
forecasts, the Company believes that its existing sources of liquidity will
satisfy the Company's projected working capital, capital lease and term loan
commitments and other cash requirements through the foreseeable future.
11
<PAGE>
Year 2000 Compliance
Year 2000 Readiness Disclosure. 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 six 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 the Year 2000 coding problem. To identify
potential issues, the Company utilized a third party consulting firm to assess
the Year 2000 risk regarding the level of dependence and the exposure of various
internal and external systems and related applications upon which the Company
may be dependent. With the completion of this third party assessment the Company
has developed a formal project plan.
The Company has completed a preliminary assessment of the components and
applications of its network and has determined that a number of these components
are Year 2000 compliant. The Company has a formal comprehensive project plan in
place and is currently taking the steps it believes are necessary to make the
remainder of the network and related applications, as well as the other systems
utilized by the Company, Year 2000 compliant. The Company's project plan
consists of five major phases: Awareness, Assessment, Detailed Analysis and
Preliminary Testing, System Conversion and Testing, and Implementation. The
above mentioned phases include education, a complete company wide inventory
assessment, testing and correction of all non-compliant systems. Each piece of
equipment or system identified by the Company will go through all five phases
and will be completed at different times throughout the year. The Company's goal
is to reach total Year 2000 compliance of all systems and equipment, technical
and non-technical, by November 1999. The Company's strategy also includes
development of contingency plans to address potential disruption of operations
arising from the Year 2000 problem. The Company is in the development stage of
contingency planning and, at this time, has not completed its contingency plan.
Awareness: The Company believes that awareness of the Year 2000 problem is
critical to its business and employees. Therefore, the Company has chosen
several means of communicating the Year 2000 problem to each sector of its
business. These include, but are not limited to, executive staff meetings, team
meetings, E-mail notices, Website updates, and communication by US Mail to
customers and vendors.
Assessment: The Company is assessing all systems including hardware,
application software and firmware. A complete company-wide inventory assessment
is nearing completion and is necessary to determine any potential Year 2000
issues. The Company is currently reviewing each vendor's Year 2000 project plan
and status. Each vendor has or will receive a compliance letter and
questionnaire to allow the Company to gauge the vendor's compliance level. Non-
Information Technology equipment such as elevators, security systems, and
electric power, have been placed into the Service Provider category and each
area is being monitored closely to ensure that no disruption in services will
occur. Mission critical suppliers have been identified and contingency plans are
being developed.
Detailed Analysis & Preliminary Testing: The Company has completed preliminary
testing and analysis on most mission critical systems. Remote testing of offsite
systems hardware began in April. All offsite systems are expected to be Year
2000 compliant by the fourth quarter of 1999. The Company's financial systems
are currently being upgraded. A detailed analysis and preliminary testing of
each remaining system has been performed.
System Conversion & Testing: The Company's network includes RPTs, CWs and DVPS
strategically placed across the country in broadcasting stations. The Company
has direct network control over its applications and has included detailed
testing and correction of all source code and associated data elements. Each
unit will be remotely tested and any necessary corrections or modifications will
be made. Internally, the Company utilizes many third party application software
programs as well as programs developed in-house. Upgrades and modifications will
be tested and implemented as needed.
Implementation: The Company will implement new or upgraded software as needed
to minimize disruption from Year 2000. All systems compliance information will
be documented and a contingency plan for each system or service is scheduled to
be in place
12
<PAGE>
by November of 1999.
Risks: Although the Company has direct programming control over its network
applications, 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 its telephone and satellite transmission suppliers, in
order to provide its electronic distribution services. 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 believes that the purchasing pattern of its current and potential
customers may be affected by the Year 2000 problem 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 not to 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 result in a loss of revenues which would have a material adverse
effect on the Company's business, financial condition and results of operations.
At this time, the Company is developing detailed contingency plans for the
possibility of significant disruption due to Year 2000 issues. Preliminary
discussions have been held but completion 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.
