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Point.360 10-K 2008

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 


FORM 10-K

x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended June 30, 2008

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

For the transition period from _________________ to _________________

Commission File Number 001-33468
 

POINT.360
(Exact name of registrant as specified in its charter)

California
(State or other jurisdiction of
incorporation or organization)
 
01-0893376
(I.R.S. Employer Identification No.)
     
2777 North Ontario Street, Burbank, CA
(Address of principal executive offices)
 
91504
(Zip Code)

Registrant's telephone number, including area code (818) 565-1400

Securities registered pursuant to Section 12(b) of the Act:
Common Stock, no par value.

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

 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes ¨     No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes ¨     No x

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

Indicate by check mark 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 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 whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer
¨
Accelerated Filer
¨
       
Non-accelerated filer
¨
Smaller reporting company
þ


 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨    No x

The aggregate market value of the voting common equity held by non-affiliates of the registrant as of the last business day of the registrant’s most recently completed second fiscal quarter (December 31, 2007) was approximately $16 million. As of August 14, 2008, there were 10,493,410 shares of Common Stock outstanding.

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 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

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive Proxy Statement relating to the Company’s Annual Meeting of Shareholders to be held on November 12, 2008 are incorporated by reference in Part III of this report.

EXPLANATORY NOTE

This Form 10-K includes restatements for the years ended December 31, 2005 and 2006, the six months ended June 30, 2007 and for the interim periods for the quarters ended September 30, 2007, December 31, 2007 and March 31, 2008 that amend, restate and adjust the following:

 
·
consolidated balance sheets for stated periods;
 
·
consolidated statements of invested and shareholders’ equity for the years ended December 31, 2005 and 2006 and the six months ended June 30, 2007;
 
·
certain financial data for the quarterly periods ended September 30, 2007, December 31, 2007 and March 31, 2008; and
 
·
certain footnotes to the above financial statements.

This Form 10-K also reflects the restatement of selected balance sheet data in “Selected Financial Data” in Item 6 for the fiscal years ended December 31, 2003, 2004, 2005, 2006 and June 30, 2007.

We have not filed amendments to our previously filed Form 10-K/T for the six months ended June 30, 2007 or to our previously filed Forms 10-Q for the interim periods affected by the restatement. The consolidated financial statements and financial information, as previously filed, should no longer be relied upon. The related audit report of Singer Lewak, LLP, our independent registered public accounting firm, with respect to the consolidated financial statements referred to in this paragraph, should also no longer be relied upon. The previously filed information reported for the periods referred to in the previous paragraph is superseded by the information contained in this Form 10-K.

For additional information, see Notes 13 and 14 to our consolidated financial statements beginning on page 45 of this Form 10-K.
 


CAUTIONARY STATEMENT
 
In our capacity as Company management, we may from time to time make written or oral forward-looking statements with respect to our long-term objectives or expectations which may be included in our filings with the Securities and Exchange Commission (the “SEC”), reports to stockholders and information provided in our web site.

The words or phrases “will likely,” “are expected to,” “is anticipated,” “is predicted,” “forecast,” “estimate,” “project,” “plans to continue,” “believes,” or similar expressions identify “forward-looking statements”. Such forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical earnings and those presently anticipated or projected. We wish to caution you not to place undue reliance on any such forward-looking statements, which speak only as of the date made. We are calling to your attention important factors that could affect our financial performance and could cause actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods in any current statements.

The following list of important factors may not be all-inclusive, and we specifically decline to undertake an obligation to publicly revise any forward-looking statements that have been made to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events. Among the factors that could have an impact on our ability to achieve expected operating results and growth plan goals and/or affect the market price of our stock are:

 
·
our recent history of losses;
 
·
Point.360’s prior breach of credit agreements;
 
·
our highly competitive marketplace;
 
·
the risks associated with dependence upon significant customers;
 
·
our ability to execute our expansion strategy;
 
·
the uncertain ability to manage in a changing environment;
 
·
our dependence upon, and our ability to adapt to, technological developments;
 
·
dependence on key personnel;
 
·
our ability to maintain and improve service quality;
 
·
fluctuation in quarterly operating results and seasonality in certain of our markets;
 
·
possible significant influence over corporate affairs by significant shareholders;
 
·
our ability to operate effectively as a stand-alone, publicly traded company; and
 
·
the cost associated with becoming compliant with the Sarbanes-Oxley Act of 2002 and the consequences of failing to implement effective internal controls over financial reporting as required by Section 404 of the Sarbanes-Oxley Act of 2002 by the date that we must comply with that section of the Sarbanes-Oxley Act.

Other factors not identified above, including the risk factors described in the “Risk Factors” section of this Form 10-K may also cause actual results to differ materially from those projected by our forward-looking statements. Most of these factors are difficult to anticipate and are generally beyond our control.

You should consider the areas of risk described above, as well as those set forth under the heading “Risk Factors” below, in connection with considering any forward-looking statements that may be made in this Form 10-K and elsewhere by us and our businesses generally. Except to the extent of obligation to disclose material information under the federal securities laws or the rules of the NASDAQ Global Market, we undertake no obligation to release publicly any revisions to any forward-looking statements, to report events or to report the occurrence of unanticipated events.
 
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PART 1

ITEM 1. BUSINESS
 
The Company was formed as a wholly-owned subsidiary (named “New 360”) of Point.360 ( “Parent Company”) in April 2007. The post production assets of the Parent Company were contributed to New 360 on August 14, 2007, after which all New.360 common stock was distributed to the Parent Company’s shareholders. New 360 subsequently changed its name to Point.360 after the merger of the Parent with DG FastChannel, Inc. (“DG FastChannel”). The Parent Company is hereinafter referred to as Old Point.360.
 
Point.360 (“Point.360” or the “Company”) is a leading integrated media management services company providing film, video and audio post-production, archival, duplication, computer graphics and distribution services to motion picture studios, television networks, independent production companies and multinational companies. We provide the services necessary to edit, master, reformat and archive our clients’ audio and video content, including television programming, feature films, and movie trailers.
 
The Company, previously part of Old Point.360, was spun off to Old Point.360’s shareholders on August 14, 2007. References to the activities of the Company prior to the spin-off refer to those of Old Point.360’s post production business which constitutes the continuing operations of the Company.
 
We seek to capitalize on growth in demand for the services related to the manipulation and distribution of rich media content without assuming the production or ownership risk of any specific television program, feature film, advertising or other form of content. The primary users of our services are entertainment studios that generally choose to outsource such services due to the sporadic demand and the fixed costs of maintaining a high-volume physical plant.
 
Since January 1, 1997, Old Point.360 successfully completed acquisitions of companies providing similar services. We will continue to evaluate acquisition opportunities to enhance our operations and profitability. In 2004, Old Point.360 acquired International Video Conversions, Inc. (“IVC”), a leading digital intermediate and digital mastering facility. In 2005, Old Point.360 acquired Visual Sound, a provider of captioning services. In 2007, Old Point.360 purchased the business of Eden FX, a producer of sophisticated computer graphics for feature films, television programming and commercials. As a result of these acquisitions, we are one of the largest and most diversified providers of technical and distribution services in our markets, and therefore are able to offer our customers a single source for such services at prices that reflect our scale economies.
 
Markets
 
We derive revenues primarily from the entertainment industry, consisting of major and independent motion picture and television studios, cable television program suppliers and television program syndicators. On a more limited basis, we also service national television networks, local television stations, corporate or instructional video providers, infomercial advertisers and educational institutions.
 
The entertainment industry creates motion pictures, television programming, and interactive multimedia content for distribution through theatrical exhibition, home video, pay and basic cable television, direct-to-home, private cable, broadcast television, on-line services and video games. Content is released into a "first-run" distribution channel, and later into one or more additional channels or media. In addition to newly produced content, film and television libraries may be released repeatedly into distribution. Entertainment content produced in the United States is exported and is in increasingly high demand internationally. We believe that several trends in the entertainment industry have and will continue to have a positive impact on our business. These trends include growth in worldwide demand for original entertainment content, the development of new markets for existing content libraries, increased demand for innovation and creative quality in domestic and foreign markets and wider application of digital technologies for content manipulation and distribution, including the emergence of new distribution channels.
 
Value-Added Services
 
Point.360 maintains video and audio post-production and editing facilities as components of its full service, value-added approach to its customers. The following summarizes the value-added post-production services that we provide to our customers:
 
Film-To-Digital Transfer. Substantially all film content ultimately is distributed to the home video, broadcast, cable or pay-per-view television markets, requiring that film images be transferred electronically to a digital video format. Each frame must be color corrected and adapted to the size and aspect ratio of a television screen in order to ensure the highest level of conformity to the original film version. We transfer film to digital formats using Spirit, URSA and Cintel MK-3 telecine equipment and DaVinci® digital color correction systems. The re-mastering of studio film and television libraries to the HDTV broadcast standard has become a growing portion of our film transfer business, as well as affiliated services such as foreign language mastering, duplication and distribution.
 
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Video Editing. We provide digital editing services in Hollywood, Burbank and West Los Angeles, California. The editing suites are equipped with (1) state-of-the-art digital editing equipment, including the Avid® 9000, that provides precise and repeatable electronic transfer of video and/or audio information from one or more sources to a new master video and (2) large production switchers to effect complex transitions from source to source while simultaneously inserting titles and/or digital effects over background video. Video is edited into completed programs such as television shows, infomercials, commercials, movie trailers, electronic press kits, specials, and corporate and educational presentations.

Standards Conversion. Throughout the world there are several different broadcasting "standards" in use. To permit a program recorded in one standard to be broadcast in another, it is necessary for the recorded program to be converted to the applicable standard. This process involves changing the number of video lines per frame, the number of frames per second, and the color system. We are able to convert video between all international formats, including NTSC, PAL and SECAM. Our competitive advantages in this service line include our state-of-the-art systems and our detailed knowledge of the international markets with respect to quality-control requirements and technical specifications.
 
