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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

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FORM 10-Q

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2003

 

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

 

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Digital Generation Systems, Inc.

(Exact name of registrant as specified in its charter)

 

 

750 West John Carpenter Freeway, Suite 700

Irving, Texas 75039

(Address of principal executive offices, including zip code)

 

(972) 581-2000

(Registrant’s telephone number, including area code)

 

Not Applicable

(Former name, former address, former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO ¨

 

Indicate by check mark if the registrant is an accelerated filer. YES ¨ NO x

 

Number of shares of registrant’s Common Stock, par value $0.001, outstanding as of October 31, 2003: 71,835,598

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DIGITAL GENERATION SYSTEMS, INC.

 

The discussion in this Report contains forward-looking statements that involve risks and uncertainties. The statements contained in this Report that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Words such as “anticipates,” “believes,” “plans,” “expects,” “future,” “intends,” and similar expressions are used to identify forward-looking statements. All forward-looking statements included in this document are based on information available to the Company on the date hereof, and we assume no obligation to update any such forward-looking statements. The Company’s actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Certain Business Considerations” as reported in the Company’s Annual Report on Form 10-K filed on March 27, 2003, as well as those risks discussed in this Report, and in the Company’s other United States Securities and Exchange Commission filings.

 

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ITEM I. FINANCIAL STATEMENTS

 

Digital Generation Systems, Inc.

Condensed Consolidated Balance Sheets

(in thousands, except share data)

 

 

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

 

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Digital Generation Systems, Inc.

Unaudited Condensed Consolidated Statements of Operations

(in thousands, except per share data)

 

 

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

 

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Digital Generation Systems, Inc.

Unaudited Condensed Consolidated Statement of Stockholders’ Equity

(in thousands)

 

 

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

 

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Digital Generation Systems, Inc.

Unaudited Condensed Consolidated Statements of Cash Flows

(in thousands)

 

 

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

 

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1. BASIS OF PRESENTATION

 

The financial statements included herein have been prepared by Digital Generation Systems, Inc. (the “Company”) without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. However, the Company believes that the disclosures are adequate to make the information presented not misleading. The unaudited condensed consolidated financial statements reflect all adjustments, which are, in the opinion of management, of a normal and recurring nature and necessary for a fair presentation of the Company’s financial position, results of operations and cash flows for the periods presented. These condensed consolidated financial statements should be read in conjunction with the financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2002. Certain reclassifications have been made to conform prior year amounts to current year classifications.

 

2. STOCK-BASED COMPENSATION

 

The Company applies Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations, in accounting for its stock option plans. As such, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. SFAS No. 123, “Accounting for Stock-Based Compensation,” established accounting and disclosure requirements using a fair value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to continue to apply the intrinsic value-based method of accounting described above, and has adopted the disclosure requirements of SFAS No. 123. Pro forma net income and earnings per share disclosures, as if the Company recorded compensation expense based on the fair value for stock-based awards, have been presented in accordance with the provisions of SFAS No. 148, “Accounting for Stock-based Compensation – Transition and Disclosure,” and are as follows for the three and nine month periods ended September 30, 2003 and 2002 (in thousands, except per share amounts).

 

 

The fair value of each option was estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:

 

 

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3. INVENTORIES

 

Inventories as of September 30, 2003 and December 31, 2002 are summarized as follows (in thousands):

 

 

 

4. PROPERTY AND EQUIPMENT

 

During the second quarter of 2003, the Company increased its estimate of the useful lives of its network equipment from 5 to 7 years. This change had the effect of decreasing depreciation expense and increasing net income by $0.3 million and $0.5 million for the three and nine month periods ended September 30, 2003, respectively. Basic earnings per share was not affected while diluted earnings per share was increased by $0.01 on a year to date basis only, before taxes. The increase in estimated useful lives was based on the Company’s planned usage of such equipment.

 

5. OTHER ASSETS

 

Prior to the second quarter of 2003, the Company had deferred legal expenses of approximately $1.3 million related to the defense of certain patents. The Company settled one case. As a result of the settlement, the Company recorded $1.0 million in amortization expense during the second quarter of 2003.

