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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _____________
TO _____________.
COMMISSION FILE NUMBER: 0-27644
DIGITAL GENERATION SYSTEMS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
CALIFORNIA 94-3140772
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)
875 BATTERY STREET
SAN FRANCISCO, CALIFORNIA 94111
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE)
(415) 276-6600
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
NOT APPLICABLE
(FORMER NAME, FORMER ADDRESS, FORMER FISCAL YEAR, IF CHANGED SINCE LAST REPORT)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES X NO __
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 the 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. [X]
The aggregate market value of the voting Common Stock held by
non-affiliates of the registrant, based upon the closing sale price of the
Common Stock on March 27, 1998 as reported on the Nasdaq National Market, was
approximately $33,688,648. Shares of Common Stock held by each officer and
director of the registrant and by each person who may be deemed to be an
affiliate have been excluded. This determination of affiliate status is not
necessarily a conclusive determination for other purposes.
As of March 27, 1998, the registrant had 12,210,625 shares of Common
Stock, without par value, outstanding.
DOCUMENTS INCORPORATED BY REFERENCE:
The registrant has incorporated by reference into Part III of this Form 10-K
portions of its Proxy Statement for the Annual Meeting of Shareholders to be
held on April 29, 1998 (the "Proxy Statement"). Except with respect to
information specifically incorporated by reference into this Form 10-K, the
Proxy Statement is not deemed to be filed as a part hereof.
===============================================================================
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DIGITAL GENERATION SYSTEMS, INC.
This Form 10-K contains forward-looking statements within the meaning of Section
27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act
of 1934. Actual results could differ materially from those indicated in the
forward-looking statements as a result of certain factors, including those set
forth under "Certain Business Considerations" in "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and elsewhere in, or
incorporated by reference into, this Form 10-K.
TABLE OF CONTENTS
PART I PAGE
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ITEM 1. BUSINESS ................................................. 1
Industry Background ...................................... 1
The Company .............................................. 2
Products and Services .................................... 3
The DG Systems Network ................................... 4
Markets and Customers .................................... 5
Sales, Marketing and Customer Service .................... 6
Competition .............................................. 7
Intellectual Property and Proprietary Rights ............. 8
ITEM 2. PROPERTIES 8
ITEM 3. LEGAL PROCEEDINGS 8
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 8
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT 9
PART II
ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS 11
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PAGE
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ITEM 6. SELECTED FINANCIAL DATA
Statement of Operations .................................. 12
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Overview ................................................. 13
Results of Operations .................................... 14
Liquidity and Capital Resources .......................... 20
Certain Business Considerations .......................... 21
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 28
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE 28
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT 29
ITEM 11. EXECUTIVE COMPENSATION 29
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT 29
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 29
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS
ON FORM 8-K. 30
SIGNATURES ................................................. 33
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PART I
ITEM 1. BUSINESS
Digital Generation Systems, Inc. ("DG Systems" or the "Company") operates a
nationwide, value added digital network which links hundreds of advertisers and
advertising agencies with more than 5,500 radio stations and 500 television
stations across the United States. The Company's fault-tolerant network
operations center delivers audio, video, image and data content which
facilitates transactions among advertising industry participants.
The Company is the leading provider of electronic distribution of audio
spot advertising to radio stations. In 1996 the Company entered the market for
the electronic distribution of video spots to television stations, cable systems
and networks. DG Systems generates its revenues principally from advertising
agencies, advertisers, tape duplication vendors and dealers, syndicated
programmers and music companies that principally service these markets. The
Company believes that its digital network enables rapid, cost-effective and
reliable transmission of audio and video broadcast content, and provides higher
levels of quality, control and flexibility than the other distribution methods
currently available. In July 1997, the Company purchased Starcom Mediatech, Inc.
("Mediatech"), a provider of broadcast video and audio duplication, syndicated
program distribution and corporate media duplication services with facilities in
Chicago, Los Angeles and New York, augmenting its November 1996 acquisition of
PDR Productions, Inc. ("PDR"), a New York City-based broadcast production
services company. As a result of these acquisitions the Company has become a
leading provider of video advertising distribution and is rapidly adding new
customers to its digital audio and video network. Moreover, the Company believes
it now offers the most complete range of post production services, including
editing, duplication, color control, close captioning, content review, quality
assurance, archiving and format conversions in this market. The Company
currently provides these services through its facilities in New York City,
Chicago, Louisville, Los Angeles and San Francisco.
INDUSTRY BACKGROUND
While many radio and television broadcasters now embrace digital technology
for much of their production processes and in-station media management, current
methods for the distribution of audio and video advertising content are based
primarily on the manual duplication and physical delivery of analog tapes.
According to industry sources, there are approximately 10,000 commercial radio
and 1,200 commercial television stations in the United States. These stations
generate revenue principally by selling air time to advertisers. Advertising is
most frequently produced under the direction of advertising agencies for large
national or regional advertisers or by station personnel for advertisers that
are local in nature. Advertising is characterized as "network" or "spot",
depending on how it is bought and distributed. Network advertising typically is
delivered to stations as part of a "network feed" (bundled with network
programming), while spot advertising is delivered to stations independently of
other programming content.
Spot advertising air time is typically purchased by advertising agencies or
media buying firms on behalf of advertisers. Advertisers and their agencies
select individual stations or groups of stations to support marketing
objectives, which usually are based on the stations' geographic and other
demographic characteristics. The actual commercials or "spots" are typically
produced at a production studio and recorded on tape. Variations of the spot
intended for specific demographic groups also are produced at this time. The
spots undergo a review of quality and content before being cleared for
transmission to broadcast stations, one submaster per market group. Tapes
containing the spot and its variations are then duplicated, packaged, labeled
and shipped to the radio and television stations and cable headends specified by
the advertiser or its agency.
The predominant method for distributing spot advertisements to radio and
television stations traditionally has been the physical delivery of analog audio
or video tapes. The Company estimates that more than 50% of radio spots and more
than 90% of video spots are delivered by air express services. The remainder are
produced within individual stations, delivered by local delivery services or
picked up from the originating studio by station employees. Many companies,
commonly known as "dub and ship houses", are in the business of duplicating
audio and video tapes and packing them for air express delivery. The Company
estimates that more than four million audio tapes and more than six million
video tapes were delivered via air express to radio and television stations in
1997 through the efforts of approximately 400 production studios and dub and
ship houses.
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THE COMPANY
DG Systems is a leading provider of electronic and physical distribution
and ancillary post-production services for audio and video content to
advertising agencies, production studios and broadcast stations throughout the
United States. The Company, a California corporation, was incorporated in 1991.
The Company has developed a digital network currently serving over 5,500 radio
stations and 500 television stations that is controlled through the Company's
network operating center. This network enables the rapid, cost-effective and
reliable electronic transmission of audio and video spots and other content and
provides a high level of quality, accountability and flexibility to both
advertisers and broadcasters. With DG Systems' network, transmissions are
automatically routed to stations through a computerized on-line transaction and
delivery system and arrive at stations in as little as one hour after an order
is received. Typically associated traffic (text) instructions are simultaneously
transmitted by facsimile to minimize station handling and scheduling errors.
Shortly after a spot is delivered to a station, the Company sends the customer a
confirmation specifying the time of delivery. Additionally, the Company's
digital network delivers close to "master" quality audio or video to broadcast
stations, which is superior to that currently delivered on analog tape.
DG Systems generates its revenues from advertising agencies as well as from
production studios and dub and ship houses that consolidate and forward the
deliveries to broadcast stations. The Company has historically operated and
currently operates without substantial backlog. The Company receives
distribution 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 delivery if a station is on the Company's network,
or scheduled for physical delivery via the Company's various dub and ship
facilities if the station is not on the network.
Audio content is delivered electronically to the Company's network
operating center from Record Send Terminals ("RSTs") that are owned by the
Company and deployed primarily in production studios. When an audio spot is
received, Company personnel currently review the audio and then initiate the
electronic transaction to transmit the audio to the designated radio stations.
Audio transmissions currently are delivered over standard telephone or ISDN
lines.
Video content is delivered electronically to the Company's network
operating center primarily from DG Video Record Transmission Systems ("VRTSs")
that are owned by the Company and deployed primarily in production studios.
Video content also can be delivered to the Company's network operating center
through air freight carriers or through high-speed communication lines from
collection points in locations where VRTSs are not available. When a video spot
is received, Company personnel initiate the electronic transaction to transmit
the video to designated television stations. Video transmissions are sent via
high speed frame relay links to a satellite uplink facility and are then
delivered directly to television stations and cable headends via the satellite
network.
Audio and video transmissions are received at designated radio and
television stations on DG's Receive Playback Terminals ("RPTs") and ADvantage
Digital Video Playback Systems ("DVPS"), respectively, which enable stations to
receive and playback material delivered through the Company's digital
distribution network. The units are owned by the Company and typically are
installed in the "master control" or production area of the stations. Upon
receipt, station personnel generally review the content and transfer the spot to
a standardized internal station format for subsequent broadcast. Through its
network operating center, the Company monitors the spots stored in each Receive
Playback Terminal or Video Playback System and ensures that space is always
available for new transmissions. The Company can quickly transmit audio or video
at the request of a station or in response to the request of a customer who
wishes to alter an existing order.
DG Systems currently offers four primary levels of digital distribution
services to broadcast advertisers distributing content to broadcast stations: DG
Priority, a service which guarantees arrival of the first spot on an order
within one hour; DG Express, which guarantees arrival within four hours; DG
Standard, which guarantees arrival by noon the next day; and DG Economy, which
guarantees arrival by noon on the second day. The Company also offers a set of
premium services enabling advertisers to distribute audio or video spots
provided after normal business hours. The DG Priority service currently is
available only for audio distribution.
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In addition to its standard services, the Company has developed unique
products to service three vertical markets with particular time-sensitive
delivery needs. "Sweeps" delivery is a specialized service to television
stations that wish to advertise on radio to stimulate viewership during the
periods of ratings conducted by the A.C. Nielsen Company in February, May,
September, and November of each year. The Company also offers delivery of
advertising for daily newspapers seeking to expand their readership based on a
dissemination of breaking news during the morning rush hour. The Company
distributes first release music singles and uses unique software functionality
to insure that the singles are released throughout the network to all stations
simultaneously thereby eliminating concerns of favoritism or premature release.
Finally, the Company delivers political advertising during election campaigns,
providing a rapid response mechanism for candidates and issue groups.
The Company also provides audio and video duplication services, syndicated
programming distribution services, and a host of other ancillary post production
services through its nationwide facilities in New York, Chicago, Louisville and
Los Angeles.
PRODUCTS AND SERVICES
The Company's mission is to become the leading provider of electronic
delivery and related value-added services to broadcast advertisers. The Company
also seeks to become the industry standard for digital delivery of both audio
and video broadcast content.
Audio Advertising Distribution. Prior to the Company's acquisitions of PDR
and Mediatech, substantially all of the Company's revenues were derived from the
delivery of radio advertising from advertising agencies, production studios and
dub and ship houses to radio stations in the United States, and such services
are expected to continue to account for a significant share of the Company's
revenues for some time. See "The Company" and "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Certain Business
Considerations -- Dependence on Radio Advertising." The Company also derives
revenue from its offering of audio distribution services in the three vertical
markets: sweeps; local/regional newspapers; and political advertising. See "The
Company." Finally, the Company derives limited revenue today through its studio
services, which enable production studios to directly exchange audio files with
each other without the intervention of Company personnel.
Video Advertising Distribution. The Company believes that the delivery of
television advertising is characterized by many of the same challenges facing
radio advertisers. The Company introduced its video distribution services in the
third quarter of 1996. To date the Company has deployed a video distribution
network consisting of over 500 television stations and cable systems, which
currently are on-line and able to receive video content through the Company's
network. The Company is actively marketing and selling its video services to
agencies, advertisers and dealers. As most of the Company's radio advertising
customers also are active television advertisers, many of its current customers
who already utilize the Company's audio spot distribution services are
candidates for or already are utilizing its video services. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Certain Business Considerations -- Dependence on Video Advertising Delivery
Service Deployment", and "-- Dependence on Technological Developments" and " --
Competition."
Further, the Company's acquisitions of PDR and Mediatech have enabled it to
provide digital delivery to a larger base of customers and to provide ancillary
post-production services in the major markets to allow "one-stop shopping" for
media preparation and distribution services.
Syndicated Program Distribution. The Company also generates revenue by
distributing syndicated programming. This service primarily consists of
integrating commercials into syndicated programs and uplinking the completed
programs to satellites for distribution to stations nationwide as well as the
physical duplication and shipping of shows to stations that do not receive a
satellite feed.
Corporate Duplication. The Company also generates revenues from the
duplication of corporate content. This service primarily consists of large
quantity duplication of training, corporate or product information tapes on
non-broadcast quality tape stock, such as VHS.
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Music Distribution. The Company also derives revenues from its "first
release music deliveries", in which it offers music labels the capability to
electronically distribute first-release music singles simultaneously to selected
radio stations. The release of a new album by an established musical artist is
often the focus of a marketing campaign culminating in the simultaneous release
of a hit single to radio stations in key markets. Music labels share the
concerns of advertisers and agencies regarding the timeliness and reliability of
delivery, and in addition seek to maximize publicity by employing a secure
delivery system that ensures all selected radio stations will receive the single
just in time for the scheduled release but prevent it from being aired before
that time. In addition, new or "up and coming" artists backed by major record
labels seek the opportunity to market their music to radio stations through
innovative means, including simultaneous, first release distribution.
The Company's future growth depends on its successful and timely
introduction of new products and services, often in markets that do not
currently exist or are just emerging. The Company currently is undertaking
efforts to develop new products and services. There can be no assurance,
however, that the Company will successfully complete such development or that,
if such development is completed, the Company's introduction of these products
and services will realize market acceptance or will meet the technical or other
requirements of potential customers. See "Management's Discussion and Analysis
of Financial Condition and Results of Operations -- Certain Business
Considerations -- Dependence on Emerging Markets."
THE DG SYSTEMS NETWORK
DG Systems has developed a sophisticated, highly scaleable network
communication system to provide network transaction services to the targeted
production studios and stations. Today this system supports two-way
communication to remote production studios and stations via standard telephone
lines, ISDN lines, digital data satellite and frame relay connections. The
Company intends to continue adding communications capabilities, such as Internet
links, as they become widely available and economically attractive. The modular
system design and use of industry standard technology enables system capacity to
be increased easily and quickly. DG Systems can maintain over 800 simultaneous
connections today. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Certain Business Considerations --
Ability to Manage Growth" and " -- Future Capital Needs; Uncertainty of
Additional Funding."
The Company's network consists of the following: (i) Record Send Terminals
(audio) and Video Record and Transmission Systems (video) owned by the Company
and installed primarily at production studios; (ii) a network operating center
at the Company's headquarters used to process, route and store digital content;
and (iii) ADvantage Receive Playback Terminals (audio) and ADvantage Digital
Video Playback Systems (video) owned by the Company and installed at broadcast
stations.
Record Send Terminal. The RST is a PC-based audio encoder and
communications server with a full screen monitor and keyboard. The RST accepts
audio in either analog or digital format and encodes the audio using an
efficient algorithm for transmissions to the Company's network operating center.
Video Record Transmission System. The VRTS is a video encoder and
communications server with a full screen monitor and keyboard. The VRTS accepts
video in either analog or digital format and encodes the video using a standard
MPEG-2 compression algorithm for transmissions to the Company's network
operating center.
Network Operating Center. DG systems has developed a fault-tolerant
client/server on-line transaction system based on relational databases and UNIX
servers from Sun Microsystems. The Company has developed software applications
incorporating critical operational capabilities such as transaction management,
communication facility monitoring, system security, intelligent network routing
and customer service databases. The major system components include (i) a
transaction scheduling, monitoring and management system, (ii) a media
collection, processing and delivery system which is designed to handle audio,
video, image and data organizing the delivery content by destination address,
and routing those deliveries by the most cost-effective route, and (iii) a
high-capacity media storage and archive system that indexes and archives every
media file delivered by the Company.
ADvantage Receive Playback Terminal. The RPT is a rack-mountable, PC-based
communication server and media decoder that enables radio stations to receive
and play back audio content delivered through the Company's digital distribution
network. The RPT communicates with the Company's network to exchange media and
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transactional information, and allows users to play back broadcast quality audio
on demand. RPT software consists of extensive remote capabilities such as system
diagnostics, storage management and remote software upgrade as well as enhanced
security features such as user authentication, network access security protocol
and media content encryption to prevent unauthorized access.
ADvantage Digital Video Playback System. The DVPS is a rack-mountable,
PC-based communication server and video decoder that enables television stations
and cable systems to receive and play back advertisements delivered through the
Company's digital distribution network. The DVPS communicates with the Company's
network to exchange media and transactional information, and allows users to
play broadcast quality video on demand. The DVPS includes a fully integrated
monitor and keyboard and has the disk capacity to store up to 250 30-second
spots. DVPS software consists of extensive remote capabilities such as system
diagnostics, storage management and remote software upgrades as well as enhanced
security features such as user authentication, network access security protocol
and media content encryption to prevent unauthorized access.
Hughes DirecPC Satellite Interface. The Company has a joint development and
deployment agreement with Hughes Network Systems, Inc. for satellite delivery to
its network of stations. The Company has developed an electronic interface
between its network operating center and the Hughes satellite uplink facility.
The Company also has integrated the Hughes DirecPC satellite technology into its
DVPSs to permit the receipt of media content from satellite as well as from
terrestrial connections.
DG's extensive network of digital audio receive playback terminals and
video playback systems strategically placed across the country in broadcast
stations, its record send terminals and video record transmission systems,
coupled with unique encoding, compression and complex communications software,
connected via its Network Operating Center described above, and an established
customer base, create important barriers to entry for potential competitors. The
transmission of content is controlled by a very comprehensive transaction
scheduling, routing, monitoring and delivery management system which the Company
believes would be very difficult to replicate. Additionally, DG's audio and
video capabilities now are complemented with facilities in New York City,
Chicago, Louisville, and Los Angeles to handle customers' other production
services needs. The Company believes that no single competitor today offers DG
System's audio, video, and production services capabilities which are
deliverable locally and nationally via several strategic locations.
MARKETS AND CUSTOMERS
A large portion of the Company's current revenue is derived from the
delivery of spot radio and television advertising to broadcast stations, cable
systems and networks. The Company derives revenue from advertising agencies
directly and from its marketing partners, which are typically dub and ship
houses that have signed agreements with the Company to consolidate and forward
the deliveries of their advertising agency customers to broadcast stations,
cable systems and networks via the Company's electronic delivery service in
exchange for price discounts from the Company. The advertisements distributed by
the Company are representative of the five leading national advertising
categories of automotive, retail, business and consumer services, food and
related products including soft drinks, and entertainment. The volume of
advertising from these segments is subject to substantial seasonal and cyclical
variations. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Certain Business Considerations -- Potential
Fluctuations in Quarterly Results; Seasonality."