Broadcast Encoding. We provide encoding services for tracking broadcast airplay of spots or television programming. Using a process called VEIL encoding; a code is placed within the video portion of an advertisement or an electronic press kit. Such codes can be monitored from standard television broadcasts to determine which advertisements or portions of electronic press kits are shown on or during specific television programs, providing customers direct feedback on allotted airtime. We provide VEIL encoding services for a number of our motion picture studio clients to enable them to customize their promotional material. We also provide ICE encoding services which enable us to place codes within the audio portion of a video, thereby enhancing the overall quality of the encoded video.
 
Audio Post-Production. We digitally edit and create sound effects, assist in replacing dialog and re-record audio elements for integration with film and video elements. We design sound effects to give life to the visual images with a library of sound effects. Dialog replacement is sometimes required to improve quality, replace lost dialog or eliminate extraneous noise from the original recording. Re-recording combines sound effects, dialog, music and laughter or applause to complete the final product. In addition, the re-recording process allows the enhancement of the listening experience by adding specialized sound treatments, such as stereo, Dolby Digital®, SDDS®, THX® and Surround Sound®.
 
Audio Layback. Audio layback is the process of creating duplicate videotape masters with sound tracks that are different from the original recorded master sound track. Content owners selling their assets in foreign markets require the replacement of dialog with voices speaking local languages. In some cases, all of the audio elements, including dialog, sound effects, music and laughs, must be recreated, remixed and synchronized with the original videotape. Audio sources are premixed foreign language tracks or tracks that contain music and effects only. The latter is used to make a final videotape product that will be sent to a foreign country to permit addition of a foreign dialogue track to the existing music and effects track.
 
Visual Effects. We provide visual effects for feature films, television programs and commercial advertising content. Content creation across all media is in continual need of highly realistic, imaginative and intriguing visual effects. Due to the lower costs of digital content as compared to the cost of live production, more heightened “realism” has been made possible by today’s highly skilled artists using sophisticated software. This offers producers of films, TV programs and commercials more production flexibility and time savings.
 
Foreign Language Mastering. Programming designed for distribution in markets other than those for which it was originally produced is prepared for export through language translation and either subtitling or voice dubbing. We provide dubbed language versioning with an audio layback and conform service that supports various audio and videotape formats to create an international language-specific master videotape. We also create music and effects tracks from programming shot before an audience to prepare television sitcoms for dialog recording and international distribution.
 
Syndication. We offer a broad range of technical services to domestic and international programmers. We service the basic and premium cable, broadcast syndication and direct-to-home market segments by providing the facilities and services necessary to assemble and distribute programming via satellite to viewers in the United States, Canada and Europe. We provide facilities and services for the delivery of syndicated television programming in the United States and Canada. Our customer base consists of the major studios and independent distributors offering network programming, world-wide independent content owners offering niche market programming, and pay-per-view services marketing movies and special events to the cable industry and direct-to-home viewers.
 
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Archival Services. We currently store approximately one million videotape and film elements in a protected environment. The storage and handling of videotape and film elements require specialized security and environmental control procedures. We perform secure management archival services in all of our operating facilities as well as our state-of-the-art Media Center in Los Angeles. We offer on-line access to archival information for advertising clients, and may offer this service to other clients in the future.
 
New Markets
 
We believe that the development of value-added services will provide us with the opportunity to enter or increase our presence in several new or expanding markets.
 
International. Point.360 currently provides electronic and physical duplication and distribution services for rich media content providers. Furthermore, we believe that available electronic distribution methods will facilitate further expansion into the international distribution arena as such technologies become standardized and cost-effective. In addition, we believe that the growth in the distribution of domestic content into international markets will create increased demand for value-added services currently provided by us such as standards conversion and audio and digital mastering.
 
High Definition Television (“HDTV”). We are capitalizing on opportunities created by emerging industry trends such as the emergence of digital television and its more advanced variant, high-definition television. HDTV has quickly become the mastering standard for domestic content providers. We believe that the aggressive timetable associated with such conversion, which has resulted both from mandates by the Federal Communications Commission for digital television and high-definition television as well as competitive forces in the marketplace, is likely to accelerate the rate of increase in the demand for these services. We maintain a state-of-the-art HDTV capability.
 
DVD Authoring. We believe that there are significant opportunities in the DVD authoring market. With the increasing rate of conversion of existing analog libraries, as well as new content being mastered to digital formats, we believe that Point.360 has positioned itself well to provide value-added services to new and existing clients. We have made capital investments to expand and upgrade our current DVD and digital compression operations in anticipation of the increasing demand for DVD and video encoding services.
 
Sales and Marketing
 
We market our services through a combination of industry referrals, formal advertising, trade show participation, special client events, and our Internet website. While we rely primarily on our reputation and business contacts within the industry for the marketing of our services, we also maintain a direct sales force to communicate the capabilities and competitive advantages of our services to potential new customers. Our marketing programs are directed toward communicating our unique capabilities and establishing us as the predominant value-added partner for entertainment, advertising and corporate customers.
 
In addition to our traditional sales efforts directed at those individuals responsible for placing orders with our facilities, we also strive to negotiate “preferred vendor” relationships with our major customers. Through this process, we negotiate discounted rates with large volume clients in return for being promoted within the client’s organization as an established and accepted vendor. This selection process tends to favor larger service providers such as Point.360 that (1) offer lower prices through scale economies, (2) have the capacity to handle large orders without outsourcing to other vendors, and (3) can offer a strategic partnership on technological and other industry-specific issues. We negotiate such agreements periodically with major entertainment studios and national broadcast networks.
 
Customers
 
Point.360 has added customers through acquisitions and by delivering a favorable mix of reliability, timeliness, quality and price. The integration of our facilities has given our customers a time advantage in the ability to deliver broadcast quality material. We market our services to major and independent motion picture and television production companies, television program suppliers and, on a more limited basis, national television networks, infomercial providers, local television stations, television program syndicators, corporations and educational institutions. Our motion picture clients include Disney, Sony Pictures Entertainment, Twentieth Century Fox, NBC Universal, Warner Bros., Metro-Goldwyn-Mayer and Paramount Pictures.
 
We solicit the motion picture and television industries to generate revenues. In the fiscal year ended December 31, 2006, the six months ended June 30, 2007 and the fiscal year ended June 30, 2008, five major motion picture studios accounted for approximately 58%, 56% and 52% of Point.360’s revenues, respectively, while sales to Twentieth Century Fox and affiliates comprised 33%, 34% and 26% of revenues in those periods, respectively. Sales to Twentieth Century Fox and affiliates were made to approximately 50 individual customers within the group.
 
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We generally do not have exclusive service agreements with our clients. Because clients generally do not make arrangements with us until shortly before our facilities and services are required, we usually do not have any significant backlog of service orders. Our services are generally offered on an hourly or per unit basis based on volume.
 
Customer Service
 
We believe we have built a strong reputation in the market with a commitment to customer service. We receive customer orders via courier services, telephone, telecopier and the Internet. The sales and customer service staff develops strong relationships with clients within the studios and is trained to emphasize our ability to confirm delivery, meet difficult delivery time frames and provide reliable and cost-effective service. Several studios are customers because of our ability to meet often changing or rush delivery schedules.
 
We have a sales and customer service staff of approximately 39 people, and we provide services 24 hours per day. This staff serves as a single point of problem resolution and supports not only our customers but also the television stations and cable systems to which we deliver.
 
Competition
 
The manipulation, duplication and distribution of rich media assets is a highly competitive service-oriented business. Certain competitors (both independent companies and divisions of large companies) provide all or most of the services provided by us, while others specialize in one or several of these services. Substantially all of our competitors have a presence in the Los Angeles area, which is currently the largest market for our services. Due to the current and anticipated future demand for video and distribution services in the Los Angeles area, we believe that both existing and new competitors may expand or establish video service facilities in this area.
 
Employees

The Company had 304 full-time employees as of June 30, 2008. The Company’s employees are not represented by any collective bargaining organization, and the Company has never experienced a work stoppage. The Company believes that its relations with its employees are good.

ITEM 1A. RISK FACTORS

You should carefully consider each of the following risk factors and all of the other information set forth in this Form 10-K. The risk factors have been separated into three groups: (1) risks relating to our business, (2) risks relating to the separation of New 360 from Point.360, and (3) risks relating to our common stock. Based on the information currently known to us, we believe that the following information identifies the most significant risk factors affecting our company in each of these categories of risks. Past financial performance may not be a reliable indicator of future performance, and historical trends should not be used to anticipate results or trends in future periods.
 
If any of the following risks and uncertainties develops into actual events, these events could have a material adverse effect on our business, financial condition or results of operations. In such case, the trading price of our common stock could decline. 

Risks Relating to Point.360’s Business

We have a history of losses, and we may incur losses in the future.
 
Point.360 had losses in the fiscal years ended June 30, 2007 and 2008 and in each of the four fiscal years ended December 31, 2006 due, in part, to increased price competition, the cost of being a publicly traded company and a number of unusual charges. There is no assurance as to future profitability on a quarterly or annual basis.
 
Old Point.360 previously breached its credit agreements, and we may do so in the future.
 
Due to lower operating cash amounts resulting from reduced sales levels in prior years and the consequential net losses, Old Point.360 breached certain covenants of its credit facility. The breaches were temporarily cured based on amendments and forbearance agreements among Old Point.360 and the banks which called for, among other provisions, scheduled payments to reduce amounts owed to the banks to the permitted borrowing base.
 
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Although we were in a cash positive position as of June 30, 2008 and expect to be for the foreseeable future, if we continue to incur losses in the future as a separate company, there is a risk that we will default under financial covenants contained in any new credit agreements and/or will not be able to pay off revolving or term loans when due. If a default condition exists in future banking arrangements, all amounts that may be outstanding under the new agreements will be due and payable which could materially and adversely affect our business.
 
We may be unable to compete effectively in a highly competitive marketplace.
 
The post-production industry is a highly competitive, service-oriented business. In general, we do not have long-term or exclusive service agreements with our customers. Business is acquired on a purchase order basis and is based primarily on customer satisfaction with reliability, timeliness, quality and price.
 
We compete with a variety of post-production firms some of which have a national presence and, to a lesser extent, the in-house post-production operations of our major motion picture studio customers. Some of these firms, and all of the studios, have greater financial marketing resources and have achieved a higher level of brand recognition than we have. In the future, we may not be able to compete effectively against these competitors merely on the basis of reliability, timeliness, quality and price or otherwise.
 
