-----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, PXjEAolqxB7QNzRwhCyfsD2+T5inG6yR/VHaxM7/6jevSOL2+xFzaBv/AGzYatY0 f060FWv8irKdL05R9sfTrA== 0000950149-98-001487.txt : 19980817 0000950149-98-001487.hdr.sgml : 19980817 ACCESSION NUMBER: 0000950149-98-001487 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 19980630 FILED AS OF DATE: 19980814 SROS: NASD 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: CA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-27644 FILM NUMBER: 98690339 BUSINESS ADDRESS: STREET 1: 875 BATTERY ST STREET 2: STE 1850 CITY: SAN FRANCISCO STATE: CA ZIP: 94111 BUSINESS PHONE: 4155466600 MAIL ADDRESS: STREET 1: 875 BATTERY ST CITY: SAN FRANCISCO STATE: CA ZIP: 94111 10-Q 1 FORM 10-Q FOR PERIOD ENDED JUNE 30,1998. 1 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 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 JUNE 30, 1998 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ____________ TO ____________ . COMMISSION FILE NUMBER: 0-27644 DIGITAL GENERATION SYSTEMS, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) CALIFORNIA 94-3140772 (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)
875 BATTERY STREET SAN FRANCISCO, CALIFORNIA 94111 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE) (415) 276-6600 (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) NOT APPLICABLE (FORMER NAME, FORMER ADDRESS, FORMER FISCAL YEAR, IF CHANGED SINCE LAST REPORT) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ] Number of shares of registrant's Common Stock, without par value, outstanding as of August 14, 1998: 22,261,436 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 2 DIGITAL GENERATION SYSTEMS, INC. This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual results could differ materially from those indicated in the forward-looking statements as a result of certain factors, including those set forth under "Certain Business Considerations" in "Management's Discussion and Analysis of Financial Condition and Results of Operations" and elsewhere in this Form 10-Q. TABLE OF CONTENTS
PAGE ---- PART I. FINANCIAL INFORMATION Item 1. Financial Statements........................................ 3 Condensed Consolidated Balance Sheets at June 30, 1998 and December 31, 1997......................................... 3 Condensed Consolidated Statements of Operations for the three and six months ended June 30, 1998 and 1997......... 4 Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 1998 and 1997....................... 5 Notes to Condensed Consolidated Financial Statements........ 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations................................. 9 PART II. OTHER INFORMATION Item 1. Legal Proceedings........................................... 23 Item 2. Changes in Securities....................................... 23 Item 3. Defaults upon Senior Securities............................. 23 Item 4. Submission of Matters to a Vote of Security Holders......... 23 Item 5. Other Information........................................... 23 Item 6. Exhibits and Reports on Form 8-K............................ 24 SIGNATURES.................................................. 27
2 3 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS DIGITAL GENERATION SYSTEMS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AMOUNTS) ASSETS
JUNE 30, DECEMBER 31, 1998 1997 ----------- ------------ (UNAUDITED) CURRENT ASSETS: Cash and cash equivalents................................. $ 4,188 $ 7,833 Short-term investments.................................... -- 987 Accounts receivable, net.................................. 8,683 8,053 Prepaid expenses and other................................ 557 649 -------- -------- Total current assets.............................. 13,428 17,522 -------- -------- PROPERTY AND EQUIPMENT, at cost: Network equipment......................................... 31,112 30,405 Office furniture and equipment............................ 3,082 2,963 Leasehold improvements.................................... 555 506 -------- -------- 34,749 33,874 Less -- Accumulated depreciation and amortization......... (21,357) (16,308) -------- -------- Property and equipment, net....................... 13,392 17,566 -------- -------- GOODWILL AND OTHER ASSETS, net.............................. 25,088 25,609 -------- -------- $ 51,908 $ 60,697 ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable.......................................... $ 3,020 $ 4,506 Accrued liabilities....................................... 3,964 3,501 Line of credit............................................ 1,672 2,834 Current portion of long-term debt......................... 7,915 7,560 -------- -------- Total current liabilities......................... 16,571 18,401 -------- -------- LONG-TERM DEBT, net of current portion...................... 12,025 11,847 -------- -------- SHAREHOLDERS' EQUITY: Convertible preferred stock, no par value -- Authorized -- 15,000,000 at June 30, 1998; 5,000,000 at December 31, 1997.................................... Outstanding -- 4,950,495 at June 30, 1998 and December 31, 1997.............................................. 31,561 31,561 Common stock, no par value -- Authorized -- 40,000,000 shares at June 30, 1998 and 30,000,000 shares at December 31, 1997................ Outstanding -- 12,216,249 shares at June 30, 1998 and 12,122,679 shares at December 31, 1997................ 57,208 57,123 Receivable from issuance of common stock.................. (175) (175) Accumulated deficit....................................... (65,282) (58,060) -------- -------- Total shareholders' equity........................ 23,312 30,449 -------- -------- $ 51,908 $ 60,697 ======== ========
The accompanying notes are an integral part of these condensed consolidated financial statements. 3 4 DIGITAL GENERATION SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 1998 AND 1997 (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ------------------ ------------------ 1998 1997 1998 1997 ------- ------- ------- ------- (UNAUDITED) (UNAUDITED) REVENUES............................................ $10,097 $ 5,405 $19,971 $10,011 ------- ------- ------- ------- COSTS AND EXPENSES: Delivery costs.................................... 3,666 1,813 7,412 3,288 Customer operations............................... 3,468 2,104 7,043 4,239 Sales and marketing............................... 1,235 1,126 2,499 2,141 Research and development.......................... 601 620 1,189 1,268 General and administrative........................ 1,015 637 2,044 1,241 Depreciation and amortization..................... 2,880 1,968 5,713 3,733 ------- ------- ------- ------- Total expenses............................ 12,865 8,268 25,900 15,910 ------- ------- ------- ------- LOSS FROM OPERATIONS................................ (2,768) (2,863) (5,929) (5,899) ------- ------- ------- ------- OTHER INCOME (EXPENSE): Interest income................................... 45 215 114 466 Interest expense.................................. (696) (553) (1,407) (1,064) ------- ------- ------- ------- NET LOSS............................................ $(3,419) $(3,201) $(7,222) $(6,497) ======= ======= ======= ======= BASIC AND DILUTED NET LOSS PER COMMON SHARE......... $ (0.28) $ (0.27) $ (0.59) $ (0.55) ======= ======= ======= ======= WEIGHTED AVERAGE COMMON SHARES...................... 12,216 11,733 12,196 11,710 ======= ======= ======= =======
The accompanying notes are an integral part of these condensed consolidated financial statements. 4 5 DIGITAL GENERATION SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE SIX MONTHS ENDED JUNE 30, 1998 AND 1997 (IN THOUSANDS)
SIX MONTHS ENDED JUNE 30, ------------------ 1998 1997 ------- ------- (UNAUDITED) CASH FLOWS FROM OPERATING ACTIVITIES: Net loss.................................................. $(7,222) $(6,497) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization of property and equipment........................................... 5,059 3,519 Amortization of goodwill and intangibles............. 654 213 Provision for doubtful accounts...................... 83 89 Changes in operating assets and liabilities -- Accounts receivable............................... (713) (630) Prepaid expenses and other assets................. (41) (369) Accounts payable and accrued liabilities.......... (1,033) (402) ------- ------- Net cash used in operating activities............. (3,223) (4,077) ------- ------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of short-term investments........................ (2,003) (6,848) Maturities of short-term investments...................... 3,000 11,816 Acquisition of property and equipment..................... (874) (3,036) ------- ------- Net cash provided by investing activities......... 113 1,932 ------- ------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from issuance of common stock.................... 85 50 Proceeds from line of credit.............................. 6,985 -- Payments on line of credit................................ (8,147) -- Proceeds from issuance of long-term debt.................. 4,465 3,706 Payments on long-term debt................................ (3,933) (2,062) ------- ------- Net cash provided by (used in) financing activities....................................... (545) 1,694 ------- ------- NET DECREASE IN CASH AND CASH EQUIVALENTS................... (3,645) (451) CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD............ 7,833 9,682 ------- ------- CASH AND CASH EQUIVALENTS AT END OF PERIOD.................. $ 4,188 $ 9,231 ======= ======= SUPPLEMENTAL CASH FLOW INFORMATION Property and equipment financed with capitalized lease obligations............................................ $ -- $ 400
The accompanying notes are an integral part of these condensed consolidated financial statements. 5 6 DIGITAL GENERATION SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The financial statements included herein have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. However, the Company believes that the disclosures are adequate to make the information presented not misleading. These condensed consolidated financial statements should be read in conjunction with the financial statements and the notes thereto included in the Company's financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 1997. The unaudited condensed consolidated financial statements included herein reflect all adjustments (which include only normal, recurring adjustments) which are, in the opinion of management, necessary to state fairly the results for the three and six month periods ended June 30, 1998. The results for the three and six month periods ended June 30, 1998, are not necessarily indicative of the results expected for the full fiscal year. 2. CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS The Company has classified all marketable debt securities as held-to-maturity and has accounted for these investments using the amortized cost method. Cash and cash equivalents consist of liquid investments with original maturities of three months or less. Short-term investments are marketable securities with original maturities greater than three months and less than one year. As of June 30, 1998 and December 31, 1997, cash and cash equivalents consist principally of U.S. Treasury bills and various money market accounts; as a result, the amortized purchase cost approximates the fair market value. As of December 31, 1997, short-term investments consist principally of U.S. Treasury bills and various money market accounts; as a result, the amortized purchase cost approximates the fair market value. 3. ACQUISITION On July 18, 1997, the Company acquired 100% of the capital stock of Starcom Mediatech, Inc. ("Mediatech"), a wholly owned subsidiary of IndeNet, Inc. ("IndeNet"), for consideration totaling approximately $25.8 million ("Mediatech Acquisition"). The consideration consisted of approximately $14.0 million in cash, 324,355 shares of the Company's Common Stock, a $2.2 million subordinated promissory note bearing interest at 9% payable to IndeNet (the "Company Note"), a $2.2 million secured subordinated promissory note bearing interest at 9% payable to Thomas H. Baur, a creditor of IndeNet (the "Baur Note"), and the Company assumed approximately $5.4 million of existing Mediatech debt. Mediatech is a media duplication and distribution company whose principal offices are located in Chicago, Illinois. On October 27, 1997, as provided for in the purchase agreement, the Company and IndeNet agreed to reduce the aggregate purchase price by $625,000 based on Mediatech's financial position at the acquisition date. The Mediatech acquisition was accounted for as a purchase. The excess of purchase price and acquisition costs over the net book value of assets acquired of approximately $17.8 million, has been included in Goodwill and Other Assets in the accompanying consolidated balance sheet and is being amortized over a twenty year period. Amortization of approximately $432,000 is included in the consolidated statement of operations for the six months ended June 30, 1998. The operating results of Mediatech have been included in the consolidated results of the Company from the date of the closing of the transaction, July 18, 1997. 6 7 DIGITAL GENERATION SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) PRO FORMA RESULTS The following table reflects unaudited pro forma combined results of operations of the Company including Mediatech on the basis that the acquisition of Mediatech had taken place at the beginning of the first fiscal period presented:
THREE MONTHS SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, ------------------ ------------------ 1998 1997 1998 1997 ------- ------- ------- ------- (IN THOUSANDS EXCEPT PER SHARE DATA) Revenues.................................... $10,097 $11,241 $19,971 $21,957 Net Loss.................................... (3,419) (3,926) (7,222) (8,183) Net Loss per Share.......................... $ (0.28) $ (0.33) $ (0.59) $ (0.70) Number of Shares used in Computation........ 12,216 11,733 12,196 11,710