 

6. LONG-TERM DEBT AND CAPITAL LEASES

 

On May 5, 2003, the Company signed a new long-term credit agreement with its current lenders that includes a term loan of $8.0 million, which matures on September 30, 2005, and a revolving credit facility with a borrowing base subject to the Company’s eligible accounts receivable balance up to $32 million, which matures on May 5, 2006. There were no amounts outstanding under the revolving credit facility at September 30, 2003 and approximately $6.2 million was available for borrowing. The proceeds from the term loan were used to refinance the Company’s outstanding debt of $8.0 million. Under the long-term credit agreement, the Company is required to maintain certain fixed charge coverage ratios, certain leverage ratios and current ratios on a quarterly basis and is subject to limitations on capital expenditures for a rolling twelve-month period and limitations on capital lease borrowings on an annual basis. The Company was in compliance with these covenants for the period ended September 30, 2003. The Company pays interest on borrowings at a variable rate based on the lender’s Prime Rate or LIBOR, plus an applicable margin. The applicable margin fluctuates based on the Company’s leverage ratios as defined in the long-term credit agreement

 

On July 3, 2003, the Company executed an amendment to its long-term credit agreement that added a new lender to the facility and increased the revolving credit facility by $7.5 million to $32 million.

 

7. INCOME TAXES

 

Generally accepted accounting principles require that the Company record a valuation allowance against the deferred tax asset associated with this NOL if it is “more likely than not” that the Company will not be able to utilize it to offset future taxes. During the three months ended September 30, 2003, the Company concluded that realization of a portion of its tax benefits from NOL carryforwards was more likely than not. As a result, $4.4 million of the valuation allowance for deferred tax assets was reversed, resulting in a non-cash tax benefit of $1.4 million, which offset fiscal 2003 income tax expense of $1.5 million.

 

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8. EARNINGS PER SHARE

 

Under SFAS No. 128, “Earnings per Share”, the Company is required to compute earnings per share under two different methods (basic and diluted). Basic income (loss) per share is calculated by dividing net income (loss) attributable to common shareholders by the weighted average shares of common stock outstanding during the period. Diluted income (loss) per share is calculated by dividing net income (loss) attributable to common shareholders by the weighted average shares of common stock outstanding and potentially dilutive securities during the period. Below is a reconciliation of basic and diluted income (loss) per share (in thousands, except per share amounts):

 

 

For the three months ended September 30, 2003, 3,043,319 options with a weighted average exercise price of $4.11 per share and warrants to purchase 4,532,670 shares of common stock at a weighted average price of $3.24 per share had exercise prices above the average market price of $2.25. As a result, 7,575,989 shares were excluded from the computation of diluted net income per share. At September 30, 2002, 8,412,148 options with a weighted average exercise price of $2.63 per share and warrants to purchase 8,544,870 shares of common stock at a weighted average price of $2.48 per share had exercise prices above the average market price of $1.05 for the nine months ended September 30, 2002. As a result, 16,957,018 shares were excluded in the computation of diluted net income per share.

 

For the nine months ended September 30, 2003, 3,359,520 options with a weighted average exercise price of $4.19 per share and warrants to purchase 4,532,670 shares of common stock at a weighted average price of $3.24 per share had exercise prices above the average market price of $2.27. As a result, 7,892,190 shares were excluded from the computation of diluted net income per share for the nine months ended September 30, 2003. For the nine months ended September 30, 2002 8,412,148 options with a weighted average exercise price of $2.63 per share and warrants to purchase 8,544,870 shares of common stock at a weighted average price of $2.48 per share had exercise prices above the average market price of $1.08 for the nine months ended September 30, 2002. As a result,16,957,018 shares were excluded in the computation of diluted net income per share.

 

9. SEGMENT INFORMATION

 

The Company operates predominantly in two industry segments: digital and physical distribution of audio and video content and other, which includes transmission and compression technology and consulting. The Company has defined its reportable segments based on internal financial reporting used for corporate management and decision-making purposes.

 

The information in the following tables is derived directly from the segments’ internal financial reporting used for corporate management purposes (in thousands):

 

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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Condensed Consolidated Financial Statements and Notes and contains forward-looking statements that involve risks and uncertainties. Actual results could differ materially from those indicated in the forward-looking statements as a result of various factors.

 

Results of Operations

 

Revenues. Revenues for the three months ended September 30, 2003 decreased $3.1 million, or 19%. The decrease was due to a $1.9 million, or 15%, decrease in advertising distribution revenues at Digital Generation Systems, Inc. (“DGS”), which reflects continued softening in the advertising market as well as 2002 political revenues not recurring in 2003. Product sales also decreased $0.9 million, or 37%, at StarGuide Digital Networks, Inc. (“StarGuide”) due to overall reductions in technology spending. For the nine months ended September 30, 2003, revenues decreased $3.1 million, or 7%, due to the aforementioned soft market conditions.

