SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ----------- FORM 10-K/A-1 ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the year ended December 31, 2001 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File Number 0-21917 ----------- POINT.360 (Exact name of registrant as specified in its charter) California 95-4272619 (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 7083 Hollywood Boulevard, Suite 200, Hollywood, CA 90028 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code (323) 957-7990 Securities registered pursuant to Section 12(b) of the Act None Securities registered pursuant to Section 12(g) of the Act Common Stock, no par value. ----------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ___ The aggregate market value of the voting stock held by non-affiliates of the registrant was approximately $9,113,000 on September 20, 2002 based upon the closing price of such stock on that date. As of September 20, 2002, there were 9,014,232 shares of Common Stock outstanding. Total number of pages in this report: 46 This Annual Report on Form 10-K/A-1 consists of 46 pages, including exhibits. The exhibit index is on page 38. EXPLANATORY NOTE The purpose of this amendment is to reflect and describe the restatement of quarterly and annual results of operations for the year ended December 31, 2001. The Company revised 2001 quarterly and annual financial statements to (i) allocate certain year-end adjustments to other than the fourth quarter of 2001, (ii) correct the quarterly amortization of other intangibles associated with an acquired company and (iii) correct the transition adjustment and the required subsequent amortization into earnings resulting from the adoption of Financial Accounting Standard No. 133 for an interest rate swap contract. The effect of this revision reduces the net loss for the year ended December 31, 2001 from $1,588,000 to $1,494,000 and reduces the net loss per share from $0.18 to $0.17. Except as otherwise expressly described herein, this Amendment continues to present information as of April 16, 2002, which is the date on which we originally filed our Annual Report on Form 10-K. We have not updated the disclosures in the Amendment to present information as of a later date. All information contained herein is subject to updating and supplementing as provided in our periodic reports filed with the Securities and Exchange Commission. DOCUMENTS INCORPORATED BY REFERENCE The Company's Form 10-K/A filed with the Securities and Exchange Commissions on April 26, 2002 is incorporated by reference in Part III of this report. ================================================================================ PART I ITEM 1. BUSINESS GENERAL Point.360 ("Point.360" or the "Company") is a leading integrated media management services company providing film, video and audio post production, archival, duplication and distribution services to motion picture studios, television networks, advertising agencies, independent production companies and global companies. The Company provides the services necessary to edit, master, reformat, archive and ultimately distribute its clients' audio and video content, including television programming, feature films, spot advertising and movie trailers. The Company provides worldwide electronic distribution, using fiber optics, satellites and the Internet. The Company delivers commercials, movie trailers, electronic press kits, infomercials and syndicated programming, by both physical and electronic means, to thousands of broadcast outlets worldwide. The Company seeks to capitalize on growth in demand for the services related to the distribution of entertainment content, without assuming the production or ownership risk of any specific television program, feature film or other form of content. The primary users of the Company's services are entertainment studios and advertising agencies that generally choose to outsource such services due to the sporadic demand and the fixed costs of maintaining a high-volume physical plant. Since January 1, 1997, the Company has successfully completed eight acquisitions of companies providing similar services. The Company will continue to evaluate acquisition opportunities to enhance its operations and profitability. As a result of these acquisitions, the Company is one of the largest and most diversified providers of technical and distribution services in its markets, and therefore is able to offer its customers a single source for such services at prices that reflect the Company's scale economies. The Company was incorporated in California in 1990. The Company's executive offices are located at 7083 Hollywood Boulevard, Hollywood, California 90028, and its telephone number is (323) 957-7990. MARKETS The Company derives revenues primarily from (i) the entertainment industry, consisting of major and independent motion picture and television studios, cable television program suppliers and television program syndicators, and (ii) the advertising industry, consisting of advertising agencies and corporate advertisers. On a more limited basis, the Company also services national television networks, local television stations, corporate or instructional video providers, infomercial advertisers and educational institutions. ENTERTAINMENT INDUSTRY. The entertainment industry creates motion pictures, television programming, and interactive multimedia content for distribution through theatrical exhibition, home video, pay and basic cable television, direct-to-home, private cable, broadcast television, on-line services and video games. Content is released into a "first-run" distribution channel, and later into one or more additional channels or media. In addition to newly produced content, film and television libraries may be released repeatedly into distribution. Entertainment content produced in the United States is exported and is in increasingly high demand internationally. The Company believes that several trends in the entertainment industry have and will continue to have a positive impact on the Company's business. These trends include growth in worldwide demand for original entertainment content, the development of new markets for existing content libraries, increased demand for innovation and creative quality in domestic and foreign markets, and wider application of digital technologies for content manipulation and distribution, including the emergence of new distribution channels. 1 ADVERTISING INDUSTRY. The advertising industry distributes video and audio commercials, or spots, to radio and television broadcast outlets worldwide. Advertising content is developed either by the originating company or in conjunction with an advertising agency. The Company receives orders with specific routing and timing instructions provided by the customer. These orders are then entered into the Company's computer system and scheduled for electronic or physical delivery. When a video spot is received, the Company's quality control personnel inspect the video to ensure that it meets customer specifications and then initiate the sequence to distribute the video to the designated television stations either electronically, over fiber optic lines and/or satellite, or via the most suitable package carrier. The Company believes that the growth in the number of video advertising outlets, driven by expansion in the number of broadcast, cable, Internet and satellite channels worldwide, will have a positive impact on the Company's businesses. VALUE-ADDED SERVICES The Company maintains video and audio post-production and editing facilities as components of its full service, value-added approach to its customers. The following summarizes the value-added post-production services that the Company provides to its customers: FILM-TO-TAPE TRANSFER. Substantially all film content ultimately is distributed to the home video, broadcast, cable or pay-per-view television markets, requiring that film images be transferred electronically to a video format. Each frame must be color corrected and adapted to the size and aspect ratio of a television screen in order to ensure the highest level of conformity to the original film version. The Company transfers film to videotape using Spirit, URSA and Cintel MK-3 telecine equipment and DaVinci(R) digital color correction systems. In 2000, the Company added high definition television ("HDTV") services to this product line. The remastering of studio film and television libraries to this new broadcast standard has begun to contribute to the growth of the Company's film transfer business, as well as affiliated services such as foreign language mastering, duplication and distribution. VIDEO EDITING. The Company provides digital editing services in Hollywood, Burbank and West Los Angeles. The editing suites are equipped with (i) state-of-the-art digital editing equipment, including the Avid(R) 9000, that provides precise and repeatable electronic transfer of video and/or audio information from one or more sources to a new master video and (ii) large production switchers to effect complex transitions from source to source while simultaneously inserting titles and/or digital effects over background video. Video is edited into completed programs such as television shows, infomercials, commercials, movie trailers, electronic press kits, specials, and corporate and educational presentations. STANDARDS CONVERSION. Throughout the world there are several different broadcasting "standards" in use. To permit a program recorded in one standard to be broadcast in another, it is necessary for the recorded program to be converted to the applicable standard. This process involves changing the number of video lines per frame, the number of frames per second, and the color system. The Company is able to convert video between all international formats, including NTSC, PAL and SECAM. The Company's competitive advantages in this service line include its state-of-the-art systems and its detailed knowledge of the international markets with respect to quality-control requirements and technical specifications. 2 BROADCAST ENCODING. The Company provides encoding services for tracking broadcast airplay of spots or television programming. Using a process called VEIL encoding, a code is placed within the video portion of an advertisement or an electronic press kit. Such codes can be monitored from standard television broadcasts to determine which advertisements or portions of electronic press kits are shown on or during specific television programs, providing customers direct feedback on allotted air time. The Company provides VEIL encoding services for a number of its motion picture studio clients to enable them to customize their promotional material. The Company also provides ICE encoding services which enable it to place codes within the audio portion of a video, thereby enhancing the overall quality of the encoded video. AUDIO POST-PRODUCTION. Through its facilities in Burbank, Hollywood and West Los Angeles, the Company digitally edits and creates sound effects, assists in replacing dialog and re-records audio elements for integration with film and video elements. The Company designs sound effects to give life to the visual images with a library of sound effects. Dialog replacement is sometimes required to improve quality, replace lost dialog or eliminate extraneous noise from the original recording. Re-recording combines sound effects, dialog, music and laughter or applause to complete the final product. In addition, the re-recording process allows the enhancement of the listening experience by adding specialized sound treatments, such as stereo, Dolby Digital(R), SDDS(R), THX(R) and Surround Sound(R). AUDIO LAYBACK. Audio layback is the process of creating duplicate videotape masters with sound tracks that are different from the original recorded master sound track. Content owners selling their assets in foreign markets require the replacement of dialog with voices speaking local languages. In some cases, all of the audio elements, including dialog, sound effects, music and laughs, must be recreated, remixed and synchronized with the original videotape. Audio sources are premixed foreign language tracks or tracks that contain music and effects only. The latter is used to make a final videotape product that will be sent to a foreign country to permit addition of a foreign dialogue track to the existing music and effects track. FOREIGN LANGUAGE MASTERING. Programming designed for distribution in markets other than those for which it was originally produced is prepared for export through language translation and either subtitling or voice dubbing. The Company provides dubbed language versioning with an audio layback and conform service that supports various audio and videotape formats to create an international language-specific master videotape. The Company's Burbank facility also creates music and effects tracks from programming shot before an audience to prepare television sitcoms for dialog recording and international distribution. SYNDICATION. The Company offers a broad range of technical services to domestic and international programmers. The Company services the basic and premium cable, broadcast syndication and direct-to-home market segments by providing the facilities and services necessary to assemble and distribute programming via satellite to viewers in the United States, Canada and Europe. The Company provides facilities and services for the delivery of syndicated television programming in the United States and Canada. The Company's customer base consists of the major studios and independent distributors offering network programming, world-wide independent content owners offering niche market programming, and pay-per-view services marketing movies and special events to the cable industry and direct-to-home viewers. Broadcast and syndication operations are conducted in Hollywood and West Los Angeles. ARCHIVAL SERVICES. The Company currently stores approximately three million videotape and film elements in a protected environment. The storage and handling of videotape and film elements require specialized security and environmental control procedures. The Company performs secure management archival systems in its Burbank, Hollywood, West Los Angeles and other locations. The Company offers on-line access to archival information for advertising clients, and may offer this service to other clients in the future. DISTRIBUTION NETWORK The Company operates a full service distribution network providing its customers with reliable, timely and high quality distribution services. The Company's historical customer base consists of motion picture and television studios and post-production facilities located primarily in the Los Angeles area. In 1997, the Company acquired Woodholly Productions ("Woodholly"), Multi-Media Services, Inc. ("Multi-Media"), Video-It, Inc. ("Video-It") and Fast Forward, Inc. ("Fast Forward"), providing it with a more diversified customer base and facilities in New York, Chicago, San Francisco and additional facilities in Los Angeles. In 1998, the Company acquired The Dub House, Inc. (the "Dub House"), All Post, Inc. ("All Post"), and Dubs, Inc. ("Dubs"), which substantially expanded its market share in Los Angeles. In 2000, the Company acquired Creative Digital, Inc. ("Creative Digital"). 3 Commercials, trailers, electronic press kits and related distribution instructions are typically collected at one of the Company's regional facilities and are processed locally or transmitted to another regional facility for processing. Orders are routinely received into the evening hours for delivery the next morning. The Company has the ability to process customer orders from receipt to transmission in less than one hour. Customer orders that require immediate, multiple deliveries in remote markets are often delivered electronically to and serviced by third parties with duplication and delivery services in such markets. The Company provides the advantage of being able to service customers from both of its primary markets (entertainment and advertising) in all of its facilities to achieve the most efficient project turnaround. The Company's network operates 24 hours a day. For electronic distribution, a video master is digitized and delivered by fiber optic, Internet, ISDN or satellite transmission to television stations equipped to receive such transmissions. The Company currently derives a small percentage of its revenues from electronic deliveries and anticipates that this percentage will increase as such technologies become more widely adopted. The Company intends to add new methods of distribution as technologies become both standardized and cost-effective. The Company currently operates facilities in Los Angeles (five locations), New York, Chicago, Dallas and San Francisco. By capitalizing on electronic technologies to link instantaneously all of the Company's facilities, the Company is able to optimize delivery, thus extending the deadline for same- or next-day delivery of time-sensitive material. As the Company continues to develop and acquire facilities in new markets, its network enables it to maximize the usage of its network-wide capacity by instantaneously transmitting video content to facilities with available capacity. The Company's network and facilities are designed to serve, cost-effectively, the time-sensitive distribution needs of its clients. Management believes that the Company's success is based on its strong customer relationships that are maintained through the reliability, quality and cost-effectiveness of its services, and its extended deadline for processing customer orders. NEW MARKETS The Company believes that the development of its network and its array of value-added services will provide the Company with the opportunity to enter or significantly increase its presence in several new or expanding markets. INTERNATIONAL. The Company currently provides video duplication services for suppliers to international markets. Through the Woodholly acquisition, the Company acquired and subsequently has leveraged this capability by offering access to international markets to its entire customer base. Further, the Company believes that electronic distribution methods will facilitate its expansion into the international distribution arena as such technologies become standardized and cost-effective. In addition, the Company believes that the growth in the distribution of domestic content into international markets will create increased demand for value-added services currently provided by the Company such as standards conversion and audio and digital mastering. HIGH DEFINITION TELEVISION (HDTV). The Company is focused on capitalizing on opportunities created by emerging industry trends such as the emergence of digital television and its more advanced variant, high-definition television. HDTV has quickly become the mastering standard for domestic content providers. The Company believes that the aggressive timetable associated with such conversion, which has resulted both from mandates by the Federal Communications Commission (the "FCC") for digital television and high-definition television as well as competitive forces in the marketplace, is likely to accelerate the rate of increase in the demand for these services. The Company opened a state-of-the-art HDTV center at its Burbank, California, facility in 2000. DVD AUTHORING. Digital formats, such as DVD, have the potential to overtake VHS videocassettes in the home video market. Industry research shows that DVD sales will surpass VHS videocassettes by 2003. The Company believes that there are significant opportunities in this market. With the increasing rate of conversion of existing analog libraries, as well as new content being mastered to digital formats, we believe that the Company has positioned itself well to provide value-added services to new and existing clients. The Company has made capital investments to expand and upgrade its current DVD and digital compression operations in anticipation of the increasing demand for DVD and video encoding services. 