We may also face competition from companies in related markets that could offer similar or superior services to those offered by us. We believe that an increasingly competitive environment as evidenced by recent price pressure and some related loss of work and the possibility that customers may utilize in-house capabilities to a greater extent could lead to a loss of market share or additional price reductions, which could have a material adverse effect on our financial condition, results of operations and prospects.
 
We would be adversely affected by the loss of key customers.
 
Although we have an active client list of approximately 1,900 customers, five motion picture studios and and/or their affiliates accounted for approximately 52%, 58%, 56% and 52% of our revenues in calendar years 2005 and 2006, and the fiscal years ended June 30, 2007 and 2008, respectively. Twentieth Century Fox (and affiliates) was the only customer which accounted for more than 10% of sales in any of the periods, or 26% and 33% in calendar years 2005 and 2006, and 34% and 26% in the fiscal years ended June 30, 2007 and 2008, respectively. If one or more of these companies were to stop using our services, our business could be adversely affected. Because we derive substantially all of our revenue from clients in the entertainment industry, our financial condition, results of operations and prospects could also be adversely affected by an adverse change in conditions which impact those industries.
 
Our expansion strategy may fail.
 
Our growth strategy involves both internal development and expansion through acquisitions. We currently have no agreements or commitments to acquire any company or business. Even though Point.360 completed a number of acquisitions in the past, the most recent of which was in March 2007, we cannot be sure additional acceptable acquisitions will be available or that we will be able to reach mutually agreeable terms to purchase acquisition targets, or that we will be able to profitably manage additional businesses or successfully integrate such additional businesses without substantial costs, delays or other problems.
 
Acquisitions may involve a number of special risks including: adverse effects on our reported operating results (including the amortization of acquired intangible assets), diversion of management’s attention and unanticipated problems or legal liabilities. In addition, we may require additional funding to finance future acquisitions. We cannot be sure that we will be able to secure acquisition financing on acceptable terms or at all. We may also use working capital or equity, or raise financing through equity offerings or the incurrence of debt, in connection with the funding of any acquisition. Some or all of these risks could negatively affect our financial condition, results of operations and prospects or could result in dilution to our shareholders. In addition, to the extent that consolidation becomes more prevalent in the industry, the prices for attractive acquisition candidates could increase substantially. We may not be able to effect any such transactions. Additionally, if we are able to complete such transactions they may prove to be unprofitable.
 
The geographic expansion of our customers may result in increased demand for services in certain regions where we currently do not have post-production facilities. To meet this demand, we may subcontract. However, we have not entered into any formal negotiations or definitive agreements for this purpose. Furthermore, we cannot assure you that we will be able to effect such transactions or that any such transactions will prove to be profitable.
 
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If we acquire any entities, we may have to finance a large portion of the anticipated purchase price and/or refinance then existing credit agreements. The cost of any new financing may be higher than our then-existing credit facilities. Future earnings and cash flow may be negatively impacted if any acquired entity does not generate sufficient earnings and cash flow to offset the increased costs.
 
We are operating in a changing environment that may adversely affect our business.
 
In prior years, we experienced industry consolidation, changing technologies and increased regulation, all of which resulted in new and increased responsibilities for management personnel and placed, and continues to place, increased demands on our management, operational and financial systems and resources. To accommodate these circumstances, compete effectively and manage future growth, we will be required to continue to implement and improve our operational, financial and management information systems, and to expand, train, motivate and manage our work force. We cannot be sure that our personnel, systems, procedures and controls will be adequate to support our future operations. Any failure to do so could have a material adverse effect on our financial condition, results of operations and prospects.
 
We may be unable to adapt our business to changing technological requirements.
 
Although we intend to utilize the most efficient and cost-effective technologies available for telecine, high definition formatting, editing, coloration and delivery of audio and video content as they develop, we cannot be sure that we will be able to adapt to such standards in a timely fashion or at all. We believe our future growth will depend in part on our ability to add to these services and to add customers in a timely and cost-effective manner. We cannot be sure we will be successful in offering such services to existing customers or in obtaining new customers for these services. We intend to rely on third-party vendors for the development of these technologies, and there is no assurance that such vendors will be able to develop such technologies in a manner that meets our needs and the needs of our customers.
 
The loss of key personnel would adversely affect our business.
 
We are dependent on the efforts and abilities of certain senior management, particularly those of Haig S. Bagerdjian, Chairman, President and Chief Executive Officer. The loss or interruption of the services of key members of management could have a material adverse effect on our financial condition, results of operations and prospects if a suitable replacement is not promptly obtained. Mr. Bagerdjian beneficially owns approximately 29% of Point.360’s outstanding stock. Although we have severance agreements with Mr. Bagerdjian and certain key executives, we cannot be sure that either Mr. Bagerdjian or other executives will remain with Point.360. In addition, our success depends to a significant degree upon the continuing contributions of, and on our ability to attract and retain, qualified management, sales, operations, marketing and technical personnel. The competition for qualified personnel is intense and the loss of any such persons, as well as the failure to recruit additional key personnel in a timely manner, could have a material adverse effect on our financial condition, results of operations and prospects. There is no assurance that we will be able to continue to attract and retain qualified management and other personnel for the development of our business.
 
We may be unable to meet the demands of our customers.
 
Our business is dependent on our ability to meet the current and future demands of our customers, which demands include reliability, timeliness, quality and price. Any failure to do so, whether or not caused by factors within our control could result in losses to such clients. Although we disclaim any liability for such losses, there is no assurance that claims would not be asserted and dissatisfied customers may refuse to place further orders with the Company in the event of a significant occurrence of lost elements, either of which could have a material adverse effect on our financial condition, results of operations and prospects. Although we maintain insurance against business interruption, such insurance may not be adequate to protect us from significant loss in these circumstances and there is no assurance that a major catastrophe (such as an earthquake or other natural disaster) would not result in a prolonged interruption of our business. In addition, our ability to deliver services within the time periods requested by customers depends on a number of factors, some of which are outside of our control, including equipment failure, work stoppages by package delivery vendors or interruption in services by telephone, internet or satellite service providers.
 
Our quarterly operating results have fluctuated significantly in the past and may fluctuate in the future.
 
Our operating results have varied in the past, and may vary in the future, depending on factors such as sales volume fluctuations due to seasonal buying patterns, the timing of new product and service introductions, the timing of revenue recognition upon the completion of longer term projects, increased competition, timing of acquisitions, general economic factors and other factors. As a result, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as an indication of future performance. Our operating results have historically been significantly influenced by the volume of business from the motion picture industry, which is an industry that is subject to seasonal and cyclical downturns, and, occasionally, work stoppages by actors, writers and others. For example, the 12,000-member Writer’s Guild of America began a strike on November 5, 2007 which affected portions of our business. In any period our revenues are subject to variation based on changes in the volume and mix of services performed during the period. It is possible that in a future quarter our operating results will be below the expectations of equity research analysts and investors. In such event, the price of our common stock would likely be materially adversely affected.

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Risks Relating to the Separation of the Company from Old Point.360

We may be unable to achieve some or all of the benefits that we expect to achieve from our separation from Old Point.360.
 
As a stand-alone, independent public company, we believe that our business will benefit from, among other things, allowing our management to design and implement corporate policies and strategies that are based primarily on the characteristics of our business, allowing us to focus our financial resources wholly on our own operations and implement and maintain a capital structure designed to meet our own specific needs. However, by separating from Old Point.360, there is a risk that we may be more susceptible to market fluctuations and other adverse events than we would have been were we still a part of Old Point.360. As part of Old Point.360, we were able to enjoy certain benefits from Old Point.360’s operating diversity, purchasing and borrowing leverage; available capital for investments and opportunities to pursue integrated strategies with Old Point.360’s other businesses. As such, we may not be able to achieve some or all of the benefits that we expect to achieve as a stand alone, independent post-production company.
 
We have no operating history as a separate public company, and our historical and pro forma financial information is not necessarily representative of the results we would have achieved as a separate publicly traded company, and may not be a reliable indicator of our future results.
 
The historical and pro forma financial information included in this Form 10-K does not necessarily reflect the financial condition, results of operations or cash flows that we would have achieved as a separate publicly traded company during the periods presented or those that we will achieve in the future primarily as a result of the following factors:
 
 
·
Prior to our August 14, 2007 separation from Old Point.360, our business has been operated by Old Point.360 as part of its broader corporate organization, rather than as an independent company. Old Point.360 performed various corporate functions for the post-production business, including, but not limited to, tax administration, certain governance functions (including compliance with the Sarbanes-Oxley Act of 2002) and external reporting. Our historical and pro forma financial results reflect allocations of corporate expenses from Old Point.360 for these and similar functions based on the relationship of our sales to sales of Old Point.360 for certain administrative functions necessary to complete the sales cycle (sales, personnel, billing, accounting, etc.), specific balance sheet accounts comprising long-lived assets (term loan interest expense) and net working capital (revolving loan interest expense), and other measurements. We believe that these allocations are comparable to the expenses we would have incurred had we operated as a separate publicly traded company, although there is a risk that we may incur higher expenses as an independent company.
 
 
·
Prior to our separation from Old Point.360, our business has been integrated with the other businesses of Point.360. Historically, we have shared economies of scope and scale in costs, employees, vendor relationships and customer relationships. The loss of these benefits could have an adverse effect on our business, results of operations and financial condition following the completion of the separation.
 
 
·
Generally, our working capital requirements and capital for our general corporate purposes, including acquisitions and capital expenditures, have historically been satisfied as part of the corporate-wide cash management policies of Old Point.360. Without the opportunity to obtain financing from Old Point.360, we may need to obtain additional financing from banks, through public offerings or private placements of debt or equity securities, strategic relationships or other arrangements.
 
 
·
Subsequent to the completion of our separation from Old Point.360, the cost of capital for our business may be higher than Old Point.360’s cost of capital prior to our separation because Old Point.360 operating results were higher than what ours are contemplated to be following the separation.
 
10

 
 
·
Other significant changes may occur in our cost structure, management, financing and business operations as a result of our operating as a company separate from Old Point.360.
 
