APPLIED GRAPHICS TECHNOLOGIES INC - 10-Q Quarterly Report

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2003

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER 1-16431

APPLIED GRAPHICS TECHNOLOGIES, INC.
(Exact name of Registrant as specified in its charter)

DELAWARE 13-3864004
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

450 WEST 33RD STREET
NEW YORK, NY
(Address of principal executive offices)

10001
(Zip Code)

212-716-6600
(Registrant's telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last
report)
N/A

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 whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [ ] No [X]

The number of shares of the registrant's common stock outstanding as of
April 30, 2003, was 9,147,565.

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PART I -- FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS.

APPLIED GRAPHICS TECHNOLOGIES, INC.

CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(IN THOUSANDS OF DOLLARS, EXCEPT SHARE AND PER-SHARE AMOUNTS)

See Notes to Interim Consolidated Financial Statements
1

APPLIED GRAPHICS TECHNOLOGIES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER-SHARE AMOUNTS)

See Notes to Interim Consolidated Financial Statements
2

APPLIED GRAPHICS TECHNOLOGIES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS OF DOLLARS)

See Notes to Interim Consolidated Financial Statements
3

APPLIED GRAPHICS TECHNOLOGIES, INC.

CONSOLIDATED STATEMENT OF STOCKHOLDERS' DEFICIT
(UNAUDITED)
(IN THOUSANDS OF DOLLARS)

See Notes to Interim Consolidated Financial Statements
4

APPLIED GRAPHICS TECHNOLOGIES, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS OF DOLLARS)

1. BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements of
Applied Graphics Technologies, Inc., and its subsidiaries (the "Company"), which
have been prepared in accordance with the instructions to Form 10-Q and,
therefore, do not include all information and footnotes necessary for a fair
presentation of financial position, results of operations, and cash flows in
conformity with generally accepted accounting principles, should be read in
conjunction with the notes to consolidated financial statements contained in the
Company's Annual Report on Form 10-K for the year ended December 31, 2002. In
the opinion of the management of the Company, all adjustments (consisting
primarily of normal recurring accruals) necessary for a fair presentation have
been included in the financial statements. The operating results of any quarter
are not necessarily indicative of results for any future period.

The accompanying financial statements have been prepared on a going concern
basis, which contemplates continuity of operations, realization of assets, and
liquidation of liabilities in the ordinary course of business, and do not
reflect adjustments that might result if the Company were unable to continue as
a going concern. The Company's existing credit facility matures on April 30,
2004, although if the Company and its senior lenders do not consummate a
restructuring or recapitalization on or before July 15, 2003, the Company will
be in default under its credit facility. Such an event of default will result in
the automatic acceleration of amounts outstanding under the Company's credit
facility. The Company's ability to continue reporting on a going concern basis
is dependent on the ability of the Company to restructure its credit facility or
obtain other sources of financing, including a recapitalization, by July 2003,
or to obtain a waiver from its senior lenders for the event of default under the
credit facility.

The Company has been pursuing an overall recapitalization that would
include an infusion of outside equity and the settlement, at a significant
discount, of the Company's long-term obligations. One set of discussions with a
third party resulted in an offer being made that was accepted by most of the
Company's senior lenders, in both number of lenders and dollar amount of
commitment, but was rejected by a few of the senior lenders for not containing
sufficient consideration. Another third party is currently in advanced
discussions with the Company, the Company's senior lenders, certain holders of
the Company's subordinated notes, and certain holders of preference shares of a
subsidiary of the Company regarding an alternative offer. The alternative offer
would be conditioned on the acquisition of all of the existing senior debt,
subordinated notes, preference shares, and the Company's common stock.
Discussions to date in connection with this offer have led to agreements in
principle being reached with the Company's senior lenders and holders of more
than 50% of the Company's subordinated notes, and include an offer to acquire
the Company under which the holders of the Company's common stock would not
receive significant consideration. There can be no assurance that the Company
will reach an agreement with its senior lenders to restructure its credit
facility or that an overall recapitalization or acquisition transaction,
including mutually satisfactory documentation for any such transaction, will be
achieved. In the event that the Company is unable to restructure its credit
facility or obtain other sources of financing by July 2003, including an overall
recapitalization, the Company will seek to obtain a waiver from its senior
lenders for the event of default under the Company's credit facility. There can
be no assurance that the Company will be able to obtain such waiver, which would
require unanimous approval from the Company's senior lenders.

Certain prior-period amounts in the accompanying financial statements have
been reclassified to conform with the 2003 presentation.