4 SALES AND MARKETING The Company markets its services through a combination of industry referrals, formal advertising, trade show participation, special client events, and its Internet website. While the Company relies primarily on its reputation and business contacts within the industry for the marketing of its services, the Company also maintains a direct sales force to communicate the capabilities and competitive advantages of the Company's services to potential new customers. In addition, the Company's sales force solicits corporate advertisers who may be in a position to influence agencies in directing deliveries through the Company. The Company currently has sales personnel located in Los Angeles, San Francisco, Chicago and New York. The Company's marketing programs are directed toward communicating its unique capabilities and establishing itself as the predominant value-added distribution network for the motion picture and advertising industries. In addition to its traditional sales efforts directed at those individuals responsible for placing orders with the Company's facilities, the Company also strives to negotiate "preferred vendor" relationships with its major customers. Through this process, the Company negotiates discounted rates with large volume clients in return for being promoted within the client's organization as an established and accepted vendor. This selection process tends to favor larger service providers such as the Company that (i) offer lower prices through scale economies; (ii) have the capacity to handle large orders without outsourcing to other vendors; and (iii) can offer a strategic partnership on technological and other industry-specific issues. The Company negotiates such agreements periodically with major entertainment studios and national broadcast networks. CUSTOMERS Since its inception in 1990, the Company has added customers and increased its sales through acquisitions and by delivering a favorable mix of reliability, timeliness, quality and price. The integration of the Company's regional facilities has given its customers a time advantage in the ability to deliver broadcast quality material. The Company markets its services to major and independent motion picture and television production companies, advertising agencies, television program suppliers and, on a more limited basis, national television networks, infomercial providers, local television stations, television program syndicators, corporations and educational institutions. The Company's motion picture clients include Disney, Sony Pictures Entertainment, Twentieth Century Fox, Universal Studios, Warner Bros., Metro-Goldwyn-Mayer and Paramount Pictures. The Company's advertising agency customers include TBWA/Chiat Day, Young & Rubicam and Saatchi & Saatchi. The Company solicits the motion picture and television industries, advertisers and their agencies to generate revenues. In the year ended December 31, 2001, the seven major motion picture studios accounted for approximately 34% of the Company's revenues. No single customer accounted for greater than 10% of the Company's revenues for the year ended December 31, 2001. The Company generally does not have exclusive service agreements with its clients. Because clients generally do not make arrangements with the Company until shortly before its facilities and services are required, the Company usually does not have any significant backlog of service orders. The Company's services are generally offered on an hourly or per unit basis based on volume. CUSTOMER SERVICE The Company believes it has built its strong reputation in the market with a commitment to customer service. The Company receives customer orders via courier services, telephone, telecopier and the Internet. The customer service staff develops strong relationships with clients within the studios and advertising agencies and is trained to emphasize the Company's ability to confirm delivery, meet difficult delivery time frames and provide reliable and cost-effective service. Several studios are customers because of the Company's ability to meet often changing or rush delivery schedules. The Company has a customer service staff of approximately 95 people, at least one member of which is available 24 hours a day. This staff serves as a single point of problem resolution and supports not only the Company's customers, but also the television stations and cable systems to which the Company delivers. 5 COMPETITION The video duplication and distribution industry is a highly competitive service-oriented business. Certain competitors (both independent companies and divisions of large companies) provide all or most of the services provided by the Company, while others specialize in one or several of these services. Substantially all of the Company's competitors have a presence in the Los Angeles area, which is currently the largest market for the Company's services. Due to the current and anticipated future demand for video duplication and distribution services in the Los Angeles area, the Company believes that both existing and new competitors may expand or establish video service facilities in this area. The Company believes that it maintains a competitive position in its market by virtue of the quality and scope of the services it provides, and its ability to provide timely and accurate delivery of these services. The Company believes that prices for its services are competitive within its industry, although some competitors may offer certain of their services at lower rates than the Company. The principal competitive factors affecting this market are reliability, timeliness, quality and price. The Company competes with a variety of duplication and distribution firms, certain post-production companies and, to a lesser extent, the in-house operations of major motion picture studios and ad agencies. Some of these competitors have long-standing ties to clients that will be difficult for the Company to change. Several companies have systems for delivering video content electronically. Moreover, some of these firms, such as Vyvx (a subsidiary of the Williams Companies), Digital Generation Systems, Inc., Liberty Live Wire and other post-production companies may have greater financial, operational and marketing resources, and may have achieved a higher level of brand recognition than the Company. As a result, there is no assurance that the Company will be able to compete effectively against these competitors merely on the basis of reliability, timeliness, quality, price or otherwise. EMPLOYEES The Company had 479 full-time employees as of December 31, 2001. The Company's employees are not represented by any collective bargaining organization, and the Company has never experienced a work stoppage. The Company believes that its relations with its employees are good. ITEM 2. PROPERTIES The Company currently leases all 16 of its facilities. Eight of these facilities have production capabilities and/or sales activities, five are storage vaults, one is used as the Company's corporate offices and two smaller facilities have been vacated. The lease terms expire at various dates from June 2002 to October 2008. The following table sets forth the location and approximate square footage of the Company's properties as of December 31, 2001: SQUARE LOCATION FOOTAGE Hollywood, CA........................................................ 9,500 Hollywood, CA........................................................ 45,000 Hollywood, CA........................................................ 4,000 Hollywood, CA........................................................ 7,200 Hollywood, CA........................................................ 13,000 Hollywood, CA........................................................ 27,000 Hollywood, CA........................................................ 11,000 Burbank, CA.......................................................... 32,000 Burbank, CA.......................................................... 10,000 North Hollywood, CA.................................................. 27,000 Los Angeles, CA...................................................... 4,000 Santa Monica, CA..................................................... 13,400 San Francisco, CA.................................................... 10,200 Chicago, IL.......................................................... 12,200 New York, NY......................................................... 9,000 Dallas, TX........................................................... 11,300 6 ITEM 3. LEGAL PROCEEDINGS From time to time the Company may become a party to various legal actions and complaints arising in the ordinary course of business, although it is not currently involved in any material legal proceedings. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to the Company's stockholders for a vote during the fourth quarter of the fiscal year covered by this report. PART II ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS MARKET INFORMATION The Company's Common Stock is traded on the National Association of Securities Dealers, Inc. Automated Quotation System ("NASDAQ") National Market ("NNM") under the symbol PTSX. The following table sets forth, for the periods indicated, the high and low closing bid price per share for the Common Stock. COMMON STOCK --------------- LOW HIGH --- ---- YEAR ENDED DECEMBER 31, 2001 First Quarter ......................................... $1.25 $4.56 Second Quarter......................................... .66 3.75 Third Quarter.......................................... .64 3.35 Fourth Quarter......................................... .46 1.39 YEAR ENDED DECEMBER 31, 2000 First Quarter ......................................... $12.63 $14.50 Second Quarter......................................... 6.19 14.08 Third Quarter.......................................... 3.13 7.00 Fourth Quarter......................................... 2.50 5.69 On March 14, 2002, the closing sale price of the Common Stock as reported on the NNM was $1.95 per share. As of March 14, 2002, there were 1,017 holders of record of the Common Stock. DIVIDENDS The Company did not pay dividends on its Common Stock during the years ended December 31, 2000 or 2001. The Company's ability to pay dividends depends upon limitations under applicable law and covenants under its bank agreements. The Company currently does not intend to pay any dividends on its Common Stock in the foreseeable future. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." 7 ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA The following data, insofar as they relate to each of the years 1997 to 2001, have been derived from the Company's annual financial statements. For 2001, certain adjustments have been made to previously reported amounts, which adjustments are described in "Management's Discussion and Analysis of Financial Condition and Results of Operations". This information should be read in conjunction with the Financial Statements and Notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere herein. All amounts are shown in thousands, except per share data. YEAR ENDED DECEMBER 31, ----------------------- 1997 1998 1999 2000 2001 ---- ---- ---- ---- ---- Statement of Income Data Revenues........................................................$ 40,772 $ 59,697 $ 78,248 $ 74,841 $ 69,628 Cost of goods sold.............................................. 25,381 36,902 47,685 45,894 46,864 --------- --------- --------- --------- --------- Gross profit.................................................... 15,391 22,795 30,563 28,947 22,764 Selling, general and administrative expense..................... 9,253 13,201 18,473 21,994 20,872 --------- --------- --------- --------- --------- Operating income ............................................... 6,138 9,594 12,090 6,953 1,892 Interest expense, net........................................... 68 976 2,147 2,889 3,070 Derivative fair value change (5)................................ - - - - 700 Provision for (benefit from) income tax ........................ 2,379 3,577 4,340 1,814 (384) --------- --------- --------- --------- --------- Income (loss) before extraordinary item, adoption of SAB 101 (2).......................................$ 3,691 $ 5,041 $ 5,603 $ 2,250 $ (1,494) Extraordinary item (net of tax benefit of $168) (1)............. - - - (232) - Cumulative effect of adopting SAB 101 (2)....................... - - - (322) - --------- --------- --------- --------- --------- Net income (loss)...............................................$ 3,691 $ 5,041 $ 5,603 $ 1,696 $ (1,494) ========= ========= ========= ========= ========= Earnings (loss) per share: Basic: Income (loss) per share before extraordinary item, adoption of SAB 101 (2).......................................$ 0.40 $ 0.52 $ 0.60 $ 0.24 $ (0.17) Extraordinary item (1).......................................... - - - (0.03) - Cumulative effect of adopting SAB 101 (2)....................... - - - (0.03) - --------- --------- --------- --------- --------- Net income (loss)...............................................$ 0.40 $ 0.52 $ 0.60 $ 0.18 $ (0.17) ========= ========= ========= ========= ========= Diluted: Income (loss) per share before extraordinary item and adoption of SAB 101.......................................$ 0.40 $ 0.51 $ 0.58 $ 0.24 $ (0.17) Extraordinary item (1).......................................... - - - (0.03) - Cumulative effect of adopting SAB 101 (2)....................... - - - (0.03) - --------- --------- --------- --------- --------- Net income (loss)...............................................$ 0.40 $ 0.51 $ 0.58 $ 0.18 $ (0.17) ========= ========= ========= ========= ========= Weighted average common shares outstanding Basic........................................................... 9,123 9,737 9,322 9,216 9,060 Diluted......................................................... 9,208 9,816 9,599 9,491 9,060 Pro forma net income and earnings per share data for the periods shown as if SAB 101 had been adopted at the beginning of each applicable year (4) Previously reported net income.................................. $ 5,041 $ 5,603 Adjustment...................................................... (253) (81) --------- --------- Pro forma net income............................................ $ 4,788 $ 5,522 ========= ========= Pro forma earnings per share: Basic - Previously reported............................................. $ 0.52 $ 0.60 Adjustment...................................................... (0.03) - --------- --------- Pro forma....................................................... $ 0.49 $ 0.60 ========= ========= Diluted - Previously reported............................................. $ 0.51 $ 0.58 Adjustment...................................................... (0.03) (0.01) --------- --------- Pro forma....................................................... $ 0.48 $ 0.57 ========= ========= 8 YEAR ENDED DECEMBER 31, ----------------------- 1997 1998 1999 2000 2001 ---- ---- ---- ---- ---- Other Data EBITDA (3)....................................................... $ 9,835 $ 14,320 $ 16,878 $ 12,171 $ 8,500 Cash flows provided by operating activities...................... 5,809 5,821 12,023 10,963 9,455 Cash flows used in investing activities.......................... (13,397) (33,406) (11,668) (9,488) (4,069) Cash flows provided by (used in) financing activities............ 9,945 26,712 (1,553) (1,556) (2,397) Capital expenditures............................................. 1,178 6,199 6,181 9,717 3,082 Selected Balance Sheet Data Cash and cash equivalents........................................ $ 2,921 $ 2,048 $ 3,030 $ 769 $ 3,758 Working capital ................................................. 5,354 8,863 1,195 12,701 (16,006)(6) Property and equipment, net...................................... 7,325 16,723 19,564 25,236 23,232 Total assets..................................................... 32,617 63,940 72,931 77,375 70,847 Borrowings under revolving credit agreements..................... 1,086 233 5,888 - - Long-term debt, net of current portion........................... 1,279 22,448 16,501 31,054 78 Shareholders' equity............................................. 21,242 28,351 30,941 32,919 30,778 - -------------------- (1) Amount represents the write off of deferred financing costs, net of tax benefit, related to a bank credit agreement which was terminated in Fiscal 2000. (2) Effective January 1, 2000, the Company adopted Staff Accounting Bulletin No. 101 ("SAB 101"), Revenue Recognition in Financial Statements. The amount represents the cumulative effect, net of tax, on January 1, 2000 retained earnings as if SAB 101 had been adopted prior to Fiscal 2000. See Note 2 of Notes to Consolidated Financial Statements elsewhere in this Form 10-K. (3) EBITDA is defined herein as earnings before interest, taxes, depreciation and amortization. EBITDA does not represent cash generated from operating activities in accordance with Generally Accepted Accounting Principles ("GAAP"), is not to be considered as an alternative to net income or any other GAAP measurements as a measure of operating performance and is not necessarily indicative of cash available to fund all cash needs. While not all companies calculate EBITDA in the same fashion and therefore EBITDA as presented may not be comparable to other similarly titled measures of other companies, management believes that EBITDA is a useful measure of cash flow available to the Company to pay interest, repay debt, make acquisitions or invest in new technologies. The Company is currently committed to use a portion of its cash flows to service existing debt, if outstanding, and, furthermore, anticipates making certain capital expenditures as part of its business plan. (4) Net income would not have been affected in 1997 had SAB 101 been adopted at the beginning of that period. (5) In November 2000, the Company entered into an interest rate swap contract to economically hedge its floating debt rate. Under the terms of the contract, the notional amount is $15,000,000, whereby the Company receives LIBOR and pays a fixed 6.50% rate of interest for three years. Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities ("FAS 133"), requires that the interest rate swap contract be recorded at fair value upon adoption of FAS 133 by recording (i) a cumulative-effect type adjustment at January 1, 2001 equal to the fair value of the interest rate swap contract on that date, (ii) amortizing the cumulative-effect type adjustment over the life of the derivative contract, and (iii) a charge or credit to income in the amount of the difference between the fair value of the interest rate swap contract at the beginning and end of such year. The effect of adopting FAS 133 was to record a cumulative effect type adjustment by charging Accumulated Other Comprehensive Income (a component of shareholders' equity $247,000 (net of $62,000 tax benefit), crediting Derivative Valuation Liability by $309,000 gross cumulative effect adjustment and charging Deferred Income Taxes $62,000. The change in the derivative fair value during the year ($579,000) and the amortization of the cumulative effect adjustment ($121,000) were recorded as a charge to Derivative Fair Value Change. (6) As of December 31, 2001, the Company had outstanding $28,999,000 under a credit facility with a group of banks. The entire amount is classified as a current liability due to existing covenant breaches. Excluding the borrowed amount, working capital would have been $12,993,000. 