In addition to its core distribution services, DG Systems has identified
vertical-market applications for services where same day delivery is used to
promote time-sensitive content. These applications include:
Sweeps Promotions. The A.C. Nielsen ratings periods take place during the
broadcast months of February, May, September, and November. The Company's
services allow local television stations, their affiliated networks and
syndicators, whose own advertising rates are based on their Nielsen ratings, to
promote viewership of their programs during ratings periods. In 1997, more than
100 television stations used the Company's sweeps delivery service.
Political Campaigns. Radio and television can provide a rapid response
mechanism for candidates and issue groups. The Company offers a same-day service
for the facilitation of such advertising during political campaigns.
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Newspaper Headlines. Newspapers use the Company's services to deliver
topical radio commercials to run during the morning or afternoon in local
markets to encourage readership for local newspapers. The producer typically
reads a special early edition of the paper. Stories are selected on the basis of
topical content with the best chance of encouraging listeners to become readers.
The spot is written, recorded, mixed and transmitted to DG Systems for
distribution to local radio stations. Delivery guarantees are typically between
one and two hours depending on the market.
THE COMPANY ALSO OFFERS THE FOLLOWING SERVICES:
Syndicated Programming Distribution. Syndicators distribute long form video
programming inclusive of advertising to local television, stations and cable
operators. The Company offers numerous post production services to prepare this
content for broadcast and distribute it across the country. Distribution
services include both satellite uplink and physical duplication and shipping to
those stations which do not or cannot receive the content via satellite.
Corporate Duplication. Corporations and other entities develop training
management communications and other general information programs for internal
and external distribution for various purposes. The Company provides high volume
duplication of such content on non-broadcast quality tape stock, typically VHS.
SALES, MARKETING AND CUSTOMER SERVICE
Brand Strategy. The Company's brand strategy is to position itself as the
standard delivery method for the radio, television, cable, and network broadcast
industry. The Company focuses its marketing messages and programs at multiple
segments within the broadcast industry. Each of the segments interacts with the
Company for a different reason. Agencies purchase services from the Company on
behalf of their advertisers. Production studios facilitate the transmission of
audio and video to the Company's network operating center. Production studios
and dub and ship houses resell delivery services to agencies. Stations join the
network to receive the content from their customers, the agencies and
advertisers. A key strategy to providing a consistent brand theme at all levels
is developing "DG" as a brand identity across these various product and services
offerings.
Sales. The Company employs a direct sales force that calls on various
departments at advertising agencies to communicate the capabilities and
comparative advantages of the Company's electronic distribution system and the
related products and services. In addition, the Company's sales force calls on
corporate advertisers who are in a position to either direct or influence
agencies in directing deliveries to the Company. The Company currently has field
sales offices in New York, Los Angeles, and Chicago, as well as sales personnel
in its San Francisco headquarters. The Company's sales force includes field
sales, inside sales, and telemarketing.
Marketing. The Company's marketing programs are directed toward demand
stimulation with an emphasis on popularizing the benefits of digital delivery,
including fast turnaround (same day services), increased flexibility, higher
quality, problem recovery, and greater reliability and accountability. These
marketing programs include direct mail and telemarketing campaigns, newsletters,
collateral material (including brochures, data sheets, etc.), application
stories, and corporate briefings in major U.S. cities. The Company also engages
in public relations activities including trade show participation, the
stimulation of articles in the trade and business press, press tours and partial
sponsorship of the annual Mercury Awards of the Radio Advertising Bureau. The
Company also engages in limited print advertising in advertising and broadcast
oriented trade publications.
The Company also markets to broadcast stations to arrange for the placement
of its RPTs and DVPSs. The service contract offers the station free use of the
RPT or DVPS, but stations generally are required to pay for a dedicated phone or
ISDN line to support the transmissions.
According to industry sources, there are over 5,200 commercial radio
stations that are located in Arbitron-rated "Areas of Dominant Influence," which
are the geographic areas in which national advertisers are most active. The
Company believes its installed base of RPTs located in an estimated 95% of these
geographic areas provides it with an important competitive advantage. The
Company similarly is focusing on the largest 100 television markets as rated by
A.C. Nielsen, along with the major cable interconnects and cable and broadcast
networks in the largest U.S. markets.
Customer Service.The Company's approach to customer service is based on a
distributed model designed to provide focused support from key market centered
offices, located in Los Angeles, San Francisco, Chicago, and New York. Clients
work with assigned account coordinators to place production service and
distribution orders. National distribution orders are electronically routed to
the San Francisco Network Operating Center for electronic distribution or the
Company's national duplication center in Louisville, Kentucky. The Company's
distributed
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service approach provides direct support in the key market cities enabling the
Company to develop closer relationships with clients as well as the ability to
support client needs for local production services, appropriate for that local
market. The Company also maintains a customer service team, dedicated to
supporting the needs of radio, television, and network stations. This support is
available 7 days a week, 24 hours a day, to respond to station requests for
information, traffic instructions or additional media. Providing direct support
alleviates the need for client traffic departments to deal with individual
stations or the challenges of staffing for off-hours support. The Company's San
Francisco customer service operation is linked to a common database system and
national distribution network. These resources enable the Company to manage the
distribution of client orders to the fulfillment location best suited to meet
critical customer requirements as well as providing order status and fulfillment
confirmation. This distributed model also provides the Company with significant
redundancy and re-route capability, enabling the Company to meet customer needs
when weather or other conditions prevent deliveries using traditional courier
services.
COMPETITION
The market for the distribution of advertising and other content to radio
and television stations and cable systems is highly competitive. The Company
currently competes in the market for the distribution of audio and video
advertising spots to broadcast stations, cable systems and networks. The
principal competitive factors affecting this market are ease of use, price, and
timeliness and accuracy of delivery.
The Company competes with a variety of dub and ship houses and production
studios that have traditionally distributed taped advertising spots via physical
delivery. As local distributors, these entities have long-standing ties with
advertising agencies that are often difficult for the Company to replace. In
addition, these dub and ship houses and production studios often provide an
array of ancillary video services, including archival storage and retrieval,
closed captioning and format conversions, enabling them to deliver to their
advertiser and agency customers a full range of customizable, media post
production, preparation, distribution and trafficking services. The Company's
acquisitions of Mediatech and PDR enable the Company to provide similar services
in the three largest domestic advertising markets: New York, Los Angeles and
Chicago. The Company plans to continue pursuing potential dub and ship house
partners where such partnerships make strategic sense.
The Company competes in the market for electronic audio distribution
services with Digital Courier International Corporation (DCI) and Musicam
Express (a subsidiary of Virtex). It competes with VDI Media and Vyvx
Advertising Distribution Services, a subsidiary of The Williams Companies, Inc.,
in the market for electronic distribution of video content.
To the extent that the Company is successful in entering new markets, such
as delivery of other content to radio and television stations, it expects to
face competition from companies in related communications markets and/or package
delivery markets which offer products and services with functionality similar to
that offered by the Company's products and services. Telecommunications
providers such as AT&T, MCI, and Regional Bell Operating Companies could enter
the market as competitors with significantly lower electronic delivery
transportation costs. The Company also could face competition from entities with
package delivery expertise such as Federal Express, United Parcel Service, DHL
and Airborne if any such companies enter the electronic data delivery market.
Radio Networks such as ABC or Westwood One also could become competitors by
selling and transmitting advertisements separately from their network content
programming.
Many of the Company's current and potential competitors in the markets for
audio and video distribution have substantially greater financial, technical,
marketing and other resources and larger installed customer bases than the
Company. The Company expects that an increasingly competitive environment may
result in price reductions that could result in reduced unit profit margins and
loss of market share, all of which would have a material adverse effect on the
Company's business, results of operations and financial condition. Moreover, the
markets for the distribution of audio and video content have become increasingly
concentrated in recent years as a result of acquisitions, which are likely to
permit many of the Company's competitors to devote significantly greater
resources to the development and marketing of new services. There can be no
assurance that the Company will be able to compete successfully with new or
existing competitors or that competitive pressures faced by the Company will not
materially and adversely affect its business, operating results and financial
condition. See "Risk Factors--Competition."
7
11
The Company believes it has the broadest coverage in broadcast radio and
the largest market share by a wide margin. The Company believes that while not
yet completely installed, its base of installed plus on order backlog gives it
the broadest coverage in video, plus the best technical solution for highest
quality and reliability.
INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS
The Company primarily relies upon a combination of copyright, trademark and
trade secret laws and license agreements to establish and protect proprietary
rights in its technologies. The source code for the Company's software is
protected both as a trade secret and as an unpublished copyrighted work. Despite
these precautions, it may be possible for a third party to copy or otherwise
obtain and use the Company's hardware, software or technology without
authorization or to develop similar technology independently. In addition,
effective copyright and trade secret protection may be unavailable or limited in
certain foreign countries. The Company does not hold any patents.
Because the Company's business is characterized by rapid technological
change, the Company believes that factors such as the technological and creative
skills of its personnel, new computer hardware, software and telecommunications
developments, frequent hardware and software enhancements, name recognition, and
reliable customer service and support are more important to establishing and
maintaining a leadership position than the various legal protections of its
technology.
The Company believes that its software, trademarks and other proprietary
rights do not infringe the proprietary rights of third parties. There can be no
assurance, however, that third parties will not assert such infringement by the
Company with respect to current or future software, hardware or services. Any
such claims, with or without merit, could be time-consuming, result in costly
litigation, cause software release delays or might require the Company to enter
into royalty or licensing agreements. Such royalty or licensing agreements, if
required, may not be available on terms acceptable to the Company.
ITEM 2. PROPERTIES
The Company's headquarters are located at leased office space located at
875 Battery Street in San Francisco. The Company's lease is for 15,000 square
feet and expires in 2001. In order to sustain uninterrupted network integrity,
the Company has an agreement for non-interruptible access to emergency power and
the Company has arranged for alternative fiber optic routes to maintain its
fiber connection between its computers and its long distance carrier. However,
there can be no assurance that a catastrophic earthquake or other natural
disaster could not interrupt the company's operations. The Company leases
approximately 5,000 square feet at a nearby facility on used for assembly of its
field equipment and for offsite storage which expires in 2001. In addition, the
Company leases approximately 3,000 square feet in Louisville, Kentucky for its
dub and ship facility which expires in 2002; approximately 22,000 square feet in
New York City which is occupied by DG East (formerly PDR) and expires in 2006;
and approximately 13,000 square feet in Los Angeles occupied by DG West
(formerly Mediatech) which expires in 2006. In addition, the Company leases
30,500 square feet in Chicago, which is occupied by DG Central (formerly
Mediatech) on a month to month rental agreement, pending finalization of a long
term lease. The Company believes that these facilities and offices, in addition
to alternative space available to it are adequate to meet its requirements for
the foreseeable future.
ITEM 3. LEGAL PROCEEDINGS
The Company is subject to various legal proceedings and claims, either
asserted or unasserted, which arise in the ordinary course of business. While
the outcome of these claims cannot be predicted with certainty, management does
not believe that the outcome of any of these legal matters will have a material
adverse effect on the Company's consolidated financial condition or results of
operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
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None.
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT
The executive officers and directors of the Company and their ages as of
December 31, 1997 are as follows:
Name Age Title(s)
----- ----- ---------
Henry W. Donaldson 52 President, Chief Executive Officer and Director
Ken K. Cheng 42 Senior Vice President, Chief Operating Officer
Robert H. Howard 48 Vice President, Sales
Gregory G. Schott 33 Vice President, Marketing
Thomas P. Shanahan 51 Vice President, Finance and Chief Financial Officer
Kevin R Compton (1) 39 Director
Jeffrey M. Drazan (2) 39 Director
Richard H. Harris (2) 68 Director
Lawrence D. Lenihan, Jr 33 Director
Leonard S. Matthews (1)(2) 75 Director
(1) Member of the Audit Committee
(2) Member of the Compensation Committee
Henry W. Donaldson joined the Company in March 1993, and since such date
has served as its President and Chief Executive Officer and as a member of the
Company's Board of Directors. He was formerly President of the Data
Communications Division of Rexel, Inc., a provider of telecommunications and
local area networking products and services, from September 1989 through January
1993. Mr. Donaldson holds a B.A. in Mathematics from Hamilton College.
Ken K. Cheng joined the Company in December 1993 and as Vice President,
Engineering. Mr. Cheng was appointed Senior Vice President and Chief Operating
Officer in June 1996 and has served as such since that date. From December 1988
to December 1993, Mr. Cheng was Director of Engineering at Network Equipment
Technologies. Mr. Cheng holds a B.Sc. in Applied Mathematics from Queen's
University, Kingston, Ontario, Canada and an M.B.A. from Santa Clara University.
Robert H. Howard joined the Company in April 1997 as Vice President of
Sales. Mr. Howard held several positions with Columbine JDS, the world's leading
provider of software to the broadcast industry, from 1977 through 1996,
including Vice President of Sales and Marketing. Mr. Howard holds a B.A. in
Communications and an MBA from the University of Memphis.
Gregory G. Schott joined the Company in July 1994 as Director of
Operations. Mr. Schott later served as Director of Business Development from
December 1995 to June 1996 and as the Vice President of Operations from July
1996 to October 1997 and is now currently the Vice President of Marketing. From
June 1991 to July 1994, Mr. Schott was a consultant with the Boston Consulting
Group. Mr. Schott holds a B.S. in Mechanical Engineering from North Carolina
State University and an M.B.A. from Stanford University.
Thomas P. Shanahan joined the company in November 1994, and since such
date has served as its Chief Financial Officer. From May 1987 to February 1992,
Mr. Shanahan was Chief Financial Officer of SBT Corporation. From March 1992 to
April 1993, Mr. Shanahan was Chief Financial Officer of Ultra Network
Technologies, Inc. From May 1993 to October 1994, he was Chief Financial Officer
of Sherpa Corporation. Mr. Shanahan holds a BA in Economics from Stanford
University and an MBA from Harvard University.
Kevin R. Compton has been a member of the Board of Directors of the
Company since March 1994. Mr. Compton has been a general partner of Kleiner,
Perkins, Caufield & Byers, a venture capital investment firm, since December
1990. Mr. Compton currently serves as a director of: Global Village
Communication, Inc., a networking hardware and software company; Citrix Systems,
a developer of server software; Corsair
9
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Communications, Inc., a developer of hardware and software systems for the
wireless telecommunications industry; Verisign, a provider of digital
authentication services; and on numerous privately held companies. He holds a BS
in Business Administration from the University of Missouri.
Jeffrey M. Drazan has been a member of the Board of Directors of the
Company since July 1992. Mr. Drazan has been a general partner of Sierra
Ventures, a venture capital investment firm, since 1985. Mr. Drazan currently
serves as a director of FaxSav, Micromuse, and Retix, a telecommunications
equipment company. Mr. Drazan holds a BSE. in Engineering from Princeton and an
MBA from New York University.
Richard H. Harris has been a member of the Board of Directors of the
Company since July 1992. Since July 1992, Mr. Harris has been President and
Owner of Harris Classical Broadcasting, operating two FM audio stations in
Milwaukee, Wisconsin. From May 1984 to May 1986, Mr. Harris was Chairman of the
Radio Advertising Bureau. From June 1964 to April 1991, Mr. Harris held various
senior management positions with Westinghouse Broadcasting Company, including
Chairman of the Radio Group. Mr. Harris holds a BA in Communications and
Economics from the University of Denver and is a graduate of the Advanced
Management Program at Harvard University.
Lawrence D. Lenihan, Jr. has been a member of the Board of Directors of
the Company since July 1997. Mr. Lenihan has been a managing member of the
General Partner for Pequot Private Equity Fund, L.P. since February 1997. He is
also a Principal at Dawson-Samberg Capital Management, Inc. Mr. Lenihan was a
Principal at Broadview Associates, LLC, prior to joining Dawson-Samberg. He
currently serves as a Director of Direc-To-Phone and Sanctuary Woods Multimedia
Corporation. Mr. Lenihan holds a BSEE. from Duke University and an MBA from the
Wharton School of Business.
Leonard S. Matthews has been a member of the Board of Directors of the
Company since April 1993. From January 1979 to January 1989, Mr. Matthews was
President and Chief Executive Officer of the American Association of Advertising
Agencies. Previously, Mr. Matthews had been president of two of the world's
leading advertising agencies, Leo Burnett and Young & Rubicam. From May 1992 to
the present, Mr. Matthews has been Chairman of the Board of Next Century Media,
an interactive television company. Mr. Matthews holds a BS in Business
Administration & Marketing from Northwestern University.
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PART II
ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Common Stock of the Company has been traded on Nasdaq National Market
under the symbol DGIT since the Company's initial public offering on February 6,
1996. Prior to that time there was no public market for the Company's Common
Stock or other securities.
HIGH LOW
---- ---
FISCAL YEAR ENDED DECEMBER 31, 1997:
First Quarter ...................................... $8.38 $4.00
Second Quarter...................................... $5.19 $3.88
Third Quarter ...................................... $6.75 $4.50
Fourth Quarter...................................... $4.63 $2.38
As of March 1, 1998, the Company had issued and outstanding 12,196,454
shares of its Common Stock held by 116 shareholders of record. The Company
estimates that there are approximately 2,000 beneficial shareholders.
The Company has never declared or paid cash dividends on its capital stock.
The Company currently expects to retain its future earnings for use in the
operation and expansion of its business and does not anticipate paying any cash
dividends in the foreseeable future.
See "Management's Discussion and Analysis of Financial Condition and
Results of Operations ---Certain Business Considerations --- Concentration of
Stock Ownership", "---Preferential Rights of Outstanding Preferred Stock" and
"---Possible Volatility of Share Price."