 

Cost of Revenues. Cost of revenues, which includes delivery and material costs and customer operations, decreased $1.2 million, or 15%, for the three months ended September 30, 2003 primarily due to revenue declines. For the nine months ended September 30, 2003, cost of revenues decreased $2.7 million, or 11%, from prior year, primarily due to the aforementioned revenue declines resulting from the soft advertising market as well as continued cost reductions initiated by management during 2003.

 

Sales and Marketing. Sales and marketing expense decreased $0.1 million, or 7%, for the three months ended September 30, 2003 primarily due to reduced spending on the Company’s CoolCast marketing activities from the same prior year period. For the nine months ended September 30, 2003, sales and marketing expense decreased $0.4 million, or 11%, due to Companywide cost reductions initiated by management during 2003.

 

Research and Development. Research and development expense decreased $0.1 million, or 8%, for the three months ended September 30, 2003 due to a decrease in staffing levels, primarily at the Company’s StarGuide division. For the nine months ended September 30, 2003, research and development expense decreased $0.1 million, or 4%, due to Companywide cost reductions initiated by management during 2003

 

General and Administrative and Restructuring Charges. General and administrative expenses for the three months ended September 30, 2003 decreased $0.6 million, or 24% from prior year due to a decrease in the Company’s provision for bad debts as a result of improvements in accounts receivable collection efforts as well as savings from continued cost reductions. For the nine months ended September 30, 2003, general and administrative expenses decreased $1.5 million, or 22%, from prior year due to continued cost reductions in 2003. During the first quarter 2002, the Company recorded a restructuring charge of $0.8 million related to the consolidation of certain corporate functions and facilities. The charge represented employee termination costs, lease obligations and the write-down of certain leasehold improvements.

 

Depreciation and Amortization. Depreciation and amortization decreased $0.5 million, or 26%, for the three months ended September 30, 2003 due to the fact that the company adjusted it useful life for selected network equipment. For the nine months ended September 30, 2003, depreciation and amortization expense increased by $0.5 million or 9%. During the nine months ended September 30, 2003, the Company recorded approximately $1.1 million in amortization expense for the previously capitalized patent defense costs.

 

Interest and Other Expense. Interest and other expense decreased $0.1 million, or 32%, for the three months ended September 30, 2003, as compared to the corresponding prior year period, due to repayments on long-term debt and capital leases as well as lower overall interest rates. Similarly, interest and other expense decreased $0.5 million, or 37%, for the nine months ended September 30, 2003, as compared to the corresponding prior year period due to repayments on long-term debt and capital leases as well as lower overall interest rates.

 

Income Taxes. During the three months ended September 30, 2003, the Company concluded that realization of a portion of its tax benefits from NOL carryforwards was more likely than not. As a result, $4.4 million of the valuation allowance for deferred tax assets was reversed, resulting in a non-cash tax benefit of $1.4 million, which offset fiscal 2003 income tax expense of $1.5 million. Excluding the effect of the reduction in the valuation allowance, the Company’s effective tax rate for the three and nine months ended September 30, 2003, and 2002, of 38% and 39%, respectively, differed from the federal statutory rate of 34%, primarily due to state income taxes.

 

Liquidity and Capital Resources

 

Net cash provided by operating activities for the nine months ended September 30, 2003 was $5.7 million compared to $3.9 million for the nine months ended September 30, 2002. The increase of $1.8 million in net cash provided by operating activities is due to increased collections of accounts receivable and continued cost reductions during 2003.

 

The Company purchased equipment and made capital additions of $0.8 million during the nine months ended September 30, 2003 versus $0.4 million in capital expenditures for the nine months ended September 30, 2002. Net principal payments on long-term debt and capital leases was $3.5 million for the nine months ended September 30, 2003 versus $4.1 million for the nine months ended September 30, 2002.

 

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At September 30, 2003, the Company’s current sources of liquidity included cash and cash equivalents of $5.2 million.

 

On May 5, 2003, the Company signed a new long-term credit agreement with its current lender that includes a term loan of $8.0 million, which matures on September 30, 2005, and a revolving credit facility with a borrowing base subject to the Company’s eligible accounts receivable balance up to $32.0 million, which matures on May 5, 2006. There were no amounts outstanding under the revolving credit facility at September 30, 2003 and approximately $6.2 million was available for borrowing. The proceeds from the term loan were used to refinance the Company’s outstanding debt of $8.0 million. Under the long-term credit agreement, the Company is required to maintain certain fixed charge coverage ratios, certain leverage ratios and current ratios on a quarterly basis and is subject to limitations on capital expenditures for a rolling twelve-month period and limitations on capital lease borrowings on an annual basis. The Company was in compliance with these covenants for the period ended September 30, 2003. The Company pays interest on borrowings at a variable rate.

