-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, GNYeJ34pcRwTD0+C0PWyc/7aksBu1XHo45QAr0DOMNNliHCgHj0rQuRS0nLFdkJh mo7rr/u0XFq6jYbMIppiWA== 0001144204-07-010415.txt : 20070228 0001144204-07-010415.hdr.sgml : 20070228 20070228140719 ACCESSION NUMBER: 0001144204-07-010415 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 6 CONFORMED PERIOD OF REPORT: 20061231 FILED AS OF DATE: 20070228 DATE AS OF CHANGE: 20070228 FILER: COMPANY DATA: COMPANY CONFORMED NAME: POINT 360 CENTRAL INDEX KEY: 0001014733 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-ALLIED TO MOTION PICTURE PRODUCTION [7819] IRS NUMBER: 954272619 STATE OF INCORPORATION: CA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-21917 FILM NUMBER: 07656804 BUSINESS ADDRESS: STREET 1: 2777 NORTH ONTARIO STREET CITY: BURBANK STATE: CA ZIP: 91504 BUSINESS PHONE: 818-565-1440 MAIL ADDRESS: STREET 1: 2777 NORTH ONTARIO STREET CITY: BURBANK STATE: CA ZIP: 91504 FORMER COMPANY: FORMER CONFORMED NAME: VDI MULTIMEDIA DATE OF NAME CHANGE: 19991115 FORMER COMPANY: FORMER CONFORMED NAME: VDI MEDIA DATE OF NAME CHANGE: 19960516 10-K 1 v067194_10k.htm
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 

FORM 10-K

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2006

OR

o 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 0-21917
 
 
POINT.360
(Exact name of registrant as specified in its charter)

California
(State or other jurisdiction of
incorporation or organization)
95-4272619
(I.R.S. Employer Identification No.)
2777 North Ontario Street, Burbank, CA
(Address of principal executive offices)
91504
(Zip Code)

Registrant's telephone number, including area code (818) 565-1400

Securities registered pursuant to Section 12(b) of the Act:
None

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, no par value.
 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes o No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes o No x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x No o
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
 
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer   ¨           Accelerated filer   ¨     Non-accelerated filer  x 
 
Indicate by check mark if whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨ No x

The aggregate market value of the voting common equity held by non-affiliates of the registrant as of the last business day of the registrant’s most recently completed second fiscal quarter (June 30, 2006) was approximately $11 million. As of February 14, 2007, there were 9,977,407 shares of Common Stock outstanding.   
     
DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive Proxy Statement relating to the Company’s Annual Meeting of Shareholders to be held on May 3, 2006 are incorporated by reference in Part III of this report.
 
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CAUTIONARY STATEMENT
 
In our capacity as Company management, we may from time to time make written or oral forward-looking statements with respect to our long-term objectives or expectations which may be included in our filings with the Securities and Exchange Commission (the “SEC”), reports to stockholders and information provided in our web site.
 
The words or phrases “will likely,” “are expected to,” “is anticipated,” “is predicted,” “forecast,” “estimate,” “project,” “plans to continue,” “believes,” or similar expressions identify “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical earnings and those presently anticipated or projected. We wish to caution you not to place undue reliance on any such forward-looking statements, which speak only as of the date made. In connection with the “Safe Harbor” provisions of the Private Securities Litigation Reform Act of 1995, we are calling to your attention important factors that could affect our financial performance and could cause actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods in any current statements.
 
The following list of important factors may not be all-inclusive, and we specifically decline to undertake an obligation to publicly revise any forward-looking statements that have been made to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events. Among the factors that could have an impact on our ability to achieve expected operating results and growth plan goals and/or affect the market price of our stock are:
 
 
·  
Recent history of losses.
     
 
· 
Prior breach and changes in credit agreements and ongoing liquidity.
     
 
· 
Our highly competitive marketplace.
     
 
· 
The risks associated with dependence upon significant customers.
     
 
· 
Our ability to execute our expansion strategy.
     
 
· 
The uncertain ability to manage in a changing environment.
     
 
· 
Our dependence upon and our ability to adapt to technological developments.
     
 
· 
Dependence on key personnel.
     
 
·   
Our ability to maintain and improve service quality.
     
 
· 
Fluctuation in quarterly operating results and seasonality in certain of our markets.
     
 
· 
Possible significant influence over corporate affairs by significant shareholders.

3

PART I

ITEM 1. BUSINESS

General
 
Point.360 ("Point.360" or the "Company") is a leading integrated media management services company providing film, video and audio post production, archival, duplication and distribution services to motion picture studios, television networks, advertising agencies, independent production companies and multinational companies. The Company provides the services necessary to edit, master, reformat, archive and ultimately distribute its clients’ audio and video content, including television programming, feature films, spot advertising and movie trailers.
 
The Company provides worldwide electronic and physical distribution using fiber optics, satellite, Internet and air and ground transportation. The Company delivers commercials, movie trailers, electronic press kits, infomercials and syndicated programming, by both physical and electronic means, to thousands of broadcast outlets worldwide.
 
The Company seeks to capitalize on growth in demand for the services related to the manipulation and distribution of rich media content, without assuming the production or ownership risk of any specific television program, feature film, advertising or other form of content. The primary users of the Company's services are entertainment studios and advertising agencies that generally choose to outsource such services due to the sporadic demand and the fixed costs of maintaining a high-volume physical plant.
 
Since January 1, 1997, the Company has successfully completed acquisitions of companies providing similar services. The Company will continue to evaluate acquisition opportunities to enhance its operations and profitability. As a result of these acquisitions, the Company is one of the largest and most diversified providers of technical and distribution services in its markets, and therefore is able to offer its customers a single source for such services at prices that reflect the Company’s scale economies.
 
The Company was incorporated in California in 1990. The Company's executive offices are located at 2777 N. Ontario Street, Burbank, California 91504, and its telephone number is (818) 565-1400. The Company’s website address is www.point360.com. 

Markets
 
The Company derives revenues primarily from (i) the entertainment industry, consisting of major and independent motion picture and television studios, cable television program suppliers and television program syndicators, and (ii) the advertising industry, consisting of advertising agencies and corporate advertisers. On a more limited basis, the Company also services national television networks, local television stations, corporate or instructional video providers, infomercial advertisers and educational institutions.

Entertainment Industry. The entertainment industry creates motion pictures, television programming, and interactive multimedia content for distribution through theatrical exhibition, home video, pay and basic cable television, direct-to-home, private cable, broadcast television, on-line services and video games. Content is released into a "first-run" distribution channel, and later into one or more additional channels or media. In addition to newly produced content, film and television libraries may be released repeatedly into distribution. Entertainment content produced in the United States is exported and is in increasingly high demand internationally. The Company believes that several trends in the entertainment industry have and will continue to have a positive impact on the Company's business. These trends include growth in worldwide demand for original entertainment content, the development of new markets for existing content libraries, increased demand for innovation and creative quality in domestic and foreign markets, and wider application of digital technologies for content manipulation and distribution, including the emergence of new distribution channels.

Advertising Industry. The advertising industry distributes video and audio commercials, or spots, to radio and television broadcast outlets worldwide. Advertising content is developed either by the originating company or in conjunction with an advertising agency. The Company receives orders with specific routing and timing instructions provided by the customer. These orders are then entered into the Company's computer system and scheduled for electronic or physical delivery. When a video spot is received, the Company's quality control personnel inspect the video to ensure that it meets customer specifications and then initiate the sequence to distribute the video to the designated television stations either electronically, over fiber optic lines and/or satellite, or via the most suitable package carrier. The Company believes that the growth in the number of video advertising outlets, driven by expansion in the number of broadcast, cable, Internet and satellite channels worldwide, will have a positive impact on the Company’s businesses.

Value-Added Services
 
The Company maintains video and audio post-production and editing facilities as components of its full service, value-added approach to its customers. The following summarizes the value-added post-production services that the Company provides to its customers:
 
Film-To-Digital Transfer. Substantially all film content ultimately is distributed to the home video, broadcast, cable or pay-per-view television markets, requiring that film images be transferred electronically to a digital video format. Each frame must be color corrected and adapted to the size and aspect ratio of a television screen in order to ensure the highest level of conformity to the original film version. The Company transfers film to digital formats using Spirit, URSA and Cintel MK-3 telecine equipment and DaVinci® digital color correction systems. The remastering of studio film and television libraries to the HDTV broadcast standard has become a growing portion of the Company's film transfer business, as well as affiliated services such as foreign language mastering, duplication and distribution.
 
4
 
Video Editing. The Company provides digital editing services in Hollywood, Burbank and West Los Angeles. The editing suites are equipped with (i) state-of-the-art digital editing equipment, including the Avid® 9000, that provides precise and repeatable electronic transfer of video and/or audio information from one or more sources to a new master video and (ii) large production switchers to effect complex transitions from source to source while simultaneously inserting titles and/or digital effects over background video. Video is edited into completed programs such as television shows, infomercials, commercials, movie trailers, electronic press kits, specials, and corporate and educational presentations.
 
Standards Conversion. Throughout the world there are several different broadcasting "standards" in use. To permit a program recorded in one standard to be broadcast in another, it is necessary for the recorded program to be converted to the applicable standard. This process involves changing the number of video lines per frame, the number of frames per second, and the color system. The Company is able to convert video between all international formats, including NTSC, PAL and SECAM. The Company's competitive advantages in this service line include its state-of-the-art systems and its detailed knowledge of the international markets with respect to quality-control requirements and technical specifications.
 
Broadcast Encoding. The Company provides encoding services for tracking broadcast airplay of spots or television programming. Using a process called VEIL encoding; a code is placed within the video portion of an advertisement or an electronic press kit. Such codes can be monitored from standard television broadcasts to determine which advertisements or portions of electronic press kits are shown on or during specific television programs, providing customers direct feedback on allotted air time. The Company provides VEIL encoding services for a number of its motion picture studio clients to enable them to customize their promotional material. The Company also provides ICE encoding services which enable it to place codes within the audio portion of a video, thereby enhancing the overall quality of the encoded video.
 
Audio Post-Production. Through its facilities in Burbank, Hollywood and West Los Angeles, the Company digitally edits and creates sound effects, assists in replacing dialog and re-records audio elements for integration with film and video elements. The Company designs sound effects to give life to the visual images with a library of sound effects. Dialog replacement is sometimes required to improve quality, replace lost dialog or eliminate extraneous noise from the original recording. Re-recording combines sound effects, dialog, music and laughter or applause to complete the final product. In addition, the re-recording process allows the enhancement of the listening experience by adding specialized sound treatments, such as stereo, Dolby Digital®, SDDS®, THX® and Surround Sound®.
 
Audio Layback. Audio layback is the process of creating duplicate videotape masters with sound tracks that are different from the original recorded master sound track. Content owners selling their assets in foreign markets require the replacement of dialog with voices speaking local languages. In some cases, all of the audio elements, including dialog, sound effects, music and laughs, must be recreated, remixed and synchronized with the original videotape. Audio sources are premixed foreign language tracks or tracks that contain music and effects only. The latter is used to make a final videotape product that will be sent to a foreign country to permit addition of a foreign dialogue track to the existing music and effects track.
 
Foreign Language Mastering. Programming designed for distribution in markets other than those for which it was originally produced is prepared for export through language translation and either subtitling or voice dubbing. The Company provides dubbed language versioning with an audio layback and conform service that supports various audio and videotape formats to create an international language-specific master videotape. One of the Company's Burbank facilities also creates music and effects tracks from programming shot before an audience to prepare television sitcoms for dialog recording and international distribution.
 
Syndication. The Company offers a broad range of technical services to domestic and international programmers. The Company services the basic and premium cable, broadcast syndication and direct-to-home market segments by providing the facilities and services necessary to assemble and distribute programming via satellite to viewers in the United States, Canada and Europe. The Company provides facilities and services for the delivery of syndicated television programming in the United States and Canada. The Company's customer base consists of the major studios and independent distributors offering network programming, world-wide independent content owners offering niche market programming, and pay-per-view services marketing movies and special events to the cable industry and direct-to-home viewers. Broadcast and syndication operations are conducted in Hollywood and West Los Angeles.
 
5
 
Archival Services. The Company currently stores approximately one million videotape and film elements in a protected environment. The storage and handling of videotape and film elements require specialized security and environmental control procedures. The Company performs secure management archival services in all of its operating facilities as well as its state-of-the-art Media Center in Los Angeles. The Company offers on-line access to archival information for advertising clients, and may offer this service to other clients in the future.
 
Distribution Network
 
The Company operates a full service distribution network providing its customers with reliable, timely and high quality distribution services. The Company's historical customer base consists of advertising agencies, multinational companies, motion picture and television studios and post-production facilities.
 
Commercials, trailers, electronic press kits and related distribution instructions are typically collected at one of the Company's regional facilities and are processed locally or transmitted to another regional facility for processing. Orders are routinely received into the evening hours for delivery the next morning. The Company has the ability to process customer orders from receipt to transmission in less than one hour. Customer orders that require immediate, multiple deliveries in remote markets are often delivered electronically to and serviced by third parties with duplication and delivery services in such markets. The Company provides the advantage of being able to service customers from both of its primary markets (entertainment and advertising) in all of its facilities to achieve the most efficient project turnaround. The Company's network operates 24 hours a day.
 
For electronic distribution, a video master is digitized and delivered by fiber optic, Internet, ISDN or satellite transmission to television stations equipped to receive such transmissions. All of the Company’s electronic, fiber optic, satellite and internet deliveries are made using third party vendors. The Company currently derives approximately one-half of its distribution revenues from electronic deliveries and anticipates that this percentage will increase as such technologies become more widely adopted.
 
The Company intends to add new methods of distribution as technologies become both standardized and cost-effective. The Company currently operates facilities in Los Angeles (seven locations), New York, Chicago, Dallas and San Francisco. By capitalizing on electronic technologies to link instantaneously all of the Company's facilities, the Company is able to optimize delivery, thus extending the deadline for same- or next-day delivery of time-sensitive material.
 
The Company's network and facilities are designed to serve, cost-effectively, the time-sensitive distribution needs of its clients. Management believes that the Company's success is based on its strong customer relationships that are maintained through the reliability, quality and cost-effectiveness of its services, and its extended deadline for processing customer orders.
 
New Markets
 
The Company believes that the development of its network and its array of value-added services will provide the Company with the opportunity to enter or increase its presence in several new or expanding markets.
 
International. The Company currently provides electronic and physical duplication and distribution services for rich media content providers. Further, the Company believes that electronic distribution methods will facilitate further expansion into the international distribution arena as such technologies become standardized and cost-effective. In addition, the Company believes that the growth in the distribution of domestic content into international markets will create increased demand for value-added services currently provided by the Company such as standards conversion and audio and digital mastering.
 
High Definition Television (HDTV). The Company is focused on capitalizing on opportunities created by emerging industry trends such as the emergence of digital television and its more advanced variant, high-definition television. HDTV has quickly become the mastering standard for domestic content providers. The Company believes that the aggressive timetable associated with such conversion, which has resulted both from mandates by the Federal Communications Commission (the "FCC") for digital television and high-definition television as well as competitive forces in the marketplace, is likely to accelerate the rate of increase in the demand for these services. The Company maintains a state-of-the-art HDTV capability.
 
DVD Authoring. The Company believes that there are significant opportunities in the DVD authoring market. With the increasing rate of conversion of existing analog libraries, as well as new content being mastered to digital formats, we believe that the Company has positioned itself well to provide value-added services to new and existing clients. The Company has made capital investments to expand and upgrade its current DVD and digital compression operations in anticipation of the increasing demand for DVD and video encoding services.
 
6
 
Sales and Marketing
 
The Company markets its services through a combination of industry referrals, formal advertising, trade show participation, special client events, and its Internet website. While the Company relies primarily on its reputation and business contacts within the industry for the marketing of its services, the Company also maintains a direct sales force to communicate the capabilities and competitive advantages of the Company's services to potential new customers. In addition, the Company's sales force solicits corporate advertisers who may be in a position to influence agencies in directing deliveries through the Company. The Company currently has sales personnel located in Los Angeles, San Francisco, Chicago, Dallas and New York. The Company's marketing programs are directed toward communicating its unique capabilities and establishing itself as the predominant value-added distribution network for the motion picture and advertising industries.
 
In addition to its traditional sales efforts directed at those individuals responsible for placing orders with the Company’s facilities, the Company also strives to negotiate “preferred vendor” relationships with its major customers. Through this process, the Company negotiates discounted rates with large volume clients in return for being promoted within the client’s organization as an established and accepted vendor. This selection process tends to favor larger service providers such as the Company that (i) offer lower prices through scale economies; (ii) have the capacity to handle large orders without outsourcing to other vendors; and (iii) can offer a strategic partnership on technological and other industry-specific issues. The Company negotiates such agreements periodically with major entertainment studios and national broadcast networks.
 