2. EMPLOYEE STOCK OPTIONS

The Company accounts for stock-based employee compensation based on the
intrinsic value of stock options granted in accordance with the provisions of
Accounting Principles Board Opinion (APB) No. 25, "Accounting for Stock Issued
to Employees." Information relating to stock-based employee compensation,
5

APPLIED GRAPHICS TECHNOLOGIES, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(IN THOUSANDS OF DOLLARS)

including the pro forma effects had the Company accounted for stock-based
employee compensation based on the fair value of stock options granted in
accordance with Statement of Financial Accounting Standards (SFAS) No. 123,
"Accounting for Stock-Based Compensation," is as follows:

3. RESTRUCTURING

The Company initiated various restructuring plans in prior periods (the
"2002 Third Quarter Plan," the "2001 Fourth Quarter Plan," the "2001 Second
Quarter Plan," the "2000 Second Quarter Plan," and the "1999 Fourth Quarter
Plan," respectively) under which it continues to make certain payments. During
the three months ended March 31, 2003, the Company paid $1,630 related to its
various restructuring plans, and the Company had a liability of $8,955 for the
future payments associated with the various restructuring plans as of March 31,
2003. The remaining liability for future payments and the amounts charged
against the respective restructuring liabilities during the three months ended
March 31, 2003, were as follows:

The number of employees paid during the three months ended March 31, 2003,
that resulted in a reduction of the restructuring plans' liabilities for
employee termination costs were one for the 2002 Third Quarter Plan and two for
the 2001 Fourth Quarter Plan.

4. INVENTORY

The components of inventory were as follows:

6

APPLIED GRAPHICS TECHNOLOGIES, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(IN THOUSANDS OF DOLLARS)

5. DERIVATIVES

The fair value of the Company's interest rate swaps was a net loss of $866
and $1,773 at March 31, 2003 and 2002, respectively. The Company recognized as a
component of interest expense a non-cash benefit of $501 and $353 for the three
months ended March 31, 2003 and 2002, respectively, which consisted of the
following:

6. RELATED PARTY TRANSACTIONS

Sales to, purchases from, and administrative charges incurred with related
parties during the three months ended March 31, 2003 and 2002, were as follows:

Administrative charges include charges for rent incurred for leases with
affiliates and for certain legal, administrative, and computer services provided
by affiliates.

7. SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION

Payments of interest and income taxes for the three months ended March 31,
2003 and 2002, were as follows:

Noncash investing and financing activities for the three months ended March
31, 2003 and 2002, were as follows:

7

APPLIED GRAPHICS TECHNOLOGIES, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(IN THOUSANDS OF DOLLARS)

8. SEGMENT INFORMATION

Segment information relating to results of operations for the three months
ended March 31, 2003 and 2002, was as follows:

Segment information relating to the Company's assets as of March 31, 2003,
and December 31, 2002, was as follows:

9. RECENTLY ADOPTED ACCOUNTING STANDARDS

Financial Accounting Standards Board Interpretation No. (FIN) 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others," was issued in November 2002. FIN
45 elaborates on certain disclosure requirements and clarifies certain
recognition criteria related to guarantees. The disclosure requirements of FIN
45 were effective for periods ending after December 15, 2002, and the
recognition criteria of FIN 45 were effective for guarantees issued or modified
after December 31, 2002. The Company adopted the recognition criteria of FIN 45
on January 1, 2003. The adoption of the recognition criteria of FIN 45 did not
have a material impact on the Company's financial condition or results of
operations.

8

APPLIED GRAPHICS TECHNOLOGIES, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(IN THOUSANDS OF DOLLARS)

10. SUBSEQUENT EVENTS

As previously reported, Kmart Corporation ("Kmart") filed for protection
under Chapter 11 of the United States Bankruptcy Code on January 22, 2002, with
the United States Bankruptcy Court for the Northern District of Illinois (the
"Bankruptcy Court"). Meridian Retail, Inc. ("Meridian"), an indirect wholly
owned subsidiary of the Company, is a provider of services to Kmart. On January
25, 2002, Kmart obtained an order from the Bankruptcy Court authorizing it to
pay pre-Chapter 11 amounts to designated categories of vendors whom Kmart deemed
critical (the "Critical Vendor Order"). As authorized by the Critical Vendor
Order, Meridian was paid substantially all of its accounts receivable for
services rendered to Kmart prior to its bankruptcy filing. By a decision dated
April 8, 2003, the United States District Court for the Northern District of
Illinois (the "District Court") reversed the Critical Vendor Order as it applies
to all of Kmart's critical vendors. The Company understands that Kmart has filed
or intends to file a notice of appeal of that reversal to the United States
Court of Appeals for the Seventh Circuit. On May 5, 2003, Kmart filed a
complaint in the Bankruptcy Court against Meridian claiming that Kmart did not
intend to treat Meridian as a critical vendor and that Meridian was erroneously
paid approximately $10,800 as a critical vendor in the postpetition period.
Kmart's complaint also refers to the District Court's reversal of the Critical
Vendor Order. In addition, Kmart's complaint alleges that virtually all payments
received by Meridian during the ninety days preceding Kmart's bankruptcy filing
totaling approximately $13,200 are recoverable as preferential payments under
the applicable provision of the Bankruptcy Code. Accordingly, Kmart is seeking
to recover amounts totaling approximately $24,000. The Company believes it has
meritorious defenses to these claims and intends to vigorously defend its
position, although there can be no assurances as to the final outcome of this
action.

