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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 October 2, 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)
<TABLE>
<S> <C>
California 94-3140772
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
</TABLE>
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, 1999: 26,741,558
================================================================================
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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 risks discussed in this Report, and in the Company's
other United States Securities and Exchange Commission filings.
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PART I. FINANCIAL INFORMATION Page
----
<S> <C> <C>
Item 1. Financial Statements........................................................ 3
Condensed Consolidated Balance Sheets at October 2, 1999
and December 31, 1998....................................................... 3
Condensed Consolidated Statements of Operations for the three and
nine months ended October 2, 1999 and September 30, 1998.................... 4
Condensed Consolidated Statements of Cash Flows for the nine months
ended October 2, 1999 and September 30, 1998................................ 5
Notes to Condensed Consolidated Financial Statements........................ 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations....................................................... 9
Item 3. Quantitative and Qualitative Disclosures about Market Risk.................. 13
PART II. OTHER INFORMATION
Item 1. Legal Proceedings........................................................... 14
Item 2. Changes in Securities and Use of Proceeds................................... 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............................................ 15
SIGNATURES.................................................................. 18
</TABLE>
2
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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
DIGITAL GENERATION SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts)
<TABLE>
<CAPTION>
October 2, December 31,
1999 1998
------------------- ------------------
(Unaudited)
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 4,386 $ 13,025
Accounts receivable, less allowance for doubtful accounts of
$1,348 in 1999 and $1,895 in 1998 10,830 9,995
Prepaid expenses and other 1,970 933
------------------- ------------------
Total current assets 17,186 23,953
------------------- ---------------------
PROPERTY AND EQUIPMENT, at cost:
Network equipment 37,609 33,211
Office furniture and equipment 1,520 3,730
Leasehold improvements 1,204 542
------------------- ------------------
40,333 37,483
Less - Accumulated depreciation (32,034) (25,738)
------------------- ------------------
Property and equipment, net 8,299 11,745
------------------- ------------------
GOODWILL AND OTHER ASSETS, net 14,378 14,094
------------------- ------------------
TOTAL ASSETS $ 39,863 $ 49,792
=================== ==================
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 6,509 $ 3,035
Accrued liabilities 1,884 4,081
Line of credit 1,570 1,433
Current portion of long-term debt 6,524 8,226
------------------- ------------------
Total current liabilities 16,487 16,775
LONG-TERM DEBT, net of current portion 6,002 9,307
SHAREHOLDERS' EQUITY:
Convertible preferred stock, no par value --
Authorized -- 15,000,000
Outstanding -- none at October 2, 1999 and
none at December 31, 1998 -- --
Common stock, no par value --
Authorized -- 40,000,000 shares
Outstanding -- 26,697,870 shares at October 2, 1999
and 26,239,520 shares at December 31, 1998 115,505 114,131
Receivable from issuance of common stock (369) (369)
Accumulated other comprehensive income 51 9
Accumulated deficit (97,813) (90,061)
------------------- ------------------
Total shareholders' equity 17,374 23,710
------------------- ------------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 39,863 $ 49,792
=================== ==================
The accompanying notes are an integral part of these condensed consolidated financial statements.
</TABLE>
3
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DIGITAL GENERATION SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
For the Three and Nine Months Ended October 2, 1999 and September 30, 1998
(in thousands, except per share amounts)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
--------------------------- ---------------------------
Oct 2, Sept 30, Oct 2, Sept 30,
1999 1998 1999 1998
------------ ----------- ------------ ------------
(Unaudited) (Unaudited)
<S> <C> <C> <C> <C>
REVENUES $ 12,202 $ 9,021 $ 35,782 $ 28,992
------------ ----------- ------------ ------------
COSTS AND EXPENSES:
Delivery and material costs 4,412 3,250 13,720 10,662
Customer operations 3,718 3,460 11,246 10,503
Sales and marketing 1,149 1,156 3,800 3,655
Research and development 756 795 2,048 1,984
General and administrative 1,650 1,097 4,259 3,141
Write down of goodwill and fixed assets (Note 5) 0 17,006 0 17,006
Depreciation and amortization 2,280 2,914 7,204 8,627
------------ ----------- ------------ ------------
Total expenses 13,965 29,678 42,277 55,578
------------ ----------- ------------ ------------
LOSS FROM OPERATIONS (1,763) (20,657) (6,495) (26,586)
------------ ----------- ------------ ------------
OTHER INCOME (EXPENSE):
Interest income 152 63 305 177
Interest expense (449) (831) (1,562) (2,238)
------------ ----------- ------------ ------------
NET LOSS $ (2,060) $ (21,425) $ (7,752) $ (28,647)
============ =========== ============ ============
BASIC AND DILUTED NET LOSS PER SHARE (Note 4) $ (0.08) $ (1.33) $ (0.29) $ (2.18)
============ =========== ============ ============
WEIGHTED AVERAGE COMMON SHARES 26,673 17,471 26,510 13,954
============ =========== ============ ============
The accompanying notes are an integral part of these condensed consolidated financial statements.