The unaudited pro forma combined results of operations are not necessarily indicative of the actual results that would have occurred had the acquisition of Mediatech been consummated at the beginning of 1997, or of future operations of the combined companies under the ownership and management of the Company. 4. SUBSEQUENT EVENTS PRIVATE PLACEMENT OF COMMON STOCK In July and August 1998, the Company's Board of Directors authorized the sale and issuance of up to $ 13.0 million worth of Common Stock in a private placement transaction. The Company has received subscriptions from current institutional and closely associated investors for approximately 4.6 million shares. These additional common shares will be issued at $2.80 per share. Total proceeds to the Company, net of issuance costs, will be approximately $12.7 million. The proceeds of this subscription were held in escrow pending the closing of the transaction on August 14, 1998. CONVERSION OF PREFERRED STOCK TO COMMON STOCK In July 1998, the Company's Board of Directors authorized conversion of all the Company's Series A Preferred Stock to Common Stock pursuant to the terms of the Series A Preferred Stock Conversion Agreement effective August 12, 1998. Each Series A Preferred Shareholder will receive 1.1 shares of Common Stock for each Preferred share converted. The Company's Board deemed this action necessary and appropriate in order to assure conversion by these shareholders which held certain preferred stock rights which could have delayed the closing of the Private Placement transaction discussed above. The conversion of the Series A Preferred Stock to Common Stock at a ratio greater than 1:1 results in a deemed dividend equal to the value of the additional shares granted to the Preferred Shareholders on the date of conversion. This deemed dividend will be considered a reduction in earnings in the computation of basic and diluted earnings per share for the quarter ended September 30, 1998. 7 8 DIGITAL GENERATION SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) PRO FORMA RESULTS The following table presents selected unaudited pro forma Consolidated Balance Sheet data for the Company as if the above transactions described above in the subsequent events note took place effective June 30, 1998 compared to the actual Consolidated Balance Sheet as of June 30, 1998 per the financial statements in this Form 10-Q:
PER JUNE 30, 1998 PRO FORMA JUNE 30, 1998 BALANCE SHEET BALANCE SHEET ----------------- ----------------------- Cash and Cash Equivalents....................... $ 4,188 $15,638 Short term notes receivable..................... -- 1,250 Total Assets.................................... $51,908 $64,608 Preferred Stock Outstanding -- 4,950,495 shares at 6/30/98 Pro forma outstanding -- none at 6/30/98... 31,561 15,161 Common Stock Outstanding -- 12,216,249 shares at 6/30/98 Pro forma outstanding -- 22,251,081 at 6/30/98.................................... 57,208 87,948 Total Shareholders' Equity...................... 23,312 36,012 Total Liabilities and Shareholders' Equity...... $51,908 $64,608
8 9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. Actual results could differ materially from those indicated in the forward-looking statements as a result of certain factors, including those set forth under "Certain Business Considerations in Management's Discussion and Analysis of Financial Condition and Results of Operations" and elsewhere in this Form 10-Q. The following table presents unaudited financial information expressed as a percentage of total revenues and operating data for the period indicated. The information and operating data has been prepared by the Company on a basis consistent with the Company's audited financial statements and includes all adjustments, consisting only of normal recurring adjustments, that management considers necessary for a fair presentation for the periods presented. The operating results for any period presented should not be relied on as indicative of results for any future period. STATEMENTS OF OPERATIONS:
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ------------------ ---------------- 1998 1997 1998 1997 ------ ------ ----- ----- Revenues...................................... 100.0% 100.0% 100.0% 100.0% Costs and Expenses: Delivery and material costs................. 36.3 33.5 37.1 32.8 Customer operations......................... 34.3 38.9 35.3 42.3 Sales and marketing......................... 12.2 20.8 12.5 21.4 Research and development.................... 6.0 11.5 6.0 12.7 General and administrative.................. 10.1 11.8 10.2 12.4 Depreciation and amortization............... 28.5 36.4 28.6 37.3 ----- ----- ----- ----- Total expenses........................... 127.4 152.9 129.7 158.9 ----- ----- ----- ----- Loss from operations.......................... (27.4) (52.9) (29.7) (58.9) Other income (expense): Interest income............................. 0.4 4.0 0.6 4.7 Interest expense............................ (6.9) (10.2) (7.0) (10.6) ----- ----- ----- ----- Net loss...................................... (33.9)% (59.1)% (36.1)% (64.8)% ===== ===== ===== =====
ACQUISITION In July 1997, the Company acquired 100% of the capital stock of Starcom Mediatech, Inc. ("Mediatech"), a wholly owned subsidiary of IndeNet, Inc. with operating facilities in Chicago, Los Angeles, New York and Louisville. Mediatech's primary operations are services typical of a traditional dub and ship house, including the physical duplication and distribution of audio and video content on a wide range of tape formats and performance of a variety of audio and video editing services. Although Mediatech's revenues are generated primarily from the duplication and distribution of short form content, consistent with those of DG Systems prior to this acquisition, Mediatech's revenues also include a significant portion generated from the distribution of long form syndicated programming of both live and previously broadcast television shows. Such services include integrating commercials into syndicated programs and uplinking the completed programs to satellites as well as the physical duplication and distribution of such programs to those stations which do not receive a satellite feed. The acquisition was accounted for as a purchase and the operating results of Mediatech have been included in the consolidated results of the Company from the date of the closing of the transactions, July 18, 1997. 9 10 Revenues
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ------------------- ------------------ 1998 1997 1998 1997 -------- ------- ------- ------- (IN THOUSANDS) (IN THOUSANDS) Audio Distribution........................... $ 4,611 $3,363 $ 8,258 $ 6,028 Video Distribution........................... 3,145 1,396 6,375 2,679 Ancillary Post-Production Services and Other Services............................. 2,341 646 5,338 1,304 ------- ------ ------- ------- Total Revenues..................... $10,097 $5,405 $19,971 $10,011 ======= ====== ======= =======
Revenues were $10,097,000, for the three months ended June 30, 1998, an 87% increase from $5,405,000 for the three months ended June 30, 1997, and revenues for the six months ended June 30, 1998 were $19,971,000, a 99% increase from $10,011,000 for the six months ended June 30, 1997. This revenue growth is due to increases of 60% and 61% in the combined volume of audio and video deliveries performed as well as the addition of revenue for other services now offered by the Company for the three and six months ended June 30, 1998 over the same periods in 1997. Of the total volume increases, for the three and six months ended June 30, 1998, approximately, 76% and 71% respectively, relate to orders delivered through the DG Systems Network Operating Center ("NOC") in San Francisco, primarily as a result of orders received at the former Mediatech facilities. The Company believes that the increases in delivery volumes are due to a number of factors, including the increased acceptance of the services offered by the Company, the increased availability of an expanded network of Company equipment located in radio and television stations and the increased market presence resulting from the Mediatech acquisition and the November 1996 acquisition of PDR Productions, Inc. ("PDR"). Average revenue per audio delivery decreased approximately 5% and 4% in the three and six months ended June 30, 1998, versus the three and six months ended June 30, 1997, respectively. The decreases are due primarily to changes in the mix of digital audio distribution services provided, particularly an increase in the proportion of deliveries made as a result of orders for the Company's Economy Service. This service, which guarantees delivery by noon of the second business day following the order, accounted for approximately 23% and 22% of digital audio deliveries in the quarter and six months ended June 30, 1998 versus 17% and 18%, respectively, in the same periods of 1997. The Company attributes this fluctuation to increased use of the Company's services for routine distribution in addition to selective usage of the Company's more expensive premium services. The other audio service categories had smaller fluctuations versus the prior year periods. Average revenue per video delivery decreased approximately 9% and 7% for the three months and six months ended June 30, 1998 from the three and six months ended June 30, 1997. The average price per delivery for the three months ended June 30, 1998 is based on the significantly higher revenues resulting from increased digital and physical delivery volume, including deliveries made directly from the former Mediatech facilities. The decrease in average revenue per video delivery is due to changes in the mix of video delivery services provided and the related customer pricing agreements resulting from the acquisition of Mediatech. For the three and six months ended June 30, 1998, revenues included approximately $2.3 million and $5.3 million, respectively, from other services provided by the Company, primarily as a result of the Mediatech acquisition. For the three months ended June 30, 1998, this revenue consisted of $.7 million for corporate duplication, $.8 million for post-production services, and $.8 million for satellite distribution services. For the six months ended June 30, 1998, revenues included approximately $1.9 million for corporate duplication, $1.7 million for post-production services, and $1.7 million for satellite distribution services. 10 11 Delivery and Material Costs
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ------------------ ---------------- 1998 1997 1998 1997 ------- ------- ------ ------ (IN THOUSANDS) (IN THOUSANDS) Audio Distribution.............................. $1,123 $ 960 $1,961 $1,696 Video Distribution.............................. 1,641 668 3,148 1,340 Ancillary Post-Production Services and Other Services................................ 902 185 2,303 252 ------ ------ ------ ------ Total Delivery and Materials Costs.... $3,666 $1,813 $7,412 $3,288 ====== ====== ====== ======
Delivery and material costs were $3,666,000 for the three months ended June 30, 1998, a 102% increase from the $1,813,000 for the three months ended June 30, 1997. Delivery and materials costs were $7,412,000 for the six months ended June 30, 1998 a 125% increase from the $3,288,000 for the six months ended June 30, 1997. The increase in costs in each period versus the same period of the prior year is primarily due to the increased delivery volumes, as well as the addition of the direct costs related to the other services now provided by the Company, in particular, as a result of the Mediatech acquisition. The increased costs include both delivery expenses and direct materials costs required when physically duplicating an audio or video spot as well as the direct materials and fees paid to other service providers in connection with ancillary post- production services and other services offered by the Company. Delivery and material costs as a percentage of revenues increased to 36% of revenues from 34% of revenues in the quarters ended June 30, 1998 and 1997, respectively; and increased to 37% of revenues from 33% of revenues in the six months ended June 30, 1998 and 1997, respectively. The increases in such costs as a percentage of total revenues is due to the change in mix of services offered by the Company as a result of the acquisition of Mediatech and the ramp up of the video distribution service. The Company's audio distribution services are performed primarily electronically, which has resulted in lower delivery and material costs as a percentage of revenues than those of the Company's video distribution and other service offerings. Audio delivery and material costs as a percentage of audio revenues decreased to approximately 24% from approximately 29% in the three months ended June 30, 1998, and 1997, respectively; and decreased to approximately 24% from 28% in the six months ended June 30, 1998, and 1997, respectively. This decrease is primarily the result of improvements in cost per electronic delivery resulting from rate improvements when the Company renewed its contract with its primary telephone service provider in May 1997. Video delivery and material costs as a percentage of video revenues has increased to approximately 52% from 48% in the three months ended June 30, 1998, and 1997, respectively; and decreased to approximately 49% from 50% in the six months ended June 30, 1998, and 1997, respectively. The increase in costs as a percentage of revenues in the quarter ended June 30, 1998 is due primarily to an increase in the volume of deliveries being performed electronically through the Company's NOC. Such deliveries increased by approximately 52% for both the three and six months ending June 30, 1998 over the same periods in the prior year. Although costs per NOC video delivery were significantly reduced versus those of the same periods in the prior year, these deliveries are still cost more than traditional physical delivery because volume has not yet reached the levels necessary to efficiently cover the fixed costs related to such deliveries. Approximately 48% and 64% of the Company's video deliveries were made through the NOC in the three and six months ended June 30, 1998 as opposed to approximately 19% and 14% in the same three and six month periods of 1997. Delivery and material costs related to the other services provided by the Company were 39% and 43% of the associated revenue for the three and six months ended June 30, 1998, and 29% and 19% of the associated revenues for the three and six months ended June 30, 1997, respectively. The direct costs as a percentage of revenues associated with these services vary widely based on the numerous services performed and the rates negotiated with the customers using these services. In general, the direct costs of corporate duplication and satellite services have higher costs as a percentage of revenues than the Company's audio and video distribution services. The Company is actively reviewing the rates charged for such services and the potential business impacts of revising these service offerings. 