Back to GetFilings.com

Table of Contents

Index to Financial Statements

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-K

For The Fiscal Year Ended December 31, 2003

OR

For the Transition Period From                      to                     .

COMMISSION FILE NUMBER: 0-27644

Digital Generation Systems, Inc.

(Exact Name of Registrant as Specified in its Charter)

750 West John Carpenter Freeway, Suite 700

Irving, Texas 75039

(Address Of Principal Executive Offices, Including Zip Code)

(972) 581-2000

(Registrant’s Telephone Number, Including Area Code)

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12 (g) of the Act: Common Stock ($0.001 par value)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months 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

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

The aggregate market value of the Common Stock held by non-affiliates of the registrant, computed by reference to the closing price and shares outstanding, was approximately $94.2 million as of December 31, 2003, and approximately $75.5 million as of June 30, 2003, the last business day of the registrant’s most recently completed second quarter. 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 February 27, 2004, the registrant had 72,398,823 shares of Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

The registrant has incorporated by reference into Part III of this Form 10-K portions of its definitive Proxy Statement for its 2003 Annual Meeting of Shareholders to be filed within 120 days after the end of the fiscal year (the “Proxy Statement”), which meeting will be held on the date set forth in 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.

Table of Contents

Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC.

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

TABLE OF CONTENTS

Table of Contents

Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC.

PART I

General

Digital Generations Systems, Inc., incorporated in 1991, offers a suite of digital technology products and services through Digital Generation Systems, Inc. (“DGS”) and its wholly owned subsidiary StarGuide Digital Networks, Inc. (“StarGuide”). Through DGS, the Company operates a nationwide digital network out of its Network Operation Center (“NOC”) located in Irving, Texas. The network beneficially links more than 5,000 advertisers and advertising agencies with more than 6,700 radio stations and over 1,875 broadcast and cable television destinations across the United States and Canada. Through the NOC, the Company delivers audio, video, image and data content that comprise transactions between the advertising and broadcast industries. Through StarGuide, the Company develops and sells proprietary digital software, hardware and communications technology, including various bandwidth satellite receivers, audio compression codes and software to operate integrated digital multimedia networks, and offers related engineering consulting services.

Available Information

The Company files annual reports, quarterly reports, proxy statements and other documents with the Securities and Exchange Commission (“SEC”) under the Securities Exchange Act of 1934 (the “Exchange Act”). The public may read and copy any materials that the Company files with the SEC at the SEC’s Public Reference Room at 450 Fifth Street N.W., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Also, the SEC maintains a website that contains reports, proxy and information statements, and other information regarding issuers, including the Company, that file electronically with the SEC. The public can obtain any documents that the Company files with the SEC at http://www.sec.gov.

The Company also makes available free of charge through its website (www.dgsystems.com) the Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and, if applicable, amendments to those reports filed or furnished pursuant to the Exchange Act as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to, the SEC.

Industry Background

Increasing demand for reliable and rapid means of information transfer in the broadcast, scientific, education, entertainment, home-computing, and telecommunications industries has driven a number of technical innovations in recent years. In particular, digital distribution technologies are increasingly used for distributing information in forms such as audio, video, text, and data. Digitized information can be stored, manipulated, transmitted, and reproduced more easily, more rapidly, with less degradation, and in greater volumes than traditional analog or hard copy information.

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 1,100 commercial television stations in the United States. These stations generate revenue by selling airtime to advertisers. Advertising is most frequently produced under the direction of advertising agencies for large national or regional advertisers or by station personnel for local advertisers. 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 airtime typically is 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” typically are produced at a digital production studio and recorded on digital 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 distribution to broadcast stations. Tapes containing the spot and its variations are then duplicated on analog tape, packaged, labeled and shipped to the radio and television stations and cable head-ends specified by the advertiser or its agency.

1

Table of Contents

Index to Financial Statements

The predominant method for distributing spot advertisements to radio and television stations traditionally has been physical delivery of analog audio or videotapes. The Company estimates that approximately 35% of radio spots and more than 60% of video spots are delivered by air express services. Many companies, commonly known as “dub and ship houses,” are in the business of duplicating audio and video tapes, assembling them according to agency-specified bills of material and packing them for air express delivery. The Company estimates that it has transitioned approximately 55% of the market for audio spot deliveries and approximately 20% of video spot deliveries, have transitioned to digital distribution.

To meet their growing need for solutions that offer reliable, high-quality digital information distribution, some companies have deployed their own terrestrial-based local and wide area computer networks. These systems are typically very costly to deploy, use, and maintain. Additionally, upgrading these systems to keep abreast of technical innovations can be particularly difficult and costly.

Other digital communication and transmission technologies, such as private network satellite systems, can offer more cost-effective and reliable solutions for the digital transmission requirements of data intensive businesses, including radio and television broadcasting. Satellite distribution can be particularly effective at meeting the needs of point-to-multipoint transmission, or “multicasting,” and other broadcasting applications.

The Company has developed proprietary software and hardware systems that can address the need for data distribution services that are both economically and technologically suitable to various commercial applications. Many of these systems are currently deployed and in service, and the Company continues to upgrade its technology, and to deploy additional units in the marketplace.

Products and Services

The Company currently markets and provides its products and services through DGS and StarGuide. See Note 17 to the Company’s consolidated financial statements and related notes, included herein, for financial information related to the Company’s business segments.

DGS provides electronic and physical distribution of and ancillary post-production services for broadcast commercial content to advertising agencies, production studios, and broadcast stations throughout the United States and Canada. Through its NOC, DGS operates a digital network, currently serving more than 5,000 advertisers and advertising agencies and more than 6,700 radio stations and over 1,875 broadcast and cable television destinations across the United States and Canada. 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 the DGS network, transmissions are automatically routed to stations through a computerized on-line transaction and delivery system and arrive, in text format, at stations in as little as one hour after an order is received. Typically, associated traffic instructions are simultaneously transmitted by facsimile to minimize station handling and scheduling errors. Shortly after a spot is delivered to a station, DGS sends the customer a confirmation specifying the time of delivery. Additionally, DGS’ digital network delivers close to “master” quality audio or video to broadcast stations, which is equal to or superior to that currently delivered on analog tape.

DGS 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. DGS has historically operated and currently operates without substantial backlog. DGS receives distribution orders with specific bills of material, routing and timing instructions provided by the customer. These orders are entered into DGS’ computer system either by the customer (through an internet-based order-entry system) or by DGS customer service personnel, and are scheduled for electronic delivery, if a station is on DGS’ network, or for physical delivery via DGS’ various dub and ship facilities, if a destination station is not on the network.

Audio content is received electronically at DGS’ NOC from Record Send Terminals and Client Workstations that are owned by DGS and deployed primarily in production studios. In addition, audio can be received using DGS’ Upload internet audio collection system (“DG Upload”). When audio spots are received, company personnel quality-assure the audio content and then initiate the electronic transaction to transmit various combinations of audio to designated radio stations. Audio transmissions are delivered over standard telephone or ISDN lines to servers that DGS has placed in each radio station on its network. The audio spots are thereafter available to the station on demand.

Video content is received electronically at DGS’ NOC primarily from Video Record Transmission Systems that are owned by DGS and deployed in video production studios. Video content also can be received through high-speed communication lines from collection points in locations where Video Record Transmission Systems are not available. When video spots are received, company personnel quality-assure the spots and release the video to the NOC, where it is combined with the customer’s electronic transaction to transmit the various combinations of video to designated television stations. Video transmissions are sent via a high-speed fiber link to the digital satellite uplink facility over which they are then delivered directly to servers that DGS has placed in television stations and cable interconnects.

2

Table of Contents

Index to Financial Statements

Audio and video transmissions are received at designated radio and television stations on DGS-owned servers, called Receive Playback Terminals, Client Workstations, Digital Media Managers and ADvantage Digital Video Playback Systems. The servers enable stations to receive and play back material delivered through DGS’ digital distribution network. The units are owned by DGS 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 NOC, DGS monitors the spots stored in each Receive Playback Terminal, Client Workstation, Digital Media Manager and Digital Video Playback System and ensures that space is always available for new transmissions. DGS 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, enabling responsiveness not possible in a physical tape distribution system.

DGS offers various levels of digital audio and video distribution services from its NOC to broadcast advertisers distributing content to broadcast stations. These include the following: DG Priority, a service which guarantees arrival of the first audio spot on an order within one hour (available for audio only); 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. DGS also offers a set of premium services enabling advertisers to distribute audio or video spots provided after normal business hours.

In addition to its standard services, DGS has developed unique products to service markets with particular time-sensitive delivery needs. “Sweeps” delivery is a specialized service for television stations that wish to advertise on radio with either topical or cooperative content to stimulate viewership during the periods of ratings measurements conducted by the A.C. Nielsen Company. DGS 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. DGS distributes first release music singles and uses unique software functionality to insure that the singles are released throughout the country to all stations simultaneously thereby eliminating concerns of favoritism or premature release. Finally, DGS delivers political advertising during election campaigns, providing a rapid response mechanism for candidates and issue groups.

StarGuide designs and provides high-speed digital information transmission and distribution systems. StarGuide’s patented technology—digital distribution, compression, and transmission systems combined with satellite and Internet technologies—allow StarGuide to achieve high-quality, economical, flexible, and high-throughput information flow without the need for point-to-point connections, regardless of digital formatting or compression protocols. Integrated into many of StarGuide’s systems are StarGuide’s proprietary digital audio compression and decompression, or “codec,” techniques and products.

StarGuide’s satellite transmission systems combine varying types of information into one single transmission, maximizing the amount of information transmitted through the satellite in a more cost-effective and reliable manner than other distribution systems available on the market. The systems are also readily upgradeable, secure, and able to direct transmissions, or components of transmissions, to multiple points simultaneously. StarGuide’s transmission systems are capable of receiving any type of digitized media including audio, simultaneous audio, video, text and data from a variety of sources including satellite, high-bandwidth connections such as ISDN or T1 lines, and other wired and wireless systems.