</TABLE>
4
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DIGITAL GENERATION SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Nine Months Ended October 2, 1999 and September 30, 1998
(in thousands)
<TABLE>
<CAPTION>
Nine Months Ended
------------------------------------------
Oct 2, Sept 30,
1999 1998
------------------- -------------------
(Unaudited)
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (7,752) $ (28,647)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation of property and equipment 6,548 7,647
Amortization of goodwill and intangibles 578 980
Writedown of goodwill and fixed assets (Note 5) -- 17,006
Stock options granted in lieu of professional fees -- 80
Foreign currency translation adjustment 42 --
Provision for doubtful accounts 206 130
Changes in operating assets and liabilities --
Accounts receivable (1,191) (367)
Prepaid expenses and other assets (1,711) (117)
Accounts payable and accrued liabilities 1,300 (947)
------------------- -------------------
Net cash used in operating activities (1,980) (4,235)
------------------- -------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of short-term investments -- (2,013)
Maturities of short-term investments -- 3,000
Purchase of DCI (Note 3) -- (9,131)
Proceeds from the sale of property, plant and equipment 75 --
Acquisition of property and equipment (3,220) (1,420)
------------------- -------------------
Net cash used in investing activities (3,145) (9,564)
------------------- -------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock 1,374 11,479
Proceeds from line of credit 2,923 10,240
Payments on line of credit (2,786) (12,120)
Proceeds from issuance of long-term debt 1,500 4,465
Payments on long-term debt (6,507) (6,497)
------------------- -------------------
Net cash provided by (used in) financing activities (3,496) 7,567
------------------- -------------------
EFFECT OF EXCHANGE RATE CHANGES ON CASH (18) --
NET DECREASE IN CASH AND CASH EQUIVALENTS (8,639) (6,232)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 13,025 7,833
------------------- -------------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 4,386 $ 1,601
=================== ===================
SUPPLEMENTAL CASH FLOW INFORMATION
Interest Paid $ 1,868 $ 2,256
=================== ===================
Preferred Stock deemed dividend $ -- $ 1,764
=================== ===================
The accompanying notes are an integral part of these condensed consolidated financial statements.
</TABLE>
5
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DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
The financial statements included herein have been prepared by Digital
Generation Systems, Inc. ("the Company"), without audit, pursuant to the rules
and regulations of the Securities and Exchange Commission. Certain information
and 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
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 ended on October 2, 1999. The Company's fiscal
year will continue to end on December 31.
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 October 2, 1999 and September 30, 1998. The
results for the three and nine month periods ended October 2, 1999 are not
necessarily indicative of the results expected for the full fiscal year.
Certain reclassifications were made to the 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 October 2, 1999 and December 31,
1998, cash equivalents consist principally of U.S. Treasury Bills.
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 October 2, 1999, and
is being amortized over a twenty year period. The operating results of DCI have
been included in the consolidated financial statements of the Company from the
date of the closing of the transaction, September 25, 1998.
6
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DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Pro Forma Results
The following table reflects unaudited pro forma combined results of
operations of the Company on the basis that the acquisition of DCI had occurred
at the beginning of fiscal 1998:
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
--------------------------------- -------------------------------------
October 2, Sept 30, October 2, Sept 30,
1999 1998 1999 1998
--------------- --------------- ----------------- -----------------
<S> <C> <C> <C> <C>
(In thousands, except per share data)
Revenues........................................ $12,202 $ 10,305 $35,782 $ 32,228
Net Loss........................................ (2,060) (23,005) (7,752) (22,657)
Basic and Diluted Net Loss per Common Share..... $ (0.08) $ (1.32) $ (0.29) $ (1.62)
Number of Shares used in Computation............ 26,673 17,471 26,510 13,954
</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.
4. NET LOSS PER SHARE:
For the three and nine month periods ended September 30, 1998, 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.
