-----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, Gd2rUgFRuuDP3AAuxwHKzTIDtO4hPemKqwukn+5ETcNUygqu6yvEreBXUJu+0uy4 CeZAOvr7DhwjeiY29A0Tyg== 0000930661-01-502411.txt : 20020410 0000930661-01-502411.hdr.sgml : 20020410 ACCESSION NUMBER: 0000930661-01-502411 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 20010930 FILED AS OF DATE: 20011114 FILER: COMPANY DATA: COMPANY CONFORMED NAME: DIGITAL GENERATION SYSTEMS INC CENTRAL INDEX KEY: 0000934448 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-ADVERTISING AGENCIES [7311] IRS NUMBER: 943140772 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-27644 FILM NUMBER: 1789875 BUSINESS ADDRESS: STREET 1: 5221 NORTH OCONNOR BLVD CITY: IRVING STATE: TX ZIP: 75039 BUSINESS PHONE: 4155466600 MAIL ADDRESS: STREET 1: 5221 NORTH OCONNOR BLVD CITY: IRVING STATE: TX ZIP: 75039 10-Q 1 d10q.txt FORM 10-Q ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 ----------------------------- FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2001 Or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________________ to ____________________. Commission file number: 0-27644 Digital Generation Systems, Inc. (Exact name of registrant as specified in its charter) Delaware 94-3140772 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 750 West John Carpenter Freeway, Suite 700 Irving, Texas 75039 (Address of principal executive offices, including zip code) (972) 581-2000 (Registrant's telephone number, including area code) Not Applicable (Former name, former address, former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES X NO ---- ---- Number of shares of registrant's Common Stock, par value $0.001, outstanding as of October 31, 2001: 70,784,475 ================================================================================ DIGITAL GENERATION SYSTEMS, INC. The discussion in this Report contains forward-looking statements that involve risks and uncertainties. The statements contained in this Report that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Words such as "anticipates," "believes," "plans," "expects," "future," "intends," and similar expressions are used to identify forward-looking statements. All forward-looking statements included in this document are based on information available to the Company on the date hereof, and we assume no obligation to update any such forward-looking statements. The Company's actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations - Certain Business Considerations" as reported in the Company's Annual Report on Form 10-K filed on March 29, 2001, as well as those risks discussed in this Report, and in the Company's other United States Securities and Exchange Commission filings. TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION Page ---- Item 1. Financial Statements Condensed Consolidated Balance Sheets at September 30, 2001 and December 31, 2000................. 3 Consolidated Statement of Shareholders' Equity for the nine months ended September 30, 2001............................................................................... 4 Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2001and September 30, 2000......................................................... 5 Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2001 and September 30, 2000............................................................................ 6 Notes to Unaudited Condensed Consolidated Financial Statements ................................... 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ............ 11 Item 3. Quantitative and Qualitative Disclosures about Market Risk........................................ 13 PART II. OTHER INFORMATION Item 1. Legal Proceedings ................................................................................ 13 Item 6. Exhibits and Reports on Form 8-K.................................................................. 14 SIGNATURES........................................................................................ 15
ITEM I. FINANCIAL STATEMENTS
Digital Generation Systems, Inc. Condensed Consolidated Balance Sheets (in thousands, except share data) September 30, December 31, 2001 2000 ---- ---- Assets (unaudited) - ------ CURRENT ASSETS: Cash $ 2,781 $ 2,891 Accounts receivable, net of allowance for doubtful accounts of $2,816 at September 30, 2001 and $847 at December 31, 2000 13,080 3,211 Inventories 2,017 2,109 Other current assets 1,883 663 -------- -------- Total current assets 19,761 8,874 Property and equipment, net 18,403 870 Goodwill and other assets, net 200,767 1,358 -------- -------- TOTAL ASSETS $238,931 $ 11,102 ======== ======== Liabilities and Stockholders' Equity (Deficit) - ---------------------------------------------- CURRENT LIABILITIES: Accounts payable and accrued liabilities $ 7,796 $ 4,479 Other current liabilities 42 216 Deferred revenue 3,491 3,260 Current portion of long-term debt and capital leases 6,515 - -------- -------- Total current liabilities 17,844 7,955 Deferred revenue 9,466 12,076 Long-term debt and capital leases 12,690 - Excess of losses over investments in and amounts due from joint venture - 2,568 -------- -------- TOTAL LIABILITIES 40,000 22,599 -------- -------- STOCKHOLDERS' EQUITY (DEFICIT): Common stock Authorized - 200,000,000 shares at September 30, 2001 Outstanding - 70,763,208 at September 30, 2001 and 41,196,828 at December 31, 2000 265,949 48,670 Accumulated deficit (66,925) (60,167) Receivables from issuance of common stock (93) - -------- -------- TOTAL STOCKHOLDERS' EQUITY (DEFICIT) 198,931 (11,497) -------- -------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $238,931 $ 11,102 ======== ======== The accompanying notes are an integral part of these condensed consolidated financial statements.