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ITEM 6. SELECTED FINANCIAL DATA
STATEMENTS OF OPERATIONS:
YEAR ENDED DECEMBER 31,
--------------------------------------------------------------
1993 1994 1995 1996 1997
------- ------- -------- -------- --------
(in thousands, except per share data)
Revenues ....................... $ 315 $ 2,432 $ 5,144 $ 10,523 $ 29,175
------- ------- -------- -------- --------
Costs and expenses:
Delivery and material costs . 200 953 1,810 3,084 11,334
Customer operations ......... 735 1,886 2,974 4,164 11,388
Sales and marketing ......... 1,126 2,248 3,406 3,998 4,417
Research and development .... 505 1,048 1,590 2,092 2,473
General and administrative .. 672 1,054 1,380 1,677 3,169
Depreciation and amortization 329 913 2,345 4,331 9,306
------- ------- -------- -------- --------
Total expenses ........... 3,567 8,102 13,505 19,346 42,087
------- ------- -------- -------- --------
Loss from operations ........... (3,252) (5,670) (8,361) (8,823) (12,912)
------- ------- -------- -------- --------
Other income (expense):
Interest income ............. 35 129 417 1,422 744
Interest expense ............ (58) (71) (836) (1,726) (2,607)
------- ------- -------- -------- --------
Net Loss ....................... $(3,275) $(5,612) $ (8,780) $ (9,127) $(14,775)
======= ======= ======== ======== ========
Basic and diluted net loss per
common share (1).................... $(6.72) $(8.23) $(9.78) $(0.87) $(2.52)
====== ====== ====== ====== ======
Weighted average common shares ..... 487 682 898 10,488 11,893
====== ====== ====== ====== ======
BALANCE SHEET DATA:
------------------------------------------------------
1993 1994 1995 1996 1997
------ ------- ------- ------- --------
Cash, cash equivalents and short-term $ 495 $ 9,221 $ 6,205 $20,597 $ 8,820
investments
Working capital ...................... 115 8,755 4,651 14,200 (879)
Property and equipment, net .......... 1,455 3,175 5,772 12,630 17,566
Total assets ......................... 2,222 13,572 14,459 45,248 60,697
Long-term debt, net of current portion 303 1,573 4,540 8,495 11,847
Shareholders' equity ................. 1,358 10,502 6,373 26,839 30,449
(1) See Note 11 of Notes to Consolidated Financial Statements - Net Loss Per Share.
12
16
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
The Company was incorporated in 1991. Through 1993, the Company was a
development-stage company, principally engaged in developing its network,
marketing its services to radio stations and advertising agencies, and producing
and deploying terminals for use at adverting agencies, production studios and
radio stations. In 1994, the Company first generated significant operating
revenues from the delivery of audio commercials and the related text traffic
instructions to radio stations through a nationwide network established by the
Company. In the third quarter of 1996, the Company began delivery of video
commercials to television stations. As the network expanded to include an
increasing number of radio and television stations, the number of deliveries
ordered by customers has increased. At the same time, the number of deliveries
performed via electronic delivery has increased relative to the number performed
by physical delivery through the Company's dub and ship facility in Louisville,
Kentucky.
The Company defines a delivery as the transmission, electronic or physical,
of a piece or pieces of audio or video content, generally a commercial ("spot")
or a set of commercials ("tied spots") to a destination, generally a radio or
television station, based on a single order from a customer. Each order usually
calls for the delivery of the same spots to multiple destinations, resulting in
multiple deliveries. The revenue earned per delivery is dependent upon the type
of service ordered, generally defined by the time interval between submission
and delivery (Priority, Express, Standard or Economy), the channel from which
the order is received (directly from an advertiser or advertising agency or
through a dub and ship house), and the quantity of audio or video being
delivered (a single spot or multiple tied spots.) DG Systems derives revenue
from advertising agencies, as well as production studios and dub and ship houses
that consolidate and forward deliveries for their agency customers. Because the
revenue earned for the delivery of the first spot is significantly greater than
the revenue earned for a tied spot and because the Company's per spot electronic
transmission cost is relatively constant regardless of volume, electronic
deliveries that comprise a single spot are generally more profitable that
deliveries which include tied spots. The Company recognizes revenue for each
order on the date the content is transmitted to the destinations ordered.
The Company assembles, owns and maintains Receive Playback Terminals
("RPTs"), which are located in radio stations, Record Send Terminals ("RSTs"),
which are located in advertising agencies and production studios, Video Record
Transmission Systems ("VRTSs"), which are located primarily in production
studios, and Digital Video Playback Systems ("DVPSs") which are located in
television stations. The capital required to build the network has been obtained
through various preferred stock offerings to investors, primarily venture
capital firms, leasing agreements, and the Company's initial public offering,
which was completed in February 1996.
In November 1996, the Company acquired 100% of the capital stock of PDR
Productions, Inc. ("PDR"), a New York City based media duplication and
distribution company. PDR's primary operations are services typical of the
traditional dub and ship house, including the physical duplication and
distribution of video content on a wide range of tape formats and performance of
a variety of audio and video editing services. The acquisition was accounted for
as a purchase and the operating results of PDR have been included in the
consolidated results of the Company from the date of the closing of the
transaction, November 8, 1996.
In July 1997, the Company acquired 100% of the capital stock of Starcom
Mediatech, Inc. ("Mediatech"), a wholly owned subsidiary of IndeNet, Inc.
("IndeNet") with operating facilities in Chicago, Los Angeles, New York and
Louisville. Mediatech's primary operations, similar to those of PDR, are also
services typical of a traditional dub and ship house. Although Mediatech's
revenues are generated primarily from the duplication and distribution of short
form content, consistent with those of DG Systems prior to this acquisition,
Mediatech's revenues also include a significant portion generated from the
distribution of long form syndicated programming of both live and previously
broadcast television shows. Such services include integrating commercials into
syndicated programs and uplinking the completed programs to satellites as well
as the physical duplication and distribution of such programs to those stations
which do not receive a satellite feed. The acquisition was accounted for as a
purchase and the operating results of Mediatech have been included in the
consolidated results of the Company from the date
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17
of the closing of the transaction, July 18, 1997.
The Company acquired PDR and Mediatech with the expectation that the
acquisitions would result in enhanced efficiencies for the combined company,
including those resulting from the capability of providing digital delivery to
new customers and the capability of providing ancillary services to new and
existing customers in the markets served by PDR and Mediatech. See the Notes to
Consolidated Financial Statements and the Company's Current Report on Form 8-K
filed on November 7, 1997. See "Certain Business Considerations ---
Uncertainties Relating to Integration of Operations" and "--Dependence on Video
Advertising Service Deployment."
RESULTS OF OPERATIONS
The following presents the statements of operations of the Company
expressed as a percentage of total revenues and the related operating data for
the periods indicated.
YEAR ENDED DECEMBER 31,
--------------------------------
1995 1996 1997
------ ----- -----
STATEMENTS OF OPERATIONS:
Revenues .................................... 100.0% 100.0% 100.0%
Cost and expenses:
Delivery and material costs ................. 35.2 29.3 38.8
Customer operations ......................... 57.8 39.6 39.0
Sales and marketing ......................... 66.2 38.0 15.1
Research and development .................... 30.9 19.9 8.5
General and administrative .................. 26.8 15.8 10.9
Depreciation and amortization................ 45.6 41.2 31.9
------ ----- -----
Total Expenses .............................. 262.5 183.8 144.2
------ ----- -----
Loss from operations ........................ (162.5) (83.8) (44.2)
Other income (expense):
Interest income ............................. 8.1 13.5 2.6
Interest expense ............................ (16.3) (16.4) (8.9)
------ ----- -----
Net loss .................................... (170.7)% (86.7)% (50.5)%
===== ===== =====
Revenues
YEAR ENDED DECEMBER 31,
--------------------------------
1995 1996 1997
------ ------- -------
Audio Distribution ................................ $5,144 $ 9,588 $13,707
Video Distribution ................................ -- 617 8,685
Ancillary Post-Production Services & Other Services -- 318 6,783
------ ------- -------
Total Revenues .................................... $5,144 $10,523 $29,175
====== ======= =======
Revenues increased from $5,144,000 to $10,523,000 to $29,175,000 in 1995,
1996, and 1997 respectively. These increases in revenues were due primarily to
the increased volume of audio and video deliveries. Such deliveries are
generally of short form content used in the spot advertising market. The Company
made 390,000, 784,000 and 1,345,000 deliveries in 1995, 1996, and 1997
respectively. Average revenue per delivery also has been increasing,
particularly in 1997, due to the increased proportion of video deliveries in the
delivery mix. Video deliveries, which the Company began offering late in the
third quarter of 1996, accounted for approximately 4% and 25% of the delivery
volume in 1996 and 1997, respectively.
The Company believes that the substantial delivery and revenue increases
since 1995 are the result of a
14
18
number of factors, including the increased acceptance by advertisers of the
services offered by the Company and the increased availability of an expanded
network of Company equipment located in radio and television stations.
Additionally, the acquisitions of PDR and Mediatech in November 1996 and July
1997, respectively, have brought the Company increased market share in video
distribution, given the Company the opportunity to provide digital distribution
services to new customers and allowed the Company to offer ancillary
post-production and other services.
The increase in delivery volume in 1996 versus 1995 was primarily due to
the increased volume of audio deliveries made via the DG Systems Network
Operating Center ("NOC") in San Francisco. Prior to the acquisition of PDR, all
deliveries were routed through the NOC. The increased volume of deliveries in
1997 versus 1996 is due to the addition of physical deliveries, particularly
video deliveries, made directly from the former PDR and Mediatech locations, as
well as additional deliveries made through the NOC. Additional deliveries made
through the NOC accounted for approximately 47% of the volume increase in 1997
over 1996.
Average revenue per audio delivery decreased from $13.19 in 1995 to $12.72
in 1996 and then increased to $13.55 in 1997. The decrease in average revenue in
1996 versus 1995 was primarily due to volume discounts offered to both direct
and indirect customers. The increase in average revenue per audio delivery in
1997 versus 1996 is due primarily to an increased proportion of deliveries made
using the Company's Priority Service, which provides delivery within one hour.
This service, which was introduced in the fourth quarter of 1996, accounted for
approximately 4% of audio volume in 1997 versus less than 1% of audio volume in
1996.
The Company began offering video delivery late in 1996. Average revenue per
video delivery was $26.00 in 1997. Retail list prices for the digital delivery
or physical duplication and distribution of a single video spot are 50% to 100%
greater than the list price for the delivery of audio. The average price per
delivery in 1997 is based on the significantly higher revenues resulting from
increased digital and physical delivery volume, including deliveries made
directly from the former PDR and Mediatech facilities.
In 1997, revenues include approximately $6.8 million recorded from other
services provided by the former PDR and Mediatech facilities. This consists of
$1.9 million of ancillary post-production services, $2.9 million of corporate
duplication, and $2.0 million of satellite distribution services. Ancillary
post-production services are generally related to the preparation of video
content for distribution. Corporate duplication includes high volume replication
of training or corporate and product information tapes on non-broadcast quality
tape stock, such as VHS. Satellite services include the integration of
commercials into syndicated programming and uplinking the completed programs to
satellites for distribution.
Delivery and Material Costs
YEAR ENDED DECEMBER 31,
-------------------------------
1995 1996 1997
------ ------ -------
Audio Distribution ................................ $1,810 $2,840 $ 3,750
Video Distribution ................................ -- 191 4,536
Ancillary Post-Production Services & Other Services
-- 57 3,048
------ ------ -------
Total Delivery and Material Costs ................. $1,810 $3,088 $11,334
====== ====== =======
Delivery costs consist of fees paid to other service providers for charges
incurred by the Company in the receipt, transmission and delivery of information
via the Company's distribution network. Delivery expenditures have principally
been for the telephone and satellite transmission of deliveries performed
electronically and for the air freight incurred in the physical delivery of
tapes to locations not directly linked to the DG network operating center.
Delivery costs also include fees paid to secure satellite transmission
capabilities in connection with the services offered by the Company. Material
costs consist primarily of audio and video tape, the related packaging, and the
direct materials and supplies used in providing the various services offered by
the Company. Material costs are not generally required in the case of electronic
distribution.
15
19
Delivery and material costs were $1,810,000, $3,084,000, and $11,334,000 in
1995, 1996, and 1997 respectively. In 1996, the increase in cost versus 1995 is
primarily due to the increased volume of deliveries, particularly audio
deliveries performed through the NOC. In 1997, delivery and material costs
increased significantly as a result of increased electronic and physical
delivery volume, particularly video deliveries made directly from the former PDR
and Mediatech facilities, as well as the addition of the direct costs related to
the other services now provided by the Company as a result of the PDR and
Mediatech acquisitions. These increased costs include both delivery expenses and
direct materials costs required when physically duplicating and distributing a
video or audio spot as well as the direct materials and fees paid to other
services providers in connection with ancillary post-production services and
other services offered by the Company.
Delivery and material costs as a percentage of revenues decreased from 35%
in 1995 to 29% in 1996. This reduction primarily was due to reduced
telecommunications cost per electronic audio delivery. This decrease was due to
a rate reduction obtained from the Company's primary long distance provider,
implementation of ISDN transmission technology at high volume delivery
destinations, which reduced the average time necessary to transmit a minute of
audio over a phone line, and more efficient access to long distance carriers due
to equipment and switching improvements made by the Company. In addition, the
proportion of audio deliveries being performed electronically improved from 75%
in 1995 to 85% in 1996.
Delivery and material costs as a percentage of revenues increased from 29%
in 1996 to 39% in 1997. The increase in such costs as a percentage of total
revenues is due to the change in mix of services offered by the Company as a
result of the acquisitions and the ramp up of the electronic video distribution
service. The Company's audio distribution services primarily are performed
electronically, which has resulted in lower delivery and material costs as a
percentage of revenues than those of the Company's video distribution and other
service offerings.
Audio distribution delivery and material costs as a percentage of the
related revenues decreased in 1997 versus 1996. This decrease is a result of an
increase in the percentage of audio deliveries performed electronically via the
NOC, improvements in cost per electronic delivery, and due to an increase in
average revenue per audio delivery. Approximately 92% of the audio deliveries
performed by the Company in 1997 were routed through the DG Systems NOC; of
these deliveries, 88% were performed electronically. In 1996, 85% of the audio
deliveries routed through the NOC had been performed electronically.
Video distribution delivery and material costs as a percentage of related
revenues was approximately 25 percentage points higher than that for audio
distribution in 1997. Approximately 25% of the video deliveries performed by the
Company in 1997 were routed through the DG Systems NOC; of these deliveries, 47%
were performed electronically. During 1997, the Company began volume electronic
video delivery, continued to add television stations to its network and
developed network communications links between the NOC and the acquired
facilities in New York, Chicago and Los Angeles. Consequently, the number of
stations capable of receiving electronic delivery and the number of orders
received at the acquired facilities which were capable of being delivered via
the NOC was increasing over the course of 1997. As a result, video delivery and
material costs primarily resulted from the physical duplication and distribution
of tapes directly from the acquired facilities or from the Company's dub and
ship facility in Louisville, Kentucky. In addition, the fixed telecommunications
costs incurred by the Company in order to offer this service were not as well
leveraged over a volume of deliveries as those incurred to offer the Company's
audio distribution.
Delivery and material costs related to the other services provided by the
Company were 45% of the associated revenues in 1997. The direct costs as a
percentage of revenues associated with these services vary widely based on the
numerous services performed and the rates negotiated with the customers using
these services. In general, the direct costs of corporate duplication and
providing satellite services have higher costs as a percentage of revenues than
the Company's audio and video distribution services. The Company is actively
reviewing the rates charged for such services and the potential business impacts
of revising these service offerings.
The Company expects that delivery costs will increase in absolute dollars
and may fluctuate as a percentage of revenues in future periods. See "Certain
Business Considerations ---Uncertainties Relating to Integration of Operations,"
"---Ability to Manage Growth," "---Dependence on Certain Suppliers" and
"---Potential Fluctuations in Quarterly Results; Seasonality."
16
20
Customer Operations
Customer operations expenses consist primarily of salaries and the related
overhead costs incurred in performing deliveries and providing services,
including order entry, customer service and assembly and maintenance of network
equipment including the Company's RPTs, RSTs, VRTSs, DVPSs, tape dubbing and
editing equipment, and the network operating center.
Customer operations expenses were $2,974,000, $4,164,000 and $11,388,000 in
1995, 1996, and 1997 respectively. The increase in expenses in 1996 versus 1995
is primarily the result of adding the personnel necessary to respond to the
greater volume of orders and deliveries made by customers and the increased
volume of requests for network terminals made by radio and television stations.
The increase in expenses in 1997 versus 1996 is primarily the result of the
consolidation of the costs of the former PDR and Mediatech facilities. In
addition, these expenses increased in both 1996 and 1997 due to the addition of
the personnel necessary to establish the operational capacity to support growth
in the electronic video delivery business. These additional expenses include the
costs, primarily labor expenses, of personnel involved in assembly of the DVPSs
as well as customer and technical support.
Customer operations expenses as a percentage of revenues has decreased
from 58% to 40% to 39% in 1995, 1996 and 1997 respectively. In 1996, customer
operations expense as a percentage of revenues was reduced versus 1995, as the
Company was able to realize the benefits of economies of scale from the
increased delivery volume and to improve the efficiency of its order processing
procedures as a result of increased experience with the system and the hiring of
additional qualified management. In 1997, the Company reduced customer
operations expenses as a percentage of revenues to less than 35% for orders
processed through the San Francisco NOC, which serves as the primary support for
the digital network. These improvements in cost as a percentage of revenues,
however, were generally offset by the impact of the relatively more expensive
customer operations expenses of the former PDR and Mediatech facilities, which
have a different cost structure in order to provide the additional services
offered at these locations.
The Company expects that customer operations expenses will increase in
absolute dollars and may fluctuate as a percentage of revenues in future
periods. Moreover, the Company believes that in order to compete effectively and
manage future growth, the Company will be required to continue to implement
changes which improve and increase the efficiency of its customer operations.
See "Certain Business Considerations -- Ability to Maintain and Improve Service
Quality" and "-- Ability to Manage Growth."
Sales and Marketing
Sales and marketing expenses include salaries, incentive compensation,
professional fees and the related overhead costs incurred in promoting,
marketing and selling the Company and its services to customers and radio and
television stations. Sales and marketing expenses were $3,406,000, $3,998,000,
and $4,417,000 or 66%, 38%, and 15% of revenues for 1995, 1996 and 1997
respectively. These increases were the result of additional costs incurred in
introducing the Company's service to the marketplace, including the salaries of
expanded sales and marketing forces, increased incentive compensation resulting
from increased revenues and increased marketing program activity. The increase
in expenses in 1996 versus 1995 was due to additional personnel and the
expansion of promotional programs to meet the Company's growth objectives. The
increase in expenses in 1997 versus 1996 is due primarily to the consolidation
of the costs of the former Mediatech and PDR sales groups. During 1997, the
Company's sales forces were united under the direction of the DG Systems' Vice
President of Sales in order to more effectively and efficiently market the
Company's complete set of services throughout the country.