We may be unable to make, on a timely or cost-effective basis, the changes necessary to operate as an independent company, and we may experience increased costs after our separation from Old Point.360 or as a result of the separation.
 
Following the completion of our separation from Old Point.360, the costs of being a public entity will be spread over a lower revenue base, which may negatively affect operating results.
 
We will be responsible for paying certain liabilities incurred by Old Point.360 prior to the date of our separation from Old Point.360.
 
Pursuant to agreements between us and DG FastChannel, Inc. (“DG”), we assumed responsibility for the payment of various liabilities that were incurred by Old Point.360 prior to the date of our separation from Old Point.360, including accounts payable and other expenses not exclusively related to Old Point.360’s ads business, taxes for periods prior to the separation date and other liabilities of Old Point.360, including contingent liabilities whose amount is not yet known, arising out of the operation of Old Point.360’s business (other than the ads business) during the period prior to the separation. Although we do not currently have any knowledge that the IRS, other governmental agencies or third parties intend to file lawsuits or initiate proceedings with respect to the operation of Old Point.360’s business prior to the separation date, that possibility exists and the payment by us of any such contingent liabilities for which we are responsible could materially and adversely affect our financial condition.
 
Risks Relating to the Company’s Common Stock

A trading market that will provide adequate liquidity for our common stock may not develop. In addition, the market price of our shares may fluctuate widely.
 
Our common stock began public trading on August 14, 2007. There is no assurance that an active trading market will be sustained in the future.
 
We cannot predict the prices at which our common stock may trade. The market price of our common stock may fluctuate widely, depending upon many factors, some of which may be beyond our control, including:
 
 
·
our business profile and market capitalization may not fit the investment objectives of our shareholders and, as a result, our shareholders may sell our shares after the distribution;
 
 
·
a shift in our investor base;
 
 
·
our quarterly or annual earnings, or those of other companies in our industry;
 
 
·
actual or anticipated fluctuations in our operating results due to the seasonality of our business and other factors related to our business;
 
 
·
changes in accounting standards, policies, guidance, interpretations or principles;
 
 
·
announcements by us or our competitors of significant acquisitions or dispositions;
 
 
·
our ability to meet earnings estimates of shareholders;
 
 
·
the operating and stock price performance of other comparable companies;
 
 
·
overall market fluctuations; and
 
 
·
general economic conditions.
 
11

 
Stock markets in general have experienced volatility that has often been unrelated to the operating performance of a particular company. These broad market fluctuations may adversely affect the trading price of our common stock.
 
Investors may be unable to accurately value our common stock.
 
Investors often value companies based on the stock prices and results of operations of other comparable companies. Currently, no public post-production company exists that is directly comparable to our size, scale and service offerings. As such, investors may find it difficult to accurately value our common stock, which may cause our common stock price to trade below our true value.
 
Your percentage ownership in the Company may be diluted in the future.
 
Your percentage ownership in the Company may be diluted in the future because of equity awards that have been or may be granted to our directors, officers and employees. We have adopted the 2007 Equity Incentive Plan, which provides for the grant of equity based awards, including restricted stock, restricted stock units, stock options, stock appreciation rights and other equity-based awards to our directors, officers and other employees, advisors and consultants.
 
Our shareholder rights agreement and ability to issue preferred stock may discourage, delay or prevent a change in control of the Company that would benefit our shareholders.
 
Our Board of Directors has the authority to issue up to 5,000,000 shares of preferred stock and to determine the price, rights, preferences, privileges and restrictions thereof, including voting rights, without any further vote or action by the Company’s shareholders. Although we have no current plans to issue any other shares of preferred stock, the rights of the holders of common stock would be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. Issuance of preferred stock could have the effect of discouraging, delaying, or preventing a change in control of the Company that would be beneficial to our shareholders.
 
On the date that the Company’s shares were distributed to Old Point.360 shareholders, each shareholder also received one preferred share purchase right for each share of our common stock received by the shareholder. The rights will be attached to the common stock and will trade separately and be exercisable only in the event that a person or group acquires or announces the intent to acquire 20% or more of our common stock. Each right will entitle shareholders to buy one one-hundredth of a share of a new series of junior participating preferred stock at an exercise price of $10. If we are acquired in a merger or other business combination transaction after a person has acquired 20% or more of our outstanding common stock, each right will entitle its holder to purchase, at the right’s then-current exercise price, a number of the acquiring company’s common shares having a market value of twice such price. In addition, if a person or group acquires 20% or more of our outstanding common stock, each right will entitle its holder (other than such person or members of such group) to purchase, at the right’s then-current exercise price, a number of Point.360 common shares having a market value of twice such price. Before a person or group acquires beneficial ownership of 20% or more of our common stock, the rights are redeemable for $.0001 per right at the option of the Board of Directors.
 
Although our shareholder rights agreement is intended to encourage anyone seeking to acquire the Company to negotiate with the Board prior to attempting a takeover, the rights agreement may have the effect of discouraging, delaying or preventing a change in control of the Company that would be beneficial to our shareholders.
 
We do not expect to pay dividends.
 
We do not believe that we will have the financial strength to pay dividends for the foreseeable future. If we do not pay dividends, the price of our common stock that you receive in the distribution must appreciate for you to receive a gain on your investment in the Company. This appreciation may not occur.
 
Our controlling shareholders may cause the Company to be operated in a manner that is not in the best interests of other shareholders.
 
Our Chairman, President and Chief Executive Officer, Haig S. Bagerdjian, beneficially owns approximately 29% of our common stock. The ex-spouse of R. Luke Stefanko, Old Point.360’s former President and Chief Executive Officer, owns approximately 12% of the common stock. By virtue of their stock ownership, Ms. Stefanko and Mr. Bagerdjian individually or together may be able to significantly influence the outcome of matters required to be submitted to a vote of shareholders, including (1) the election of the Board of Directors, (2) amendments to our Articles of Incorporation and (3) approval of mergers and other significant corporate transactions. The foregoing may have the effect of discouraging, delaying or preventing certain types of transactions involving an actual or potential change of control of the Company, including transactions in which the holders of common stock might otherwise receive a premium for their shares over current market prices.
 
12


ITEM 1. B. UNRESOLVED STAFF COMMENTS

Not applicable

ITEM 2. PROPERTIES
 
The Company currently owns or leases 6 facilities which all have production capabilities and/or sales activities. The terms of leases for leased facilities expire at various dates from 2009 to 2021. The following table sets forth the location and approximate square footage of the Company's properties:

   
Square
Footage
 
Hollywood, CA (leased)
   
32,000
 
Hollywood, CA (leased)
   
8,000
 
Burbank, CA (owned)
   
32,000
 
Burbank, CA (leased)
   
45,500
 
Los Angeles, CA (leased)
   
64,600
 
Los Angeles, CA (leased)
   
13,400
 
 
ITEM 3. LEGAL PROCEEDINGS
 
In July 2008, the Company was served with a complaint filed in the Superior Court of the State of California for the County of Los Angeles by Aryana Farshad and Aryana F. Productions, Inc. (“Farshad”). The complaint alleges that Point.360 and its janitorial cleaning company failed to exercise reasonable care for the protection and preservation of Farshad’s film footage which was lost. As a result of the defendant’s negligence, Farshad claims to have suffered damages in excess of $2 million and additional unquantified general and special damages. While the outcome of this claim cannot be predicted with certainty, management does not believe that the outcome will have a material effect on the financial condition or results of operation of the Company.
 
From time to time, the Company may become a party to other legal actions and complaints arising in the ordinary course of business, although it is not currently involved in any such material legal proceedings.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
No matters were submitted to the Company’s shareholders for a vote during the period covered by this report.
 
13

 
PART II

ITEM 5.  
MARKET FOR THE COMPANY'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
 
Market Information
 
The Company's Common Stock is traded on the NASDAQ Global Market under the symbol PTSX. The following table sets forth, for the periods since the separation on August 14, 2007 from Old Point.360, the high and low closing price per share for the Common Stock.

   
Common Stock
 
   
Low
 
High
 
Year Ended June 30, 2008
             
First Quarter
 
$
2.00
 
$
2.59
 
Second Quarter
 
$
1.80
 
$
2.24
 
Third Quarter
 
$
1.25
 
$
2.01
 
Fourth Quarter
 
$
1.50
 
$
1.75
 

On August 31, 2008, the closing sale price of the Common Stock as reported on the NASDAQ Global Market $1.39 per share. On that date, there were approximately 1,000 holders of record of the Common Stock.

Dividends
 
Neither the Company nor Old Point.360 have paid dividends on its Common Stock. The Company’s ability to pay dividends depends upon limitations under applicable law and covenants under its bank agreements. The Company currently does not intend to pay any dividends on its Common Stock in the foreseeable future. See "Management's Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources."

Stock Repurchases

The Company did not repurchase any shares of its Common Stock during the fiscal year ended June 30, 2008.
 
14


ITEM 6. SELECTED FINANCIAL DATA
 
The following data, insofar as they relate to each of the calendar years 2003 to 2006, and the fiscal years ended June 30, 2007 and 2008 have been derived from the Company’s annual financial statements. This information should be read in conjunction with the Financial Statements and Notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere herein. All amounts are shown in thousands, except per share data.
 
The amounts of Invested Equity in Selected Balance Sheet Data below as of December 31, 2003, 2004, 2005 and 2006, and as of June 30, 2007 have been restated to reflect the matters described in the “Explanatory Note” immediately preceding Part I, Item 1 and in Notes 13 and 14 to our consolidated financial statements included elsewhere in this report.