As previously disclosed, the Company received notification from The
American Stock Exchange (the "Exchange") in February 2003 that the Company was
not in compliance with certain listing standards of the Exchange relating to
stockholders' equity and net losses. In March 2003, the Company submitted a plan
to the Exchange setting forth the steps the Company intends to take in order to
regain compliance with the listing standards. In May 2003, the Exchange notified
the Company that it had accepted the Company's proposed plan and granted the
Company an extension to September 30, 2004, to regain compliance with the
Exchange's continued listing standards. During such period, the Company's common
stock will continue to trade on the Exchange, but the Company will be subject to
periodic review by the Exchange staff and will be required to make progress
consistent with its plan.

9

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.

Certain statements made in this Quarterly Report on Form 10-Q are
"forward-looking" statements (within the meaning of the Private Securities
Litigation Reform Act of 1995, as amended). Such statements involve known and
unknown risks, uncertainties, and other factors that may cause actual results,
performance, or achievements of the Company to be materially different from any
future results, performance, or achievements expressed or implied by such
forward-looking statements. Although the Company believes that the expectations
reflected in such forward-looking statements are based upon reasonable
assumptions, the Company's actual results could differ materially from those set
forth in the forward-looking statements. Certain factors that might cause such a
difference include the following: the ability of the Company to restructure its
credit facility or achieve a recapitalization by July 15, 2003; the ability of
the Company to retain customers; the ability of the Company to maintain
compliance with the covenant requirements under its credit facility; the ability
of the Company to attract and retain management; the impact of technological
advancements on the ability of customers and competitors to provide services
comparable to those provided by the Company; the continued softness in the
advertising market; the impact of geopolitical events on the economy; the
success of the Company's restructuring plans and integration efforts; and the
adequacy of the Company's credit facility and cash flows to fund cash needs.

The following discussion and analysis (in thousands of dollars) should be
read in conjunction with the Company's Interim Consolidated Financial Statements
and notes thereto.

CRITICAL ACCOUNTING POLICIES

Management must make certain estimates and assumptions in preparing the
financial statements of the Company. Certain of these estimates and assumptions
relate to matters that are inherently uncertain as they pertain to future
events. Management believes that the estimates and assumptions used in preparing
the financial statements of the Company were the most appropriate at that time,
although actual results could differ significantly from those estimates under
different conditions.

The accompanying financial statements have been prepared on a going concern
basis, which contemplates continuity of operations, realization of assets, and
liquidation of liabilities in the ordinary course of business (see Note 1 to the
Interim Consolidated Financial Statements).

In assessing the carrying value of goodwill in accordance with Statement of
Financial Accounting Standards (SFAS) No. 142, "Goodwill and Other Intangible
Assets," the Company compared such carrying value of each of its reporting units
to their fair values. The Company estimated the fair value of its reporting
units by applying a multiple to each reporting unit's earnings before interest,
taxes, depreciation, and amortization ("EBITDA"). In estimating the fair value
of its reporting units, the Company had to make various assumptions, including,
but not limited to, projections of each reporting unit's future EBITDA, the fair
value of each reporting unit's net assets, and the EBITDA multiple a willing
buyer would apply to each reporting unit's EBITDA to determine its fair value.
Based on the use of these assumptions in estimating the fair value of each
reporting unit, the Company incurred an impairment charge, net of taxes,
relating to its goodwill of $327,875 upon the adoption of SFAS No. 142 on
January 1, 2002. Such impairment charge was reported as a cumulative effect of a
change in accounting principle. A change in the Company's assumptions,
including, but not limited to, higher EBITDA for any reporting unit, lower fair
market values of net assets, or a buyer willing to pay more than the assumed
EBITDA multiple could result in the goodwill of certain reporting units to have
a fair value greater than that estimated. Such an outcome would not have an
impact on the Company's results of operations or financial position because
under SFAS No. 142 the carrying value of goodwill cannot be increased once it
has been impaired.

In assessing the recoverability of its deferred tax assets, the Company
compared the carrying value of its deferred tax assets to the tax-effected
projections of its taxable income over future periods in which such assets could
be realized. In estimating its future taxable income, the Company had to make
various assumptions about its future operating performance, the stability of the
markets and customers the Company serves, and the future financial position of
the Company. Based on the Company's estimates, a valuation allowance of $17,539
was established against the carrying value of the Company's deferred tax assets
at March 31, 2003,
10

and December 31, 2002, resulting in net deferred tax assets of $15,927 at March
31, 2003 and $15,857 at December 31, 2002. A change in the Company's
assumptions, including better or worse operating performance than projected, the
loss of a significant customer, or a deterioration in the markets served by the
Company would result in a change in the amount of deferred tax assets that will
be recovered by the Company, and therefore will result in an adjustment to the
valuation allowance established at March 31, 2003. Such adjustment, either
positive or negative, would be reflected as a component of the Company's
provision for income taxes.

In assessing the carrying value of its accounts receivable, the Company
estimated the recoverability by making assumptions regarding the financial
stability of its customers and the validity of any potential claims raised by
its customers. Based on the Company's estimates, an allowance for doubtful
accounts of $7,655 was established at March 31, 2003, compared to an allowance
of $7,832 at December 31, 2002. A change in the Company's assumptions, including
the financial stability of the Company's customers, would result in the Company
recovering an amount of its accounts receivable that differs from its current
carrying value. Such difference, either positive or negative, would be reflected
as a component of the Company's selling, general, and administrative expense.