9 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Except for the historical information contained herein, certain statements in this annual report are "forward-looking statements" as defined in the Private Securities Litigation Reform Act of 1995, which involve certain risks and uncertainties, which could cause actual results to differ materially from those discussed herein, including but not limited to competition, customer and industry concentration, depending on technological developments, risks related to expansion, dependence on key personnel, fluctuating results and seasonality and control by management. See the relevant discussions in the Company's documents filed with the Securities and Exchange Commission, including the Company's registration statement on Form S-1 as declared effective on February 14, 1997, and Cautionary Statements and Risk Factors in this Item 7, for a further discussion of these and other risks and uncertainties applicable to the Company's business. OVERVIEW The Company generates revenues principally from duplication, distribution and ancillary services. Duplication services are comprised of the physical duplication of video materials from a source video or audiotape "master" to a target tape "clone." Distribution services include the physical or electronic distribution of video and audio materials to a customer-designated location utilizing one or more of the Company's delivery methods. Distribution services typically consist of deliveries of national television spot commercials and electronic press kits and associated trafficking instructions to designated stations and supplemental deliveries to non-broadcast destinations. Ancillary services include video and audio editing, element storage, closed captioning, transcription services, standards conversion, video encoding for air play verification, audio post-production and layback and foreign language mastering. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates and judgments, including those related to allowance for doubtful accounts, valuation of long-lived assets, and accounting for income taxes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. Critical accounting policies are those that are important to the portrayal of the Company's financial condition and results, and which require management to make difficult, subjective and/or complex judgements. Critical accounting policies cover accounting matters that are inherently uncertain because the future resolution of such matters is unknown. We have made critical estimates in the following areas: ALLOWANCE FOR DOUBTFUL ACCOUNTS. We are required to make judgments, based on historical experience and future expectations, as to the collectibility of accounts receivable. The allowances for doubtful accounts and sales returns represent allowances for customer trade accounts receivable that are estimated to be partially or entirely uncollectible. These allowances are used to reduce gross trade receivables to their net realizable value. The Company records these allowances based on estimates related to the following factors: i) customer specific allowances; ii) amounts based upon an aging schedule and iii) an estimated amount, based on the Company's historical experience, for issues not yet identified. 10 VALUATION OF LONG-LIVED AND INTANGIBLE ASSETS. Long-lived assets, consisting primarily of property, plant and equipment and intangibles comprise a significant portion of the Company's total assets. Long-lived assets, including goodwill and intangibles are reviewed for impairment whenever events or changes in circumstances have indicated that their carrying amounts may not be recoverable. Recoverability of assets is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by that asset. The cash flow projections are based on historical experience, managements' view of growth rates within the industry and the anticipated future economic environment. Factors we consider important which could trigger an impairment review include the following: o significant underperformance relative to expected historical or projected future operating results; o significant changes in the manner of our use of the acquired assets or the strategy for our overall business; o significant negative industry or economic trends; o significant decline in our stock price for a sustained period; and o our market capitalization relative to net book value. When we determine that the carrying value of intangibles, long-lived assets and related goodwill and enterprise level goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model. Net intangible assets, long-lived assets, and goodwill amounted to $49.6 million as of December 31, 2001. In 2002, Statement of Financial Accounting Standards ("SFAS") No. 142, "GOODWILL AND OTHER INTANGIBLE ASSETS" became effective and as a result, we will cease to amortize approximately $26.3 million of goodwill beginning in 2002. We had recorded approximately $2.0 million of amortization on these amounts during the year ended December 31, 2001. In lieu of amortization, we are required to perform an initial impairment review of our goodwill in 2002 and an annual impairment review thereafter. We expect to complete our initial review during the first quarter of 2002. ACCOUNTING FOR INCOME TAXES. As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves us estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense within the tax provision in the statement of operations. Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. The net deferred tax liability as of December 31, 2001 was $1.8 million. The Company did not record a valuation allowance against its deferred tax assets as of December 31, 2001. 11 RESULTS OF OPERATIONS During 2002, the Company revised 2001 financial statements to correct the transition adjustment and the required subsequent amortization into earnings resulting from the adoption of FAS 133 for an interest rate swap contract. These adjustments are as follows: DECREASE (INCREASE) ------------------ AS ORIGINALLY AS REPORTED RESTATED CHANGE -------- -------- ------ Income Statement - ---------------- Derivative fair value To correct FAS 133 interest rate swap contract amortization................... $ 508,000 $ 700,000 $(192,000) Balance Sheet - ------------- Derivative valuation liability Reversal of previous incorrect cumulative effect of adopting FAS 133... 579,000 888,000 309,000 --------- Adjustments to loss before income taxes... $ 117,000 Tax effect of adjustments................. (23,000) --------- Adjustment to net loss.................... $ 94,000 ========= The effect of this revision reduces the net loss for the year ended December 31, 2001 from $1,588,000 to $1,494,000 and reduces the net loss per share from $0.18 to $0.17. The following table sets forth the amount and percentage relationship to revenues of certain items included within the Company's Consolidated Statement of Income for the years ended December 31, 1999, 2000 and 2001, after giving effect to the above adjustments. The commentary below is based on these financial statements. YEAR ENDED DECEMBER 31 (DOLLARS IN THOUSANDS) ---------------------- 1999 2000 2001 --------------------- --------------------- ---------------------- PERCENT OF PERCENT OF PERCENT OF AMOUNT REVENUES AMOUNT REVENUES AMOUNT REVENUES ------ -------- ------ -------- ------ -------- (as restated) Revenues............................................. $ 78,248 100.0% $ 74,841 100.0% $ 69,628 100.0% Costs of goods sold.................................. 47,685 60.9 45,894 61.3 46,864 67.3 --------- ------- --------- ------- -------- ------- Gross profit......................................... 30,563 39.1 28,947 38.7 22,764 32.7 Selling, general and administrative expense.......... 18,473 23.6 21,994 29.4 20,872 30.0 --------- ------- --------- ------- -------- ------- Operating income..................................... 12,090 15.5 6,953 9.3 1,892 2.7 Interest expense, net................................ 2,147 2.7 2,889 3.9 3,070 4.4 Derivative fair value change......................... - - - - 700 1.0 Provision for (benefit from) income taxes............ 4,340 5.5 1,814 2.4 (384) (0.6) --------- ------- --------- ------- -------- ------- Income (loss) before extraordinary item and adoption of SAB 101(2000).......................... 5,603 7.2 2,250 3.0 (1,494) (2.1) Extraordinary item (net of tax benefit of $168)...... - - (232) (0.3) - - Cumulative effect of adopting SAB 101 (2000)......... - - (322) (0.4) - - --------- ------- --------- ------- -------- ------- Net income (loss).................................... $ 5,603 7.2% $ 1,696 2.3% $ (1,494) (2.1)% ========= ======= ========= ======= ======== ======= 12 YEAR ENDED DECEMBER 31, 2001 COMPARED TO YEAR ENDED DECEMBER 31, 2000 REVENUES. Revenues decreased by $5.2 million or 7% to $69.6 million for the year ended December 31, 2001, compared to $74.8 million for the year ended December 31, 2000 due to a decline in studio post production sales as some work was brought in-house. Studios have traditionally maintained in-house capacity and several customers utilized that capacity in 2001 to a greater extent thereby affecting our sales. GROSS PROFIT. Gross profit decreased $6.2 million or 21.4% to $22.8 million for the year ended December 31, 2001, compared to $28.9 million for the year ended December 31, 2000. As a percent of revenues, gross profit decreased from 38.7% to 32.7%. The decrease in gross profit as a percentage of revenues was due to increased depreciation associated with investments in high definition equipment ($0.9 million) and higher delivery costs for distribution services ($0.7 million), all of which amounted to approximately 2% of reported revenues. The remaining decline in gross margin is due to the Company's inability to cover other fixed costs with lower sales. SELLING, GENERAL AND ADMINISTRATIVE EXPENSE. Selling, general and administrative expense decreased $1.1 million, or 5.1% to $20.9 million for the year ended December 31, 2001, compared to $22.0 million for the year ended December 31, 2000. As a percentage of revenues, selling, general and administrative expense increased to 30% for the year ended December 31, 2001, compared to 29.4% for the year ended December 31, 2000. The fiscal 2000 period included $0.8 million of expenses associated with a terminated merger. The fiscal 2001 period included $0.4 million of bank agreement restructuring charges, $0.3 million of employee benefit plan one-time change expense, $0.3 million of severance accruals, and $0.3 million of consulting expense associated with the Company's rebranding efforts. Excluding these items and amortization of goodwill of $2.0 million in 2001 and $1.6 million in 2000, selling, general and administrative expenses were $17.5 million, or 25% of sales in 2001 compared to $19.6 million, or 26% of sales in 2000. The decrease was due principally to a $1.7 million decrease in the provision for doubtful accounts. Beginning in 2002, the amortization of goodwill will cease as the Company adopts Statement of Financial Accounting Standards No. 142, "Goodwill and Other Tangible Assets" ("FAS 142"). FAS 142 changes the accounting for goodwill and other intangible assets with indefinite useful lives from an amortization method to an impairment-only approach (the procedures going forward are described in Footnote 2 of Notes to Consolidated Financial Statements elsewhere in this Form 10-K). In connection with the adoption of FAS 142, the Company will be required to perform a transitional goodwill impairment assessment in the first half of 2002, which may result in a write off which would be treated as a change in accounting principle. As of December 31, 2001, goodwill, net of accumulated amortization, was $26 million. To the extent an impairment is indicated in the application of FAS 142, fiscal 2002 results of operations will be adversely affected, which effect may be material. Any impairment will not affect cash flow. OPERATING INCOME. Operating income decreased $5.1 million or 73% to $1.9 million for 2001, compared to $7.0 million for 2000. INTEREST EXPENSE. Interest expense increased $0.2 million, or 6.3%, to $3.1 million for 2001, compared to $2.9 million for 2000 due to a 2% default rate of interest premium charged by the Company's banks, commencing in July 2001. ADOPTION OF FAS 133 AND DERIVATIVE FAIR VALUE CHANGE. On January 1, 2001, the Company adopted FAS 133 by recording a cumulative effect adjustment of $247,000 after tax benefit as a charge to shareholders' equity. During 2001, the Company recorded the difference between the derivative fair value of the Company's interest rate swap contract at the beginning and end of the period, and amortization of the cumulative-effect adjustment during the year, of $0.7 million ($0.6 million net of tax benefit). INCOME TAXES. The Company's effective tax rate was 20% for 2001 and 46% for 2000. The lower tax rate is due to the effect of permanent differences on a lower pre-tax income base. NET INCOME (LOSS). The net loss for 2001 was $1.5 million, a decrease of $3.2 million compared to a profit of $1.7 million for 2000. 13 YEAR ENDED DECEMBER 31, 2000 COMPARED TO YEAR ENDED DECEMBER 31, 1999 REVENUES. Revenues decreased by $3.4 million or 4.4% to $74.8 million for the year ended December 31, 2000 compared to $78.2 million for the year ended December 31, 1999. This decrease in revenue was due to a decrease in the use of the Company's services in 2000 by certain customers resulting from service failures that occurred during the integration of its two largest facilities in 1999, and the loss of certain key sales personnel in 2000. Revenues were also negatively impacted by an actors' strike in the advertising industry. GROSS PROFIT. Gross profit decreased $1.7 million or 5.3% to $28.9 million for the year ended December 31, 2000 compared to $30.6 million for the year ended December 31, 1999. As a percentage of revenues, gross profit decreased from 39.1% to 38.7%. The decrease in gross profit as a percentage of revenues was due to increased depreciation associated with investments in high definition equipment. SELLING, GENERAL AND ADMINISTRATIVE EXPENSE. Selling, general and administrative expense increased $3.5 million or 19.1% to $22.0 million for the year ended December 31, 2000 compared to $18.5 million for the year ended December 31, 1999. As a percentage of revenues, selling, general and administrative expense increased to 29.4% for the year ended December 31, 2000 compared to 23.6% for the year ended December 31, 1999. This increase was due to an increase in the provision for doubtful accounts of $1.4 million, $0.5 million of severance costs, increased wages related to new management appointments and increased depreciation related to investments in computer systems. Additionally, in 2000, the Company recognized $0.8 million in expenses related to the proposed merger with an affiliate of Bain Capital, which was terminated in April 2000, compared to $0.4 million in 1999. The increase in the provision for doubtful accounts resulted from numerous delinquent accounts which, in management's judgment, were deemed to be no longer collectible in the fourth quarter due to the age of the account, financial condition of the customer or the inability to resolve disputes. OPERATING INCOME. Operating income decreased $5.1 million or 42.5% to $7.0 million for the year ended December 31, 2000 compared to $12.1 million for the year ended December 31, 1999. As a percentage of revenue, operating income decreased from 15.5% to 9.3%. INTEREST EXPENSE. Interest expense, net, increased 34.6% from $2.1 million in 1999 to $2.9 million in 2000. This increase was due to increased borrowings under the Company's debt agreements. INCOME TAXES. The Company's effective income tax rate was 45.5% for 2000 and 43.7% for 1999 due to the effect of permanent differences on a lower pre-tax income base. EXTRAORDINARY ITEM. During 2000, the Company wrote off $0.4 million of deferred financing costs related to prior credit facilities that were terminated. This item was treated as an extraordinary item in Fiscal 2000 and is reported net of income taxes. CUMULATIVE EFFECT OF ADOPTING SAB 101. During Fiscal 2000, the Company adopted SAB 101. The effect of applying this change in accounting principle is a cumulative charge, after tax, of $322,000, or $0.03 per share. Previously, the Company had recognized revenues from certain post production processes as work was performed. Under SAB 101, the Company will now recognize these revenues when the entire project is completed. NET INCOME. Net income for the year ended December 31, 2000 decreased $3.9 million or 69.7% to $1.7 million compared to $5.6 million for the year ended December 31, 1999. LIQUIDITY AND CAPITAL RESOURCES On December 31, 2001, the Company's cash and cash equivalents aggregated $3.8 million. The Company's operating activities provided cash of $9.5 million for the year ended December 31, 2001. 14 The Company's investing activities used cash of $4.1 million in the year ended December 31, 2001. The Company spent approximately $3.1 million for the addition and replacement of capital equipment and management information systems which we believe is a reasonable capital expenditure level given the current revenue volume. In the prior year, the Company's capital expenditures were greater than a normal recurring amount due to the investment of approximately $6.0 million in high definition television equipment. The Company's business is equipment intensive, requiring periodic expenditures of cash or the incurrence of additional debt to acquire additional fixed assets in order to increase capacity or replace existing equipment. The Company also made $1.0 million in acquisition earn-out payments in the year ended December 31, 2001. In September 2000, the Company signed a $45 million revolving credit facility agented by Union Bank of California. Due to lower sales levels in the second and third quarters of Fiscal 2001, the borrowing base (eligible accounts receivable, inventory and machinery and equipment) securing the Company's bank line of credit was less than the amount borrowed under the line. Consequently, the Company was in breach of certain covenants. On June 11 and on July 20, 2001, the Company entered into amendment and forbearance agreements with the banks and agreed to repay the overdraft amount in weekly increments. In August 2001, the Company failed to meet the repayment schedule and again entered discussions with the banks. In December 2001, the banks terminated their formal commitment. As of December 31, 2001, there was $29 million outstanding under the facility, which was classified as a current liability. The Company is currently negotiating a restructured credit agreement with the banks. If the Company is not successful in completing a final contract with the banks, the Company's liquidity would be materially and adversely affected. The Company, from time to time, considers the acquisition of businesses complementary to its current operations. Consummation of any such acquisition or other expansion of the business conducted by the Company may be subject to the Company securing additional financing. RECENT ACCOUNTING PRONOUNCEMENTS In December 1999, the U.S. Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 101 ("SAB 101"), REVENUE RECOGNITION IN FINANCIAL STATEMENTS. SAB 101 summarizes the SEC's views in applying generally accepted accounting principles to selected revenue recognition issues in financial statements. In June 2000, the SEC issued SAB 101B, an amendment to SAB 101, which delays the implementation of SAB 101. The Company adopted SAB 101 effective January 1, 2000. Effective January 1, 2001, the Company adopted Statement of Financial Accounting Standards No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES ("FAS 133"). The standard, as amended, requires that all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value of derivatives are recorded each period in other income. In June 2001, the Financial Accounting Standards Board ("FASB") issued FAS Nos. 141 and 142, "BUSINESS COMBINATIONS" and "GOODWILL AND OTHER INTANGIBLE ASSETS," respectively. FAS No. 141 replaces Accounting Principles Board ("APB") Opinion No. 16. It also provides guidance on purchase accounting related to the recognition of intangible assets and accounting for negative goodwill. FAS No. 142 changes the accounting for goodwill and other intangible assets with indefinite useful lives ("GOODWILL") from an amortization method to an impairment-only approach. Under FAS No. 142, goodwill will be tested annually and whenever events or circumstances occur indicating that goodwill might be impaired. FAS No. 141 and FAS No. 142 are effective for all business combinations completed after June 30, 2001. Upon adoption of FAS No. 142, amortization of goodwill recorded for business combinations consummated prior to July 1, 2001 will cease, and intangible assets acquired prior to July 1, 2001 that do not meet the criteria for recognition under FAS No. 141 will be reclassified to goodwill. The Company will be required to implement FAS No. 142 in the first quarter of fiscal 2002. In connection with the adoption of FAS No. 142, the Company will be required to perform a transitional goodwill impairment assessment. The Company is in the process of evaluating the impact of adoption of FAS 141 and 142. 15 In August 2001, the FASB issued FAS No. 143, "ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS," which requires entities to record the fair value of a liability for an asset retirement obligation in the period in which the obligation is incurred. When the liability is initially recorded, the entity capitalizes the cost by increasing the carrying amount of the related long-lived asset. FAS No. 143 is effective for fiscal years beginning after June 15, 2002. The Company does not have asset retirement obligations and, therefore, believes there will be no impact upon adoption of FAS No. 143. In October 2001, the FASB issued FAS No. 144, "ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS," which is applicable to financial statements issued for fiscal years beginning after December 15, 2001. The FASB's new rules on asset impairment supersede FAS No. 121, "ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF," and portions of APB Opinion No. 30, "REPORTING THE RESULTS OF OPERATIONS." FAS No. 144 provides a single accounting model for long-lived assets to be disposed of and significantly changes the criteria that would have to be met to classify an asset as held-for-sale. Classification as held-for-sale is an important distinction since such assets are not depreciated and are stated at the lower of fair value and carrying amount. FAS No. 144 also requires expected future operating losses from discontinued operations to be displayed in the period(s) in which the losses are incurred, rather than as of the measurement date as presently required. The Company is in the process of evaluating the impact of adopting FAS No. 144. CAUTIONARY STATEMENTS AND RISK FACTORS In our capacity as Company management, we may from time to time make written or oral forward-looking statements with respect to our long-term objectives or expectations which may be included in our filings with the Securities and Exchange Commission, reports to stockholders and information provided in our web site. The words or phrases "will likely," "are expected to," "is anticipated," "is predicted," "forecast," "estimate," "project," "plans to continue," "believes," or similar expressions identify "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical earnings and those presently anticipated or projected. We wish to caution you not to place undue reliance on any such forward-looking statements, which speak only as of the date made. In connection with the "Safe Harbor" provisions of the Private Securities Litigation Reform Act of 1995, we are calling to your attention important factors that could affect our financial performance and could cause actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods in any current statements. The following list of important factors may not be all-inclusive, and we specifically decline to undertake an obligation to publicly revise any forward-looking statements that have been made to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events. Among the factors that could have an impact on our ability to achieve expected operating results and growth plan goals and/or affect the market price of our stock are: o Recent history of losses o Prior breach of credit agreement covenants and new principal payment requirements. o Our highly competitive marketplace. o The risks associated with dependence upon significant customers. o Our ability to execute our expansion strategy. o The uncertain ability to manage growth. o Our dependence upon and our ability to adapt to technological developments. o Dependence on key personnel. o Our ability to maintain and improve service quality. o Fluctuation in quarterly operating results and seasonality in certain of our markets. o Possible significant influence over corporate affairs by significant shareholders. These risk factors are discussed further below. 16 RECENT HISTORY OF LOSSES. The Company has reported losses for each of the four fiscal quarters ended September 30, 2001 due, in part, to lower gross margins and lower sales levels and a number of unusual charges. Although we achieved profitability in Fiscal 2000 and prior years, there can be no assurance as to future profitability on a quarterly or annual basis. BREACH OF CREDIT AGREEMENT COVENANTS. Due to lower operating cash amounts resulting from reduced sales levels in 2001 and the consequential net losses, the Company breached certain covenants of its credit facility. The breaches were temporarily cured based on amendments and forbearance agreements among the Company and the banks which called for, among other provisions, scheduled payments to reduce amounts owed to the banks to the permitted borrowing base. In August 2001, the Company failed to meet the principal repayment schedule and was once again in breach of the credit facility, even though we remain current on interest payments. The banks ended their formal commitment to the Company in December 2001. We are currently negotiating for a restructured credit with the banks. We cannot be sure that the final contract will be successfully negotiated or, if successful, that the Company will not again breach established covenants. COMPETITION. Our broadcast video post production, duplication and distribution industry is a highly competitive, service-oriented business. In general, we do not have long-term or exclusive service agreements with our customers. Business is acquired on a purchase order basis and is based primarily on customer satisfaction with reliability, timeliness, quality and price. We compete with a variety of post production, duplication and distribution firms, some of which have a national presence, and to a lesser extent, the in-house post production and distribution operations of our major motion picture studio and advertising agency customers. Some of these firms, and all of the studios, have greater financial, distribution and marketing resources and have achieved a higher level of brand recognition than the Company. In the future, we may not be able to compete effectively against these competitors merely on the basis of reliability, timeliness, quality and price or otherwise. We may also face competition from companies in related markets which could offer similar or superior services to those offered by the Company. We believe that an increasingly competitive environment and the possibility that customers may utilize in-house capabilities to a greater extent could lead to a loss of market share or price reductions, which could have a material adverse effect on our financial condition, results of operations and prospects. CUSTOMER AND INDUSTRY CONCENTRATION. Although we have an active client list of over 2,500 customers, seven motion picture studios accounted for approximately 34% of the Company's revenues during the year ended December 31, 2001. If one or more of these companies were to stop using our services, our business could be adversely affected. Because we derive substantially all of our revenue from clients in the entertainment and advertising industries, the financial condition, results of operations and prospects of the Company could also be adversely affected by an adverse change in conditions which impact those industries. EXPANSION STRATEGY. Our growth strategy involves both internal development and expansion through acquisitions. We currently have no agreements or commitments to acquire any company or business. Even though we have completed eight acquisitions in the last four fiscal years, we cannot be sure additional acceptable acquisitions will be available or that we will be able to reach mutually agreeable terms to purchase acquisition targets, or that we will be able to profitably manage additional businesses or successfully integrate such additional businesses into the Company without substantial costs, delays or other problems. Certain of the businesses previously acquired by the Company reported net losses for their most recent fiscal years prior to being acquired, and our future financial performance will be in part dependent on our ability to implement operational improvements in, or exploit potential synergies with, these acquired businesses. 17 Acquisitions may involve a number of special risks including: adverse effects on our reported operating results (including the amortization of acquired intangible assets), diversion of management's attention and unanticipated problems or legal liabilities. In addition, we may require additional funding to finance future acquisitions. We cannot be sure that we will be able to secure acquisition financing on acceptable terms or at all. We may also use working capital or equity, or raise financing through equity offerings or the incurrence of debt, in connection with the funding of any acquisition. Some or all of these risks could negatively affect our financial condition, results of operations and prospects or could result in dilution to the Company's shareholders. In addition, to the extent that consolidation becomes more prevalent in the industry, the prices for attractive acquisition candidates could increase substantially. We may not be able to effect any such transactions. Additionally, if we are able to complete such transactions they may prove to be unprofitable. The geographic expansion of the Company's customers may result in increased demand for services in certain regions where it currently does not have post production, duplication and distribution facilities. To meet this demand, we may subcontract. However, we have not entered into any formal negotiations or definitive agreements for this purpose. Furthermore, we cannot assure you that we will be able to effect such transactions or that any such transactions will prove to be profitable. MANAGEMENT OF GROWTH. During the three years ended December 31, 1999, we experienced rapid growth that resulted in new and increased responsibilities for management personnel and placed and continues to place increased demands on our management, operational and financial systems and resources. To accommodate this growth, compete effectively and manage future growth, we will be required to continue to implement and improve our operational, financial and management information systems, and to expand, train, motivate and manage our work force. We cannot be sure that the Company's personnel, systems, procedures and controls will be adequate to support our future operations. Any failure to do so could have a material adverse effect on our financial condition, results of operations and prospects. DEPENDENCE ON TECHNOLOGICAL DEVELOPMENTS. Although we intend to utilize the most efficient and cost-effective technologies available for telecine, high definition formatting, editing, coloration and delivery of video content, including digital satellite transmission, as they develop, we cannot be sure that we will be able to adapt to such standards in a timely fashion or at all. We believe our future growth will depend in part, on our ability to add to these services and to add customers in a timely and cost-effective manner. We cannot be sure we will be successful in offering such services to existing customers or in obtaining new customers for these services, including the Company's significant investment in high definition technology in 2000 and 2001. We intend to rely on third party vendors for the development of these technologies and there is no assurance that such vendors will be able to develop such technologies in a manner that meets the needs of the Company and its customers. Any material interruption in the supply of such services could materially and adversely affect the Company's financial condition, results of operations and prospects. DEPENDENCE ON KEY PERSONNEL. The Company is dependent on the efforts and abilities of certain of its senior management, particularly those of R. Luke Stefanko, President and Chief Executive Officer. The loss or interruption of the services of key members of management could have a material adverse effect on our financial condition, results of operations and prospects if a suitable replacement is not promptly obtained. Although we have employment agreements with Mr. Stefanko and certain of our other key executives and technical personnel, we cannot be sure that such executives will remain with the Company during or after the term of their employment agreements. In addition, our success depends to a significant degree upon the continuing contributions of, and on our ability to attract and retain, qualified management, sales, operations, marketing and technical personnel. The competition for qualified personnel is intense and the loss of any such persons, as well as the failure to recruit additional key personnel in a timely manner, could have a material adverse effect on our financial condition, results of operations and prospects. There is no assurance that we will be able to continue to attract and retain qualified management and other personnel for the development of our business. 18 ABILITY TO MAINTAIN AND IMPROVE SERVICE QUALITY. Our business is dependent on our ability to meet the current and future demands of our customers, which demands include reliability, timeliness, quality and price. Any failure to do so, whether or not caused by factors within our control, could result in losses to such clients. Although we disclaim any liability for such losses, there is no assurance that claims would not be asserted or that dissatisfied customers would refuse to make further deliveries through the Company in the event of a significant occurrence of lost deliveries, either of which could have a material adverse effect on our financial condition, results of operations and prospects. Although we maintain insurance against business interruption, such insurance may not be adequate to protect the Company from significant loss in these circumstances and there is no assurance that a major catastrophe (such as an earthquake or other natural disaster) would not result in a prolonged interruption of our business. In addition, our ability to make deliveries within the time periods requested by customers depends on a number of factors, some of which are outside of our control, including equipment failure, work stoppages by package delivery vendors or interruption in services by telephone or satellite service providers. FLUCTUATING RESULTS, SEASONALITY. Our operating results have varied in the past, and may vary in the future, depending on factors such as the volume of advertising in response to seasonal buying patterns, the timing of new product and service introductions, the timing of revenue recognition upon the completion of longer term projects, increased competition, timing of acquisitions, general economic factors and other factors. As a result, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as an indication of future performance. For example, our operating results have historically been significantly influenced by the volume of business from the motion picture industry, which is an industry that is subject to seasonal and cyclical downturns, and, occasionally, work stoppages by actors, writers and others. In addition, as our business from advertising agencies tends to be seasonal, our operating results may be subject to increased seasonality as the percentage of business from advertising agencies increases. In any period our revenues are subject to variation based on changes in the volume and mix of services performed during the period. It is possible that in some future quarter the Company's operating results will be below the expectations of equity research analysts and investors. In such event, the price of the Company's Common Stock would likely be materially adversely affected. Fluctuations in sales due to seasonality may become more pronounced if the growth rate of the Company's sales slows. CONTROL BY PRINCIPAL SHAREHOLDER; POTENTIAL ISSUANCE OF PREFERRED STOCK; ANTI-TAKEOVER PROVISIONS. The Company's President and Chief Executive Officer, R. Luke Stefanko, beneficially owned approximately 18.4% of the outstanding common stock as of February 28, 2002. Mr. Stefanko's ex-spouse owned approximately 25.2% of the common stock on that date. Together, they owned approximately 43.6%. In August 2000 and May 2001, Mr. Stefanko was granted one-time proxies to vote his ex-spouse's shares in connection with the election of directors at the Company's annual meetings. The Company's Chairman of the Board, Haig Bagerdjian, beneficially owned approximately 6.7% of the common stock on February 28, 2002. By virtue of their stock ownership, Messrs. Stefanko and Bagerdjian individually or together may be able to significantly influence the outcome of matters required to be submitted to a vote of shareholders, including (i) the election of the board of directors, (ii) amendments to the Company's Restated Articles of Incorporation and (iii) approval of mergers and other significant corporate transactions. The foregoing may have the effect of discouraging, delaying or preventing certain types of transactions involving an actual or potential change of control of the Company, including transactions in which the holders of common stock might otherwise receive a premium for their shares over current market prices. Our Board of Directors also has the authority to issue up to 5,000,000 shares of preferred stock without par value (the "Preferred Stock") and to determine the price, rights, preferences, privileges and restrictions thereof, including voting rights, without any further vote or action by the Company's shareholders. Although we have no current plans to issue any shares of Preferred Stock, the rights of the holders of common stock would be subject to, and may be adversely affected by, the rights of the holders of any Preferred Stock that may be issued in the future. Issuance of Preferred Stock could have the effect of discouraging, delaying, or preventing a change in control of the Company. Furthermore, certain provisions of the Company's Restated Articles of Incorporation and By-Laws and of California law also could have the effect of discouraging, delaying or preventing a change in control of the Company. 