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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

For the quarterly period ended March 31, 2004

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)

Not Applicable

(Former name, former address, former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  x    NO  ¨

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

Number of shares of registrant’s Common Stock, par value $0.001, outstanding as of April 30, 2004: 72,229,985

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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. 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 reported in the Company’s Annual Report on Form 10-K filed on March 12, 2004, as well as those risks discussed in this Report, and in the Company’s other United States Securities and Exchange Commission filings.

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ITEM I. FINANCIAL STATEMENTS

Digital Generation Systems, Inc.

Condensed Consolidated Balance Sheets

(in thousands)

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

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Digital Generation Systems, Inc.

Unaudited Condensed Consolidated Statements of Income

(in thousands, except per share data)

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

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Digital Generation Systems, Inc.

Unaudited Condensed Consolidated Statement of Stockholders’ Equity

(in thousands)

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

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Digital Generation Systems, Inc.

Unaudited Condensed Consolidated Statements of Cash Flows

(in thousands)

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

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

The financial statements included herein have been prepared by Digital Generation Systems, Inc. (the “Company”) without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. However, the Company believes that the disclosures are adequate to make the information presented not misleading. The unaudited condensed consolidated financial statements reflect all adjustments, which are, in the opinion of management, of a normal and recurring nature and necessary for a fair presentation of the Company’s financial position, results of operations and cash flows for the periods presented. These condensed consolidated financial statements should be read in conjunction with the financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. Certain reclassifications have been made to conform prior year amounts to current year classifications.

2. STOCK-BASED COMPENSATION

The Company applies Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations, in accounting for its stock option plans. As such, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. SFAS No. 123, “Accounting for Stock-Based Compensation,” established accounting and disclosure requirements using a fair value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to continue to apply the intrinsic value-based method of accounting described above, and has adopted the disclosure requirements of SFAS No. 123. Pro forma net income and earnings per share disclosures, as if the Company recorded compensation expense based on the fair value for stock-based awards, have been presented in accordance with the provisions of SFAS No. 148, “Accounting for Stock-based Compensation – Transition and Disclosure”, and are as follows for the three months ended March 31, 2004 and 2003 (in thousands, except per share amounts).

The fair value of each option grant is estimated on the date of grant using the multiple option approach of the Black-Scholes option pricing model. There were no grants during the first quarter of 2004 and the following assumptions were used for grants during the first quarter of 2003; risk-free interest rates of 3.0%; a dividend yield of 0%; expected life of 3.6 years; and volatility factors of the expected market price of the Company’s common stock of 79%.

3. INVENTORIES

Inventories as of March 31, 2004 and December 31, 2003 are summarized as follows (in thousands):

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4. LONG-TERM DEBT

Pursuant to the Company’s credit agreement with its main lender, 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 all such covenants as of March 31, 2004. In addition, the Company pays interest on borrowings at a variable rate, currently 4.63%.

5. INCOME TAXES

Income tax expense in the amount of $0.5 million and $0.7 million has been recorded for the three months ended March 31, 2004 and 2003, respectively, and is a provision for both state and federal income taxes. The Company has recorded a valuation allowance on its net deferred tax assets. Generally accepted accounting principles require that the Company record a valuation allowance against the net deferred tax assets if it is “more likely than not” that the Company will not be able to utilize them in the future. As of March 31, 2004, and December 31, 2003, the Company has concluded that realization of $4.4 million of its tax benefits is more likely than not.

6. EARNINGS PER SHARE

Under SFAS No. 128, “Earnings per Share”, the Company is required to compute earnings per share under two different methods (basic and diluted). Basic income per share is calculated by dividing net income attributable to common shareholders by the weighted average shares of Common Stock outstanding during the period. Diluted income per share is calculated by dividing net income attributable to common shareholders by the weighted average shares of outstanding Common Stock and potentially dilutive securities during the period. Below is a reconciliation of basic and diluted income per share (in thousands, except per share amounts):

For the three months ended March 31, 2004, 3,832,542 options with a weighted average exercise price of $3.55 per share and warrants to purchase 3,479,418 shares of common stock at a weighted average price of $3.26 per share had exercise prices above the average market price of $1.80. As a result, 7,311,960 shares were excluded from the computation of diluted net income per share as their effect would be antidilutive. At March 31, 2003, 5,146,043 options with a weighted average exercise price of $2.38 per share and warrants to purchase 8,544,870 shares of common stock at a weighted average price of $2.48 per share had exercise prices above the average market price of $1.68. As a result, 13,690,913 shares were excluded in the computation of diluted net income per share as their effect would be antidilutive.

9. SEGMENT INFORMATION

The Company operates predominantly in two industry segments: digital and physical distribution of audio and video content and other, which includes transmission and compression technology and consulting. The Company has defined its reportable segments based on internal financial reporting used for corporate management and decision-making purposes.