                   
Six Months Ended
June 30,
 
Year Ended 
June 30,
 
Statement of Income (Loss) Data
 
2003
 
2004
 
2005
 
2006
 
2006
 
2007
 
2007
 
2008
 
   
(unaudited)
             
(unaudited)
     
(unaudited)
     
                                   
Revenues
 
$
37,542
 
$
38,588
 
$
43,059
 
$
43,533
 
$
21,692
 
$
20,850
 
$
42,691
 
$
45,150
 
Cost of services sold
   
(25,774
)
 
(27,958
)
 
(29,472
)
 
(29,976
)
 
(14,948
)
 
(15,760
)
 
(30,788
)
 
(31,156
)
                                                   
Gross profit
   
11,769
   
10,631
   
13,587
   
13,557
   
6,744
   
5,090
   
11,903
   
13,994
 
                                                   
Selling, general and administrative expense
   
(11,627
)
 
(13,649
)
 
(14,972
)
 
(13,554
)
 
(6,995
)
 
(7,071
)
 
(13,631
)
 
(15,124
)
                                                   
Operating income (loss)
   
142
   
(3,018
)
 
(1,385
)
 
3
   
(251
)
 
(1,981
)
 
(1,728
)
 
(1,130
)
                                                   
Interest expense, net
   
(1,644
)
 
(654
)
 
(1,280
)
 
(659
)
 
(448
)
 
(263
)
 
(473
)
 
(205
)
                                                   
Other income
   
-
   
-
   
-
   
-
   
-
   
-
   
-
   
100
 
                                                   
Benefit from income tax
   
604
   
1,489
   
1,045
   
342
   
280
   
607
   
668
   
292
 
                                                   
Net income (loss)
 
$
(899
)
$
(2,183
)
$
(1,620
)
$
(314
)
$
(419
)
$
(1,637
)
$
(1,533
)
$
( 943
)
                                                   
Pro forma earnings (loss) per share
                   
$
(0.03
)
$
(0.04
)
$
(0.16
)
$
(0.15
)
$
(0.09
)
                                                   
Pro forma weighted average common share outstanding
                     
10,554
   
10,554
   
10,554
   
10,554
   
10,554
 
 
15


   
Year Ended December 31,
 
Year Ended June 30,
 
Other Data
 
2003
 
2004
 
2005
 
2006
 
2007
 
2008
 
   
(unaudited)
         
(unaudited)
 
(unaudited)
     
Capital expenditures
 
$
1,981
 
$
4,014
 
$
2 ,317
 
$
2,064
 
$
839
 
$
2,037
 
                                       
Selected Balance Sheet Data
                                     
                                       
Cash and cash equivalents
 
$
8,006
 
$
668
 
$
595
 
$
 
$
7,302
 
$
13,056
 
                                       
Working capital (deficit)
   
4,170
   
1,565
   
(234
)
 
1,325
   
9,814
   
16,497
 
                                       
Property and equipment, net
   
13,431
   
29,437
   
26,474
   
12,850
(1)
 
11,330
   
8,667
 
                                       
Total assets
   
37,935
   
49,108
   
47,229
   
33,482
(1)
 
38,103
   
42,358
 
                                       
Due to parent company
   
13,683
   
17,126
   
17,416
   
5,690
(1)
 
5,871
   
-
 
                                       
Invested or Shareholders’ Equity
   
18,002
(2)
 
20,541
(2)
 
19,757
(2)
 
17,424
(2)
 
24,035
(2)
 
30,800
 

(1)
On March 29, 2006, Old Point.360 sold and leased back its Media Center facility. Proceeds were used to repay debt. See Notes 4 and 5 of the notes to consolidated financial statements included elsewhere herein.
 
(2)
Represents Old Point.360’s invested equity in the Company restated as follows:
 
   
Year Ended December 31,
 
Year Ended June 30,
 
   
2003
 
2004
 
2005
 
2006
 
2007
 
   
(unaudited)
         
(unaudited)
 
(unaudited)
 
Invested Equity as originally reported
 
$
14,554
 
$
17,093
 
$
16,309
 
$
13,976
 
$
20,587
 
Correction
   
3,448
   
3,448
   
3,448
   
3,448
   
3,448
 
                                 
As restated
 
$
18,002
 
$
20,541
 
$
19,757
 
$
17,424
 
$
24,035
 
 
In presenting the financial data above in conformity with general accepted accounting principles, we are required to make estimates and assumptions that affect the amounts reported. See “Critical Accounting Policies” included elsewhere herein for a detailed discussion of the accounting policies that we believe require subjective and complex judgments that could potentially affect reported results.
 
Between January 1, 2003 and June 30, 2007, Old Point.360 completed a number of acquisitions, the results of operations and financial position of which have been included from their acquisition dates forward. See Note 3 to our consolidated financial statements for a discussion of the acquisitions for the annual periods ended 2004, 2005 and 2006 and the first six months of 2007, respectively.

ITEM 7.  
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Except for the historical information contained herein, certain statements in this annual report are "forward-looking statements" as defined in the Private Securities Litigation Reform Act of 1995, which involve certain risks and uncertainties, which could cause actual results to differ materially from those discussed herein, including but not limited to competition, customer and industry concentration, depending on technological developments, risks related to expansion, dependence on key personnel, fluctuating results and seasonality and control by management. See the relevant portions of the Company's documents filed with the Securities and Exchange Commission and Risk Factors in Item 1A of this Form 10-K, for a further discussion of these and other risks and uncertainties applicable to the Company's business.
 
16


Overview
 
We are one of the largest providers of video and film asset management services to owners, producers and distributors of entertainment content. We provide the services necessary to edit, master, reformat and archive our clients’ film and video content, including television programming, feature films and movie trailers using electronic and physical means. Clients include major motion picture studios and independent producers.
 
We operate in a highly competitive environment in which customers desire a broad range of service at a reasonable price. There are many competitors offering some or all of the services provided by us. Additionally, some of our customers are large studios, which also have in-house capabilities that may influence the amount of work outsourced to companies like us. We attract and retain customers by maintaining a high service level at reasonable prices.
 
We have an opportunity to expand our business by establishing closer relationships with our customers through excellent service at a competitive price and expanding our service offering. Our success is also dependent on attracting and maintaining employees capable of maintaining such relationships. Also, growth can be achieved by acquiring similar businesses (for example, the acquisition of IVC in July 2004) that can increase revenues by adding new customers, or expanding services provided to existing customers.
 
Our business generally involves the immediate servicing needs of our customers. Most orders are fulfilled within several days, with occasional larger orders spanning weeks or months. At any particular time, we have little firm backlog.
 
We believe that our interconnected facilities provide the ability to better service customers than single-location competitors. We will look to expand both our service offering and geographical presence through acquisition of other businesses or opening additional facilities.
 
In conjunction with the merger of Old Point.360 into DG FastChannel, we changed our fiscal year end from December 31 to June 30, a date closer to the transaction. The following table sets forth the amount and percentage relationship to revenues of certain items included within our consolidated statement of income (loss) for the twelve month periods ended June 30, 2007 (unaudited) and June 30, 2008. The commentary below is based on these financial statements (in thousands).
 
   
Twelve Months Ended June 30,
 
   
2007
 
2008
 
   
Amount
 
Percent of
Revenues
 
 
Amount
 
Percent of
Revenues
 
   
(unaudited) 
             
Revenues
 
$
42,691
   
100.0
 
$
45,150
   
100.0
 
Costs of services sold
   
(30,788
)
 
(72.1
)
 
(31,156
)
 
( 69.0
)
Gross profit
   
11,904
   
27.9
   
13,994
   
31.0
 
Selling, general and administrative expense
   
(10,395
)
 
24.3
   
(14,491
)
 
(32.1
)
Restructuring costs
   
-
   
-
   
(513
)
 
(1.1
)
Allocation of Old Point.360 corporate expenses
   
(3,236
)
 
7.6
   
(120
)
 
(0.3
)
Operating income (loss)
   
(1,727
)
 
(4.0
)
 
(1,130
)
 
(2.5
)
Interest expense, net
   
(473
)
 
(1.1
)
 
(105
)
 
(0.2
)
Benefit from income taxes
   
668
   
1.6
   
292
   
0.6
 
Net income (loss)
 
$
(1,532
)
 
(3.6
)
$
(943
)
 
(2.1
)
 
Twelve Months Ended June 30, 2008 Compared to Twelve Months Ended June 30, 2007 (unaudited)
 
Revenues. Revenues were $45.2 million for the twelve months ended June 30, 2008, compared to $42.7 million for the twelve months ended June 30, 2007 (unaudited). The addition of Eden FX in March 2007 contributed an additional $3.5 million of revenues in the 2008 period. Excluding the net effect of Eden FX, revenues declined by $1.0 million or 2.5% from the prior period. We expect revenues to be under some downward pressure in the future due to lower prices being offered by some studio clients, offset by potential future increases as we continue to invest in high definition capabilities where demand is expected to grow. We believe our high definition service platform will attract additional business in the future.
 
17


Gross Profit. In 2008, gross margin was 31.0% of sales, compared to 27.9% for the same period last year. The increase in gross profit percentage is due to the contribution of Eden FX as compared to last year and the elimination of a facility (see “restructuring charge” below). Additionally, headcount was reduced by 37 employees during fiscal 2008, offset by normal wage and facility rent increases. From time to time, we will increase staff capabilities to satisfy potential customer demand. If the expected demand does not materialize, we will adjust personnel levels. We expect gross margins to fluctuate in the future as the sales mix changes.
 
Selling, General and Administrative Expense. SG&A expense was $14.5 million (32.1% of sales) in the 2008 period as compared to $13.6 million (31.9% of sales) in 2007. Approximately $0.9 of the increase was due to the addition of Eden FX for an entire year.
 
Restructuring Costs. In the first quarter of 2008, in conjunction with the completion of the Merger and Spin-off transactions, we decided to close down one of our post production facilities. Future costs associated with the facility lease and certain severance payments were treated as restructuring costs.
 
Allocation of Point.360 Corporate Expenses. Corporate expense allocation in the 2008 period was $0.1 million, or 0.3% of sales, compared to $3.2 million, or 7.6% of sales in 2007. Such amounts are included in the explanation of SG&A variances above.
 
Operating Income (Loss). Operating loss was $1.1 million in 2008 compared to a loss of $1.7 million in 2007.
 
Interest Expense, Net. Interest expense, net for 2008 was $0.1 million, a decrease of $0.4 million from 2007. The decrease was due to lower debt levels and payment of revolving credit debt with the proceeds of employee stock option exercises, offset partially by higher rates on remaining variable interest debt. Interest income in 2008 was $0.3 million, an increase of $0.3 million from 2007 due to higher cash balances.
 
Net Loss. Net loss for 2008 was $0.9 million compared to $1.5 million in 2007.
 