StarGuide has developed a patented store-and-forward system called Transportal 2000(TM), a cost-effective, reliable, high-speed electronic media delivery system that serves the broadcast industry with Internet connectivity, compatible StarGuide satellite transmission and terrestrial overlays, automatic fall-back dub and ship service, and automated confirmation of delivery. This proprietary automated media distribution system is being deployed across the radio broadcasting industry. StarGuide intends to expand its presence in the broadcasting industry and to target new market opportunities for high-quality, high-throughput digital information systems.

In the United States radio industry, StarGuide has deployed its digital transmission systems to radio stations owned by or affiliated with Jacor, ABC Radio, Clear Channel, Infinity, Westwood One, CBS, Bloomberg, Jones Broadcast Programming, One-On-One Sports, and Voice of America. Abroad, StarGuide has deployed its digital transmission systems for Osaka-Yusen (Japan), the Shenzhen Stock Exchange (China), and other entities in Australia, New Zealand, and South America.

The core of the StarGuide transmission system is StarGuide’s patented MX3 Multiplexer and the StarGuide Receiver. The MX3 Multiplexer can accept up to 120 simultaneous digital, audio, video, or data services in various digital formats. The MX3 Multiplexer then breaks up these differing digital service streams and re-orders and consolidates the various data streams into a single data stream. The system can then cost-effectively transmit this data stream in a single transmission signal, via satellites or other wired or wireless communications vehicles. The MX3 Multiplexer does so in a highly efficient manner, resulting in less consumption of costly bandwidth capacity on the satellites than other transmission systems on the market, such as DVB systems.

Upon receipt of a transmission, the patented StarGuide II and III Receivers re-assemble and transmit data packets into their respective types of digital information streams (audio, video, text, or data). StarGuide’s receivers are flexible and adaptable,

3

Table of Contents

Index to Financial Statements

employing low cost insertion cards that are installed in any of a number of slots in the receivers, thus adapting the capabilities of the receivers to varying needs of broadcasters who use them.

Current StarGuide receiver insertion cards include:

StarGuide’s transmission systems are controlled by StarGuide’s Windows-based, propriety Network Management Control System, or NMCS, which allows a system operator to maintain and control the entire transmission system locally or remotely. The StarGuide NMCS allows the system operator to control both the use of satellite bandwidth by the system and the accessing of transmitted data by the individual StarGuide Receivers in the field.

StarGuide also has developed a StarGuide DVB Multiplexer and mating StarGuide DVB Receiver. StarGuide developed its StarGuide DVB transmission system for applications requiring transmission in compliance with the DVB standard. StarGuide’s DVB system is being deployed throughout Japan by Osaka-Yusen.

Markets and Customers

A large portion of DGS’ revenue is derived from the delivery of spot radio and television advertising to broadcast stations, cable systems and networks. DGS derives revenue from brand advertisers and advertising agencies, and from its marketing partners, which are typically dub and ship houses that have signed agreements with DGS to consolidate and forward the deliveries of their advertising agency customers to broadcast stations, cable systems and networks via DGS’ electronic delivery service in exchange for price discounts from DGS. The advertisements distributed by DGS are representative of the five leading national advertising categories of automotive, retail, business and consumer services, food and related products and entertainment. The volume of advertising from these segments is subject to seasonal and cyclical variations.

StarGuide maintains established relationships with producers and broadcasters such as Infinity, Westwood One, Clear Channel, ABC Radio, Jacor, CBS, Bloomberg, Jones Broadcast Programming, One-on-One Sports and Voice of America. As part of these relationships, StarGuide has sold approximately 6,000 of its StarGuide II Receiver systems, and has sold over 8,000 of its StarGuide III Receiver systems. In addition, StarGuide’s audio codecs are recognized and used throughout the radio production and broadcast industries. StarGuide intends to utilize its existing relationships to leverage its technology to develop new customers in the broadcast industry.

Sales, Marketing and Customer Service

Brand Strategy. DGS’ brand strategy is to position itself as the standard transaction method for the radio, television, cable, and network broadcast industries. DGS focuses its marketing messages and programs at multiple segments within the advertising and broadcast industries. Each of the segments interacts with DGS for a different reason. Agencies purchase services from DGS on behalf of their advertisers. Production studios facilitate the transmission of audio and video to DGS’ NOC. 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.

4

Table of Contents

Index to Financial Statements

Internet/E-Commerce Strategy. In 2002, DGS introduced Open Interface, an industry first that allows agency traffic systems to interface directly with DGS’ order management system, reducing duplicate entry of information. In 2001, DGS introduced AdCatalog, a web-based asset management system that allows geographically dispersed marketing groups the ability to view and request distribution for corporate broadcast commercial content. Additionally, DGS introduced Netclear, a web-based system that allows brand advertisers, advertising agencies and broadcasters the ability to approve spots for network clearance. DGS estimates that approximately 40% of its orders were entered electronically via the Internet during 2003 and 2002. In addition, DGS also offers its DG Upload service that allows audio content to be received from clients via the Internet.

Sales. DGS employs a direct sales force that calls on various departments at advertising agencies to communicate the capabilities and comparative advantages of DGS’ electronic distribution system and related products and services. In addition, DGS’ sales force calls on corporate advertisers who are in a position to either direct or influence agencies in directing deliveries to DGS. A separate staff sells to and services audio and video dealers, who resell DGS’ distribution services. An inside sales staff also represents DGS’ services to radio stations. DGS currently has regional sales offices in New York, Los Angeles and Chicago. DGS’ sales force includes regional sales, inside sales, and telemarketing personnel.

StarGuide presently markets and sells its transmission and distribution systems and audio compression products directly to corporate and commercial end-users, distributors, and to radio stations and networks. StarGuide currently promotes and sells the StarGuide integrated transmission and distribution systems and promote the digital distribution services provided to the radio broadcast industry. StarGuide also employs salespersons that market and sell StarGuide’s audio compression products. StarGuide currently maintains relationships with distributors marketing and selling StarGuide’s audio compression products in Europe, Asia, South America, and Australia. StarGuide is presently seeking to expand these relationships to include the distribution of StarGuide transmission and information management systems.

Marketing. DGS’ marketing programs are directed to stimulate demand with an emphasis on popularizing the benefits of digital delivery, including fast turnaround (same day services), increased flexibility, higher quality, 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 United States cities. DGS also engages in public relations activities including trade show participation, the stimulation of articles in the trade and business press, press tours and advertisements in advertising and broadcast oriented trade publications.

DGS markets to broadcast stations to arrange for the placement of its Receive Playback Terminals, Digital Media Managers, and Digital Video Playback Systems for the receipt of audio and video advertisements, or Client Workstations, which provide the ability to both receive and to originate distribution of audio advertisements to other radio stations.

StarGuide currently engages in several promotions and other activities to generate interest in its systems and to consummate sales, including trade shows. StarGuide seeks to maximize its visibility at trade shows by hosting a customer booth and providing complimentary product literature describing StarGuide’s systems. StarGuide also conducts several on-site demonstrations with technical and other senior level personnel and regularly contacts potential customers who have indicated an interest in utilizing StarGuide’s systems or products.

Customer Service. DGS’ approach to customer service is based on a model designed to provide focused support from key market centered offices, located in Los Angeles, Dallas, Chicago and New York. Clients work with specific, assigned account coordinators to place production service and distribution orders. National distribution orders are electronically routed to the NOC for electronic distribution or, for off-line destinations, to DGS’ national duplication center in Louisville, Kentucky. DGS’ distributed service approach provides direct support in key market cities enabling DGS to develop closer relationships with clients as well as the ability to support client needs for local production services. DGS 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. DGS’ customer service operation centers are linked to DGS’ order management and media storage systems, and national distribution network. These resources enable DGS 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 distribution model also provides DGS with significant redundancy and re-route capability, enabling DGS to meet customer needs when weather or other conditions prevent deliveries using traditional courier services.

An important element of StarGuide’s product offering is to support its sales efforts with comprehensive technical support. Technical personnel often accompany sales personnel when meeting with prospective customers and aid in the implementation of StarGuide’s products. Customer feedback received through the sales process is incorporated into the product development process and allows StarGuide to upgrade its service and support capabilities.

5

Table of Contents

Index to Financial Statements

Competition

DGS 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 DGS 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 postproduction, preparation, distribution and trafficking services. DGS plans to continue pursuing potential dub and ship house partners where such partnerships make strategic sense.

In the video marketplace, DGS competes with dub and ship houses across the country but additionally with a satellite-based real-time video distribution network operated by Vyvx, an operating division of Willtel Communications. DGS also anticipates that certain common and/or value-added telecommunications carriers may develop and deploy high bandwidth network services targeted at the advertising and broadcast industries, although DGS believes that no such carriers have yet entered the market for spot distribution.

We are aware of other companies that are focusing or may in the future focus significant resources on developing and marketing products and services that will compete with ours. We believe that our ability to compete successfully depends on a number of factors, both within and outside of our control, including: (1) the price, quality and performance of our products and those of our competitors; (2) the timing and success of new product introductions; (3) the emergence of new technologies; (4) the number and nature of our competitors in a given market; (5) the protection of intellectual property rights; and (6) general market and economic conditions.