11 12 Customer Operations Customer operations expenses were $3,468,000 and $2,104,000 for the quarters ended June 30, 1998 and 1997, respectively, and $7,043,000 and $4,239,000 for the six months ended June 30, 1998 and 1997, respectively. These increases are primarily the result of the consolidation of the costs of the former Mediatech operations. In addition, expenses have increased versus the same periods of the prior year due to the addition of the personnel necessary to respond to the greater volume of orders and deliveries. Additional costs are primarily the labor and overhead expenses of personnel involved in customer and technical support and fulfillment of orders for all services offered by the former Mediatech locations. Customer operations expenses as a percentage of revenues decreased to 34% from 39% of revenues in the quarters ended June 30, 1998 and 1997, respectively; and decreased to 35% of revenues from 42% of revenues in the six months ended June 30, 1998 and 1997, respectively. These decreases are primarily due to the reduced cost of customer operations as a percentage of revenues for orders processed through the Company's NOC, which serves as the primary support for the digital network. These improvements in cost as a percentage of revenues, however, were offset slightly by the impact of the relatively more expensive customer operations expenses of the Company's other facilities, which have a different cost structure in order to provide the additional services offered at these locations. The Company believes that in order to compete effectively and manage future growth it will be necessary to continue to implement changes which improve and increase the efficiency of its customer operations. Sales and Marketing Sales and marketing expenses were $1,235,000 for the three months ended June 30, 1998, a 10% increase from $1,126,000 for the quarter ended June 30, 1997, and increased 17% to $2,499,000 from $2,141,000 in the six months ended June 30, 1998 and 1997, respectively. The increase in sales and marketing expenses in the quarter and six months ended June 30, 1998 is due primarily to the consolidation of the costs of the former Mediatech sales group. However, sales and marketing expenses as a percentage of revenues was reduced to 12% from 21% of revenues for the three months ended June 30, 1998 and 1997, respectively and was reduced to 13% from 21% of revenues for the six months ended June 30, 1998 and 1997, respectively. The Company united its sales forces in 1997 and believes it is now more capable of effectively and efficiently marketing the Company's complete set of services throughout the country. The Company expects to continue to expand sales and marketing programs designed to introduce the Company's services to the marketplace and to attract new customers for its services. Research and Development Research and development expenses decreased 3% to $601,000 for the quarter ended June 30, 1998 from $620,000 for the quarter ended June 30, 1997, and decreased 6% to $1,189,000 from $1,268,000 for the six months ended June 30, 1998 and June 30, 1997 respectively. The decrease is primarily due to a reduction in development and testing costs, principally frame relay and satellite transmission testing, versus those incurred in the three and six months ended June 30, 1997 to prepare the NOC for video delivery. The decreased testing costs were partially offset by other spending increases, primarily engineering labor costs. The Company expects that additional research and development spending will be necessary to remain competitive and its future success will depend in significant part upon the technological quality of its products and processes relative to those of its competitors and its ability both to develop new and enhanced products and services. General and Administrative General and administrative expenses increased 59% to $1,015,000 for the quarter ended June 30, 1998, from $637,000 for the quarter ended June 30, 1997; and increased 65% to $2,044,000 from $1,241,000 in the six months ended June 30, 1997. The increase is primarily due to the consolidation of the costs of certain 12 13 former Mediatech staff, as well as system conversion costs for consolidating and upgrading the Company's order entry, billing and financial reporting systems. The Company expects to continue to spend on the consolidation and upgrade of the Company's systems over the course of 1998 to improve reporting and operating efficiency. Depreciation and Amortization Depreciation and amortization expenses increased 46% to $2,880,000 in the quarter ended June 30, 1998 from $1,968,000 in the quarter ended June 30, 1997; and increased 53% to $5,713,000 for the six months ended June 30, 1998 from $3,733,000 for the six months ended June 30, 1997. These increases are due to the continued expansion of the Company's network. The Company's total investment in network equipment has increased 47% to $31.1 million at June 30, 1998, from $21.2 million at June 30, 1997. In particular, the Company has acquired approximately $7.5 million of network equipment as a result of the acquisition of Mediatech, has made capital additions of approximately $2.2 million between June 30, 1997 and June 30, 1998, in support of its video delivery service plan, and has increased the number of units located at broadcast stations at June 30, 1998. In addition, amortization expense increased by $220,000 and $440,000 in the three and six months ended June 30, 1998 over the same periods last year, as a result of the goodwill recorded in connection with the July 1997 acquisition of Mediatech. The Company expects to continue to invest in the expansion of its network. In particular, the Company is in the process of expanding its infrastructure within the television broadcast industry that will require additional DG Video Transmission Systems and Digital Video Playback Systems to be built and installed in production studios and television stations. The Company expects depreciation and amortization to increase in absolute dollars in proportion to this growth. Interest Income and Interest Expense Interest income decreased 79% to $45,000 in the quarter ended June 30, 1998 from $215,000 for the quarter ended June 30, 1997 and decreased 76% to $114,000 for the six months ended June 30, 1998, from $466,000 in the six months ended June 30, 1997. These decreases are primarily the result of reductions in the levels of cash and cash equivalents and short-term investments versus the same periods of the prior year. The Company's initial public offering was completed in February 1996 and since that time the offering's proceeds have been used to fund the Company's operating, investing and financing activities. The Company expects that interest income will fluctuate in the future based on the levels of cash raised and used in the Company's operations. Interest expense increased 26% to $696,000 for the quarter ended June 30, 1998, from $553,000 in the quarter ended June 30, 1997 and increased 32% to $1,407,000 for the six months ended June 30, 1998, from $1,064,000 for the six months ended June 30, 1997. The increases are due primarily to interest expense totaling $213,000 on the term debt and line of credit assumed in conjunction with the Mediatech acquisition, as well as $127,000 of interest expense on the promissory notes given as consideration in the July 1997 acquisition of Mediatech. The remaining increases result from interest expense incurred from leasing and loan agreements used to fund the acquisition of components and equipment needed to develop the Company's network and to provide Company personnel with the capital resources necessary to support the Company's business growth. Debt outstanding under these agreements has increased to $14.9 million at June 30, 1998 from $14.2 million at June 30, 1997. The Company expects interest expense will increase in the future based on the increased levels of borrowing. Liquidity and Capital Resources Net cash used in operating activities, including the adjustment for depreciation and amortization, decreased to $3.2 million in the six months ended June 30, 1998 from $4.1 million in the six months ended June 30, 1997. This change is primarily the result of a reduced net loss, exclusive of depreciation and amortization. The Company's earnings before interest, taxes and depreciation improved from a loss of 13 14 $2.2 million for the six months ended June 30, 1997 to a loss of $216,000 for the six months ended June 30, 1998. The Company used cash of $874,000 for the purchase of property and equipment in the six months ended June 30, 1998. In the six months ended June 30, 1997, the Company used cash of $3.0 million for the purchase of property and equipment. The capital additions for both periods were the result of the Company's continued expansion of its network. As the primary video network infrastructure is now in place, fiscal 1998 capital equipment additions are not expected to reach the levels of fiscal 1997. Principal payments on long-term debt were $3.9 million for the six months ended June 30, 1998 versus $2.1 million in the six months ended June 30, 1997. Such payments increased due primarily to $450,000 of payments on other long-term debt of Mediatech assumed by the Company in conjunction with the Mediatech acquisition and principal payments of $400,000 on the promissory notes issued in connection with the Mediatech acquisition. In addition, there was an increase in regularly scheduled repayment of the increased capital lease liability and term debt incurred to finance equipment and property acquisitions. At June 30, 1998, the Company's current sources of liquidity included cash and cash equivalents of $4.2 million and $1.7 million available to finance capital expenditures under a long-term credit facility which can be drawn against until December 1998. Mediatech has a revolving line of credit available to fund the working capital requirements of Mediatech. The maximum available under the Mediatech line is $3,525,000, dependent upon the level of qualifying receivables maintained by Mediatech. During the six months ended June 30, 1998, $1.2 million of net paydown was made on the line of credit, and the outstanding balance at June 30, 1998 of $1,672,000 was approximately equal to the maximum available under the agreement at that time. The Company expects to fully utilize the funding available under the existing credit agreements. As discussed in the Notes to the Condensed Consolidated Financial Statements, in August 1998 the Company raised approximately $12.7 million through a Private Placement of Common Stock. The Company expects to use these proceeds to fund the Company's operating, investing and financing requirements. The Company believes that its current sources of liquidity will satisfy the Company's projected working capital, capital lease and term loan commitments and other cash requirements through June 1999. CERTAIN BUSINESS CONSIDERATIONS The Company's business is subject to the following risks in addition to those described elsewhere in this Form 10-Q. History of Losses; Future Operating Results Uncertain. The Company was founded in 1991 and has been unprofitable since its inception. The Company expects to generate continued, but decreased net losses for the next several quarters. As of June 30, 1998, the Company's accumulated deficit was $65.3 million. The Company has had difficulty in accurately forecasting its future sales and operating results due to its limited operating history. Accordingly, although the Company has recently experienced significant growth, a significant portion of which is due to acquisitions, such growth rates may not be sustainable and should not be used as an indication of future sales growth, if any, or of future operating results. The Company's future success also will depend in part on obtaining continued reductions in delivery and service costs, particularly continued automation of order processing and reductions in telecommunications costs. There can be no assurance that the Company's sales will grow or be sustained in future periods, that the Company will be able to reduce delivery and service costs, or that the Company will achieve or sustain profitability in any future period. Dependence on Electronic Video Advertising Delivery Service Deployment. The Company has made a substantial investment in upgrading and expanding its network operating center and populating television stations with the units necessary for the receipt of electronically delivered video advertising content. However there can be no assurance that placement of these units will cause this service to achieve adequate market acceptance among customers which require video advertising content delivery. The inability to place units in an adequate number of stations or the inability to capture market share among content delivery customers as a result of price competition or new product introductions from competitors would have a material adverse effect 14 15 on the Company's business, operating results and financial position. In addition, the Company believes that in order to more fully address the needs of potential video delivery customers it will need to develop a set of ancillary services which typically are provided by dub and ship houses. These ancillary services, which include physical archiving, closed captioning, modification of slates and format conversions, will need to be provided on a localized basis in each of the major cities in which the Company provides services directly to agencies and advertisers. The Company currently has the capability to provide such services through its facilities in New York, Los Angeles and Chicago. However, there can be no assurance that the Company will successfully contract for and provide these services in each major metropolitan area or that the Company will be able to provide competitive video distribution