5. IMPAIRMENT OF LONG LIVED ASSETS
The Company has adopted Statement of Financial Accounting Standards 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 indicate that the carrying values of such
assets are not recoverable based on estimated undiscounted cash flows. In
September 1998, the Company wrote off 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 estimated by discounting the related expected
future cash flows over the remaining life of the goodwill amortization period of
19 years.
6. SEGMENT INFORMATION:
In 1998, the Company adopted Statement of Financial Accounting Standards
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.
7
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DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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 October 2, 1999, 5% of operating
assets are located outside of the United States. The assets of the Company's Los
Angeles segment are maintained as a part of the Chicago segment and it is
impractical to break out such assets separately as of September 30, 1998.
<TABLE>
<CAPTION>
For the Three Months Ended October 2, 1999
In $000's
------------------------------------------------------------------------------------------------------
San New Los Adjustments &
Francisco York Chicago Angeles Vancouver Eliminations Consolidated
------------- ---------- ----------- ----------- ------------- ------------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
Revenue $ 3,685 $ 2,808 $ 3,864 $ 690 $ 1,155 $ -- $ 12,202
Net income (loss) $(4,898) $ 926 $ 1,788 $ 260 $ (136) $ -- $ (2,060)
Total identifiable assets $11,999 $ 9,850 $ 7,586 $1,384 $ 9,044 $ -- $ 39,863
For the Three Months Ended September 30, 1998
In $000's
------------------------------------------------------------------------------------------------------
San New Los Adjustments &
Francisco York Chicago Angeles Vancouver Eliminations Consolidated
------------- ---------- ----------- ----------- ------------- ------------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
Revenue $ 3,861 $ 2,369 $ 2,100 $ 691 $ -- $ -- $ 9,021
Net income (loss) $(3,466) $ 277 $(18,018) $ (218) $ -- $ -- $(21,425)
Total identifiable assets $49,888 $10,231 $ 7,814 $ -- $ 9,131 $ (38,247) $ 38,817
For the Nine Months Ended October 2, 1999
In $000's
------------------------------------------------------------------------------------------------------
San New Los Adjustments &
Francisco York Chicago Angeles Vancouver Eliminations Consolidated
------------- ---------- ----------- ----------- ------------- ------------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
Revenue $11,921 $ 8,710 $ 10,037 $1,462 $ 3,652 $ -- $ 35,782
Net income (loss) $(9,189) $ 1,722 $ 1,010 $ (278) $(1,017) $ -- $ (7,752)
For the Nine Months Ended September 30, 1998
In $000's
------------------------------------------------------------------------------------------------------
San New Los Adjustments &
Francisco York Chicago Angeles Vancouver Eliminations Consolidated
------------- ---------- ----------- ----------- ------------- ------------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
Revenue $11,293 $ 7,384 $ 8,274 $2,041 $ -- $ -- $ 28,992
Net income (loss) $(9,823) $ 930 $(19,484) $ (270) $ -- $ -- $(28,647)
</TABLE>
8
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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.
Revenues
Revenues were $ 12,202,000 for the three months ended October 2, 1999, a
35% increase from $9,021,000 for the three months ended September 30, 1998, and
revenues for the nine months ended October 2, 1999 were $35,782,000, a 23%
increase from $28,992,000 for the nine months ended September 30, 1998.
Revenues increased primarily due to the acquisition of DCI in September
1998 and greater acceptance of its video delivery services. This acquisition
accounted for a substantial portion of the increased combined revenue for the
three months ended October 2, 1999 over the same period in 1998. In addition to
the DCI acquisition, the Company believes that the increase 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 $4,412,000 for the three months ended
October 2, 1999, a 36% increase from the $3,250,000 for the three months ended
September 30, 1998. Delivery and materials costs were $13,720,000 for the nine
months ended October 2, 1999, a 29% increase from the $10,662,000 from the nine
months ended September 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 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
Networking Operating Center ("NOC"). 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 material costs include the direct material and fees paid
to other service providers in connection with postproduction services and other
services offered by the Company.
Total delivery and material costs as a percentage of revenues remained
unchanged at 36% of revenues for the three months ended October 2, 1999 and
September 30, 1998 and increased to 38% of revenues from 37% of revenues in the
nine months ended October 2, 1999 compared to the nine months ended September
30, 1998.
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.