Customers
 
Since its inception in 1990, the Company has added customers through acquisitions and by delivering a favorable mix of reliability, timeliness, quality and price. The integration of the Company's regional facilities has given its customers a time advantage in the ability to deliver broadcast quality material. The Company markets its services to major and independent motion picture and television production companies, advertising agencies, television program suppliers and, on a more limited basis, national television networks, infomercial providers, local television stations, television program syndicators, corporations and educational institutions. The Company's motion picture clients include Disney, Sony Pictures Entertainment, Twentieth Century Fox, Universal Studios, Warner Bros., Metro-Goldwyn-Mayer and Paramount Pictures. The Company's advertising agency customers include TBWA/Chiat Day, Young & Rubicam and Saatchi & Saatchi.
 
The Company solicits the motion picture and television industries, advertisers and their agencies to generate revenues. In the year ended December 31, 2006, ten major motion picture studios and advertising agencies accounted for approximately 51% of the Company's revenues, while sales to Twentieth Century Fox and affiliates comprised 24% of 2006 revenues. Sales to Twentieth Century Fox and affiliates were made to approximately 50 individual customers within the group.
 
The Company generally does not have exclusive service agreements with its clients. Because clients generally do not make arrangements with the Company until shortly before its facilities and services are required, the Company usually does not have any significant backlog of service orders. The Company's services are generally offered on an hourly or per unit basis based on volume.
 
Customer Service
 
The Company believes it has built its strong reputation in the market with a commitment to customer service. The Company receives customer orders via courier services, telephone, telecopier and the Internet. The sales and customer service staff develops strong relationships with clients within the studios and advertising agencies and is trained to emphasize the Company's ability to confirm delivery, meet difficult delivery time frames and provide reliable and cost-effective service. Several studios are customers because of the Company's ability to meet often changing or rush delivery schedules.
 
The Company has a sales and customer service staff of approximately 75 people, at least one member of which is available 24 hours a day. This staff serves as a single point of problem resolution and supports not only the Company's customers, but also the television stations and cable systems to which the Company delivers.
 
Competition
 
The manipulation, duplication and distribution of rich media assets is a highly competitive service-oriented business. Certain competitors (both independent companies and divisions of large companies) provide all or most of the services provided by the Company, while others specialize in one or several of these services. Substantially all of the Company's competitors have a presence in the Los Angeles area, which is currently the largest market for the Company's services. Due to the current and anticipated future demand for video duplication and distribution services in the Los Angeles area, the Company believes that both existing and new competitors may expand or establish video service facilities in this area.
 
7
 
The Company believes that it maintains a competitive position in its market by virtue of the quality and scope of the services it provides, and its ability to provide timely and accurate delivery of these services. The Company believes that prices for its services are competitive within its industry, although some competitors may offer certain of their services at lower rates than the Company.
 
The principal competitive factors affecting this market are reliability, timeliness, quality and price. The Company competes with a variety of duplication and distribution firms, certain post-production companies and, to a lesser extent, the in-house operations of major motion picture studios and ad agencies. Some of these competitors have long-standing ties to clients that will be difficult for the Company to change. Several companies have systems for delivering video content electronically. Moreover, some of these firms, such as Vyvx (a unit of Level 3 Communications, Inc.), DG FastChannel, Inc., Liberty Media Inc. (formerly Ascent Media Group, Inc.) and other post-production companies may have greater financial, operational and marketing resources, and may have achieved a higher level of brand recognition than the Company. As a result, there is no assurance that the Company will be able to compete effectively against these competitors merely on the basis of reliability, timeliness, quality, price or otherwise.
 
Employees
 
The Company had 440 full-time employees as of December 31, 2006. The Company's employees are not represented by any collective bargaining organization, and the Company has never experienced a work stoppage. The Company believes that its relations with its employees are good.
 
ITEM 1A. RISK FACTORS
 
We have a recent history of losses, and we may incur losses in the future. The Company reported losses in each of the five fiscal quarters ended December 31, 2001 and in some quarters thereafter due, in part, to lower gross margins and lower sales levels and a number of unusual charges. Although we achieved profitability in Fiscal 2000 and prior years, as well as in most fiscal quarters between March 31, 2002 and December 31, 2006, there can be no assurance as to future profitability on a quarterly or annual basis.
 
We have previously breached our credit agreements and may do so in the future. Due to lower operating cash amounts resulting from reduced sales levels in 2001 and the consequential net losses, the Company breached certain covenants of its credit facility. The breaches were temporarily cured based on amendments and forbearance agreements among the Company and the banks which called for, among other provisions, scheduled payments to reduce amounts owed to the banks to the permitted borrowing base. In August 2001, the Company failed to meet the principal repayment schedule and was once again in breach of the credit facility. The banks ended their formal commitment to the Company in December 2001.

In May 2002, we entered into an agreement with the banks to restructure the credit facility to a term loan maturing on December 31, 2004. As part of this restructuring, the banks waived all existing defaults and the Company was required to make principal payments of $5.5 million, $5.0 million and $18.5 million in 2002, 2003, and 2004, respectively.

In March 2004, we entered into a revised agreement with the banks providing revolving and term loan facilities. Annual principal payments for the term loan were to be $1.6 million each for five years. Any principal outstanding under the revolver was to be due in March 2006.

In July and August 2004, the credit agreement was amended in connection with the acquisition of International Video Conversion, Inc. (“IVC”) to increase the amounts that can be borrowed under the revolving and term loan portions of the arrangement. Approximately $4.7 million was borrowed to consummate the transaction. Also, in August 2004, we borrowed $6,435,000 to purchase land and a building to house our Los Angeles area media storage capability.

During the second quarter of 2005, we entered into discussions with the banks to amend certain financial covenants contained in our credit agreement to more closely track our changing business environment which has contributed to lower sales and profits in previous quarters. As of June 30, 2005, our credit agreement was changed to shorten the due date of the outstanding revolving loan from March 12, 2006 to January 31, 2006 (subsequently extended to March 31, 2006), eliminate a re-borrowing provision of the term loan, increase interest rates on the revolver and term loans by 0.5% and revise certain financial covenants.

As of December 30, 2005, the Company did not meet certain financial covenants contained in the credit facility and received a compliance waiver from the bank. The credit facility was paid in full in March 2006.

In December 2005, we entered a new five-year term loan, paying off the previously existing term loan with the proceeds there from.

In March 2006, we entered a new revolving credit agreement providing for borrowing up to $10 million (based on qualified accounts receivable) for a two-year period. Additionally, we sold and leased back our Media Center facility which reduced mortgage debt by $6.0 million and generated approximately $8.0 million for other debt reduction and general corporate purposes. The resulting annual lease payments are approximately $1,100,000 as compared to $687,000 of previously scheduled mortgage debt service (principal and interest) and approximately $600,000 of annual interest cost on other debt repaid with the sale proceeds.
 
8

If the Company incurs losses in the future, there is a risk that we will default under certain financial covenants contained in the new agreements and/or will not be able to pay off the revolving and term loans when due. If a default condition exists in the future, all amounts outstanding under the new agreements will be due and payable which could materially and adversely affect our business.
 
We may be unable to compete effectively in a highly competitive marketplace. Our post production, duplication and distribution industry is a highly competitive, service-oriented business. In general, we do not have long-term or exclusive service agreements with our customers. Business is acquired on a purchase order basis and is based primarily on customer satisfaction with reliability, timeliness, quality and price.
 
We compete with a variety of post production, duplication and distribution firms, some of which have a national presence, and to a lesser extent, the in-house post production and distribution operations of our major motion picture studio and advertising agency customers. Some of these firms, and all of the studios, have greater financial, distribution and marketing resources and have achieved a higher level of brand recognition than the Company. In the future, we may not be able to compete effectively against these competitors merely on the basis of reliability, timeliness, quality and price or otherwise.
 
We may also face competition from companies in related markets which could offer similar or superior services to those offered by the Company. We believe that an increasingly competitive environment as evidenced by recent price pressure and some related loss of work and the possibility that customers may utilize in-house capabilities to a greater extent could lead to a loss of market share or additional price reductions, which could have a material adverse effect on our financial condition, results of operations and prospects.
 
There is also the risk that third party vendors who directly compete with us will succeed in taking away business or curtailing services to us. We rely on such companies principally to electronically deliver commercial spots on behalf of our advertising clients. In June 2005, one such vendor notified us that its electronic distribution channel was no longer available to us except under certain circumstances. While curtailment of these services in this instance has not materially affected our ability to deliver commercial spots, any future interruption in the supply of such services could materially and adversely affect the Company’s financial condition, results of operations and prospects.
 
We would be adversely affected by the loss of key customers. Although we have an active client list of over 2,500 customers, ten motion picture studios and advertising agencies and/or their affiliates accounted for approximately 51%, 47% and 38% of the Company’s revenues in 2006, 2005 and 2004, respectively. If one or more of these companies were to stop using our services, our business could be adversely affected. Because we derive substantially all of our revenue from clients in the entertainment and advertising industries, the financial condition, results of operations and prospects of the Company could also be adversely affected by an adverse change in conditions which impact those industries.
 
Our expansion strategy may fail. Our growth strategy involves both internal development and expansion through acquisitions. We currently have no agreements or commitments to acquire any company or business. Even though we have completed a number of acquisitions in the past, the most recent of which was in November 2005, we cannot be sure additional acceptable acquisitions will be available or that we will be able to reach mutually agreeable terms to purchase acquisition targets, or that we will be able to profitably manage additional businesses or successfully integrate such additional businesses into the Company without substantial costs, delays or other problems.

Acquisitions may involve a number of special risks including: adverse effects on our reported operating results (including the amortization of acquired intangible assets), diversion of management’s attention and unanticipated problems or legal liabilities. In addition, we may require additional funding to finance future acquisitions. We cannot be sure that we will be able to secure acquisition financing on acceptable terms or at all. We may also use working capital or equity, or raise financing through equity offerings or the incurrence of debt, in connection with the funding of any acquisition. Some or all of these risks could negatively affect our financial condition, results of operations and prospects or could result in dilution to the Company’s shareholders. In addition, to the extent that consolidation becomes more prevalent in the industry, the prices for attractive acquisition candidates could increase substantially. We may not be able to effect any such transactions. Additionally, if we are able to complete such transactions they may prove to be unprofitable.

The geographic expansion of the Company’s customers may result in increased demand for services in certain regions where it currently does not have post production, duplication and distribution facilities. To meet this demand, we may subcontract. However, we have not entered into any formal negotiations or definitive agreements for this purpose. Furthermore, we cannot assure you that we will be able to effect such transactions or that any such transactions will prove to be profitable.
 
9

If we acquire any entities, we may have to finance a large portion of the anticipated purchase price and/or refinance our existing credit agreements. The cost of any new financing may be higher than our existing credit facilities. Future earnings and cash flow may be negatively impacted if any acquired entity does not generate sufficient earnings and cash flow to offset the increased costs.

We are operating in a changing environment that may adversely affect our business. In prior years, we experienced rapid growth, industry consolidation, changing technologies and increased regulation, all of which resulted in new and increased responsibilities for management personnel and placed, and continues to place, increased demands on our management, operational and financial systems and resources. To accommodate these circumstances, compete effectively and manage future growth, we will be required to continue to implement and improve our operational, financial and management information systems, and to expand, train, motivate and manage our work force. We cannot be sure that the Company’s personnel, systems, procedures and controls will be adequate to support our future operations. Any failure to do so could have a material adverse effect on our financial condition, results of operations and prospects.

We may be unable to adapt our business to changing technological requirements. Although we intend to utilize the most efficient and cost-effective technologies available for telecine, high definition formatting, editing, coloration and delivery of audio and video content, including digital satellite transmission, as they develop, we cannot be sure that we will be able to adapt to such standards in a timely fashion or at all. We believe our future growth will depend in part, on our ability to add to these services and to add customers in a timely and cost-effective manner. We cannot be sure we will be successful in offering such services to existing customers or in obtaining new customers for these services. We intend to rely on third party vendors for the development of these technologies and there is no assurance that such vendors will be able to develop such technologies in a manner that meets the needs of the Company and its customers. Additionally, in recent years, electronic delivery services have grown while physical duplication and delivery have been declining. We expect this trend to continue over a long term (i.e. the next 5 to 10 years). All of our electronic, fiber optics, satellite and Internet deliveries are made using third party vendors, which eliminates our need to invest in such capability. However, the use of others to deliver our services poses the risk that costs may rise in certain situations that cannot be passed on to customers, thereby lowering gross margins.

The loss of key personnel would adversely affect our business. The Company is dependent on the efforts and abilities of certain of its senior management, particularly those of Haig S. Bagerdjian, Chairman, President and Chief Executive Officer. The loss or interruption of the services of key members of management could have a material adverse effect on our financial condition, results of operations and prospects if a suitable replacement is not promptly obtained. Mr. Bagerdjian beneficially owns approximately 29% of the Company’s outstanding stock. Although we have severance agreements with Mr. Bagerdjian and certain key executives, we cannot be sure that either Mr. Bagerdjian or other executives will remain with the Company. In addition, our success depends to a significant degree upon the continuing contributions of, and on our ability to attract and retain, qualified management, sales, operations, marketing and technical personnel. The competition for qualified personnel is intense and the loss of any such persons, as well as the failure to recruit additional key personnel in a timely manner, could have a material adverse effect on our financial condition, results of operations and prospects. There is no assurance that we will be able to continue to attract and retain qualified management and other personnel for the development of our business.

We may be unable to meet the demands of our customers. Our business is dependent on our ability to meet the current and future demands of our customers, which demands include reliability, timeliness, quality and price. Any failure to do so, whether or not caused by factors within our control could result in losses to such clients. Although we disclaim any liability for such losses, there is no assurance that claims would not be asserted or that dissatisfied customers would refuse to make further deliveries through the Company in the event of a significant occurrence of lost deliveries, either of which could have a material adverse effect on our financial condition, results of operations and prospects. Although we maintain insurance against business interruption, such insurance may not be adequate to protect the Company from significant loss in these circumstances and there is no assurance that a major catastrophe (such as an earthquake or other natural disaster) would not result in a prolonged interruption of our business. In addition, our ability to make deliveries within the time periods requested by customers depends on a number of factors, some of which are outside of our control, including equipment failure, work stoppages by package delivery vendors or interruption in services by telephone or satellite service providers.

Our quarterly operating results have fluctuated significantly in the past and may fluctuate in the future. Our operating results have varied in the past, and may vary in the future, depending on factors such as the volume of advertising in response to seasonal buying patterns, the timing of new product and service introductions, the timing of revenue recognition upon the completion of longer term projects, increased competition, timing of acquisitions, general economic factors and other factors. As a result, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as an indication of future performance. For example, our operating results have historically been significantly influenced by the volume of business from the motion picture industry, which is an industry that is subject to seasonal and cyclical downturns, and, occasionally, work stoppages by actors, writers and others. In addition, as our business from advertising agencies tends to be seasonal, our operating results may be subject to increased seasonality if the percentage of business from advertising agencies increases. In any period our revenues are subject to variation based on changes in the volume and mix of services performed during the period. It is possible that in some future quarter the Company’s operating results will be below the expectations of equity research analysts and investors. In such event, the price of the Company’s Common Stock would likely be materially adversely affected.
 
10

Our controlling shareholders may cause our company to be operated in a manner that is not in the best interests of other shareholders. The Company’s Chairman, President and Chief Executive Officer, Haig S. Bagerdjian, beneficially owned approximately 29% of the Company’s common stock as of December 31, 2006. The ex-spouse of R. Luke Stefanko, the Company’s former President and Chief Executive Officer, owned approximately 13% of the common stock on that date. In January 2007, Mr. Bagerdjian and Mr. Stefanko entered into an 18-month agreement giving Mr. Bagerdjian Ms. Stefanko’s proxy regarding proposals for change in control (as defined) of the Company. DG FastChannel, Inc., a competitor, owned approximately 15% of the common stock on December 31, 2006. By virtue of their stock ownership, Ms. Stefanko, DG and Mr. Bagerdjian individually or together may be able to significantly influence the outcome of matters required to be submitted to a vote of shareholders, including (i) the election of the board of directors, (ii) amendments to the Company’s Restated Articles of Incorporation and (iii) approval of mergers and other significant corporate transactions. The foregoing may have the effect of discouraging, delaying or preventing certain types of transactions involving an actual or potential change of control of the Company, including transactions in which the holders of common stock might otherwise receive a premium for their shares over current market prices.