The Company expects to continue to expand sales and marketing programs
designed to introduce the Company's services to the marketplace and to attract
new customers for its services. See "Certain Business Considerations --
Dependence on Emerging Markets." The Company expects that sales and marketing
expenses will increase in absolute dollars in future periods and may fluctuate
as a percentage of revenue in future periods.
Research and Development
Research and development expenses consist primarily of salaries, testing
costs, consulting fees, and the related
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overhead incurred in the development and enhancement of the delivery system
used to distribute information via the DG Systems' network. Research and
development costs are expensed as incurred until technological feasibility is
established, after which any additional costs are capitalized, in accordance
with Statement of Financial Accounting Standards No. 86, "Accounting for the
Costs of Computer Software to be sold, Leased or Otherwise Marketed." To date,
no software development costs have been capitalized by the Company as the
capitalizable amounts have been immaterial. Research and development expenses
were $1,590,000, $2,092,000, and $2,473,000 in 1995, 1996 and 1997,
respectively. Research and development expenses have increased in 1996 and 1997
primarily due to the hiring of additional staff, including increased
compensation and recruiting fees, and the development and testing costs,
principally frame relay and satellite transmissions, associated with preparing
the delivery system for the transmission of video content as well as the
continued costs of research on potential new methods of delivery and new
services to be offered
The Company expects that research and development expenses will increase
substantially in absolute dollars and may fluctuate as a percentage of revenues
in future periods.
General and Administrative
General and administrative expenses consist primarily of personnel and
related overhead costs for finance and general management of the Company.
General and administrative expenses were $1,380,000, $1,677,000 and $3,169,000
in 1995, 1996, and 1997 respectively. These increases were primarily due to the
addition of personnel to support the growth of the Company's business, including
the consolidation of certain staff of Mediatech and PDR, as well as the
additional costs necessary to meet the reporting requirements of a publicly
traded company. Although general and administrative expenses have increased in
absolute dollars, these expenses as a percentage of revenues have decreased from
27% to 16% to 11% in 1995, 1996, and 1997 respectively. The Company expects that
general and administrative expenses will increase in absolute dollars and may
fluctuate as a percentage of revenues in future periods.
Depreciation and Amortization
Depreciation and amortization expenses are attributable primarily to the
Company's distribution network, including RPTs, RSTs, DVPSs, VRTSs, video
dubbing and editing equipment and the network operating center. This equipment
is expensed over the estimated useful life, generally three years. Depreciation
and amortization expense was $2,345,000, $4,331,000 and $9,306,000 in 1995,
1996, and 1997 respectively. These increases were due to the continued expansion
of the Company's network. The Company's total investment in network equipment
has increased from $7.9 million to $18.0 million to $30.4 million at the end of
1995, 1996, and 1997 respectively. In particular, the Company made equipment
additions of $6.0 million and $4.7 million in 1996 and 1997, respectively, to
support its video delivery service plan and acquired approximately $2.3 million
and $7.5 million of equipment in connection with the acquisitions of PDR and
Mediatech, respectively.
In addition, the Company recorded amortization expense of $71,000 and
$787,000 in 1996 and 1997, respectively, related to the goodwill and other
intangible assets recorded in connection with the acquisitions of PDR and
Mediatech.
The Company expects to continue to invest in the expansion of its network.
In particular, the Company is in the process of expanding its infrastructure
within the television broadcast industry that will require additional VRTSs and
DVPSs to be built and installed in production studios and television stations.
The Company expects depreciation and amortization to increase in absolute
dollars in proportion to this growth. However, there can be no assurance that
the Company will make such investments or that such investments will result in
future revenue growth. See "Certain Business Considerations -- Future Capital
Needs; Uncertainty of Additional Funding."
Interest Income and Interest Expense
The Company has derived interest income from the short-term investment of
the proceeds received in various preferred stock offerings, including the $16.4
million of net proceeds from the Series A offering in July 1997, and from the
investment of the $29.5 million of net proceeds from its initial public offering
in February 1996. Interest income was $417,000, $1,422,000 and $744,000 1995,
1996 and 1997, respectively. The fluctuations in interest
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income were due to differences in the amounts raised and the timing of each
offering as well as the differences in the levels of cash used to fund Company
operations and strategic acquisitions. The Company expects that interest income
will decrease in the future in proportion to the levels of cash used to fund
operations and acquisition activity. See "Liquidity and Capital Resources."
Interest expense incurred by the Company was $836,000, $1,726,000 and
$2,607,000 in 1995, 1996, and 1997, respectively. This expense has been due
primarily to lease agreements used to fund the acquisition of components and
equipment needed to develop the network and to provide Company personnel with
the capital resources necessary to support the Company's business growth. Debt
outstanding under these agreements has increased from $6.3 million to $12.2
million to $13.8 million at the end of 1995, 1996, and 1997, respectively. In
addition, during 1997 the Company incurred additional interest expense totaling
$314,000 on the promissory notes given as consideration in the acquisitions of
PDR and Mediatech and incurred $277,000 of interest expense on the term debt and
line of credit assumed in conjunction with the Mediatech acquisition. The
Company expects interest expense will increase in the future based on the
increased levels of borrowing. See "Liquidity and Capital Resources."
QUARTERLY RESULTS OF OPERATIONS
The following table presents unaudited quarterly statements of
operations for the Company. The information has been prepared by the Company on
a basis consistent with the Company's audited financial statements and includes
all adjustments, consisting of only normal recurring adjustments that management
considers necessary for a fair presentation of the information for the periods
presented. The Company's quarterly operating results have in the past and may in
the future vary significantly depending on factors such as the volume of
advertising in response to seasonal buying patterns, the timing of new product
and service introductions, increased competition, the timing of the Company's
promotional efforts, general economic factors, and other factors. For example,
the Company has historically experienced lower sales in the first quarter and
higher sales in the fourth quarter, due to increased customer advertising
volumes for the November television sweeps rating period and Christmas selling
season. As a result, the Company believes that period to period comparisons of
its results are not necessarily meaningful and should not be relied upon as an
indication of future performance.
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THREE MONTHS ENDED
---------------------------------------------------------------------------------------------------
MARCH 31, JUNE 30, SEPT. 30, DEC. 31, MARCH 31, JUNE 30, SEPT. 30, DEC. 31,
1996 1996 1996 1996 1997 1997 1997 1997
-------- -------- -------- -------- -------- -------- -------- --------
(in thousands, except operating data)
STATEMENTS OF OPERATIONS
Revenues ..................... $ 1,894 $ 2,359 $ 2,265 $ 4,005 $ 4,606 $ 5,405 8,798 $ 10,366
-------- -------- -------- -------- -------- -------- -------- --------
Costs and expenses:
Delivery and material
costs .................... 595 732 694 1,063 1,475 1,813 3,886 4,160
Customer operations ........ 920 948 904 1,392 2,135 2,104 3,241 3,908
Sales and marketing ........ 983 970 905 1,140 1,015 1,126 1,232 1,044
Research and development ... 498 510 519 565 648 620 688 517
General and administrative . 384 396 407 490 604 637 998 930
Depreciation and
amortization .............. 838 936 1,181 1,376 1,765 1,968 2,628 2,945
-------- -------- -------- -------- -------- -------- -------- --------
Total expenses ........... 4,218 4,492 4,610 6,026 7,642 8,268 12,673 13,504
-------- -------- -------- -------- -------- -------- -------- --------
Loss from operations.......... (2,324) (2,133) (2,345) (2,021) (3,036) (2,863) (3,875) (3,138)
Other income (expense):
Interest income ............ 263 434 399 326 251 215 138 140
Interest expense ........... (327) (388) (451) (560) (511) (553) (762) (781)
-------- -------- -------- -------- -------- -------- -------- --------
Net loss ..................... $ (2,388) $ (2,087) $ (2,397) $ (2,255) $ (3,296) $ (3,201) $ (4,499) $ (3,779)
Basic and diluted net loss.... $ (0.33) $ (0.18) $ (0.21) $ (0.19) $ (0.28) $ (0.27) $ (1.63) $ (0.31)
per common share(1)
Weighted average common shares 7,252 11,482 11,575 11,642 11,686 11,733 12,035 12,118
(1) See Note 11 to Consolidated Financial Statements - Net Loss Per Share.
LIQUIDITY AND CAPITAL RESOURCES
From its inception through December 31, 1995, the Company financed its
operations and met its capital expenditure requirements primarily from the
proceeds of private sales of Preferred and Common Stock and through capital
lease agreements. Through December 31, 1995, the Company had raised $25.5
million from the sale of Preferred and Common Stock and had funded $7.6 million
of capital expenditures with long term lease agreements. In 1996, the Company
raised $29.6 million from the sale of Common Stock, primarily through it's
initial public offering, and an additional $8.0 million of capital equipment was
funded through capital lease agreements. In 1997, the Company raised $16.4
million from sale of Series A Preferred Stock and funded $5.8 million of capital
equipment through long-term credit facilities.
At December 31, 1997, the Company's current sources of liquidity included
cash and cash equivalents of $7.8 million and short-term investments of
$987,000. In addition, the Company has $900,000 and $1.7 million available to
fund capital expenditures remaining under two long-term credit facilities which
can be drawn against until June 30, 1998 and December 31, 1998, respectively.
The Company also has $3.5 million available for working capital under a
long-term credit agreement which can be drawn on through December 31, 1998 and
Mediatech, a wholly owned subsidiary, has a revolving line of credit available
to fund the working capital requirements of Mediatech. The maximum available
under the Mediatech line is $3,525,000, dependent upon the level of qualifying
receivables maintained by Mediatech; the balance outstanding at December 31,
1997 is $2,834,000, which is approximately equal to the maximum available under
the agreement at that time. The Company expects to fully utilize the funding
available under the existing credit agreements.
The Company's operating activities have used cash of $6.6 million, $4.3
million, and $6.3 million in 1995, 1996, and 1997. Net cash used in operating
activities decreased in 1996 versus 1995, primarily as a result of a reduced net
loss, exclusive of depreciation and amortization. Net cash used in operating
activities increased in 1997 versus 1996, primarily because net interest expense
increased by $1.6 million and offset improved operating results. The Company's
earnings before interest, taxes and depreciation has improved from a loss of
$6.0 million in 1995 to a loss of $4.5 million 1996 to a loss of $3.6 million in
1997. In addition, changes in working capital, principally payments on accounts
payable and accrued liabilities, used $.9 million of cash in 1997.
The Company used $2.4 million and $5.1 million of cash in 1996 and 1997,
respectively to purchase property and equipment. In 1995, substantially all of
the Company's equipment additions were financed through capital lease
agreements. In addition, $5.0 million, $8.0 million and $.4.million of property
and equipment has been acquired through term lease or credit agreements in 1995,
1996, and 1997, respectively. The capital additions for each of the three years
were a result of the Company's continued expansion of its network. In
particular, capital additions in 1996 and 1997 were primarily in support its
video delivery service plan.
The Company completed its initial public offering in February 1996. The net
proceeds to the Company in 1996 after underwriting discounts and offering
expenses were $29,490,000. The Company raised $16.4 million, net of offering
expenses,
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through its Series A Preferred Stock offering in 1997. The proceeds from these
two offerings have been used in the acquisitions of PDR in November 1996 and
Mediatech in July 1997, as well as to fund the acquisition of property and
equipment, the payment of lease obligations and to fund the continuing
operations of the Company. Approximately, $20.5 million has been invested in the
purchases of PDR and Mediatech and an additional $2.5 million was used to repay
the promissory note payable in November 1997 as a result of the PDR acquisition.
In connection with the July 1997 acquisition of Mediatech, the Company also
issued 324,355 shares of the Company's Common Stock, $3.8 million of promissory
notes, and assumed $5.4 million of term and line of credit debt payable by
Mediatech. As of December 31, 1997, the remaining $8.8 million of the net
proceeds of the offerings were invested in short-term investments and cash and
cash equivalents. See the Notes to the Financial Statements.
The Company, through its Mediatech subsidiary, made net payments on the
Mediatech line of credit of $341,000 between the date of the Mediatech
acquisition and December 31, 1997. As mentioned above, the maximum available
under the Mediatech line is $3,525,000, dependent upon the level of qualifying
receivables maintained by Mediatech and the balance outstanding on the line at
December 31, 1997 was $2,834,000, which was approximately equal to the maximum
available under the agreement at that time
Principal payments on long-term debt were $1.0 million, $2.1 million and
$8.0 million in 1995, 1996, and 1997, respectively, reflecting the increases in
regularly scheduled repayment of the increased capital lease liability incurred
to finance equipment and property acquisitions. Principal payments in 1997 also
included the following scheduled payments: repayment of a $2.5 promissory note
issued in connection with the PDR acquisition, $500,000 of payments on the
promissory notes issued in connection with the Mediatech acquisition and
$346,000 of payments on other long-term debt of Mediatech assumed by the Company
in conjunction with the Mediatech acquisition.
The Company currently has no significant capital commitments other than the
commitments under capital leases and the debt assumed and notes payable issued
in conjunction with the purchase of Mediatech. Based on management's current
plans and forecasts, the Company believes that its existing sources of liquidity
will satisfy the Company's projected working capital, capital lease and term
loan commitments and other cash requirements through December 1998. To provide
additional flexibility for growth and other general corporate purposes, however,
the Company plans to raise additional capital in 1998. See "Certain Business
Considerations -- Future Capital Needs; Uncertainty of Additional Funding."
CERTAIN BUSINESS CONSIDERATIONS
The Company's business is subject to the following risks in addition to
those described elsewhere in this Form 10-K.
History of Losses; Future Operating Results Uncertain. The Company was
founded in 1991 and has been unprofitable since its inception. The Company
expects to continue to generate net losses for a minimum of the next twelve
months. As of December 31, 1997, the Company's accumulated deficit was $42.9
million. The Company has had difficulty in accurately forecasting its future
sales and operating results due to its limited operating history. Accordingly,
although the Company has recently experienced significant growth, a significant
portion of which is due to acquisitions, such growth rates may not be
sustainable and should not be used as an indication of future sales growth, if
any, or of future operating results. The Company's future success also will
depend in part on obtaining continued reductions in delivery and service costs,
particularly continued automation of order processing and reductions in
telecommunications costs. There can be no assurance that the Company's sales
will grow or be sustained in future periods, that the Company will be able to
reduce delivery and service costs, or that the Company will achieve or sustain
profitability in any future period.
Dependence on Electronic Video Advertising Delivery Service Deployment. The
Company has made a substantial investment in upgrading and expanding its network
operating center and populating television stations with the units necessary for
the receipt of electronically delivered video advertising content. However there
can be no assurance that placement of these units will cause this service to
achieve adequate market acceptance among customers which require video
advertising content delivery. The inability to place units in an adequate number
of stations or the inability to capture market share among content delivery
customers as a result of price competition or new product introductions from
competitors would have a material adverse effect on the Company's business,
operating results and financial position. In addition, the Company believes that
in order to more fully address the
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25
needs of potential video delivery customers it will need to develop a set
of ancillary services which typically are provided by dub and ship houses. These
ancillary services, which include physical archiving, closed captioning,
modification of slates and format conversions, will need to be provided on a
localized basis in each of the major cities in which the Company provides
services directly to agencies and advertisers. The Company currently has the
capability to provide such services through its facilities in New York, Los
Angeles and Chicago. However, there can be no assurance that the Company will
successfully contract for and provide these services in each major metropolitan
area or that the Company will be able to provide competitive video distribution
services in other U.S. markets. Unless the Company can successfully continue to
develop and provide video transmission services, it may be unable to retain
current or attract future audio delivery customers who may ultimately demand
delivery of both media content.
Uncertainties Relating to Integration of Operations. DG Systems acquired
PDR and Mediatech with the expectation that such strategic acquisitions would
result in enhanced efficiencies for the combined company. To date the Company
has not fully completed the integration of PDR and Mediatech with the Company.
Achieving the anticipated benefits of the PDR and Mediatech acquisitions will
depend in part upon whether the integration of the organizations and businesses
of PDR and Mediatech with those of the Company is achieved in an efficient,
effective and timely manner; however, there can be no assurance that this will
occur. The successful integration and expansion of the Company's business
following its acquisition of PDR and Mediatech requires communication and
cooperation among the senior executives and key technical personnel of DG
Systems, PDR, and Mediatech. Given the inherent difficulties involved in
completing a business combination, there can be no assurance that such
cooperation will occur or that the integration of the respective organizations
will be successful and will not result in disruptions in one or more sectors of
the Company's business. Failure to effectively accomplish the integration of the
operations of PDR and Mediatech with those of the Company could have a material
adverse effect on DG Systems' results of operations and financial condition. In
addition, there can be no assurance that current and potential customers will
favorably view the Company's services as offered through PDR and Mediatech or
that DG Systems will realize any of the other anticipated benefits of the PDR or
Mediatech acquisitions. Moreover, as a result of these acquisitions, certain DG
Systems customers may perceive PDR or Mediatech to be a competitor, and this
could affect such customers' willingness to do business with DG Systems in the
future. The loss of significant customers could have a material adverse effect
on DG Systems' results of operations and financial condition.
Future Capital Needs; Uncertainty of Additional Funding. The Company
intends to continue making capital expenditures to produce and install RSTs,
RPTs, VRTSs and DVPS units and to introduce additional services. The Company
also continually analyzes the costs and benefits of acquiring certain
businesses, products or technologies that it may from time to time identify, and
its related ability to finance such acquisitions. Assuming that the Company does
not pursue one or more additional acquisitions funded by internal cash reserves,
the Company anticipates its existing capital, cash from operations, and funds
available under existing term loan and line of credit agreements should be
adequate to satisfy its capital requirements through December 1998.
There can be no assurance, however, that the net proceeds of the Company's
initial public offering and such other sources of funding will be sufficient to
satisfy the Company's future capital requirements or that the Company will not
require additional capital sooner than currently anticipated.
Based on its current business plan, the Company anticipates that it will
eventually use the entire proceeds of its initial public offering and the Series
A Convertible Preferred Stock financing and there can be no assurance that other
sources of funding will be adequate to fund the Company's capital needs, which
depend upon numerous factors, including the progress of the Company's product
development activities, the cost of increasing the Company's sales and marketing
activities and the amount of revenues generated from operations, none of which
can be predicted with certainty. In addition, the Company is unable to predict
the precise amount of future capital that it will require, particularly if it
were to pursue one or more acquisitions, and there can be no assurance that any
additional financing will be available to the Company on acceptable terms, or at
all. The inability to obtain financing for acquisitions on acceptable terms may
prevent the Company from completing advantageous acquisitions and consequently
may adversely effect the Company's prospects and future rates of growth. The
inability to obtain required financing for continuing operations or an
acquisition would have a material adverse effect on the Company's business,
financial condition and results of operations. Consequently, the Company could
be required to significantly reduce or suspend its operations, seek a merger
partner or sell additional securities on terms that are highly dilutive to
existing investors.