In assessing the carrying value of the liabilities associated with its
various restructuring efforts, the Company had to estimate the timing and amount
of future payments to be made under certain contractual obligations, primarily
those relating to building leases. In making such estimates, the Company has to
make various assumptions, including but not limited to, the real estate rental
market in future periods, the financial stability of the Company's existing
subtenants, the willingness of existing subtenants to renew their subleases, and
the timing and pricing of any future subleases. Based on the Company's
estimates, the carrying value of the Company's restructuring liabilities was
$8,955 at March 31, 2003, as compared to $10,585 at December 31, 2002. A change
in the Company's assumptions, including, but not limited to, the timing and
pricing of any future sublease arrangements, the willingness of existing
subtenants to renew their subleases, and the ability of existing subtenants to
continue to meet their current obligations would result in the Company paying
amounts that differ from the current carrying value of its restructuring
liabilities. Such difference, either positive or negative, would be reflected as
a restructuring charge or restructuring income.

RESULTS OF OPERATIONS

THREE MONTHS ENDED MARCH 31, 2003, COMPARED WITH 2002

Revenues in the first three months of 2003 were $775, or less than 1%,
lower than in the comparable period in 2002. Revenues in the 2003 period
decreased by $1,848 from content management services and $97 from digital
services, and were partially offset by increased revenues of $1,170 from
broadcast media distribution services. Decreased revenues from content
management services primarily resulted from the continued weakness in the
advertising market in the first three months of 2003 that adversely impacted the
Company's operations servicing advertising agencies and magazine publishers.
Increased revenues from broadcast media distribution services resulted from
additional volume of premium services provided for which the Company receives
higher rates.

Gross profit increased by $1,925 in the first three months of 2003. The
gross profit percentage in the first three months of 2003 was 33.5% as compared
to 31.3% in the 2002 period. The increase in the gross profit percentage
primarily resulted from improved operating efficiencies and cost cutting related
to the Company's operational restructuring and integration efforts.

Selling, general, and administrative expenses in the first three months of
2003 were $441 higher than in the 2002 period. Selling, general, and
administrative expenses as a percent of revenue increased to 31.7% in the 2003
period from 31.0% in the 2002 period due primarily to additional costs incurred
to support the higher volumes of revenue achieved in the latter part of 2002.

Interest expense in the first three months of 2003 was $188 higher than in
the 2002 period due primarily to $580 of interest allocated to discontinued
operations in 2002 with no comparable allocation in 2003, partially offset by
lower interest incurred during the 2003 period due to reduced borrowings
outstanding under

11

the Company's credit facility and a larger non-cash benefit recognized in the
2003 period related to the accounting for the Company's interest rate swap
arrangements.

Revenues from business transacted with affiliates for the three months
ended March 31, 2003 and 2002, totaled $710 and $1,611, respectively,
representing 0.7% and 1.6%, respectively, of the Company's revenues.

FINANCIAL CONDITION

In April 2003, the Company entered into an amended and restated credit
agreement (the "Amended Credit Agreement") that extended the maturity of its
credit facility through April 2004. In connection with the Amended Credit
Agreement, the Company incurred fees totaling $2,000 to be paid quarterly and
issued immediately exercisable warrants with an exercise price of $0.01 per
share to its lenders to purchase 453,377 shares of the Company's common stock.
As part of the Amended Credit Agreement, the Company agreed that the failure of
the Company and its senior lenders to consummate a restructuring or
recapitalization on or before July 15, 2003, will constitute an event of
default. Such an event of default will result in the automatic acceleration of
amounts outstanding under the Amended Credit Agreement. Also as part of the
Amended Credit Agreement, the Company agreed that in addition to scheduled
principal payments, it would permanently repay $20,000 of borrowings by December
31, 2003. Failure to repay such borrowings would not constitute an event of
default, but would result in the Company paying additional fees of $2,000 to its
lenders upon maturity of the credit facility. Additionally, under the Amended
Credit Agreement, maximum availability under the Company's revolving credit line
was reduced from $66,000 to $63,500, and will be further reduced to $62,500 on
July 1, 2003, $60,500 on October 1, 2003, and $60,000 on January 1, 2004. Also,
the ability to borrow funds at interest rates based on LIBOR was restricted to
only those periods in which the Company's trailing twelve-month EBITDA (as
defined in the Amended Credit Agreement) exceeds $50,000. The Company does not
anticipate exceeding this EBITDA threshold, and therefore the Amended Credit
Agreement effectively requires the Company to borrow funds at interest rates
based on the prime rate for the foreseeable future. The Company does not believe
that the reduced borrowing capacity will have a material adverse effect on its
financial condition or liquidity.