The following table sets forth the amount and percentage relationship to revenues of certain items included within Point.360’s consolidated statement of income (loss) for the six months ended June 30, 2006 and 2007. The commentary below is based on these financial statements (in thousands).

   
Six Months Ended June 30,
 
   
2006
 
2007
 
   
Amount
 
Percent of
Revenues
 
 
Amount
 
Percent of
Revenues
 
   
(unaudited)
             
                   
Revenues
 
$
21,642
   
100.0
 
$
20,850
   
100.0
 
Costs of services sold
   
(14,948
)
 
(68.9
)
 
(15,760
)
 
(75.6
)
Gross profit
   
6,744
   
31.1
   
5,090
   
24.4
 
Selling, general and administrative expense
   
(5,303
)
 
(24.4
)
 
(5,590
)
 
(26.8
)
Allocation of Old Point.360 corporate expenses
   
(1,692
)
 
(7.8
)
 
(1,481
)
 
(7.1
)
Operating income (loss)
   
(251
)
 
(1.2
)
 
(1,981
)
 
(9.5
)
Interest expense, net
   
(448
)
 
(2.0
)
 
(263
)
 
(1.2
)
Benefit from income taxes
   
280
   
1.3
   
607
   
3.8
 
Net income (loss)
 
$
(419
)
 
(1.9
)
$
(1,637
)
 
(7.0
)
 
Six Months Ended June 30, 2007 Compared to Six Months Ended June 30, 2006 (unaudited)
 
Revenues. Revenues were $20.9 million for the six months ended June 30, 2007, compared to $21.7 million for the six months ended June 30, 2006 (unaudited). The addition of Eden FX in March 2007 contributed $0.6 million of revenues in the 2007 period. Excluding the effect of Eden FX, revenues declined by $1.4 million or 6.5% from the prior period due to lower ordering patterns of our major studio customers.
 
18

 
Gross Profit. In 2007, gross margin was 24.4% of sales, compared to 31.1% for the same period last year. The sale/leaseback of our Media Center facility penalized gross margin by 1% of sales (i.e., lease costs increased $0.2 million in the 2007 period net of depreciation associated with the previously-owned facility). The impact of the sale/leaseback will be continuing. The remaining decrease in gross profit percentage is due to higher wages and benefits due to the addition of editors, graphic artists and others associated with Eden FX and to attract new business and general salary increases.
 
Selling, General and Administrative Expense. SG&A expense was $5.6 million (26.8% of sales) in the 2007 period as compared to $5.3 million (24.4% of sales) in 2006. The increase of $0.3 million was due principally to the addition of Eden FX.
 
Allocation of Point.360 Corporate Expenses. Corporate expense allocation in the 2007 period was $1.5 million, or 7.1% of sales, compared to $1.7 million, or 7.8% of sales in 2006.
 
Operating Income (Loss). Operating loss was $2.0 million in 2007 compared to a loss of $0.3 million in 2006. The operating loss associated with Eden FX was $0.5 million as Eden’s business is seasonally low as it participates largely in the television episodic market.
 
Interest Expense, Net. Interest expense, net for 2007 was $0.3 million, a decrease of $0.1 million from 2006. The decrease was due to lower debt levels resulting from the sale/leaseback transaction and payment of revolving credit debt with the proceeds of employee stock option exercises, offset partially by higher rates on remaining variable interest debt.
 
Net Loss. Net loss for 2007 was $1.6 million compared to $0.4 million in 2006.
 
The following table sets forth the amount and percentage relationship to revenues of certain items included within Point.360’s consolidated statement of income (loss) for the years ended December 31, 2006 and 2005. The commentary below is based on these financial statements (in thousands).
 
   
Year Ended 
 
   
December 31, 2005
 
December 31, 2006
 
   
 
Amount
 
Percent of
Revenues
 
 
Amount
 
Percent of
Revenues
 
                   
Revenues
 
$
43,059
   
100.00
 
$
43,533
   
100.0
 
Costs of services sold
   
(29,472
)
 
(68.4
)
 
(29,976
)
 
( 68.9
)
Gross profit
   
13,587
   
31.6
   
13,557
   
31.1
 
Selling, general and administrative expense
   
(11,201
)
 
(26.0
)
 
(10,108
)
 
(23.2
)
Allocation of Old Point.360 corporate expenses
   
(3,771
)
 
(8.8
)
 
(3,446
)
 
(7.9
)
Operating income (loss)
   
(1,385
)
 
(3.2
)
 
3
   
-
 
Interest expense, net
   
(1,280
)
 
(3.0
)
 
(659
)
 
(1.5
)
Benefit from income taxes
   
1,045
   
2.4
   
342
   
0.7
 
Net income (loss)
 
$
(1,620
)
 
(3.8
)
$
(314
)
 
(0.1
)
 
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005
 
Revenues. Revenues were $43.5 million for the year ended December 31, 2006, compared to $43.1 million for the year ended December 31, 2005. There were no significant trends affecting 2006 sales when compared to 2005.
 
Gross Profit. In 2006, gross margin was 31.1% of sales, compared to 31.6% for last year. The sale/leaseback of our Media Center facility penalized gross margin by 1% of sales (i.e., lease costs increased $0.6 million in the 2006 period net of depreciation associated with the previously-owned facility). The impact of the sale/leaseback will be continuing. The remaining increase in gross profit percentage is due to lower wages and benefits.
 
Selling, General and Administrative Expense. SG&A expense was $10.1 million (23% of sales) in 2006 as compared to $11.2 million (26% of sales) in 2005. The reduction of $1.1 million was due principally to lower wages and benefits.
 
19

 
Allocation of Old Point.360 Corporate Expenses. Corporate expense allocation in 2006 was $3.4 million, or 7.9% of sales, compared to $3.8 million, or 8.8% of sales in 2005. The decline is due principally to lower Point.360 administrative personnel costs.
 
Operating Income (Loss) Operating income was $3,000 in 2006, compared to a loss of $1.4 million in 2005.
 
Interest Expense, Net. Interest expense, net for 2006 was $0.7 million, a decrease of $0.6 million from 2005. The decrease was due to lower debt levels resulting from the sale/leaseback transaction offset partially by higher rates on remaining variable interest debt.
 
Net Loss. Net loss for 2006 was $0.3 million compared to $1.6 million in 2005.
 
LIQUIDITY AND CAPITAL RESOURCES
 
This discussion should be read in conjunction with the notes to the financial statements and the corresponding information more fully described elsewhere in this Form 10-K.
 
On August 14, 2007 and thereafter, the Company received $7 million from DG FastChannel upon completion of the Merger. The Company also received approximately $2.2 million for reimbursement of merger expenses and prepayment for ADS Business working capital. The Company expects to receive an additional $0.4 million from DG FastChannel for ADS Business working capital.
 
On December 30, 2005, Old Point.360 entered a $10 million term loan agreement. The term loan provides for interest at LIBOR (2.91% at June 30, 2008) plus 3.15%, or 6.06% on that date, and is secured by the Company’s equipment. The term loan will be repaid in 60 equal principal payments plus interest.
 
On March 30, 2007, Old Point.360 entered into an additional $2.5 million term loan agreement. The loan provides for interest at 8.35% per annum and is secured by the Company’s equipment. The loan will be repaid in 45 equal monthly installments of principal and interest. Both the December 2005 and March 2007 term loans were assumed by the Company in the Spin-off.
 
In August 2007, the Company entered into a new credit agreement which provides up to $8 million of revolving credit based on 80% of acceptable accounts receivables, as defined. The two-year agreement provides for interest of either (i) prime (5.00% at June 30, 2008) minus 0% - 1.00% or (ii) LIBOR plus 1.50% - 2.50% depending on the level of the Company’s ratio of outstanding debt to fixed charges (as defined), or 4.50% or 4.91%, respectively, at June 30, 2008. The facility is secured by all of the Company’s assets, except for equipment securing term loans as described above.
 
In March 2006, Old Point.360 entered into a sale and leaseback transaction with respect to its Media Center vaulting real estate. The real estate was sold for $13,946,000 resulting in a $1.3 million after tax gain. Additionally, Old Point.360 received $500,000 from the purchaser for improvements. In accordance with SFAS No.28, “Accounting for Sales with Leasebacks” (“SFAS28”), the gain and the improvement allowance will be amortized over the initial 15-year lease term as reduced rent.
 
The following table summarizes the June 30, 2008 amounts outstanding under our revolving line of credit and term loans:

Revolving credit
 
$
-
 
Current portion of term loan
   
1,811,000
 
Long-term portion of term loan
   
2,839,000
 
Total
 
$
4,650,000
 

Monthly and annual principal and interest payments due under the term debt are approximately $193,000 and $2.3 million, respectively, assuming no change in interest rates.

In July 2008, the Company entered into a Promissory Note with a bank (the “Note”) in order to purchase land and a building that has been occupied by the Company since 1998. Pursuant to the Note, the Company borrowed $6.0 million payable in monthly installments of principal and interest on a fully amortized bases over 30 years. The mortgage debt is secured by the land and building. The resulting annual mortgage and interest payments on the Note will be approximately $0.2 million less than the annual rent payments on the property at the time of the transaction.

Cash generated by operating activities is directly dependent upon sales levels and gross margins achieved. We generally receive payments from customers in 50-90 days after services are performed. The larger payroll component of cost of sales must be paid currently. Payment terms of other liabilities vary by vendor and type. Income taxes must be paid quarterly. Fluctuations in sales levels will generally affect cash flow negatively or positively in early periods of growth or contraction, respectively, because of operating cash receipt/payment timing. Other investing and financing cash flows also affect cash availability.
 
20


The bank revolving credit agreement requires us to maintain a minimum “fixed charge coverage ratio.” Our fixed charge coverage ratio compares, on a rolling twelve-month basis, EBITDA plus rent expense and non-cash charges less income tax payments, to (ii) interest expense plus rent expense, the current portion of long term debt and maintenance capital expenditures. As of June 30, 2008, the fixed charge coverage ratio was 1.37 as compared to a minimum requirement of 1.10.

We expect that amounts available under the revolving credit arrangement (approximately $3.8 million at June 30, 2008), the availability of bank or institutional credit from new sources and cash generated from operations will be sufficient to fund debt service, operating needs and about $2.0 – $3.0 million of capital expenditures for the next twelve months.