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The information in the following tables is derived directly from the segments’ internal financial reporting used for corporate management purposes (in thousands).

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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 which are usually net 30 days.

Results of Operations

Revenues. Revenues for the three months ended March 31, 2004 decreased $2.3 million, or 15%, as compared to the prior year period, primarily due to the loss of a significant customer in Digital Generations Systems, Inc. (“DGS division”) and cyclical advertising patterns of a few major customers. This decrease was offset to some extent by increases in product sales at StarGuide Digital Networks, Inc. (“StarGuide division”).

Cost of Revenues. Cost of revenues, which includes delivery and material costs and customer operations, decreased $0.9 million, or 11%, for the three months ended March 31, 2004, as compared to the prior year period, primarily due to revenue declines at the DGS division and continued cost reductions implemented during the latter part of 2003.

Research and Development. Research and development expense for the three months ended March 31, 2004 decreased $0.4 million, or 43%, as compared to the prior year period, primarily due to headcount reductions at both the DGS and StarGuide divisions, and an increase in capitalization of selected engineering salaries for internally developed software.

General and Administrative and Restructuring Charges. General and administrative expenses for the three months ended March 31, 2004 decreased $0.6 million, or 28%, as compared to the prior year period, due to aggressive cost containment by the Company’s management which included, but was not limited to, headcount reduction and office closures.

Depreciation and Amortization. Depreciation and amortization decreased $0.6 million for the three months ended March 31, 2004, or 35%, as compared to the prior year period, primarily due to the fact that certain intangible assets acquired as result of the 2001 merger between DGS and StarGuide became fully amortized during 2003. In addition, the useful lives of network equipment were also extended during the second quarter of 2003, reducing depreciation expense.

Interest and Other Expense. Interest and other expense increased $0.1 million, or 28%, for the three months ended March 31, 2004, as compared to the corresponding prior year period, due to the fact that, as a result of entering into a new credit facility in May 2003, the Company gained access to a line of credit that requires payment of commitment fees if unutilized. No such fees were required on the facility in place during the prior year.

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Liquidity and Capital Resources

On a reported basis, net cash provided by operating activities for the three months ended March 31, 2004 was $0.8 million compared to net cash provided by operating activities of $1.8 million for the three months ended March 31, 2003. The decrease of $1.0 million in net cash provided by operating activities is primarily due to decreased revenues at the Company’s DGS division during the first quarter of 2004.

The Company purchased equipment and made capital additions of $0.4 million both during the three months ended March 31, 2004 as well as for the three months ended March 31, 2003. Net principal payments on long term debt and capital leases was $0.8 million for the three months ended March 31, 2004 versus $1.7 million for the three months ended March 31, 2004.

At March 31, 2004, the Company’s current sources of liquidity included cash and cash equivalents of $6.9 million while the Company’s only debt consisted of a term loan totaling only $4.8 million; the Company has a cash surplus of approximately $2.1 million. In addition, as part of the long term credit agreement entered into during 2003, the Company has access to a revolving credit facility with a borrowing base subject to the Company’s eligible accounts receivable balance up to $32 million, which matures on May 5, 2006. Currently, the Company may borrow up to $5.9 million based on eligible accounts receivable. Under the new 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 all covenants of its credit facility as of March 31, 2004.

Finally, at March 31, 2004, the Company had positive working capital in excess of $8.6 million and also filed a shelf registration with the SEC in January 2004. As a result of the shelf registration, the Company may offer, from time to time, 7,000,000 shares of common stock and up to $5,000,000 in preferred shares. As of March 31, 2004, no shares had been sold pursuant to this registration. The Company believes it has sufficient capital and capital resources to sustain liquidity in the foreseeable future.

Impact of Recently Issued Accounting Standards

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.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company provides some services to entities located outside of the United States of America and, therefore, is subject to the risk that the applicable 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.

Item 4. CONTROLS AND PROCEDURES

Our principal executive and financial officers have concluded, based on their evaluation as of a date within 90 days before the filing of this Form 10-Q, that our disclosure controls and procedures under Rule 13a-14 of the Securities Exchange Act of 1934 are effective to ensure that information we are required to disclose in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and include controls and procedures designed to ensure that information we are required to disclose in such reports is accumulated and communicated to management, including our principle executive and financial officers, as appropriate to allow timely decisions regarding required disclosure.

Subsequent to our evaluation, there were no significant changes in internal controls or other factors that could significantly affect these internal controls.

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PART II. OTHER INFORMATION

Item 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

(b) Report on Form 8-K

Current Report on Form 8-K dated May 6, 2004, furnishing its press release regarding its results for the three months ended March 31, 2004.

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SIGNATURES

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

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