Our shareholder rights plan and ability to issue preferred stock may discourage, delay or prevent a change in control of our company that would benefit our shareholders. Our Board of Directors has the authority to issue up to 5,000,000 shares of preferred stock without par value (the “Preferred Stock”) and to determine the price, rights, preferences, privileges and restrictions thereof, including voting rights, without any further vote or action by the Company’s shareholders. On November 17, 2004, the Company declared a dividend distribution of one Preferred Share Purchase Right on each outstanding share of its common stock. The Rights will be attached to the Company’s Common Stock and will trade separately and be exercisable only in the event that a person or group acquires or announces the intent to acquire 20% or more of Point.360’s Common Stock. Each Right will entitle shareholders to buy one one-hundredth of a share of a new series of junior participating preferred stock at an exercise price of $10. If the Company is acquired in a merger or other business combination transaction after a person has acquired 20% or more of the Company’s outstanding Common Stock, each Right will entitle its holder to purchase, at the Right’s then-current exercise price, a number of the acquiring company’s common shares having a market value of twice such price. In addition, if a person or group acquires 20% or more of Point.360’s outstanding Common Stock, each Right will entitle its holder (other than such person or members of such group) to purchase, at the Right’s then-current exercise price, a number of the Company’s common shares having a market value of twice such price. Following an acquisition by a person or group of beneficial ownership of 20% of more of the Company’s Common Stock and before an acquisition of 50% or more of the Common Stock, Point.360’s Board of Directors may exchange the Rights (other than Rights owned by such person or group), in whole or in part, at an exchange ratio of one one-hundredth of a share of the new series of junior participating preferred stock per Right. Before a person or group acquires beneficial ownership of 20% or more of the Company’s Common Stock, the Rights are redeemable for $.0001 per Right at the option of the Board of Directors. The Rights are intended to enable Point.360’s shareholders to realize the long-term value of their investment in the Company. They will not prevent a takeover, but should encourage anyone seeking to acquire the Company to negotiate with the Board prior to attempting a takeover.
 
Although we have no current plans to issue any other shares of Preferred Stock, the rights of the holders of common stock would be subject to, and may be adversely affected by, the rights of the holders of any Preferred Stock that may be issued in the future. Issuance of Preferred Stock could have the effect of discouraging, delaying, or preventing a change in control of the Company. Furthermore, certain provisions of the Company’s Restated Articles of Incorporation and By-Laws and of California law also could have the effect of discouraging, delaying or preventing a change in control of the Company.
 
ITEM 1B. UNRESOLVED STAFF COMMENTS

Not applicable
 
11
 
ITEM 2. PROPERTIES
 
The Company currently leases 11 facilities which all have production capabilities and/or sales activities. The terms of leases for leased facilities expire at various dates from 2008 to 2021. The following table sets forth the location and approximate square footage of the Company's properties as of December 31, 2006:

 
Square Footage
Hollywood, CA.
31,000
Hollywood, CA.
13,400
Hollywood, CA.
13,000
Burbank, CA.
32,000
Burbank, CA.
45,500
Los Angeles, CA.
64,600
Los Angeles, CA.
13,400
San Francisco, CA.
9,500
Chicago, IL.
13,200
New York, NY.
9,000
Dallas, TX.
11,300
 
ITEM 3. LEGAL PROCEEDINGS
 
From time to time, the Company may become a party to various legal actions and complaints arising in the ordinary course of business, although it is not currently involved in any such material legal proceedings.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
No matters were submitted to the Company’s shareholders for a vote during the fourth quarter of the fiscal year covered by this report.
 
12
 
PART II

ITEM 5.
MARKET FOR THE COMPANY'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
 
Market Information
 
The Company's Common Stock is traded on the Nasdaq National Market ("NNM") under the symbol PTSX. The following table sets forth, for the periods indicated, the high and low closing price per share for the Common Stock.

   
Common Stock
  
   
Low
  
High
  
Year Ended December 31, 2005
          
First Quarter
 
$
3.21
  
$
3.95
  
Second Quarter
    
2.76
    
3.50
  
Third Quarter
    
2.21
    
3.21
  
Fourth Quarter
    
1.65
    
2.25
  
Year Ended December 31, 2006
              
First Quarter
 
$
1.85
  
$
2.70
  
Second Quarter
    
1.98
    
2.70
  
Third Quarter
    
1.74
    
2.40
  
Fourth Quarter
    
1.64
    
3.59
  

On February 14, 2007, the closing sale price of the Common Stock as reported on the NNM was $3.36 per share. On that date, there were approximately 1,000 holders of record of the Common Stock.

Dividends
 
The Company did not pay dividends on its Common Stock during the years ended December 31, 2005 or 2006. The Company’s ability to pay dividends depends upon limitations under applicable law and covenants under its bank agreements. The Company currently does not intend to pay any dividends on its Common Stock in the foreseeable future. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources."

Stock Repurchases

The Company did not repurchase any shares of its Common Stock during the year ended December 31, 2006.
 
13
 
ITEM 6. SELECTED FINANCIAL DATA
 
The following data, insofar as they relate to each of the years 2002 to 2006, have been derived from the Company’s annual financial statements. This information should be read in conjunction with the Financial Statements and Notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere herein. All amounts are shown in thousands, except per share data.
 
   
Year Ended December 31,
  
   
2002
  
2003
  
2004
  
2005
  
2006
  
Statement of Income Data
                      
Revenues
  
$
68,419
  
$
64,900
  
$
63,344
  
$
66,199
  
$
64,218
  
Cost of services sold
    
(42,172
)
  
(39,670
)
  
(40,519
)
  
(43,167
)
  
(43,071
)
Gross profit
    
26,247
    
25,230
    
22,825
    
23,032
    
21,147
  
Selling, general and administrative expense
    
(18,977
)
  
(17,479
)
  
(18,936
)
  
(21,424
)
  
(20,037
)
Write-off of deferred acquisition and financing costs
   
-
    
(1,043
)
  
(1,050
)
  
-
    
-
  
Operating income  
    
7,270
    
6,708
    
2,839
    
1,608
    
1,110
  
Interest expense, net
    
(2,528
)
  
(2,056
)
  
(811
)
  
(1,524
)
  
(846
)
Derivative fair value change (2)
    
82
    
611
    
-
    
-
    
-
  
Provision for income tax  
    
(2,007
)
  
(2,114
)
  
(781
)
  
(70
)
  
(188
)
Net income
 
$
2,817
  
$
3,149
  
$
1,247
  
$
14
  
$
76
  
Earnings per share:
                                
Basic
  
$
0.31
  
$
0.35
  
$
0.14
  
$
0.00
  
$
0.01
  
Diluted
  
$
0.30
  
$
0.33
  
$
0.13
  
$
0.00
  
$
0.01
  
Weighted average common shares outstanding:
                                
Basic
    
9,013
    
9,067
    
9,197
    
9,347
    
9,511
  
Diluted
    
9,377
    
9,555
    
9,671
    
9,714
    
9,615
  

   
Year Ended December 31,
  
   
2002
  
2003
  
2004
  
2005
  
2006
  
Other Data
          
(3)
      
(4)
  
EBITDA(1)
  
$
12,690
  
$
12,818
  
$
8,715
  
$
7,659
  
$
6,650
  
Cash flows provided by operating activities
    
10,381
    
10,480
    
6,814
    
6,407
   
2,362
 
Cash flows used in investing activities
    
(3,485
)
  
(1,599
)
  
(8,426
)
  
(4,412
)
  
10,908
 
Cash flows provided by (used in) financing activities
    
(5,282
)
  
(7,047
)
  
(4,926
)
  
(2,068
)
  
(14,127
)
Capital expenditures
    
1,949
    
1,237
    
5,307
    
2,202
    
2,635
  
Selected Balance Sheet Data
                                
Cash and cash equivalents
  
$
5,372
  
$
7,206
  
$
668
  
$
595
  
$
-
  
Working capital
   
8,185
    
3,663
    
(119
)
  
1,275
    
3,721
  
Property and equipment, net
    
19,965
    
15,751
    
31,451
    
28,079
    
14,138
  
Total assets
    
70,080
    
64,744
    
76,647
    
75,459
    
62,956
  
Borrowings under revolving credit agreements
    
-
    
-
    
4,323
    
4,054
    
3,007
  
Current portion of notes payable
    
-
    
-
    
2,849
    
2,310
    
1,174
  
Long-term debt, net of current portion
    
18,065
    
6,762
    
14,494
    
13,744
    
3,474
  
Shareholders' equity 
    
34,512
    
37,368
    
38,944
    
39,510
    
40,021
  

(1)
EBITDA is defined herein as earnings before interest, taxes, depreciation and amortization. Interest, taxes, depreciation and amortization are annual recurring costs for the Company. EBITDA represents a performance measure before deducting interest which can vary depending upon debt levels, taxes which can affect net income depending upon effective tax rates from year to year, and depreciation and amortization expenses which do not require a cash outlay. Management uses EBITDA (i) to measure the Company’s performance as compared to its competitors which also disclose EBITDA, (ii) as the principle performance criteria for banks and financial institutions as the basis for covenant compliance calculations, and (iii) to compare performance among the Company’s facilities. EBITDA is also a common performance measurement used to determine the possible contributions to earnings of acquisition candidates. EBITDA is not a performance measure in accordance with Generally Accepted Accounting Principles (“GAAP”) and is not to be considered as an alternative to net income or any other GAAP measurements as a measure of operating performance. The Company’s determination of EBITDA may not be comparable to other similarly titled measures of other companies. Using EBITDA as a performance measure may lead to erroneous conclusions as to the Company’s net income, the most directly comparable GAAP measure. A reader of the financial statements should concentrate on computation net income shown in accordance with GAAP, while using the EBITDA reconciliation to net income shown below as supplemental disclosure.

14

Computation of EBITDA (in thousands):

   
2002
  
2003
  
2004
  
2005
  
2006
  
Net income (loss)  
  
$
2,817
  
$
3,149
  
$
1,247
  
$
14
  
$
76
  
Add back:
                                
Interest 
    
2,528
    
2,056
    
811
    
1,524
    
846
  
Income taxes 
    
2,007
    
2,114
    
781
    
70
    
188
  
Depreciation & Amortization 
    
5,338
    
5,499
    
5,876
    
6,051
    
5,540
  
EBITDA 
  
$
12,690
  
$
12,818
  
$
8,715
  
$
7,659
  
$
6,650
  

(2)
In November 2000, the Company entered into an interest rate swap contract to economically hedge its floating debt rate. Under the terms of the contract, the notional amount is $15,000,000, whereby the Company received LIBOR and paid a fixed 6.50% rate of interest for three years. Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (“FAS 133”), required that the interest rate swap contract be recorded at fair value upon adoption of FAS 133 by recording (i) a cumulative-effect type adjustment at January 1, 2001 equal to the fair value of the interest rate swap contract on that date, (ii) amortizing the cumulative-effect type adjustment over the life of the derivative contract, and (iii) a charge or credit to income in the amount of the difference between the fair value of the interest rate swap contract at the beginning and end of such year. The effect of adopting FAS 133 was to record a cumulative effect type adjustment by charging Accumulated Other Comprehensive Income (a component of shareholders’ equity $247,000 (net of $62,000 tax benefit), crediting Derivative Valuation Liability by $309,000 gross cumulative effect adjustment and charging Deferred Income Taxes $62,000. The change in the derivative fair value during the year ($186,000 and $701,000 in 2002 and 2003, respectively) and the amortization of the cumulative effect adjustment (($104,000) and ($90,000) in 2002 and 2003 respectively) were recorded as a charge to Derivative Fair Value Change.

(3)
On July 1, 2004, the Company acquired International Video Conversions, Inc. See Note 3 of the Notes to Consolidated Financial Statements in this Form 10-K.

(4)
On March 29, 2006, the Company sold and leased back its Media Center facility. Proceeds were used to repay debt. See Notes 4 and 5 of Notes to Consolidated Financial Statements.
 
15
 
ITEM 7.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
Except for the historical information contained herein, certain statements in this annual report are "forward-looking statements" as defined in the Private Securities Litigation Reform Act of 1995, which involve certain risks and uncertainties, which could cause actual results to differ materially from those discussed herein, including but not limited to competition, customer and industry concentration, depending on technological developments, risks related to expansion, dependence on key personnel, fluctuating results and seasonality and control by management. See the relevant portions of the Company's documents filed with the Securities and Exchange Commission and Risk Factors in Item 1A of this Form 10-K, for a further discussion of these and other risks and uncertainties applicable to the Company's business.
 
Overview
 
We are one of the largest providers of video and film asset management services to owners, producers and distributors of entertainment and advertising content. We provide the services necessary to edit, master, reformat, archive and ultimately distribute our clients’ film and video content, including television programming, spot advertising, feature films and movie trailers using electronic and physical means. We deliver commercials, movie trailers, electronic press kits, infomercials and syndicated programming to hundreds of broadcast outlets worldwide. Our interconnected facilities in Los Angeles, New York, Chicago, Dallas and San Francisco provide service coverage in each of the major U.S. media centers. Clients include major motion picture studios, advertising agencies and corporations.
 
We operate in a highly competitive environment in which customers desire a broad range of service at a reasonable price. There are many competitors offering some or all of the services provided by the Company. Additionally, some of our customers are large studios, which also have in-house capabilities that may influence the amount for the foreseeable future like Point.360. We attract and retain customers by maintaining a high service level at reasonable prices.
 
In recent years, electronic delivery services have grown while physical duplication and delivery have been declining. We expect this trend to continue for the foreseeable future. All of our electronic, fiber optics, satellite and Internet deliveries are made using third party vendors, which eliminates our need to invest in such capability. However, the use of others to deliver our services poses the risk that costs may rise in certain situations that cannot be passed on to customers, thereby lowering gross margins. There is also the risk that third party vendors who directly compete with us will succeed in taking away business or refuse to allow us to use their distribution channels. In fact, in June 2005, one such vendor/competitor notified us that its electronic distribution channel would not be available to us except in very limited circumstances, or unless we entered certain “preferred vendor” arrangements that we believed would not be in the best long-term interests of Point.360. While curtailment of these services has not materially affected our ability to deliver commercial spots, we have not been able to pass on increased alternative delivery costs to our customers since June 2005. While we are exploring other lower cost alternatives, gross margins related to spot delivery revenues will be lower until such alternatives become available.
 
The Company has an opportunity to expand its business by establishing closer relationships with our customers through excellent service at a competitive price and maintaining adequate third party distribution channels. Our success is also dependent on attracting and maintaining employees capable of maintaining such relationships. Also, growth can be achieved by acquiring similar businesses (for example, the acquisition of International Video Conversions, Inc. (“IVC”) in July 2004) which can increase revenues by adding new customers, or expanding services provided to existing customers.
 
Our business generally involves the immediate servicing needs of our customers. Most orders are fulfilled within several days, with occasional larger orders spanning weeks or months. At any particular time, we have little firm backlog.
 
We believe that our nationwide interconnected facilities provide the ability to better service national customers than single-location competitors. We will look to expand both our service offering and geographical presence through acquisition of other businesses or opening additional facilities.
 
During 2004, we completed the acquisition of IVC and settled all disputes related to a proposed acquisition of three subsidiaries of Alliance Atlantis Communications, Inc. (“Alliance”). In 2006, we completed a sale/leaseback transaction of our Media Center facility.

The following table sets forth the amount and percentage relationship to revenues of certain items included within the Company's Consolidated Statement of Income for the years ended December 31, 2004, 2005 and 2006. The commentary below is based on these financial statements (in thousands).
 
16

   
Year Ended December 31    
  
   
2004
  
2005
  
2006
  
   
 
Amount
  
Percent of
Revenues
  
 
Amount
  
Percent of
Revenues
  
 
Amount
  
Percent of
Revenues
  
                           
Revenues
  
$
63,344
    
100.0
%
$
66,199
    
100.0
%
$
64,218
    
100.0
%
Costs of services sold
    
(40,519
)
  
(64.0
)
  
(43,167
)
  
(65.2
)
  
(43,071
)
  
(67.1
)
Gross profit
    
22,825
    
36.0
    
23,032
    
34.8
    
21,147
    
32.9
  
Selling, general and administrative expense
    
(18,936
)
  
(29.9
)
  
(21,424
)
  
(32.4
)
  
(20,038
)
  
(31.2
)
Write-off of deferred acquisition and financing costs
    
(1,050
)
  
(1.6
)
  
-
    
-
    
-
    
-
  
Operating income
    
2,839
    
4.5
    
1,608
    
2.4
    
1,110
   
1.7
 
Interest expense, net
    
(811
)
  
(1.3
)
  
(1,524
)
  
(2.3
)
  
(846
)
  
(1.3
)
(Provision for) benefit from income taxes
    
(781
)
  
(1.2
)
  
(70
)
  
(0.1
)
  
(188
)
  
(0.3
)
Net income (loss)
  
$
1,247
    
2.0
%
$
14
    
0.0
%
$
76
    
0.1
%
 
Year Ended December 31, 2006 Compared To Year Ended December 31, 2005.
 