The Company expects competition to continue to intensify as existing and new competitors begin to offer products, services, or systems that compete with our products. Our current or future competitors, many of whom, individually or together with their affiliates, have substantially greater financial resources, research, and development resources, distribution, marketing, and other capabilities than us, may apply these resources and capabilities to compete successfully against our products and service. A number of the markets in which we sell our products and services are also served by technologies that currently are more widely accepted than ours. Although we believe that our products and services are less expensive to use and more functional than competing products and services that rely on other technologies, it is uncertain whether our potential customers will be willing to make the initial capital investment that may be necessary to convert to our products and services. The success of our systems against these competing technologies depends in part upon whether our systems can offer significant improvements in productivity and sound quality in a cost-effective manner. It is uncertain whether our competitors will be able to develop systems compatible with, or that are alternatives to, our proprietary technology or systems. It is also not certain that we will be able to compete successfully against current or future competitors or that competitive pressures faced by us will not materially adversely affect our business, operating results, and financial condition.

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 Company currently has twenty-eight patents issued and five other allowed and awaiting issuance and thirty other patent applications pending domestically and abroad. The Company also has nine trademark registrations and one hundred ninety-two copyright registrations.

Employees

As of December 31, 2003, the Company had a total of 283 employees, including 54 in research and development, 31 in sales and marketing, 166 in operations and manufacturing, and 32 in finance and administration. All of these employees were located in the United States. The Company’s employees are not represented by a collective bargaining agreement and the Company has not experienced a work stoppage. The Company considers its relations with its employees to be good.

The Company’s business and prospects depend in significant part upon the continued service of its key management, sales and marketing and administrative personnel. The loss of key management or technical personnel could materially adversely affect the Company’s operating results and financial condition. The Company believes that its prospects depend in large part upon its ability to attract and retain highly skilled managerial, sales and marketing and administrative personnel. Competition for such personnel is intense, and the Company may not be successful in attracting and retaining such personnel. Failure to attract and retain key personnel could have a material adverse effect on the Company’s operating results and financial condition.

6

Table of Contents

Index to Financial Statements

The Company’s principal executive offices are at 750 West John Carpenter Freeway in Irving, Texas. The Irving offices include 26,000 square feet of leased space, for which the lease expires in June 2006. In addition, the Company leases approximately 3,000 square feet in Louisville, Kentucky for its dub and ship facility which expires in 2006; approximately 22,000 square feet in New York City which is occupied by production service and sales personnel and expires in 2006; approximately 13,000 square feet in Los Angeles occupied by production service and sales personnel which expires in 2006; and 25,000 square feet in Chicago, which is occupied by production service and sales personnel which expires in 2006. An additional 11,305 square feet of space in San Diego that expires on April 30, 2005 is currently being sublet to a lessee. In addition, the Company leases an office in Holmdel, New Jersey that is 30,000 square feet and includes audio operations and administrative staff for StarGuide’s wholly owned subsidiary, Corporate Computer Systems, Inc. (“CCS”), which expires on August 31, 2004.

On October 12, 2001, StarGuide filed a complaint against Williams Communications Group, Inc. (“Williams”) in the United States District Court for the District of Nevada alleging that Williams has willfully infringed three StarGuide patents. On March 4, 2002, StarGuide opposed Williams’ motion for summary judgment and moved to amend its complaint to add Williams Communications, LLC (“WCL”), a subsidiary of Williams, as a party defendant. On July 3, 2002, WCL answered StarGuide’s complaint and asserted counterclaims seeking a declaratory judgment that the StarGuide patents are invalid and not infringed. On July 28, 2003, StarGuide, DGS, Williams and WCL reached a settlement resolving all litigation. Both lawsuits were dismissed as part of the settlement and the company expensed related patent defense costs totaling $1.5 million.

In addition to the matters discussed above, the Company is subject, from time to time, 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 asserted to date will have a material effect on the financial condition or results of operations of the Company.

The Company held its annual shareholders meeting on November 18, 2003, at which shareholders were asked (i) to elect two directors, to serve for three-year terms or until their successors have been duly elected and qualified and (ii) to ratify the selection of KPMG LLP as the Company’s independent accountants for the fiscal year ending December 31, 2003. The results are as follows:

Information regarding the other directors whose term of office continued after the meeting is included under Part III, Item 10 – Directors and Officers of the Registrant.

The executive officers of the Company and their ages are as follows:

Scott K. Ginsburg joined the Company in December 1998 as Chief Executive Officer and Chairman of the Board. In July 1999, Matthew E. Devine assumed the responsibilities as Chief Executive Officer, but Mr. Ginsburg remained the Company’s Chairman. Mr. Ginsburg reassumed the responsibilities as Chief Executive Officer of the Company in November 2003. Mr. Ginsburg founded the Boardwalk Auto Group in 1998, which consists of several car dealerships located in the Dallas area. From 1997 to 1998, Mr. Ginsburg served as Chief Executive Officer and Director of Chancellor Media (now AMFM Corporation). Mr. Ginsburg founded Evergreen Media Corporation in 1988, and was the co-founder of Statewide Broadcasting, Inc. and H&G Communications, Inc. Mr. Ginsburg earned a B.A. from George Washington University in 1974 and a J.D. from Georgetown University in 1978.

7

Table of Contents

Index to Financial Statements

Omar A. Choucair joined the Company as Chief Financial Officer in July 1999. Prior to joining the Company, Mr. Choucair served as Vice President of Finance for AMFM Corporation (formerly Chancellor Media), and served as Vice President of Finance for Evergreen Media before it was acquired by Chancellor Media in 1997. Prior to entering the media industry, Mr. Choucair was a Senior Manager at KPMG LLP, where he specialized in media and telecommunications clients. Mr. Choucair received a B.B.A. from Baylor University and became a Director in February 2001.

8

Table of Contents

Index to Financial Statements

PART II

The Common Stock of the Company has been traded on the 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.

The following table sets forth the high and low closing sales prices of our Common Stock from January 1, 2002 to December 31, 2003. Such prices represent prices between dealers, do no include retail mark-ups, markdowns or commissions and may not represent actual transactions.

As of December 31, 2003, the Company had issued 72,117,726 and outstanding 72,094,809 shares of its Common Stock. As of February 27, 2004, the Company had issued 72,421,740 and outstanding 72,398,823 shares of its Common Stock. As of February 27, 2004 the Company’s Common Stock was held by approximately 170 shareholders of record. The Company estimates that there are approximately 7,700 beneficial shareholders.

See Note 13 to the Company’s consolidated financial statements and related notes, included herein, for a description of the securities authorized for issuance under equity compensation plans.

The Company has never declared or paid cash dividends on its capital stock. The Company currently expects to retain any future earnings for use in the operation and expansion of its business and does not anticipate paying any cash dividends in the foreseeable future.

9

Table of Contents

Index to Financial Statements

The selected data should be read in conjunction with the consolidated financial statements for the year ended December 31, 2003, the related notes, and the independent auditors’ report, which refers to a change in the method for accounting for goodwill and other intangible assets and in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations”. The selected data presented below under the captions “Selected Statement of Operations Data” and “Selected Balance Sheet Data” for, and as of the end of, each of the years ended December 31, 2000 and 1999, are derived from the consolidated financial statements of StarGuide Digital Networks, Inc., which financial statements have been audited by KPMG LLP, independent auditors. The selected data presented below under the captions “Selected Statement of Operations Data” and “Selected Balance Sheet Data” for, and as of the end of, each of the years in the three year period ended December 31, 2003, are derived from the consolidated financial statements of Digital Generation Systems, Inc., which financial statements have been audited by KPMG LLP, independent auditors. The consolidated financial statements as of December 31, 2003 and 2002, and for each of the years in the three-year period ended December 31, 2003, and the report thereon, are included elsewhere in this Report.

Selected Statement of Operations Data:

10

Table of Contents

Index to Financial Statements

Selected Balance Sheet Data

Overview

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

We are the leading provider of digital media distribution services to the advertising and broadcast industries. In addition, we operate this industry’s largest electronic digital distribution network. Our primary source of revenue is the delivery of television and radio advertisements, or spots, which is typically performed digitally but sometimes physically; we introduced a digital alternative to dub-and-ship delivery of spots. We bill our services on a per transaction basis on payment terms of net 30 days.

Our services include audio/video distribution services, production services and the sale/license of audio/video transmission equipment. We rely on the national TV/radio spot advertising industry for the majority of our revenues and we operate in a very competitive industry. We have offices in New York, Los Angeles and Chicago while our network operations center (NOC) is located in Irving, Texas.

We seek to grow and broaden our revenue base through a combination of new business initiatives and strategic acquisitions. We intend to pursue complementary acquisitions that leverage the Company’s sales force, network infrastructure and close agency/advertiser relationships.

Furthermore, we are currently investing in new digital distribution technology that combines satellite, Internet and physical means to fulfill the delivery of video content to our network of broadcast and cable television destinations. By leveraging our existing satellite transmission assets with an added Internet component, we seek to provide customers with the most reliable, flexible and cost efficient broadcast server network in the industry. We intend to roll out this new technology beginning during the second quarter of 2004.

In addition, we are updating and enhancing our business platform via the newest version of DG Online(TM), the Internet-based software application our customers utilize to enter and track orders. The upgraded interface will provide customers fully automated access to DG’s services through a more streamlined, easier-to-navigate portal. As part of this platform upgrade, we plan to integrate new features into the DG Media Manager(TM) hardware that links stations to the DG’s network, including a wider range of storage, delivery and spot management options, among other enhancements. DGS is working with a top IT services vendor to develop this application, one that DG Systems believes will be unrivaled in the industry in terms of functionality, convenience and ease-of-use. The Company intends to continue to invest in the re-design, re-launch and re-branding of additional new customer applications throughout 2004.

Finally, we are streamlining back office functions at our operations in New York, Los Angeles and Chicago to simplify customer interaction and deliver services more efficiently.

11

Table of Contents

Index to Financial Statements

This strategy is not without risks. Our 2003 revenue decreased after losing a significant customer; the Company believes this was an isolated incident and does not anticipate a trend. Also, given the ongoing cost containment efforts evident in the advertising industry, it is essential that we continue to provide customers with effective, easy-to-use and efficient solutions. We intend to utilize our product awareness, people, industry connections and cash flow to grow our business and vigorously compete for market share.