Dependence on Emerging Markets. The market for the electronic delivery of
digital audio and video transmissions by advertisers, advertising agencies,
production studios, and video and music distributors to radio and
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television stations, is relatively new and alternative technologies are
rapidly evolving. The Company's marketing task requires it to overcome buyer
inertia related to the diffuse and relatively low level decision making
regarding an agency's choice of delivery services and long standing
relationships with existing dub and ship vendors. Therefore, it is difficult to
predict the rate at which the market for the electronic delivery of digital
audio and video transmissions will grow, if at all. If the market fails to grow,
or grows more slowly than anticipated, the Company's business, operating results
and financial condition will be materially adversely affected. Even if the
market does grow, there can be no assurance that the Company's products and
services will achieve commercial success. Although the Company intends to
conform its products and services to meet existing and emerging standards in the
market for the electronic delivery of digital audio and video transmissions,
there can be no assurance that the Company will be able to conform its products
to such standards in a timely fashion, or at all. The Company believes that its
future growth will depend, in part, on its ability to add these services and
additional customers in a timely and cost-effective manner, and there can be no
assurance that the Company will be successful in developing such services, and
in obtaining new customers for such services. See "Dependence on New Product
Introductions." There can also be no assurance that the Company will be
successful in obtaining a sufficient number of radio and television stations,
radio and television networks, advertisers, advertising agencies, production
studios, and audio and video distributors who are willing to bear the costs of
expanding and increasing the integration of the Company's network, including the
Company's field receiving equipment and rooftop satellite antennae.
The Company's marketing efforts to date with regard to the Company's
products and services have involved identification and characterization of
specific market segments for these products and services with a view to
determining the target markets that will be the most receptive to such products
and services. There can be no assurance that the Company has correctly
identified such markets or that its planned products and services will address
the needs of such markets. Furthermore, there can be no assurance that the
Company's technologies, in their current form, will be suitable for specific
applications or that further design modifications, beyond anticipated changes to
accommodate different markets, will not be necessary. Broad commercialization of
the Company's products and services will require the Company to overcome
significant market development hurdles, many of which may not currently be
foreseen.
Dependence on Technological Developments. The market for the distribution
of digital audio and video transmissions is characterized by rapidly changing
technology. The Company's ability to remain competitive and its future success
will depend in significant part upon the technological quality of its products
and processes relative to those of its competitors and its ability both to
develop new and enhanced products and services and to introduce such products
and services at competitive prices and in a timely and cost-effective fashion.
The Company's development efforts have been focused on the areas of satellite
transmission technology, video compression technology, TV station system
interface, and work on reliability and throughput enhancement of the network.
The Company's ability to successfully grow electronic video delivery services
depends on its ability to obtain satellite delivery capability. Work in
satellite technology is oriented to development and deployment of software to
lower transmission costs and increase delivery reliability. Work in video
compression technology is directed toward integration of emerging broadcast
quality compression systems, which further improve picture quality while
increasing the compression ratio, with the Company's existing network. Work in
TV station system interface includes implementation of various system control
protocols and improvement of system throughput and reliability. The Company has
an agreement with Hughes Network Systems, Inc. ("Hughes") which allows the
Company to use Hughes' satellite capacity for electronic delivery of digital
audio and video transmissions by that media. The Company has developed and
incorporated software designed to enable the current DVPSs to receive digital
satellite transmissions over the Hughes satellite system. There can be no
assurance that the Hughes satellite system will have the capacity to meet the
Company's future delivery commitments and broadcast quality requirements and to
do so on a cost-effective basis. See "Dependence on Certain Suppliers."
The introduction of products embodying new technologies can render existing
products obsolete or unmarketable. There can be no assurance that the Company
will be successful in identifying, developing, contracting for the manufacture
of, and marketing product enhancements or new products that respond to
technological change, that the Company will not experience difficulties that
could delay or prevent the successful development, introduction and marketing of
these products, or that its new products and product enhancements will
adequately meet the requirements of the marketplace and achieve market
acceptance. Delays in the commencement of commercial availability of new
products and services and enhancements to existing products and services may
result in customer dissatisfaction and delay or loss of revenue. If the Company
is unable, for other reasons, to develop and introduce new products and services
or enhancements of existing products and services in a timely
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manner or if new versions of existing products do not achieve a significant
degree of market acceptance, there could be a material adverse effect on the
Company's business, financial condition and results of operations.
Dependence on Radio Advertising. Prior to the Company's acquisitions of PDR
and Mediatech, the Company's revenues were derived principally from a single
line of business, the delivery of radio advertising spots from advertising
agencies, production studios and dub and ship houses to radio stations in the
United States, and such services are expected to continue to account for a
significant portion of the Company's revenues for some time. A decline in demand
for, or average selling prices of, the Company's radio advertising delivery
services, whether as a result of competition from new advertising media, new
product introductions or price competition from competitors, a shift in
purchases by customers away from the Company's premium services such as DG
Priority or DG Express, technological change or otherwise, would have a material
adverse effect on the Company's business, operating results and financial
condition. Additionally, the Company is dependent upon its relationship with and
continued support of the radio stations in which it has installed communications
equipment. Should a substantial number of these stations go out of business,
experience a change in ownership, or discontinue the use of the Company's
equipment in any way, it could materially adversely affect the Company's
business, operating results and financial condition.
Ability to Maintain and Improve Service Quality. The Company's business is
dependent on its ability to make cost-effective deliveries to broadcast stations
within the time periods requested by customers. Any failure to do so, whether or
not within the control of the Company, could result in an advertisement not
being run and in the station losing air-time which it could have otherwise sold.
Although the Company disclaims any liability for lost air-time, there can be no
assurance that claims by stations for lost air-time would not be asserted in
these circumstances or that dissatisfied advertisers would refuse to make
further deliveries through the Company in the event of a significant occurrence
of lost deliveries, either of which would have a material adverse that effect on
the Company's business, results of operations and financial condition. Although
the Company maintains insurance against business interruption, there can be no
assurance that such insurance will be adequate to protect the Company from
significant loss in these circumstances or that a major catastrophe (such as an
earthquake or other natural disaster) would not result in a prolonged
interruption of the Company's business. In particular, the Company's network
operating center is located in the San Francisco Bay area, which has in the past
and may in the future experience significant, destructive seismic activity that
could damage or destroy the Company's network operating center. In addition, the
Company's ability to make deliveries to stations within the time periods
requested by customers depends on a number of factors, some of which are outside
of its control, including equipment failure, interruption in services by
telecommunications service providers, and the Company's inability to maintain
its installed base of RSTs, RPTs, VRTSs and DVPS video units that comprise its
distribution network. The result of the Company's failure to make timely
deliveries for whatever reason could be that dissatisfied advertisers would
refuse to make further deliveries through the Company which would have a
material adverse effect on the Company's business, results of operations and
financial condition.
Competition. The Company currently competes in the market for the
distribution of audio advertising spots to radio stations and the distribution
of video advertising spots to television stations. The principal competitive
factors affecting these markets are ease of use, price, timeliness and accuracy
of delivery. The Company competes with a variety of dub and ship houses and
production studios that have traditionally distributed taped advertising spots
via physical delivery. Although such dub and ship houses and production studios
do not currently offer electronic delivery, they have long-standing ties to
local distributors that will be difficult for the Company to replace. Some of
these dub and ship houses and production studios have greater financial,
distribution and marketing resources and have achieved a higher level of brand
recognition than the Company. Moreover, Digital Courier International
Corporation has deployed a system to electronically deliver audio content in
Canada and the United States and several other companies have announced such
systems. As a result, there can be no assurance that the Company will be able to
compete effectively against these competitors merely on the basis of ease of
use, timeliness and accuracy of delivery.
In the market for the distribution of video content to television stations,
the Company encounters competition from VDI Media and Vyvx Advertising
Distribution Services ("VADS"), a subsidiary of The Williams Companies which
includes CycleSat, Inc., in addition to dub and ship houses and production
studios, certain of which currently function as marketing partners with the
Company in the audio distribution market. To the extent that the Company is
successful in entering new markets, such as the delivery of other forms of
content to radio and television stations
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28
and content delivery to radio and television stations, it would expect to face
competition from companies in related communications markets and/or package
delivery markets which could offer products and services with functionality
similar or superior to that offered by the Company's products and services.
Telecommunications providers such as AT&T, MCI and Regional Bell Operating
Companies could also enter the market as competitors with materially lower
electronic delivery transportation costs. The Company could also face
competition from entities with package delivery expertise such as Federal
Express, United Parcel Service, DHL and Airborne if any such companies enter the
electronic data delivery market. Radio networks such as ABC or Westwood One
could also become competitors by selling and transmitting advertisements as a
complement to their content programming. In addition, Applied Graphics
Technologies, Inc., a provider of digital pre-press services, has indicated its
intention to provide electronic distribution services and acquired Spotlink, a
dub and ship house and current customer of the Company, in December 1996 as an
entry to this market. In 1997, Applied Graphics is reported to have acquired
additional dub and ship operations.
Many of the Company's current and potential competitors in the markets for
audio and video transmissions have substantially greater financial, technical,
marketing and other resources and larger installed customer bases than the
Company. There can be no assurance that the Company will be able to compete
successfully against current and future competitors based on these and other
factors. The Company expects that an increasingly competitive environment will
result in price reductions that could result in reduced unit profit margins and
loss of market share, all of which would have a material adverse effect on the
Company's business, results of operations and financial condition. Moreover, the
market for the distribution of audio and video transmissions has become
increasingly concentrated in recent years as a result of acquisitions, which are
likely to permit many of the Company's competitors to devote significantly
greater resources to the development and marketing of new competitive products
and services. The Company expects that competition will increase substantially
as a result of these and other industry consolidations and alliances, as well as
the emergence of new competitors. There can be no assurance that the Company
will be able to compete successfully with new or existing competitors or that
competitive pressures faced by the Company will not materially and adversely
affect its business, operating results and financial condition.
Ability to Manage Growth. The Company has recently experienced a period of
rapid growth that has resulted in new and increased responsibilities for
management personnel and has placed and continues to place a significant strain
on the Company's management, operating and financial systems and resources. To
accommodate this recent growth and to compete effectively and manage future
growth, if any, the Company will be required to continue to implement and
improve its operational, financial and management information systems,
procedures and controls on a timely basis and to expand, train, motivate and
manage its work force. In particular, the Company believes that to achieve these
objectives it must complete the automation of the customer order entry process
and the integration of the delivery fulfillment process into the customer
billing system and integrate these systems with those of PDR and Mediatech.
There can be no assurance that the Company's personnel, systems, procedures and
controls will be adequate to support the Company's existing and future
operations. Any failure to implement and improve the Company's operational,
financial and management systems or to expand, train, motivate or manage
employees could have a material adverse effect on the Company's business,
operating results and financial condition.
Potential Fluctuations in Quarterly Results; Seasonality. The Company's
quarterly operating results have in the past and may in the future vary
significantly depending on factors such as the volume of advertising in response
to seasonal buying patterns, the timing of new product and service
introductions, increased competition, the timing of the Company's promotional
efforts, general economic factors, and other factors. For example, the Company
has historically experienced lower sales in the first quarter and higher sales
in the fourth quarter, due to increased customer advertising volumes for the
Christmas selling season. As a result, the Company believes that period to
period comparisons of its results of operations are not necessarily meaningful
and should not be relied upon as an indication of future performance. In any
period, the Company's revenues and delivery costs are subject to variation based
on changes in the volume and mix of deliveries performed during the period. In
particular, the Company's operating results have historically been significantly
influenced by the volume of deliveries ordered by television stations during the
"Sweeps" rating periods that currently take place in February, May, August and
November. The increased volume of these deliveries during such periods and the
Company's pricing for "Sweeps" advertisements have historically increased the
total revenues and revenues per delivery of the Company and tended to reduce
delivery costs as a percentage of revenues. The Company's expense levels are
based, in part, on its expectations of future sales levels. If sales levels are
below expectations, operating results are likely to be materially adversely
affected. In addition, the Company has historically operated with little or no
backlog. The absence of backlog
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29
increases the difficulty of predicting sales and operating results. Fluctuations
in sales due to seasonality may become more pronounced as the growth rate of the
Company's sales slows. Due to the unique nature of the Company's products and
services, the Company believes that it will incur significant expenses for sales
and marketing, including advertising, to educate potential customers about such
products and services.
Dependence on Key Personnel. The Company's success depends to a significant
degree upon the continuing contributions of, and on its ability to attract and
retain, qualified management, sales, operations, marketing and technical
personnel. The competition for qualified personnel, particularly engineering
staff, is intense and the loss of any of such persons, as well as the failure to
recruit additional key personnel in a timely manner, could adversely affect the
Company. There can be no assurance that the Company will be able to continue to
attract and retain qualified management, sales and technical personnel for the
development of its business. The Company generally has not entered into
employment or noncompetition agreements with any of its employees. The Company
does not maintain key man life insurance on the lives of any of its key
personnel. The Company's failure to attract and retain key personnel could have
a material adverse effect on its business, operating results and financial
condition.
Dependence on Certain Suppliers. The Company relies on certain single or
limited-source suppliers for certain integral components used for the assembly
of the Company's audio and video units. Although the Company's suppliers are
generally large, well-financed organizations, in the event that a supplier were
to experience financial or operational difficulties that resulted in a reduction
or interruption in component supply to the Company, it would delay the Company's
deployment of audio and video units which would have the effect of depressing
the Company's business until the Company established sufficient component supply
through an alternative source. The Company believes that there are alternative
component manufacturers that could supply the components required to produce the
Company's products, but the Company is not currently pursuing agreements or
understandings with such alternative sources. If a reduction or interruption of
supply were to occur, it could take a significant period of time for the Company
to qualify an alternative subcontractor, redesign its products as necessary and
contract for the manufacture of such products. The Company does not have
long-term supply contracts with its sole- or limited-source vendors and
purchases its components on a purchase order basis. The Company has experienced
component shortages in the past and there can be no assurance that material
component shortages or production or delivery delays will not occur in the
future. The inability in the future to obtain sufficient quantities of
components in a timely manner as required, or to develop alternative sources as
required, could result in delays or reductions in product shipments or product
redesigns, which would materially and adversely affect the Company's business,
operating results and financial condition.
Pursuant to its development efforts in the area of satellite transmission
technology, the Company has successfully completed live field trials of software
designed to enhance and enable the current RPTs to receive digital satellite
transmissions over the Hughes satellite system. The Company's dependence on
Hughes entails a number of significant risks. The Company's business, results of
operations and financial condition would be materially adversely affected if
Hughes were unable for any reason to continue meeting the Company's delivery
commitments on a cost-effective basis or if any transmissions failed to satisfy
the Company's quality requirements. In the event that the Company were unable to
continue to use Hughes' satellite capacity, the Company would have to identify,
qualify and transition deliveries to an acceptable alternative satellite
transmission vendor. This identification, qualification and transition process
could take nine months or longer, and no assurance can be given that an
alternative satellite transmission vendor would be available to the Company or
be in a position to satisfy the Company's delivery requirements on a timely and
cost-effective basis.
The Company obtains its local access telephone transmission services
through Teleport Communications Group. The Company obtains its long distance
telephone access through an exclusive contract with MCI. During 1997, the
Company renegotiated its agreement, which now expires in 2001. Any material
interruption in the supply or a material adverse change in the price of either
local access or long distance carrier service could have a material adverse
effect on the Company's business, results of operations and financial condition.
Dependence on New Product Introductions. The Company's future growth
depends on its successful and timely introduction of new products and services
in markets that do not currently exist or are just emerging. The Company's goals
are to introduce new services, such as media archiving and the ability to
quickly and reliably give an agency the ability to preview and authorize
electronic delivery of video advertising spots. There can be no assurance that
the Company will successfully complete development of such products and
services, or that if any such development is completed, that the Company's
planned introduction of these products and services will realize market
acceptance or will meet the technical or other requirements of potential
customers.
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Dependence on Proprietary Technology, Protection of Trademarks, Copyrights,
and Other Proprietary Information; Risk of Third Party Claims of Infringement.
The Company considers its trademarks, copyrights, advertising, and promotion
design and artwork to be of value and important to its business. The Company
relies on a combination of trade secret, copyright and trademark laws and
nondisclosure and other arrangements to protect its proprietary rights. The
Company does not have any patents or patent applications pending. Despite the
Company's efforts to protect its proprietary rights, unauthorized parties may
attempt to copy or obtain and use information that the Company regards as
proprietary. There can be no assurance that the steps taken by the Company to
protect its proprietary information will prevent misappropriation of such
information and such protection may not preclude competitors from developing
confusingly similar brand names or promotional materials or developing products
and services similar to those of the Company. In addition, the laws of some
foreign countries do not protect the Company's proprietary rights to the same
extent as do the laws of the United States. While the Company believes that its
trademarks, copyrights, advertising and promotion design and artwork do not
infringe upon the proprietary rights of third parties, there can be no assurance
that the Company will not receive future communications from third parties
asserting that the Company's trademarks, copyrights, advertising and promotion
design and artwork infringe, or may infringe, on the proprietary rights of third
parties. Any such claims, with or without merit, could be time-consuming,
require the Company to enter into royalty arrangements or result in costly
litigation and diversion of management personnel. No assurance can be given that
any necessary licenses can be obtained or that, if obtainable, such licenses can
be obtained on commercially reasonable terms. In the event of a successful claim
of infringement against the Company and failure or inability of the Company to
license the infringed or similar proprietary information, the Company's
business, operating results and financial condition could be materially
adversely affected.
Year 2000 Risk Compliance. Many currently installed computer systems and
software products are coded to accept only two digit entries in the date code
field. Beginning in the year 2000, these date codes fields will need to accept
four digit entries to distinguish 21st century dates from 20th century dates. As
a result, in less than two years, many such currently installed computer systems
and software products used by many companies will need to be upgraded to enable
such systems and computer hardware and software products to avoid the potential
effects associated with this year 2000 coding problem. Although the Company has
begun taking the steps it believes are necessary to make its network and other
systems year 2000 compliant and despite the Company's belief that it utilizes
the most recently available hardware and software products of leading industry
providers, whom the Company believes are allocating significant resources to
address and resolve these issues, there can be no assurance that the Company's
computer hardware and software products will contain all necessary code changes
in their date code fields to avoid any or all damaging interruptions and other
problems associated with date entry limitations.