Upon issuance of the warrants in April 2003 in connection with the Amended
Credit Agreement, the Company's senior lenders held warrants issued directly by
the Company that are convertible into approximately 12.9% of the Company's
outstanding common stock. In addition, in July 2001, Applied Printing
Technologies, L.P. ("Applied Printing"), an affiliate of the Company, granted a
call option to the Company's senior lenders to purchase 680,067 shares of the
Company's common stock held by Applied Printing at a purchase price of $0.01 per
share. This call option became exercisable on January 15, 2003. The combination
of the call option granted by Applied Printing and the warrants issued directly
by the Company provide the Company's senior lenders with instruments that are
convertible into approximately 19.4% of the Company's common stock.

In order to avoid an event of default under the Amended Credit Agreement,
the Company continues to negotiate with its senior lenders to consummate a
restructuring or recapitalization by July 2003. Any such restructuring or
recapitalization would most likely require an amendment, or a repurchase at a
significant discount, of the Company's subordinated notes. There can be no
assurances that the Company will reach an agreement with its senior lenders
before July 2003. The Company is also seeking other sources of financing,
including an overall recapitalization that would include an infusion of outside
equity and the settlement, at a significant discount, of amounts due to the
senior lenders for amounts borrowed under the credit facility, amounts due to
holders of the Company's subordinated notes, and amounts due to holders of
preference shares of a subsidiary of the Company. One such set of discussions
with a third party resulted in an offer being made that was accepted by most of
the Company's senior lenders, in both number of lenders and dollar amount of
commitment, but was rejected by a few of the senior lenders for not containing
sufficient consideration. The Company, however, continues to seek an overall
recapitalization, and another third party is currently in advanced discussions
with the Company, the Company's senior lenders, certain holders of the Company's
subordinated notes, and certain holders of preference shares of a subsidiary of
the Company regarding an alternative offer. The alternative offer would be
conditioned on the acquisition of all of the existing senior debt, subordinated
notes, preference shares, and the Company's common stock. Discussions to date in
connection
12

with this offer have led to agreements in principle being reached with the
Company's senior lenders and holders of more than 50% of the Company's
subordinated notes, and included an offer to acquire the Company under which the
holders of the Company's common stock would not receive significant
consideration. There can be no assurances as to the terms or the success of any
recapitalization or acquisition transaction or that mutually satisfactory
documentation for any such transaction can be accomplished.

In the event that the Company is unable to restructure its credit facility
or obtain other sources of financing by July 2003, including an overall
recapitalization, the Company will seek to obtain a waiver from its senior
lenders for the event of default under the Amended Credit Agreement. There can
be no assurances that the Company will be able to obtain such waiver, which
would require unanimous approval from the Company's senior lenders.

In connection with the Company's discussions with third parties regarding
an infusion of outside equity, the Company did not pay the semi-annual interest
payment on the subordinated notes due on January 31, 2003, until February 28,
2003. Such failure to pay the interest on its initial due date did not
constitute an event of default since payment was made by the expiration of a
30-day grace period.

Under the terms of its credit facility, the Company must comply with
certain quarterly covenants related to leverage ratios, interest coverage
ratios, fixed charge coverage ratios, and capital spending. In addition, the
Company must satisfy a monthly minimum cumulative EBITDA (as defined in the
credit facility) covenant. If the Company does not satisfy such minimum
cumulative EBITDA covenant for any individual non-quarter month end, the
Company's short-term borrowing availability would be limited until such time as
the Company is in compliance with the covenant, but such failure would not
constitute an event of default. Failure to satisfy such cumulative EBITDA
covenant for any quarter month end or for two consecutive non-quarter month ends
would constitute an event of default. The Company was in compliance with all
covenants at March 31, 2003. Based on current projections, the Company believes
that it will be able to remain in compliance with the covenant requirements
throughout 2003, although there can be no assurance that such compliance will be
maintained.

In accordance with the requirements of its credit facility, the Company has
outstanding two interest rate swap agreements with an aggregate notional amount
of $50,000 that expire in August 2003. Under the swap agreements, the Company
paid a fixed rate of 5.798% per annum on a quarterly basis and was paid a
floating rate based on the three-month LIBOR rate in effect at the beginning of
each quarterly payment period.

As previously reported, Kmart Corporation ("Kmart") filed for protection
under Chapter 11 of the United States Bankruptcy Code on January 22, 2002, with
the United States Bankruptcy Court for the Northern District of Illinois (the
"Bankruptcy Court"). Meridian Retail, Inc. ("Meridian"), an indirect wholly
owned subsidiary of the Company, is a provider of services to Kmart. On January
25, 2002, Kmart obtained an order from the Bankruptcy Court authorizing it to
pay pre-Chapter 11 amounts to designated categories of vendors whom Kmart deemed
critical (the "Critical Vendor Order"). As authorized by the Critical Vendor
Order, Meridian was paid substantially all of its accounts receivable for
services rendered to Kmart prior to its bankruptcy filing. By a decision dated
April 8, 2003, the United States District Court for the Northern District of
Illinois (the "District Court") reversed the Critical Vendor Order as it applies
to all of Kmart's critical vendors. The Company understands that Kmart has filed
or intends to file a notice of appeal of that reversal to the United States
Court of Appeals for the Seventh Circuit. On May 5, 2003, Kmart filed a
complaint in the Bankruptcy Court against Meridian claiming that Kmart did not
intend to treat Meridian as a critical vendor and that Meridian was erroneously
paid approximately $10,800 as a critical vendor in the postpetition period.
Kmart's complaint also refers to the District Court's reversal of the Critical
Vendor Order. In addition, Kmart's complaint alleges that virtually all payments
received by Meridian during the ninety days preceding Kmart's bankruptcy filing
totaling approximately $13,200 are recoverable as preferential payments under
the applicable provision of the Bankruptcy Code. Accordingly, Kmart is seeking
to recover amounts totaling approximately $24,000. The Company believes it has
meritorious defenses to these claims and intends to vigorously defend its
position, although there can be no assurances as to the final outcome of this
action.