Revenues. Revenues were $64.2 million for the year ended December 31, 2006, compared to $66.2 million for the year ended December 31, 2005. Revenues declined in 2006 due to a number of factors including: (i) price compression due to competition in post production and spot advertising distribution, (ii) consolidation among some customers that has resulted in less business being available to Point.360, and (iii) the continuing trend toward electronic distribution of commercial spots as opposed to physical duplication and distribution which results in lower revenues. Revenue from freight, the charge to customers for sending commercial spots physically, declined to about 4.5% of sales in 2006 from 5.0% in the prior year. These factors have been somewhat offset by acquiring new customers and adding new service offerings. We expect the negative trends to continue at a slower pace in the future, and we will continue to invest in high definition capabilities where demand is expected to grow. We believe our high definition service platform will attract additional business in the future.
 
Gross Profit. In 2006, gross margin was 33% of sales, compared to 35% for last year. The sale/leaseback penalized gross margin by 1% of sales (i.e., lease costs increased $0.6 million in the 2006 period net of depreciation associated with the previously-owned facility). The impact of the sale/leaseback will be continuing. The remaining decrease in gross profit percentage is due to lower sales offset by declining wages and benefits. Gross margins have been historically higher as a percentage of sales for advertising related revenue as compared to post production, the latter requiring a greater investment in equipment (greater depreciation) and higher personnel costs when compared to duplication and distribution of advertising content. We expect gross margins to fluctuate in the future as the sales mix changes.
 
Selling, General and Administrative Expense. SG&A expense was $20.0 million (31% of sales) in 2006 as compared to $21.4 million (32% of sales) in 2005.
 
Operating Income. Operating income decreased $0.5 million to $1.1 million in 2006, compared to $1.6 million in 2005.
 
Interest Expense. Interest expense for 2006 was $0.9 million, a decrease of $0.7 million from 2005. The decrease was due to lower debt levels resulting from the sale/leaseback transaction offset partially by higher rates on remaining variable interest debt.
 
Net Income. Net income for 2006 was $0.1 million compared to $0.0 million in 2006.
 
Year Ended December 31, 2005 Compared To Year Ended December 31, 2004.
 
Revenues. Revenues increased $2.9 million to $66.2 million for the year ended December 31, 2005, compared to $63.3 million in 2004. A $5.8 million increase is due to the inclusion of IVC for the entire fiscal year as opposed to six months in 2004 (IVC was acquired on July 1, 2004). Without IVC sales for the first six months of 2005, twelve month 2005 sales declined $2.9 million to $60.4 million as compared to 2004. The decline is due to lower spot advertising revenues as customer’s switched to electronic from physical distribution. Revenues for physical distribution of tapes containing commercial spot advertising include tape stock and freight. Revenue from freight, the charge to customers for sending commercial spots physically, declined to about 5.0% of sales in 2005 from 5.6% in the prior year. In electronic distribution, sales consist of only the electronic fee for distributing the advertisement.
 
Gross Profit. In 2005, gross profit decreased by 1.2% of sales. Gross profit on sales was 35% in 2005 compared to 36% in 2004, the decline being due principally to higher wages and benefits and delivery costs.
 
Selling, General And Administrative Expense.  SG&A expense increased $1.4 million, or 7%, to $21.4 million in 2005, compared to $20.0 million in 2004 due principally to higher selling costs. As a percentage of revenues, SG&A was 32% for 2005 and 2004.
 
17
 
In 2004, the Company wrote off approximately $1.1 million of deferred acquisition and financing and settlement costs related to the termination of the potential acquisition of three subsidiaries of Alliance. This expense has been set forth separately.
 
Operating Income. Operating income decreased $1.2 million to $1.6 million, compared to $2.8 million in 2004.
 
Interest Expense.  Interest expense for 2005 was $1.5 million compared to $0.8 million in 2004. The 2005 amount included a $0.2 million write-off of deferred financing costs associated with a terminated term loan. The remainder of the increase in 2005 resulted in generally increasing interest rates on the Company’s variable rate debt and increased outstanding borrowings and a mortgage for all of 2005 due to the purchase of IVC in July 2004 and our Media Center land and building in August 2004, respectively.
 
Income Taxes. The Company’s effective tax rate was 83% for 2005 and 39% for 2004. The increase in effective tax rate is the result of the Company’s periodic assessment of the relationship of book/tax timing differences to total expected annual pre-tax results and the elimination of goodwill expense for financial statement purposes. The effective tax rate percentage may change from period to period depending on the difference in the timing of the recognition of revenues and expenses for book and tax purposes. The high effective rate for 2005 resulted from the relatively low amount of pre-tax income when compared to such differences.
 
Net Income. The net income for 2005 was $0.0 million, a decrease of $1.2 million compared to net income of $1.2 million for 2004.
 
LIQUIDITY AND CAPITAL RESOURCES
 
This discussion should be read in conjunction with the notes to the financial statements and the corresponding information more fully described elsewhere in this Form 10-K.
 
On December 30, 2006, the Company entered a new $10 million term loan agreement. The term loan provides for interest at LIBOR (5.37% at December 31, 2006) plus 3.15%, or 8.52% at December 31, 2006, and is secured by the Company’s equipment. The term loan was to be repaid in 60 equal principal payments plus interest. Proceeds of the loans were used to pay off our previously existing term loan.
 
In March 2006, the Company entered into a new credit agreement which provides up to $10 million of revolving credit based on 80% of acceptable accounts receivables, as defined. The two-year agreement provides for interest of LIBOR plus 1.85% for the first six months of the agreement, and thereafter either (i) prime (8.25% at December 31, 2006) minus 0% - 1.00% or (ii) LIBOR plus 1.50% - 2.50% depending on the level of the Company’s ratio of outstanding debt to fixed charges (as defined), or 7.25% or 7.07%, respectively, at December 31, 2006. The facility is secured by all of the Company’s assets, except for equipment securing a new term loan as described above.
 
In March 2006, the Company entered into a sale and leaseback transaction with respect to its Media Center vaulting real estate. The real estate was sold for $13,946,000 resulting in a $1.2 million after tax gain. Additionally, we received $500,000 from the purchaser for improvements. In accordance with SFAS No.28. “Accounting for Sales with Leasebacks” (“SFAS28”), the gain and the improvement allowance will be amortized over the initial 15-year lease term as reduced rent. Net proceeds at the closing of the sale and the improvement advance (approximately $13.9 million) were used to pay off the mortgage and other outstanding debt. In accordance with our agreement with the revolving credit lender, we prepaid $4 million of the term loan. As a result of the prepayment, monthly principal payments on the term loan were reduced by approximately $70,000 per month (840,000 per year).
 
The following table summarizes the December 31, 2006 status of our revolving line of credit and term loans:

Revolving credit
 
$
3,006,000
  
Current portion of term loan
   
1,174,000
  
Long-term portion of term loan
   
3,474,000
  
Total
 
$
7,654,000
  
 
Monthly and annual principal and interest payments due under the term debt are approximately $94,000 and $1.1 million, respectively, assuming no change in interest rates, down from $260,000 and $3,100,000, respectively, from the term loan in existence in 2005. Simultaneously, monthly and annual cash lease costs have increased by $93,000 and $1,111,000, respectively.

Cash generated by operating activities is directly dependent upon sales levels and gross margins achieved. We generally receive payments from customers in 50-90 days after services are performed. The larger payroll and freight components of cost of sales must be paid currently and within 30 days, respectively. Payment terms of other liabilities vary by vendor and type. Income taxes must be paid quarterly. Fluctuations in sales levels will generally affect cash flow negatively or positively in early periods of growth or contraction, respectively, because of operating cash receipt/payment timing. Other investing and financing cash flows also affect cash availability.
 
18

The bank revolving credit agreement requires us to maintain a minimum “quick ratio” and a minimum “fixed charge coverage ratio.” Our quick ratio (current assets less current liabilities) was 1.13 as of December 31, 2006 as compared to a minimum requirement of 0.70 (increasing to .80 on March 31, 2007). Our fixed charge coverage ratio compares, on a rolling twelve-month basis, EBITDA plus rent expense and non-cash charges less income tax payments, to (ii) interest expense plus rent expense, the current portion of long term debt and maintenance capital expenditures. As of December 31, 2006, the fixed charge coverage ratio was 1.55 as compared to a minimum requirement of 1.10. If we fail to meet minimum covenant levels, amounts outstanding under the credit agreement and, by cross default provisions, the term loan will become due and payable.

We expect that remaining amounts available under the revolving credit arrangement (approximately $9,100,000 at December 31, 2006), the availability of bank or institutional credit from new sources and cash generated from operations will be sufficient to fund debt service, operating needs and about $2.5 - 3.5 million of capital expenditures for the next twelve months.

The acquisition of IVC was completed in July 2004 for $2.3 million in cash and $4.7 million in borrowings. The IVC purchase agreement also required payments of $1 million, $2 million and $2 million in 2005, 2006 and 2007, respectively, if certain predetermined earnings levels (as defined) are met. In April 2005, $1 million was paid. $2 million was paid in 2006. $2 million will be paid in 2007.

The following table summarizes contractual obligations as of December 31, 2006 due in the future:

   
Payment due by Period
  
 
Contractual Obligations
  
 
Total
  
 
Less than 1 Year
  
Years
2 and 3
  
Years
4 and 5
  
 
Thereafter
  
Long Term Debt Obligations
  
$
4,632,000
  
$
1,158,000
  
$
2,316,000
  
$
1,158,000
  
$
-
  
Capital Lease Obligations
    
16,000
    
16,000
    
-
    
-
    
-
 
Operating Lease Obligations
    
31,870,000
    
5,054,000
    
8,177,000
    
5,298,000
    
13,341,000
  
Total
  
$
36,518,000
  
$
6,228,000
  
$
10,493,000
  
$
6,456,000
  
$
13,341,000
  
 
During the past year, the Company has generated sufficient cash to meet operating, capital expenditure and debt service needs and obligations, as well as to provide sufficient cash reserves to address contingencies. When preparing estimates of future cash flows, we consider historical performance, technological changes, market factors, industry trends and other criteria. In our opinion, the Company will continue to be able to fund its needs for the foreseeable future.
 
We will continue to consider the acquisition of businesses complementary to its current operations. Consummation of any such acquisition or other expansion of the business conducted by the Company may be subject to the Company securing additional financing, perhaps at a cost higher than our existing term loans. Future earnings and cash flow may be negatively impacted to the extent that any acquired entities do not generate sufficient earnings and cash flow to offset the increased financing costs.
 
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
 
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates and judgments, including those related to allowance for doubtful accounts, valuation of long-lived assets, and accounting for income taxes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions and conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.
 
Critical accounting policies are those that are important to the portrayal of the Company’s financial condition and results, and which require management to make difficult, subjective and/or complex judgments. Critical accounting policies cover accounting matters that are inherently uncertain because the future resolution of such matters is unknown. We have made critical estimates in the following areas:
 
Revenues. We perform a multitude of services for our clients, including film-to-tape transfer, video and audio editing, standards conversions, adding effects, duplication, distribution, etc. A customer orders one or more of these services with respect to an element (commercial spot, movie, trailer, electronic press kit, etc.) The sum total of services performed on a particular element (a “package”) becomes the deliverable (i.e., the customer will pay for the services ordered in total when the entire job is completed). Occasionally, a major studio will request that package services be performed on multiple elements. Each element creates a separate revenue stream which is recognized only when all requested services have been performed on that element.
 
19
 
Allowance for doubtful accounts. We are required to make judgments, based on historical experience and future expectations, as to the collectibility of accounts receivable. The allowances for doubtful accounts and sales returns represent allowances for customer trade accounts receivable that are estimated to be partially or entirely uncollectible. These allowances are used to reduce gross trade receivables to their net realizable value. The Company records these allowances as a charge to selling, general and administrative expenses based on estimates related to the following factors: i) customer specific allowance; ii) amounts based upon an aging schedule and iii) an estimated amount, based on the Company’s historical experience, for issues not yet identified.
 
Valuation of long-lived and intangible assets. Long-lived assets, consisting primarily of property, plant and equipment and intangibles (consisting only of goodwill), comprise a significant portion of the Company’s total assets. Long-lived assets, including goodwill are reviewed for impairment whenever events or changes in circumstances have indicated that their carrying amounts may be recoverable. Recoverability of assets is measured by comparing the carrying amount of an asset to its fair value in a current transaction between willing parties, other than in a forced liquidation sale. Fair value was estimated by independent appraisals and other valuation techniques.
 
Factors we consider important which could trigger an impairment review include the following:
 
 
·
Significant underperformance relative to expected historical or projected future operating results;
 
 
·
Significant changes in the manner of our use of the acquired assets or the strategy of our overall business;
 
 
·
Significant negative industry or economic trends
 
 
·
Significant decline in our stock price for a sustained period; and
 
 
·
Our market capitalization relative to net book value.
 
When we determine that the carrying value of intangibles, long-lived assets and related goodwill and enterprise level goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure any impairment based on comparing the carrying amount of the asset to its fair value in a current transaction between willing parties or, in the absence of such measurement, on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model. Any amount of impairment so determined would be written off as a charge to the income statement, together with an equal reduction of the related asset. Net intangible assets, long-lived assets and goodwill amounted to approximately $45.6 million as of December 31, 2006.
 
In 2002, Statement of Financial Accounting Standards (“SFAS”) No.142, “Goodwill and Other Intangible Assets” (“SFAS 142”) became effective and as a result, we ceased to amortize approximately $26.3 million of goodwill in 2002 and an annual impairment review thereafter. The initial test on January 1, 2002 and the Fiscal 2002 to 2006 tests performed as of September 30 of each year required no goodwill impairment. In the 2006 test performed as of September 30, 2006, we determined the fair value of the enterprise using independent appraisals and other valuation techniques. If future appraisals or future performances are affected by the factors cited above, resulting potential impairment could adversely affect the reported goodwill asset value and earnings.
 
Accounting for income taxes. As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves us estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense within the tax provision in the statement of operations.
 
Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. The net deferred tax liability as of December 31, 2006 was $5.2 million. The Company did not record a valuation allowance against its deferred tax assets as of December 31, 2006.
 
20
 
RECENT ACCOUNTING PRONOUNCEMENTS
 
In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS 155”), which amends SFAS No. 133, “Accounting for Derivatives Instruments and Hedging Activities” (SFAS 133”) and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities” (SFAS 140”). SFAS 155 amends SFAS 133 to narrow the scope exception for interest-only and principal-only strips on debt instruments to include only such strips representing rights to receive a specified portion of the contractual interest or principle cash flows. SFAS 155 also amends SFAS 140 to allow qualifying special-purpose entities to hold a passive derivative financial instrument pertaining to beneficial interests that it is derivative instrument. The Company is currently evaluating the impact this new Standard, but believes that it will not have a material impact on the Company’s financial position, results of operations or cash flows.
 
In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets - an amendment of FASB Statement No. 140”. The provisions of SFAS 156 are effective for fiscal years beginning after September 15, 2006. This statement was issued to simplify the accounting for servicing rights and to reduce the volatility that results from using different measurement attributes. The Company is currently assessing the impact that the adoption of SFAS 156 will have on its results of operations and financial position.
 
In July 2006, the FASB released FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting and reporting for uncertainties in income tax law. This interpretation prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. This statement is effective for fiscal years beginning after December 15, 2006. If there are changes in net assets as a result of application of FIN 48, these will be accounted for as an adjustment to retained earnings. The Company expects to adopt FIN 48 in the first quarter of 2007 and is currently assessing the impact of FIN 48 on its consolidated financial position and results of operations.
 
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurement.” SFAS 157 establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company is required to adopt the provision of SFAS 157, as applicable, beginning in fiscal year 2008. Management does not believe the adoption of SFAS 157 will have a material impact on the Company’s financial position or results of operations.
 
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
Market Risk. The Company had borrowings of $7.6 million at December 31, 2006 under term loan and revolving credit agreements. All debt was subject to a variable interest rate. The weighted average interest rate paid during 2006 was 7.8%. For variable rate debt outstanding at December 31, 2006, a .25% increase in interest rates will increase annual interest expense by approximately $19,000. Amounts outstanding under the revolving credit facility provide for interest at the banks’ prime rate minus 0%-1.00% assuming the same amount of outstanding debt or LIBOR plus 1.5% to 2.5% and LIBOR plus 3.15% for the term loan. The Company’s market risk exposure with respect to financial instruments is to changes in prime or LIBOR rates.
 