services in other U.S. markets. Unless the Company can successfully continue to develop and provide video transmission services, it may be unable to retain current or attract future audio delivery customers who may ultimately demand delivery of both media content. Uncertainties Relating to Integration of Operations. DG Systems acquired PDR and Mediatech with the expectation that such strategic acquisitions would result in enhanced efficiencies for the combined company. To date the Company has not fully completed the integration of PDR and Mediatech with the Company. Achieving the anticipated benefits of the PDR and Mediatech acquisitions will depend in part upon whether the integration of the organizations and businesses of PDR and Mediatech with those of the Company is achieved in an efficient, effective and timely manner; however, there can be no assurance that this will occur. The successful integration and expansion of the Company's business following its acquisition of PDR and Mediatech requires communication and cooperation among the senior executives and key technical personnel of DG Systems, PDR, and Mediatech. Given the inherent difficulties involved in completing a business combination, there can be no assurance that such cooperation will occur or that the integration of the respective organizations will be successful and will not result in disruptions in one or more sectors of the Company's business. Failure to effectively accomplish the integration of the operations of PDR and Mediatech with those of the Company could have a material adverse effect on DG Systems' results of operations and financial condition. In addition, there can be no assurance that current and potential customers will favorably view the Company's services as offered through PDR and Mediatech or that DG Systems will realize any of the other anticipated benefits of the PDR or Mediatech acquisitions. Moreover, as a result of these acquisitions, certain DG Systems customers may perceive PDR or Mediatech to be a competitor, and this could affect such customers' willingness to do business with DG Systems in the future. The loss of significant customers could have a material adverse effect on DG Systems' results of operations and financial condition. Future Capital Needs; Uncertainty of Additional Funding. The Company intends to continue making capital expenditures to produce and install RSTs, RPTs, VRTSs and DVPS units and to introduce additional services. The Company also continually analyzes the costs and benefits of acquiring certain businesses, products or technologies that it may from time to time identify, and its related ability to finance such acquisitions. Assuming that the Company does not pursue one or more additional acquisitions funded by internal cash reserves, the Company anticipates its existing capital, cash from operations, and funds available under existing term loan and line of credit agreements should be adequate to satisfy its capital requirements through December 1998. There can be no assurance, however, that the net proceeds of the Company's initial public offering and such other sources of funding will be sufficient to satisfy the Company's future capital requirements or that the Company will not require additional capital sooner than currently anticipated. Based on its current business plan, the Company anticipates that it will eventually use the entire proceeds of its initial public offering, the Series A Convertible Preferred Stock financing and the August 1998 private placement of Common Stock, there can be no assurance that other sources of funding will be adequate to fund the Company's capital needs, which depend upon numerous factors, including the progress of the Company's product development activities, the cost of increasing the Company's sales and marketing activities and the amount of revenues generated from operations, none of which can be predicted with certainty. In addition, the Company is unable to predict the precise amount of future capital that it will require, particularly if it were to pursue one or more acquisitions, and there can be no assurance that any additional financing will be available to the Company on acceptable terms, or at all. The inability to obtain financing for acquisitions on acceptable terms may prevent the Company from completing advantageous acquisitions and consequently may adversely effect the Company's 15 16 prospects and future rates of growth. The inability to obtain required financing for continuing operations or an acquisition would have a material adverse effect on the Company's business, financial condition and results of operations. Consequently, the Company could be required to significantly reduce or suspend its operations, seek a merger partner or sell additional securities on terms that are highly dilutive to existing investors. Potential for Additional Nasdaq Review. In connection with the potential delisting of the Company's securities from the Nasdaq National Market, as explained further in "Part II. Item 5. Other Information - Nasdaq National Market Listing Qualifications", the Company received a letter from Nasdaq on August 12, 1998, containing a written decision allowing the continued inclusion of the Company's Common Stock on the Nasdaq National Market based upon the determination of the Nasdaq Listing Qualifications Panel (the "Nasdaq Panel") after a hearing was held on August 7, 1998. However, in accordance with Nasdaq rules, the Nasdaq Listing and Hearing Review Council (the "Review Council") may, on its own motion, determine to review any Nasdaq Panel decision within 45 calendar days after issuance of the written decision. If the Review Council determines to review any aspect of the decision of the Nasdaq Panel, it may affirm, modify, reverse, dismiss, or remand the decision to the Nasdaq Panel. The holders of the registered Common Stock of the Company currently enjoy a substantial benefit in terms of liquidity by having such Common Stock listed on the Nasdaq National Market trading system which would be lost if the Company were to be delisted. While the Company fully expects to comply with the written decision of Nasdaq, and to be able to demonstrate compliance with all requirements for the continued listing on the Nasdaq National Market and does not expect any further review of this matter, there can be no assurance that the Company will be able to continue to have its registered Common Stock listed on the Nasdaq National Market or similar public securities exchange. Concentration of Stock Ownership; Antitakeover Provisions. At June 30, 1998 present executive officers and directors of the Company and their respective affiliates own approximately 41% of the Company's Common Stock and recently-issued Series A Convertible Preferred Stock, which votes together with Common Stock on all matters submitted to the shareholders of the Company. After the August 1998 closing of the private placement of the Company's Common Stock and the conversion of all of the Series A Preferred Stock, as described in Note 4 of the Condensed Consolidated Financial Statements, the ownership will be approximately 35%. As a result, these shareholders will be able to control or significantly influence all matters requiring shareholder approval, including the election of directors and the approval of significant corporate transactions. Such concentration of ownership may have the effect of delaying or preventing a change in control of the Company. Furthermore, certain provisions of the Company's Amended and Restated Articles of Incorporation and Bylaws, and of California law, could have the effect of delaying, deferring or preventing a change in control of the Company. Preferential Rights of Preferred Stock. As of June 30, 1998, the Company had 5,000,000 shares of Series A Convertible Preferred Stock (the "Series A Preferred") authorized of which 4,950,495 shares were then issued and outstanding. The rights of such Series A Preferred included certain rights and preferences set forth in the Company's Certificate of Determination of Rights of Series A Convertible Preferred Stock. At the Company's 1998 Annual Meeting of Shareholders held on April 29, 1998, the Company's shareholders approved an amendment to the Company's Articles of Incorporation which increased the authorized number of shares of the Company's Preferred Stock to 15,000,000. On August 12, 1998 holders of all the outstanding shares of Series A Preferred elected to convert such shares of Series A Preferred into shares of the Company's Common Stock, as further described in "Part II. Item 5. Other Information - Nasdaq National Market Listing Qualifications". Accordingly, pursuant to the Company's articles of incorporation, the Company's Board of Directors has the authority to issue up to 10,049,505 additional shares of Preferred Stock and may divide such 10,049,505 remaining authorized shares of Preferred Stock into any number of series, to fix the number of and determine the rights, preferences, privileges and restrictions granted to or imposed upon, any such series. The rights of the holders of the Company's Common Stock will be subject to, and may be adversely affected by, the rights of the holders of any such Preferred Stock that may be issued in the future. In addition, the issuance of such Preferred Stock may have the effect of delaying, deferring or preventing a change of control of the Company without any further action by the shareholders and may adversely affect the voting and other rights of the holders of the Company's Common Stock. The provisions of such Preferred Stock could also have the effect of limiting the price that investors might be willing to pay in the future for shares of the Company's Common Stock. While the Company has no present plans to issue shares of Preferred Stock, there can be no assurance that such shares of Preferred Stock will not be issued in the future in accordance with the terms and conditions that the Board of Directors deems to be in the best interests of the Company and its shareholders. Registration Rights. In connection with the sale of shares of the Company's Common Stock which occurred on August 14, 1998 as described further in "Part II. Item 5. Other Information - Nasdaq National Market Listing Qualifications", the Company has agreed to file a registration statement with the SEC for the purposes of registering the re-sale of such shares and to list such shares on the Nasdaq National Market. The Company presently intends to begin such registration process within 60 days of the closing of the sale of the shares of its Common Stock and has granted demand registration rights exercisable no earlier than 60 days from the closing of the sale of such shares. In addition, certain other holders of the Company's Common Stock including former holders of the Company's Series A Preferred, previously have been granted similar demand and piggy-back registration rights. Following the successful completion of such registration and listing processes, such additional shares of the Company's Common Stock will be freely tradable in the public market, subject to volume limitations applicable to affiliates of the Company. Sales of a substantial number of additional shares in the public market could adversely affect the market price of the Company's Common Stock and could impair the Company's future ability to raise capital through the sale of its equity securities. Dependence on Emerging Markets. The market for the electronic delivery of digital audio and video transmissions by advertisers, advertising agencies, production studios, and video and music distributors to radio and television stations, is relatively new and alternative technologies are rapidly evolving. The Company's marketing task requires it to overcome buyer inertia related to the diffuse and relatively low level decision making regarding an agency's choice of delivery services and long standing relationships with existing dub and ship vendors. Therefore, it is difficult to predict the rate at which the market for the electronic delivery of digital audio and video transmissions will grow, if at all. If the market fails to grow, or grows more slowly than anticipated, the Company's business, operating results and financial condition will be materially adversely affected. Even if the market does grow, there can be no assurance that the Company's products and services will achieve commercial success. Although the Company intends to conform its products and services to meet existing and emerging standards in the market for the electronic delivery of digital audio and video transmissions, there can be no assurance that the Company will be able to conform its products to such standards in a timely fashion, or at all. The Company believes that its future growth will depend, in part, on its ability to add these services and additional customers in a timely and cost-effective manner, and there can be no assurance that the Company will be successful in developing such services, and in obtaining new customers for such services. See "Dependence on New Product Introductions." There can also be no assurance that the Company will be successful in obtaining a sufficient number of radio and television stations, radio and television networks, advertisers, advertising agencies, production studios, and audio and video distributors who are willing to bear the costs of expanding and increasing the integration of the Company's network, including the Company's field receiving equipment and rooftop satellite antennae. The Company's marketing efforts to date with regard to the Company's products and services have involved identification and characterization of specific market segments for these products and services with a view to determining the target markets that will be the most receptive to such products and services. There can be no assurance that the Company has correctly identified such markets or that its planned products and services will address the needs of such markets. Furthermore, there can be no assurance that the Company's technologies, in their current form, will be suitable for specific applications or that further design modifications, beyond anticipated changes to accommodate different markets, will not be necessary. Broad commercialization of the Company's products and services will require the Company to overcome significant market development hurdles, many