Critical Accounting Policies

The SEC recently released Financial Reporting Release No. 60, which requires all companies to include a discussion of critical accounting policies or methods used in the preparation of financial statements. In addition, Financial Reporting Release No. 61 was recently released by the SEC to require all companies to include a discussion to address, among other matters, liquidity, off-balance sheet arrangements, contractual obligations and commercial commitments. The Company’s significant accounting policies and methods used in the preparation of the Consolidated Financial Statements are discussed in Note 2 of the Notes to Consolidated Financial Statements. The following is a listing of the Company’s critical accounting policies and a brief discussion of each:

Allowance for Doubtful Accounts. The Company’s allowance for doubtful accounts relates to trade accounts receivable. Financial Statement Schedule II summarizes the activity in this account. The allowance for doubtful accounts is an estimate prepared by management based on identification of the collectibility of specific accounts and the overall condition of the receivable portfolios. The Company specifically analyzes trade receivables, historical bad debts, customer credits, customer concentrations, customer credit-worthiness, current economic trends and changes in customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. If the financial condition of the Company’s customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Likewise, should the Company determine that it would be able to realize more of its receivables in the future than previously estimated, an adjustment to the allowance would increase income in the period such determination was made. The allowance for doubtful accounts is reviewed on a monthly basis and adjustments are recorded as deemed necessary.

Revenue Recognition. The Company derives revenue from primarily two sources- (1) services—which consist primarily of revenue for digital and analog audio, video and videotape distribution and (2) product sales—which consist of sales of audio and video distribution equipment.

The Company’s services revenue from digital distribution of audio and video advertising content is billed based on a rate per transmission, and the Company recognizes revenue for these services upon notification of successful transmission of the content at the broadcast destination. Revenue for distribution of analog audio and video content by tape is recognized when delivery has occurred, which is at the time the tapes are delivered to a common carrier.

The Company recognizes product revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed and determinable and collectibility is probable. Generally for product sales, these criteria are met at the time of delivery to a common carrier. Provision is made at the time the related revenue is recognized for estimated product returns, which historically have been immaterial. The Company analyzes historical returns, current economic trends, and changes in customer demand when evaluating the adequacy of provisions for sales returns. At the time of the transaction, the Company assesses whether the fee associated with revenue transactions is fixed and determinable and whether or not collection is reasonably assured. The Company assesses whether the fee is fixed and determinable based on the payment terms associated with the transaction. The Company assesses collectibility based on a number of factors, including past transaction history with the customer and the credit-worthiness of the customer. The Company does not request collateral from customers. For all sales, the Company uses either a binding purchase order or signed sales agreement as evidence of an arrangement. Shipping and handling revenues are included in product revenues and costs are included in product costs. Revenue from arrangements for the sale of products that include software components that are more than incidental to the functionality of the related product are accounted for under AICPA Statement of Position 97-2, “Software Revenue Recognition” (“SOP 97-2”). SOP 97-2 requires that when a product is sold that contains a significant software component, and the Company has no objective third party evidence as to the relative fair values of each of the components sold, the total sales value should be deferred and recognized on a straight line basis over the life of the arrangement as documented in the sales agreement.

12

Table of Contents

Index to Financial Statements

Long-Lived Assets and Goodwill. The Company assesses the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors that the Company considers important which could trigger an impairment review include the following:

If the Company determines that the carrying value of long-lived assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, the Company assesses the recoverability of the intangibles by determining whether the amortization of the asset balance over its remaining life can be recovered through undiscounted future operating cash flow of the acquired operations. Any impairment is measured based on a projected discounted cash flow method using a discount rate reflecting the Company’s average cost of funds.

In 2002, Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” became effective, and as a result, the Company ceased amortization of goodwill beginning January 1, 2002 and evaluates goodwill for impairment at least annually. The Company recorded approximately $9.5 million of goodwill amortization during 2001. SFAS No. 142 requires the Company to test goodwill for impairment at a level referred to as a reporting unit. Goodwill is considered impaired and a loss is recognized, when its carrying value exceeds its implied fair value. As an overall check on the reasonableness of the fair values attributed to the Company’s reporting units, the Company is required to compare and contrast the aggregate fair values for all reporting units with the Company’s average total market capitalization for a reasonable period of time. SFAS No.142 states that the fair value may exceed market capitalization due to factors such as control premiums and synergies. The Company completed its initial impairment review during the first quarter of 2002 and recorded an impairment of approximately $130.2 million, which is reported as a cumulative effect of change in accounting principle. There were no impairments of either long-lived assets or goodwill during 2003.

Deferred Taxes and the Deferred Tax Valuation Allowance. The Company has recorded both assets and liabilities for deferred taxes that arise as the result of timing differences between amounts recorded for federal income tax purposes versus items recorded in accordance with generally accepted accounting principals. The company offsets deferred tax liabilities against deferred tax assets for the purpose of financial statement disclosure.

The company also has net operating loss carryforwards (NOL’s) of approximately $63.3 million which will expire on various dates ranging from 2016 to 2020. Generally accepted accounting principles require that the Company record a valuation allowance against the deferred tax asset associated with this NOL if it is “more likely than not” that the Company will not be able to utilize it to offset future taxes. During 2003, the Company concluded that realization of a portion of its tax benefits from NOL carryforwards was more likely than not. As a result, $4.4 million of the valuation allowance for deferred tax assets was reversed, resulting in a non-cash tax benefit of $1.4 million, which offset fiscal 2003 income tax expense of $1.9 million. The remaining $1.6 million reduction in the valuation allowance was due to the reduction in net deferred tax assets attributable to 2003 income.

New Accounting Pronouncement

In May 2003, the FASB issued SFAS No 150 “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity” (SFAS 150). SFAS 150, which became effective July 1, 2003, established standards for the classification and measurement of certain financial instruments with characteristics of both liabilities and equity. The adoption of SFAS 150 did not have any effect on the Company’s financial statements.

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

FASB Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest Entities”, or FIN 46R replaces FIN 46, which was issued July 1, 2003. FIN 46R clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements” to certain entities in which equity investors do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support. There was no effect on the Company as a result of the adoption of these rules.

13

Table of Contents

Index to Financial Statements

FASB Interpretation No. 45 (FIN 45) enhances the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. There was no effect on the Company as a result of the adoption of this rule.

The Company adopted the provisions of Emerging Issues Task Force (“EITF”) 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. EITF 00-21 governs how to identify whether goods or services, or both, that are to be delivered separately in a bundled sales arrangement should be accounted for separately. The adoption of EITF 00-21 had no impact on the Company’s financial statements.

Results of Operations

2003 versus 2002

Revenues. Revenues for the year ended December 31, 2003 decreased $8.6 million, or 13%, primarily due to a decrease in advertising distribution revenues at DGS which reflects increased competition in the advertising market, loss of a key customer, non-recurring StarGuide licensing revenue in 2002 and also 2002 political revenues not recurring during 2003.

Cost of Revenues. Cost of revenues, which includes delivery and material costs and customer operations, decreased $4.1 million, or 12%, for the year ended December 31, 2003 primarily due to cost reductions implemented by management during 2003 and lower revenues. Year over year, product margins remained constant at approximately 50%.

Sales and Marketing. Sales and marketing expense decreased $0.5 million, or 10%, for the year ended December 31, 2003 primarily due to reductions in headcount and cost reductions, including reduced spending on the Company’s CoolCast service, which was terminated during August 2002.

Research and Development. Research and development expense for the year ended December 31, 2003 decreased $0.7 million, or 17%, as compared to the prior year, due to the capitalization of salaries for internally developed software initiatives, benefits and other costs related to the development of new software and cost reductions due to reductions in personnel.

General and Administrative and Restructuring Charges. General and administrative expenses decreased $2.5 million, or 26%, as compared to the prior year, primarily due to a decrease in the Company’s provision for bad debts as well as savings from continued cost reductions implemented by management during 2003. During the first quarter 2002, the Company recorded a restructuring charge of $0.8 million related to the consolidation of certain corporate functions and facilities. The charge represented employee termination costs, lease obligations and the write-down of certain leasehold improvements.

Depreciation and Amortization. Depreciation and amortization increased $0.5 million, or 7%, for the year ended December 31, 2003, as compared to the prior year, primarily due to the $1.5 million settlement of a large patent case.

Interest and Other Expense. Interest and other expense decreased $0.6 million, or 37%, for the year ended December 31, 2003, as compared to the prior year, due to lower average outstanding long-term debt and capital lease obligations as well as a reduction in interest rates, year over year.

Income tax expense. The Company’s effective income tax rate was approximately 10.5% for 2003, which differed from the federal statutory rate of 34% primarily due to a $1.4 million deferred tax benefit recognized when the Company adjusted its deferred tax asset valuation allowance based upon projected taxable income.

2002 versus 2001

Revenues. Revenues for the year ended December 31, 2002 decreased $4.4 million, or 6%, primarily due to satellite receiver sales of $5.4 million during the year ended December 31, 2001 and a $1.7 million decline in consulting revenues. These declines were partially offset by increased advertising distribution revenues of $2.7 million.

Cost of Revenues. Cost of revenues, which includes delivery and material costs and customer operations, decreased $4.1 million, or 11%, for the year ended December 31, 2002 primarily due to cost reductions implemented during 2002 and lower revenues.

Sales and Marketing. Sales and marketing expense decreased $0.6 million, or 11%, for the year ended December 31, 2002 primarily due to reductions in headcount and cost reductions, including reduced spending on the Company’s CoolCast service, which was terminated during August 2002.

14

Table of Contents

Index to Financial Statements

Research and Development. Research and development expense for the year ended December 31, 2002 decreased $0.7 million, or 14%, as compared to the prior year, due to the capitalization of salaries, benefits and other costs related to the development of new software and cost reductions due to reductions in personnel.