 

On July 3, 2003, the Company signed an amendment to its long-term credit agreement that added a new lender to the facility and increased the revolving credit facility by $7.5 million to $32 million.

 

Impact of Recently Issued Accounting Standards

 

In August 2001, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 143, “Accounting for Asset Retirement Obligations.” SFAS No. 143 requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred. The Company adopted SFAS No. 143 in fiscal year 2003. The provisions of SFAS No. 143 did not have any impact on its financial condition or results of operations.

 

In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections”. The Company adopted SFAS No. 145 effective January 1, 2003. The adoption of SFAS No. 145 did not have any impact on the Company’s financial position or consolidated statements of operations for the periods presented.

 

In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which addresses the recognition, measurement, and reporting of costs associated with exit or disposal activities, and supercedes Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” The principal difference between SFAS No. 146 and EITF 94-3 relates to the requirements for recognition of a liability for a cost associated with an exit or disposal activity. SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity, including those related to employee termination benefits and obligations under operating leases and other contracts, be recognized when the liability is incurred, and not necessarily the date of an entity’s commitment to an exit plan, as under EITF 94-3. SFAS No. 146 also establishes that the initial measurement of a liability recognized under SFAS No. 146 be based on fair value. The provisions of SFAS No. 146 are effective for exit or disposal activities that are initiated after December 31, 2002. The Company adopted SFAS No. 146 effective January 1, 2003. The adoption of SFAS No. 146 did not have any impact on the Company’s financial position or consolidated statements of operations for the periods presented.

 

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure — an amendment of FASB Statement No. 123.” SFAS No. 148 amends SFAS No. 123, “Accounting for Stock-Based Compensation”, to provide alternative methods of transition for a voluntary change to the fair-value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require disclosure in interim financial statements regarding the method used on reported results. The Company does not intend to adopt a fair-value based method of accounting for stock-based employee compensation until a final standard is issued by the FASB that requires this accounting. Proforma disclosures of quarterly earnings are included in Note 2 to the condensed consolidated financial statements included in this quarterly report.

 

On May 15, 2003, the Financial Accounting Standards Board issued Statement No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” which requires that certain financial instruments be presented as liabilities that were previously presented as equity or as temporary equity. Such instruments include mandatory redeemable preferred and common stock, and certain options and warrants. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003 and is generally effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS No. 150 did not have any impact on the Company’s financial position or results of operations.

 

On November 21, 2002, the EITF reached a final consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Elements.” EITF 00-21 provides guidance on (a) how arrangement consideration should be measured, (b) whether the arrangement should be divided into separate units of accounting, and (c) how the arrangement consideration should be allocated among the separate units of accounting. EITF 00-21 also requires disclosure of the accounting policy for recognition of revenue from multiple-deliverable arrangements and the description and nature of such arrangements. The guidance of EITF 00-21 is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. Alternatively, EITF 00-21’s guidance may be accounted for and reported

 

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as a cumulative-effect adjustment. The Company does not expect that applying the guidance of EITF 00-21 to its multiple element arrangements will have a material impact on its financial position, results of operations or cash flows.

 

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

The Company provides some services to entities located outside of the United States of America and, therefore, is subject to the risk that the applicable exchange rates will adversely impact the Company’s results of operations. The Company believes this risk to be immaterial to the Company’s results of operations.

 

Item 4. CONTROLS AND PROCEDURES

 

Our principal executive and financial officers have concluded, based on their evaluation as of the end of the period covered by this report, that our disclosure controls and procedures under Rule 13a-15 of the Securities Exchange Act of 1934 are effective to ensure that information we are required to disclose in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and include controls and procedures designed to ensure that information we are required to disclose in such reports is accumulated and communicated to management, including our principle executive and financial officers, as appropriate to allow timely decisions regarding required disclosure.

 

Subsequent to our evaluation, there were no significant changes in internal controls or other factors that could significantly affect these internal controls.

 

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PART II. OTHER INFORMATION

 

Item 6. EXHIBITS AND REPORTS ON FORM 8-K

 

(a) Exhibits

 

 

(b) Report on Form 8-K

 

Current Report on Form 8-K dated October 23, 2003, furnishing its press release regarding a preliminary review of results for the three months ended September 30, 2003 and an outlook for the fourth quarter ending December 31, 2003.

 

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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.

 

 

 

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