of which may not currently be foreseen. Dependence on Technological Developments. The market for the distribution of digital audio and video transmissions is characterized by rapidly changing technology. The Company's ability to remain competitive and its future success will depend in significant part upon the technological quality of its products and processes relative to those of its competitors and its ability both to develop new and enhanced products and services and to introduce such products and services at competitive prices and in a timely and cost-effective fashion. The Company's development efforts have been focused on the areas of satellite transmission technology, video compression technology, TV station system interface, and work on reliability and throughput enhancement of the network. The Company's ability to successfully grow electronic video delivery services depends on its ability to obtain satellite delivery capability. Work in satellite technology is oriented to development and deployment of software to lower transmission costs and increase delivery reliability. Work in video compression technology is directed toward integration of emerging broadcast quality compression systems, which further improve picture quality while maintaining compliance with industry standards, with the Company's existing network. Work in TV station system interface includes implementation of various system control protocols and improvements of the system throughput and reliability. The Company has an agreement with Hughes Network Systems, Inc. ("Hughes") which allows the Company to use Hughes' satellite capacity for electronic delivery of digital audio and video transmissions by that media. The Company has developed and incorporated software designed to enable the current DVPSs to receive digital satellite transmissions over the Hughes satellite system. There can be no assurance that the Hughes satellite system will have the capacity to 16 17 meet the Company's future delivery commitments and broadcast quality requirements and to do so on a cost-effective basis. See "Dependence on Certain Suppliers." The introduction of products embodying new technologies can render existing products obsolete or unmarketable. There can be no assurance that the Company will be successful in identifying, developing, contracting for the manufacture of, and marketing product enhancements or new products that respond to technological change, that the Company will not experience difficulties that could delay or prevent the successful development, introduction and marketing of these products, or that its new products and product enhancements will adequately meet the requirements of the marketplace and achieve market acceptance. Delays in the commencement of commercial availability of new products and services and enhancements to existing products and services may result in customer dissatisfaction and delay or loss of revenue. If the Company is unable, for other reasons, to develop and introduce new products and services or enhancements of existing products and services in a timely manner or if new versions of existing products do not achieve a significant degree of market acceptance, there could be a material adverse effect on the Company's business, financial condition and results of operations. Dependence on Radio Advertising. Prior to the Company's acquisitions of PDR and Mediatech, the Company's revenues were derived principally from a single line of business, the delivery of radio advertising spots from advertising agencies, production studios and dub and ship houses to radio stations in the United States, and such services are expected to continue to account for a significant portion of the Company's revenues for some time. A decline in demand for, or average selling prices of, the Company's radio advertising delivery services, whether as a result of competition from new advertising media, new product introductions or price competition from competitors, a shift in purchases by customers away from the Company's premium services such as DG Priority or DG Express, technological change or otherwise, would have a material adverse effect on the Company's business, operating results and financial condition. Additionally, the Company is dependent upon its relationship with and continued support of the radio stations in which it has installed communications equipment. Should a substantial number of these stations go out of business, experience a change in ownership, or discontinue the use of the Company's equipment in any way, it could materially adversely affect the Company's business, operating results and financial condition. Ability to Maintain and Improve Service Quality. The Company's business is dependent on its ability to make cost-effective deliveries to broadcast stations within the time periods requested by customers. Any failure to do so, whether or not within the control of the Company, could result in an advertisement not being run and in the station losing air-time which it could have otherwise sold. Although the Company disclaims any liability for lost air-time, there can be no assurance that claims by stations for lost air-time would not be asserted in these circumstances or that dissatisfied advertisers would refuse to make further deliveries through the Company in the event of a significant occurrence of lost deliveries, either of which would have a material adverse effect on the Company's business, results of operations and financial condition. Although the Company maintains insurance against business interruption, there can be no assurance that such insurance will be adequate to protect the Company from significant loss in these circumstances or that a major catastrophe (such as an earthquake or other natural disaster) would not result in a prolonged interruption of the Company's business. In particular, the Company's network operating center is located in the San Francisco Bay area, which has in the past and may in the future experience significant, destructive seismic activity that could damage or destroy the Company's network operating center. In addition, the Company's ability to make deliveries to stations within the time periods requested by customers depends on a number of factors, some of which are outside of its control, including equipment failure, interruption in services by telecommunications service providers, and the Company's inability to maintain its installed base of RSTs, RPTs, VRTSs and DVPS video units that comprise its distribution network. The result of the Company's failure to make timely deliveries for whatever reason could be that dissatisfied advertisers would refuse to make further deliveries through the Company which would have a material adverse effect on the Company's business, results of operations and financial condition. Competition. The Company currently competes in the market for the distribution of audio advertising spots to radio stations and the distribution of video advertising spots to television stations. The principal competitive factors affecting these markets are ease of use, price, timeliness and accuracy of delivery. The 17 18 Company competes with a variety of dub and ship houses and production studios that have traditionally distributed taped advertising spots via physical delivery. Although such dub and ship houses and production studios do not currently offer electronic delivery, they have long-standing ties to local distributors that will be difficult for the Company to replace. Some of these dub and ship houses and production studios have greater financial, distribution and marketing resources and have achieved a higher level of brand recognition than the Company. Digital Courier International Corporation ("DCI") has deployed a system to electronically deliver audio content in Canada and the United States. There can be no assurance that the Company will be able to compete effectively against these competitors merely on the basis of ease of use, timeliness and accuracy of delivery. In addition, the Company has learned that DCI was recently placed in receivership and potentially could be sold. If DCI were to be sold to one of the Company's current competitors, or a company with greater resources desiring entry to this market, it could adversely impact the Company's ability to compete in the market for the delivery of audio content as well as the other markets served by the Company. In the market for the distribution of video content to television stations, the Company encounters competition from VDI Media and Vyvx Advertising Distribution Services ("VADS"), a subsidiary of The Williams Companies which includes CycleSat, Inc., in addition to dub and ship houses and production studios, certain of which currently function as marketing partners with the Company in the audio distribution market. To the extent that the Company is successful in entering new markets, such as the delivery of other forms of content to radio and television stations and content delivery to radio and television stations, it would expect to face competition from companies in related communications markets and/or package delivery markets which could offer products and services with functionality similar or superior to that offered by the Company's products and services. Telecommunications providers such as AT&T, MCI and Regional Bell Operating Companies could also enter the market as competitors with materially lower electronic delivery transportation costs. The Company could also face competition from entities with package delivery expertise such as Federal Express, United Parcel Service, DHL and Airborne if any such companies enter the electronic data delivery market. Radio networks such as ABC or Westwood One could also become competitors by selling and transmitting advertisements as a complement to their content programming. In addition, Applied Graphics Technologies, Inc., a provider of digital pre-press services, has indicated its intention to provide electronic distribution services and acquired Spotlink, a dub and ship house and current customer of the Company, in December 1996 as an entry to this market. In 1997, Applied Graphics is reported to have acquired additional dub and ship operations. Many of the Company's current and potential competitors in the markets for audio and video transmissions have substantially greater financial, technical, marketing and other resources and larger installed customer bases than the Company. There can be no assurance that the Company will be able to compete successfully against current and future competitors based on these and other factors. The Company expects that an increasingly competitive environment will result in price reductions that could result in reduced unit profit margins and loss of market share, all of which would have a material adverse effect on the Company's business, results of operations and financial condition. Moreover, the market for the distribution of audio and video transmissions has become increasingly concentrated in recent years as a result of acquisitions, which are likely to permit many of the Company's competitors to devote significantly greater resources to the development and marketing of new competitive products and services. The Company expects that competition will increase substantially as a result of these and other industry consolidations and alliances, as well as the emergence of new competitors. There can be no assurance that the Company will be able to compete successfully with new or existing competitors or that competitive pressures faced by the Company will not materially and adversely affect its business, operating results and financial condition. Ability to Manage Growth. The Company has recently experienced a period of rapid growth that has resulted in new and increased responsibilities for management personnel and has placed and continues to place a significant strain on the Company's management, operating and financial systems and resources. To accommodate this recent growth and to compete effectively and manage future growth, if any, the Company will be required to continue to implement and improve its operational, financial and management information systems, procedures and controls on a timely basis and to expand, train, motivate and manage its work force. 