Costs: 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 significant adverse effect on its operating results or financial
position. To date, the Company has incurred approximately $900,000 in Year 2000
readiness related costs, and estimates that total Year 2000 related costs will
be approximately $1.9 million.
The foregoing assessment is based on information currently available to the
Company. The Company can provide no assurance that applications and equipment
that the Company believes to be Year 2000 compliant will not experience
problems. Failure by the Company or third parties on which it relies to resolve
Year 2000 problems could have a material adverse effect on the Company's results
of operations.
13
<PAGE>
PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
On February 6, 1999, City National Bank filed a lawsuit against Starcom
Television Services, Inc. ("Starcom Television"), a predecessor in interest of
the Company's Mediatech subsidiary, Gary J. Worth, a former officer of Starcom
Television, and certain other parties in Superior Court of California for the
County of Los Angeles. The lawsuit alleges causes of action for breaches of a
certain September 1993 Assumption Agreement whereby Starcom Television allegedly
agreed to assume certain monetary obligations of Program Entertainment Group,
Inc. to City National Bank. City National Bank is seeking monetary damages plus
interest and recovery of certain collateral. These claims arose prior to the
Company's acquisition of Mediatech. The Company believes it has several
material defenses to these claims as well as claims for indemnity against
certain of the co-defendants and other third parties. In the event that the
Company's defenses are unsuccessful, the Company may be required to pay damages
and deliver collateral to City National Bank, and such a judgment could
seriously harm the Company's business, financial condition and results of
operations.
In addition, the Company may from time to time become involved in
litigation proceedings incidental to the conduct of its business. Other than as
set forth above, the Company does not believe that any such proceedings
presently pending will have a material adverse effect on the Company's financial
condition or results of operations.
Item 2. CHANGES IN SECURITIES
Not applicable.
Item 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
Item 5. OTHER INFORMATION
As mentioned in the Notes to the Consolidated Financial Statements, effective
for fiscal year 1999, beginning January 1, the Company elected to adjust its
fiscal quarters so that each quarter is thirteen weeks in length and ends on the
Saturday nearest to March 31, June 30, and September 30. Therefore, the first
fiscal quarter of 1999 ended on April 3, 1999, second quarter ended on July 3,
1999 and third quarter will end on October 2, 1999. Fiscal fourth quarter will
continue to end on December 31, 1999.
Item 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
<TABLE>
<CAPTION>
Exhibit Number Exhibit Title
-------------- -------------
<S> <C>
3.1.1 (d) Restated Articles of Incorporation of registrant.
3.1.2 (h) Certificate of Determination of Rights of Series A Convertible Preferred Stock of Digital Generation
Systems, Inc., filed by the Secretary of State of the State of California on July 16, 1997.
3.2 (b) Bylaws of registrant, as amended to date.
4.1 (b) Form of Lock-Up Agreement.
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 Non-statutory
Stock Option Agreement.
</TABLE>
14
<PAGE>
<TABLE>
<CAPTION>
Exhibit Number Exhibit Title
-------------- -------------
<S> <C>
10.2 (b) Form of Directors' and Officers' Indemnification Agreement.
10.3 (b) 1995 Director Option Plan and form of Incentive Stock Option Agreement thereto.
10.4 (b) Form of Restricted Stock Agreement.
10.5.1 (c) Content Delivery Agreement between the Company and Hughes Network Systems, Inc., dated November 28,
1995.
10.5.2 (c) Equipment Reseller Agreement between the Company and Hughes Network Systems, Inc., dated November
28, 1995.
10.6 (b) Amendment to Warrant Agreement between the Company and Comdisco, Inc., dated January 31, 1996.
10.7(j) Special Customer Agreement between the Company and MCI Telecommunications Corporation, dated May 5,
1997.
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 (h) 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.