In March 2007, we acquired substantially all the assets of Eden FX for approximately $2.2 million in cash. The purchase agreement requires additional payments of $0.7 million, $0.9 million and $1.2 million in March of 2008, 2009 and 2010, respectively, if earnings during the three years after acquisition meet certain predetermined levels. The earnings level for calendar 2007 was not met; therefore, the 2008 payment was not made. No possible additional payments have been accrued in the financial statements as of June 30, 2008.

The following table summarizes contractual obligations as of June 30, 2008 due in the future:

   
Payment due by Period
 
 
Contractual Obligations
 
 
Total
 
 
Less than 1 Year
 
Years
2 and 3
 
Years 
4 and 5
 
 
Thereafter
 
Long Term Debt Principal Obligations
 
$
4,650,000
 
$
1,811,000
 
$
2,839,000
 
$
-
 
$
-
 
Long Term Debt Interest Obligations (1)
   
400,000
   
254,000
   
146,000
   
-
   
-
 
Operating Lease Obligations
   
20,434,000
   
2,219,000
   
4,651,000
   
3,657,000
   
9,907,000
 
Total
 
$
25,483,000
 
$
4,283,000
 
$
7,635,000
 
$
3,657,000
 
$
9,907,000
 
 
 
(1)
Interest on variable rate debt has been computed using the rate on the latest balance sheet date.
 
The table below summarizes contractual obligations as of June 30, 2008 due in the future including obligations related to a mortgage note for the July 2008 purchase of real estate (see Note 14 - Subsequent Events of Notes to Consolidated Financial Statements elsewhere in this Form 10-K):

   
Payment due by Period
 
 
Contractual Obligations
 
 
Total
 
 
Less than 1 Year
 
Years
2 and 3
 
Years 
4 and 5
 
 
Thereafter
 
Long Term Debt Principal Obligations
 
$
10,649,000
 
$
1,860,000
 
$
2,968,000
 
$
148,000
 
$
5,673,000
 
Long Term Debt Interest Obligations (1)
   
8,296,000
   
612,000
   
994,000
   
830,000
   
5,860,000
 
Operating Lease Obligations
   
20,434,000
   
2,219,000
   
4,651,000
   
3,657,000
   
9,907,000
 
Total
 
$
39,379,000
 
$
4,691,000
 
$
8,613,000
 
$
4,635,000
 
$
21,440,000
 
 
 
(1)
Interest on variable rate debt has been computed using the rate on the latest balance sheet date.
 
During the past year, the Company has generated sufficient cash to meet operating, capital expenditure and debt service needs and obligations, as well as to provide sufficient cash reserves to address contingencies. When preparing estimates of future cash flows, we consider historical performance, technological changes, market factors, industry trends and other criteria. In our opinion, the Company will continue to be able to fund its needs for the foreseeable future.
 
We will continue to consider the acquisition of businesses which compliment our current operations. Consummation of any such acquisition or other expansion of the business conducted by the Company may be subject to the Company securing additional financing, perhaps at a cost higher than our existing term loans. Future earnings and cash flow may be negatively impacted to the extent that any acquired entities do not generate sufficient earnings and cash flow to offset the increased financing costs.
 
21

 
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
 
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates and judgments, including those related to allowance for doubtful accounts, valuation of long-lived assets, and accounting for income taxes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions and conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.
 
Critical accounting policies are those that are important to the portrayal of the Company’s financial condition and results, and which require management to make difficult, subjective and/or complex judgments. Critical accounting policies cover accounting matters that are inherently uncertain because the future resolution of such matters is unknown. We have made critical estimates in the following areas:
 
Revenues. We perform a multitude of services for our clients, including film-to-tape transfer, video and audio editing, standards conversions, adding special effects, duplication, distribution, etc. A customer orders one or more of these services with respect to an element (commercial spot, movie, trailer, electronic press kit, etc.). The sum total of services performed on a particular element (a “package”) becomes the deliverable (i.e., the customer will pay for the services ordered in total when the entire job is completed). Occasionally, a major studio will request that package services be performed on multiple elements. Each element creates a separate revenue stream which is recognized only when all requested services have been performed on that element.
 
Allowance for doubtful accounts. We are required to make judgments, based on historical experience and future expectations, as to the collectibility of accounts receivable. The allowances for doubtful accounts and sales returns represent allowances for customer trade accounts receivable that are estimated to be partially or entirely uncollectible. These allowances are used to reduce gross trade receivables to their net realizable value. The Company records these allowances as a charge to selling, general and administrative expenses based on estimates related to the following factors: i) customer specific allowance; ii) amounts based upon an aging schedule and iii) an estimated amount, based on the Company’s historical experience, for issues not yet identified.
 
Valuation of long-lived and intangible assets. Long-lived assets, consisting primarily of property, plant and equipment and intangibles (consisting only of goodwill), comprise a significant portion of the Company’s total assets. Long-lived assets, including goodwill are reviewed for impairment whenever events or changes in circumstances have indicated that their carrying amounts may not be recoverable. Recoverability of assets is measured by comparing the carrying amount of an asset to its fair value in a current transaction between willing parties, other than in a forced liquidation sale. Fair value was estimated by an independent appraisal of the value of the Company.
 
Factors we consider important which could trigger an impairment review include the following:
 
·
Significant underperformance relative to expected historical or projected future operating results;
 
·
Significant changes in the manner of our use of the acquired assets or the strategy of our overall business;
 
·
Significant negative industry or economic trends;
 
·
Significant decline in our stock price for a sustained period; and
 
·
Our market capitalization relative to net book value.
 
When we determine that the carrying value of intangibles, long-lived assets and related goodwill and enterprise level goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure any impairment based on comparing the carrying amount of the asset to its fair value in a current transaction between willing parties or, in the absence of such measurement, on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model. Any amount of impairment so determined would be written off as a charge to the income statement, together with an equal reduction of the related asset. Net intangible assets, long-lived assets and goodwill amounted to approximately $9.9 million as of June 30, 2008.
 
22

 
In 2002, Statement of Financial Accounting Standards (“SFAS”) No.142, “Goodwill and Other Intangible Assets” (“SFAS 142”) became effective and as a result, Old Point.360 ceased to amortize approximately $26.3 million of goodwill in 2002 and an annual impairment review thereafter. The initial test on January 1, 2002 and the Fiscal 2002 to 2007 tests performed as of September 30 of each year required no goodwill impairment. On August 14, 2007, the Company was formed by a spin-off transaction (see Note 12 – Sale of ADS Distribution Business in the accompanying financial statements), and a certain portion of Old Point.360’s goodwill was assigned to the Company (see Note 3-Acquisitions for a description of the allocation methodology). In the 2008 test performed as of June 30, 2008, the discounted cash flow method was used to evaluate goodwill impairment and included cash flow estimates for 2009 and subsequent years. If actual flow performance does not meet these expectations due to factors cited above, any resulting potential impairment could adversely affect reported goodwill asset values and earnings.
 
Accounting for income taxes. As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves us estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense within the tax provision in the statement of operations.
 
Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. The net deferred tax liability as of March 31, 2008 was $3.7 million. The Company did not record a valuation allowance against its deferred tax assets as of June 30, 2008.
 
In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with Statement FAS 109. This interpretation prescribes a recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition of tax benefits, classification on the balance sheet, interest and penalties, accounting in interim periods, disclosure, and transition. As the Company is responsible for the taxes resulting from Old Point.360’s operation prior to the Spin-off, the Company effectively adopted FIN 48 on January 1, 2007. The Company or one of its subsidiaries files income tax returns in the U.S. federal jurisdiction, and various state jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal, state or local income tax examinations by tax authorities for years before 2002. The Company has analyzed its filing positions in all of the federal and state jurisdictions where it is required to file income tax returns. The Company was last audited by New York taxing authorities for the years 2002 through 2004 resulting in no change. Old Point.360 and, consequently, the Company, are currently under audit by The U.S. Internal Revenue Service for calendar 2005. The Company believes that its income tax filing positions and deductions will be sustained and does not anticipate any adjustments that will result in a material change to its financial position. As a result, upon the implementation of FIN 48, the Company did not recognize any increase in the liability for unrecognized tax benefits. In addition, the Company did not record a cumulative effect adjustment related to the adoption of FIN 48.

Recent Accounting Pronouncements
 
In December 2007, the FASB issued SFAS No. 141R, “Business Combinations” (“SFAS 141R”), which requires most identifiable assets, liabilities, non-controlling interests, and goodwill acquired in a business combination to be recorded at “full fair value.” SFAS 141R applies to all business combinations, including combinations among mutual entities and combinations by contract alone. Under Statement 141R, all business combinations will be accounted for by applying the acquisition method. Statement 141R is effective for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. SFAS 141R will affect further acquisitions by the Company. 
 
In December 2007, the FASB issued SFAS No. 160, “Non-controlling Interests in Consolidated Financial Statements” (“SFAS 160”). SFAS 160 requires the ownership interests in subsidiaries held by parties other than the parent to be treated as a separate component of equity and be clearly identified, labeled, and presented in the consolidated financial statements. SFAS 160 is effective for periods beginning on or after December 15, 2008. Earlier adoption is prohibited. SFAS 160 has not yet affected the Company’s financial statements.
 
In January 2008, the SEC issued Staff Accounting Bulletin No. 110, “Certain Assumptions Used in Valuation Methods” (“SAB 100”) which amends Staff Accounting Bulletin No. 107, “Share-Based Payment” (“SAB 107”). SAB 110 allows for the continued use, under certain circumstances, of the “simplified” method in developing an estimate of expected term of so-called “plain vanilla” stock options accounted for under FAS 123R. SAB 110 amends SAB 107 to permit the use of the “simplified” method beyond December 31, 2007. The adoption of SAB 110 did not have a significant effect on the Company’s consolidated financial statements.
 
23

 
In March 2008, the FASB issued SFAS No. 161. “Disclosures about Derivative Instruments and Hedging Activities – an amendment of FASB Statement No, 133” (“FAS 161”). The standard requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments, and disclosures about credit-risk related contingent features in derivative agreements. FAS 161 is effective for financial statements issued after November 15, 2008. The adoption of FAS 161 will not have a significant effect on the Company’s consolidated financial statements.
 