21
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 
Page
   
Report of Independent Registered Public Accounting Firm
21
   
Financial Statements:
  
   
Consolidated Balance Sheets -
  
December 31, 2005 and 2006
22
   
Consolidated Statements of Income -
  
Fiscal Years Ended December 31, 2004, 2005 and 2006
23
   
Consolidated Statements of Shareholders’ Equity -
  
Fiscal Years Ended December 31, 2004, 2005 and 2006
24
   
Consolidated Statements of Cash Flows -
  
Fiscal Years Ended December 31, 2004, 2005 and 2006
25
   
Notes to Consolidated Financial Statements
26
   
Financial Statement Schedule:
  
   
Schedule II - Valuation and Qualifying Accounts
41
   
Consent of Independent Registered Public Accounting Firm
47

Schedules other than those listed above have been omitted since they are either not required, are not applicable or the required information is shown in the financial statements or the related notes.
 
22

Report of Independent Registered Public Accounting Firm
 
To the Board of Directors and
Shareholders of Point.360
Burbank, California
 
We have audited the accompanying consolidated balance sheets of Point.360 and subsidiary (collectively, the “Company”) as of December 31, 2006 and 2005, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit.

We conducted our audits in accordance with auditing standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provided a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Point.360 and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America.
 
Singer Lewak Greenbaum & Goldstein LLP (signed)
Los Angeles, California
February 28, 2007

23
 
Point.360
Consolidated Balance Sheets

   
 December 31,
  
   
 2005
  
 2006
  
Assets
          
Current assets:
          
Cash and cash equivalents
 
$
595,000
  
$
-
  
Accounts receivable, net of allowances for doubtful accounts of $563,000 and $783,000,
             
respectively
   
12,662,000
    
14,786,000
  
Inventories, net
    
796,000
    
750,000
  
Prepaid expenses and other current assets
   
2,432,000
    
570,000
  
Deferred income taxes
   
828,000
    
683,000
 
Total current assets
   
17,313,000
    
16,789,000
  
               
Property and equipment, net (Note 4)
   
28,079,000
    
14,138,000
  
Other assets, net
   
593,000
    
555,000
  
Goodwill (Note 3)
    
29,474,000
    
31,474,000
 
Total assets
 
$
75,459,000
  
$
62,956,000
  
               
Liabilities and Shareholders’ Equity
              
Current liabilities:
              
Accounts payable
 
$
3,986,000
  
$
4,259,000
  
Accrued wages and benefits
    
1,711,000
    
1,861,000
  
Accrued earn-out payments
    
2,000,000
    
2,000,000
  
Other accrued expenses
    
683,000
    
466,000
 
Income tax payable
    
1,231,000
    
123,000
  
Borrowings under revolving credit agreement (Notes 6)
   
4,054,000
    
3,007,000
  
Current portion of borrowings under notes payable
    
2,310,000
    
1,158,000
  
Current portion of capital lease obligations (Note 6)
    
63,000
    
16,000
 
Current portion of deferred gain on sale of real estate
    
-
    
178,000
  
               
Total current liabilities
   
16,038,000
    
13,068,000
  
               
Deferred income taxes
   
6,121,000
    
4,030,000
  
Notes payable, less current portion (Note 6)
   
13,744,000
    
3,474,000
  
Capital lease and other obligations, less current portion (Note 6)
   
46,000
    
-
  
Deferred gain on sale of real estate, less current portion
   
-
    
2,363,000
  
               
Total long-term liabilities
    
19,911,000
    
9,867,000
  
               
Total liabilities
    
35,949,000
    
22,935,000
  
               
Commitments and contingencies (Note 8)
    
-
    
-
  
               
Shareholders’ equity
             
Preferred stock - no par value; 5,000,000 shares authorized; none outstanding
    
-
    
-
  
Common stock - no par value; 50,000,000 shares authorized; 9,368,857 and 9,749,582
              
shares issued and outstanding, respectively
   
17,971,000
    
18,488,000
  
Additional paid-in capital 
    
1,159,000
    
1,077,000
  
Retained earnings
   
20,380,000
    
20,456,000
  
Total shareholders’ equity
    
39,510,000
    
40,021,000
  
               
Total liabilities and shareholders’ equity
  
$
75,459,000
  
$
62,956,000
  

The accompanying notes are an integral part of these consolidated financial statements.
 
24

Point.360
Consolidated Statements of Income

   
Year Ended December 31,
  
   
2004
  
2005
  
2006
  
Revenues
  
$
63,344,000
  
$
66,199,000
  
$
64,218,000
  
Cost of services sold
   
(40,519,000
)
  
(43,167,000
)
  
(43,071,000
)
                     
Gross profit
   
22,825,000
    
23,032,000
    
21,147,000
  
                     
Selling, general and administrative expense
   
(18,936,000
)
  
(21,424,000
)
  
(20,037,000
)
Write-off of deferred acquisition and financing costs (Note 3)
    
(1,050,000
)
  
-
    
-
 
                     
Operating income
   
2,839,000
    
1,608,000
    
1,110,000
  
Interest expense (net)
    
(811,000
)
  
(1,524,000
)
  
(846,000
)
                     
Income before income taxes
    
2,028,000
    
84,000
    
264,000
  
Provision for income taxes
   
(781,000
)
  
(70,000
)
  
(188,000
)
                     
Net income
 
$
1,247,000
  
$
14,000
  
$
76,000
  
                     
Earnings per share:
                    
Basic:
                    
Net income
  
$
0.14
  
$
0.00
  
$
0.01
  
Weighted average number of shares
    
9,196,620
    
9,346,533
    
9,511,006
  
Diluted:
                    
Net income
  
$
0.13
  
$
0.00
  
$
0.01
  
Weighted average number of shares including the dilutive effect of
                    
stock options
    
9,671,395
    
9,713,811
    
9,615,431
  
 
The accompanying notes are an integral part of these consolidated financial statements.

25
 
Point.360
Consolidated Statements of Shareholders’ Equity
(in thousands except for share amounts)

           
Additional
Paid-in
  
Retained
  
Share-holders
  
   
Shares
  
Amount
  
Capital
  
Earnings
  
 Equity
  
                       
Balance on December 31, 2003
    
9,134,559
 
$
17,625
  
$
624
  
$
19,119
  
$
37,368
  
                                 
Net income
    
-
    
-
    
-
    
1,247
    
1,247
  
Shares issued in connection with
exercise of stock options
    
101,573
    
278
    
-
    
-
    
278
  
Tax effect of options exercised
    
-
    
-
    
51
    
-
    
51
  
Balance on December 31, 2004
    
9,236,132
   
17,903
    
675
    
20,366
    
38,944
  
                                 
Net income
    
-
    
-
    
-
    
14
    
14
  
Shares issued in connection with
purchase of equipment (Note 3)
    
105,000
    
-
    
484
    
-
    
484
  
Shares issued in connection with
exercise of stock options
    
27,725
    
68
    
-
    
-
    
68
  
Balance on December 31, 2005
    
9,368,857
    
17,971
    
1,159
    
20,380
    
39,510
  
                                 
Net income
    
-
    
-
    
-
    
76
   
76
  
Shares issued in connection with
                               
exercise of stock options
    
380,725
    
517
    
-
    
-
    
517
  
Incentive - based option expense    
-
    
-
    
140
    
-
    
140
  
Cash paid in conjunction with
acquisition
    
-
    
-
    
(222
)
  
-
    
(222
)
Balance on December 31, 2006
  
$
9,749,582
  
$
18,488
  
$
1,077
  
$
20,456
  
$
40,021
  
 
The accompanying notes are an integral part of these consolidated financial statements.
 
26
 
Point.360
Consolidated Statements of Cash Flows

   
Year Ended December 31,
  
   
2004
  
2005
  
2006
  
Cash flows from operating activities:
              
Net income
  
$
1,247,000
  
$
14,000
  
$
76,000
  
Adjustments to reconcile net income to net cash
                   
provided by operating activities:
                   
Depreciation and amortization
   
5,876,000
    
6,051,000
    
5,540,000
  
Provision for (recovery of) doubtful accounts
   
(48,000
)
  
32,000
    
220,000
  
Deferred income taxes
   
(324,000
)
  
815,000
    
(1,946,000
)
Other noncash items
    
(242,000
)
  
-
    
-
  
                     
Changes in operating assets and liabilities (net of acquisitions):
                    
(Increase) decrease in accounts receivable
   
(1,146,000
)
  
(226,000
)
  
(2,344,000
)
(Increase) decrease in inventories
   
(18,000
)
  
136,000
    
47,000
  
(Increase) in prepaid expenses and other current assets
   
(732,000
)
  
(645,000
)
  
1,863,000
  
(Increase) decrease in other assets
   
606,000
    
149,000
    
37,000
  
(Decrease) increase in accounts payable
    
996,000
    
(912,000
)
  
273,000
  
Increase (decrease) in accrued expenses
   
(340,000
)
  
394,000
    
(67,000
)
Increase in income taxes payable (receivable), net
    
939,000
    
83,000
    
(1,108,000
)
Increase in other current liabilities
    
-
    
-
    
33,000
  
Net cash and cash equivalents provided by operating activities
   
6,814,000
    
5,891,000
    
2,624,000
  
                     
Cash flows from investing activities:
                    
Capital expenditures
   
(5,307,000
)
  
(2,355,000
)
  
(2,635,000
)
Proceeds from sale of Media Center real estate
    
-
    
-
    
13,543,000
  
Proceeds from sale of equipment
    
40,000
    
-
    
-
  
Net cash paid for acquisitions
   
(1,094,000
)
  
(2,025,000
)
  
-
 
Net cash paid for acquisition of building
    
(2,065,000
)
  
-
    
-
 
Net cash and cash equivalents used in investing activities
    
(8,426,000
)
  
(4,380,000
)
  
10,908,000
  
                     
Cash flows from financing activities:
                    
Change in revolving credit agreement
    
4,323,000
   
(269,000
)
  
(1,047,000
)
Proceeds from bank note for new loan
    
8,000,000
   
266,000
    
-
  
Change in note payable
    
182,000
   
-
    
-
 
Proceeds from exercise of stock options
   
329,000
    
68,000
    
657,000
  
Cash issued for an acquisition
   
-
    
-
   
(2,222,000
)
Repayment of notes payable
   
(17,657,000
)
  
(1,555,000
)
  
(11,422,000
)
Repayment of capital lease obligations
   
(103,000
)
  
(94,000
)
  
(93,000
)
Net cash and cash equivalents used in financing activities
   
(4,926,000
)
  
(1,584,000
)
  
(14,127,000
)
                     
Net increase in cash and cash equivalents
   
(6,538,000
)
  
(73,000
)
  
(595,000
)
Cash and cash equivalents at beginning of year
    
7,206,000
    
668,000
    
595,000
  
Cash and cash equivalents at end of year
  
$
668,000
  
$
595,000
  
$
-
  
 
The accompanying notes are an integral part of these consolidated financial statements.
 
27

Point.360
Notes to Consolidated Financial Statements

1. THE COMPANY:
 
Point.360 (“Point.360” or the “Company”) provides video and film asset management services to owners, producers and distributors of entertainment and advertising content. The Company provides the services necessary to edit, master, reformat, archive and distribute its clients’ video content, including television programming, spot advertising and movie trailers. The Company provides worldwide electronic distribution, using fiber optics and satellites. The Company delivers commercials, movie trailers, electronic press kits, infomercials and syndicated programming, by both physical and electronic means, to thousands of broadcast outlets worldwide. The Company operates in one reportable segment.
 
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
 
Basis of Consolidation
 
The consolidated financial statements include the accounts of the Company and one subsidiary, International Video Conversions, Inc. (“IVC”), a California corporation. All significant intercompany accounts and transactions have been eliminated in consolidation.

Use of Estimates in the Preparation of Financial Statements
 
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
 
Cash and Cash Equivalents
 
Cash equivalents represent highly liquid short-term investments with original maturities of less than three months.
 
Revenues and Receivables
 
The Company records revenues when the services have been completed. Although sales and receivables are concentrated in the entertainment and advertising industries, credit risk due to financial insolvency is limited because of the financial stability of the customer base (i.e., large studios and advertising agencies).
 
 Concentration of Credit Risk
 
Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents, and accounts receivable. The Company maintains its cash and cash equivalents with high credit quality financial institutions; at times, such balances with any one financial institution may exceed FDIC insured limits.

Credit risk with respect to trade receivables is concentrated due to the large number of orders with major entertainment studios and advertising agencies in any particular reporting period. Our ten largest studio and advertising agency customers represented 52% and 62% of accounts receivable at December 31, 2005 and December 31, 2006, respectively. The Company reviews credit evaluations of its customers but does not require collateral or other security to support customer receivables.

The ten largest studio and advertising agency customers accounted for 38%, 47% and 51% of net sales for the years ended December 31, 2004, 2005 and 2006, respectively. Twentieth Century Fox (and affiliates) was the only customer, which accounted for more than 10% of net sales in any of the last three years, or 17% and 24% in 2005 and 2006, respectively.
 
Inventories
 
Inventories comprise raw materials, principally tape stock, and are stated at the lower of cost or market. Cost is determined using the average cost method.
 
28
 
Property and Equipment
 
Property and equipment are stated at cost. Expenditures for additions and major improvements are capitalized. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets. Amortization of leasehold improvements is computed using the straight-line method over the lesser of the estimated useful lives of the improvements or the remaining lease term.
 
Goodwill
 
Prior to the January 1, 2002 implementation of Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”), goodwill was amortized on a straight-line basis over 5-20 years. Since that date, goodwill has been subject to periodic impairment tests in accordance with SFAS 142.
 
The Company identifies and records impairment losses on long-lived assets, including goodwill that is not identified with an impaired asset, when events and circumstances indicate that such assets might be impaired. Events and circumstances that may indicate that an asset is impaired include significant decreases in the market value of an asset, a change in the operating model or strategy and competitive forces.
 
The Company evaluates its goodwill on an annual basis and when events and circumstances indicate that the carrying amount of an asset may not be recoverable. If the independent appraisal or other indicator of value of the asset or the expected undiscounted future cash flow attributable to the asset is less than the carrying amount of the asset, an impairment loss equal to the excess of the asset’s carrying value over its fair value is recorded. In 2006, fair value was determined using independent appraisals and other valuation techniques, depending on the nature of the assets. To date, no such impairment has been recorded.
 
Income Taxes
 
The Company accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”). SFAS 109 requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts for financial reporting purposes and the tax basis of assets and liabilities. A valuation allowance is recorded for that portion of deferred tax assets for which it is more likely than not that the assets will not be realized.
 
Advertising Costs
 
Advertising costs are not significant to the Company’s operations and are expensed as incurred.
 
Fair Value of Financial Instruments
 
To meet the reporting requirements of SFAS No. 107, “Disclosures About Fair Value of Financial Instruments” (“SFAS 107”), the Company calculates the fair value of financial instruments and includes this additional information in the notes to financial statements when the fair value is different than the book value of those financial instruments. When the fair value is equal to the book value, no additional disclosure is made. The Company uses quoted market prices whenever available to calculate these fair values.

Accounting for Stock-Based Compensation
 
Prior to January 1, 2006, as permitted by SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), the Company measured compensation costs in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees (“APB 25”), but provided pro forma disclosures of net income and earnings per share using the fair value method defined by FAS 123. Under APB No. 25, compensation expense was recognized over the vesting period based on the difference, if any, on the date of grant between the deemed fair value for accounting purposes of the Company’s stock and the exercise price on the date of grant. The Company accounted for stock issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force (“EITF”) 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods and Services.”
 
29
 
Had the Company determined compensation cost based on the fair value for its stock options at grant date, as set forth under SFAS 123, the Company’s net income and earnings per share would have been reduced to the pro forma amounts indicated below:
 
   
2004
  
2005
  
Net income (loss):
          
As reported
 
$
1,247,000
  
$
14,000
  
Deduct: Total stock-based employee compensation
expense determined under fair value based method
for all awards, net of related tax effects
    
(255,000
)
  
(738,000
)
Pro forma
   
992,000
    
(724,000
)
Earnings (loss) per share:
              
As reported:
              
Basic
   
0.14
   
0.00
 
Diluted
   
0.13
   
0.00
  
Pro forma:
              
Basic
   
0.11
   
(0.07
)
Diluted
   
0.10
   
(0.07
)
 
The fair value for these options was estimated at the grant date using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 2004 and 2005, respectively: expected volatility of 44% and 38% and risk-free interest rates of 1.33% and 3.26%. A dividend yield of 0% and expected life of five years was assumed for 2004 and 2005 grants. The weighted average fair value of options granted at the fair market price on the grant date in 2004 and 2005 were $1.03 and $1.05, respectively. All options granted in 2004 and 2005 were at fair market price.
 
On January 1, 2006, the Company adopted SFAS No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values. SFAS 123(R) supersedes the Company’s previous accounting under APB 25 for periods beginning in fiscal 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123(R). The Company applied the provisions of SAB 107 in its adoption of SFAS 123(R). See Note 10.
 
