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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

For the quarterly period ended June 30, 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 July 31, 2004: 73,174,692

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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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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. ACQUISITIONS

Effective June 1, 2004, the Company purchased substantially all of the net assets and certain liabilities of the Broadcast Division (“Broadcast”) of Applied Graphics Technologies, Inc. (“AGT”). Accordingly, the results of Broadcast’s operations have been included in the consolidated financial statements since that date. The purpose of the acquisition was to expand the Company’s operations. Based in New York, Broadcast’s core services are the distribution of program and/or advertising content to television and radio stations throughout the country utilizing conventional and electronic duplication technology. Broadcast currently distributes content to radio stations and television destinations across the United States and maintains operations in California, Illinois, Michigan, New York and Ohio.

The Company paid $15.0 million to AGT as consideration for the assets of Broadcast and has recorded a receivable of $0.9 million at June 30, 2004 due to a working capital adjustment which was collected in July 2004. Purchase price consideration also included $0.4 million in receivables due from Broadcast which were forgiven as a result of the acquisition. The cash payment was comprised of $1.0 million of the Company’s cash reserves and $14 million borrowed under the Company’s Amended and Restated Credit Agreement. The purchase price was allocated based on the current estimated fair values of the assets acquired and liabilities assumed at the date of acquisition, which may be revised at a later date. The excess of the purchase price over the net assets acquired was allocated to Goodwill as of June 30, 2004. Goodwill created as a result of the acquisition totaled $6.7 million.

The following pro forma information details the results of operations as if the acquisition had taken place on January 1, 2003:

3. 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. Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” establishes 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 and six month periods ended June 30, 2004 and 2003 (in thousands, except per share amounts).

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The fair value of each option was estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:

4. INVENTORIES

Inventories as of June 30, 2004 and December 31, 2003 are summarized as follows (in thousands):

5. LONG-TERM DEBT AND CAPITAL LEASES

In conjunction with the purchase of Broadcast, on June 10, 2004, the Company signed an amended and restated credit agreement with its current lenders that includes an additional term loan of $6.0 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 $26 million, which matures on May 5, 2006. At June 30, 2004 there was $8.0 million outstanding under the revolver and $1.2 million was available for borrowing. The proceeds from the additional term loan and the revolver were used to purchase Broadcast. Payments on the term loans are scheduled to be made quarterly through September 30, 2005 with payments totaling $1.55 million each quarter and a balloon payment of $3.0 million on September 30, 2005.

Under the amended 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 June 30, 2004. 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 amended long-term credit agreement.

6. INCOME TAXES

Income tax expense totaled $0.6 and $0.5 million for the three months ended June 30, 2004 and June 30, 2003, respectively; for the six month periods ending June 30, 2004 and June 30, 2003, the expense totaled $1.2 million and $1.2 million, respectively. SFAS No. 109, “Accounting for Income Taxes,” requires that the Company record a valuation allowance when it is more likely than not that

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some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets depends on the Company’s ability to generate sufficient taxable income in the future. As of June 30, 2004 and December 31, 2003, the Company has concluded that realization of $4.4 million of its net tax benefits is more likely than not.

7. 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 (loss) per share is calculated by dividing net income (loss) attributable to common shareholders by the weighted average shares of Common Stock outstanding during the period. Diluted income (loss) per share is calculated by dividing net income (loss) 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 (loss) per share (in thousands, except per share amounts):

For the three months ended June 30, 2004, 3,713,437 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 $1.45. As a result, 7,192,855 shares were excluded from the computation of diluted net income per share. At June 30, 2003, 2,661,402 options with a weighted average exercise price of $4.35 per share and warrants to purchase 4,532,670 shares of common stock at a weighted average price of $3.24 per share had exercise prices above the average market price of $2.87. As a result, 7,194,072 shares were excluded from the computation of diluted net income per share.

For the six months ended June 30, 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 $1.62. As a result, 7,311,960 shares were excluded from the computation of diluted net income per share for the six months ended June 30, 2004. For the six months ended June 30, 2003, 2,935,402 options with a weighted average exercise price of $4.19 per share and warrants to purchase 4,532,670 shares of common stock at a weighted average price of $3.24 per share had exercise prices above the average market price of $2.28. As a result, 7,468,072 shares were excluded from the computation of diluted net income per share for the six months ended June 30, 2003.

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.

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

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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 June 30, 2004 decreased $0.4 million, or 3%, compared to the prior year period. The decrease was primarily due to a $0.5 million non-recurring patent defense settlement recognized by the Company’s StarGuide division during the three months ended June 30, 2003. In addition revenues decreased in the Company’s Digital Generations Systems, Inc. (“DGS division”) primarily due to the loss of a significant customer. This decrease was offset by revenues generated from the recently acquired Broadcast Division of Applied Graphics Technologies, Inc. (the “Broadcast division”), whose results are included since the June 1, 2004 acquisition date. For the six months ended June 30, 2004, revenues decreased $2.7 million or 9%, as compared to the prior year period, primarily due to the loss of a significant customer in the DGS division and cyclical advertising patterns of a few major customers.