13

During the first three months of 2003, the Company repaid $6,562 of term
loans, invested $2,346 in facility construction and new equipment, and repaid
$215 of notes and capital lease obligations. Such amounts were primarily funded
by borrowings under the Company's revolving credit facility.

Cash flows from operating activities of continuing operations during the
first three months of 2003 decreased by $9,805 as compared to the comparable
period in 2002 due primarily to the timing and amounts of payroll-related
payments and the timing of customer collections, including additional amounts
collected in the 2002 period related to pre-petition amounts due from Kmart
Corporation.

The Company expects to spend approximately $12,000 over the course of the
next twelve months for capital improvements, essentially all of which is for
modernization. The Company intends to finance these expenditures under leasing
arrangements, with working capital, or with borrowings under its credit
facility.

The Company believes that the cash flow from operations, including
potential improvements in operations as a result of its integration and
restructuring efforts, and available borrowing capacity, subject to the
Company's ability to remain in compliance with the financial covenants under its
credit facility and to restructure its credit facility or achieve a
recapitalization by July 2003, will provide sufficient cash flows to fund its
cash needs throughout 2003.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

The Company's primary exposure to market risk is interest rate risk. The
Company had $176,261 outstanding under its credit facility at March 31, 2003.
Interest rates on funds borrowed under the Company's credit facility vary based
on changes to the prime rate or LIBOR. The Company partially manages its
interest rate risk through two interest rate swap agreements under which the
Company pays a fixed rate and is paid a floating rate based on the three month
LIBOR rate. The notional amounts of the two interest rate swaps totaled $50,000
at March 31, 2003. A change in interest rates of 1.0% would result in a change
in income before taxes of $1,263 based on the outstanding balance under the
Company's credit facility and the notional amounts of the interest rate swap
agreements at March 31, 2003.

ITEM 4. CONTROLS AND PROCEDURES.

(a) The Company maintains disclosure controls and procedures that are
designed to ensure that information required to be disclosed in the Company's
filings under the Securities Exchange Act of 1934 is recorded, processed,
summarized, and reported within the time periods specified in the rules and
forms of the Securities and Exchange Commission. Such information is accumulated
and communicated to the Company's management, including its principal executive
officer and principal financial officer, as appropriate, to allow timely
decisions regarding required disclosure. The Company's management, including its
principal executive officer and principal financial officer, recognizes that any
set of controls and procedures, no matter how well designed and operated, can
provide only reasonable assurance of achieving the desired control objectives.

Within 90 days prior to the filing date of this quarterly report on Form
10-Q, the Company has carried out an evaluation, under the supervision and with
the participation of the Company's management, including the Company's principal
executive officer and the Company's principal financial officer, of the
effectiveness of the design and operation of the Company's disclosure controls
and procedures. Based on such evaluation, the Company's principal executive
officer and principal financial officer concluded that the Company's disclosure
controls and procedures are effective.

(b) There have been no significant changes in the Company's internal
controls or in other factors that could significantly affect the internal
controls subsequent to the date of their evaluation in connection with the
preparation of this quarterly report on Form 10-Q.

14

PART II. -- OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS.

As previously reported, Kmart Corporation ("Kmart") filed for protection
under Chapter 11 of the United States Bankruptcy Code on January 22, 2002, with
the United States Bankruptcy Court for the Northern District of Illinois (the
"Bankruptcy Court"). Meridian Retail, Inc. ("Meridian"), an indirect wholly
owned subsidiary of the Company, is a provider of services to Kmart. On January
25, 2002, Kmart obtained an order from the Bankruptcy Court authorizing it to
pay pre-Chapter 11 amounts to designated categories of vendors whom Kmart deemed
critical (the "Critical Vendor Order"). As authorized by the Critical Vendor
Order, Meridian was paid substantially all of its accounts receivable for
services rendered to Kmart prior to its bankruptcy filing. By a decision dated
April 8, 2003, the United States District Court for the Northern District of
Illinois (the "District Court") reversed the Critical Vendor Order as it applies
to all of Kmart's critical vendors. The Company understands that Kmart has filed
or intends to file a notice of appeal of that reversal to the United States
Court of Appeals for the Seventh Circuit. On May 5, 2003, Kmart filed a
complaint in the Bankruptcy Court against Meridian claiming that Kmart did not
intend to treat Meridian as a critical vendor and that Meridian was erroneously
paid approximately $10,800,000 as a critical vendor in the postpetition period.
Kmart's complaint also refers to the District Court's reversal of the Critical
Vendor Order. In addition, Kmart's complaint alleges that virtually all payments
received by Meridian during the ninety days preceding Kmart's bankruptcy filing
totaling approximately $13,200,000 are recoverable as preferential payments
under the applicable provision of the Bankruptcy Code. Accordingly, Kmart is
seeking to recover amounts totaling approximately $24,000,000. The Company
believes it has meritorious defenses to these claims and intends to vigorously
defend its position, although there can be no assurances as to the final outcome
of this action.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.