The Company believes that the purchasing pattern of its current and
potential customers may be affected by the year 2000 problem described above in
a variety of ways. For example, as the year 2000 approaches, some of the
Company's current customers may develop concerns about the reliability of the
Company's electronic delivery services and, as a result, shift their delivery
work to less technical dub and ship operations. Likewise, some potential
customers of the Company with the same concern may elect not to utilize the
Company's electronic delivery services until after year 2000 and beyond. If any
current customers of the Company shift some or all of their delivery work to
other delivery providers, the Company's business, financial condition and
results of operations will be adversely affected, and if any potential customers
elect to not utilize the Company's delivery services for any period of time on
the basis of year 2000 concerns, the Company's business and financial prospects
for growth could be adversely affected. In addition to the foregoing, in the
event that the Company does experience interruptions and problems with its
computer hardware and software products due to year 2000 limitations of such
products, some or all of the Company's current customers may shift some or all
of their delivery work to other delivery providers without year 2000 problems.
Moreover, potential customers of the Company may elect not to utilize the
Company's delivery services in the event of any such interruptions and problems.
Any of the foregoing could have a material adverse affect on the Company's
business, financial condition and results of operations.
Expansion into International Markets. Although the Company's long-term
plans include expansion of its operations to Europe and Asia, it does not at
present have network operating center personnel experienced in operating in
these locations. Telecommunications standards in foreign countries differ from
those in the United States and may work require the Company to incur substantial
costs and expend significant managerial resources to obtain any necessary
regulatory approvals and comply with differing equipment interface and
installation standards promulgated by regulatory authorities of those countries.
Changes in government policies, regulations and telecommunications systems in
foreign countries could require the Company's products and services to be
redesigned, causing product and service delivery delays that could materially
adversely affect the Company's operating results. The Company's ability to
successfully enter these new markets will depend, in part, on its ability to
attract personnel with experience in these locations and to attract partners
with the necessary local business relationships. There can be no assurance,
however, that the Company's products and services will achieve market acceptance
in foreign countries. The inability of the Company to successfully establish and
expand its international operations may also limit its ability to obtain
significant international revenues and could materially adversely affect the
business, operating results and financial condition of the Company. Furthermore,
international business is subject to a number of country-specific risks and
circumstances, including different tax laws, difficulties in expatriating
profits, currency exchange rate fluctuations, and the complexities of
administering business abroad. Moreover, to the extent the Company increases its
international sales, the Company's business, operating results and financial
condition could be materially adversely affected by these risks and
circumstances, as well as by increases in duties, price controls or other
restrictions on foreign currencies, and trade barriers imposed by foreign
governments, among other factors.
Concentration of Stock Ownership; Antitakeover Provisions. The present
executive officers and directors of the Company and their respective affiliates
own approximately 46% of the Company's Common Stock and recently-issued Series A
Convertible Preferred Stock, which votes together with Common Stock on all
matters submitted to the shareholders of the Company. As a result, these
shareholders will be able to control or significantly influence all matters
requiring shareholder approval, including the election of directors and the
approval of significant corporate transactions. Such concentration of ownership
may have the effect of delaying or preventing a change in control of the
Company. Furthermore, certain provisions of the Company's Amended and Restated
Articles of Incorporation and Bylaws, and of California law, could have the
effect of delaying, deferring or preventing a change in control of the Company.
Preferential Rights of Outstanding Preferred Stock. The Company has
issued and outstanding 4,950,495
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shares of its Series A Convertible Preferred Stock (the "Series A Preferred").
The rights of the Series A Preferred include certain rights and preferences set
forth in the Company's Certificate of Determination of Rights of Series A
Convertible Preferred Stock, which rights could materially limit or qualify the
rights of holders of the Company's Common Stock and have a material adverse
effect on the prevailing market price of the Common Stock. Such rights include,
without limitation, the right to participate, on an as converted basis, in any
and all dividends declared or paid, or set aside for payment, in respect of
outstanding shares of the Company's Common Stock. The rights of the Series A
Preferred also include the right to receive payment prior to any payment to the
holders of the Company's Common Stock, in a per share amount equal to the
purchase price paid per share of the Series A Preferred in the event of any
voluntary or involuntary liquidation, distribution of assets (other than payment
of dividends), dissolution or winding up of the affairs of the Company. In
addition, the Series A Preferred have special voting rights which enable the
holders thereof to designate one member of the Board of Directors of the Company
for election by the holders of the Series A Preferred. The rights of the holders
of Common Stock are subject to, and may be adversely affected by, the rights of
the holders of Series A Preferred, which in turn could adversely affect the
prevailing market price for the Company's Common Stock.
The Series A Preferred is convertible, at the option of the holder, into
shares of the Company's Common Stock. The Series A Preferred also will
automatically convert into shares of the Company's Common Stock upon the
satisfaction of certain conditions. The Series A Preferred, and the shares of
Common Stock issuable upon the conversion of such shares of Series A Preferred,
are "restricted securities" as that term is defined in Rule 144 promulgated by
the Securities and Exchange Commission under the Securities Act of 1933, as
amended. Accordingly, such shares, if sold pursuant to Rule 144, will be subject
to the resale provisions applicable to restricted securities under Rule 144. The
availability for sale, as well as actual sales, of the Company's Common Stock
issuable or issued upon the conversion of the Series A Preferred may depress the
prevailing market price for the Common Stock and could adversely affect the
terms upon which the Company would be able to obtain additional equity
financing.
Possible Volatility of Share Price. The trading prices of the Company's
Common Stock may be subject to wide fluctuations in response to a number of
factors, including variations in operating results, changes in earnings
estimates by securities analysts, announcements of extraordinary events such as
litigation or acquisitions, announcements of technological innovations or new
products or services by the Company or its competitors, as well as general
economic, political and market conditions. In addition, stock markets have
experienced extreme price and volume trading volatility in recent years. This
volatility has had a substantial effect on the market prices of the securities
of many high technology companies for reasons frequently unrelated to the
operating performance of specific companies. These broad market fluctuations may
adversely affect the market price of the Company's Common Stock.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this Item is set forth in the Company's
Consolidated Financial Statements and the Notes thereto beginning at Page F-1 of
this Form 10-K.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
Not applicable.
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PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this Item with respect to the Company's
directors is incorporated by reference to the information contained in the
section captioned "Proposal One -- Election of Directors by Common Shareholders"
and "Proposal Two -- Election of Director by Preferred Shareholders." in the
definitive proxy statement filed with the Securities and Exchange Commission by
the Company for its 1998 Annual Meeting of Shareholders (the "Proxy Statement").
For information with respect to executive officers of the Company, see Item 4A.
of this Form 10-K.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference from the
section captioned "Executive Compensation" contained in the Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is incorporated by reference from the
section captioned "Security Ownership of Certain Beneficial Owners and
Management" contained in the Proxy Statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item is incorporated by reference to the
information contained in the sections captioned "Compensation Committee
Interlocks and Insider Participation" and "Certain Transactions with Management"
contained in the Proxy Statement.
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PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) 1. FINANCIAL STATEMENTS
The following financial statements are filed as part of this Report:
PAGE
----
Report of Arthur Andersen LLP, Independent Public Accountants F-2
Consolidated Balance Sheets ................................. F-3
Consolidated Statements of Operations ....................... F-4
Consolidated Statements of Stockholders' Equity ............. F-5
Consolidated Statements of Cash Flows ....................... F-6
Notes to Consolidated Financial Statements .................. F-7
(a) 2. FINANCIAL STATEMENT SCHEDULES
II - Valuation and Qualifying Accounts ...................... S-1
ITEM 14 (CONTINUED). EXHIBITS AND REPORTS ON FORM 8-K
(a) 3. EXHIBITS
EXHIBIT
NUMBER EXHIBIT TITLE
------- -------------
3.1.1(d) Restated Articles of Incorporation of registrant.
3.1.2(h) Certificate of Determination of Rights of Series A Convertible
Preferred Stock of Digital Generation Systems, Inc., filed by
the Secretary of State of the State of California on July 16,
1997.
3.2(b) Bylaws of registrant, as amended to date.
4.1(b) Form of Lock-Up Agreement.
4.2(b) Form of Common Stock Certificate.
10.1(b) 1992 Stock Option Plan (as amended) and forms of Incentive
Stock Option Agreement and Nonstatutory Stock Option
Agreement.
10.2(b) Form of Directors' and Officers' Indemnification Agreement.
10.3(b) 1995 Director Option Plan and form of Incentive Stock Option
Agreement thereto.
10.4(b) Form of Restricted Stock Agreement.
10.5.1(c) Content Delivery Agreement between the Company and Hughes
Network Systems, Inc., dated November 28, 1995.
10.5.2(c) Equipment Reseller Agreement between the Company and Hughes
Network Systems, Inc., dated November 28, 1995.
10.6(b) Amendment to Warrant Agreement between the Company and
Comdisco, Inc., dated January 31, 1996.
10.7(j) Special Customer Agreement between the Company and MCI
Telecommunications Corporation, dated May 5, 1997.
10.8(b) Master Lease Agreement between the Company and Comdisco, Inc.,
dated October 20, 1994, and Exhibits thereto.
10.9(b) Loan and Security Agreement between the Company and Comdisco,
Inc., dated October 20, 1994, and Exhibits thereto.
10.10(b) Master Equipment Lease between the Company and Phoenix
Leasing, Inc., dated January 7, 1993.
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34
EXHIBIT
NUMBER EXHIBIT TITLE
------- -------------
10.15(c) Audio Server Network Prototype Vendor Agreement and Satellite
Vendor Agreement between the Company and ABC Radio Networks,
dated December 15, 1995.
10.17(b) Promissory Note between the Company and Henry W. Donaldson,
dated March 18, 1994, December 5, 1994, December 5, 1994, and
March 14, 1995.
10.18(b) Warrant Agreement to purchase Series B Preferred Stock between
the Company and Comdisco, Inc., dated as of October 20, 1994.
10.19(b) Warrant Agreement to purchase Series C Preferred Stock between
the Company and Comdisco, Inc., dated as of June 13, 1995.
10.20(b) Warrant Agreement to purchase Series D Preferred Stock between
the Company and Comdisco, Inc., dated as of January 11, 1996.
10.22(d) Agreement of Sublease for 9,434 rentable square feet at 855
Battery Street, San Francisco, California between the Company
and T.Y. Lin International dated September 8, 1995 and
exhibits thereto.
10.23(d) Agreement of Sublease for 5,613 rentable square feet at 855
Battery Street, San Francisco, California between the Company
and Law/Crandall, Inc. dated September 29, 1995 and exhibits
thereto.
10.24(e) Digital Generation Systems, Inc. Supplemental Stock Option
Plan.
10.25(e) Stock Purchase Agreement by and among Digital Generation
Systems, Inc. and PDR Productions, Inc. and Pat DeRosa dated
as of October 15, 1996 and exhibits thereto.
10.26(f) Amendment to Stock Purchase Agreement dated November 8, 1996,
among Digital Generation Systems, Inc., and Pat DeRosa.
10.27(h) Loan Agreement dated as of January 28, 1997 between Digital
Generation Systems, Inc. as Borrower, and Venture Lending and
Leasing, Inc. as Lender and exhibits thereto.
10.28(i) Stock Purchase Agreement, dated as of July 18, 1997, by and
between Digital Generation Systems, Inc., a California
corporation, IndeNet, Inc., a Delaware Corporation, and
exhibits thereto.
10.29(i) Preferred Stock Purchase Agreement, dated as of July 14, 1997,
by and among Digital Generation Systems, Inc. and the parties
listed on the Schedule of Purchasers attached, as Exhibit A
thereto.
10.30(i) Amendment to Preferred Stock Purchase Agreement, dated as of
July 23, 1997, by and among Digital Generation Systems, Inc.
and the purchasers listed on the Exhibit A thereto.
10.31(a) Loan Agreement dated as of December 1, 1997 between Digital
Generation Systems, Inc. as Borrower, and Venture Lending and
Leasing, Inc. as Lender and exhibits thereto.
10.32(a) First Amendment to Loan Agreement dated as of January 28, 1997
between Digital Generation Systems, Inc. as Borrower, and
Venture Lending and Leasing, Inc. as Lender and exhibits
thereto.
11.1(a) Statements of computation of weighted average common shares.
21.1(a) Subsidiaries of the Registrant.
23.1(a) Consent of Independent Public Accountants.
27 (a) Financial Data Schedule.
27.96(a) Restated Financial Data Schedule for year ended December
31, 1996.
27.961(a) Restated Financial Data Schedule for quarter ended March
31, 1996.
- - ----------
(a) Filed herewith.
(b) Incorporated by reference to the exhibit bearing the same number filed
with registrant's Registration Statement on Form S-1 (Registration No.
33-80203).
(c) Incorporated by reference to the exhibit bearing the same number filed
with registrant's Registration Statement on Form S-1 (Registration No.
33-80203). The registrant has received confidential treatment with
respect to certain portions of this exhibit. Such portions have been
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35
omitted from this exhibit and have been filed separately with the
Securities and Exchange Commission.
(d) Incorporated by reference to the exhibit bearing the same number filed
with registrant's Quarterly Report on Form 10-Q filed May 3, 1996, as
amended.
(e) Incorporated by reference to the exhibit bearing the same number filed
with registrant's Quarterly report on Form 10-Q filed November 13, 1996.
(f) Incorporated by reference to the exhibit bearing the same title filed
with registrant's Current Report on Form 8-K/A filed January 21, 1997.
(g) Incorporated by reference to the exhibit bearing the same number filed
with registrant's Annual Report on Form 10-K filed March 18, 1997.
(h) Incorporated by reference to the exhibit bearing the same number filed
with registrant's quarterly report on Form 10-Q filed May 15, 1997.
(i) Incorporated by reference to the exhibit bearing the same title filed
with registrant's Form 8-K filed August 1, 1997.
(j) Incorporated by reference to the exhibit bearing the same title filed
with registrant's Quarterly report on Form 10-Q filed August 14, 1997.
Confidential treatment has been requested with respect to certain
portions of this exhibit pursuant to a request for confidential
treatment filed with the Securities and Exchange Commission. Omitted
portions have been filed separately with the Commission.
(b) Reports on Form 8-K
(1) Current Report on Form 8-K/A-3 filed on November 7, 1997, reporting
a post-closing adjustment to the purchase price for the acquisition of
Mediatech.
(2) Current Report on Form 8-K/A-4 filed on January 8, 1998, reporting
the release of Series A proceeds held in escrow to the registrant.
(c) EXHIBITS
See items 14 (a) (3) above
(d) FINANCIAL STATEMENT SCHEDULES
Financial Statement Schedules. See Item 14(a) (2) above.
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36
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.
DIGITAL GENERATION SYSTEMS, INC.
Dated: March 31, 1998 By: /s/ Henry W. Donaldson
-------------------------------
Henry W. Donaldson
President and Chief Executive
Officer
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below hereby constitutes and appoints Henry W. Donaldson as his
attorney-in-fact, with full power of substitution for him in any and all
capacities, to sign any and all amendments to this report on Form 10-K, and to
file the same, with exhibits thereto, and other documents in connection
therewith, with the Securities and Exchange Commission.
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
Signature Title Date
--------- ----- ----
/s/ Henry W. Donaldson March 31, 1998
- - ----------------------------- President, Chief Executive Officer and
Henry W. Donaldson Director (Principal Executive Officer)
/s/ Paul W. Emery, II
- - ----------------------------- Chief Financial Officer March 31, 1998
Paul W. Emery, II (Principal Financial and Accounting
Officer)
/s/ Kevin R. Compton
- - ----------------------------- Director March 31, 1998
Kevin R. Compton
/s/ Jeffrey M. Drazan
- - ----------------------------- Director March 31, 1998
Jeffrey M. Drazan
/s/ Richard H. Harris
- - ----------------------------- Director March 31, 1998
Richard H. Harris
/s/ Lawrence D. Lenihan, Jr.
- - ----------------------------- Director March 31, 1998
Lawrence D. Lenihan, Jr.
/s/ Leonard S. Matthews
- - ----------------------------- Director March 31, 1998
Leonard S. Matthews
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DIGITAL GENERATION SYSTEMS, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Public Accountants ............................. F-2
Consolidated Balance Sheets as of December 31, 1997 and 1996 ........ F-3
Consolidated Statements of Operations for the three years ended
December 31, 1997 .................................................... F-4
Consolidated Statements of Shareholders' Equity for the three years
ended December 31, 1997 .............................................. F-5
Consolidated Statements of Cash Flows for the three years ended
December 31, 1997 .................................................... F-6
Notes to Consolidated Financial Statements ........................... F-7
F-1
38
DIGITAL GENERATION SYSTEMS, INC.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Digital Generation Systems, Inc.:
We have audited the accompanying consolidated balance sheets of Digital
Generation Systems, Inc. (a California Corporation) and subsidiaries as of
December 31, 1997 and 1996, and the related consolidated statements of
operations, shareholders' equity and cash flows for each of the three years in
the period ended December 31, 1997. These financial statements and the schedule
referred to below are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements and
schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards 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. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Digital Generation Systems,
Inc. and subsidiaries as of December 31, 1997 and 1996, and the results of its
operations and its cash flows for each of the three years in the period ended
December 31, 1997, in conformity with generally accepted accounting principles.
Our audits were made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The schedule listed under Item 14(a)2 is
presented for purposes of complying with the Securities and Exchange
Commission's rules and is not a required part of the basic financial statements.
This schedule has been subjected to the auditing procedures applied in our
audits of the basic financial statements and, in our opinion, fairly states in
all material respects the financial data required to be set forth therein in
relation to the basic financial statements taken as a whole.
ARTHUR ANDERSEN LLP
San Jose, California
February 4, 1998
F-2
39
DIGITAL GENERATION SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
DECEMBER 31, DECEMBER 31,
1997 1996
------------ ------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 7,833 $ 9,682
Short-term investments 987 10,915
Accounts receivable, less allowance for doubtful
accounts of $585 in 1997 and $257 in 1996 8,053 3,349
Prepaid expenses and other 649 168
-------- --------
Total current assets 17,522 24,114
-------- --------
PROPERTY AND EQUIPMENT, at cost:
Network equipment 30,405 17,974
Office furniture and equipment 2,963 2,093
Leasehold improvements 506 353
-------- --------
33,874 20,420
Less - Accumulated depreciation and amortization (16,308) (7,790)
-------- --------
Property and equipment, net 17,566 12,630
-------- --------
GOODWILL AND OTHER ASSETS, net 25,609 8,504
-------- --------
$ 60,697 $ 45,248
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 4,506 $ 1,546
Accrued liabilities 3,501 2,174
Line of credit 2,834 --
Note payable from acquisition of PDR -- 2,500
Current portion of long-term debt 7,560 3,694
-------- --------
Total current liabilities 18,401 9,914
-------- --------
LONG-TERM DEBT, net of current portion 11,847 8,495
-------- --------
COMMITMENTS AND CONTINGENCIES (Note 5)
SHAREHOLDERS' EQUITY:
Convertible preferred stock, no par value -
Authorized - 5,000,000 shares
Outstanding - 4,950,495 shares at December 31, 1997
and none outstanding at December 31, 1996 31,561 --
Common stock, no par value - -
Authorized - 30,000,000 shares
Outstanding - 12,122,679 shares at December 31, 1997
and 11,653,625 shares at December 31, 1996 57,123 55,138
Receivable from issuance of common stock (175) (175)
Accumulated deficit (58,060) (28,124)
-------- --------
Total shareholders' equity 30,449 26,839
-------- --------
$ 60,697 $ 45,248
======== ========
The accompanying notes are an integral part of these
consolidated financial statements.