Earnings Per Share
 
The Company follows SFAS No. 128, “Earnings per Share” (“SFAS 128”), and related interpretations for reporting Earnings per Share. SFAS 128 requires dual presentation of Basic Earnings per Share (“Basic EPS”) and Diluted Earnings per Share (“Diluted EPS”). Basic EPS excludes dilution and is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the reported period. Diluted EPS reflects the potential dilution that could occur if stock options were exercised using the treasury stock method.

In accordance with SFAS 128, basic earnings (loss) per share are calculated based on the weighted average number of shares of common stock outstanding during the reporting period. Diluted earnings per share are calculated giving effect to all potentially dilutive common shares, assuming such shares were outstanding during the reporting period.

A reconciliation of the denominator of the basic EPS computation to the denominator of the diluted EPS computation is as follows:

 
  
2004
  
2005
  
2006
  
 
              
Weighted average number of common shares outstanding
              
used in computation of basic EPS
    
9,196,620
    
9,346,533
    
9,511,006
  
Dilutive effect of outstanding stock options
   
474,775
    
367,278
    
104,425
  
Weighted average number of common and potential
                    
common shares outstanding used in computation of diluted EPS
    
9,674,395
    
9,713,811
    
9,615,431
  
Outstanding stock options excluded in the
                   
computation of diluted EPS
    
1,878,172
    
1,342,357
    
1,921,405
  
 
30

Supplemental Cash Flow Information
 
Selected cash payments and noncash activities were as follows:
   
2004
  
2005
  
2006
  
Cash payments for income taxes (net of refunds)
  
$
441,000
  
$
131,000
  
$
1,568,000
  
Cash payments for interest
    
708,000
    
1,345,000
   
790,000
  
                     
Noncash investing and financing activities:
                    
Tax benefits related to stock options
    
51,000
    
-
    
 
Accrual for earn-out payments
    
1,000,000
   
2,000,000
    
2,000,000
  
                     
Detail of acquisitions:
                    
Goodwill (1)
    
242,000
   
2,186,000
   
2,000,000
  

 
(1)
Includes additional purchase price payments made or accrued to former owners in periods subsequent to various acquisitions of $1,000,000, $2,000,000 and $2,000,000 in 2004, 2005 and 2006, respectively.

Recent Accounting Pronouncements
 
In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS 155”), which amends SFAS No. 133, “Accounting for Derivatives Instruments and Hedging Activities” (SFAS 133”) and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities” (SFAS 140”). SFAS 155 amends SFAS 133 to narrow the scope exception for interest-only and principal-only strips on debt instruments to include only such strips representing rights to receive a specified portion of the contractual interest or principle cash flows. SFAS 155 also amends SFAS 140 to allow qualifying special-purpose entities to hold a passive derivative financial instrument pertaining to beneficial interests that itself is derivative instrument. The Company is currently evaluating the impact this new Standard, but believes that it will not have a material impact on the Company’s financial position, results of operations or cash flows.
 
In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets - an amendment of FASB Statement No. 140”. The provisions of SFAS 156 are effective for fiscal years beginning after September 15, 2006. This statement was issued to simplify the accounting for servicing rights and to reduce the volatility that results from using different measurement attributes. The Company is currently assessing the impact that the adoption of SFAS 156 will have on its results of operation and financial position.
 
In July 2006, the FASB released FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting and reporting for uncertainties in income tax law. This interpretation prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. This statement is effective for fiscal years beginning after December 15, 2006. If there are changes in net assets as a result of application of FIN 48, these will be accounted for as an adjustment to retained earnings. The Company expects to adopt FIN 48 in the first quarter of 2007 and is currently assessing the impact of FIN 48 on its consolidated financial position and results of operations.
 
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS 157 establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company is required to adopt the provision of SFAS 157, as applicable, beginning in fiscal year 2008. Management does not believe the adoption of SFAS 157 will have a material impact on the Company’s financial position or results of operations.
 
3. ACQUISITIONS

During 1997 to 2005, the Company acquired ten businesses. These acquisitions were accounted for as purchases, with the excess of the purchase price over the fair value of the net assets acquired allocated to goodwill. The contingent portion of the purchase prices, to the extent earned was recorded as an increase to goodwill. As of December 31, 2006, additional earn-out payments are as described below. The consolidated financial statements reflect the operations of the acquired companies since their respective acquisition dates.
 
31
 
Goodwill and other intangibles, net as of December 31, 2005 and 2006, consist of the following:

   
Actual .
  
   
2005
  
2006
  
Goodwill
  
$
35,050,000
  
$
37,050,000
  
Covenant not to compete
    
1,000,000
    
1,000,000
  
     
36,050,000
    
38,050,000
  
Less accumulated amortization
    
(6,576,000
)
  
(6,576,000
)
   
$
29,474,000
  
$
31,474,000
  

The Company ceased amortizing goodwill on January 1, 2002 with the adoption of SFAS 142. The covenant not to compete was fully amortized in 2003.

In July 2002, the Company acquired an option to purchase three subsidiaries (the “Subsidiaries”) of Alliance Atlantis Communications Inc. (“Alliance”) engaged in businesses directly related to those of the Company. In consideration for the option, the Company issued to Alliance a warrant to acquire 500,000 shares of the Company’s common stock at $2.00 per share. The warrant was to expire five years from the closing date of the transaction, or July 3, 2005 if the Company did not purchase the Subsidiaries. In connection therewith, the Company capitalized the fair value of the warrant ($619,000 determined by using the Black-Scholes valuation model) as an other asset on the balance sheet.
 
In December 2002, the option was extended to March 10, 2003. In connection with the extension, the Company made a $300,000 deposit toward the purchase price of the Subsidiaries, which deposit was nonrefundable except in very limited circumstances. The deposit was capitalized as an other asset. Additionally, the Company capitalized approximately $700,000 of due diligence and other expenses associated with the proposed acquisition during the six months ended June 30, 2003.

The Company did not exercise its option to purchase the Subsidiaries by the March 10, 2003 termination date; however, Alliance agreed to continue negotiations with the Company to complete the transaction.

In connection with the possible acquisition of the Subsidiaries, the Company entered discussions with several possible lenders to provide financing for the purchase of the Subsidiaries and to pay off the Company’s then existing term loan with a group of banks. A provision in the Company’s term loan agreement prohibited acquisitions unless approved by the banks, which permission had been denied.

In June 2003, discussions with Alliance and the new lenders were terminated. As a result, the Company wrote off the above mentioned deposit, due diligence costs and approximately $400,000 of legal and other costs associated with the proposed new financing. The $619,000 value of the warrant was reversed against Additional Paid-in Capital because, in management’s opinion, Alliance had breached certain provisions of the option agreement resulting in a termination event according to the provisions of the warrant. In July 2003, Alliance filed a complaint in the United States District Court, Central District of California, seeking a judicial determination that Alliance has full right of legal ownership to the warrant as well as the $300,000 deposit. If the Company was not successful in this defense, the warrant value would have to be expensed.

On July 18, 2003, Alliance filed a complaint against the Company in the Superior Court of Justice, Ontario, Canada, alleging that the Company breached a non-disclosure agreement between Alliance and the Company by issuing a press release with respect to termination of negotiations to purchase the Subsidiaries without obtaining the required prior written consent of Alliance. Alliance maintained that the press release impaired its ability to extract value from the Subsidiaries and negatively affected its ability to sell the Subsidiaries to a third party. The complaint sought breach of contract and punitive damages of approximately $4.4 million, expenses and a permanent order enjoining further such statements by the Company.

On August 11, 2003, the Company filed a counterclaim in the United States District Court, Central District of California against Alliance for, among other things, misrepresentation and breach of contract seeking cancellation of the warrant and general damages of at least $1.2 million.

Pursuant to a Settlement and Mutual Release Agreement executed in November 2004, Alliance and the Company agreed to settle all claims. Pursuant to the agreement, the Company paid Alliance $575,000 in cash in November 2004.

In order to expand our relationships with our studio customers and gain new customers, on July 1, 2004, the Company acquired all of the outstanding stock of IVC for $7 million in cash. The purchase agreement required possible additional payments of $1 million, $2 million and $2 million in 2005, 2006 and 2007, respectively, if earnings before interest, taxes, depreciation and amortization during the 30 months after the acquisition reached certain predetermined levels (the second two increments of $2 million each were earned and are reflected as accrued liabilities on the balance sheets as of December 31, 2005 and 2006, respectively). As part of the transaction, the Company entered into employment and/or non competition agreements with four senior officers of IVC which fixed responsibilities, salaries and other benefits and set forth limitations on the individuals’ ability to compete with the Company for the term of the earn-out period (30 months). IVC is a high definition and standard definition digital mastering and data conversion entity serving the motion picture/television production industry. To pay for the acquisition, the Company used $2.3 million of cash on hand and borrowed $4.7 million under the term loan portion of the Company’s bank facility.
 
32

The total purchase consideration ($12 million either paid or accrued as of December 31, 2006) has been allocated to the assets and liabilities acquired based on their respective estimated fair values as summarized below.

Cash and cash equivalents
  
$
1,205,000
  
Inventories
    
120,000
  
Other current assets
    
1,000
  
Accounts receivable
    
2,036,000
  
Goodwill
    
5,242,000
  
Property, plant and equipment
    
6,009,000
  
Total assets acquired
    
14,613,000
  
         
Accounts payable
    
(442,000
)
Accrued
    
(417,000
)
Income tax payable
    
(72,000
)
Deferred tax liabilities
    
(1,682,000
)
         
Current and other liabilities assumed
    
(2,613,000
)
         
Net assets acquired over liabilities,
       
and purchase price
  
$
12,000,000
  

The following table presents unaudited pro forma results of the combined operations for the year ended December 31, 2004, as if the acquisition had occurred as of the beginning of 2004 rather than as of the acquisition date. The pro forma information presented below is for illustrative purposes only and is not indicative of results that would have been achieved or results which may be achieved in the future:

   
2004
  
Revenue
  
$
69,032,000
  
Operating Income
    
3,303,000
  
Net income (loss)
    
1,456,000
  
Basic earnings per share
    
0.16
  
Diluted earnings per share
    
0.15
  
 
In 2005, the Company issued 105,000 shares in connection with a purchase of assets. The shares were recorded at fair value on the issue date. In connection with the transition, $186,000 was recorded as goodwill.
 
During 2005, the amount of goodwill, net, increased from $27,288,000 to $29,474,000 due to the $2,000,000 earn-out payment accrued for the IVC acquisition and $186,000 of excess of fair value of stock issued over the fair value of purchased assets, as noted above. During 2006, the amount of goodwill, net, increased from $29,474,000 to $31,474,000 due to the $2,000,000 earn-out payment accrued for the IVC acquisition. The periodic impairment test of goodwill performed in accordance with SFAS 142 as of September 30, 2006 required no goodwill impairment.
 
4. PROPERTY AND EQUIPMENT:

In November 2003, the Company leased a new 64,600 square foot building in Los Angeles, California, for the purpose of consolidating four vault locations then occupying approximately 71,000 square feet. As part of the transaction, the Company paid $600,000 for an option to purchase the facility for $8,571,500. Additionally, the landlord, General Electric Capital Business Asset Funding Corporation (“General Electric”), committed to finance approximately $6,500,000 of the purchase price at a fixed interest rate of 7.75% over 15 years. The Company was not obligated to purchase the building or, if the option was exercised, borrow any portion of the purchase price from General Electric. The cost of the option was included in other assets on the balance sheet as of December 31, 2003, to be capitalized as a cost of the building or written off when the Company exercised the purchase option or did not exercise the option, respectively.

Pursuant to the lease, General Electric also advanced the Company $800,000 to pay for improvements to the building. As of December 31, 2003, the $800,000 was reflected as an obligation to purchase property and equipment with an offsetting liability on the balance sheet. In 2004, the Company reduced the right and the obligation to purchase property and equipment by $800,000 expended for improvements to the building. In August 2004, the Company purchased the facility for $8.6 million ($2.2 in cash and a $6.4 million mortgage).
 
33
 
In March 2006, the Company entered into a sale and leaseback transaction with respect to its Media Center vaulting real estate. The real estate was sold for approximately $14.0 million resulting in a $1.3 million after tax gain. Additionally, the Company received $0.5 million from the purchaser for improvements. In accordance with SFAS No. 28, “Accounting for Sales with Leasebacks,” the gain will be amortized over the initial 15-year lease term as reduced rent. Net proceeds at the closing of the sale and the improvement advance (approximately $13.8 million) were used to pay off the mortgage and other outstanding debt.
 
The lease is treated as an operating lease for financial reporting purposes. After the initial lease term, the Company has four five-year options to extend the lease. Minimum annual rent payments for the initial five years of the lease are $1,111,000, increasing annually thereafter based on the consumer price index change from year to year.
 
The following table presents unaudited pro forma results the year ended December 31, 2005, as if the sale and leaseback transaction had occurred as of the beginning of the year. The pro forma information presented below is for illustrative purposes only and is not indicative of results that would have been achieved or results which may be achieved in the future (in thousands):
 
   
As Reported
  
Adjustments
  
Pro Forma
  
Revenue
  
$
66,199
        
$
66,199
  
Cost of sales
    
(43,167
)
  
(837) (1
)
  
(44,004
)
Gross profit
    
23,032
          
22,195
  
Selling, general and administrative expense
    
(21,424
)
        
(21,424
)
Operating income
    
1,608
          
771
  
Interest expense
    
(1,524
)
  
881 (2
)
  
(643
)
Income before income taxes
    
84
          
128
  
Provision for income taxes
    
(70
)
  
(17) (3
)
  
(87
)
Net income
  
$
14
        
$
41
  
                     
Diluted net income per share
  
$
0.00
        
$
0.00
  
 
 
(1)
First year rent expense net of amortization of the deferred gain on the sale, partially offset by the elimination of depreciation expense associated with the building.
 
(2)
Pro forma interest saved on the amount of mortgage, term and revolving credit debt paid off with net sales proceeds.
 
(3)
Tax effect at 40%.
 
34
 
The following table presents an unaudited pro forma summary balance sheet as of December 31, 2005 as if the sale and leaseback had occurred on that date (in thousands):

   
As Reported
  
Adjustments
  
Pro Forma
  
Current assets
  
$
17,313
        
$
17,313
  
Property and equipment, net
    
28,079
    
(11,261) (1
)
  
16,818
  
Goodwill and other assets
    
30,067
          
30,067
  
Total assets
  
$
75,459
        
$
64,198
  
                     
Accounts payable and accrued expenses
  
$
8,380
        
$
8,380
  
Deferred income taxes
    
1,231
    
879 (2
)
  
2,110
  
Short-term debt
    
2,373
    
(310) (4
)
  
2,063
  
Borrowings under revolving credit
    
4,054
    
(3,904) (4
)
  
150
  
Current liabilities
    
16,038
          
12,703
  
                     
Deferred gain on sale
    
-
    
1,318 (3
)
  
1,318
 
Deferred income taxes and other
    
6,121
    
500 (5
)
  
6,621
  
Long-term notes payable
    
13,790
    
(9,744) (4
)
  
4,046
  
Shareholders’ equity
    
39,510
          
39,510
  
Total liabilities and shareholders’ equity
  
$
75,459
        
$
64,198
  

 
(1)
Net book value of assets sold.
 
 
(2)
Tax on gain on sale at 40%.
 
 
(3)
Deferred gain on sale to be amortized over life of lease.
 
 
(4)
Pay-down of debt with net proceeds.
 
(5)
Non-refundable advance from purchaser for improvements.
 
Property and equipment consist of the following:

   
December 31,
  
   
2005
  
2006
  
           
Land
  
$
4,500,000
  
$
-
  
Building
   
6,230,000
    
-
  
Machinery and equipment
    
35,537,000
    
36,761,000
  
Leasehold improvements
    
8,051,000
    
8,243,000
  
Computer equipment
    
4,693,000
    
5,325,000
  
Equipment under capital lease
    
297,000
    
297,000
  
     
59,308,000
    
50,626,000
  
Less accumulated depreciation and amortization
    
(31,229,000
)
  
(36,487,000
)
   
$
28,079,000
  
$
14,139,000
  
 
Depreciation is expensed over the estimated lives of machinery and equipment (7 years), computer equipment (5 years) and leasehold improvements (2 to 10 years depending on the remaining term of the respective leases or estimated useful life of the improvement). Depreciation expense totaled $5,876,000, $6,051,000 and $ 5,540,000 for the years ended December 31, 2004, 2005 and 2006, respectively. Accumulated amortization on capital leases amounted to $211,000 and $254,000, as of December 31, 2005 and 2006, respectively.
 