Digital Generation Systems, Inc. Statement of Stockholders' Equity (Deficit) (in thousands) Common Stock Total and Additional Stockholders' Paid-In-Capital Notes Treasury Accumulated Equity Shares Dollars Receivable Stock Deficit (Deficit) -------------------------------------------------------------------------------------------------- Balance at December 31, 2000 41,197 $ 49,641 $ - $(971) $(60,167) $(11,497) DG Systems/StarGuide merger 28,236 211,518 (93) 971 - 212,396 Musicam Express acquisition 693 4,000 4,000 Exercises of stock options 385 44 44 Non cash stock compensation 156 156 Net loss (1,429) (1,429) ---------------------------------------------------------------------------------------------------- Balance at March 31, 2001 70,511 265,359 (93) - (61,596) 203,670 ---------------------------------------------------------------------------------------------------- Purchase of shares through ESPP 26 52 52 Exercises of stock options 122 183 183 Net loss (2,870) (2,870) ---------------------------------------------------------------------------------------------------- Balance at June 30, 2001 70,659 265,594 (93) - (64,466) 201,035 ---------------------------------------------------------------------------------------------------- Exercises of stock options 104 140 140 Settlement of legal claim 215 215 Net loss (2,459) (2,459) ---------------------------------------------------------------------------------------------------- Balance at September 30, 2001 70,763 $265,949 $(93) $ - $(66,925) $198,931 ==================================================================================================== The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
Digital Generation Systems, Inc. Condensed Consolidated Statement of Operations Three and nine months ended September 30, 2001 and September 30, 2000 (in thousands, except share and per share data) (unaudited) Three months ended September 30, Nine months ended September 30, -------------------------------- ------------------------------- 2001 2000 2001 2000 ---- ---- ---- ---- Revenues: Audio and video content distribution $11,151 $ - $37,248 $ - Product sales 2,910 1,638 10,581 4,330 Other 1,858 2,466 5,609 6,374 ------- ------- ------- ------- Total revenues 15,919 4,104 53,438 10,704 ------- ------- -------- -------- Costs and expenses: Cost of revenues: Audio and video content distribution 6,558 - 20,739 - Product sales 1,275 1,011 4,197 2,625 ------- ------- -------- -------- Other 1,015 1,700 3,563 4,451 Total cost of revenues 8,848 2,711 28,499 7,076 Sales and marketing 1,267 932 4,313 2,105 Research and development 1,045 787 3,304 2,266 General and administrative: Noncash stock award charges - - - 18,375 Other 2,452 1,817 8,989 3,826 Merger charge - - 791 - Depreciation and amortization 4,258 226 12,739 659 ------- ------- -------- -------- Total operating expenses 17,870 6,473 58,635 34,307 ------- ------- -------- -------- Loss from operations (1,951) (2,369) (5,197) (23,603) Other (income) expense: Interest income and other expense, net 133 (70) 294 (265) Interest expense 375 1 1,265 18 Equity in losses of joint venture - 103 - 932 ------- ------- -------- -------- Net loss $(2,459) $(2,403) $(6,756) $(24,288) ======= ======= ======= ======== Basic and diluted net loss per share $ (0.04) $ (0.06) $ (0.10) $ (0.59) ======= ======= ======== ======== Basic and diluted weighted average shares outstanding 70,739 41,172 70,330 40,827 ======= ======= ======== ======== The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
Digital Generation Systems, Inc. Condensed Consolidated Statements of Cash Flows (in thousands) (unaudited) Nine Months Ended September 30, --------------------------------------- 2001 2000 ---- ---- CASH FLOWS FROM OPERATING ACTIVITIES: Net loss $ (6,756) $(24,288) Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Depreciation and amortization of property and equipment 3,316 427 Amortization of goodwill and intangibles 9,423 232 Noncash stock award charges 371 18,375 Equity in losses of joint venture - 932 Provision for doubtful accounts 1,825 212 Changes in operating assets and liabilities: Accounts receivable 1,192 3,253 Prepaid expenses and other assets 575 55 Accounts payable and accrued liabilities (7,893) (2,661) -------- -------- Net cash provided by (used in) operating activities 2,053 (3,461) -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Acquisition of property and equipment (3,896) (574) Acquisitions, net of cash acquired (876) - Advance to joint venture - (428) -------- -------- Net cash used in investing activities (4,772) (1,002) -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from issuance of common stock 419 12,111 Purchase of common stock - (701) Payment of debt issue costs (699) - Proceeds from line of credit and long-term debt 40,864 - Payments on line of credit and long-term debt (37,975) (5,653) -------- -------- Net cash provided by financing activities 2,609 5,757 -------- -------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (110) 1,294 CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 2,891 2,145 -------- -------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 2,781 $ 3,438 ======== ======== Supplemental Cash Flow Information: Interest paid $ 274 $ 16 ======== ======== Property, plant and equipment acquired through capital lease $ 1,569 $ - ======== ======== The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
Digital Generation Systems, Inc. Notes to Unaudited Condensed Consolidated Financial Statements 1. BASIS OF PRESENTATION The financial statements included herein have been prepared by Digital Generation Systems, Inc. ("the Company" or "DG Systems") without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. However, the Company believes that the disclosures are adequate to make the information presented not misleading. The unaudited condensed consolidated financial statements reflect all adjustments, which are, in the opinion of management, of a normal and recurring nature and necessary for a fair presentation of the Company's financial position, results of operations and cash flows for the periods presented. These condensed consolidated financial statements should be read in conjunction with the financial statements and the notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2000 and Form 8-K/A filed on March 29, 2001 and Form 8-K filed on November 2, 2001. During January 2001, DG Systems completed its merger with StarGuide Digital Networks, Inc. ("StarGuide"). Following the merger, DG Systems is the sole shareholder of StarGuide. However, for accounting purposes, StarGuide was deemed to be the acquirer, and accordingly, the merger was accounted for as a reverse acquisition. Under this method of accounting, the Company's historical results of operations for periods prior to January 1, 2001 are the same as StarGuide's historical results of operations. All share and per share information has been restated to reflect the exchange ratio on a retroactive basis. See Note 2. 2. MERGERS AND ACQUISITIONS During January 2001, the Company completed its merger with StarGuide, which was accounted for under the purchase method of accounting. In this merger, the holders of StarGuide Common Stock received for each share of StarGuide Common Stock approximately 1.7332 shares of DG Systems' Common Stock, and the holders of Company Common Stock continued to hold their shares. StarGuide effectively issued approximately 28,236,000 shares of Common Stock as a result of the merger. StarGuide was the acquirer for financial reporting purposes and as a result, the historical results of operations do not include DG Systems' results of operations for the three or nine months ended September 30, 2000. The total purchase consideration of $217.2 million included $212.6 million related to the fair value of DG Systems' Common Shares (at $6.50 per Common Share), options and warrants and merger transaction costs of $4.6 million. The purchase price was allocated to the assets acquired and liabilities assumed based on their fair values. The excess of purchase price over fair value of net assets acquired of $181.5 million was allocated to goodwill and is being amortized over a 20-year period. The Company finalized the initial purchase price allocation in the third quarter of 2001, upon receipt of final independent valuations of tangible and intangible assets acquired. Changes to the preliminary purchase price allocation did not have a significant impact on previously recorded depreciation and amortization or financial position of the Company. During March 2001, the Company completed its purchase of the 50% interest in Musicam Express ("Musicam") owned by Westwood One, Inc. and Infinity Broadcasting Corporation. The transaction was accounted for under the purchase method of accounting. The total purchase price of $13.7 million included $4.0 million for the issuance of approximately 693,000 shares of Common Stock plus the assumption of outstanding bank debt and other liabilities of Musicam of $9.7 million. The purchase price was allocated to the assets acquired and liabilities assumed based on their fair values. The excess of purchase price over fair value of net assets acquired of $11.1 million was allocated to goodwill and is being amortized over a 20-year period. Prior to the purchase, the Company accounted for its 50% interest in Musicam under the equity method of accounting and recognized losses in excess of its investment and its guaranteed minimum contribution based on its intent to fund these excess losses. Results of operations of Musicam have been consolidated beginning January 1, 2001. Pre- acquisition losses of $96,000 related to the 50% acquired interest have been eliminated in determining net loss and are included in interest expense and other in the consolidated statement of operations. The table below presents the Company's total revenues and net loss, as reported and on a pro forma basis for the three and nine months ended September 30, 2001 and 2000, respectively, as if the StarGuide and Musicam acquisitions had occurred at the beginning of each period presented, unless already included in the historical results. The pro forma results are presented for informational purposes only and are not indicative of the operating results that would have occurred had the transactions actually occurred on the indicated dates above, nor are they necessarily indicative of future operating results. Digital Generation Systems, Inc. Notes to Unaudited Condensed Consolidated Financial Statements
Three months ended September 30, Nine months ended September 30, 2001 2000 2001 2000 ---- ---- ---- ---- Total revenues (in thousands): As reported $ 15,919 $ 4,104 $ 53,438 $ 10,704 Pro forma $ 15,919 $ 17,882 $ 53,438 $ 50,731 Net loss (in thousands): As reported ($2,459) ($2,403) ($6,756) ($24,288) Pro forma ($2,459) ($4,035) ($6,660) ($31,700) Basic and diluted net loss per share: As reported ($0.04) ($0.06) ($0.10) ($0.59) Pro forma ($0.04) ($0.06) ($0.10) ($0.46)
3. INVENTORIES Inventories as of September 30, 2001 and December 31, 2000 are summarized as follows (in thousands):
September 30, December 31, Inventories 2001 2000 ------ ------ Raw materials $ 655 $ 582 Work-in-process 548 202 Finished goods 814 1,325 ------ ------ $2,017 $2,109 ====== ======
4. LONG-TERM DEBT AND CAPITAL LEASES During June 2001, the Company signed a new long-term credit agreement that includes a term loan of $12.5 million and a revolving credit facility with a borrowing base subject to the Company's eligible accounts receivable balance. The proceeds from the term loan were used in part to refinance outstanding debt of $9.8 million that was assumed as a result of the acquisition of Musicam during March 2001. Approximately $4.0 million was outstanding under the revolving credit facility at September 30, 2001 and an additional $3.9 million was available for borrowing. Under the long-term credit agreement, the Company is required to maintain minimum EBITDA, fixed charge coverage ratios and current ratios on a quarterly basis. In addition, the Company's capital expenditures and capital lease borrowings are limited on an annual basis. During the quarter ended September 30, 2001, the Company failed to meet its minimum EBITDA covenant under the agreement. On November 9, 2001, this covenant was waived by the lender and the credit agreement was amended to reduce the EBITDA requirement as of December 31, 2001 and to eliminate the EBITDA requirement for the remaining term of the agreement. During the nine months ended September 30, 2001, the Company purchased $1.6 million of equipment under capital lease agreements with terms ranging from 24 months to 36 months. 5. SEGMENT INFORMATION The Company operates predominantly in two industry segments: digital and physical distribution of audio and video content and transmission and compression technology and consulting. The Company has defined its reportable segments based on internal financial reporting used for corporate management and decision-making purposes. Digital Generation Systems, Inc. Notes to Unaudited Condensed Consolidated Financial Statements The information in the following tables is derived directly from the segments' internal financial reporting used for corporate management purposes.