Customer Operations
Customer operations expenses were $3,718,000 and $3,460,000 for the
quarters ended October 2, 1999 and September 30, 1998, respectively, and
$11,246,000 and $10,503,000 for the nine months ended October 2, 1999 and
September 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 30%
from 38% of revenues for the quarters ended October 2, 1999 and September 30,
1998, respectively, and decreased to 31% of revenues from 36% of revenues for
the nine months ended October 2, 1999 and September 30, 1998, respectively. This
decrease is primarily due to process improvements in orders processed through
the Company's NOC, which
9
<PAGE>
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 $1,149,000 for the three months ended
October 2, 1999, a 1% decrease from $1,156,000 for the quarter ended September
30, 1998, and increased 4% to $3,800,000 in the nine months ended October 2,
1999 from $3,655,000 for the nine months ended September 30, 1998. The decrease
in sales and marketing expense in the quarter ended October 2, 1999 is a result
of improved efficiency of the Company's sales and marketing efforts. Sales and
marketing expense increased in the nine months ended October 2, 1999 from the
period ended September 30, 1998 primarily due to the consolidation of the sales
and marketing departments of DCI with those of the Company.
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 decreased 5% to $756,000 for the quarter
ended October 2, 1999 from $795,000 for the quarter ended September 30, 1998,
and increased 3% to $2,048,000 from $1,984,000 for the nine months ended October
2, 1999 and September 30, 1998, respectively. The decrease in research and
development expense for the quarter from the corresponding quarter in the
previous year is due primarily to the fact that a portion of engineering
expenses for the quarter ended October 2, 1999 was being capitalized as a result
of the Company's efforts to integrate its network with that of its DCI
subsidiary. The year to date increase in research and development costs is due
to an increase in expenses related to 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 that 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 50% to $1,650,000 for the
quarter ended October 2, 1999, from $1,097,000 for the quarter ended September
30, 1998; and increased 36% to $4,259,000 for the nine months ended October 2,
1999 from $3,141,000 for the nine months ended September 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 increased to 14% and 12% of revenues for the quarter and nine months ended
October 2, 1999 from 12% and 11% for the quarter and nine months ended September
30, 1998.
Depreciation and Amortization
Depreciation and amortization expenses decreased 22% to $2,260,000 in the
quarter ended October 2, 1999 from $2,914,000 in the quarter ended September 30,
1998; and decreased 17% to $7,126,000 for the nine
10
<PAGE>
months ended October 2, 1999 from $8,627,000 for the nine months ended September
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 reached the end of their
depreciable lives. The decline of depreciation expense in the first three
quarters of 1999 reflects this fact. As of October 2, 1999, the Company's total
investment in network equipment has increased 11% to $37.6 million, from $33.8
million at September 30, 1998.
The Company recorded amortization expense of $191,000 and $578,000 for the
quarter and the nine months ended October 2, 1999, and $216,000 and $648,000 for
the quarter and nine months ended September 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 141% to $152,000 in the quarter ended October 2,
1999 from $63,000 for the quarter ended September 30, 1998 and increased 72% to
$305,000 for the nine months ended October 2, 1999, from $177,000 in the nine
months ended September 30, 1998. This increase is primarily the result of an
increased level of cash and cash equivalents in the first quarter and nine
months of 1999 over the first quarter and nine 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 46% to $449,000 for the quarter ended October 2,
1999, from $831,000 in the quarter ended September 30, 1998 and decreased 30% to
$1,562,000 for the nine months ended October 2, 1999, from $2,238,000 for the
nine months ended September 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 $8.2 million at October 2, 1999 from
$13.0 million at September 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 $2.0 million in the nine
months ended October 2, 1999 from $4.2 million in the nine months ended
September 30, 1998.
The Company made capital additions of $3.2 million during the nine months
ended October 2, 1999 versus $1.4 million in the nine months ended September 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
$6.5 million for both the nine month periods ended October 2, 1999 and September
30, 1998.
At October 2, 1999, the Company's current sources of liquidity included
cash and cash equivalents of $4.4 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
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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 three 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 an 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 December 1999. The Company's strategy also includes development of
contingency plans to address potential disruption of operations arising from the
Year 2000 problem. Contingency plans for external delivery systems are complete.
The remainder of the Company's business process and systems contingency plans
are scheduled for completion in mid-December.
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 has assessed all systems including hardware,
application software and firmware. A complete Company-wide inventory assessment
is completed. 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 & Testing: The Company has completed testing and analysis
on mission critical systems. End to end delivery testing is currently underway.
Remote testing of offsite systems hardware began in April. All offsite systems
are expected to be Year 2000 compliant by the end of the fourth quarter of 1999.
The Company's financial systems have been upgraded. A detailed analysis and
testing of each remaining system has been performed.