10.28 (I) Stock Purchase Agreement, dated as of July 18, 1997, by and between Digital Generation Systems,
Inc., a California corporation, IndeNet, Inc., a Delaware Corporation, 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 (k) 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 (q) 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.
</TABLE>
15
<PAGE>
<TABLE>
<CAPTION>
Exhibit Number Exhibit Title
-------------- -------------
<S> <C>
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 (n) Series A Preferred Stock Conversion Agreement dated as of August 12, 1998.
10.36 (p) Amendment and Restatement No. 5 of the Registration Rights Agreement, dated July 14, 1997, by and
among the Registrant and certain of its securityholders.
10.37 (p) Amended and Restated Registration Rights Agreement, dated December 9, 1998, by and among the
Registrant and certain of its securityholders
10.38 (p) Registration Rights Agreement, dated December 9, 1998, by and among the Registrant and certain of
its securityholders.
10.39(q) Common Stock and Warrant Purchase Agreement dated December 9, 1998 by and among the registrant and
investors listed in Schedule A thereto.
10.40(q) Common Stock Subscription Agreement dated December 9, 1998 by and among the Registrant and Scott
Ginsburg.
10.41(q) Warrant Purchase Agreement dated December 9, 1998 by and among the Registrant and Scott Ginsburg.
10.42(q) Warrant No. 1 to Purchase Common Stock dated December 9, 1998 by and among Registrant and Scott K.
Ginsburg.
10.43(q) Warrant No. 2 to Purchase Common Stock dated December 9, 1998 by and among Registrant and Scott K.
Ginsburg
27 (a) Financial Data Schedule.
</TABLE>
__________
(a) Filed herewith.
(b) Incorporated by reference to the exhibit bearing the same number filed with
registrant's Registration Statement on Form S-1 (Registration No. 33-80203).
(c) Incorporated by reference to the exhibit bearing the same number filed with
registrant's Registration Statement on Form S-1 (Registration No. 33-80203).
The registrant has received confidential treatment with respect to certain
portions of this exhibit. Such portions have been omitted from this exhibit
and have been filed separately with the Securities and Exchange Commission.
(d) Incorporated by reference to the exhibit bearing the same number filed with
registrant's Quarterly Report on Form 10-Q filed May 3, 1996, as amended.
(e) Incorporated by reference to the exhibit bearing the same number filed with
registrant's Quarterly report on Form 10-Q filed November 13, 1996.
(f) Incorporated by reference to the exhibit bearing the same title 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 18, 1997.
(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.
16
<PAGE>
(k) Incorporated by reference to the exhibit bearing the same number filed with
registrant's Annual Report on Form 10-K filed March 31, 1998.
(l) Incorporated by reference to the exhibit bearing the same title filed with
registrant's Quarterly report on Form 10-Q filed May 15, 1998.
(m) Incorporated by reference to the exhibit bearing the same title filed with
registrant's Quarterly report on Form 10-Q filed August 14, 1998.
(n) Incorporated by reference to the exhibit bearing the same title filed with
registrant's Current Report on Form 8-K filed October 13, 1998.
(o) Incorporated by reference to the exhibit bearing the same title filed with
registrant's Quarterly report on Form 10-Q filed November 16, 1998.
(p) Incorporated by reference to the exhibit bearing the same title filed with
registrant's Registration Report on Form S-3 filed on December 31, 1998.
(q) Incorporated by reference to the exhibit bearing the same title filed with
registrant's Registration Report on Form 10-K filed on March 31, 1999.
(b) Reports on Form 8-K
Current Report on Form 8-K filed on August 4, 1999 regarding the appointment
of Matthew Devine as the Chief Executive Officer and Omar Choucair as Chief
Financial Officer; and the appointment of Matthew Devine and Michael Linnert to
the Company's Board of Directors
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: August 17, 1999 By /s/ OMAR CHOUCAIR
---------------------------------------
Omar Choucair
Chief Financial Officer (Principal
Financial and Chief Accounting Officer)
17
<TABLE> <S> <C>
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