19 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK MARKET RISK. The Company's market risk exposure with respect to financial instruments is to changes in the London Interbank Offering Rate ("LIBOR"). The Company had borrowings of $28,999,000 at December 31, 2001 under a credit agreement. Amounts outstanding under the credit agreement bear interest at the bank's reference rate plus a base rate margin not to exceed 1.00%, or, at the Company's election, at LIBOR plus a LIBOR margin not to exceed 2.75%. In November 2000, the Company entered into an interest rate swap contract to economically hedge its floating debt rate. Under the terms of the contract, the notional amount is $15,000,000, whereby the Company receives LIBOR and pays a fixed 6.50% rate of interest for three years. On June 15, 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities. The standard, as amended by Statement of Financial Accounting Standards No. 137, Accounting for Derivative Instruments and Hedging Activities Deferral of the Effective Date of FASB Statement No. 133, an amendment of FASB Statement No. 133, and Statement of Financial Accounting Standards No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities, an amendment of FASB Statement No. 133 (referred to hereafter as "FAS 133"), is effective for all fiscal quarters of all fiscal years beginning after June 15, 2000 (January 1, 2001 for the Company). FAS 133 requires that all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value of derivatives are recorded each period in current earnings or in other comprehensive income, depending on whether a derivative is designated as part of a hedging relationship and, if it is, depending on the type of hedging relationship. During 2001, the Company recorded a cumulative effect balance sheet adjustment by charging Accumulated Other Comprehensive Income (a component of shareholders' equity) $247,000 (net of $62,000 tax benefit), crediting Derivative Valuation Liability by the $309,000 gross cumulative effect adjustment and charging Deferred Income Taxes $62,000. Additionally, an expense of $700,000 ($560,000 net of tax benefit) was expensed in 2001 for the derivative fair value change during the year. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA PAGE Report of Independent Accountants.........................................18 Financial Statements: Consolidated Balance Sheets - December 31, 2000 and 2001..............................................19 Consolidated Statements of Income - Fiscal Years Ended December 31, 1999, 2000 and 2001.....................20 Consolidated Statements of Shareholders' Equity - Fiscal Years Ended December 31, 1999, 2000 and 2001.....................21 Consolidated Statements of Cash Flows - Fiscal Years Ended December 31, 1999, 2000 and 2001.....................22 Notes to Consolidated Financial Statements................................23-34 Financial Statement Schedule: Schedule II - Valuation and Qualifying Accounts.........................38 Consent of Independent Accountants........................................43 Schedules other than those listed above have been omitted since they are either not required, are not applicable or the required information is shown in the financial statements or the related notes. 20 Report of Independent Accountants To the Board of Directors and Shareholders of Point.360 In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, shareholders' equity and cash flows present fairly, in all material respects, the financial position of Point.360 ("the Company") and its subsidiaries at December 31, 2001 and December 31, 2000, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2001 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Notes 2 and 6 to the consolidated financial statements, during the year ended December 31, 2000 the Company changed its method of acccounting for revenue to conform to the requirements of SEC Staff Accounting Bulletin No. 101, and during the year ended December 31, 2001 the Company changed its method of accounting for derivatives to conform to the requirements of Financial Accounting Standard No. 133 ("SFAS 133"). As discussed in Notes 2 and 6 to the consolidated financial statements, during the year ended December 31, 2001 the Company revised its financial statements with respect to an interest rate swap contract under SFAS 133. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company has breached its debt covenants and amounts outstanding under its credit facility are immediately due and payable which raises substantial doubt about its ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. PricewaterhouseCoopers LLP (signed) Century City, California February 25, 2002, except for Notes 2 and 6 as to which the date is October 28, 2002 21 Point.360 Consolidated Balance Sheets DECEMBER 31, ------------ 2000 2001 ---- ---- (as restated) Assets ------ Current assets: Cash and cash equivalents....................................... $ 769,000 $ 3,758,000 Accounts receivable, net of allowances for doubtful accounts of $1,473,000 and $681,000, respectively ............ 16,315,000 12,119,000 Notes receivable from officers (Note 11) ....................... 1,001,000 928,000 Income tax receivable........................................... 1,362,000 1,399,000 Inventories..................................................... 1,031,000 820,000 Prepaid expenses and other current assets....................... 1,780,000 554,000 Deferred income taxes........................................... 1,574,000 884,000 ------------ ------------ Total current assets............................................ 23,832,000 20,462,000 Property and equipment, net (Note 4)............................ 25,236,000 23,232,000 Other assets, net............................................... 920,000 833,000 Goodwill and other intangibles, net (Note 3).................... 27,387,000 26,320,000 ------------ ------------ $ 77,375,000 $ 70,847,000 ============ ============ Liabilities and Shareholders' Equity ------------------------------------ Current liabilities: Accounts payable................................................ $ 8,564,000 $ 4,675,000 Accrued expenses................................................ 2,513,000 2,715,000 Borrowings under revolving credit agreement (Note 5)............ - 28,999,000 Current portion of capital lease obligations (Note 6)........... 54,000 79,000 ------------ ------------ Total current liabilities....................................... 11,131,000 6,468,000 ------------ ------------ Deferred income taxes........................................... 2,271,000 2,635,000 Notes payable (Note 6).......................................... 31,024,000 - Capital lease obligations, less current portion (Note 6)........ 30,000 78,000 Derivative valuation liability.................................. - 888,000 Commitments and contingencies (Note 8) Shareholders' equity Preferred stock - no par value; 5,000,000 shares authorized; none outstanding................ - - Common stock - no par value; 50,000,000 shares authorized; 9,162,670 and 8,992,806 shares issued and outstanding, respectively........ 17,943,000 17,336,000 Additional paid-in capital...................................... 329,000 439,000 Accumulated other comprehensive income.......................... - (150,000) Retained earnings............................................... 14,647,000 13,153,000 ------------ ------------ Total shareholders' equity...................................... 32,919,000 30,778,000 ------------ ------------ $ 77,375,000 $ 70,847,000 ============ ============ The accompanying notes are an integral part of these consolidated financial statements. 22 Point.360 Consolidated Statements of Income YEAR ENDED DECEMBER 31, ----------------------- 1999 2000 2001 ---- ---- ---- (as restated) Revenues................................................... $ 78,248,000 $ 74,841,000 $ 69,628,000 Cost of goods sold......................................... 47,685,000 45,894,000 46,864,000 ------------ ------------ ------------ Gross profit............................................... 30,563,000 28,947,000 22,764,000 Selling, general and administrative expense................ 18,473,000 21,994,000 20,872,000 ------------ ------------ ------------ Operating income........................................... 12,090,000 6,953,000 1,892,000 Interest expense (net)..................................... 2,147,000 2,889,000 3,070,000 Derivative fair value change............................... - - 700,000 ------------ ------------ ------------ Income (loss) before income taxes.......................... 9,943,000 4,064,000 (1,878,000) Provision for (benefit from) income taxes.................. 4,340,000 1,814,000 (384,000) ------------ ------------ ------------ Income (loss) before extraordinary item and cumulative effect of adopting SAB 101 (Note 2)........... 5,603,000 2,250,000 (1,494,000) Extraordinary item (net of tax benefit of $168,000) (Note 6)................................................. - (232,000) - Cumulative effect of adopting SAB 101 (Note 2)............. - (322,000) - ------------ ------------ ------------ Net income (loss).......................................... $ 5,603,000 $ 1,696,000 $ (1,494,000) Earnings (loss) per share: Basic: Income (loss) per share before extraordinary item and adoption of SAB 101.................................. $ 0.60 $ 0.24 $ (0.17) Extraordinary item......................................... - (0.03) - Cumulative effect of adopting SAB 101...................... - (0.03) - ------------ ------------ ------------ Net income (loss).......................................... $ 0.60 $ 0.18 $ (0.17) ============ ============ ============ Weighted average number of shares.......................... 9,322,249 9,216,163 9,060,487 Diluted: Income (loss) per share before extraordinary item and adoption of SAB 101.................................. $ 0.58 $ 0.24 $ (0.17) Extraordinary item......................................... - (0.03) - Cumulative effect of adopting SAB 101...................... - (0.03) - ------------ ------------ ------------ Net income (loss).......................................... $ 0.58 $ 0.18 $ (0.17) ============ ============ ============ Weighted average number of shares including the dilutive effect of stock options (Note 2)............ 9,598,554 9,491,424 9,060,487 The accompanying notes are an integral part of these consolidated financial statements. 23 Point.360 Consolidated Statements of Shareholders' Equity (in thousands except for share amounts) ACCUMULATED OTHER ADDITIONAL DEFERRED COMPRE- PAID-IN STOCK-BASED RETAINED HENSIVE SHAREHOLDERS' SHARES AMOUNT CAPITAL COMPENSATION EARNINGS INCOME EQUITY ------ -------- -------- ------------ -------- ------- ------------ Balance at December 31, 1998.............. 9,776,094 $ 20,948 $ - $ - $ 7,403 $ - $28,351 Net income................................ - - - - 5,603 - 5,603 Shares repurchased in connection with stock repurchase plan................... (572,700) (3,064) - - - - (3,064) Shares issued in connection with exercise of stock options............... 7,303 51 - - - - 51 --------- -------- ------- -------- -------- ------- -------- Balance at December 31, 1999.............. 9,210,697 17,935 - - 13,006 - 30,941 Net income................................ - - - - 1,696 - 1,696 Shares repurchased in connection with stock repurchase plan................... (171,400) (710) - - - (710) Shares issued and tax benefit associated with exercise of stock options........................... 47,698 368 - - - - 368 Shares issued in connection with company acquisition..................... 75,675 350 - - - - 350 Issuance of stock options to consultants............................. - - 329 (329) - - - Stock-based compensation.................. - - - 329 - - 329 Distribution to shareholder (Note 1)...... - - - - (55) - (55) --------- -------- -------- -------- -------- ------- -------- Balance at December 31, 2000.............. 9,162,670 $ 17,943 $ 329 $ - $ 14,647 - $ 32,919 Net loss.................................. - - - - (1,494) - (1,494) Shares repurchased in connection with stock repurchase plan................... (116,666) (300) - - - - (300) Issuance of stock options to consultants............................. - - 110 (110) - - - Stock-based compensation.................. - - - 110 - - 110 Shares issued in settlement of a debt..... 15,384 10 - - - - 10 Adjustment of shares issued for an acquisition.......................... (68,582) (317) - - - - (317) Cumulative effect of adoption of FAS 133 net of amortization and tax..... - - - - - (150) (150) --------- -------- -------- -------- -------- ------- -------- Balance at December 31, 2001.............. 8,992,806 $ 17,336 $ 439 $ - $ 13,153 $ (150) $30,778 ========= ======== ======== ======== ======== ======= ======== Comprehensive (loss) is as follows: 2001 ---- Net loss $ (1,494) Cumulative effect of adoption of FAS 133 net of tax ($62) $ (247) Amortization of cumulative effect adjustment, net of tax ($24) 97 --------- Comprehensive loss $ (1,644) ========= The accompanying notes are an integral part of these consolidated financial statements. 24 Point.360 Consolidated Statements of Cash Flows YEAR ENDED DECEMBER 31, ----------------------- 1999 2000 2001 ---- ---- ---- (as restated) Cash flows from operating activities: Net income (loss)........................................... $ 5,603,000 $ 1,696,000 $ (1,494,000) Adjustments to reconcile net income (loss) to net cash and cash equivalents provided by operating activities: Depreciation and amortization............................... 4,788,000 5,773,000 7,308,000 Provision for doubtful accounts............................. 790,000 2,195,000 529,000 Abandonment of leasehold improvements....................... 190,000 - - Deferred income taxes ...................................... 170,000 476,000 1,054,000 Other noncash items......................................... - 329,000 858,000 Cumulative effect of adopting SAB 101....................... - 322,000 - Extraordinary item.......................................... - 232,000 - Changes in operating assets and liabilities: (Increase) decrease in accounts receivable.................. (3,297,000) 1,359,000 3,667,000 (Increase) decrease in inventories.......................... (388,000) 91,000 211,000 Decrease (increase) in prepaid expenses and other current assets...................................... 28,000 (822,000) 1,229,000 Decrease (increase) in other assets......................... 109,000 (5,000) 87,000 Increase (decrease) in accounts payable..................... 2,518,000 1,397,000 (3,889,000) Increase (decrease) in accrued expenses..................... 1,461,000 (668,000) (68,000) Increase in income taxes payable (receivable), net.......... 51,000 (1,412,000) (37,000) ------------ ------------ ------------ Net cash and cash equivalents provided by operating activities...................................... 12,023,000 10,963,000 9,455,000 ------------ ------------ ------------ Cash flows from investing activities: Capital expenditures........................................ (6,181,000) (9,717,000) (3,082,000) Net cash paid for acquisitions.............................. (3,307,000) (1,951,000) (987,000) Net cash and cash equivalents used in investing activities...................................... (9,488,000) (11,668,000) (4,069,000) ------------ ------------ ------------ Cash flows from financing activities: S Corporation distributions to shareholders................. - (55,000) - Issuance of notes receivable................................ - (1,001,000) - Repurchase of common stock.................................. (3,064,000) (710,000) (300,000) Proceeds from exercise of stock options..................... 51,000 256,000 - Change in revolving credit agreement........................ 5,655,000 (5,888,000) - Deferred financing costs.................................... (365,000) (239,000) - Proceeds from bank note..................................... 2,500,000 32,174,000 - Repayment of notes payable.................................. (5,819,000) (25,892,000) (2,025,000) Repayment of capital lease obligations...................... (511,000) (201,000) (72,000) ------------- ------------ ------------ Net cash and cash equivalents used in financing activities...................................... (1,553,000) (1,556,000) (2,397,000) ------------- ------------ ------------ Net increase (decrease) in cash and cash equivalents........ 982,000 (2,261,000) 2,989,000 Cash and cash equivalents at beginning of year.............. 2,048,000 3,030,000 769,000 ------------- ------------ ------------ Cash and cash equivalents at end of year.................... $ 3,030,000 $ 769,000 $ 3,758,000 ============= ============ ============ The accompanying notes are an integral part of these consolidated financial statements. 25 Point.360 Notes to Consolidated Financial Statements 1. THE COMPANY: Point.360 ("Point.360" or the "Company") provides video and film asset management services to owners, producers and distributors of entertainment and advertising content. The Company provides the services necessary to edit, master, reformat, archive and distribute its clients' video content, including television programming, spot advertising and movie trailers. The Company provides worldwide electronic distribution, using fiber optics and satellites. The Company delivers commercials, movie trailers, electronic press kits, infomercials and syndicated programming, by both physical and electronic means, to thousands of broadcast outlets worldwide. The Company operates in one reportable segment. In February 1997, the Company completed the sale of a portion of its common shares in an initial public offering ("IPO"). Prior to the offering, the Company had elected S-Corporation status for federal and state income tax purposes. As a result of the offering, the S-Corporation status terminated. Thereafter, the Company has paid federal and state income taxes as a C-Corporation. In connection with the termination of S-Corporation status, the Company made a final $55,000 distribution to a shareholder in Fiscal 2000, which has been recorded as a reduction of retained earnings. As of April 30, May 31 and June 30, 2001, outstanding amounts under the Company's line of credit with a group of banks exceeded the borrowing base (see Note 6). On June 11 and July 20, 2001, the Company entered into amendment and forbearance agreements with the banks which required the Company to repay the amount of excess borrowings. In August 2001, the Company did not make required debt payments which created a breach of the amendment and forbearance agreements. As a consequence of the breach, the amount outstanding under the credit facility is immediately due and payable and, therefore, is reclassified as a current liability as of December 31, 2001. These circumstances raise substantial doubt about the Company's ability to continue as a going concern. These financial statements do not include any adjustments that might result from the outcome of this uncertainty. Management is also pursuing other financing sources to meet its capital and operating requirements, including new equity and debt financing. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: BASIS OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its two non-operating wholly owned subsidiaries, VDI Multimedia, Inc. and Multimedia Services, Inc. All significant intercompany accounts and transactions have been eliminated in consolidation. RECLASSIFICATIONS Certain previously reported amounts have been reclassified to conform to classifications adopted in 2001. ADJUSTMENTS TO PREVIOUSLY ISSUED FINANCIAL STATEMENTS During 2002, the Company revised 2001 financial statements to correct the transition adjustment and the required subsequent amortization into earnings resulting from the adoption of FAS 133 for an interest rate swap contract. These adjustments are as follows: 26 DECREASE (INCREASE) ------------------ AS ORIGINALLY AS REPORTED RESTATED CHANGE -------- -------- ------ Income Statement - ---------------- Derivative fair value To correct FAS 133 interest rate swap contract amortization................... $ 508,000 $ 700,000 $(192,000) Balance Sheet - ------------- Derivative valuation liability Reversal of previous incorrect cumulative effect of adopting FAS 133... 579,000 888,000 309,000 --------- Adjustments to loss before income taxes... $ 117,000 Tax effect of adjustments................. (23,000) --------- Adjustment to net loss.................... $ 94,000 ========= The effects of these adjustments on 2001 net loss and basic and diluted loss per share were as follows: Previously reported net loss $ (1,588,000) Adjustments 94,000 ------------ As adjusted $ (1,494,000) ============ Basic earnings per share: Previously reported $ (0.18) Adjustments .01 ------------ As adjusted $ (0.17) Diluted earnings per share: Previously reported $ (0.18) Adjustments .01 ------------ As adjusted $ (0.17) ============ USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. CASH AND CASH EQUIVALENTS Cash equivalents represent highly liquid short-term investments with original maturities of less than three months. REVENUES AND RECEIVABLES The Company records revenues when the services have been completed. Although sales and receivables are concentrated in the entertainment and advertising industries, credit risk due to financial insolvency is limited because of the financial stability of the customer base (i.e., large studios and advertising agencies). However, in 2000, the Company's evaluation of accounts receivable balances resulted in an increase in the reserve for doubtful accounts of approximately $2.2 million which was related primarily to smaller entities. No sales to a single customer were more than 10% of sales for 1999, 2000 or 2001. 27 Effective January 1, 2000, the Company adopted Staff Accounting Bulletin No. 101 ("SAB 101"), Revenue Recognition in Financial Statements. The effect of applying this Staff Accounting Bulletin has been accounted for as a change in accounting principle, with a cumulative charge of $322,000, or $0.03 per share, net of tax benefit of $233,000. Previously, the Company had recognized revenues from certain post production services as work was performed. Under SAB 101, the Company now recognizes these revenues when all services have been completed. As a result of adopting SAB 101, revenues of $555,000 were recognized in the year ended December 31, 2000 which were also recognized in the year ended December 31, 1999. The table below sets forth pro forma net income and earnings per share data for the periods shown as if the change in accounting policy had been adopted at the beginning of 1999. 1999 Previously reported $ 5,603,000 Adjustment (81,000) ------------ Pro forma $ 5,522,000 ============ Pro forma earnings per share: Basic - Previously reported $ 0.60 Adjustment - ------------ Pro forma $ 0.60 ============ Diluted - Previously reported $ 0.58 Adjustment (0.01) ------------ Pro forma $ 0.57 ============ CONCENTRATION OF CREDIT RISK Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents, and accounts receivable. The Company maintains its cash and cash equivalents with high credit quality financial institutions; at times, such balances with any one financial institution may exceed FDIC insured limits. Credit risk with respect to trade receivables is concentrated due to the large number of orders with major entertainment studios in any particular reporting period. The seven major studios represented 37% of accounts receivable at December 31, 2000 and 40% of accounts receivable at December 31, 2001. The Company reviews credit evaluations of its customers but does not require collateral or other security to support customer receivables. The seven major studios accounted for 37% and 34% of net sales for the years ended December 31, 2000 and 2001, respectively. No single customer had outstanding balances of greater than 10% of total accounts receivable as of December 31, 2000 or 2001. INVENTORIES Inventories comprise raw materials, principally tape stock, and are stated at the lower of cost or market. Cost is determined using the average cost method. PROPERTY AND EQUIPMENT Property and equipment are stated at cost. Expenditures for additions and major improvements are capitalized. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets. Amortization of leasehold improvements is computed using the straight-line method over the lesser of the estimated useful lives of the improvements or the remaining lease term. The estimated useful life of property and equipment is seven years and leasehold improvements are ten years. 28 GOODWILL AND OTHER INTANGIBLES Goodwill is amortized on a straight-line basis over 5-20 years. Other intangibles consist primarily of covenants not to compete and are amortized on a straight-line basis over 3-5 years. The Company identifies and records impairment losses on long-lived assets, including goodwill that is not identified with an impaired asset, when events and circumstances indicate that such assets might be impaired. Events and circumstances that may indicate that an asset is impaired include significant decreases in the market value of an asset, a change in the operating model or strategy and competitive forces. If events and circumstances indicate that the carrying amount of an asset may not be recoverable and the expected undiscounted future cash flow attributable to the asset is less than the carrying amount of the asset, an impairment loss equal to the excess of the asset's carrying value over its fair value is recorded. Fair value is determined based on the present value of estimated expected future cash flows using a discount rate commensurate with the risk involved, quoted market prices or appraised values, depending on the nature of the assets. To date, no such impairment has been recorded. INCOME TAXES The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109, "ACCOUNTING FOR INCOME TAXES" ("FAS 109"). FAS 109 requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts for financial reporting purposes and the tax basis of assets and liabilities. A valuation allowance is recorded for that portion of deferred tax assets for which it is more likely than not that the assets will not be realized. ADVERTISING COSTS Advertising costs are not significant to the Company's operations and are expensed as incurred. FAIR VALUE OF FINANCIAL INSTRUMENTS To meet the reporting requirements of Statement of Financial Accounting Standards No. 107, "DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS," the Company calculates the fair value of financial instruments and includes this additional information in the notes to financial statements when the fair value is different than the book value of those financial instruments. When the fair value is equal to the book value, no additional disclosure is made. The Company uses quoted market prices whenever available to calculate these fair values. The accrual method of accounting is used for the interest rate swap agreement entered into by the Company which converts the interest rate on $15 million of the Company's variable-rate debt to a fixed rate (see Note 6). Under the accrual method, each net payment or receipt due or owed under the derivative is recognized in income in the period to which the payment or receipt relates. Amounts to be paid/received under these agreements are recognized as an adjustment to interest expense. The related amounts payable to counter parties is included in other accrued liabilities. The estimated fair value of the interest rate swap agreement is a net payable of $888,000 at December 31, 2001. ACCOUNTING FOR STOCK-BASED COMPENSATION As permitted by Statement of Financial Accounting Standards No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION ("FAS 123"), the Company measures compensation costs in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, but provides pro forma disclosures of net income and earnings per share using the fair value method defined by FAS 123. Under APB No. 25, compensation expense is recognized over the vesting period based on the difference, if any, on the date of grant between the deemed fair value for accounting purposes of the Company's stock and the exercise price on the date of grant. The Company accounts for stock issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force ("EITF") 96-18, ACCOUNTING FOR EQUITY INSTRUMENTS THAT ARE ISSUED TO OTHER THAN EMPLOYEES FOR ACQUIRING, OR IN CONJUNCTION WITH SELLING, GOODS AND SERVICES. 29 EARNINGS PER SHARE The Company follows Statement of Financial Accounting Standards No. 128, EARNINGS PER SHARE ("FAS 128") and related interpretations for reporting Earnings per Share. FAS 128 requires dual presentation of Basic Earnings per Share ("Basic EPS") and Diluted Earnings per Share ("Diluted EPS"). Basic EPS excludes dilution and is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the reported period. Diluted EPS reflects the potential dilution that could occur if stock options were exercised using the treasury stock method. In accordance with Statement of Financial Accounting Standards No. 128, "EARNINGS PER SHARE", basic earnings (loss) per share is calculated based on the weighted average number of shares of common stock outstanding during the reporting period. Diluted earnings per share is calculated giving effect to all potentially dilutive common shares, assuming such shares were outstanding during the reporting period. Stock options for the purchase of 386,245 shares with a weighted average exercise price of $1.40 for the year ended December 31, 2001 were not included in the computation of diluted EPS as they are anti-dilutive as a result of net loss during the year. A reconciliation of the denominator of the basic EPS computation to the denominator of the diluted EPS computation is as follows: 1999 2000 2001 ---- ---- ---- Weighted average number of common shares outstanding used in computation of basic EPS.................................. 9,322,249 9,216,163 9,060,487 Dilutive effect of outstanding stock options ................................ 276,305 275,261 - --------- --------- --------- Weighted average number of common and potential common shares outstanding used in computation of diluted EPS............ 9,598,554 9,491,424 9,060,487 ========= ========= ========= COMPREHENSIVE INCOME In 1998, the Company adopted Statement of SFAS No. 130, "Reporting Comprehensive Income." This Statement establishes standards for the reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. Comprehensive income, as defined, includes all changes in equity during a period from non-owner sources. SUPPLEMENTAL CASH FLOW INFORMATION Selected cash payments and noncash activities were as follows: 1999 2000 2001 ---- ---- ---- Cash payments for income taxes.................. $ 4,154,000 $ 2,447,000 $ 121,000 Cash payments for interest...................... 2,151,000 2,920,000 2,830,000 Noncash investing and financing activities: Capitalized lease obligations incurred.......... 57,000 - 145,000 Tax benefits related to stock options........... - 112,000 - Adjustment of acquisition holdback shares....... - - (317,000) Acquisition of equipment in exchange for reduction of note receivable from shareholder.............................. - - 68,000 Accrual for earn-out payments................... - - 270,000 Detail of acquisitions: Fair value of assets, net of cash acquired...... - 147,000 - Goodwill (1).................................... 3,307,000 2,515,000 1,257,000 Liabilities (2)................................. - (711,000) - ------------ ------------ ------------ Net cash paid for acquisitions.................. $ 3,307,000 $ 1,951,000 $ 1,257,000 ============ ============ ============ (1) Includes additional purchase price payments made to former owners in periods subsequent to various acquisitions of $3,307,000, $1,353,000 and $965,000 in 1999, 2000 and 2001, respectively, and accrual for earn-out payments of $270,000 in 2001. (2) Includes common stock issued to sellers totaling $350,000 in 2000. 30 RECENT ACCOUNTING PRONOUNCEMENTS Effective January 1, 2001, the Company adopted Statement of Financial Accounting Standards No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES ("FAS 133"). The standard, as amended, requires that all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value of derivatives are recorded each period in other income. In June 2001, the Financial Accounting Standards Board ("FASB") issued FAS Nos. 141 and 142, "BUSINESS COMBINATIONS" and "GOODWILL AND OTHER INTANGIBLE ASSETS," respectively. FAS No. 141 replaces Accounting Principles Board ("APB") Opinion No. 16. It also provides guidance on purchase accounting related to the recognition of intangible assets and accounting for negative goodwill. FAS No. 142 changes the accounting for goodwill and other intangible assets with indefinite useful lives ("GOODWILL") from an amortization method to an impairment-only approach. Under FAS No. 142, goodwill will be tested annually and whenever events or circumstances occur indicating that goodwill might be impaired. FAS No. 141 and FAS No. 142 are effective for all business combinations completed after June 30, 2001. Upon adoption of FAS No. 142, amortization of goodwill recorded for business combinations consummated prior to July 1, 2001 will cease, and intangible assets acquired prior to July 1, 2001 that do not meet the criteria for recognition under FAS No. 141 will be reclassified to goodwill. The Company will be required to implement FAS No. 142 in the first quarter of fiscal 2002. In connection with the adoption of FAS No. 142, the Company will be required to perform a transitional goodwill impairment assessment. The Company is in the process of evaluating the impact of adoption of FAS 141 and 142. In August 2001, the FASB issued FAS No. 143, "ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS," which requires entities to record the fair value of a liability for an asset retirement obligation in the period in which the obligation is incurred. When the liability is initially recorded, the entity capitalizes the cost by increasing the carrying amount of the related long-lived asset. FAS No. 143 is effective for fiscal years beginning after June 15, 2002. The Company does not have asset retirement obligations and, therefore, believes there will be no impact upon adoption of FAS No. 143. In October 2001, the FASB issued FAS No. 144, "ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS," which is applicable to financial statements issued for fiscal years beginning after December 15, 2001. The FASB's new rules on asset impairment supersede FAS No. 121, "ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF,"and portions of APB Opinion No. 30, "REPORTING THE RESULTS OF OPERATIONS." FAS No. 144 provides a single accounting model for long-lived assets to be disposed of and significantly changes the criteria that would have to be met to classify an asset as held-for-sale. Classification as held-for-sale is an important distinction since such assets are not depreciated and are stated at the lower of fair value and carrying amount. FAS No. 144 also requires expected future operating losses from discontinued operations to be displayed in the period(s) in which the losses are incurred, rather than as of the measurement date as presently required. The Company is in the process of evaluating the impact of adopting FAS No. 144. 