Three months ended September 30, 2001 -------------------------------------------------------------------------------------------- Audio and Video Content Other (a) Intersegment Consolidated Totals Distribution Eliminations (b) -------------------------------------------------------------------------------------------- Revenues $ 14,484 $1,435 $ - $ 15,919 Operating Income (Loss) $ (2,136) $ 185 $ - $ (1,951) Total assets $264,415 $3,132 $(28,616) $238,931
Three months ended September 30, 2000 -------------------------------------------------------------------------------------------- Audio and Video Content Other (a) Intersegment Consolidated Totals Distribution Eliminations (b) -------------------------------------------------------------------------------------------- Revenues $ 1,817 $2,287 $ - $ 4,104 Operating Income (Loss) $ (2,551) $ 178 $ - $ (2,369) Total assets $ 27,756 $3,293 $(19,299) $ 11,750
Nine months ended September 30, 2001 -------------------------------------------------------------------------------------------- Audio and Video Content Other (a) Intersegment Consolidated Totals Distribution Eliminations (b) -------------------------------------------------------------------------------------------- Revenues $ 48,811 $4,627 $ - $ 53,438 Operating Income (Loss) $ (5,562) $ 365 $ - $ (5,197) Total assets $264,415 $3,132 $(28,616) $238,931
Nine months ended September 30, 2000 -------------------------------------------------------------------------------------------- Audio and Video Content Other (a) Intersegment Consolidated Totals Distribution Eliminations (b) -------------------------------------------------------------------------------------------- Revenues $ 4,916 $5,788 $ - $ 10,704 Operating Income (Loss) $(24,079) $ 456 $ 20 $(23,603) Total assets $ 27,756 $3,293 $(19,299) $ 11,750
(a) Other includes operations of Corporate Computer Systems, Inc. (CCS), responsible for the Company's digital compression technology and consulting. (b) Intersegment eliminations relate to intercompany receivables and payables that occur when one operating segment pays costs that are related to another operating segment. Digital Generation Systems, Inc. Notes to Unaudited Condensed Consolidated Financial Statements 6. INCOME TAXES There was no income tax expense (benefit) for the three months ended September 30, 2001 and September 30, 2000 due to the existence of net operating losses and a full valuation allowance for related deferred tax assets. Statement of Financial Accounting Standards (SFAS) No. 109 requires that the Company record a valuation allowance when it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets depends on the Company's ability to generate sufficient taxable income in the future. The Company has recognized a full valuation allowance for the amount of net deferred tax assets as of September 30, 2001 and December 31, 2000. 7. NET LOSS PER SHARE Under SFAS No. 128 "Earnings per Share," the Company is required to compute earnings per share under two different methods (basic and diluted). Basic earnings per share is calculated by dividing net income (loss) attributable to common shareholders by the weighted average shares of Common Stock outstanding during the period. Diluted earnings per share is calculated by dividing net income (loss) attributable to common shareholders by the weighted average shares of outstanding Common Stock and potentially dilutive securities during the period. Due to net losses, inclusion of potentially dilutive securities would be anti-dilutive. At September 30, 2001, outstanding potentially dilutive securities consisted of options and warrants exercisable into a total of 16,995,166 shares of Common Stock, with exercise prices ranging from $0.30 to $10.13 per share. Therefore, basic and diluted loss per share for the Company were the same. 8. EQUITY TRANSACTIONS During the nine months ended September 30, 2001, the Company granted options to purchase approximately 1.7 million shares of Common Stock at a weighted average exercise price of $3.27. Approximately 26,000 shares of Common Stock were issued under the Company's Employee Stock Purchase Plan and 611,000 shares of Common Stock were issued as a result of stock option exercises, yielding total cash proceeds of $419,000. In addition, as discussed in Note 2, the Company issued 28,236,000 shares in connection with its merger with StarGuide and 693,000 shares for the acquisition of Musicam. Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Condensed Consolidated Financial Statements and Notes and contains forward-looking statements that involve risks and uncertainties. Actual results could differ materially from those indicated in the forward-looking statements as a result of various factors. Results of Operations Reported operating results for the three and nine months ended September 30, 2001 are not comparable with the same prior-year periods due to the merger between DG Systems and StarGuide, which occurred effective January 1, 2001. The merger was accounted for as a reverse acquisition, thus historical results of DG Systems are not included in the results for the three and nine months ended September 30, 2000. In order to enhance comparability, the following discussion of the Company's results of operations is supplemented by pro forma financial information that gives effect to the StarGuide merger as if it had occurred at the beginning of 2000.