In April 2003, pursuant to the terms of its amended and restated credit
agreement, the Company issued warrants with an exercise price of $0.01 to its
lenders to purchase 453,377 shares of the Company's common stock. Such warrants
became exercisable immediately upon their issuance. The issuance of such
securities by the Company were effected without registration based on reliance
upon the exemption from registration provided by Section 4(2) of the Securities
Act of 1933 for private placements.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES.

As previously disclosed in its filings with the Securities and Exchange
Commission, a subsidiary of the Company, Wace Group Limited ("Wace"), is in
arrears on the dividend payments related to its 8% Cumulative Convertible
Redeemable Preference Shares. Wace has been prohibited from making dividend
payments due to its lack of distributable reserves, and has not made a dividend
payment since July 1999. The arrearage, which is included as part of "Minority
interest" in the Consolidated Balance Sheets, totals $9,488,000 at May 15, 2003.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.

(a) Exhibits:

2.1 Agreement and Plan of Merger, dated as of February 13, 1998,
by and among Devon Group, Inc., Applied Graphics
Technologies, Inc., and AGT Acquisition Corp. (Incorporated
by reference to Exhibit No. 2.2 forming part of the
Registrant's Annual Report on Form 10-K (File No. 0-28208)
filed with the Securities and Exchange Commission under the
Securities Exchange Act of 1934, as amended, for the fiscal
year ended December 31, 1997).

15

2.2 Stock Purchase Agreement dated as of April 11, 2002, by and
among DPG Holdings, Inc., Devon Group, Inc., and Applied
Graphics Technologies, Inc. (Incorporated by reference to
Exhibit No. 2.2 forming part of the Registrant's Quarterly
Report on Form 10-Q (File No. 1-16431) filed with the
Securities and Exchange Commission under the Securities
Exchange Act of 1934, as amended, for the quarterly period
ended March 31, 2002).
3.1(a) First Restated Certificate of Incorporation (Incorporated by
reference to Exhibit No. 3.1 forming part of the
Registrant's Registration Statement on Form S-1 (File No.
333-00478) filed with the Securities and Exchange Commission
under the Securities Act of 1933, as amended).
3.1(b) Certificate of Amendment of First Restated Certificate of
Incorporation (Incorporated by reference to Exhibit No.
3.1(b) forming part of the Registrant's Quarterly Report on
Form 10-Q (File No. 0-28208) filed with the Securities and
Exchange Commission under the Securities Exchange Act of
1934, as amended, for the quarterly period ended June 30,
1998).
3.1(c) Second Certificate of Amendment of First Restated
Certificate of Incorporation (Incorporated by reference to
Exhibit No. 3.1(c) forming part of the Registrant's Annual
Report on Form 10-K (File No. 0-28208) filed with the
Securities and Exchange Commission under the Securities
Exchange Act of 1934, as amended, for the fiscal year ended
December 31, 2000).
3.2(a) Amended and Restated By-Laws of Applied Graphics
Technologies, Inc. (Incorporated by reference to Exhibit No.
3.2 forming part of Amendment No. 3 to the Registrant's
Registration Statement on Form S-1 (File No. 333-00478)
filed with the Securities and Exchange Commission under the
Securities Act of 1933, as amended).
3.2(b) Amendment to Amended and Restated By-Laws of Applied
Graphics Technologies, Inc. (Incorporated by reference to
Exhibit No. 3.3 forming part of the Registrant's
Registration Statement on Form S-4 (File No. 333-51135)
filed with the Securities and Exchange Commission under the
Securities Act of 1933, as amended).
3.2(c) Amendment to Amended and Restated By-Laws of Applied
Graphics Technologies, Inc. (Incorporated by reference to
Exhibit No. 3.2(c) forming part of Registrant's Quarterly
Report on Form 10-Q (File No. 0-28208) filed with the
Securities and Exchange Commission under the Securities
Exchange Act of 1934, as amended, for the quarterly period
ended September 30, 2000).
4 Specimen Stock Certificate (Incorporated by reference to
Exhibit 7 forming part of Registrant's Registration
Statement on Form 8-A (File No. 1-16431) filed with the
Securities and Exchange Commission under the Securities
Exchange Act of 1934, as amended, on April 5, 2001).
10.2 Applied Graphics Technologies, Inc. 1996 Stock Option Plan
(Incorporated by reference to Exhibit No. 10.2 forming part
of Amendment No. 3 to the Registrant's Registration
Statement on Form S-1 (File No. 333-00478) filed with the
Securities and Exchange Commission under the Securities Act
of 1933, as amended).
10.3 Applied Graphics Technologies, Inc. Non-Employee Directors
Nonqualified Stock Option Plan (Incorporated by reference to
Exhibit No. 10.3 forming part of Amendment No. 3 to the
Registrant's Registration Statement on Form S-1 (File No.
333-00478) filed with the Securities and Exchange Commission
under the Securities Act of 1933, as amended).
10.6(a) Employment Agreement dated as of January 16, 2003, by and
between the Registrant and Joseph D. Vecchiolla.
10.6(b) Employment Agreement dated as of January 31, 2003, by and
between the Registrant and Fred Drasner.
10.6(c) Employment Agreement dated as of January 31, 2003, by and
between the Registrant and Martin D. Krall.
10.6(d) Employment Agreement dated as of January 31, 2003, by and
between the Registrant and Kenneth G. Torosian.

