1.  General

 

The Company

 

Digital Generation, Inc. and subsidiaries (the “Company,” “we,” “us” or “our”) is a provider of digital technology services that enable the electronic delivery of advertisements, syndicated programs, and video news releases to traditional broadcasters, online publishers and other media outlets. We also provide digital advertising campaign management solutions to media agencies and advertisers. We provide our customers with an integrated campaign management platform that helps advertisers and agencies simplify the complexities of managing their advertising budgets across multiple digital media channels and formats, including online, mobile, rich media, in-stream video, display and search. We provide our customers with the ability to plan, create, deliver, measure, track and optimize digital media campaigns. We also offer a variety of other ancillary products and services to the advertising industry. Our business has grown largely from acquisitions. See Note 4.

 

We market our services directly in the United States and through our subsidiaries in several countries, including Canada, Israel, the United Kingdom, France, Germany, Australia, Ireland, Spain, Japan, China, Mexico and Brazil. See Note 11.

 

Acquisitions

 

During 2012 we completed the following acquisitions:

 

Business Acquired		Date of Closing		Net Assets Acquired (in millions)			Form of Consideration
North Country		July 31, 2012		$	3.7		Cash
Peer 39		April 30, 2012		15.7			Cash/Stock

 

Each of the acquired businesses has been included in our results of operations since the date of closing.  Due to these acquisitions and related costs, our 2013 and 2012 operating results are not entirely comparable.  See Note 4.

 

Basis of Presentation

 

The consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) and include the accounts of our subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

 

These financial statements have been prepared by us without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).  Certain information and disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations.  However, we believe the disclosures are adequate to make the information presented not misleading.  The unaudited 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 our financial position as of the balance sheet dates, and the results of operations and cash flows for the periods presented.  These unaudited consolidated financial statements should be read in conjunction with the financial statements and the notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2012 (“Annual Report”).

 

Seasonality and Political Advertising

 

Our business is seasonal.  Revenues tend to be the highest in the fourth quarter as a large portion of our revenues follow the advertising patterns of our customers.  Further, our revenues are affected by political advertising, which peaks every other year consistent with the national, state and local election cycles in the United States.

 

Use of Estimates

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate our estimates, including those related to the recoverability and useful lives of our long-lived assets, the adequacy of our allowance for doubtful accounts and credit memo reserves, office closure exit costs, contingent consideration and income taxes. We base our estimates on historical experience, future expectations and on other relevant assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates.

 

During the three months ended March 31, 2012, we reduced our estimated bonus for 2011 by approximately $1.1 million. The reduction was credited to general and administrative expense during the three months ended March 31, 2012.  The revised estimate increased income from continuing operations, net income and diluted earnings per share by $0.6 million, $0.6 million and $0.02, respectively, during the three months ended March 31, 2012.

 

See Note 5 for a discussion of the risk of a future impairment of our goodwill.

 

Derivative Instruments

 

We enter into foreign currency forward contracts and options with a single counterparty (i.e., an Israeli bank) to hedge the exposure to the variability in expected future cash flows resulting from changes in related foreign currency exchange rates between the New Israeli Shekel (“NIS”) and the U.S. Dollar. Portions of these transactions are designated as cash flow hedges, as defined by Accounting Standards Codification (“ASC”) Topic 815, “Derivatives and Hedging.”

 

ASC Topic 815 requires that we recognize derivative instruments as either assets or liabilities in our balance sheet at fair value. These contracts are Level 2 fair value measurements in accordance with ASC Topic 820, “Fair Value Measurements and Disclosures.” For derivative instruments that are designated and qualify as a cash flow hedge (i.e., hedging the exposure to variability in expected future cash flows that is attributable to a particular risk), the effective portion of the gain or loss on the derivative instrument is reported as a component of other comprehensive income (loss), net of taxes, and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Any ineffectiveness, which historically has not been material, is recognized in the statement of operations (interest income and other, net).

 

Our cash flow hedging strategy is to hedge against the risk of overall changes in cash flows resulting from certain forecasted foreign currency rent and salary payments during the next 12 months. We hedge portions of our forecasted expenses denominated in the NIS with foreign currency forward contracts and options. At March 31, 2013, we had $11.6 million notional amount of foreign currency forward contracts and options outstanding that had a net fair value asset balance of $0.5 million ($0.6 million asset, net of a $0.1 million liability). The net asset is included in “other current assets” and is expected to be recognized in our results of operations in the next 12 months. As a result of our hedging activities, for the three months ended March 31, 2013 and 2012 we incurred gains of $0.2 million and $0.0 million, respectively.  The vast majority of any gain or loss is included in various operating expenses.  It is our policy to offset fair value amounts recognized for derivative instruments executed with the same counterparty. In connection with our foreign currency forward contracts and options and other banking arrangements, we have agreed to maintain $1.6 million of cash in bank accounts with our counterparty.

 

Accumulated Other Comprehensive Loss

 

Components of accumulated other comprehensive loss (“AOCL”), net of tax, for the three months ended March 31, 2013 were as follows (in thousands):

 

		Foreign Currency Translation			Unrealized Gain on Foreign Currency Derivatives			Unrealized Gain (Loss) on Available for Sale Securities			Accumulated Other Comprehensive Loss
Balance at December 31, 2012		$	(2,024	)	$	373		$	(4	)	$	(1,655	)
Other comprehensive income (loss) before reclassifications		(1,722		)	94			86			(1,542		)
Amounts reclassified out of AOCL		—			(141		)	—			(141		)
Net current period activity		(1,722		)	(47		)	86			(1,683		)
Balance at March 31, 2013		$	(3,746	)	$	326		$	82		$	(3,338	)

 

The following table summarizes the reclassifications from accumulated other comprehensive loss to the consolidated statement of operations for the three months ended March 31, 2013 (in thousands):

 

		Amount Reclassified out of AOCL			Affected Line Item in the Consolidated Statement of Operations
Gains (losses) on cash flow hedges:
Foreign currency derivatives		$	22		Cost of revenues
Foreign currency derivatives		14			Sales and marketing
Foreign currency derivatives		128			Research and development
Foreign currency derivatives		36			General and administrative
Foreign currency derivatives		(1		)	Interest income and other, net
Total before taxes		199
Tax amounts		(58		)
Income after tax		$	141

 

Acquisition, Integration and Other Expenses

 

Acquisition, integration and other expenses reflect the expenses incurred in acquiring a business (e.g., investment banking fees, legal fees), costs to integrate an acquired operation (e.g., severance pay, office closure costs) into the Company and certain other expenses.  A summary of our acquisition, integration and other expenses are as follows (in thousands):

 

		Three Months Ended March 31,
Description		2013			2012
Legal, accounting and due diligence fees		$	4		$	278
Severance		483			1,179
Strategic alternatives		785			—
MediaMind preacquisition liability		720			—
Proxy contest		446			—
Integration costs		224			13
Total		$	2,662		$	1,470

 

Discontinued Operations

 

In 2011, management committed to a plan to sell certain assets and the operations of our Springbox unit since it was not deemed to be part of our core business going forward.  As a result, the Springbox operating results have been reclassified to discontinued operations in the accompanying consolidated statements of operations.  The Springbox operation was sold on June 1, 2012.  For the three months ended March 31, 2012, Springbox reported revenues, loss from discontinued operations and diluted loss per share from discontinued operations of $0.9 million, $0.3 million and $0.01, respectively.