18 19 In particular, the Company believes that to achieve these objectives it must complete the automation of the customer order entry process and the integration of the delivery fulfillment process into the customer billing system and integrate these systems with those of PDR and Mediatech. There can be no assurance that the Company's personnel, systems, procedures and controls will be adequate to support the Company's existing and future operations. Any failure to implement and improve the Company's operational, financial and management systems or to expand, train, motivate or manage employees could have a material adverse effect on the Company's business, operating results and financial condition. Year 2000 Risk Compliance. Many currently installed computer systems and software products are coded to accept only two digit entries in the date code field. Beginning in the year 2000, these date codes fields will need to accept four digit entries to distinguish 21st century dates from 20th century dates. As a result, in less than two years, many such currently installed computer systems and software products used by many companies will need to be upgraded to enable such systems and computer hardware and software products to avoid the potential effects associated with this year 2000 coding problem. The Company has done a preliminary assessment of the components and applications of its Network and has determined that a number of these components are year 2000 compliant. The Company has begun taking the steps it believes are necessary to make the remainder of the network and related applications as well as the other systems utilized by the Company year 2000 compliant. Although the Company currently does not anticipate that the resource requirements or expenses related to these procedures will have a material affect on its operating results or financial position, there can be no assurance that such steps will be successful. In addition, although the Company has direct programming control over its Network applications and believes that it utilizes the most recently available hardware and software products of leading industry providers, whom the Company believes are allocating significant resources to address and resolve these issues, there can be no assurance that the Company's computer hardware and software products will contain all necessary code changes in their date code fields to avoid any or all damaging interruptions and other problems associated with date entry limitations. The Company believes that the purchasing pattern of its current and potential customers may be affected by the year 2000 problem described above in a variety of ways. For example, as the year 2000 approaches, some of the Company's current customers may develop concerns about the reliability of the Company's electronic delivery services and, as a result, shift their delivery work to less technical dub and ship operations. Likewise, some potential customers of the Company with the same concern may elect not to utilize the Company's electronic delivery services until after year 2000 and beyond. If any current customers of the Company shift some or all of their delivery work to other delivery providers, the Company's business, financial condition and results of operations will be adversely affected, and if any potential customers elect to not utilize the Company's delivery services for any period of time on the basis of year 2000 concerns, the Company's business and financial prospects for growth could be adversely affected. In addition to the foregoing, in the event that the Company does experience interruptions and problems with its computer hardware and software products due to year 2000 limitations of such products, some or all of the Company's current customers may shift some or all of their delivery work to other delivery providers without year 2000 problems. Moreover, potential customers of the Company may elect not to utilize the Company's delivery services in the event of any such interruptions and problems. Any of the foregoing could have a material adverse effect on the Company's business, financial condition and results of operations. Potential Fluctuations in Quarterly Results; Seasonality. The Company's quarterly operating results have in the past and may in the future vary significantly depending on factors such as the volume of advertising in response to seasonal buying patterns, the timing of new product and service introductions, increased competition, the timing of the Company's promotional efforts, general economic factors, and other factors. For example, the Company has historically experienced lower sales in the first quarter and higher sales in the fourth quarter, due to increased customer advertising volumes for the Christmas selling season. As a result, the Company believes that period to period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as an indication of future performance. In any period, the Company's revenues and delivery costs are subject to variation based on changes in the volume and mix of deliveries performed during the period. In particular, the Company's operating results have historically been significantly influenced by the volume of deliveries ordered by television stations during the "Sweeps" rating periods that currently take place in February, May, August and November. The increased volume of these deliveries during such periods and the Company's pricing for "Sweeps" advertisements have historically increased the total revenues and revenues per delivery of the Company and tended to reduce delivery costs as a percentage of revenues. The Company's expense levels are based, in part, on its expectations of future sales levels. If sales levels are below expectations, operating results are likely to be materially adversely affected. In addition, the Company has historically operated with little or no backlog. The absence of backlog increases the difficulty of predicting sales and operating results. Fluctuations in sales due to seasonality may become more pronounced as the growth rate of the Company's sales slows. Due to the unique nature of the Company's products and services, the Company believes that it will incur significant expenses for sales and marketing, including advertising, to educate potential customers about such products and services. Dependence on Key Personnel. The Company's success depends to a significant degree upon the continuing contributions of, and on its ability to attract and retain, qualified management, sales, operations, marketing and technical personnel. The competition for qualified personnel, particularly engineering staff, is intense and the loss of any of such persons, as well as the failure to recruit additional key personnel in a timely manner, could adversely affect the Company. There can be no assurance that the Company will be able to continue to attract and retain qualified management, sales and technical personnel for the development of its business. The Company generally has not entered into employment or noncompetition agreements with any of its employees. The Company does not maintain key man life insurance on the lives of any of its key personnel. The Company's failure to attract and retain key personnel could have a material adverse effect on its business, operating results and financial condition. Dependence on Certain Suppliers. The Company relies on certain single or limited-source suppliers for certain integral components used for the assembly of the Company's audio and video units. Although the Company's suppliers are generally large, well-financed organizations, in the event that a supplier were to experience financial or operational difficulties that resulted in a reduction or interruption in component supply to the Company, it would delay the Company's deployment of audio and video units which would have the effect of depressing the Company's business until the Company established sufficient component supply through an alternative source. The Company believes that there are alternative component manufacturers that could supply the components required to produce the Company's products, but the Company is not currently pursuing agreements or understandings with such alternative sources. If a reduction or interruption of supply were to occur, it could take a significant period of time for the Company to qualify an alternative subcontractor, redesign its products as necessary and contract for the manufacture of such products. The Company does not have long-term supply contracts with its sole- or limited-source vendors and purchases its components on a purchase order basis. The Company has experienced component shortages in the past and 19 20 there can be no assurance that material component shortages or production or delivery delays will not occur in the future. The inability in the future to obtain sufficient quantities of components in a timely manner as required, or to develop alternative sources as required, could result in delays or reductions in product shipments or product redesigns, which would materially and adversely affect the Company's business, operating results and financial condition. Pursuant to its development efforts in the area of satellite transmission technology, the Company has successfully completed live field trials of software designed to enhance and enable the current RPTs to receive digital satellite transmissions over the Hughes satellite system. The Company's dependence on Hughes entails a number of significant risks. The Company's business, results of operations and financial condition would be materially adversely affected if Hughes were unable for any reason to continue meeting the Company's delivery commitments on a cost-effective basis or if any transmissions failed to satisfy the Company's quality requirements. In the event that the Company were unable to continue to use Hughes' satellite capacity, the Company would have to identify, qualify and transition deliveries to an acceptable alternative satellite transmission vendor. This identification, qualification and transition process could take nine months or longer, and no assurance can be given that an alternative satellite transmission vendor would be available to the Company or be in a position to satisfy the Company's delivery requirements on a timely and cost-effective basis. The Company obtains its local access telephone transmission services through Teleport Communications Group. The Company obtains its long distance telephone access through an exclusive contract with MCI. During 1997, the Company renegotiated its agreement, which now expires in 2001. Any material interruption in the supply or a material adverse change in the price of either local access or long distance carrier service could have a material adverse effect on the Company's business, results of operations and financial condition. Dependence on New Product Introductions. The Company's future growth depends on its successful and timely introduction of new products and services in markets that do not currently exist or are just emerging. The Company's goals are to introduce new services, such as media archiving and the ability to quickly and reliably give an agency the ability to preview and authorize electronic delivery of video advertising spots. There can be no assurance that the Company will successfully complete development of such products and services, or that if any such development is completed, that the Company's planned introduction of these products and services will realize market acceptance or will meet the technical or other requirements of potential customers. Dependence on Proprietary Technology, Protection of Trademarks, Copyrights, and Other Proprietary Information; Risk of Third Party Claims of Infringement. The Company considers its trademarks, copyrights, advertising, and promotion design and artwork to be of value and important to its business. The Company relies on a combination of trade secret, copyright and trademark laws and nondisclosure and other arrangements to protect its proprietary rights. The Company does not have any patents or patent applications pending. Despite the Company's efforts to protect its proprietary rights, unauthorized parties may attempt to copy or obtain and use information that the Company regards as proprietary. There can be no assurance that the steps taken by the Company to protect its proprietary information will prevent misappropriation of such information and such protection may not preclude competitors from developing confusingly similar brand names or promotional materials or developing products and services similar to those of the Company. In addition, the laws of some foreign countries do not protect the Company's proprietary rights to the same extent as do the laws of the United States. While the Company believes that its trademarks, copyrights, advertising and promotion design and artwork do not infringe upon the proprietary rights of third parties, there can be no assurance that the Company will not receive future communications from third parties asserting that the Company's trademarks, copyrights, advertising and promotion design and artwork infringe, or may infringe, on the proprietary rights of third parties. Any such claims, with or without merit, could be time-consuming, require the Company to enter into royalty arrangements or result in costly litigation and diversion of management personnel. No assurance can be given that any necessary licenses can be obtained or that, if obtainable, such licenses can be obtained on commercially reasonable terms. In the event of a successful claim of infringement against the Company and failure or inability of the Company to license the infringed or similar proprietary information, the Company's business, operating results and financial condition could be materially adversely affected. 20 21 Expansion into International Markets. Although the Company's long-term plans include expansion of its operations to Europe and Asia, it does not at present have network operating center personnel experienced in operating in these locations. Telecommunications standards in foreign countries differ from those in the United States and may work require the Company to incur substantial costs and expend significant managerial resources to obtain any necessary regulatory approvals and comply with differing equipment interface and installation standards promulgated by regulatory authorities of those countries. Changes in government policies, regulations and telecommunications systems in foreign countries could require the Company's products and services to be redesigned, causing product and service delivery delays that could materially adversely affect the Company's operating results. The Company's ability to successfully enter these new markets will depend, in part, on its ability to attract personnel with experience in these locations and to attract partners with the necessary local business relationships. There can be no assurance, however, that the Company's products and services will achieve market acceptance in foreign countries. The inability of the Company to successfully establish and expand its international operations may also limit its ability to obtain significant international revenues and could materially adversely affect the business, operating results and financial condition of the Company. Furthermore, international business is subject to a number of country-specific risks and circumstances, including different tax laws, difficulties in expatriating profits, currency exchange rate fluctuations, and the complexities of administering business abroad. Moreover, to the extent the Company increases its international sales, the Company's business, operating results and financial condition 21 22 could be materially adversely affected by these risks and circumstances, as well as by increases in duties, price controls or other restrictions on foreign currencies, and trade barriers imposed by foreign governments, among other factors. Possible Volatility of Share Price. The trading prices of the Company's Common Stock may be subject to wide fluctuations in response to a number of factors, including variations in operating results, changes in earnings estimates by securities analysts, announcements of extraordinary events such as litigation or acquisitions, announcements of technological innovations or new products or services by the Company or its competitors, as well as general economic, political and market conditions. In addition, stock markets have experienced extreme price and volume trading volatility in recent years. This volatility has had a substantial effect on the market prices of the securities of many high technology companies for reasons frequently unrelated to the operating performance of specific companies. These broad market fluctuations may adversely affect the market price of the Company's Common Stock. 22 23 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS From time to time the Company has been, or may become, involved in litigation proceedings incidental to the conduct of its business. The Company does not believe that any such proceedings presently pending will have a material adverse affect on the Company's financial position or its results of operations. ITEM 2. CHANGES IN SECURITIES Not applicable. ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not applicable. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The 1998 Annual Meeting of Shareholders of the Company was held on April 29, 1998 (the "Annual Meeting"). The following matters were voted upon at the Annual Meeting: (i) the election of the Board of Directors of Kevin R. Compton, Henry W. Donaldson, Jeffrey M. Drazan, Richard H. Harris, and Leonard S. Matthews; (ii) the election of Board of Director Lawrence D. Lenihan, Jr.; (iii) amendment of the Company's 1992 Stock Option Plan to increase by 500,000 the authorized number of options under the plan; (iv) amendment of the Company's Articles of Incorporation by increasing the authorized number of shares of the Company's Common Stock to 40,000,000 shares from 30,000,000 and increasing the authorized number of the Company's Preferred Shares to 15,000,000 shares from 5,000,000; and (v) ratification of the appointment of Arthur Andersen, LLP, as independent auditors of the Registrant for the fiscal year ending December 31, 1998. The results of the vote were as follows:
VOTES AGAINST/ BROKER MATTER VOTES FOR WITHHELD ABSTENTIONS NON-VOTES ------ ---------- -------- ----------- --------- 1. Elect Directors Kevin R. Compton 9,977,101 442,331 0 0 Henry W. Donaldson 9,906,360 515,072 0 0 Jeffrey M. Drazan 9,977,301 442,131 0 0 Richard H. Harris 9,945,601 473,831 0 0 Leonard S. Matthews 9,977,101 442,331 0 0 2. Elect Director Lawrence D. Lenihan 3,609,374 0 0 0 3. Amend the Company's 1992 Stock Option Plan 13,165,138 813,490 21,129 29,049 4. Amend the Company's Articles of Incorporation 9,242,447 803,559 5,904 3,976,896 5. Ratify the Appointment of Arthur Andersen, LLP 14,001,890 17,462 9,454 0
ITEM 5. OTHER INFORMATION NASDAQ NATIONAL MARKET LISTING QUALIFICATIONS On May 20, 1998, the Company received notice from the Nasdaq Stock Market, Inc. ("Nasdaq") that, on the basis of its report on Form 10- Q for the quarter ending March 31, 1998, the Company's net tangible assets fell below the level required for continued inclusion of the Company's common stock on the Nasdaq National Market System ("NNM"). On June 26, 1998, the Company announced it had received notification from Nasdaq of Nasdaq's intention to delist its securities from the NNM. Nasdaq had taken the position, in its interpretation of its policies, that the Company did not meet the minimum capitalization requirements for continued listing on the NNM and the Company filed a request for a hearing. On August 5, 1998, the Company announced that it had received subscriptions from certain of its investors and affiliates of its current and other institutional investors to purchase approximately 3.9 million shares of the Company's Common Stock for nearly $11 million in a private placement transaction of registrable common stock (the "private placement"). On August 7, 1998, the Company appeared before a Nasdaq Listing Qualifications Panel (the "Panel") to disclose its intent to raise additional capital and to convert its outstanding Preferred Stock in order to meet and sustain long-term compliance with Nasdaq's computational requirements for continued listing on the NNM. The Company discussed with the Panel its plan to close the Private Placement for approximately 4.6 million shares of the Company's Common Stock, compared to the 3.9 million level subscribed at August 5, at $2.80 per share, and to issue to all holders of the Company's Series A Preferred Stock ("Preferred Stock") who agreed immediately to convert their shares of Preferred Stock into Common Stock at the applicable one-to-one ratio, with one additional share of Common Stock for every ten shares of Preferred Stock so converted. On August 12, 1998, Nasdaq notified the Company in writing that the hearing Panel was of the opinion that the Company's plans would enable the Company to maintain long-term compliance with the requirements for continued listing on the NNM. On August 14, the Company announced that it had closed the private placement, thereby raising approximately $12.9 million, and that all holders of the Company's Preferred Stock had accepted the conversion. The Company has agreed to use its diligent efforts to file a registration statement with the Securities and Exchange Commission on Form S-3 within sixty days of August 14, 1998 with respect to the shares purchased in the private placement. The Company has also agreed to enter into a registration rights agreement with the purchasers of the shares issued in the private placement granting demand registration rights exercisable no earlier than that same date. DEADLINE FOR RECEIPT OF SHAREHOLDER PROPOSALS FOR 1999 ANNUAL MEETING Shareholders are entitled to present proposals for action at forthcoming shareholder meetings of the Company if they comply with the requirements of the appropriate proxy rules promulgated by the Securities and Exchange Commission. According to the Securities and Exchange Commission rules, proposals of shareholders of the Company intended to be presented for consideration at the Company's 1999 Annual Meeting of Shareholders must be received at the Company's principal executive offices not less than 120 calendar days before the date on which the Company's proxy statement is released to shareholders in connection with the previous year's annual meeting. Therefore, as the Company mailed proxy statements to shareholders on April 3, 1998 in connection with its 1998 Annual Meeting of Shareholders, the deadline for shareholders to submit proposals to be presented for consideration at the Company's 1999 Annual Meeting of Shareholders is December 28, 1998, in order that they may be included in the proxy statement and form of proxy related to that meeting. 23 24 The proxy card used in connection with the Company's 1998 Annual Meeting of Shareholders granted the proxy holders discretionary authority to vote on any matter properly raised at the 1998 Annual Meeting of Shareholders and the Company presently intends to use a similar form of proxy card for its 1999 Annual Meeting of Shareholders. If a shareholder intends to submit a proposal at the Company's 1999 Annual Meeting which is not eligible for inclusion in the proxy statement and form of proxy relating to that shareholder meeting, a new rule recently established by the Securities and Exchange Commission requires that such proposals must be received by the Company no later than February 17, 1999. If such a shareholder fails to comply with the foregoing notice provision for proposals not included in the proxy statement and related form of proxy, the proxy holders will be allowed to use their discretionary voting authority if such a proposal is properly raised at the Company's 1999 Annual Meeting of Shareholders. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits
EXHIBIT NUMBER EXHIBIT TITLE --------- ------------- 3.1(d) Restated Articles of Incorporation of registrant. 3.2(b) Bylaws of registrant, as amended to date. 3.3(a) Certificate of Amendment of the Articles of Incorporation filed with California Secretary of State on July 3, 1998. 4.2(b) Form of Common Stock Certificate. 10.1(b) 1992 Stock Option Plan (as amended) and forms of Incentive Stock Option Agreement and Nonstatutory Stock Option Agreement. 10.2(b) Form of Directors' and Officers' Indemnification Agreement. 10.3(b) 1995 Director Option Plan and form of Incentive Stock Option Agreement thereto. 10.4(b) Form of Restricted Stock Agreement. 10.6(b) Amendment to Warrant Agreement between the Company and Comdisco, Inc., dated January 31, 1996. 10.7.1(c) Corporate Service Plan Agreement between the Company and MCI Telecommunications Corporation, dated March 23, 1994. 10.7.2(c) First Amendment to Corporate Service Plan Agreement between the Company and MCI Telecommunications Corporation, dated November 2, 1995. 10.8(b) Master Lease Agreement between the Company and Comdisco, Inc., dated October 20, 1994, and Exhibits thereto. 10.9(b) Loan and Security Agreement between the Company and Comdisco, Inc., dated October 20, 1994, and Exhibits thereto. 10.10(b) Master Equipment Lease between the Company and Phoenix Leasing, Inc., dated January 7, 1993. 10.15(c) Audio Server Network Prototype Vendor Agreement and Satellite Vendor Agreement between the Company and ABC Radio Networks, dated December 15, 1995. 10.17(b) Promissory Note between the Company and Henry W. Donaldson, dated March 18, 1994, December 5, 1994, December 5, 1994, and March 14, 1995. 10.18(b) Warrant Agreement to purchase Series B Preferred Stock between the Company and Comdisco, Inc., dated as of October 20, 1994. 10.19(b) Warrant Agreement to purchase Series C Preferred Stock between the Company and Comdisco, Inc., dated as of June 13, 1995. 10.20(b) Warrant Agreement to purchase Series D Preferred Stock between the Company and Comdisco, Inc., dated as of January 11, 1996. 10.22(d) Agreement of Sublease for 9,434 rentable square feet at 855 Battery Street, San Francisco, California between the Company and T.Y. Lin International dated September 8, 1995 and exhibits thereto.
24 25
EXHIBIT NUMBER EXHIBIT TITLE --------- ------------- 10.23(d) Agreement of Sublease for 5,613 rentable square feet at 855 Battery Street, San Francisco, California between the Company and Law/Crandall, Inc. dated September 29, 1995 and exhibits thereto. 10.24(e) Digital Generation Systems, Inc. Supplemental Stock Option Plan. 10.25(e) Stock Purchase Agreement by and among Digital Generation Systems, Inc. and PDR Productions, Inc. and Pat DeRosa dated as of October 15, 1996 and exhibits thereto. 10.26(f) Amendment to Stock Purchase Agreement dated November 8, 1996, among Digital Generation Systems, Inc., and Pat DeRosa. 10.27(k) Loan Agreement dated as of January 28, 1997 between Digital Generation Systems, Inc. as Borrower, and Venture Lending and Leasing, Inc. as Lender and exhibits thereto. 10.29(i) Preferred Stock Purchase Agreement, dated as of July 14, 1997, by and among Digital Generation Systems, Inc. and the parties listed on the Schedule of Purchasers attached, as Exhibit A thereto . 10.30(i) Amendment to Preferred Stock Purchase Agreement, dated as of July 23, 1997, by and among Digital Generation Systems, Inc. and the purchasers listed on the Exhibit A thereto. 10.31(g) Loan Agreement dated as of December 1, 1997 between Digital Generation Systems, Inc. as Borrower, and Venture Lending and Leasing, Inc. as Lender and exhibits thereto. 10.32(g) First Amendment to Loan Agreement dated as of January 28, 1997 between Digital Generation Systems, Inc. as Borrower, and Venture Lending and Leasing, Inc. as Lender and exhibits thereto. 10.33(a) Common Stock Subscription Agreement for private placement of Company's common stock at $2.80 per share. 21.1(g) Subsidiaries of the Registrant. 27(a) Financial Data Schedule.
- --------------- (a) Filed herewith. (b) Incorporated by reference to the exhibit bearing the same number filed with registrant's Registration Statement on Form S-1 (Registration No. 33-80203). (c) Incorporated by reference to the exhibit bearing the same number filed with registrant's Registration Statement on Form S-1 (Registration No. 33-80203). The registrant has received confidential treatment with respect to certain portions of this exhibit. Such portions have been omitted from this exhibit and have been filed separately with the Securities and Exchange Commission. (d) Incorporated by reference to the exhibit bearing the same number filed with registrant's Quarterly Report on Form 10-Q filed May 3, 1996, as amended. (e) Incorporated by reference to the exhibit bearing the same number filed with registrant's Quarterly report on Form 10-Q filed November 13, 1996. (f) Incorporated by reference to the exhibit bearing the same number filed with registrant's Current Report on Form 8-K/A filed January 21, 1997. (g) Incorporated by reference to the exhibit bearing the same number filed with registrant's Annual Report on Form 10-K filed March 31, 1998. (h) Incorporated by reference to the exhibit bearing the same number filed with registrant's quarterly report on Form 10-Q filed May 15, 1997. (i) Incorporated by reference to the exhibit bearing the same title filed with registrant's Form 8-K filed August 1, 1997. 25 26 (j) Incorporated by reference to the exhibit bearing the same title filed with registrant's Quarterly report on Form 10-Q filed August 14, 1997. Confidential treatment has been requested with respect to certain portions of this exhibit pursuant to a request for confidential treatment filed with the Securities and Exchange Commission. Omitted portions have been filed separately with the Commission. (k) Incorporated by reference to the exhibit bearing the same title filed with registrant's Quarterly Report on Form 10-Q filed May 15, 1998. (b) Reports on Form 8-K. Not applicable. 26 27 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. DIGITAL GENERATION SYSTEMS, INC. Dated: August 14, 1998 By: /s/ PAUL W. EMERY, II ------------------------------------ Paul W. Emery, II Vice President & Chief Financial Officer (Principal Financial and Chief Accounting Officer) 27 EX-3.3 2 CERTIFICATE OF AMEND. OF ARTICLES OF INCORPORATION 1 EXHIBIT 3.3 CERTIFICATE OF AMENDMENT OF THE ARTICLES OF INCORPORATION OF DIGITAL GENERATION SYSTEMS, INC. Henry W. Donaldson and John B. Goodrich hereby certify as follows: 1. They are the duly elected, qualified and acting President and the Secretary, respectively, of Digital Generation Systems, Inc., a California corporation (the "Corporation"). 