Three months ended September 30, Nine months ended September 30, 2001 2000 2001 2000 ---- ---- ---- ---- As reported: Revenues $15,919 $ 4,104 $53,438 $10,704 Cost of revenues $ 8,848 $ 2,711 $28,499 $ 7,076 Pro Forma: Revenues $15,919 $17,882 $53,438 $50,731 Cost of revenues $ 8,848 $10,275 $28,499 $30,091
Revenues. Revenues for the three months ended September 30, 2001 increased $11,815,000, or 288%, primarily due to the DG Systems business that was acquired in the merger and incremental revenues for StarGuide related to new radio syndication agreements with major broadcasters. On a year-to-date basis, revenues increased $42,734,000, or 399%, due to the DG Systems business that was acquired in the merger and incremental revenues for StarGuide related to new radio syndication agreements with major broadcasters. On a pro forma basis, revenues decreased 11% for the three months ended September 30, 2001 and increased 5% for the nine months ended September 30, 2001. Revenue decreases for the quarter were a result of a decline in advertising spending over the past few months primarily due to a slowdown in the economy. Revenue increased for the nine-month period due primarily to significant first and second quarter revenue growth at StarGuide related to new radio syndication agreements with major broadcasters. Cost of revenues. Cost of revenues, which includes delivery and material costs and customer operations, increased $6,137,000, or 226%, for the three months ended September 30, 2001 primarily due to the following: . $6,558,000 incremental expense relates to the DG Systems business that was acquired in the merger. . $421,000 decline in expenses as a result of an increase in sales of higher- margin products versus lower-margin products during 2000. For the nine months ended September 30, 2001, cost of revenues increased $21,423,000 as follows: . $20,743,000 relates to the DG Systems business that was acquired in the merger. . $680,000 relates to StarGuide and its new radio syndication agreements with major broadcasters. On a pro forma basis, cost of revenues for the three months ended September 30, 2001 decreased 14% to $8.8 million compared to $10.3 million for the three months ended September 30, 2000. Cost of revenues decreased 5% for the nine months ended September 30, 2001 to $28.5 million compared to $30.1 million for the same prior-year period. The decline is primarily a result of lower telecommunications costs during the nine months ended September 30, 2001, which is a result of a lower rate structure with our primary telecommunications provider, MCI WorldCom, reductions in headcount due to the DG Systems/StarGuide merger and reduced operating expenses as a result of the relocation of the DG Systems Network Operating Center (NOC) from San Francisco, CA to Irving, TX during 2001. Sales and marketing. Sales and marketing expense increased $335,000, or 36%, for the three months ended September 30, 2001, which is comprised of additional expenses of $1,010,000 related to the DG Systems business that was acquired in the merger and a decline of $675,000 in expenses for StarGuide due to reduction in headcount and decreased spending on marketing the CoolCast (TM) product. For the nine months ended September 30, 2001, sales and marketing expenses increased $2,208,000, or 105%, due to additional expenses of $3,090,000 related to the DG Systems business acquired in the merger offset by a reduction in StarGuide expenses of $882,000 due to reduction in headcount. Research and development. Research and development expense increased $258,000, or 33%, for the three months ended September 30, 2001, of which $533,000 relates to the DG Systems business that was acquired in the merger, partially offset by decreases in research and development activity and the capitalization of salaries and other costs related to the development of new software. For the nine months ended September 30, 2001, research and development expense increased $1,038,000, or 46%, of which $1,631,000 relates to the DG Systems business that was acquired in the merger, offset by decreases in research and development activity and the capitalization of salaries and other costs related to the development of new software. General and administrative. General and administrative expense increased $635,000, or 35%, for the three months ended September 30, 2001, of which $1,878,000 relates to the DG Systems business that was acquired in the merger. For the nine months ended September 30, 2001, general and administrative expense decreased $13,212,000, or 60%, primarily due to the following: . $5,934,000 of incremental expense related to the DG Systems business that was acquired in the merger. . $18,375,000 reduction of expense related to noncash stock awards recognized during the nine months ended September 30, 2000 that was nonrecurring. . $771,000 reduction in expenses due to reductions in headcount and savings associated with the merger. Depreciation and amortization. Depreciation and amortization increased $4,032,000 for the three months ended September 30, 2001 and $12,080,000 for the nine months ended September 30, 2001, primarily due to the merger between DG Systems and StarGuide, as a result of which the Company recorded intangible assets of approximately $197 million. These intangibles are being amortized on a straight-line basis over periods ranging from 3 to 20 years. Liquidity and Capital Resources On a reported basis, net cash provided by operating activities increased to $2.1 million for the nine months ended September 30, 2001 from cash used by operating activities of $3.5 million for the