System Conversion & Testing: The Company's network includes Receive
Playback Terminals ("RPTs"), Client Workstations ("CWs") and Advantage Digital
Video Playback Systems ("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 in its compliance program. Each unit has been
remotely tested and any necessary corrections or modifications are being 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
12
<PAGE>
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 by mid-
December 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 significant customers of the
Company were to shift some or all of their delivery work to other delivery
providers, the Company's business, financial condition and results of operations
could 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. 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 $1.2 million 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.
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company has some operations in Canada and, therefore, is subject to the
risk that the Canadian dollar/US dollar exchange rates will adversely impact the
Company's results of operations. The Company believes this risk to be
immaterial to the Company's results of operations.
13
<PAGE>
PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
The Company is involved in routine 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 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
The 1999 Annual Meeting of Shareholders of the Company was held on
September 23, 1999 (the "Annual Meeting"). The following matters were voted upon
at the Annual Meeting: (i) the election of six (6) directors to serve until the
next Annual Meeting or until their successors have been duly elected and
qualified; (ii) amendment of the Company's Articles of Incorporation to increase
the authorized number of shares of the Company's Common Stock to 100,000,000
shares from 40,000,000; (iii) amendment of the Company's 1992 Stock Option Plan
to increase the number of shares available for issuance; (iv) amendment of the
Company's 1995 Stock Option Plan to increase the number of shares available for
issuance; and (v) ratification of the appointment of Arthur Andersen, LLP, as
independent auditors of the Company for the fiscal year ending December 31,
1999. The results of the vote were as follows:
<TABLE>
<CAPTION>
Votes Against/ Broker
Matter Votes For Withheld Abstentions Non-Votes
- -------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
1. Elect Directors
Scott K. Ginsburg 23,339,671 649,082 0 0
Matthew E. Devine 23,340,879 647,874 0 0
Henry W. Donaldson 23,337,779 650,974 0 0
Lawrence D. Lenihan 23,342,879 645,874 0 0
Michael G. Linnert 23,342,679 646,074 0 0
David M. Kantor 23,342,859 645,894 0 0
- -------------------------------------------------------------------------------------------------------------------
2. Amend the Company's Articles
of Incorporation 22,757,317 1,220,635 10,801 0
- -------------------------------------------------------------------------------------------------------------------
3. Amend the Company's 1992 Stock
Option Plan 17,143,807 1,143,709 12,491 5,688,746
- -------------------------------------------------------------------------------------------------------------------
4. Amend the Company's 1995 Stock
Option Plan 17,888,694 398,657 12,656 5,688,746
- -------------------------------------------------------------------------------------------------------------------
5. Ratify the Appointment of
Arthur Andersen, LLP 23,941,691 38,906 8,156 0
- -------------------------------------------------------------------------------------------------------------------
</TABLE>
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 ended on October 2, 1999. The Company's fiscal
year will continue to end on December 31.
14
<PAGE>
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.
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.
</TABLE>
15
<PAGE>
<TABLE>
<CAPTION>
Exhibit Number Exhibit Title
- ------------------ -----------------------------------------------------------------------------------------------------
<S> <C>
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.
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.
16
<PAGE>
(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.
(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 October 27, 1999 regarding the October
20, 1999 resignation of Arthur Andersen, LLP as the Company's Certified Public
Accountants and the October 27, 1999 appointment of KPMG LLP as the Company's
Certified Public Accountants, subject to finalization of its standard
prospective client evaluation procedures.
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.
17
<PAGE>
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, 1999 By /S/ OMAR CHOUCAIR
------------------------------------
Omar Choucair
Chief Financial Officer (Principal Financial
and Chief Accounting Officer)
18
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> OCT-02-1999
<CASH> 4,386
<SECURITIES> 0
<RECEIVABLES> 10,830
<ALLOWANCES> (1,348)
<INVENTORY> 484
<CURRENT-ASSETS> 17,186
<PP&E> 40,333
<DEPRECIATION> (32,034)
<TOTAL-ASSETS> 39,863
<CURRENT-LIABILITIES> 16,487
<BONDS> 0
0
0
<COMMON> 115,505
<OTHER-SE> (98,131)
<TOTAL-LIABILITY-AND-EQUITY> 39,863
<SALES> 0
<TOTAL-REVENUES> 39,863
<CGS> 0
<TOTAL-COSTS> 42,277
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 1,257
<INCOME-PRETAX> (7,752)
<INCOME-TAX> 0
<INCOME-CONTINUING> (7,752)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (7,752)
<EPS-BASIC> (0.29)
<EPS-DILUTED> (0.29)
</TABLE>