3. ACQUISITIONS On November 3, 2000, the Company acquired the assets and assumed certain liabilities of Creative Digital, Inc. ("Creative Digital"). The purchase price of the transaction was approximately $1,309,000. This amount included $500,000 paid in cash, $98,000 in estimated transaction costs and 75,675 shares of Point.360 common stock valued at $350,000. The acquisition was accounted for using the purchase method of accounting. The purchase price was allocated to the fair value of net assets of $147,000 and intangible assets of $1,162,000. Creative Digital provides colorization, editing, and other post production services to major motion picture studios and television producers. The Company may also pay up to an additional $3,000,000 in earn-out payments if Creative Digital achieves certain performance goals through 2005. No earn-out amounts have been paid as of December 31, 2001. In November 2001, 68,582 of the 75,675 shares of Point.360 stock valued at $317,000 were returned to the Company as certain conditions outlined in the acquisition agreement were not met. 31 On November 9, 1998, the Company acquired substantially all of the assets of Dubs, Inc. ("Dubs"). Dubs provides full service duplication, distribution, video content storage and ancillary services to major motion picture studios and independent production companies for both domestic and international use. As consideration, the Company paid Dubs $11,312,000, of which $10,437,000 was paid in 1998 and $875,000 was paid in 1999. On June 12, 1998, the Company acquired substantially all of the assets of All Post, Inc. ("All Post"). All Post provides full service duplication, distribution, video content storage and ancillary services to major motion picture studios and independent production companies for both domestic and international use. As consideration, the Company paid All Post $13,000,000 in 1998. On November 21, 1997, the Company acquired all of the outstanding shares of Fast Forward, Inc. ("Fast Forward"), a provider of video duplication and distribution services primarily to advertising agencies and post production companies. The purchase price consisted of $1,400,000 of cash, of which $1,150,000 was paid during 1998, 30,770 shares of common stock which were issued in December 31, 1997 and earn-out payments of up to $600,000 based upon Fast Forward attaining certain performance goals through December 2000. In August 1997, the Company acquired all of the outstanding capital stock of Multi-Media Services, Inc. ("Multi-Media"). Multi-Media principally provides video duplication, distribution, and content storage to major advertising agencies. Through the acquisition of Multi-Media, the Company acquired facilities in Los Angeles, Chicago and New York. The purchase price paid by the Company for Multi-Media was $6,867,000 (including the immediate repayment of $1,545,000 of indebtedness). In addition, the Company may be required to pay, as an earn-out, up to an aggregate of $2,000,000, plus interest from the closing date, in the event that Multi-Media, as a separate subsidiary of the Company, achieves certain financial goals through December 2002. If Multi-Media fails to achieve the targeted results in any particular quarter, the related earn-out payment will be deferred up to two years until the results are achieved. No earn-out payments will be made after December 31, 2004. As of December 31, 2001, the Company has paid or accrued $1,289,000 in earn-out payments. On January 1, 1997, the Company acquired all of the assets and certain liabilities of Woodholly Productions ("Woodholly"). Woodholly provides full service video duplication, distribution, content storage and ancillary services to major motion picture studios, advertising agencies and independent production companies for both domestic and international use. As consideration, the Company will pay the partners of Woodholly a maximum of $8,000,000, of which $4,000,000 was paid in January 1997. The remaining balance is subject to earn-out provisions that are predicated upon Woodholly attaining certain operating income goals, as set forth in the purchase agreement in each quarter through December 31, 2001. If Woodholly fails to achieve the targeted results in any particular quarter, the related earn-out payment will be deferred until the next quarter in which the quarterly minimum results are achieved as long as such minimum results are achieved before December 31, 2003. As of December 31, 2001, the Company has paid or accrued $3,415,000 in earn-out payments. The above acquisitions were accounted for as purchases, with the excess of the purchase price over the fair value of the net assets acquired allocated to goodwill. The contingent purchase price, to the extent earned, will be recorded as an increase to goodwill and will be amortized over the remaining useful life of the goodwill. As of December 31, 2001, based on prior performance of the applicable acquired entities, there can be no assurance that additional earn-out amounts will be paid. The consolidated financial statements reflect the operations of the acquired companies since their respective acquisition dates. Goodwill and other intangibles, net consist of the following: DECEMBER 31, ------------ 2000 2001 ---- ---- Goodwill $ 30,889,000 $ 31,807,000 Covenant not to compete 962,000 983,000 ------------- ------------- $ 31,851,000 $ 32,790,000 Less accumulated amortization (4,464,000) (6,470,000) ------------- ------------- $ 27,387,000 $ 26,320,000 ============= ============= Amortization expense totaled $1,581,000, $1,638,000 and $2,007,000 for the years ended December 31, 1999, 2000 and 2001, respectively. 32 4. PROPERTY AND EQUIPMENT: Property and equipment consist of the following: DECEMBER 31, ------------ 2000 2001 ---- ---- Machinery and equipment $ 34,600,000 $ 36,769,000 Leasehold improvements 7,304,000 7,634,000 Computer equipment 2,990,000 3,707,000 Equipment under capital lease 410,000 251,000 ------------- ------------ 45,304,000 48,361,000 Less accumulated depreciation and amortization (20,068,000) (25,129,000) ------------- ------------ $ 25,236,000 $ 23,232,000 ============= ============ Depreciation expense totaled $3,207,000, $4,135,000 and $5,301,000 for the years ended December 31, 1999, 2000 and 2001, respectively. Accumulated amortization on capital leases amounted to $219,000 and $73,000, as of December 31, 2000 and 2001, respectively. 5. REVOLVING CREDIT AGREEMENT: On December 31, 1999, the Company had a $6,000,000 revolving credit agreement with a bank. The outstanding borrowing on this line of credit was $5,888,000 at December 31, 1999. The Company repaid all amounts outstanding under the agreement in 2000. 6. LONG TERM DEBT AND NOTES PAYABLE: Term Loans and Revolving Credit In November 1998, the Company borrowed $29,000,000 on a term loan with a bank, payable in 60 monthly installments of $483,000 plus interest. The term loan was repaid in 2000 with the proceeds of a new borrowing arrangement with a group of banks. Deferred financing costs related to the term loan of approximately $232,000, net of $168,000 tax benefit, were concurrently written off and treated as an extraordinary item during the year ended December 31, 2000. In September 2000, the Company entered into a credit agreement ("Agreement") with a group of banks providing a revolving credit facility of up to $45,000,000. The purpose of the facility was to repay previously outstanding amounts under a prior agreement with a bank, fund working capital and capital expenditures and for general corporate purposes including up to $5,000,000 of stock repurchases under the Company's repurchase program. The Agreement provides for interest at the banks' adjusted reference rate, an adjusted federal funds effective rate plus 0.5%, or a LIBOR adjusted rate. Loans made under the Agreement are collateralized by substantially all of the Company's assets. The borrowing base under the Agreement is limited to 90% of eligible accounts receivable, 50% of inventory and 100% of operating machinery and equipment with such percentages decreasing in years subsequent to 2001. The Agreement provided that the aggregate commitment will decline by $5,000,000 on each December 31 beginning in 2002 until expiration of the entire commitment on December 31, 2005. The Agreement also contained covenants requiring certain levels of annual earnings before interest, taxes, depreciation and amortization (EBITDA) and net worth, and limits the amount of capital expenditures. By December 31, 2000, the Company had borrowed $31,024,000 under the Agreement and was not in compliance with certain financial covenants due to adjustments recorded to prior years' and 2000 results. The bank waived compliance with the covenants and amended the Agreement in April 2001 (the "Amendment"). In connection with the Amendment, the Company paid the banks a restructuring fee of $225,000 which was expensed in fiscal 2001. As of April 30, May 31 and June 30, 2001, outstanding amounts under the line of credit exceeded the borrowing base. On June 11 and July 20, 2001, the Company entered into amendment and forbearance agreements with the banks which required the Company to repay the amount of excess borrowings. In August 2001, the Company did not make required debt payments which created a breach of the amendment and forbearance agreements. As a consequence of the breach, the amount outstanding under the credit facility is immediately due and payable and, therefore, is reclassified as a current liability as of December 31, 2001. In December 2001, the banks terminated the commitment. The Company remains current in its interest payments to the banks and is actively engaged in renegotiating its relationship with the banks. During the year ended December 31, 2001, the Company made principal payments of $2,025,000. See Note 1. 33 INTEREST RATE SWAP In November 2000, the Company entered into an interest rate swap contract to economically hedge its floating debt rate. Under the terms of the contract, the notional amount is $15,000,000, whereby the Company receives LIBOR and pays a fixed 6.50% rate of interest for three years. Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities ("FAS 133") requires that the interest rate swap contract be recorded at fair value upon adoption of FAS 133 and quarterly by recording (i) a cumulative-effect type adjustment at January 1, 2001 equal to the fair value of the interest rate swap contract on that date, (ii) amortizing the cumulative-effect type adjustment quarterly over the life of the derivative contract, and (iii) a charge or credit to income in the amount of the difference between the fair value of the interest rate swap contract at the beginning and end of such quarter. The effect of adopting FAS 133 was to record an initial cumulative-effect balance sheet adjustment by charging Accumulated Other Comprehensive Income (a component of shareholders' equity) $247,000 (net of $62,000) tax benefit), crediting Derivative Valuation Liability by the $309,000 gross cumulative-effect adjustment and charging Deferred Income Taxes $62,000. The following adjustments were recorded to reflect changes during the year ended December 31, 2001: INCREASE (DECREASE) INCOME -------------------------- DERIVATIVE FAIR (PROVISION FOR ) BENEFIT NET DERIVATIVE VALUE CHANGE FROM INCOME TAXES FAIR VALUE CHANGE ------------ ----------------- ----------------- Amortization of cumulative-effect type adjustment $ (121,000) $ 24,000 $ (97,000) Difference in the derivative fair value between the beginning and end of the year (579,000) 116,000 (463,000) ----------- ----------- ----------- $ (700,000) $ 140,000 $ (560,000) =========== =========== =========== EQUIPMENT FINANCING AND CAPITAL LEASES The Company has financed the purchase of certain equipment through the issuance of notes payable and under capital leasing arrangements. The notes bear interest at rates ranging from 9.3% to 12.9%. Such obligations are payable in monthly installments through September 2004. Annual maturities for debt, under both the New Agreement and capital lease obligations as of December 31, 2001, are as follows: 2002................................ $ 29,078,000 2003................................ 47,000 2004................................ 31,000 Thereafter.......................... - ------------ $ 29,156,000 34 7. INCOME TAXES: The Company's provision for (benefit from) income taxes for the three years ended December 31, 2001 consists of the following: YEAR ENDED DECEMBER 31, -------------------------------------------- 1999 2000 2001 ---- ---- ---- Current tax (benefit) expense: Federal.......................................... $ 3,201,000 $ 683,000 $ (1,229,000) State............................................ 969,000 254,000 - ------------ ------------ ------------ Total current.................................... 4,170,000 937,000 (1,229,000) ------------ ------------ ------------ Deferred tax expense: Federal.......................................... 107,000 416,000 844,000 State............................................ 63,000 60,000 1,000 ------------ ------------ ------------ Total deferred................................... 170,000 476,000 845,000 ------------ ------------ ------------ Total provision for (benefit from) for income taxes................................. $ 4,340,000 $ 1,413,000 $ (384,000) ============ ============ ============ The following is a reconciliation of the components of the provision for (benefit from) income taxes: 2000 2001 ---- ---- Provision for (benefit from) income taxes per the income statement.................. $ 1,814,000 $ (384,000) Extraordinary item tax benefit.................... (168,000) - Cumulative effect tax benefit of adopting SAB 101................................ (233,000) - ------------ ----------- Provision for (benefit from) income taxes......... $ 1,413,000 $ (384,000) ============ =========== The composition of the deferred tax assets (liabilities) at December 31, 2000 and December 31, 2001 are listed below: 2000 2001 ---- ---- Accrued liabilities............................... $ 617,000 $ 474,000 Allowance for doubtful accounts................... 631,000 143,000 Other............................................. 326,000 267,000 ------------ ----------- Total current deferred tax assets................. 1,574,000 884,000 ------------ ----------- Property and equipment............................ (2,212,000) (2,915,000) Goodwill and other intangibles.................... (138,000) (236,000) State net operating loss carry forward............ - 173,000 Other............................................. 79,000 343,000 ------------ ----------- Total non-current deferred tax liabilities........ (2,271,000) (2,635,000) ------------ ----------- Net deferred tax liability........................ $ (697,000) $(1,751,000) ============ =========== 35 The provision for (benefit from) income taxes differs from the amount of income tax determined by applying the applicable U.S. Statutory income taxes rates to income before taxes as a result of the following differences: 2000 2001 ------ ------ Federal tax computed at statutory rate............ 34% (34)% State taxes, net of federal benefit and net operating loss limitation................... 6% 2% Non-deductible goodwill........................... 5% 9% Other............................................. 1% 3% ------ ------ 46% (20)% ====== ====== 8. COMMITMENTS AND CONTINGENCIES: OPERATING LEASES The Company leases office and production facilities in California, Illinois, Texas and New York under various operating leases. Approximate minimum rental payments under these non-cancelable operating leases as of December 31, 2001 are as follows: 2002................................ $ 3,119,000 2003................................ 2,560,000 2004................................ 2,136,000 2005................................ 1,557,000 2006................................ 1,404,000 Thereafter.......................... 1,771,000 -------------- $ 12,547,000 ============== Total rental expense was approximately $3,251,000, $3,206,000 and $3,482,000 for the three years in the period ended December 31, 2001, respectively. 9. STOCK REPURCHASE PLAN: In February 1999, the Company announced that it would commence a stock repurchase program approved by the Board. The Company did not set a target number of shares to be repurchased. Under the stock repurchase program, the Company was to purchase outstanding shares in such amounts and at such times and prices determined at the sole discretion of management. The funds for the stock repurchases were provided by the Company's credit facility with a bank which permitted repurchases up to $5,000,000. During 1999, 2000 and 2001, the Company repurchased $3,064,000, $710,000 and $617,000 of common stock, respectively. The Company was then restricted from further repurchases by the Amendment. 10. STOCK OPTION PLANS: STOCK OPTION PLANS In May 1996, the Board of Directors, approved the 1996 Stock Incentive Plan (the "1996 Plan"). The 1996 Plan provides for the award of options to purchase up to 900,000 shares of common stock, as well as stock appreciation rights, performance share awards and restricted stock awards. In July 1999, the Company's shareholders approved an amendment to the 1996 Plan increasing the number of shares reserved for grant to 2,000,000 and providing for automatic increases of 300,000 shares on each August 1 thereafter to a maximum of 4,000,000 shares. As of December 31, 2001, there were 2,397,000 options outstanding under the 1996 Plan and 283,000 options were available for grant. 36 In December 2000, the Company's Board of Directors adopted the 2000 Nonqualified Stock Option Plan (the "2000 Plan"). As amended, the 2000 Plan provides for the award of options to purchase up to 1,500,000 shares of common stock. Options may be granted under the 2000 Plan solely to attract people who have not previously been employed by the Company as a substantial inducement to join the Company. As of December 31, 2001, there were 890,000 options outstanding under the plan and 610,000 options were available for grant. Under both plans, the stock option price per share for options granted is determined by the Board of Directors and is based on the market price of the Company's common stock on the date of grant, and each option is exercisable within the period and in the increments as determined by the Board, except that no option can be exercised later than ten years from the date it was granted. The stock options generally vest over one to five years and for some options, earlier if the market price of the Company's common stock exceeds certain levels. In accounting for its plans, the Company, in accordance with the provisions of FAS 123, applies Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees." As a result of this election, the Company does not recognize compensation expense for its stock option plans since the exercise price of the options granted equals the fair value of the stock on the date of grant. Had the Company determined compensation cost based on the fair value for its stock options at grant date, as set forth under FAS 123, the Company's net income and earning per share would have been reduced to the pro forma amounts indicated below: 1999 2000 2001 ---- ---- ---- Net income (loss): As reported.................................. $ 5,603,000 $ 1,696,000 $ (1,494,000) Pro forma................................... 4,993,000 731,000 (3,266,000) Earnings (loss) per share: As reported: Basic........................................ 0.60 0.18 (0.17) Diluted...................................... 0.58 0.18 (0.17) Pro forma: Basic........................................ 0.54 0.08 (0.36) Diluted...................................... 0.52 0.08 (0.36) The fair value for these options was estimated at the grant date using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 1999, 2000 and 2001, respectively: expected volatility of 63%, 70% and 88% and risk-free interest rates of 5.28%, 5.59% and 4.53%. A dividend yield of 0% and expected life of five years was assumed for 1999, 2000 an 2001 grants. The weighted average fair value of options granted at the fair market price on the grant date in 1999, 2000 and 2001 were $4.37, $2.35 and $1.64, respectively. In 2001, the weighted average fair value of options granted at an exercise price in excess of the fair market price on the grant date was $0.48. All options granted in 1999 and 2000 were at fair market price. Transactions involving stock options are summarized as follows: NUMBER WEIGHTED AVERAGE OF SHARES EXERCISE PRICE --------- -------------- Balance at December 31, 1998............... 159,231 $ 7.24 Granted during 1999........................ 1,295,437 7.51 Exercised during 1999...................... (7,303) 7.00 Cancelled during 1999...................... (39,044) 7.00 --------- ------- Balance at December 31, 1999............... 1,408,321 $ 7.50 --------- ------- Granted during 2000........................ 1,779,100 3.76 Exercised during 2000...................... (47,698) 5.37 Cancelled during 2000...................... (242,716) 6.12 --------- ------- Balance at December 31, 2000............... 2,897,007 $ 5.43 --------- ------- Granted during 2001........................ 1,176,350 2.06 Cancelled during 2001...................... (786,729) 3.88 --------- ------- Balance at December 31, 2001............... 