2. Article III(A) of the Articles of Incorporation of the Corporation (the "Articles of Incorporation") is hereby amended to read as follows: "(A) Classes of Stock. The Company is authorized to issue 55,000,000 shares of its capital stock, which are divided into two classes designated "Common Stock" and "Preferred Stock," respectively. The Company is authorized to issue 40,000,000 shares of Common Stock and 15,000,000 of Preferred Stock." 3. The foregoing amendment of the Articles of Incorporation has been duly approved by the Board of Directors of the Corporation. 4. The foregoing amendment of Articles of Incorporation has been duly approved by the required vote of shareholders in accordance with Section 902 and 903 of the General Corporation Law of California. The total number of outstanding shares of Common Stock of the Corporation entitled to vote with respect to the foregoing amendment of the Articles of Incorporation was 12,210,625 shares, and the total number of outstanding shares of Series A Convertible Preferred Stock of the Corporation entitled to vote with respect to the foregoing amendment to the Articles of Incorporation was 4,950,495 shares. The number of shares of Common Stock of the Corporation and the number of shares of Series A Convertible Preferred Stock of the Corporation voting in the favor of the foregoing amendment to the Articles of Incorporation equaled or exceeded the vote required. The percentage vote required to approve the foregoing amendment to the Articles of Incorporation was a majority of the outstanding shares of Common Stock of the Corporation, voting as a separate class and a majority of the outstanding shares of Series A Convertible Preferred Stock, voting as a separate class in accordance with Section 903(a)(1) of the General Corporation Law of California, and a majority of the outstanding shares of Common Stock of the Corporation and Series A Convertible Preferred Stock of the Corporation, voting together as a single class in accordance with Section 902(a) of the General Corporation Law of California and the applicable provisions of the Articles of Incorporation. 2 We further declare under penalty of perjury under the laws of the State of California that the matters set forth in this certificate are true and correct of our own knowledge. San Francisco, California /s/ HENRY W. DONALDSON July 29, 1998 ----------------------------------------- Henry W. Donaldson President Palo Alto, California /s/ JOHN B. GOODRICH July 30, 1998 ----------------------------------------- John B. Goodrich Secretary -2- EX-10.33 3 COMMON STOCK SUBSCRIPTION AGREEMENT 1 EXHIBIT 10.33 DIGITAL GENERATION SYSTEMS, INC. COMMON STOCK SUBSCRIPTION AGREEMENT The undersigned ("Subscriber") hereby offers to purchase ________________________ shares of the Common Stock (the "Shares") of Digital Generation Systems, Inc., a California corporation (the "Company") at a price of $2.80 per share, and is herewith delivering payment for such Shares by check or wire transfer payable to the Company. 1. Subscriber, by offering to purchase the Shares, (a) hereby represents and warrants to the Company that all information provided by Subscriber herewith is true and correct and (b) hereby represents and warrants to the Company as follows: a. Investment. Subscriber is acquiring the Shares for investment for Subscriber's own account, not as a nominee or agent, and not with the view to, or for resale in connection with, any distribution thereof in violation of applicable securities laws. Subscriber understands that such Shares have not been, and will not be, registered under the Securities Act of 1933, as amended, (the "Securities Act") by reason of a specific exemption from the registration provisions of the Securities Act which depends upon, among other things, the bona fide nature of the investment intent and the accuracy of such Subscriber's representations as expressed herein. b. Rule 144. Subscriber acknowledges that the Shares must be held indefinitely unless subsequently registered under the Securities Act or an exemption from such registration is available. Subscriber is aware of the provisions of Rule 144 promulgated under the Securities Act which permit limited resale of shares purchased in a private placement subject to the satisfaction of certain conditions, including, among other things, except as otherwise permitted under Rule 144(k), if applicable, (i) the availability of certain current public information about the Company, (ii) the resale occurring not less than one year after a party has purchased and fully paid for the shares to be sold, (iii) the sale being effected through a "broker's transaction" or in transactions directly with a "market maker" (as provided by Rule 144(f)) and (iv) the number of shares being sold during any three-month period not exceeding specified limitations. c. Legends. Subscriber agrees that each certificate or other document evidencing any of the Shares shall be endorsed with the legend set forth below. Subscriber agrees not to transfer the Shares represented by any such certificate without complying with the restrictions on transfer described in the legend endorsed on such certificate. THE SECURITIES REPRESENTED BY THIS INSTRUMENT HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED, OR QUALIFIED UNDER APPLICABLE STATE SECURITIES LAWS. THE SECURITIES MAY NOT BE SOLD, TRANSFERRED, OR ASSIGNED IN THE ABSENCE OF SUCH REGISTRATION OR QUALIFICATION, WITHOUT AN OPINION OF COUNSEL FOR THE HOLDER, CONCURRED IN BY COUNSEL FOR THE COMPANY, STATING 2 THAT SUCH SALE, TRANSFER, OR ASSIGNMENT IS EXEMPT FROM THE REGISTRATION REQUIREMENTS OF SAID ACT. THIS CERTIFICATE MUST BE SURRENDERED TO THE CORPORATION OR ITS TRANSFER AGENT AS A CONDITION PRECEDENT TO THE TRANSFER OF ANY INTEREST IN THE SECURITIES REPRESENTED BY THIS CERTIFICATE. d. Access to Data. Subscriber has requested and received from the Company all the information Subscriber considers necessary or appropriate for deciding whether to purchase the Shares. Subscriber has had an opportunity to ask questions of and receive answers from management of the Company concerning the Company, the Company's business and financial affairs and the Subscriber's purchase of Shares hereunder. Subscriber has had such questions answered to Subscriber's satisfaction. Subscriber understands that any information contained in any written documentation or made by management during discussions with the Company were intended to describe the aspects of the Company's business and prospects which the Company believes to be material, but such information does not necessarily provide a thorough exhaustive description. Subscriber acknowledges that any estimates or projections as to events that may occur in the future were based upon the best judgment of the Company's management at the time such estimates or projections were made and that whether or not such estimates or projections will depend upon the Company's achieving its overall business objectives, including the availability of funds resulting from the sale of the Shares. Subscriber acknowledges there is no assurance that any projections will be attained. e. Preexisting Personal or Business Relationship. Subscriber either has a preexisting personal or business relationship with the Company or any of its officers, directors or controlling persons or, by reason of Subscriber's business or financial experience, could be reasonably assumed to have the capacity to protect Subscriber's own interests in connection with the purchase of the Shares. f. Authorization. This agreement, upon acceptance by the Company, will constitute a valid and legally binding obligation of Subscriber, enforceable in accordance with its terms. g. Brokers or Finders. There are no arrangements or claims for brokerage or finders' fees or agents' commissions or any similar charges in connection with this agreement or any transaction contemplated hereby based on any arrangement or agreement known to Subscriber. h. No Reliance on Third Parties. In purchasing the Shares, Subscriber is not relying upon any representation or assurance from any person. i. Risk of Investment. Subscriber understands the risks inherent in new ventures and the risks associated with unproven technologies such as those of the Company, and Subscriber has experience in investing in such ventures. Subscriber can bear the entire loss of his investment in the Company. j. No Legal Tax or Investment Advice. Subscriber understands that nothing in this Agreement or any other materials presented to Subscriber or information provided by the Company's management in connection with the purchase and sale of the Shares constitutes 2 3 legal, tax, or investment advice. Subscriber has consulted such legal, tax, and investment advisors as it, in its sole discretion, has deemed necessary or appropriate in connection with its purchase of the Shares. 2. Address. Subscriber's address listed below is true and correct. 3. Subscriber understands that the final number of Shares which may be purchased by Subscriber will be determined by the Company and that this offer to purchase Shares is subject to acceptance, in whole or in part, by the Company. Funds not accepted for the purchase of Shares will be refunded. 4. Subject to acceptance by the Company of Subscriber's offer to purchase Shares hereunder and upon receipt of Subscriber's payments, the Company will cause a stock certificate representing the Shares purchased by Subscriber to be prepared, and the Company will cause such stock certificate to be transmitted to the Subscriber at the address shown below. 5. By accepting below, the Company undertakes, within 60 days of the closing of the round in which the Shares are purchased, to use its diligent efforts to prepare and file a registration statement with the Securities and Exchange Commission on Form S-3 registering the shares under the Securities Act of 1933, as amended, and hereby represents, warrants, covenants and agrees as to the matters set forth on Annex I attached hereto. IN WITNESS WHEREOF, Subscriber hereby executes this Agreement as of _____________, 1998. _________________________________________ Signature _________________________________________ Print Name Address:_________________________________ _________________________________________ _________________________________________ (Do not write below this line.) Accepted as to ________ Shares as of ____________, 1998. Digital Generation Systems, Inc. By: ____________________________________ Henry Donaldson, President 3 4 ANNEX I TO SUBSCRIPTION AGREEMENT 1. By executing the attached Subscription Agreement (the "Agreement"), the Company hereby represents and warrants to Subscriber that: (a) the Shares have been duly authorized and, when issued, will be duly and validly issued, fully paid and non-assessable; (b) the Company has registered its Common Stock pursuant to Section 12 of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and the Common Stock is listed and traded on the NASDAQ National Market and the Company has timely filed all material required to be filed pursuant to all reporting obligations under either Section 13(a) or 15(d) of the Exchange Act for a period of at least twelve (12) months immediately preceding the offer or sale of the Shares; (c) the Company has legally available sufficient authorized and unissued Common Stock as may be reasonably necessary to effect the sale and issuance of the Shares; (d) the Agreement has been duly and validly authorized by the Company and, when executed and delivered by the Company, will be the valid and binding agreement of the Company enforceable in accordance with its terms; (e) the execution and delivery of the Agreement by the Company, the issuance of the Shares, and the consummation by the Company of the other transactions contemplated by the Agreement, do not and will not conflict with or result in a breach by the Company of any of the terms or provisions of, or constitute a default under, the articles of incorporation or by-laws of the Company, or any material agreement or instrument to which the Company is a party or by which it or any of its properties or assets are bound, or any material existing applicable law, rule, or regulation or any applicable decree, judgment, or order of any court or other governmental body having jurisdiction over the Company or any of its properties or assets, except such conflict, breach or default which would not have a material adverse effect on the transactions contemplated herein; and (f) no authorization, approval or consent of any court, governmental body, regulatory agency, self-regulatory organization, or stock exchange or market or the stockholders of the Company is required to be obtained by the Company for the issuance and sale of the Shares to Subscriber as contemplated by the Agreement, except such authorizations, approvals and consents that have been obtained. 2. By accepting Subscriber's offer to purchase the Shares, the Company hereby agrees to enter into a separate registration rights agreement with Subscriber (and any other purchasers of common stock of the Company in the same round in which the Shares are purchased) granting Subscriber the demand registration rights contained in Section 1.3 of the Amendment and Restatement No. 5 to Rights Agreement entered into as of July 14, 1997 by and among the Company and certain of its securityholders, which rights shall apply to the registration statement on Form S-3 referred to in Section 5 of the Agreement. The demand registration rights so granted will be exercisable no earlier than sixty (60) days following the closing of the round in which the Shares are purchased. Nothing in this Section 2 is intended to limit the Company's obligations under section 5 of the Agreement to file the Form S-3. Notwithstanding anything herein to the contrary, the Form S-3 shall be maintained effective by the Company until the earlier of (i) the date as to which Subscriber may sell all of the Shares without registration in a single transaction pursuant to Rule 144(k) or (ii) the date on which Subscriber has sold all of the Shares to the public. EX-27 4 FINANCIAL DATA SCHEDULE
5 1,000 6-MOS DEC-31-1998 JAN-01-1998 JUN-30-1998 4,188 0 9,351 (668) 327 13,428 34,749 (21,357) 51,908 16,571 12,025 31,561 0 57,208 (65,457) 51,908 0 19,971 0 25,900 0 83 1,407 (7,222) 0 (7,222) 0 0 0 (7,222) (0.59) (0.59) FOR PURPOSES OF THIS EXHIBIT, PRIMARY MEANS BASIC.
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