General and Administrative and Restructuring Charges. General and administrative expenses decreased $2.5 million, or 21%, as compared to the prior year, primarily due to reductions in headcount and the consolidation of administrative support functions. During the first quarter 2002, the Company recorded a restructuring charge of $0.8 million related to the consolidation of certain corporate functions and facilities. The charge represents employee termination costs, lease obligations and the write-down of certain leasehold improvements. During the year ended December 31, 2001, the Company incurred costs of approximately $0.8 million for the move of its Network Operating Center and corporate accounting department from San Francisco, California to Irving, Texas.

Depreciation and Amortization. Depreciation and amortization decreased $9.7 million for the year ended December 31, 2002, as compared to the prior year, primarily due to the elimination of amortization expense for goodwill. Effective January 1, 2002, the Company adopted SFAS No. 142, and as a result, ceased to amortize goodwill beginning January 1, 2002. During the year ended December 31, 2001, the Company recorded approximately $9.5 million in goodwill amortization expense. In accordance with SFAS No. 142, the Company tested goodwill for impairment and as a result, recorded an impairment charge of approximately $130.2 million as a cumulative effect of change in accounting principle during the three months ended March 31, 2002.

Interest and Other Expense. Interest and other expense decreased $0.6 million for the year ended December 31, 2002, as compared to the prior year, due to lower average outstanding long-term debt and capital lease obligations.

Income tax expense. The Company’s effective income tax rate was approximately 39% for 2002, which differed from the federal statutory rate of 34%, primarily due to state income taxes. For fiscal 2001, the Company’s book loss was offset by goodwill amortization resulting in no income tax expense in fiscal 2001.

Liquidity and Capital Resources

The Company’s operating activities provided cash of $8.9 million in 2003 compared to $7.5 million in 2002. Cash provided by operating activities was $4.9 million in 2001. Cash flows from operating activities increased during 2003 as compared to 2002 and 2001 primarily due to higher income, improved collection efforts and the resulting $3.6 million reduction in accounts receivable in 2003 versus a $0.8 million reduction in 2002. The improvement in accounts receivable was offset, to some extent, by a similar reduction in accounts payable and accrued liabilities which was a use of cash totaling $2.7 million.

The Company used $1.1 million, $0.7 million and $3.2 million of cash in 2003, 2002 and 2001, respectively, to purchase property and equipment. In addition, $1.6 million of property and equipment was acquired through capital leases during 2001. The capital additions for each of the three years were a result of the Company’s continued expansion of its network and continued product development.

On May 5, 2003, the Company signed a new long-term credit agreement with its current lender that includes a term loan of $8.0 million, which matures on September 30, 2005, and a revolving credit facility with a borrowing base subject to the Company’s eligible accounts receivable balance up to $24.5 million, which matures on May 5, 2006. There were no amounts outstanding under the revolving credit facility at December 31, 2003 and approximately $6.5 million was available for borrowing. The proceeds from the term loan were used to refinance the Company’s outstanding debt of $8.0 million. The Company does not anticipate an operational need for borrowings under the revolving credit facility during the next 12 months, however, it retains the right under the facility to use it for acquisitions, capital improvements and general corporate purposes. Under the long-term credit agreement, the Company is required to maintain certain fixed charge coverage ratios, certain leverage ratios and current ratios on a quarterly basis and is subject to limitations on capital expenditures for a rolling twelve-month period and limitations on capital lease borrowings on an annual basis. The Company was in compliance with these covenants for the period ended December 31, 2003. The Company pays interest on borrowings at a variable rate based on the lender’s Prime Rate or LIBOR, plus an applicable margin. The applicable margin fluctuates based on the Company’s leverage ratios as defined in the long-term credit agreement. At December 31, 2003, the weighted average interest rate on outstanding borrowings was 4.68%. The credit facility requires the Company to pay a quarterly facility fee of 0.50% of the average unused portion of the revolving line of credit and a commission fee on outstanding letters of credit.

Net principal payments on long-term debt were $4.4 million, $6.8 million and $0.6 million in 2003, 2002 and 2001, respectively.

The Company has raised cash through the sale of common and preferred stock in the past, most recently in 2003 via the exercise of employee stock options and prior to that during 1999. Proceeds from the sale of stock have been used to fund acquisitions, make

15

Table of Contents

Index to Financial Statements

capital expenditures, repay debt and fund continuing operations. There can be no assurances that the Company could raise additional funds through the sale of common or preferred stock in the future.

The Company currently has no significant capital commitments other than the commitments under capital leases. The Company also has ongoing commitments with a telephone service provider to spend a minimum of $2.0 million in 2004 and 2005. 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 and capital lease commitments and other cash requirements through the foreseeable future. The Company believes that is has the resources necessary either on hand or available under its revolving credit facility or through the issuance of common stock to execute its business plan, to continue to build infrastructure or to make accretive acquisitions.

The table below summarizes the Company’s contractual obligations (in thousands):

Certain Business Considerations

In evaluating an investment in our Company, the following business considerations should be considered.

We have a history of losses and our future operating results are uncertain.

2003 was the first year the Company has reported net income after having been unprofitable since its inception. In 2002, the Company was profitable only after excluding the effect of a change in accounting principle. We could continue to generate net losses in the future, which could depress our stock price. Recent decreases in revenues could continue, which could impair our ability to operate profitably in the future. Future success also depends in part on obtaining continued reductions in delivery and service costs, particularly our ability to continue to automate order processing and to reduce telecommunications costs. Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in new and rapidly evolving markets, such as risks that the market might fail to grow, expenses relating to modifying products and services to meet industry standards as they change over time, and difficulties in gaining and maintaining market share. To address these risks, we must, among other things, respond to competitive developments, continue to attract, retain and motivate qualified persons, continue to upgrade our technologies and begin to commercialize products incorporating such technologies. We may not be successful in addressing any or all of these risks and may not be able to achieve or sustain profitability.

Our revenues are subject to seasonal buying patterns and lengthy sales cycles that can adversely affect operating results and lead to potential fluctuations in quarterly results.

We have historically experienced lower sales for services in the first quarter and higher sales in the fourth quarter due to increased customer advertising volumes for the Christmas selling season. Additionally, in any single period, our service revenues and delivery costs are subject to variation based on changes in the volume and mix of deliveries performed during such period. In particular, our service 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. We have historically operated with little or no backlog. The absence of backlog increases the difficulty of predicting revenues and operating results. Fluctuations in revenues due to seasonality may become more pronounced as revenue increases or decreases. In addition, service revenues are influenced by political advertising, which generally occurs every two years.

Due to the complexity and substantial cost associated with providing integrated product solutions to provide audio, video, data and other information across a variety of media and platforms, licensing and selling our products to customers typically involves a significant technical evaluation and commitment of cash and other resources. In addition, there are frequently delays associated with educating customers as to the productive applications of our products, complying with customers’ internal procedures for approving large expenditures and evaluating and accepting new technologies that affect key operations. In addition, certain of our foreign customers have lengthy purchasing cycles that may increase the amount of time it takes us to place our products with these customers. For these and other reasons, the sales cycle associated with the licensing and selling of our products is lengthy and subject to a number of significant risks, including customers’ budgetary constraints and internal acceptance evaluations, both of which are beyond our control. Because of the lengthy sales cycle and the large size of customers’ average orders, if revenue projected from a specific customer for a particular quarter is not realized in that quarter, our product revenues and operating results for that quarter could be

16

Table of Contents

Index to Financial Statements

negatively affected. We expect revenues to vary significantly as a result of the timing of product purchases and introductions, fluctuations in the rate of development of new markets and new applications, the degree of market acceptance of new and enhanced versions of our products and services, and the level of use of satellite networking and other transmission systems. In addition, increased competition and the general strength of domestic and international economic conditions also impact revenues.

Our expense levels are based, in part, on our expectations of future revenue levels. If revenue levels are below expectations, operating results are likely to be seriously harmed. To the extent that some of our costs are relatively fixed, such as personnel and facilities costs, any unanticipated shortfall in revenue in any fiscal quarter would have an adverse effect on our results of operations in that quarter.

We may not be able to secure additional financing to satisfy future capital needs.

We may require additional capital sooner than currently anticipated in order to fund future operations and growth and we may not be able to obtain additional funds adequate for our needs. We intend to continue making capital expenditures to produce and install various equipment required by our customers to receive our services and to introduce additional services. In addition, we will continue to analyze the costs and benefits of acquiring certain additional businesses, products or technologies that we may from time to time identify. Assuming that we do not pursue one or more additional acquisitions funded by internal cash reserves, we anticipate that existing capital, cash from operations and funds available under existing line of credit agreements should be adequate to satisfy our capital requirements through the foreseeable future. Our capital needs depend upon numerous factors, including:

We cannot predict any of the foregoing factors with certainty. In addition, we cannot predict the precise amount of future capital that we will require, particularly if we pursue one or more additional acquisitions. Furthermore, additional financing may not be available to us, or if it is available, it may not be available on acceptable terms. Our inability to obtain financing for additional acquisitions on acceptable terms may prevent us from completing advantageous acquisitions and consequently could seriously harm our prospects and future rates of growth. Our inability to obtain additional funding for continuing operations or an acquisition would deter the growth of our business and could impair our operations. Consequently, we could be required to significantly reduce or suspend operations, seek an additional merger partner or sell additional securities on terms that are dilutive to existing investors.

We operate in developing markets. If these markets do not continue to develop, or do not accept our products and services, our future growth could be jeopardized.