35
 
5. 401(K) PLAN

The Company has a 401(K) plan, which covers substantially all employees. Each participant is permitted to make voluntary contributions not to exceed the lesser of: 20% of his or her respective compensation or the applicable statutory limitation, and is immediately 100% vested. The Company matches one-fourth of the first 4% contributed by the employee. Company contributions to the plan were $92,000, $127,000 and $119,000 in 2004, 2005 and 2006, respectively.
 
6. LONG TERM DEBT AND NOTES PAYABLE:
 
On December 30, 2005, the Company entered into a $10 million term loan agreement. The term loan provides for interest at LIBOR (5.37% as of December 31, 2006) plus 3.15% and is secured by the Company’s equipment. In March 2006, the Company prepaid $4 million of the principal with proceeds of a sale/leaseback transaction. The term loan will be repaid in 60 equal monthly principal payments plus interest. Proceeds of the term loan were used to repay the previously existing term loan.

In March 2006, the Company entered into a new revolving credit agreement, which provides up to $10 million of revolving credit. The two-year agreement provides for interest of LIBOR (5.37% as of December 31, 2006) plus 1.85% for the first six months of the agreement, and thereafter at either (i) prime minus 0% - 1.00% or (ii) LIBOR plus 1.50% - 2.5%, depending on the level of the Company’s ratio of outstanding debt to fixed charges (as defined). The facility is secured by all of the Company’s assets, except for equipment securing the new term loan as described in Note 6. The revolving credit agreement requires the Company to comply with various financial and business covenants. There are cross default provisions contained in the two in both the new revolving and term loan agreements. As of December 31, 2006, the company was in compliance with revolving and term loan agreement covenants.
 
The Company has financed the purchase of certain equipment through the issuance of bank notes payable and under capital leasing arrangements. The notes bear interest at rates ranging from 3% to LIBOR plus 3.15%. Such obligations are payable in monthly installments through May 2019.
 
Annual maturities for debt under bank notes payable and capital lease obligations as of December 31, 2006, are as follows:

2007
  
$
1,174,000
  
2008
   
1,158,000
  
2009
   
1,158,000
  
2010
   
1,158,000
  
 
  
$
4,648,000
  

7.INCOME TAXES:
 
The Company’s provision for (benefit from) income taxes for the three years ended December 31, 2006 consists of the following:

   
Year Ended December 31,  .
  
   
2004
 
2005
 
2006
  
Current tax (benefit) expense:
              
Federal
 
$
642,000
  
$
329,000
  
$
1,897,000
  
State
   
142,000
    
6,000
    
331,000
  
                     
Total current
   
784,000
    
335,000
    
2,228,000
  
                     
Deferred tax expense:
                    
Federal
   
(13,000
)
  
(253,000
)
  
(1,750,000
)
State
   
10,000
    
(12,000
)
  
(290,000
)
Total deferred
   
(3,000
)
  
(265,000
)
  
(2,040,000
)
                     
Total provision for (benefit from) for income taxes
  
$
781,000
  
$
70,000
  
$
188,000
  

36
 
The composition of the deferred tax assets (liabilities) at December 31, 2005 and December 31, 2006 are listed below:

   
2005
  
2006
  
           
Accrued liabilities
 
$
393,000
  
$
319,000
  
Allowance for doubtful accounts
    
241,000
    
335,000
  
Other
    
194,000
    
29,000
 
Total current deferred tax assets
   
828,000
    
688,000
  
               
Property and equipment
    
(3,869,000
)
  
(1,970,000
)
Goodwill and other intangibles
    
(2,763,000
)
  
(3,975,000
)
Other
    
511,000
    
1,915,000
  
Total non-current deferred tax liabilities
   
(6,121,000
)
  
(4,030,000
)
 
              
Net deferred tax liability
  
$
(5,293,000
)
$
(3,347,000
)
 
The provision for (benefit from) income taxes differs from the amount of income tax determined by applying the applicable U.S. Statutory income taxes rates to income before taxes as a result of the following differences:

   
 2004
  
 2005
  
 2006
  
               
Federal tax computed at statutory rate
   
34
%
  
34
%
  
34
%
State taxes, net of federal benefit and net operating loss limitation
    
2
%
  
6
%
  
6
%
Other (meals and entertainment)
    
3
%
  
43
%
  
32
%
                     
     
39
%
  
83
%
  
72
%

37

8. COMMITMENTS AND CONTINGENCIES:

Operating Leases

The Company leases office and production facilities in California, Illinois, Texas and New York under various operating leases. Approximate minimum rental payments under these non-cancelable operating leases as of December 31, 2006 are as follows:

2007
  
$
4,915,000
  
2008
    
4,624,000
  
2009
    
3,376,000
  
2010
    
2,593,000
  
2011
    
2,600,000
  
Thereafter
    
14,486,000
  

Total rental expense was approximately $4,299,000, $3,838,000 and $4,651,000 for the three years in the period ended December 31, 2006, respectively.

On September 30, 2003 the Company entered into severance agreements with its Chief Executive Officer and Chief Financial Officer which continue in effect through December 31, 2007, and are renewed automatically on an annual basis after that unless notice is received terminating the agreement by September 30 of the preceding year. The severance agreements contain a “Golden Parachute” provision.

Contingencies

On July 10, 2006, Digital Generation Systems, Inc. (“DG”) filed a claim in the District Court of Dallas County, Texas, alleging that the Company interfered with a contract between DG and Pathfire, Inc. (“Pathfire”), which contract provided that DG was granted exclusive use of Pathfire’s network for the distribution of advertising content. The DG/Pathfire exclusivity excluded the distribution of certain other types of content (other than advertising content) to be distributed by Pathfire for CBS/ Viacom. The claim alleges that the Company was aware of the exclusivity provision during its negotiations with CBS Worldwide Distribution. CBS Broadcasting, Inc. (“CBS”), which resulted in a January 2006 contract between the Company and CBS (“CBS Contract”). Under the CBS Contract, the Company licensed advertising content distribution services from CBS, which services were to be performed utilizing Pathfire’s IP-Multicast Format Store & Forward technology. DG alleges that the Company’s knowledge of the exclusivity provision during the Company’s negotiations with CBS and the resulting use of Pathefire’s technology for distribution of ads caused damage to DG. The claim seeks unspecified actual and punitive damages and other costs of prosecution.

If DG is successful in its claim, the possibility exists that the Pathfire distribution technology will become unavailable to the Company, through which the Company currently distributes a portion of its commercial spots. If that occurs, the Company believes it has alternative means to fulfill customer needs.

The Company believes the complaint is without merit and will not have a material effect on the Company’s financial position. Regardless, CBS has agreed to indemnify the Company pursuant to the CBS Contract to the extent permitted by law or otherwise.

From time to time the Company may become a party to other legal actions and complaints arising in the ordinary course of business, although it is not currently involved in any such material legal proceedings.
 
9. STOCK RIGHTS PLAN:

In November 2004, the Company implemented a stock rights program. Pursuant to the program, stockholders of record November 17, 2004 received a dividend of one right to purchase for $10 one one-hundredth of a share of a newly created Series A Junior Participating Preferred Stock. The rights are attached to the Company’s Common Stock and will also become attached to shares issued subsequent to November 17, 2004. The rights will not be traded separately and will not become exercisable until the occurrence of a triggering event, defined as an accumulation by a single person or group of 20% or more of the Company’s Common Stock. The rights will expire on November 16, 2014 and are redeemable at $0.0001 per right.

After a triggering event, the rights will detach from the Common Stock. If the Company is then merged into, or is acquired by, another corporation, the Company has the opportunity to either (i) redeem the rights or (ii) permit the rights holder to receive in the merger stock of the Company or the acquiring company equal to two times the exercise price of the right (i.e., $20). In the latter instance, the rights attached to the acquirer’s stock become null and void. The effect of the rights program is to make a potential acquisition of the Company more expensive for the acquirer if, in the opinion of the Company’s Board of Directors, the offer is inadequate.
 
38
 
10. STOCK OPTION PLANS:

In May 1996, the Board of Directors approved the 1996 Stock Incentive Plan (the “1996 Plan”). The 1996 Plan provided for the award of options to purchase up to 900,000 shares of common stock, as well as stock appreciation rights, performance share awards and restricted stock awards. In July 1999, the Company’s shareholders approved an amendment to the 1996 Plan increasing the number of shares reserved for grant to 2,000,000 and providing for automatic increases of 300,000 shares on each August 1 thereafter to a maximum of 4,000,000 shares. As of December 31, 2006, there were 1,293,904 options outstanding under the 1996 Plan and no options were available for grant.

In December 2000, the Company’s Board of Directors adopted the 2000 Nonqualified Stock Option Plan (the “2000 Plan”). As amended, the 2000 Plan provided for the award of options to purchase up to 1,500,000 shares of common stock. Options may be granted under the 2000 Plan solely to attract people who have not previously been employed by the Company as a substantial inducement to join the Company. As of December 31, 2006, there were 627,950 options outstanding under the plan and no options were available for grant.
 
In February 2005, the Board of Directors approved the 2005 Equity Incentive Plan (the “2005 Plan”). The 2005 Plan provides for the award of options to purchase up to 2,000,000 shares of common stock, as well as stock appreciation rights and restricted stock awards. Upon approval of the 2005 Plan by the Company’s shareholders in May 2005, the 1996 Plan and the 2000 Plan were terminated, except that outstanding options under those plans were not terminated. As of December 31, 2006, there were 521,150 options outstanding under the 2005 Plan and 1,478,850 options were available for grant.
 
Under all plans, the stock option price per share for options granted is determined by the Board of Directors and is based on the market price of the Company’s common stock on the date of grant, and each option is exercisable within the period and in the increments as determined by the Board, except that no option can be exercised later than ten years from the date it was granted. The stock options generally vest over one to five years.

On January 1, 2006, the Company adopted SFAS 123(R) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values. SFAS 123(R) requires companies to estimate the fair value of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in our Consolidated Statements of Income. Prior to the adoption of SFAS 123(R), the Company accounted for stock-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under SFAS 123. Under the intrinsic value method, no stock-based compensation expense had been recognized in our Consolidated Statements of Income for awards to employees and directors because the exercise price of our stock options equaled the fair market value of the underlying stock at the date of grant.

SFAS 123(R) requires companies to estimate the fair value of share-based payment awards to employees and directors on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s Consolidated Statements of Income (loss). Stock-based compensation expense recognized in the Consolidated Statements of Income (Loss) for the year ended December 31, 2006 included compensation expense for the share-based payment awards granted subsequent to January1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). There were no outstanding uninvested share-based payment awards as of January 1, 2006. For stock-based awards issued to employees and directors, stock-based compensation is attributed to expense using the straight-line single option method, which is consistent with how the prior-priced pro formas were provided were provided. As stock-based compensation expense recognized in the Statements of Consolidated Income (Loss) for 2006 is based on awards expected to vest, SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. For the year ended December 31, 2006, expected forfeitures are immaterial and as such the Company is recognizing forfeitures as the occur. In the pro-forma information provided under SFAS 123 for the periods prior to fiscal 2006, the Company accounted for forfeitures as the occurred.

The Company adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Company’s fiscal year 2006. The consolidated financial statements as of and for the year ended December 31, 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). Stock-based compensation expense related to employee or director stock options recognized for the year ended December 31, 2006 was $81,000 ($23,000 net of tax benefit).

The Company’s determination of fair value of share-based payment awards to employees and directors on the date of grant uses the Black-Sholes model, which is affected by the Company’s stock price as well as assumptions regarding a number of complex and subjective variables. These variables include, but are not limited to, the expected stock price volatility over the expected volatility over the expected term of the awards, and actual and projected employee stock options exercise behaviors. The Company estimates expected volatility using historical data. The expected term is estimated using the “safe harbor” provisions under SAB 107.

39
 
During the year ended December 31, 2006, the Company granted awards of stock options for 399,950 shares at an average market price of $2.25 per share. At December 31, 2006, there were options outstanding to acquire 2,443,004 shares at an average exercise price of $2.89 per share. The estimated fair value of all awards granted during the year ended December 31, 2006 was $399,000. The total fair value of options expensed during 2006 was $81,000. The fair value of each option was estimated on the date of grant using the Black-Sholes option -pricing model with the following weighted average assumptions:

   
Year Ended
December 31,
  
   
2005
  
2006
  
Risk-free interest rate
    
3.26
%
  
4.95
%
Expected term (years)
    
5.0
   
5.0
 
Volatility
    
38
%
  
47
%
Expected annual dividends
    
-
   
-
  
               
 
The following table summarizes the status of these plans as of December 31, 2006:

   
1996 Plan
  
2000 Plan
  
2005 Plan
  
Options originally available
    
3,800,000
    
1,500,000
    
2,000,000
  
Stock options outstanding
   
1,314,000
    
632,000
    
540,000
  
Options available for grant
    
-
    
-
    
1,479,000
  

 
Transactions involving stock options are summarized as follows:
   
Number
of Shares
  
Weighted Average
Exercise Price
  
           
Balance at December 31, 2003
    
2,050,678
 
$
2.91
  
               
Granted during 2004
    
608,100
    
2.58
  
Exercised during 2004
    
(101,573
)
  
2.76
  
Cancelled during 2004
    
(204,258
)
  
3.14
  
               
Balance at December 31, 2004
   
2,352,947
  
$
2.82
  
               
Granted during 2005
    
606,400
    
2.63
  
Exercised during 2005
   
(27,725
)
  
1.97
  
Cancelled during 2005
    
(265,825
)
  
3.01
  
               
Balance at December 31, 2005
    
2,665,797
  
$
2.79
  
               
Granted during 2006
    
399,950
    
2.25
  
Exercised during 2006
   
(380,725
)
  
1.50
  
Cancelled during 2006
    
(242,018
)
  
2.95
  
               
Balance at December 31, 2006
    
2,443,004
  
$
2.89
  
 
As of December 31, 2006, the total compensation costs related to non-vested awards yet to be expensed was approximately $0.3 million to be amortized over the next four years.

The weighted average exercise prices for options granted and exercisable and the weighted average remaining contractual life for options outstanding as of December 31, 2005 and 2006 was as follows:

40
 
 
 
As of December 31, 2005
  
Number of
Shares
  
Weighted Average Exercise Price
  
Weighted Average Remaining Contractual Life (Years)
  
Intrinsic
Value
  
Employees - Outstanding
    
2,300,797
  
$
2.69
    
3.33
  
$
116,000
  
Employees - Expected to Vest
    
2,300,797
  
$
2.69
    
3.33
  
$
116,000
  
Employees - Exercisable
    
2,300,797
  
$
2.69
    
3.33
  
$
116,000
  
                           
Non-Employees - Outstanding
   
365,000
  
$
3.44
    
3.87
  
$
1,000
  
Non-Employees - Expected to Vest
    
365,000
  
$
3.44
    
3.87
  
$
1,000
  
Non-Employees - Exercisable
    
365,000
  
$
3.44
    
3.87
  
$
1,000
  
                           
As of December 31, 2006
                          
                       
 
Employees - Outstanding
   
2,078,004
  
$
2.80
    
3.09
  
$
1,802,000
  
Employees - Expected to Vest
   
2,041,009
  
$
2.81
    
3.04
 
$
1,752,000
  
Employees - Exercisable
    
1,726,854
 
$
2.91
    
2.79
 
$
1,331,000
  
                           
Non-Employees - Outstanding
    
365,000
 
$
3.42
    
3.26
  
$
114,000
  
Non-Employees - Expected to Vest
    
365,000
  
$
3.42
    
3.26
  
$
114,000
  
Non-Employees - Exercisable
    
365,000
  
$
3.42
    
3.26
 
$
114,000
  
 
Additional information with respect to outstanding options as of December 31, 2006 is a follows (shares in thousands):
 
   
 Options Outstanding  
 
Options Exercisable
  
 
Options Exercise
Price Range
  
 
Number of
Shares
  
Weighted Average
Remaining
Contractual Life
  
 
Weighted Average
Exercise Price
  
 
Number of
Shares
  
Weighted Average
Exercise Price
  
$1.75 - 4.79
    
2,438
    
3.1 Years
  
$
2.88
    
2,087
  
$
2.99
  
$7.00 - 10.00
    
5
   
0.2 Years
  
$
7.00
    
5
  
$
7.00
  

We have elected to adopt the detailed method provided in SFAS 123(R) for calculating the beginning balance of the additional paid-in capital pool (APIC pool) related to the tax effects of employee stock-based compensation, and to determine the subsequent impact on the APIC pool and Consolidated Statements of Cash Flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS 123(R).
 
11. SUPPLEMENTAL DATA (unaudited)

The following tables set forth quarterly supplementary data for each of the years in the two-year period ended December 31, 2006 (in thousands except per share data).