F-3
40
DIGITAL GENERATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
YEARS ENDED DECEMBER 31,
------------------------------------
1997 1996 1995
-------- -------- --------
REVENUES $ 29,175 $ 10,523 $ 5,144
-------- -------- --------
COSTS AND EXPENSES:
Delivery and material costs 11,334 3,084 1,810
Customer operations 11,388 4,164 2,974
Sales and marketing 4,417 3,998 3,406
Research and development 2,473 2,092 1,590
General and administrative 3,169 1,677 1,380
Depreciation and amortization 9,306 4,331 2,345
-------- -------- --------
Total expenses 42,087 19,346 13,505
-------- -------- --------
LOSS FROM OPERATIONS (12,912) (8,823) (8,361)
OTHER INCOME (EXPENSE):
Interest income 744 1,422 417
Interest expense (2,607) (1,726) (836)
-------- -------- --------
NET LOSS $(14,775) $ (9,127) $ (8,780)
======== ======== ========
BASIC AND DILUTED NET LOSS PER COMMON
SHARE (Note 11) $ (2.52) $ (0.87) $ (9.78)
======== ======== ========
WEIGHTED AVERAGE COMMON SHARES 11,893 10,488 898
======== ======== ========
The accompanying notes are an integral part of these
consolidated financial statements.
F-4
41
DIGITAL GENERATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
RECEIVABLE
FROM
CONVERTIBLE ISSUANCE
PREFERRED STOCK COMMON STOCK OF TOTAL
------------------------------------------------- COMMON ACCUMULATED SHAREHOLDERS'
SHARES AMOUNT SHARES AMOUNT STOCK DEFICIT EQUITY
---------- -------- ---------- ------- ----- -------- --------
BALANCE AT DECEMBER 31, 1994 6,692,510 $ 20,690 885,833 $ 106 $ (77) $(10,217) $ 10,502
Issuance of common stock at $.30 to $.60
per share for services rendered -- -- 32,686 13 -- -- 13
Exercise of stock options at $.20 to $.30
per share -- -- 31,185 7 -- -- 7
Sale of common stock at $.60 per
share to a related party -- -- 162,500 98 (98) -- --
Sale of Series D preferred stock at $8.00
per share, net of issuance costs of $19 581,249 4,631 -- -- -- -- 4,631
Net loss -- -- -- -- -- (8,780) (8,780)
---------- -------- ---------- ------- ----- -------- --------
BALANCE AT DECEMBER 31, 1995 7,273,759 25,321 1,112,204 224 (175) (18,997) 6,373
Conversion of preferred stock to common stock (7,273,759) (25,321) 7,273,759 25,321 --
Issuance of common stock in connection
with initial public offering, net of
issuance costs of $1,200 -- -- 3,000,000 29,490 -- -- 29,490
Net exercise of stock warrants for surrender
of 5,839 additional warrants -- -- 29,161 -- -- -- --
Exercise of stock options at $.20 to $7.00
per share -- -- 238,501 103 -- -- 103
Net loss (9,127) (9,127)
---------- -------- ---------- ------- ----- -------- --------
BALANCE AT DECEMBER 31, 1996 -- 0 11,653,625 55,138 (175) (28,124) 26,839
Issuance of Series A preferred stock,
net of issuance costs of $1,100 4,950,495 16,400 16,400
Preferred stock deemed dividend -- 15,161 -- -- -- (15,161) --
Issuance of common stock in connection with
acquisition of Mediatech -- -- 324,355 1,906 -- -- 1,906
Exercise of stock options at $.20 to $5.00
per share -- -- 144,699 79 -- -- 79
Net loss (14,775) (14,775)
---------- -------- ---------- ------- ----- -------- --------
BALANCE AT DECEMBER 31, 1997 4,950,495 $ 31,561 12,122,679 $57,123 $(175) $(58,060) $ 30,449
========== ======== ========== ======= ===== ======== ========
The accompanying notes are an integral part of these
consolidated financial statements.
F-5
42
DIGITAL GENERATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
YEARS ENDED DECEMBER 31,
-------------------------------
1997 1996 1995
-------- -------- -------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $(14,775) $ (9,127) $(8,780)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization 8,519 4,260 2,345
Amortization of goodwill and intangibles 787 71 --
Stock issued for services rendered -- -- 13
Provision for doubtful accounts 246 97 137
Changes in operating assets and liabilities --
Accounts receivable (122) (779) (604)
Prepaid expenses and other assets (212) (27) (841)
Accounts payable and accrued liabilities (751) 1,241 1,128
-------- -------- -------
Net cash used in operating activities (6,308) (4,264) (6,602)
-------- -------- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of short-term investments (8,810) (33,138) --
Maturities of short-term investments 18,738 22,223 --
Acquisition of PDR, net of cash acquired -- (6,394) --
Acquisition of Mediatech, net of cash acquired (13,921) -- --
Acquisition of property and equipment (5,131) (2,417) (13)
-------- -------- -------
Net cash used in investing activities (9,124) (19,726) (13)
-------- -------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock 79 29,593 7
Proceeds from issuance of convertible preferred stock 16,400 -- 4,631
Proceeds from line of credit 7,686 -- --
Payments on line of credit (8,027) -- --
Proceeds from short-term loans used to finance Mediatech acquisition 6,000 -- --
Repayment of short-term loans used to finance Mediatech acquisition (6,000) -- --
Proceeds from issuance of long term debt 5,419 -- --
Payments on long-term debt (7,974) (2,126) (1,039)
-------- -------- -------
Net cash provided by financing activities 13,583 27,467 3,599
-------- -------- -------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (1,849) 3,477 (3,016)
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 9,682 6,205 9,221
-------- -------- -------
CASH AND CASH EQUIVALENTS AT END OF YEAR $ 7,833 $ 9,682 $ 6,205
======== ======== =======
The accompanying notes are an integral part of these
consolidated financial statements.
F-6
43
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. THE COMPANY:
Digital Generation Systems, Inc. (the "Company") was incorporated in 1991.
The Company operates a nationwide multimedia network designed to provide media
distribution and related services to the broadcast industry by linking content
providers to radio and television stations. The Company is primarily a provider
of electronic and physical distribution of audio and video spot advertising to
radio and television stations. The Company primarily generates its revenues from
advertising agencies, production studios.
The Company is subject to certain risks that include, but are not limited
to: the continued development of technology to enhance the delivery and variety
of the Company's services in the most cost-effective manner, including the
successful integration of the operations of its recently acquired subsidiaries;
the ability to compete successfully against current and future competitors; and
dependence on key personnel and the need for additional financing to fund
operations and its capital expenditure requirements. The Company obtains certain
components used in the assembly of the units which are placed at radio and
television stations and production studios from a few single or limited source
suppliers and obtains its primary long distance telephone access through an
exclusive contract with a telephone service provider which expires in 2001. Any
material interruption in these services could have a material adverse effect on
the Company's business. Although the Company believes that alternate vendors can
be obtained, the transition to alternative vendors could have a material adverse
impact on the Company's costs and shipping schedules. The Company regularly
evaluates the remaining life and recoverability of its network equipment. Given
the emerging nature of its markets, it is possible that the Company's estimate
that it will recover the net carrying value of the equipment from future
operations could change in the future.
2. ACQUISITIONS:
PDR ACQUISITION
On November 8, 1996 the Company completed the acquisition of 100% of the
capital stock of PDR Productions, Inc. ("PDR"), a media duplication and
distribution company located in New York City, for consideration totaling $9.0
million. The consideration was $6.5 million in cash and a $2.5 million
promissory note with interest payable at 8%. The note and accrued interest were
paid in November 1997. The acquisition was accounted for as a purchase. The net
book value of assets and liabilities acquired was approximately $1.5 million.
The excess of purchase price and acquisition costs over the net book value of
assets acquired (including customer list, covenant not to compete and goodwill)
of approximately $7.9 million, has been included in Goodwill and Other Assets in
the accompanying consolidated balance sheet and is being amortized over a twenty
year period. Amortization expense of approximately $427,000 and $71,000 is
included in the consolidated statements of operations for the years ended
December 31, 1997 and 1996, respectively. The operating results of PDR have been
included in the consolidated results of the Company from the date of the closing
of the transaction, November 8, 1996.
MEDIATECH ACQUISITION
On July 18, 1997, the Company acquired 100% of the capital stock of
Starcom Mediatech, Inc. ("Mediatech"), a wholly owned subsidiary of IndeNet,
Inc. ("IndeNet"), for consideration totaling approximately $25.8 million
("Mediatech Acquisition"). The consideration consisted of approximately $14.0
million in cash, 324,355 shares of the Company's Common Stock, a $2.2 million
subordinated promissory note bearing interest at 9% payable to IndeNet (the
"Company Note"), a $2.2 million secured subordinated promissory note bearing
interest at 9% payable to Thomas H. Baur, a creditor of IndeNet (the "Baur
Note"), and the Company assumed
F-7
44
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
approximately $5.4 million of existing Mediatech debt. Mediatech is a media
duplication and distribution company whose principal offices are located in
Chicago, Illinois.
On October 27, 1997, as provided for in the purchase agreement, the Company
and IndeNet agreed to reduce the aggregate purchase price by $625,000 based on
Mediatech's financial position at the acquisition date. The Company and IndeNet
entered into an agreement which provides that the adjustment will be made in the
form of a $25,000 immediate cash payment by IndeNet to the Company and a
reduction of the aggregate principal amount payable under the Company Note by an
amount equal to $600,000.
The Mediatech acquisition was accounted for as a purchase. The excess of
purchase price and acquisition costs over the net book value of assets acquired
of approximately $17.8 million, has been included in Goodwill and Other Assets
in the accompanying consolidated balance sheet and is being amortized over a
twenty year period. Amortization of approximately $360,000 is included in the
consolidated statement of operations for the year ended December 31, 1997. The
operating results of Mediatech have been included in the consolidated results of
the Company from the date of the closing of the transaction, July 18, 1997.
Additionally, the Company granted IndeNet the right to request the
registration of the shares received in the transaction under the Securities Act
of 1933, as amended, in the event that the anticipated offering price of a
registered sale of such shares exceeds $500,000 in the aggregate, or in the
event that the Company registers any securities for its own account or the
account of any other security holders of the Company. Such registration rights,
however, may not be exercised until July 14, 1998, and are subject to certain
restrictions resulting from underwriting limitations on the size of a registered
sale of the Company's securities.
The Company Note, as amended, matures on March 31, 2001, and is payable in
installments of $150,000 principal plus accrued interest commencing on December
31, 1997. Subsequent payments are due June 30, 1998; December 31, 1998; and June
30, 1999; to be followed by quarterly payments until the note is paid in full on
March 31, 2001. The Baur Note, which matures on January 1, 2000, is also payable
in installments. The first installment of $350,000 was paid July 30, 1997;
subsequent installments of $200,000 principal plus accrued interest are due
quarterly commencing January 1, 1998.
The Company drew upon two sources of funds to finance the cash portion of
the consideration for the Mediatech Acquisition. An entity affiliated with
Kleiner Perkins Caufield & Byers and another affiliated with Dawson-Samberg
Capital Management, Inc. each provided the Company with a $3.0 million cash loan
in exchange for a promissory note, each in the aggregate principal amount of
$3.0 million and bearing interest at the rate of 10% per annum. The Company
funded the remaining portion of the cash consideration for the Mediatech
Acquisition from its internal cash reserves.
PRO FORMA RESULTS
The following table reflects unaudited pro forma combined results of
operations of the Company including PDR and Mediatech on the basis that the
acquisitions of both PDR and Mediatech had taken place at the beginning of the
first fiscal year presented:
TWELVE MONTHS ENDED
DECEMBER 31,
------------------------
1997 1996
-------- ---------
Revenues ............................ $ 41,121 $ 40,273
Net Loss ............................ (16,414) (13,059)
Basic and Diluted Net Loss Per
Common Share (See Note 11) ........ $ (2.65) $ (1.25)
Number of Shares used in
Computation ....................... 11,893 10,488
F-8
45
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The unaudited pro forma combined results of operations are not
necessarily indicative of the actual results that would have occurred had the
acquisitions of PDR and Mediatech been consummated at the beginning of 1996, or
of future operations of the combined companies under the ownership and
management of the Company.
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
CONSOLIDATION
The consolidated financial statements include the accounts of the
Company and its subsidiaries, PDR and Mediatech, after elimination of
intercompany accounts and transactions.
USE OF ESTIMATES IN PREPARATION OF FINANCIAL STATEMENTS
The preparation of financial statements in conformity with generally
accepted accounting principles 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 AND SHORT-TERM INVESTMENTS
The Company has classified all marketable debt securities as
held-to-maturity and has accounted for these investments using the amortized
cost method. Cash and cash equivalents consist of liquid investments with
original maturities of three months or less. Short-term investments are
marketable securities with original maturities greater than three months and
less than one year. As of December 31, 1997 and December 31, 1996, cash and cash
equivalents and short term investments consist principally of U.S. Treasury
bills and various money market accounts; as a result, the amortized purchase
cost approximates the fair market value.
PROPERTY AND EQUIPMENT
Network equipment includes the network operating center, Record Send
Terminals, Receive Playback Terminals, Video Record Transmission Systems,
Digital Video Playback Systems and the related terminal and system components as
well as audio and video taping and dubbing equipment. The Company depreciates
its property and equipment on a straight-line basis over their estimated useful
lives, generally three years.
SOFTWARE DEVELOPMENT COSTS
Under the criteria set forth in Statement of Financial Accounting Standards
No. 86, "Accounting for the Costs of Computer Software to be Sold, Leased, or
Otherwise Marketed," capitalization of software development costs begins upon
the establishment of technological feasibility of the product. The establishment
of technological feasibility and the ongoing assessment of the recoverability of
these costs requires considerable judgment by management with respect to certain
external factors, including, but not limited to, anticipated future gross
product revenues, estimated economic life, changes in software and hardware
technology and the losses that the Company has incurred to date. Amounts that
could have been capitalized under this statement after consideration of the
above factors were immaterial and, therefore, no software development costs have
been capitalized by the Company to date.
REVENUE RECOGNITION
Revenues for distribution services are recognized for each transaction
on the date audio, video or related information is successfully transmitted from
the Company's operating facilities to the destination ordered.
DELIVERY AND MATERIAL COSTS
Delivery costs consist of fees paid to other service providers for charges
incurred by the Company in the
F-9
46
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
receipt, transmission and delivery of information via the company's distribution
network. Material costs consist primarily of audio and video tape and the
related packaging used in delivery.
CUSTOMER OPERATIONS
Customer operations expenses consist primarily of salaries and the related
overhead costs incurred in performing deliveries and providing services,
including order entry, customer service and assembly and maintenance of the
Company's network equipment.
CONCENTRATION OF CREDIT RISK
Financial instruments which potentially subject the Company to a
concentration of credit risk consist principally of cash and cash equivalents,
short-term investments and accounts receivable. The Company has an investment
policy that limits the amount of credit exposure to any one issuer and restricts
these investments to issuers evaluated as credit worthy.
The Company believes that a concentration of credit risk with respect to
accounts receivable is limited because its customers are geographically
disbursed and the end-users (the customer's clients) are diversified across
industries.
The Company's receivables are principally from advertising agencies, dub
and ship houses, and syndicated programmers. The timing of collections from its
customers is affected by the billing cycle in which the customer bills its
end-users (the customer's clients). The Company provides reserves for credit
losses and such losses have been insignificant.
SUPPLEMENTAL CASH FLOW INFORMATION
Noncash investing and financing activities for 1997, 1996 and 1995
consisted of the following (in thousands):
FOR THE YEAR
ENDED DECEMBER 31,
-------------------------------
1997 1996 1995
------ ------- ------
Property and equipment financed with capitalized lease
obligations ......................................... $ 400 $ 8,028 $5,019
Long term debt used to finance Mediatech acquisition . 3,850 -- --
Common stock issued to finance Mediatech acquisition . 1,906 -- --
Preferred stock deemed dividend ...................... 15,161 -- --
Conversion of preferred stock to common stock ........ -- 25,321
Note payable used to finance PDR acquisition ......... -- 2,500 --
Common stock issued for notes receivable ............. -- -- 98
Common stock issued for services rendered ............ -- -- 13
RECLASSIFICATIONS
Certain amounts in the prior years have been reclassified to conform with
the current year presentation.
F-10
47
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4. ACCRUED LIABILITIES:
Accrued liabilities consist of the following (in thousands):
DECEMBER 31,
------------------
1997 1996
------ ------
Telecommunications costs ......................... $ 769 $ 621
Employee compensation ............................ 734 334
Legal and consulting fees ........................ 706 321
Other ............................................ 1,292 898
------ ------
$3,501 $2,174
====== ======
5. COMMITMENTS AND CONTINGENCIES:
The Company leases its facilities and certain equipment under noncancelable
operating leases. As of December 31, 1997, future minimum annual rental payments
under these leases are as follows (in thousands):
YEAR ENDING DECEMBER 31,
------------------------
1998.............................. $1,139
1999.............................. 1,049
2000.............................. 1,026
2001.............................. 735
2002.............................. 572
Thereafter........................ 1,960
-----
$6,481
======
Rent expense totaled approximately $1,540,000, $477,000 and $361,000 in
1997, 1996 and 1995 respectively.
In addition, as of December 31, 1997 the Company had noncancelable future
minimum purchase commitments with its primary telephone service provider. These
commitments range between $2.4 million and $6.2 million per year and extend
through December 2001.
The Company is subject to legal proceedings and claims, either asserted or
unasserted, which arise in the ordinary course of business from time to time.