Our products and services are relatively new, and alternative technologies are rapidly evolving. It is difficult to predict the rate at which the market for such products and services will grow, if at all. If the market fails to grow, or grows more slowly than anticipated, we may also fail to grow. Even if the market does grow, our products and services may not achieve commercial success. We may not be able to conform our products to existing and emerging industry standards in a timely fashion, if at all. We believe that our future growth will depend, in part, on our ability to add these services and additional customers in a timely and cost-effective manner. However, we may not be successful in developing such services or in obtaining new customers for such services. Furthermore, we may not 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.

Our marketing efforts to date with regard to our 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. We may not have correctly identified such markets and our planned products and services may not address the needs of such markets. Furthermore, our technologies, in their current form, may not be suitable for specific applications and further design modifications, beyond anticipated changes to accommodate different markets, may be necessary. Broad commercialization of our products and services will require us to overcome significant market development hurdles, many of which we cannot predict. To achieve sustained growth, the market for such products must continue to develop and we must expand our product offering to include additional applications within the broadcast market. Such new products and applications for existing products in new markets such as distance learning and training, finance and retail. We believe that our products and services are among the first commercial products to serve the convergence of several industry segments, including digital networking, telecommunications, compression products and Internet services. However, the market may not accept our products. In addition, it is possible that:

17

Table of Contents

Index to Financial Statements

Because the convergence of digital networking, telecommunications, compression products and Internet services is new and evolving, we cannot predict the growth rate, if any, and the size of the potential market for our products. If markets for our products fail to develop, develop more slowly than expected or become served by numerous competitors, or if our products do not achieve the anticipated level of market acceptance, our future growth could be jeopardized.

If we are not able to develop new products and services to respond to rapid technological changes, our success could be compromised.

If we are not able to develop new products and services in a timely and cost-effective fashion to respond to technological changes and deliver products and services at competitive prices, operating results will likely suffer and our stock price could decline. The markets for our products and services are characterized by rapidly changing technology. The introduction of new products and services can render existing products obsolete or unmarketable. We may not be successful in identifying, developing, contracting for the manufacture of and marketing product enhancements for new products and services that respond to technological change or meet emerging industry standards. In addition, we may experience difficulties that could delay or prevent the successful development, introduction and marketing of any new products, product enhancements or services, and these products and services may not adequately meet the requirements of the marketplace and achieve market acceptance. If we experience delays in introducing new products and services or enhancements to existing products and services, our customers may begin to use the products and services of our competitors, resulting in a loss of revenue. Furthermore, new or enhanced products offered by us may contain defects when they are first introduced or released. If we are unable to develop and introduce new products and services or enhancements of existing products and services in a timely manner and with a significant degree of market acceptance, our ability to become profitable in the future would be jeopardized.

If we are not able to maintain and improve service quality, our business and results of operations will be susceptible to decline.

We depend on making cost-effective deliveries to broadcast stations within the time periods requested by our customers. If we are unsuccessful, for whatever reason, a station might be prevented from selling airtime that it otherwise could have sold. Although we disclaim any liability for lost air-time, stations may nevertheless assert claims for lost air-time in these circumstances and dissatisfied advertisers may refuse to make further deliveries through us in the event of a significant occurrence of lost deliveries, which would result in a decrease in our revenues or an increase in our expenses, either of which could lead to a reduction in net income or an increase in net loss. Although we maintain insurance against business interruption, such insurance may not be adequate to protect us from significant loss in these circumstances or from the effects of a major catastrophe (such as an earthquake or other natural disaster), which could result in a prolonged interruption of our business. Our 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 our control, including:

Our business is highly dependent on radio and television advertising; if demand for, or margins from, our radio and television advertising delivery services declines, our business results will decline.

We expect that a significant portion of our revenues will continue to be derived from the delivery of radio and television advertising spots from advertising agencies, production studios and dub and ship houses to radio stations in the United States. A decline in demand for, or average selling prices of, our radio and television advertising delivery services for any of the following reasons, or otherwise, would seriously harm our business:

18

Table of Contents

Index to Financial Statements

Additionally, we are dependent on our relationship with the radio and television stations in which we have installed communications equipment. Should a substantial number of these stations go out of business, experience a change in ownership or discontinue the use of our equipment in any way, our revenues and results of operations would decline.

Our business is highly dependent on electronic video advertising delivery service deployment.

Our inability to place units necessary for the receipt of electronically delivered video advertising content in an adequate number of television stations or our inability to capture market share among content delivery customers, which may be the result of price competition, new product introductions from competitors or otherwise, would be detrimental to our business objectives and deter future growth. We have made a substantial investment in upgrading and expanding our NOC and in populating television stations with the units necessary for the receipt of electronically delivered video advertising content. However, we cannot assure the investor that the placement of these units will cause this service to achieve adequate market acceptance among customers that require video advertising content delivery.

In addition, we believe that to more fully address the needs of potential video delivery customers we will need to develop a set of ancillary services that typically are provided by dub and ship houses. These ancillary services include cataloging, physical archiving, closed-captioning, modification of slates and format conversions. We will need to provide these services on a localized basis in each of the major cities in which we provide services directly to agencies and advertisers. We currently provide certain of such services to a portion of our customers through our facilities in New York, Los Angeles and Chicago. However, we may not be able to successfully provide these services to all customers in those markets or any other major metropolitan area at competitive prices. Additionally, we may not be able to provide competitive video distribution services in other United States markets because of the additional costs and expenses necessary to do so and because we may not be able to achieve adequate market acceptance among current and potential customers in those markets.

While we are taking the steps we believe are required to achieve the network capacity and scalability necessary to deliver video content reliably and cost effectively as video advertising delivery volume grows, we may not achieve such goals because they are highly dependent on the services provided by our telecommunication providers and the technological capabilities of both our customers and the destinations to which content is delivered. If our telecommunication providers are unable or unwilling to provide us the services necessary at a rate we are willing to pay or if our customers and/or their delivery destinations do not have the technological capabilities necessary to send and/or receive video content, our goals of adequate network capacity and scalability could be jeopardized.

In addition, we may be unable to retain current audio delivery customers or attract future audio delivery customers who may ultimately demand delivery of both media content unless we can successfully continue to develop and provide video transmission services. The failure to retain such customers could result in a reduction of revenues, thereby decreasing our ability to achieve and maintain profitability.

The markets in which we operate are highly competitive, and we may be unable to compete successfully against new entrants and established companies with greater resources.

We provide services that compete with a variety of dub and ship houses and production studios 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. Although such dub and ship houses and production studios generally do not offer electronic delivery, they have long-standing ties to local distributors that may be difficult for us 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 we have. Certain of our competitors in the video distribution market are also our marketing partners in the audio distribution market.

To the extent that we are successful in entering new markets, such as the delivery of other forms of content to radio and television stations, we would expect to face competition from companies in related communications markets and/or package delivery markets. Some of these companies in related markets could offer products and services with functionality similar or superior to ours. Telecommunications providers, such as AT&T, MCI Worldcom and Regional Bell Operating Companies, could also enter the market as competitors with materially lower electronic delivery transportation costs. We 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.

19

Table of Contents

Index to Financial Statements

We expect that an increasingly competitive environment will result in price reductions that could result in lower profits and loss of market share. 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 our competitors to devote significantly greater resources to the development and marketing of new competitive products and services. We expect that competition will increase substantially as a result of these and other industry consolidations and alliances, as well as the emergence of new competitors. Accordingly, we may not be able to compete successfully with new or existing competitors, and the effects of such competition could result in a decrease in our anticipated future growth.

The markets in which we sell products are highly competitive, and we may be unable to compete successfully against new entrants and established companies with greater resources. We believe that our ability to compete successfully depends on a number of factors, both within and outside of our control, including the price, quality and performance of our products and those of our competitors, the timing and success of new product introductions, the emergence of new technologies and the number and nature of competitors in a given market. In addition, the assertion of intellectual property rights by others and general market and economic conditions factor into our ability to compete successfully.

We are aware of other companies that are intensifying their focus and may commit significant resources on developing and marketing products and services that will compete with ours. Such competitors and potential competitors may have substantially greater financial, technical, research and development, distribution, marketing and other resources and larger installed customer bases than us. We may not be able to compete successfully against current and future competitors based on these and other factors. A number of the markets in which our products are sold are also served by technologies that are currently more widely accepted. Our potential customers may not be willing to make the initial capital investment necessary to convert to StarGuide’s products and services. The success of our systems against these competing technologies depends in part upon whether our systems can offer significant improvements in productivity and sound quality in a cost-effective manner. Additionally, competitors may be able to develop systems compatible with, or that are alternatives to, our proprietary technology or systems.

Our business may be adversely affected if we are not able to protect our intellectual property rights from third-party challenges.

We cannot assure that our intellectual property does not infringe on the proprietary rights of third parties. The steps that we have taken to protect our proprietary information may not 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 ours. We consider our trademarks, copyrights, advertising and promotion design and artwork to be of value and important to our business. We rely on a combination of trade secret, copyright and trademark laws and nondisclosure and other arrangements to protect our proprietary rights. We generally enter into confidentiality or license agreements with our employees, distributors and customers and limit access to and distribution of our software, documentation and other proprietary information. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or obtain and use information that we regard as proprietary. In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as do the laws of the United States.

While we believe that our trademarks, copyrights, advertising and promotion design and artwork do not infringe upon the proprietary rights of third parties, we may still receive future communications from third parties asserting that we are infringing, or may be infringing, on the proprietary rights of third parties. Any such claims, with or without merit, could be time-consuming, require us to enter into royalty arrangements or result in costly litigation and diversion of management attention. If such claims are successful, we may not be able to obtain licenses necessary for the operation of our business, or, if obtainable, such licenses may not be available on commercially reasonable terms, either of which could prevent our ability to operate our business.

We may enter into or seek to enter into business combinations and acquisitions that may be difficult to integrate, disrupt our business, dilute shareholder value or divert management attention.