16

10.7 Form of Registration Rights Agreement (Incorporated by
reference to Exhibit No. 10.7 forming part of Amendment No.
3 to the Registrant's Registration Statement on Form S-1
(File No. 333-00478) filed with the Securities and Exchange
Commission under the Securities Act of 1933, as amended).
10.8 Applied Graphics Technologies, Inc., 1998 Incentive
Compensation Plan, as Amended and Restated (Incorporated by
reference to Exhibit No. 10.8 forming part of Registrant's
Quarterly Report on Form 10-Q (File No. 0-28208) filed with
the Securities and Exchange Commission under the Securities
Exchange Act of 1934, as amended, for the quarterly period
ended June 30, 1999).
10.8(a) Amendment No. 1, dated as of May 8, 2000, to the Applied
Graphics Technologies, Inc., Amended and Restated 1998
Incentive Compensation Plan (Incorporated by reference to
Exhibit No. 10.8(a) forming part of the Registrant's
Quarterly Report on Form 10-Q (File No. 0-28208) filed with
the Securities and Exchange Commission under the Securities
Exchange Act of 1934, as amended, for the quarterly period
ended June 30, 2000).
10.9 Second Amended and Restated Credit Agreement, dated as of
April 15, 2003, among Applied Graphics Technologies, Inc.,
Other Institutional Lenders, and Fleet National Bank as
Administrative Agent (Incorporated by reference to Exhibit
No. 10.9 forming part of Registrant's Annual Report on Form
10-K (File No. 1-16431) filed with the Securities and
Exchange Commission under the Securities Exchange Act of
1934, as amended, for the fiscal year ended December 31,
2002).
10.10 Consulting Agreement, dated as of March 1, 2001, by and
between the Company and Knollwood Associates, LLC.
(Incorporated by reference to Exhibit No. 10.10 forming part
of the Registrant's Quarterly Report on Form 10-Q (File No.
1-16431) filed with the Securities and Exchange Commission
under the Securities Exchange Act of 1934, as amended, for
the quarterly period ended March 31, 2001).
99.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
99.2 Certification pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

- ---------------

(b) The Registrant filed the following reports on Form 8-K during the quarter
ended March 31, 2003:

Current Report on Form 8-K filed on March 3, 2003, announcing the failure
of the Company to make the semi-annual interest payment on the Company's
outstanding 10% subordinated notes on its due date and the payment of the
semi-annual interest within the allowable grace period.

17

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

APPLIED GRAPHICS TECHNOLOGIES, INC.
(Registrant)

By: /s/ FRED DRASNER
------------------------------------
Fred Drasner
Chairman of the Board and
Chief Executive Officer
(Principal Executive Officer)

Date: May 15, 2003

/s/ KENNETH G. TOROSIAN
--------------------------------------
Kenneth G. Torosian
Senior Vice President,
Chief Financial Officer, and Treasurer
(Principal Financial Officer)

Date: May 15, 2003

18

CERTIFICATION

I, Fred Drasner, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Applied Graphics
Technologies, Inc.;

2. Based on my knowledge, this quarterly 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
quarterly report;

3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly 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 quarterly report;

4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

(a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;

(b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the filing
date of this quarterly report (the "Evaluation Date"); and

(c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;

5. The registrant's other certifying officer and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):

(a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have identified
for the registrant's auditors any material weaknesses in internal controls;
and

(b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and

6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.

/s/ FRED DRASNER
--------------------------------------
Fred Drasner
Chairman of the Board and Chief
Executive Officer

May 15, 2003

19

CERTIFICATION

I, Kenneth G. Torosian, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Applied Graphics
Technologies, Inc.;

2. Based on my knowledge, this quarterly 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
quarterly report;

3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly 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 quarterly report;

4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

(a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;

(b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the filing
date of this quarterly report (the "Evaluation Date"); and

(c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;

5. The registrant's other certifying officer and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):

(a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have identified
for the registrant's auditors any material weaknesses in internal controls;
and

(b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and

6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.

/s/ KENNETH G. TOROSIAN
--------------------------------------
Kenneth G. Torosian
Senior Vice President, Chief Financial
Officer, and Treasurer

May 15, 2003

20