While the outcome of these claims cannot be predicted with certainty, management
does not believe that the outcome of any of the pending legal matters will have
a material adverse effect on the Company's consolidated results of operations or
consolidated financial position.
6. LINE OF CREDIT:
Mediatech, a wholly owned subsidiary of the Company, is party to a
financing agreement with a bank which provides a revolving line of credit
available to fund the working capital requirements of Mediatech. The maximum
available to Mediatech under this agreement is $3,525,000, dependent upon the
level of qualifying receivables maintained by Mediatech. The agreement is
collateralized by a security agreement covering substantially all of the assets
of Mediatech and is guaranteed by the Company. The interest rate on advances
under the agreement is the bank's reference rate, approximately equal to the
prime rate, plus 2.25% (10.75% at December 31, 1997) and interest payments are
due monthly. Advances under the agreement are due and payable on demand. The
balance outstanding under this agreement at December 31, 1997 is $2,834,000,
which is approximately equal to the maximum available under the agreement at
that time.
F-11
48
DIGITAL GENERATION SYSTEMS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
7. LONG-TERM DEBT:
The Company has used several lease and loan agreements to finance the
purchase of certain property and equipment. Borrowings are secured by the
equipment. The cost of equipment under lease and term loan obligations at
December 31, 1997 and 1996 was $21,820,000 and $15,648,000 respectively. Related
accumulated depreciation at December 31, 1997 and 1996 was $11,593,000 and
$5,791,000 respectively. These loans have repayment terms of 36 to 60 months per
drawdown and the Company has the option at the end of the terms to purchase the
equipment at mutually agreed upon prices not to exceed 10 to 20% of the
equipment's original cost. As of December 31, 1997, approximately $2.6 million
remained available under these agreements to fund future capital requirements.
Of the balance remaining available at December 31, 1997, $.9 million expires on
June 30, 1998, and $1.7 million expires on December 31, 1998.
In December 1997, the Company entered a new loan agreement to finance an
additional $2 million of equipment purchases and $3.5 million of working capital
through a long-term facility which can be drawn upon through December 1998. As
of December 31, 1997, $300,000 of the equipment purchases discussed above have
been financed through this agreement and no borrowings have been made for
working capital purposes. The agreement has repayment terms consistent with
those discussed above.
In October 1994, the Company signed a $1.6 million secured term note to
finance the purchase of certain equipment. The note is due in monthly
installments of $46,000 through April 1998, with a final payment of the
remainder due in May 1998.
Mediatech, a wholly owned subsidiary of the Company, has long-term debt
outstanding per the terms of a promissory note signed in February 1997. The
remaining principal balance of the note was $2.125 million at December 31, 1997.
The note bears interest at the bank's reference rate, approximately equal to the
prime rate, plus 2.25% (10.75% at December 31, 1997) and principal and interest
payments are due monthly. This note is payable to the same bank which provides
the line of credit discussed in Note 6 and is collateralized by the same
security agreement as the line of credit. In addition the note is also
guaranteed by the Company.
F-12
49
DIGITAL GENERATION SYSTEMS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Future minimum lease and term loan payments as of December 31, 1997, are as
follows (in thousands):
Year Ending December 31,
- - ------------------------
1998.........................................$9,760
1999......................................... 7,959
2000......................................... 4,619
2001......................................... 709
2002......................................... 127
------
Total minimum debt payments 23,174
Less -- Amount representing interest
(effective interest rates ranging from
9 percent to 19 percent) ................... (3,767)
-------
Present value of minimum lease payments .... 19,407
Less -- Current portion .................... (7,560)
-------
Long-term portion ..........................$11,847
=======
Interest paid was $2,502,000, $1,716,000 and $766,000 in 1997, 1996 and
1995, respectively.
8. CAPITAL STOCK:
COMMON STOCK
In January 1996, the shareholders approved a one-for-two reverse split
of the Company's preferred and common stock. All share and per share amounts in
the accompanying financial statements have been adjusted retroactively to give
effect to this reverse stock split.
In February 1996, the Company completed the initial public offering of
its common stock. The Company sold 3,000,000 shares for net proceeds of
$29,490,000. Concurrent with the closing of the initial public offering
7,273,759 shares of convertible preferred stock and warrants to purchase 29,161
shares of preferred stock were converted into an equivalent number of shares of
common stock.
As of December 31, 1997, the Company has reserved the following shares
of common stock for future issuance:
Number
of Shares
---------
1992 Stock Option Plan .................................................... 2,015,458
1996 Supplemental Stock Option Plan ....................................... 750,000
Stock warrants ............................................................ 492,177
1995 Director Option Plan ................................................. 100,000
Common stock to be issued as incentives to certain dealers
and distributors......................................................... 20,000
---------
Total potential shares ............................................... 3,377,635
F-13
50
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SERIES A CONVERTIBLE PREFERRED STOCK
During 1997, the Company issued 4,950,495 shares of its Series A
Convertible Preferred Stock (the ''Series A Preferred''). The Series A Preferred
include certain rights and preferences. Such rights include, without limitation,
the right to participate, on an as converted basis, in any and all dividends
declared or paid, or set aside for payment, in respect of outstanding shares of
the Company's Common Stock. The rights of the Series A Preferred also include
the right to receive a payment, prior to any payment to the holders of the
Company's Common Stock, in a per share amount equal to the purchase price paid
per share of Series A Preferred in the event of any voluntary or involuntary
liquidation, distribution of assets (other than a payment of dividends),
dissolution or winding up of the affairs of the Company. The Series A Preferred
has voting rights equivalent to the number of shares of common stock into which
the preferred shares may be converted. In addition, the Series A Preferred has
certain special voting rights which enable the holders thereof to designate one
member of the Board of Directors of the Company for election by the holders of
the Series A Preferred. Finally, the Series A Preferred is convertible, at the
option of the holder thereof, into one share of common stock, or converts
automatically based on a defined conversion ratio in certain circumstances as
defined in the Series A Preferred agreement.
The Series A Preferred was issued at less than the publicly traded price
per share. The difference between the publicly traded price per share and the
sales price per share has been reflected as a deemed dividend to the preferred
shareholders in the accompanying consolidated statements of shareholders'
equity.
WARRANTS
In connection with certain financing and leasing transactions made in 1993
through 1996, the Company issued warrants to purchase at fair market value an
aggregate of 35,000 shares of Series A preferred stock at a range of $2.00 to
$3.00 per share in January 1993 and April 1994, 71,174 shares of Series B
preferred stock at $2.70 per share in October 1994, 60,000 shares of Series C
preferred stock at $6.00 per share in June 1995 and 67,500 shares of Series D
preferred stock at $8.00 per share in January 1996. On December 31, 1995,
warrants to purchase 15,000 shares of Series C preferred stock were canceled
pursuant to the terms of the warrant agreement. A total of 29,161 of the Series
A warrants were exercised in return for surrender of the remaining 5,839
warrants upon the closing of the Company's initial public offering in February
1996. The remaining Series B, C and D warrants, which expire on the earlier of
ten years from the date of the related warrant agreement or five years from the
effective date of the Company's initial public offering, were converted to
warrants for common stock of the Company as per the conversion terms of the
agreements.
In December 1996, the Company issued 9,351 warrants to purchase common
stock at $8.02 per share in connection with an increase in an existing lease
line. The warrants expire in 2006.
In January 1997, the Company completed an agreement to finance an
additional $6.0 million of equipment purchases through a long-term credit
facility which can be drawn against through December 31, 1997. In December 1997
the term of the agreement was extended to June 30, 1998. Warrants to purchase
112,500 shares of the Company's Common Stock at a price of $8.00 per share were
issued to the lender per the terms of the agreement and the warrants were
subsequently repriced at $4.42 per share in return for the extension of the
agreement.
In December 1997, 186,652 warrants were issued at a price of $4.42 in
connection with a new loan agreement to finance an additional $2 million of
equipment purchases and $3.5 million of working capital through a long-term
facility which can be drawn upon through December 1998.
F-14
51
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
9. STOCK PLANS:
The Company has three Stock Option Plans:
1992 STOCK OPTION PLAN
Under the Company's 1992 Stock Option (the "1992 Plan"), the Company may
issue up to 2,450,000 shares of common stock to employees, officers, directors
and consultants. At the Company's Annual Shareholders' Meeting in April 1997 the
shareholders approved an increase of 700,000 shares to be authorized under this
plan from the previously authorized total of 1,750,000 shares. The exercise
price and terms of the options granted is determined by the Board of Directors,
provided that such price cannot be less than the fair value of the common stock
on the date of grant for incentive stock options or, in the case of nonstatutory
options, less than 85 percent of the fair value of the common stock on the date
of grant. The options generally vest over four to five years. In January 1996,
the Board of Directors amended the 1992 Plan to provide that, in the event of a
change in control of the Company, executive officers of the Company will receive
accelerated vesting for a portion of their unvested option shares. The term of
the options granted is seven years.
1996 SUPPLEMENTAL OPTION PLAN
In July 1996, the Company's Board of Directors adopted the 1996
Supplemental Option Plan. Under this Plan, the Company may issue up to 750,000
shares of common stock to employees, officers, directors and consultants. The
exercise price and terms of the options granted is determined by the Board of
Directors. The options generally vest over four YEARS. The term of the options
granted is seven years.
1995 DIRECTOR OPTION PLAN
In September 1995, the Company's Board of Directors adopted the 1995
Director Option Plan (the "Director Plan"). A total of 100,000 shares of common
stock has been reserved for issuance under the Director Plan. At the Company's
Annual Shareholders' Meeting in April 1997 the shareholders approved an increase
of 25,000 shares to be authorized under this plan from the previously authorized
total of 75,000 shares. The Director Plan provides that each future nonemployee
director of the Company will be automatically granted an option to purchase
10,000 shares of common stock (the "First Option") on the date on which the
optionee first becomes a nonemployee director of the Company and an additional
option to purchase 2,500 shares of common stock (the "Subsequent Option") on the
next anniversary. The exercise price per share of all options granted under the
Director Plan shall be equal to the fair market value of a share of the
Company's common stock on the date of grant of the option. Shares subject to the
First Option vest over 36 months, and the Subsequent Option shares vest over 12
months beginning with the month following the second anniversary of its date of
grant. The terms of the options granted is ten years.
ACCOUNTING FOR STOCK OPTION COMPENSATION EXPENSE
Effective January 1, 1996, the Company adopted the disclosure provisions of
Financial Accounting Standards No. 123 ("SFAS No. 123"), "Accounting for
Stock-Based Compensation." The adoption did not have a significant effect on the
Company's results of operations as the Company continues to apply the principles
of APB Opinion No. 25 and related interpretations in accounting for the
Company's stock options plans. Had compensation cost for the Company's stock
option plans been determined based on the fair value at the date of grant of the
stock options consistent with the method of SFAS No. 123, the Company's net loss
and loss per share would have been reduced to the pro forma amounts (in
thousands) indicated below:
F-15
52
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1997 1996 1995
---- ---- ----
Net Loss As reported $(14,775) $ (9,127) $(8,780)
Pro forma $(15,696) $(10,174) $(8,831)
Basic and diluted net loss
per common share (See
Note 11) As reported $(2.52) $(0.87) $(9.78)
Pro forma $(2.59) $(0.97) $(9.83)
The fair value of each option grant is estimated on the date of grant using
the multiple option approach of the Black-Scholes option pricing model with the
following assumptions used for grants in 1997, 1996 and 1995: risk-free interest
rates, based upon the grant dates, ranging from 5.2% to 7.8%; expected dividend
yields of zero percent; expected lives of one year from the vesting date;
expected volatility of zero percent prior to the filing date of the Company's
February 1996 initial public offering and sixty-five percent for grants made
subsequent to the filing through December 31, 1996; and seventy-five percent for
grants made between January 1, 1997 and December 31, 1997.
A Summary of the Company's fixed stock options plans at December 31, 1997,
1996 and 1995 and changes during the years then ended is presented below:
1997 1996 1995
------------------------ ------------------------ ------------------------
WTD AVG WTD AVG WTD AVG
SHARES EX. PRICE SHARES EX. PRICE SHARES EX. PRICE
--------- -------- --------- -------- --------- --------
Outstanding at beginning of 1,806,355 $ 5.29 1,456,500 $ 1.73 550,500 $ 0.26
the year
Granted 2,037,000 $ 4.87 842,500 9.14 965,000 2.48
Exercised (144,699) $ .55 (238,501) 0.43 (31,185) 0.20
Canceled (1,163,949) $ 7.71 (254,144) 2.20 (27,815) 0.26
--------- -------- --------- -------- --------- --------
Outstanding at end of the year 2,534,707 $ 4.11 1,806,355 $ 5.29 1,456,500 $ 1.73
--------- -------- --------- -------- --------- --------
Exercisable at end of the year 494,276 $2.54 378,797 $2.29 194,112 $0.34
Weighted average fair value
of options granted $2.65 $4.41 $0.44
The following table summarizes information about stock options outstanding
at December 31, 1997:
Options Outstanding Options Exercisable
- - ---------------------------------------------------------------- -------------------------------
Number Number
Outstanding Weighted-Average Exercisable
Range of at Remaining Weighted-Average at December Weighted-Average
Exercise December Contractual Exercise 31, 1997 Exercise
Prices 31, 1997 Life Price Price
- - --------------- ------------ -------------- -------------- ------------- --------------
$0.20 - $2.00 470,020 3.86 $0.68 297,143 $0.69
$3.875 - $5.00 1,705,812 6.74 $4.58 177,918 $5.00
$5.625 - $10.125 358,875 6.57 $6.41 19,215 $8.48
---------- --------
$0.20 - $10.125 2,534,707 494,276
========= =======
As of December 31, 1997, there were 330,751 shares available for future
grant under the stock option plans.
Subsequent to December 31, 1997, 112,625 options were canceled and the Board
of Directors granted options to purchase 300,000 shares at $2.75 per share and
88,000 shares at $3.875 per share. The Board of Directors also authorized a
grant of options to purchase 200,000 additional shares pending the availability
of such shares for grant.
10. INCOME TAXES:
F-16
53
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company accounts for taxes using a liability approach under which
deferred income taxes are provided based upon enacted tax laws and rates
applicable to the periods in which the taxes become payable.
The provision for income taxes differs from the statutory U.S. federal
income tax rate due to the following:
YEAR ENDED DECEMBER 31,
---------------------------
1997 1996 1995
------ ------ ------
Provision at US statutory rate................................. 34.0% 34.0% 34.0%
State income taxes, net of federal benefit..................... 5.9 6.1 6.1
Change in valuation allowance.................................. (39.9) (40.1) (40.1)
------ ------ ------
--% --% --%
====== ====== ======
Components of the net deferred income tax asset are as follows:
1997 1996
-------- --------
Deferred income tax assets:
Net operating loss carryforwards ................ $ 12,702 $ 8,670
Cumulative temporary differences ................ 2,175 1,782
Capitalized start-up costs ...................... -- 37
Research and development credit ................. 543 324
Valuation allowance, equity ......................... (411) (292)
Valuation allowance, provision for income taxes ..... (15,009) (10,521)
-------- --------
Net deferred income tax asset ....................... $ -- $ --
======== ========
The net operating loss and research and development credit carryforwards of
approximately $49.7 million expire on various dates through December 31, 2012.
Utilization of these carryforwards may be annually limited if there is a change
in the Company's ownership, as defined by the Internal Revenue Code.
A valuation allowance has been recorded for the entire deferred tax asset
as a result of uncertainties regarding the realization of the asset including
the limited operating history of the Company, the lack of profitability to date
and the variability of operating results. The portion of the valuation allowance
which will affect equity and which will not be available to offset future
provisions of income tax is stated in the above table as "Valuation allowance,
equity".
11. NET LOSS PER SHARE:
In 1997, the Company adopted Statement of Financial Accounting Standards
(SFAS) No. 128 "Earnings per Share." SFAS No. 128 requires companies to compute
earnings per share under two different methods (basic and diluted). Basic
earnings per share is calculated by dividing net income (loss) by the weighted
average shares of common stock outstanding during the period. Diluted earnings
per share is calculated by dividing net income (loss) by the weighted average
shares of outstanding common stock and common stock equivalents during the
period. As a result, the 1996 and 1995 pro forma net loss per share amounts have
been restated. The effect of this accounting change on previously reported
earnings per share (EPS) data was as follows:
1996 1995
------ ------
Pro forma net loss per share as previously reported $(0.79) $(0.94)
Effect of SFAS No. 128 ............................ (0.08) (8.84)
------ ------
Basic and diluted net loss per common share ....... $(0.87) $(9.78)
===== =====
Net loss per share was calculated on net loss available to common
stockholders. For the year ended December 31, 1997, the net loss per share was
computed as net loss of $14,775,000 plus $15,161,000 relating to the preferred
stock deemed dividend (Note 8) divided by the weighted average common shares
outstanding.
F-17
54
DIGITAL GENERATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
12. NEW ACCOUNTING STANDARDS:
In June 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting
Comprehensive Income," which establishes standards for reporting comprehensive
income and its components (revenues, expenses, gains and losses) in financial
statements. SFAS No. 130 requires classification of other comprehensive income
in a financial statement, and the display of the accumulated balance of other
comprehensive income separately from retained earnings and additional paid-in
capital. SFAS No. 130 is effective for fiscal years beginning after December 15,
1997. The Company believes this pronouncement will not have a material effect on
its financial statements.
In June 1997, the FASB also issued SFAS No. 131, "Disclosures about
Segments of an Enterprise and Related Information," which established standards
for reporting information about operating segments in annual financial
statements and requires that enterprises report selected information about
operating segments in interim financial reports to shareholders. SFAS No. 131
also establishes standards for related disclosures about products and services,
geographic areas and major customers. SFAS No. 131 is effective for fiscal years
beginning after December 15, 1997, although earlier application is encouraged.
The Company believes this pronouncement will not have a material effect on its
financial statements.
F-18
55
DIGITAL GENERATION SYSTEMS, INC.
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
BALANCE AT ADDITIONS BALANCE
BEGINNING CHARGED AT END
CLASSIFICATION OF PERIOD TO OPERATIONS OTHER(a) WRITEOFFS OF PERIOD
-------------- --------- ------------- -------- --------- ---------
Allowance for Doubtful Accounts
Year Ended:
December 31, 1995....... $ 73,000 $ 137,000 $ -- $ (75,000) $ 135,000
December 31, 1996....... $ 135,000 $ 97,000 $ 25,000 $ -- $ 257,000
December 31, 1997....... $ 257,000 $ 246,000 $259,000 $(177,000) $ 585,000
(a) Additions resulting from acquisitions of PDR in 1996 and Mediatech in
1997.
S-1