Our business strategy includes the acquisition of complementary businesses and product lines. Any such acquisitions would be accompanied by the risks commonly encountered in such acquisitions, including:

20

Table of Contents

Index to Financial Statements

We may not be able to successfully complete any acquisition or, if completed, the acquired business or product line may not be successfully integrated with our operations, personnel or technologies. Any inability to successfully integrate the operations, personnel, and technologies associated with an acquired business and/or product line may negatively affect our business and results of operation. We may dispose of any of the Company’s businesses or product lines in the event that we are unable to successfully integrate them, or in the event that management determines that any such business or product line is no longer in the strategic interests of the Company or for other business reasons.

Failure to manage future growth could hinder the future success of our business.

Our personnel, systems, procedures and controls may not be adequate to support our existing and future operations. To accommodate any potential future growth and to compete effectively and manage future growth, if any, we must continue to implement and improve our operational, financial and management information systems, procedures and controls on a timely basis and to expand, train, motivate and manage our work force. We must continue to further develop our products and services while we manage anticipated growth by implementing effective planning and operating processes, such as continuing to implement and improve our operational, financial and management information systems; hiring and training additional qualified personnel; continuing to expand and upgrade our core technologies; and effectively managing multiple relationships with various customers, joint venture and technological partners and other third parties.

We depend on our key personnel to manage the business effectively, and if we are unable to retain our key employees or hire additional qualified personnel, our ability to compete could be harmed.

We believe that our future success will depend to a significant extent upon the services of Scott K. Ginsburg, our Chairman of the Board and Chief Executive Officer; and Omar A. Choucair, our Chief Financial Officer. Uncontrollable circumstances, such as the death or incapacity of any key executive officer, could have a serious impact on our business.

Our future success also depends upon our ability to retain and to attract and retain highly qualified management, sales, operations, technical and marketing personnel. We believe there is, and will continue to be, intense competition for personnel with experience in the markets applicable to our products and services. Because of this intense competition, we may not be able to retain our key personnel or attract, assimilate or retain other highly qualified technical and management personnel in the future. Our inability to retain or to attract additional qualified personnel as needed could have a considerable impact on our business.

Certain provisions of our bylaws may have anti-takeover effects that could prevent a change in control even if the change would be beneficial to our shareholders.

Our classified board might discourage the acquisition of a controlling interest of our stock because such acquirer would not have the ability to replace our directors, except as the term of each class expires. Our directors are divided into three classes with respect to the time for which they hold office. The term of office of one class of directors expires at each annual meeting of stockholders. At each annual meeting of stockholders, directors elected to succeed those directors whose terms then expire are elected for a term of office to expire at the third succeeding annual meeting of stockholders after their election.

Because the Nasdaq National Market is likely to continue to experience extreme price and volume fluctuations, the price of our common stock may decline, thus making your investment more risky.

The stock markets, particularly the Nasdaq National Market, on which our common stock is listed, have experienced extreme price and volume fluctuations. These fluctuations have particularly affected the market prices of equity securities of technology-related companies and have often been unrelated or disproportionate to the operating performance of those companies. Our common stock may not trade at the same levels of shares as that of other technology companies.

Some of the factors that may cause the market price of our common stock to fluctuate significantly, include:

21

Table of Contents

Index to Financial Statements

Sales of substantial amounts of our common stock in the public market could negatively affect the market price of our common stock.

Sales of substantial amounts of common stock, or the perception that these sales could occur, may depress prevailing market prices for the common stock. The sale of substantial amounts of our shares (including shares issued upon exercise of outstanding options) may cause substantial fluctuations in the price of our common stock. In addition, sales of a substantial amount of our shares within a short period of time could cause our stock price to steeply fall. Because investors would more than likely be reluctant to purchase shares of our common stock following substantial sales, our ability to raise capital through the sale of additional stock could be impaired.

Insiders have substantial control over us, which will limit an investor’s ability to influence corporate actions, including changes in control.

Our executive officers and directors and their respective affiliates own approximately 42% of our common stock, not including options or warrants to purchase additional shares of common stock. As a result, these shareholders are 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 even if a change of control is in the best interest of all shareholders.

We face risks associated with being delisted from the Nasdaq National Market.

The holders of our common stock currently enjoy a substantial benefit in terms of liquidity by having such common stock listed on the Nasdaq National Market. This benefit would be lost if we were to be delisted from the Nasdaq National Market. Nasdaq rules require, among other things, that our common stock trade at $1 per share or more on a consistent basis. While we believe we are currently in compliance with Nasdaq’s listing requirements and corporate governance rules, we cannot assure the investor that this is the case or that we will be able to continue to keep our common stock listed on the Nasdaq National Market or a similar securities exchange.

Our inability to enter into or develop strategic relationships in our key industry segments could impact our operating results.

Our strategy depends in part on the development of strategic relationships with leading companies in key industry segments, including media broadcasters and digital system providers. We may not be able to successfully form or enter into such relationships, which may jeopardize our ability to generate sales of our products or services in those segments. Specific product lines are dependent to a significant degree on strategic alliances and joint ventures formed with other companies. Various factors could limit our ability to enter into or develop strategic relationships, including, but not limited to, our relatively short operating history, history of losses and the resources available to our competitors.

Our business will suffer if it is not able to overcome the numerous risks associated with the use of complex technology.

The networks and the individual components within networks used in providing our distribution services are highly complex. Our services may be subject to errors and defects in software or hardware. Additional problems in delivery of service could result from a variety of causes, including human error, physical or electronic security breaches, natural disasters, power loss, sabotage or vandalism. Such problems or defects could result in:

22

Table of Contents

Index to Financial Statements

In addition, because some equipment involved in providing our information distribution services are located in the facilities of others, such as broadcast affiliates, Internet service providers and broadband access providers, we must rely on third parties to care for equipment needed to provide our services. For example, after we place our equipment in the facilities of others and ensure it is functioning properly, we rely on the facility to monitor the equipment to ensure that it maintains power, continues to receive a signal from the carrier and is connected to the facilities network in order to deliver the signal.

We depend upon single or limited-source suppliers, and our ability to produce audio and video distribution equipment could be impacted if those relationships were discontinued.

We rely on fewer than five single or limited-source suppliers for integral components used in the assembly of our audio and video units. Although these 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 us, it would delay our deployment of audio and video units. We rely on our suppliers to manufacture components for use in our products. Some of our suppliers also sell products to our competitors and may in the future become our competitors, possibly entering into exclusive arrangements with our existing competitors. In addition, our suppliers may stop selling their products or components to us at commercially reasonable prices or completely stop selling their products or components to us. If a reduction or interruption of supply were to occur, it could take a significant period of time for us to qualify an alternative subcontractor, redesign its products as necessary and contract for the manufacture of such products. This would have the effect of depressing our business until we were able to establish sufficient component supply through an alternative source. We believe that there are currently alternative component manufacturers that could supply the components required to produce our products, but based on the financial condition and service levels of our current suppliers, we do not feel the need to pursue agreements or understandings with such alternative sources or pursue long-term contracts with our current suppliers. We have experienced component shortages in the past, and material component shortages or production or delivery delays may occur in the future.

We obtain our local access transmission services and long distance telephone access through contracts with Sprint and MCI that expire in 2005. Our agreements with Sprint and MCI provide for reduced pricing on various services provided in exchange for minimum purchases under the contracts of $2.0 million and $0.5 million per year, respectively. The agreement provides for certain achievement credits once specified purchase levels are met. Any material interruption in the supply or a material change in the price of either local access or long distance carrier service could increase our costs or cause a significant decline in our revenues, thereby decreasing our operating results.

We face various risks associated with purchasing satellite capacity.

As part of our strategy of providing transmittal of audio, video, data, and other information using satellite technology, we periodically purchase satellite capacity from third parties owning satellite systems. Although we attempt to match these expenditures against anticipated revenues from sales of our products to customers, we may not be successful at estimating anticipated revenues, and actual revenues from sales of our products may not exceed our expenditures for satellite capacity. In addition, purchases of satellite capacity require a significant amount of capital. Any inability to purchase satellite capacity or to achieve revenues sufficient to offset the capital expended to purchase satellite capacity may make our business more vulnerable and significantly affect our financial condition and results of operations.

If our relationship with Hughes Network Systems is terminated, or if Hughes fails to perform as required under our agreement, our business could be interrupted.

We have designed and developed the necessary software to enable our current video delivery systems to receive digital satellite transmissions over the Hughes Network Systems satellite system. However, the Hughes satellite system may not have the capacity to meet our future delivery commitments and broadcast quality requirements on a cost-effective basis, if at all. We have a non-exclusive agreement with Hughes that expires in December 2005. The agreement provides for fixed pricing on dedicated bandwidth and gives us access to satellite capacity for electronic delivery of digital audio and video transmissions by satellite. Hughes is required to meet performance specifications as outlined in the agreement, and we are given a credit allowance for future fees if Hughes does not meet

23

Table of Contents

Index to Financial Statements

these requirements. The agreement states that Hughes can terminate the agreement if we do not make timely payments or become insolvent.

Certain of our products depend on satellites; any satellite failure could result in interruptions of our service that could negatively impact our business and reputation.

A reduction in the number of operating satellites or an extended disruption of satellite transmissions would impair the current utility of the accessible satellite network and the growth of current and additional market opportunities. Satellites and their ground support systems are complex electronic systems subject to weather conditions, electronic and mechanical failures and possible sabotage. The satellites have limited design lives and are subject to damage by the hostile space environment in which they operate. The repair of damaged or malfunctioning satellites is nearly impossible. If a significant number of satellites were to become inoperable, there could be a substantial delay before they are replaced with new satellites. In addition, satellite transmission can be disrupted by natural phenomena causing atmospheric interference, such as sunspots.

Certain of our products rely on signals from satellites, including, but not limited to, satellite receivers and head-end equipment. Any satellite failure could result in interruptions of our service, negatively impacting our business. We attempt to mitigate this risk by having our customers procure their own agreements with satellite providers.