Cost of Revenues. For the three months ended June 30, 2004, cost of revenues, which includes delivery and material costs and customer operations, was consistent with the prior year period reflecting lower costs at the DGS division offset by costs incurred by the Broadcast division. For the six months ended June 30, 2004, cost of revenues decreased $1.0 million, or 6%, from prior the year period, primarily due to lower sales volumes as noted above.

Sales and Marketing. Sales and marketing expense decreased $0.1 million, or 5%, for the three months ended June 30, 2004 primarily due to reduced spending from the same prior year period. These decreases were offset, to some extent, by increases in costs from the recently acquired Broadcast division, whose results are included since the June 1, 2004 acquisition date. For the six months ended June 30, 2004, sales and marketing expense was consistent with the prior year.

Research and Development. Research and development expense decreased $0.3 million, or 31%, for the three months ended June 30, 2004 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. For the six months ended June 30, 2004, research and development expense decreased $0.7 million, or 37%. This was primarily due to reductions in headcount as well as increased capitalization of expenses related to internally developed software.

General and Administrative. General and administrative expenses for the three months ended June 30, 2004 increased $0.1 million, or 7%, from the prior year period due to an increase in the Company’s provision for bad debts. For the six months ended June 30, 2004, general and administrative expenses decreased $0.4 million, or 12%, from prior year 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 $1.0 million, or 40%, for the three months ended June 30, 2004, 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 at December 31, 2003. In addition, during the three month period ended June 30, 2003, the Company recorded approximately $1.1 million in amortization expense for a capitalized patent defense settlement. These decreases were offset, to some extent, by depreciation expense from fixed assets of the newly acquired Broadcast division as well as from amortization of the purchased intangible assets also acquired in the acquisition. Depreciation and amortization decreased $1.6 million, or 38%, during the six months ended June 30, 2004, again 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, as well as the aforementioned non-recurring $1.1 million amortization of a patent defense settlement.

Interest and Other Expense. Interest and other expense decreased $0.1 million, or 19%, for the three months ended June 30, 2004, as compared to the prior period, primarily due to a decrease in the average loan balance during the period as well as a decrease

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in interest rates. For the six months ended June 30, 2004, as compared to the corresponding prior year period, interest expense remained relatively consistent.

Provision for Income Taxes. For the three months and six months ended June 30, 2004, the Company has recognized income tax expense at an effective tax rate of 29% as compared to 39% in the prior periods. The decrease in effective tax rate is the result of a decrease in the Company’s valuation allowance for deferred tax assets related to non acquired net operating loss carryforwards.

Liquidity and Capital Resources

On a reported basis, net cash provided by operating activities for the six months ended June 30, 2004 was $5.5 million compared to net cash provided by operating activities of $4.5 million for the six months ended June 30, 2004. The increase of $1.0 million in net cash provided by operating activities is primarily due to improvements in working capital.

The Company purchased equipment and made capital additions of $1.4 million during the six months ended June 30, 2004 as compared to capital additions totaling $0.6 million for the six months ended June 30, 2003. The increase was largely due to network upgrades including, but not limited to, the rollout of the Company’s new spot box.

Net principal payments on long term debt and capital leases was $1.6 million for the six months ended June 30, 2004 versus $2.7 million for the six months ended June 30, 2003. Also, as previously noted, the company drew down $14.0 million on the available credit facility for the purchase of the Broadcast Division The Company paid all remaining amounts owed on their two remaining capital leases during the second quarter of 2004 and exercised bargain purchase options on the leased equipment.

At June 30, 2004, the Company’s current sources of liquidity included cash and cash equivalents of $9.8 million while the Company’s debt consisted of term loans totaling $10.0 million and a balance on the revolving credit facility totaling $8.0 million. The revolving credit facility matures on May 5, 2006. The availability under the revolving credit facility is subject to the Company’s eligible accounts receivable balance up to $26 million. Currently, the Company may borrow an additional $1.2 million under the revolving facility based on eligible accounts receivable. 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 all covenants of its credit facility as of June 30, 2004.

Finally, at June 30, 2004, the Company had positive working capital in excess of $11.2 million. The Company filed a shelf registration statement 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 June 30, 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.

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.

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.

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

PART II. OTHER INFORMATION

(a) Exhibits

(b) Report on Form 8-K

Current Report on Form 8-K dated August 5, 2004, furnishing its press release regarding its results for the three and six months ended June 30, 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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