3,286,628 $ 4.55 ========= ======= 37 The Company granted 212,500 and 30,000 stock options to consultants in 2000 and 2001, respectively, of which 100,000 were vested as of December 31, 2000 and 230,000 were vested as of December 31, 2001. The fair value of the vested options estimated at the grant date using the Black-Scholes option pricing model following the assumptions mentioned above and expensed during 2000 and 2001 were $329,000 and $110,000, respectively. During fiscal 2000, $151,000 was attributable to services related to the revolving credit agreement, accordingly, such amount was capitalized as a deferred financing cost to be amortized over the five-year life of a new credit agreement (see Note 6), and $178,000 was expensed as a consulting cost. In 2001, $110,000 was expensed as a consulting cost. Additional information with respect to the outstanding options as of December 31, 2001 is as follows (shares in thousands): OPTIONS OUTSTANDING OPTIONS EXERCISABLE ------------------------------------------------------- ---------------------------- AVERAGE WEIGHTED OPTION EXERCISE REMAINING AVERAGE NUMBER OF AVERAGE PRICE RANGE . NUMBER OF SHARES CONTRACTUAL LIFE EXERCISE PRICE SHARES EXERCISE PRICE - --------------------- ---------------- ---------------- --------------- ----------- -------------- $ 1.20 to 5.38 2,625 7.4 $ 3.15 792 $ 3.84 7.00 to 10.00 485 7.3 8.48 480 8.48 10.75 to 15.00 177 7.5 14.68 176 14.68 ------ ------ 3,287 1,448 ===== ===== 11. RELATED PARTY TRANSACTIONS At December 31, 2001, the Company had a loan outstanding to its Chief Executive Officer totaling $766,000, including accrued interest of $64,000. The loan is collateralized by a trust deed and bears interest at a rate of 6.19%. The loan is due on or before December 31, 2002. At December 31, 2001, the Company also had a $162,000 loan outstanding to one of its Division Presidents, including accrued interest of $12,000. This loan is collateralized by 7,093 shares of the Company's common stock owned by the Division President and bears interest at a rate of 7%. The loan is due on or before November 15, 2002. 12. 401(K) Plan The Company has a 401(K) plan which covers substantially all employees. Each participant is permitted to make voluntary contributions not to exceed the lesser of 20% of his or her respective compensation or the applicable statutory limitation, and is immediately 100% vested. The Company matches one-fourth of the first 4% contributed by the employee. Company contributions to the plan were $125,000, $93,000 and $102,000 in 1999, 2000 and 2001, respectively. 38 13. SUPPLEMENTAL DATA (unaudited) The following tables set forth quarterly supplementary data for each of the years in the two-year period ended December 31, 2001 (in thousands except per share data). The 2001 amounts have been restated from amounts previously reported, as indicated. A reconciliation from 2001 amounts previously reported appears at the end of the 2001 table. 2000 -------------------------------------------------------------- QUARTER ENDED YEAR ---------------------------------------------------- ENDED MARCH 31 JUNE 30 SEPT 30 DEC 31 DEC 31 -------- ------- ------- ------ ------ Revenues.................................................. $ 19,090 $ 18,480 $ 18,121 $ 19,150 $ 74,841 Gross profit.............................................. 8,205 7,159 6,708 6,875 28,947 Income (loss) before extraordinary item and adoption of SAB 101..................................... 1,287 786 812 (635) 2,250 Extraordinary item, net of $168 tax benefit (1) .......... - - (232) - (232) Cumulative effect of adopting SAB 101 (2)................. (322) - - - (322) --------- --------- --------- --------- --------- Net income (loss)......................................... $ 965 $ 786 $ 580 $ (635) $ 1,696 ========= ========= ========= ========= ========= Earnings per share: Basic - Income (loss) per share before extraordinary item and adoption of SAB 101................................. $ 0.14 $ 0.09 $ 0.09 $ (0.07) $ 0.24 Extraordinary item (1).................................... - - (0.03) - (0.03) Cumulative effect of adopting SAB 101 (2)................. (0.04) - - - (0.03) --------- --------- --------- --------- ---------- Net income (loss)......................................... $ 0.10 $ 0.09 $ 0.06 $ (0.07) $ 0.18 ========= ========= ========= ========= ========== Diluted - Income (loss) per share before extraordinary item and adoption of SAB 101................................. $ 0.13 $ 0.08 $ 0.09 $ (0.07) $ 0.24 Extraordinary item (1).................................... - - (0.03) - (0.03) Cumulative effect of adopting SAB 101 (2)................. (0.03) - - - (0.03) --------- --------- --------- --------- ---------- Net income (loss)......................................... $ 0.10 $ 0.08 $ 0.06 $ (0.07) $ 0.18 ========= ========= ========= ========= ========== - ---------------------------- (1) Amount represents the write off of deferred financing costs, net of tax benefit, related to a bank credit agreement which was terminated in Fiscal 2000. (2) Effective January 1, 2000, the Company adopted Staff Accounting Bulletin No. 101 ("SAB 101"), Revenue Recognition in Financial Statements. The amount represents the cumulative effect, net of tax, on January 1, 2000 retained earnings as if SAB 101 had been adopted prior to Fiscal 2000. The pro forma effect on Fiscal 1999 of adopting SAB 101 would have been to reduce net income by approximately $81,000, or $0.00 per basic $0.01 per diluted share. The pro forma impact of adopting SAB 101 on the fourth quarter of 1999 would have been to reduce net income by $122,000, or $0.01 per basic and diluted share. 2001 -------------------------------------------------------------- QUARTER ENDED YEAR ---------------------------------------------------- ENDED MARCH 31 JUNE 30 SEPT 30 DEC 31 DEC 31 -------- ------- ------- ------ ------ (as (as (as (as (as restated) restated) restated) restated) restated) Revenues.................................................. $ 19,108 $ 16,446 $ 16,905 $ 17,169 $ 69,628 Gross profit.............................................. 6,501 5,185 5,659 5,419 22,764 Net income (loss)......................................... $ (62) $ (654) $ (720) $ (58) $ (1,494) ========= ========= ======== ======== ========= Loss per share: Basic..................................................... $ (0.01) $ (0.07) $ (0.08) $ (0.01) $ (0.17) Diluted................................................... $ (0.01) $ (0.07) $ (0.08) $ (0.01) $ (0.17) 39 Reconciliation from net loss amounts previously reported: AS PREVIOUSLY REPORTED ADJUSTMENTS (1) AS RESTATED -------- --------------- ----------- Quarter ended March 31, 2001: Revenues.................................................. $ 19,108 $ - $ 19,108 Gross Profit.............................................. 6,465 36 (2) 6,501 Loss before adoption of FAS 133........................... (32) (30)(4) (62) Cumulative effect of adopting FAS 133 (3)................. (139) 139 (3) - ---------- ---------- --------- Net Loss.................................................. $ (171) $ 109 $ (62) ========== ========== ========= Loss per share Basic - Loss per share before adoption of FAS 133................. $ - $ (0.01) $ (0.01) Cumulative effect of adopting FAS 133 (3)................. (0.02) 0.02 - ---------- ---------- --------- Net loss.................................................. $ (0.02) $ 0.01 $ (0.01) ========== ========== ========= Diluted - Loss per share before adoption of FAS 133................. $ - $ (0.01) $ (0.01) Cumulative effect of adopting FAS 133..................... (0.02) 0.02 - ---------- ---------- --------- Net loss.................................................. $ (0.02) $ 0.01 $ (0.01) ========== ========== ========= Quarter ended June 30, 2001: Revenues.................................................. $ 16,446 $ - $ 16,446 Gross profit.............................................. 4,959 226 (2) 5,185 ---------- ---------- --------- Net loss.................................................. $ (676) $ 22 (4)(5) $ (654) ========== ========== ========= Loss per share Basic..................................................... $ (0.07) $ - $ (0.07) Diluted................................................... $ (0.07) $ - $ (0.07) ========== ========== ========= Quarter ended September 30, 2001: Revenues.................................................. $ 16,905 $ - $ 16,905 Gross profit.............................................. 5,486 173 (2) 5,659 ---------- ---------- --------- Net loss.................................................. $ (744) $ 24 (4)(6) $ (720) ========== ========== ========= Loss per share Basic..................................................... $ (0.08) $ - $ (0.08) Diluted................................................... $ (0.08) $ - $ (0.08) ========== ========== ========= Quarter ended December 31, 2001: Revenues.................................................. $ 17,169 $ - $ 17,169 Gross profit.............................................. 5,854 (435)(2) 5,419 ---------- ---------- --------- Net income (loss)......................................... $ 3 $ (61)(4)(5)(6) $ (58) ========== ========== ========= Loss per share Basic..................................................... $ - $ (0.01) $ (0.01) Diluted................................................... $ - $ (0.01) $ (0.01) ========== ========== ========= - --------------------- (1) Adjustments to previously issued financial statement reflect (i) allocating certain year-end adjustments to other than the fourth quarter of 2001, (ii) correcting the quarterly amortization of other intangibles associated with an acquired company and (iii) correcting the transition adjustment and the required subsequent reclassification into earnings resulting from the adoption of FAS 133 for an interest rate swap contract. (2) The principal component of the adjustment to gross profit was to allocate a portion of a fourth quarter depreciation expense adjustment to the first three quarters. (3) Reversal of the FAS 133 cumulative-effect adjustment originally charged to income. The corrected adjustment was to charge the cumulative-effect amount to Accumulated Other Comprehensive Income, a component of shareholders' equity. (4) In addition to the depreciation adjustment, includes correction of amortization of other intangibles and accounting for the interest rate swap contract according to FAS 133. (5) Includes allocation of raw materials purchases to the proper quarter and an accrual for the estimated liability for two abandoned leases. (6) Includes the correct allocation of software amortization expense. 40 To the Board of Directors and Shareholders of Point.360 Our audits of the consolidated financial statements referred to in our report dated February 25, 2002, except for Notes 2 and 6, as to which the date is October 28, 2002, which is qualified as to the Company's ability to continue as a going concern, appearing in this Annual Report on Form 10-K also included an audit of the financial statement schedule listed in Item 8 of this Form 10-K. In our opinion, this financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PricewaterhouseCoopers LLP Century City, California February 25, 2002 , except for Notes 2 and 6, as to which the date is October 28, 2002 Point.360 Schedule II- Valuation and Qualifying Accounts BALANCE AT CHARGED TO BALANCE AT BEGINNING OF COSTS AND DEDUCTIONS/ END OF ALLOWANCE FOR DOUBTFUL ACCOUNTS YEAR EXPENSES OTHER WRITE-OFFS YEAR - ------------------------------- ---- -------- ----- ---------- ---- Year ended December 31, 2001 $ 1,473,000 $ 529,000 $ -- $(1,321,000) $ 681,000 Year ended December 31, 2000 971,000 2,195,000 -- (1,693,000) 1,473,000 Year ended December 31, 1999 878,000 790,000 -- (697,000) 971,000 41 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item of Form 10-K is contained in the Company's Form 10-K/A filed with the Securities and Exchange Commission on April 26, 2002 and is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The information required by this item of Form 10-K is contained in the Company's Form 10-K/A filed with the Securities and Exchange Commission on April 26, 2002 and is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item of Form 10-K is contained in the Company's Form 10-K/A filed with the Securities and Exchange Commission on April 26, 2002 and is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item of Form 10-K is contained in the Company's Form 10-K/A filed with the Securities and Exchange Commission on April 26, 2002 and is incorporated herein by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents Filed as Part of this Report: (1,2) Financial Statements and Schedules. The following financial documents of Point.360 are filed as part of this report under Item 8: Consolidated Balance Sheets - December 31, 2000 and 2001 (restated) Consolidated Statements of Income - Fiscal Years Ended December 31, 1999, 2000 and 2001 (restated) Consolidated Statements of Shareholders' Equity - Fiscal Years Ended December 31, 1999, 2000 and 2001 (restated) Consolidated Statements of Cash Flows - Fiscal Years Ended December 31, 1999, 2000 and 2001(restated) Notes to Consolidated Financial Statements (restated) 42 (3) Exhibit Number Description ------ ----------- 3.1 Restated Articles of Incorporation of the Company . (3) 3.2 By-laws of the Company. (3) 10.1 Agreement and Plan of Merger, dated as of December 24, 1999, among VDI MultiMedia, VDI MultiMedia, Inc. and VMM Merger Corp. (1) 10.2 Shareholders Agreement, dated as of December 24, 1999, among VMM Merger Corp., R. Luke Stefanko and Julia Stefanko. (2) 10.3 1996 Stock Incentive Plan of the Company. (3) 10.4 2000 Stock Incentive Plan of the Company. (9) 10.5 Business Loan Agreement (Revolving Credit) between the Company and Union Bank dated July 1, 1995, as amended on April 1, 1996, and June 1996. (3) 10.6 Joint Operating Agreement effective as of March 1, 1994, between the Company and Vyvx, Inc. (3) 10.7 Lease Agreement between the Company and 6920 Sunset Boulevard Associates dated May 17, 1994 (Hollywood facility). (3) 10.8 Lease Agreement between the Company and 3767 Overland Associates, Ltd. dated April 25, 1996 (West Los Angeles facility). (3) 10.9 Asset Purchase Agreement, dated as of December 28, 1996 by and among VDI Media, Woodholly Productions, Yvonne Parker, Rodger Parker, Jim Watt and Kim Watt. (3) 10.10 Asset Purchase Agreement, dated as of June 12, 1998 by and between VDI Media and All Post, Inc. (4) 10.11 Asset Purchase Agreement, dated as of November 9, 1998 by and among VDI Media, Dubs Incorporated, Vincent Lyons and Barbara Lyons. (5) 10.12 Second Amended and Restated Credit Agreement dated September 28, 2000 between the Company and Union Bank of California, N.A. (6) 10.13 Secured Promissory Note dated December 28, 2000 between R. Luke Stefanko and the Company. (7) 10.14 Asset Purchase Agreement dated November 3, 2000 by and among the Company, Creative Digital, Inc. and Larry Hester. (7) 10.15 First Amendment to Second Amended and Restated Credit Agreement and Waiver dated March 30, 2001 among the Company, the Lenders party to the Credit Agreement and Union Bank of California, N.A. as administrative agent for such Lenders. (7) 10.16 Second Amendment to Second Amended and Restated Credit Agreement and Forbearance dated June 11, 2001 among the Company, the Lenders party to the Credit Agreement and Union Bank of California, N.A. as administrative agent for such Lenders. (8) 10.17 Third Amendment to Second Amended and Restated Credit Agreement and Forbearance dated July 20, 2001 among the Company, the Lenders party to the Credit Agreement and Union Bank of California, N.A. as administrative agent for such Lenders. (8) 10.18 Employment Agreement dated June 7, 2001 between the Company and R. Luke Stefanko. (8) 10.19 Employment Agreement dated June 7, 2001 between the Company and Alan R. Steel. (8) 43 10.20 Employment Agreement dated June 7, 2001 between the Company and Neil Nguyen. (8) 23.1 Consent of Independent Accountants. 99.1 Certification of Chief Executive Officer Pursuant to 18 U.S.C.ss. 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 99.2 Certification of Chief Financial Officer Pursuant to 18 U.S.C.ss.1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ------------------------------------- (1) Filed with the Securities and Exchange Commission ("SEC") on January 11, 2000 as an exhibit to the Company's Form 8-K and incorporated herein by reference. (2) Filed with the SEC on January 3, 2000 at part of the Schedule 13D of VMM Corp, Bain Capital Fund VI, L.P., Bain Capital Partners VI, L.P. and Bain Capital Investors VI, Inc. and incorporated herein by reference. (3) Filed with the SEC as an exhibit to the Company's Registration Statement on Form S-1 filed with the SEC on May 17, 1996 or as an exhibit to Amendment No. 1 to the Form S-1 filed with the SEC on December 31, 1996 and incorporated herein by reference. (4) Filed with the SEC on June 29, 1998 as an exhibit to the Company's Form 8-K and incorporated herein by reference (5) Filed with SEC on December 2, 1998 as an exhibit to the Company's Form 8-K and incorporated herein by reference. (6) Filed with the SEC on November 14, 2000 as an exhibit to the Company's Form 10-Q and incorporated herein by reference. (7) Filed with the SEC on April 11, 2001 as an exhibit to the Company's Form 10-K and incorporated herein by reference. (8) Filed with the SEC on August 14, 2001 as an exhibit to the Company's Form 10-Q and incorporated herein by reference. (9) Filed with the SEC on September 7, 2001 as an exhibit to the Company's Form S-8 and incorporated herein by reference. (b) Reports on 8-K: No reports on Form 8-K were filed during the quarter ended December 31, 2001. 44 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: November 7, 2002 Point.360 By: /s/ Alan R. Steel --------------------------- Alan R. Steel Chief Financial Officer CERTIFICATIONS I, Haig S. Bagerdjian, certify that: 1. I have reviewed this annual report on Form 10-K/A-1 of Point.360; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; and 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report. Date: November 7, 2002 /s/ Haig S. Bagerdjian --------------------------- Haig S. Bagerdjian Chairman of the Board of Directors, President and Chief Executive Officer I, Alan R. Steel, certify that: 1. I have reviewed this annual report on Form 10-K/A-1 of Point.360; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; and 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report. Date: November 7, 2002 /s/ Alan R. Steel ---------------------------- Alan R. Steel Executive Vice President, Finance and Administration & Chief Financial Officer 45 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statements on Forms S-8 (Nos. 333-69174 and 333-69168) of Point.360 of our report dated February 25, 2002, except for Notes 2 and 6, as to which the date is October 28, 2002, which is qualified as to the Company's ability to continue as a going concern, relating to the financial statements, which appears in this Annual Report on Form 10-K/A-1. We also consent to the incorporation by reference of our report dated February 25, 2002 relating to the financial statement schedule, which appears in this Form 10-K/A-1. PricewaterhouseCoopers LLP Century City, California November 7, 2002 46 EXHIBIT 99.1 CERTIFICATION PURSUANT TO 18 U.S.C. ss. 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Point.360 ( the "Company") on Form 10-K/A-1 for the period ended December 31, 2001, as filed with the Securities and Exchange Commission (the "Report"), I, Haig S. Bagerdjian, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13 (a) or 15 (d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Haig S. Bagerdjian - -------------------------- Haig S. Bagerdjian Chief Executive Officer November 7, 2002 47 EXHIBIT 99.2 CERTIFICATION PURSUANT TO 18 U.S.C. ss. 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Point.360 ( the "Company") on Form 10-K/A-1 for the period ended December 31, 2001, as filed with the Securities and Exchange Commission (the "Report"), I, Alan R. Steel, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13 (a) or 15 (d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Alan R. Steel - ------------------------- Alan R. Steel Chief Financial Officer November 7, 2002 48