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

The Company is exposed to interest rate risk primarily through its borrowing activities. As of December 31, 2003, the Company had $5.6 million outstanding under its credit facility and other variable rate debt. A one-percentage point increase in the variable interest rate based on debt amounts outstanding would result in approximately $44,000 reduction in annual pre-tax earnings. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources” for additional discussion of the terms of the Company’s credit facility.

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 report.

None.

The Company maintains a system of disclosure controls and procedures that is designed to ensure information required to be disclosed by the Company is accumulated and communicated to management, including our chief executive officer and chief financial officer, in a timely manner.

An evaluation of the effectiveness of this system of disclosure controls and procedures was performed under the supervision and with the participation of the Company’s management, including the Company’s chief executive officer and chief financial officer, as of the end of the period covered by this report. Based upon this evaluation, the Company’s management, including the Company’s chief executive officer and chief financial officer, concluded that the current system of controls and procedures is effective.

The Company maintains a system of internal control over financial reporting. There has been no change in the Company’s internal control over financial reporting that occurred during the Company’s fourth fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

24

Table of Contents

Index to Financial Statements

PART III

Scott K. Ginsburg joined the Company in December 1998 as Chief Executive Officer and Chairman of the Board. In July 1999, Matthew E. Devine assumed the responsibilities as Chief Executive Officer, but Mr. Ginsburg remained the Company’s Chairman. Mr. Ginsburg reassumed the responsibilities as Chief Executive Officer of the Company in November 2003. Mr. Ginsburg founded the Boardwalk Auto Group in 1998, which consists of several car dealerships located in the Dallas area. From 1997 to 1998, Mr. Ginsburg served as Chief Executive Officer and Director of Chancellor Media (now AMFM Corporation). Mr. Ginsburg founded Evergreen Media Corporation in 1988, and was the co-founder of Statewide Broadcasting, Inc. and H&G Communications, Inc. Mr. Ginsburg earned a B.A. from George Washington University in 1974 and a J.D. from Georgetown University in 1978.

Omar A. Choucair joined the Company as Chief Financial Officer in July 1999. Prior to joining the Company, Mr. Choucair served as Vice President of Finance for AMFM Corporation (formerly Chancellor Media), and served as Vice President of Finance for Evergreen Media before it was acquired by Chancellor Media in 1997. Prior to entering the media industry, Mr. Choucair was a Senior Manager at KPMG LLP, where he specialized in media and telecommunications clients. Mr. Choucair received a B.B.A. from Baylor University and became a Director in February 2001.

David M. Kantor has been a member of the Board of Directors of the Company since August 1999. Mr. Kantor is a media industry consultant and Vice Chairperson and CEO of Reach Media, a company that develops, acquires and partners in quality media and marketing opportunities targeting the African American population. Formerly, he was Senior Vice President for Network Operations of AMFM, Inc. (formerly Chancellor Media Corporation) and President of ABC Radio Network, having previously served as Executive Vice President. Prior to joining ABC Radio Network, he held executive positions with Cox Cable and Satellite Music Network. Mr. Kantor holds a B.S. from the University of Massachusetts and an MBA from Harvard Business School.

Cappy R. McGarr has been a member of the Board of Directors of the Company since February 2001. Mr. McGarr is President of McGarr Capital Holdings, LLC, an asset management company. He received Bachelor of Arts, Bachelor of Journalism and Master of Business Administration degrees from the University of Texas at Austin. Upon completing his graduate degree in 1977, Mr. McGarr was employed by Goldman, Sachs & Co. He serves on the Board of Trustees of The National Archives Foundation and the Board of Directors of the Lyndon Baines Johnson Foundation.

Kevin C. Howe is the Managing Partner of Mercury Ventures and has been a member of the Board of Directors of the Company since February 2001. Mercury Ventures manages 3 different funds that invest in emerging technology companies that focus on Internet applications. Mr. Howe serves on the board of two publicly traded technology firms, the Company and The Sage Group, plc. which is traded on the London Stock Exchange. Mr. Howe also sits on the boards of seven privately held technology firms. In 1985, he co-founded DacEasy, an early leader in packaged application software. In 1987, Mr. Howe led the sale of DacEasy to Insilco (a Fortune 500 company). In 1991, Mr. Howe led the carve-out of DacEasy from Insilco and subsequent sale to The Sage Group, plc. which had market capitalization of over $7 billion. He was CEO of the US operations responsible for operations and acquisitions until 1999. In 1993, Mr. Howe also co-founded Martin Howe Associates, which was an early leader in the merchant credit card processing industry and a pioneer in wireless solutions. The company was sold in 1997 to PMT, a Nasdaq listed company. Mr. Howe received his MBA from SMU in 1976.

Resignation of Directors

Two members of the Board of Directors resigned their Board positions subsequent to the annual shareholder’s meeting that took place on November 18, 2003. Lawrence D. Lenihan resigned on January 9, 2004 and Robert J. Schlegal resigned on December 23, 2003. Both individuals resigned their positions without any disagreement with the Company on any matter relating to the Company’s operations, policies or practices.

25

Table of Contents

Index to Financial Statements

OTHER INFORMATION

In September 1999, a civil lawsuit was filed by the SEC in the United States District Court for the Southern District of Florida against Scott Ginsburg, the Chairman of the Board of the Company, his brother and his father. The lawsuit alleged that Mr. Ginsburg had violated the insider trading provisions of the federal securities laws by communicating material, non-public information to his brother in 1996 regarding the securities of EZ Communications, Inc. (“EZ”) and in 1997 regarding the securities of Katz Media, Inc. (“Katz”). The lawsuit further alleged that Mr. Ginsburg’s father and brother, relying upon the information allegedly furnished by Mr. Ginsburg, purchased securities in EZ and Katz, and subsequently profited from the sale of such securities.

In April 2002, a jury found that Mr. Ginsburg did make these communications, known as “tipping,” and therefore concluded that he had violated Sections 10(b) and 14(e) of the Securities Exchange Act of 1934 and Rules 10b-5 and 14e-3 thereunder. In July 2002, the United States District Court imposed a $1,000,000 civil penalty against Mr. Ginsburg.

Mr. Ginsburg filed a motion asking the Court to set aside its ruling and the verdict of the jury. On December 19, 2002, the United States District Court granted Mr. Ginsburg’s motion for judgment notwithstanding the verdict. The Court overturned the jury verdict in its entirety and set aside the civil penalty.

On February 13, 2003, the SEC filed a Notice of Appeal, seeking to reverse the Court’s decision and challenging the Court’s earlier refusal to impose an injunction against Mr. Ginsburg. The appeal is pending.

SECTION 16 (a) BENEFICIAL OWNERSHIP

REPORTING COMPLIANCE

The members of the Board of Directors, the executive officers of the Company and persons who hold more than 10% of the Company’s outstanding common stock are subject to the reporting requirements of Section 16 (a) of the Securities Exchange Act of 1934, as amended, which require them to file reports with respect to their ownership of the Company’s common stock and their transactions in such common stock. Based upon (i) the copies of Section 16 (a) reports that the Company received from such persons for their 2003 fiscal year transactions in the common stock and their common stock holdings and (ii) the written representation received from one or more of such persons that no annual Form 5 reports were required to be filed by them for the 2003 fiscal year, the Company believes that all reporting requirements under Section 16 (a) for such fiscal year were met in a timely manner by its executive officers, Board members and greater than ten-percent shareholders at all times during the 2003 fiscal year.

Certain other information required by this item is incorporated by reference to the section captioned “Directors” in the Proxy Statement.

The information required by this item is incorporated by reference to the section captioned “Executive Compensation” in the Proxy Statement.

The information required by this item is incorporated by reference to the sections captioned “Security Ownership of Certain Beneficial Owners and Management” and “Securities Authorized for Issuance Under Equity Compensation Plans” in the Proxy Statement.

The information required by this item is incorporated by reference to the sections captioned “Compensation Committee Interlocks and Insider Participation” and “Certain Transactions with Management” in the Proxy Statement.

The information required by this item is incorporated by reference to the section captioned “Principal Accounting Fees and Services” in the Proxy Statement.

26

Table of Contents

Index to Financial Statements

PART IV

3. EXHIBITS

27

Table of Contents

Index to Financial Statements

Current report on Form 8-K dated February 20, 2004, furnishing its press release announcing financial results for the three and twelve month periods ended December 31, 2003.

28

Table of Contents

Index to Financial Statements

Current report on Form 8-K dated February 20, 2004, furnishing its press release outlining strategies for growth in 2004.

See Item 15 (a) (3) above.

See Item 15(a) (2) above.

29

Table of Contents

Index to Financial Statements

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.

POWER OF ATTORNEY

KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Scott K. Ginsburg and Omar A. Choucair, and each of them, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him in his name, place and stead, in any and all capacities, to sign any or all amendments to this Form 10-K and to file the same, with all exhibits thereto, and all other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue thereof.

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.

30

Table of Contents

Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

F-1

Table of Contents

Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

INDEPENDENT AUDITORS’ REPORT

The Board of Directors

Digital Generation Systems, Inc.:

We have audited the accompanying consolidated balance sheets of Digital Generation Systems, Inc. and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of operations, stockholders’ equity (deficit) and cash flows for each of the years in the three-year period ended December 31, 2003. In connection with our audits of the consolidated financial statements, we have also audited the related financial statement schedule. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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 consolidated 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, 2003 and 2002, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

As discussed in Note 6 to the consolidated financial statements, the Company changed its method of accounting for goodwill and other intangible assets in accordance with Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” in 2002.

KPMG LLP

Dallas, Texas

February 12, 2004

F-2

Table of Contents

Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands, except per share amounts)

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

F-3

Table of Contents

Index to Financial Statements

DIGITAL GENERATION SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)