nine months ended September 30, 2000. The Company purchased equipment and capital additions of $3.9 million during the nine months ended September 30, 2001 related to the Company's continued expansion of its network and its NOC and the relocation of its NOC during 2001. Borrowings on long-term debt, net of principal payments, were $2.9 million for the nine months ended September 30, 2001 versus net principal payments of $5.7 million for the nine months ended September 30, 2000. At September 30, 2001, the Company's current sources of liquidity included cash and cash equivalents of $2.8 million. During June 2001, the Company signed a new long-term credit agreement that includes a term loan of $12,500,000 and a revolving credit facility with a borrowing base subject to the Company's eligible accounts receivable balance. The proceeds from the term loan were used in part to refinance outstanding debt of $9.8 million that was assumed as a result of the acquisition of Musicam during March 2001. Approximately $4.0 million was outstanding under the revolving credit facility at September 30, 2001 and an additional $3.9 million was available for borrowing. Under the long- term credit agreement, the Company is required to maintain minimum EBITDA, fixed charge coverage ratios and current ratios on a quarterly basis. In addition, the Company's capital expenditures and capital lease borrowings are limited on an annual basis. During the quarter ended September 30, 2001, the Company failed to meet its minimum EBITDA covenant under the agreement. On November 9, 2001, this covenant was waived by the lender and the credit agreement was amended to reduce the EBITDA requirement as of December 31, 2001 and to eliminate the EBITDA requirement for the remaining term of the agreement. The Company believes it has sufficient capital and capital resources to sustain liquidity in the foreseeable future. Impact of Recently Issued Accounting Standards In June 2001, the FASB issued Statement No. 141, Business Combinations, and Statement No. 142, Goodwill and Other Intangible Assets. Statement 141 requires that the purchase method of accounting be used for all business combinations initiated or completed after June 30, 2001. Statement 141 also specifies the criteria intangible assets acquired in a purchase method business combination must meet to be recognized and reported apart from goodwill, noting that any purchase price allocable to an assembled workforce may not be accounted for separately. Statement 142 will require that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually. Statement 142 will also require that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. The Company is required to adopt the provisions of Statement 141 immediately. Furthermore, any goodwill and any intangible asset determined to have an indefinite useful life that are acquired in a purchase business combination completed after June 30, 2001 will not be amortized, but will continue to be evaluated for impairment. Goodwill and intangible assets acquired in business combinations completed before July 1, 2001 will continue to be amortized prior to the adoption of Statement 142. As of the date of adoption (January 1, 2002), the Company expects to have unamortized goodwill in the amount of $183.2 million and unamortized identifiable intangible assets in the amount of $13.2 million, all of which will be subject to the transition provisions of Statements 141 and 142. Amortization expense related to goodwill was $7.0 million for the nine months ended September 30, 2001. Because of the extensive effort needed to comply with adopting Statements 141 and 142, it is not practicable to reasonably estimate the impact of adopting these Statements on the Company's financial statements at the date of this report, including whether any transitional impairment losses will be required to be recognized. In August 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations." SFAS No. 143 requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred. The Company will adopt SFAS No. 143 in fiscal year 2003. The Company does not expect the provisions of SFAS No. 143 to have any significant impact on its financial condition or results of operations. In October 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which replaces SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." The Company will adopt SFAS No. 144 in fiscal year 2002. The Company does not expect the provisions of SFAS No. 144 to have any significant impact on its financial condition or results of operations. Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company provides some services to entities located in Canada and, therefore, is subject to the risk that the Canadian dollar/US dollar exchange rates will adversely impact the Company's results of operations. The Company believes this risk to be immaterial to the Company's results of operations. PART II. OTHER INFORMATION Item 1. LEGAL PROCEEDINGS The Company is involved in routine litigation proceedings incidental to the conduct of its business. The Company does not believe that any such proceedings presently pending will have a material adverse effect on the Company's financial condition or results of operations. Item 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits Not applicable. (b) Report on Form 8-K Not applicable. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. DIGITAL GENERATION SYSTEMS, INC. Dated: November 14, 2001 By /S/ OMAR CHOUCAIR ------------------ Omar Choucair Chief Financial Officer (Principal Financial and Chief Accounting Officer) -----END PRIVACY-ENHANCED MESSAGE-----