   
2005
 
 
 
Quarter Ended
 
Year Ended
 
 
 
March 31
 
June 30
  
Sept 30
  
Dec 31
  
Dec 31
  
                       
Revenues
 
$
17,183
  
$
15,890
  
$
16,748
  
$
16,378
  
$
66,199
  
Gross profit
 
$
5,781
  
$
5,262
  
$
5,965
  
$
6,024
  
$
23,032
  
Net income (loss)
  
$
69
  
$
(268
)
$
214
  
$
(1
)
$
14
  
                                 
Income (loss) per share:
                                
Basic
 
$
0.01
  
$
(0.03
)
$
0.02
  
$
(0.00
)
$
0.00
  
Diluted
 
$
0.01
  
$
(0.03
)
$
0.02
  
$
(0.00
)
$
0.00
  

41
 
   
2006
  
 
  
Quarter Ended
  
Year Ended
  
 
  
March 31
  
June 30
  
Sept 30
  
Dec 31
  
Dec 31
  
                       
Revenues
 
$
16,039
  
$
16,302
  
$
15,313
  
$
16,564
  
$
64,218
  
Gross profit
 
$
5,324
  
$
5,364
  
$
4,978
  
$
5,481
  
$
21,147
  
Net income (loss)
  
$
(92
)
$
117
  
$
65
  
$
(14
)
$
76
  
                                 
Income (loss) per share:
                                
Basic
 
$
(0.01
)
$
0.01
  
$
0.01
  
$
-
  
$
0.01
  
Diluted
 
$
(0.01
)
$
0.01
  
$
0.01
  
$
-
  
$
0.01
  
 
42
 
Report of Independent Registered Public Accounting Firm

To the Board of Directors
and Shareholders of Point.360
Burbank, California

Our audit of the consolidated financial statements referred to in our report dated February 28, 2007, also included the financial statement schedule of Point.360, listed in Item 8 of this Form 10-K. This schedule is the responsibility of Point.360's management. Our responsibility is to express an opinion based on our audit of the consolidated financial statements.

In our opinion, the financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
 
Singer Lewak Greenbaum & Goldstein, LLP (signed)
Los Angeles, CA
February 28, 2007
 
Point.360
Schedule II- Valuation and Qualifying Accounts
 
 
 
Allowance for Doubtful Accounts
  
Balance at
Beginning of
Year
  
Charged to
Costs and
Expenses
  
 
 
Other
  
 
Deductions/
Write-Offs
  
Balance at
End of
Year
  
                       
Year ended December 31, 2004
  
$
735,000
  
$
48,000
  
$
(153,000
)
$
(99,000
)
$
531,000
  
                                 
Year ended December 31, 2005
  
$
531,000
  
$
113,000
  
$
--
  
$
(81,000
)
$
563,000
  
                                 
Year ended December 31, 2006
  
$
563,000
  
$
341,000
  
$
--
  
$
(121,000
)
$
783,000
  
 
43
 
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
 
None.
 
ITEM 9A. CONTROLS AND PROCEDURES
 
Pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934 (the “Exchange Act”), the Company’s management, with the participation of the Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the Company’s disclosure controls and procedures, as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in ensuring that information required to be disclosed in reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. No change in the Company’s internal control over financial reporting occurred during the Company’s most recent fiscal quarter that materially affected, or is reasonably likely to materially affect the Company’s internal control over financial reporting.
 
ITEM 9B. OTHER INFORMATION
 
 
None.

PART III

ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

On July 3, 2003, the Company adopted a Code of Ethics (the “Code”) applicable to the Company’s Chief Executive Officer, Chief Financial Officer and all other employees. Among other provisions, the Code sets forth standards for honest and ethical conduct, full and fair disclosure in public filings and shareholder communications, compliance with laws, rules and regulations, reporting of code violations and accountability for adherence to the Code. The text of the Code has been posted on the Company’s website (www.point360.com). A copy of the Code can be obtained free-of-charge upon written request to:

Corporate Secretary
Point.360
2777 North Ontario Street
Burbank, CA 91504 

If the Company makes any amendment to, or grant any waivers of, a provision of the Code that applies to our principal executive officer or principal financial officer and that requires disclosure under applicable SEC rules, we intend to disclose such amendment or waiver and the reasons for the amendment or waiver on our website.

Other information called for by Item 10 of Form 10-K is set forth under the heading “Election of Directors” in the Company’s Proxy Statement for its annual meeting of shareholders to be held on May 9, 2007 (the “Proxy Statement”), which is incorporated herein by reference.
 
ITEM 11. EXECUTIVE COMPENSATION

Information called for by Item 11 of Form 10-K is set forth under the heading “Executive Compensation” in the Proxy Statement, which is incorporated herein by reference.
 
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
 
Information called for by Item 12 of Form 10-K is set forth under the headings “Security Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information” in the Proxy Statement, which is incorporated herein by reference.
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

Information called for by Item 13 of Form 10-K is set forth under the heading “Certain Relationships and Related Transactions” in the Proxy Statement, which is incorporated herein by reference.
 
44

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

Information called for by Item 14 of Form 10-K is set forth under the heading “Independent Public Accountants” in the Proxy Statement, which is incorporated herein by reference.
 
PART IV

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a) Documents Filed as Part of this Report:

(1,2) Financial Statements and Schedules.

The following financial documents of Point.360 are filed as part of this report under Item 8:

Consolidated Balance Sheets - December 31, 2005 and 2006
Consolidated Statements of Income - Fiscal Years Ended December 31, 2004, 2005 and 2006
Consolidated Statements of Shareholders’ Equity - Fiscal Years Ended December 31, 2004, 2005 and 2006
Consolidated Statements of Cash Flows - Fiscal Years Ended December 31, 2004, 2005 and 2006
Notes to Consolidated Financial Statements
Schedule II - Valuation and Qualifying Accounts    

      (3)
 Exhibit
Number
Description
 
 
3.1
Restated Articles of Incorporation of the Company. (2)

 
3.2
By-laws of the Company. (2)

 
10.1
Agreement and Plan of Merger, dated as of December 24, 1999, among VDI MultiMedia, VDI MultiMedia, Inc. and VMM Merger Corp. (1)

10.2
1996 Stock Incentive Plan of the Company. (2)

10.3
2000 Stock Incentive Plan of the Company. (7)

 
10.4
Asset Purchase Agreement, dated as of December 28, 1996 by and among VDI Media, Woodholly Productions, Yvonne Parker, Rodger Parker, Jim Watt and Kim Watt. (3)

 
10.5
Asset Purchase Agreement, dated as of June 12, 1998 by and between VDI Media and All Post, Inc. (4)

10.6
Asset Purchase Agreement, dated as of November 9, 1998 by and among VDI Media, Dubs  Incorporated, Vincent Lyons and Barbara Lyons. (5)

 
10.7
Asset Purchase Agreement dated November 3, 2000 by and among the Company, Creative Digital, Inc. and Larry Hester. (7)
 
 
10.8
Third Amendment and Restated Credit Agreement dated May 2, 2002, among the Company, Union Bank of California, N.A., United California Bank, and U.S. Bank National Association. (8)
 
 
10.9
Option Agreement dated July 3, 2002 between the Company and Alliance Atlantis Communications Inc. (9)

10.10
First Amendment to Credit Agreement dated October 2, 2002, among the Company, Union Bank of California, Bank of the West and U.S. National Bank Association. (11) 

10.11
Resignation and General Release Agreement dated October 2, 2002 between R. Luke Stefanko and the Company. (10)

10.12
Consulting Agreement dated October 2, 2002 between R. Luke Stefanko and the Company. (10)

10.13
Non-competition Agreement dated October 2, 2002 between R. Luke Stefanko and the
Company. (10)
 
45
 
10.14
Amended and Restated Option Agreement dated December 30, 2002 between the Company and Alliance Atlantis Communications Inc. (12)

10.15
Severance Agreement dated September 30, 2003 between the Company and Haig S.
Bagerdjian. (13)

 
10.16
Severance Agreement dated September 30, 2003 between the Company and Alan R. Steel. (13)

 
10.17
Lease Agreement dated November 26, 2003 between the Company and General Electric Capital Business Asset Funding Corporation.

 
10.18
Credit Agreement dated March 12, 2004 among the Company, Union Bank of California, N.A. and U.S. National Bank Association. (14)

 
10.19
Stock Purchase Agreement dated June 23, 2004 among the Company, International Video Conversions, Inc. (“IVC”) and the Stockholders of IVC. (15)

 
10.20
First Amendment to Credit Agreement dated July 1, 2004 among the Company, Union Bank of California, N.A. and U.S. National Bank Association. (15)

 
10.21
Second Amendment to Credit Agreement dated August 13, 2004 among the Company, Union Bank of California, N.A. and U.S. National Bank Association. (16)

 
10.22
Standing Loan Agreement and Swap Commitment dated August 18, 2004 between the Company and Bank of America, N.A. (17)

 
10.23
Settlement and Mutual Release Agreement executed November 9, 2004 between the Company and Alliance Atlantis Communications, Inc. (18)

 
10.24
Amended and Restated Rights Agreement, dated as of November 17, 2004, between the Company and American Stock Transfer and Trust Company. (19)

 
10.25
2005 Equity Incentive Plan of Point.360. (20)

 
10.26
Promissory Note between General Electric Capital Corporation and the Company dated December 30, 2005. (21)

 
10.27
Master Security Agreement between General Electric Capital Corporation and the Company dated December 30, 2005. (21)

 
10.28
Standard Loan Agreement dated March 29, 2006 between the Company and Bank of America, N.A. (22)

 
10.29
Agreement of Purchase and Sale dated December 30, 2005 between the Company and United Trust Fund Limited Partnership. (22)

 
10.30
Lease Agreement between UTFLA LLC and the Company dated March 28, 2006. (22)

 
23.1
Consent of Independent Accountants.

31.1
Certification of Chief Executive Officer Pursuant to 15 U.S.C. § 7241, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2
Certification of Chief Financial Officer Pursuant to 15 U.S.C. § 7241, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1
Certification of Chief Executive Officer Pursuant to 18 U.S.C. § 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2
Certification of Chief Financial Officer Pursuant to 18 U.S.C. § 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
(1)
Filed with the Securities and Exchange Commission (“SEC”) on January 11, 2000 as an exhibit to the Company’s Form 8-K and incorporated herein by reference.
     
 
(2)
Filed with the SEC as an exhibit to the Company’s Registration Statement on Form S-1 filed with the SEC on May 17, 1996 or as an exhibit to Amendment No. 1 to the Form S-1 filed with the SEC on December 31, 1996 and incorporated herein by reference.
     
 
(3)
Filed with the SEC on June 29, 1998 as an exhibit to the Company’s Form 8-K and incorporated herein by reference
     
 
(4)
Filed with SEC on December 2, 1998 as an exhibit to the Company’s Form 8-K and incorporated herein by reference.
     
 
(5)
Filed with the SEC on April 11, 2001 as an exhibit to the Company’s Form 10-K and incorporated herein by reference.
     
 
(6)
Filed with the SEC on August 14, 2001 as an exhibit to the Company’s Form 10-Q and incorporated herein by reference.
     
 
(7)
Filed with the SEC on September 7, 2001 as an exhibit to the Company’s Form S-8 and incorporated herein by reference.
     
 
(8)
Filed with the Commission on May 14, 2002 as an exhibit to Form 10-Q for the period ended March 31, 2002.
     
 
(9)
Filed as an exhibit to Form 8-K with the Commission on July 15, 2002.
     
 
(10)
Filed as an exhibit to Form 8-K with the Commission on October 7, 2002.
     
 
(11)
Filed with the Commission on November 14, 2002 as an exhibit to Form 10-Q for the period ended September 30, 2002.
     
 
(12)
Filed as exhibit to Form 8-K with the Commission on January 8, 2003.
     
 
(13)
Filed as an exhibit to Form 10-Q with the Commission on November 12, 2003.
     
 
(14)
Filed as an exhibit to Form 8-K with the Commission on March 16, 2004.
     
 
(15)
Filed as an exhibit to Form 8-K with the Commission on July 1, 2004.
     
 
(16)
Filed as an exhibit to Form 8-K with the Commission on August 20, 2004.
     
 
(17)
Filed as an exhibit to Form 8-K with the Commission on August 26, 2004.
     
 
(18)
Filed as an exhibit to Form 10-Q with the Commission on November 12, 2004.
     
 
(19)
Filed as an exhibit to Form 8-K with the Commission on December 29, 2004.
     
 
(20)
Filed as an exhibit to Form S-8 with the Commission on May 25, 2005.
     
 
(21)
Filed as an exhibit to Form 8-K with the Commission on January 3, 2006.
     
 
(22)
Filed as an exhibit to Form 8-K with the Commission on March 30, 2006.

46
 
SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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.

Dated: February 22, 2007
     
 
Point.360
 
 		  
 		  
 
By:   /s/ Haig S. Bagerdjian 
 
Haig S. Bagerdjian
Chairman of the Board of Directors,
President and Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
 
     
/s/ Haig S. Bagerdjian 
Haig S. Bagerdjian
Chairman of the Board of Directors,
President and Chief Executive Officer
February 22, 2007
 
 
    
/s/ Alan R. Steel 
Alan R. Steel
Executive Vice President,
Finance and Administration, Chief Financial Officer
(Principal Accounting and Financial Officer)
February 22, 2007
 
 
    
/s/ Robert A. Baker  
Robert A. Baker
Director
February 22, 2007
 
 
    
/s/ Greggory J. Hutchins 
Greggory J. Hutchins
Director
February 22, 2007
 
 
    
/s/ Sam P. Bell 
Sam P. Bell
Director
February 22, 2007
 
 
    
/s/ G. Samuel Oki 
G. Samuel Oki
Director
February 22, 2007

47
 
 EX-23.1 2 v067194_ex23-1.htm
 
Exhibit 23.1

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We consent to the incorporation by reference in Registration Statement on Forms S-8 (Nos. 333-125253, 333-69174 and 333-69168) of Point.360 and subsidiaries of our report dated February 28, 2007, appearing in this Annual Report on Form 10-K of Point.360 and subsidiary for the three years ended December 31, 2006.
 
Singer Lewak Greenbaum & Goldstein LLP (signed)
February 28, 2007
 
 
 
EX-31.1 3 v067194_ex31-1.htm
 
Exhibit 31.1
 
CERTIFICATION PURSUANT TO
15 U.S.C. § 7241
AS ADOPTED PURSUANT TO
SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

I, Haig S. Bagerdjian, certify that:
 
1.
I have reviewed this annual report on Form 10-K of Point.360;
 
2.
Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
 
3.
Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
 
4.
The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:
 
(a)
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
 
(b)
Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures as of the end of the period covered by this report based on such evaluation; and
 
(c)
Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 
 
5.
The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors:
 
(a)
All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
 
(b)
Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.
 
     
Date: February 28, 2007
 /s/ Haig S. Bagerdjian
 
Haig S. Bagerdjian
Chairman of the Board of Directors,
President and Chief Executive Officer
 
 
 EX-31.2 4 v067194_ex31-2.htm
 
Exhibit 31.2
 
CERTIFICATION PURSUANT TO
15 U.S.C. § 7241
AS ADOPTED PURSUANT TO
SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

I, Alan R. Steel, certify that:
 
1.
I have reviewed this annual report on Form 10-K of Point.360;
 
2.
Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
 
3.
Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
 
4.
The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:
 
(a)
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
 
(b)
Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures as of the end of the period covered by this report based on such evaluation; and
 
(c)
Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 
 
5.
The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors:
 
(a)
All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
 
(b)
Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.
     
     
Date: February 28, 2007
/s/ Alan R. Steel
 
Alan R. Steel
Executive Vice President, Finance and Administration, and Chief Financial Officer
 
 
 EX-32.1 5 v067194_ex32-1.htm
 
Exhibit 32.1
 
CERTIFICATION PURSUANT TO
18 U.S.C. § 1350
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Annual Report of Point.360 (the “Company”) on Form 10-K for the period ended December 31, 2006, as filed with the Securities and Exchange Commission (the “Report”), I, Haig S. Bagerdjian, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to my knowledge:

 
(1)
The Report fully complies with the requirements of Section 13 (a) or 15 (d) of the Securities Exchange Act of 1934; and

 
(2)
The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.
 
 
/s/ Haig S. Bagerdjian 
Haig S. Bagerdjian
Chief Executive Officer
February 28, 2007 
 
 
 EX-32.2 6 v067194_ex32-2.htm
 
Exhibit 32.2

CERTIFICATION PURSUANT TO
18 U.S.C. § 1350
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Annual Report of Point.360 (the “Company”) on Form 10-K for the period ended December 31, 2006, as filed with the Securities and Exchange Commission (the “Report”), I, Alan R. Steel, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to my knowledge:

 
(1)
The Report fully complies with the requirements of Section 13 (a) or 15 (d) of the Securities Exchange Act of 1934; and

 
(2)
The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.
 

/s/ Alan R. Steel
Alan R. Steel
Chief Financial Officer
February 28, 2007


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