ITEM 7. A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
 Market Risk. The Company had borrowings of $4.7 million on June 30, 2008 under term loan agreements. One term loan was subject to variable interest rates. The weighted average interest rate paid during fiscal 2008 was 7.65%. For variable rate debt outstanding at June 30, 2008, a .25% increase in interest rates will increase annual interest expense by approximately $7,000. Amounts that may become outstanding under the revolving credit facility provide for interest at the banks’ prime rate minus 0%-1.00% assuming the same amount of outstanding debt or LIBOR plus 1.5% to 2.5% and LIBOR plus 3.15% for the term loan. The Company’s market risk exposure with respect to financial instruments is to changes in prime or LIBOR rates.
 
24

 
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
 
Page
   
26
   
Financial Statements:
 
   
Consolidated Balance Sheets –
 
December 31, 2006 (restated) and June 30, 2007 (restated) and 2008
27
   
Consolidated Statements of Income (Loss) –
 
Fiscal Years Ended December 31, 2005 and 2006, the six months ended
 
June 30, 2007 and the year ended June 30, 2008
28
   
Consolidated Statements of Invested and Shareholders’ Equity –
 
Fiscal Years Ended December 31, 2005 (restated) and 2006 (restated),
 
the six months ended June 30, 2007 (restated) and the year ended June 30, 2008
29
   
Consolidated Statements of Cash Flows –
 
Fiscal Years Ended December 31, 2005 and
 
2006, the six months ended June 30, 2007 and the year ended June 30, 2008
30
   
Notes to Consolidated Financial Statements
31
   
Financial Statement Schedule:
 
   
Schedule II – Valuation and Qualifying Accounts
56
 
Schedules other than those listed above have been omitted since they are either not required, are not applicable  or the required information is shown in the financial statements or the related notes.

25


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and
Shareholders of Point.360
Burbank, California

We have audited the consolidated balance sheets of Point.360 (formerly New 360) and its subsidiary (collectively the “Company”) as of June 30, 2008, June 30, 2007 (restated), and December 31, 2006 (restated) and the related consolidated statements of income (loss), invested and shareholders equity and cash flows for the year ended June 30, 2008, for the six months ended June 30, 2007 (restated) (the transition period 2007), and for each of the two years in the two-year period ended December 31, 2006 (restated). Our audits also included the financial statement schedule of Point.360 listed in Item 15(a). These 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 based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). 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 Point.360 and its subsidiaries as of June 30, 2008, 2007(restated), and December 31, 2006 (restated) and the results of their operations and their cash flows for the year ended June 30, 2008, for the six months ended June 30, 2007 (the transition period 2007), and for each of the two years in the two-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. 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.

We were not engaged to examine management’s assertion about the effectiveness of Point. 360’s internal control over financial reporting as of June 30, 2008 discussed in the accompanying Item 9A Controls and Procedures and, accordingly, we do not express an opinion thereon.

As discussed in Note 7 to the consolidated financial statements, the Company has adopted the provisions of Statement of Financial Accounting Standards Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement No. 109” on July 1, 2007.
 
As described in Notes 1, 13 and 14 to the financial statements, the Company has restated its financial statements for each of the two years ended December 31, 2006 and for the six month period ending June 30, 2007 for correction of an error in the calculation of deferred tax liability.

SingerLewak, LLP
September 18, 2008

26


Point.360
Consolidated Balance Sheets
(in thousands)

   
December 31,
 
June 30,
 
   
2006
 
2007
 
2008
 
   
(Restated)
 
(Restated)
     
                     
Assets
                   
Current assets:
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
 
$
-
 
$
7,302
 
$
13,056
 
Accounts receivable, net of allowances for doubtful accounts of $513, $490 and $541, respectively
 
 
9,522
 
 
6,253
 
 
6,971
 
Inventories, net
 
 
539
 
 
555
 
 
502
 
Prepaid expenses and other current assets
 
 
533
 
 
868
 
 
667
 
Prepaid income taxes
 
 
439
 
 
1,535
 
 
1,441
 
Deferred income taxes
 
 
-
 
 
532
 
 
490
 
Total current assets
 
 
11,033
 
 
17,045
 
 
23,127
 
 
 
 
 
 
 
 
 
 
 
 
Property and equipment, net
 
 
12,850
 
 
11,330
 
 
8,667
 
Other assets, net
 
 
346
 
 
322
 
 
743
 
Goodwill
 
 
9,253
 
 
9,868
 
 
9,820
 
Total assets
 
$
33,482
 
$
38,565
 
$
42,358
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities and Shareholders’ Equity
 
 
 
 
 
 
 
 
 
 
Current liabilities:
 
 
 
 
 
 
 
 
 
 
Accounts payable
 
$
3,045
 
$
2,497
 
$
1,716
 
Accrued wages and benefits
 
 
1,592
 
 
2,216
 
 
2,109
 
Accrued earn-out payments
 
 
2,000
 
 
-
 
 
-
 
Other accrued expenses
 
 
237
 
 
726
 
 
816
 
Income taxes payable
 
 
123
 
 
-
 
 
-
 
Due to parent company
 
 
2,533
 
 
1,614
 
 
-
 
Current portion of borrowings under notes payable
 
 
-
 
 
-
 
 
1,810
 
Current portion of deferred gain on sale of real estate
 
 
178
 
 
178
 
 
178
 
 
 
 
 
 
 
 
 
 
 
 
Total current liabilities
 
 
9,708
 
 
7,231
 
 
6,631
 
 
 
 
 
 
 
 
 
 
 
 
Deferred income taxes
 
 
635
 
 
768
 
 
-
 
Notes payable, less current portion
 
 
-
 
 
-
 
 
2,839
 
Due to parent company, less current portion
 
 
3,157
 
 
4,257
 
 
-
 
Deferred gain on sale of real estate, less current portion
 
 
2,363
 
 
2,274
 
 
2,089
 
 
 
 
 
 
 
 
 
 
 
 
Total long-term liabilities
 
 
6,350
 
 
7,299
 
 
4,928
 
 
 
 
 
 
 
 
 
 
 
 
Total liabilities
 
 
16,058
 
 
14,530
 
 
11,558
 
 
 
 
 
 
 
 
 
 
 
 
Commitments and contingencies
 
 
-
 
 
-
 
 
-
 
 
 
 
 
 
 
 
 
 
 
 
Shareholders’ equity
 
 
 
 
 
 
 
 
 
 
Parent company’s invested equity
 
 
17,424
 
 
24,035
 
 
-
 
Preferred stock – no par value; 5,000,000 shares authorized; none outstanding
 
 
-
 
 
-
 
 
-
 
Common stock – no par value; 50,000,000 shares authorized; 10,553,410 shares issued and outstanding on each date
 
 
-
 
 
-
 
 
21,583
 
Additional paid-in capital
 
 
-
 
 
-
 
 
9,320
 
Retained earnings (deficit)
 
 
-
 
 
-
 
 
(103
)
Total shareholders’ equity
 
 
17,424
 
 
24,035
 
 
30,800
 
 
 
 
 
 
 
 
 
 
 
 
Total liabilities and shareholders’ equity
 
$
33,482
 
$
38,565
 
$
42,358
 

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

27


Point.360
Consolidated Statements of Income (Loss)
(in thousands, except per share amounts)

   
Year Ended
December 31,
 
Six Months
Ended June 30,
 
Year Ended
June 30,
 
   
2005
 
2006
 
2007
 
2008
 
Revenues
 
$
43,059
 
$
43,533
 
$
20,850
 
$
45,150
 
Cost of services sold
   
(29,472
)
 
(29,976
)
 
(15,760
)
 
(31,156
)
                           
Gross profit
   
13,587
   
13,557
   
5,090
   
13,994
 
                           
Selling, general and administrative expense
   
(11,201
)
 
(10,108
)
 
(5,590
)
 
(14,491
)
Allocation of Point.360 corporate expenses (Note 1)
   
(3,771
)
 
(3,446
)
 
(1,481
)
 
(120
)
Restructuring costs
   
-
   
-
   
-
   
(513
)
                           
Operating income (loss)
   
(1,385
)
 
3
   
(1,981
)
 
(1,130
)
                           
Interest expense
   
(1,280
)
 
(659
)
 
(299
)
 
(553
)
Interest income
   
-
   
-
   
35
   
348
 
Other income (expense)
   
-
   
-
   
-
   
100
 
                           
Income (loss) before income taxes
   
(2,665
)
 
(656
)
 
(2,244
)
 
(1,235
)
                           
Benefit from income taxes
   
1,045
   
342
   
607
   
292
 
                           
Net income (loss)
 
$
(1,620
)
$
(314
)
$
(1,637
)
$
(943
)
                           
Pro forma basic and diluted earnings (loss) per share
 
$
(0.15
)
$
(0.03
)
$
(0.16
)
$
(0.09
)
Pro forma weighted average number of shares
   
10,554
   
10,554
   
10,554
   
10,554
 

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

28

 
Point.360
Consolidated Statements of Invested and Shareholders’ Equity
(in thousands)

       
Common
             
   
Invested
 
Stock
 
Paid-in
 
Retained
 
Shareholders’
 
   
Equity
 
Shares
 
Dollars
 
Capital
 
Earnings
 
Equity
 
   
(Restated)
     
(Restated)
         
(Restated)
 
                           
Balance on December 31, 2004
 
$
20,541
 
 
 
 
$
 
 
$
  
 
$
 
 
$
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Changes in investment account due to allocation of operating activities (Note 1)
 
 
836
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income (loss)
 
 
(1,620
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance on December 31, 2005
 
 
19,757
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Changes in investment account due to allocation of operating activities (Note 1)
 
 
(2,019
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income (loss)
 
 
(314
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance on December 31, 2006
 
 
17,424
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
                                       
Changes in investment account due to allocation of operating activities (Note 1)
 
 
8,248
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
                                       
Net income (loss)
 
 
(1,637
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
                                       
Balance on June 30, 2007
 
 
24,035
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
                                       
Net income (loss)
 
 
-
 
 
-
 
 
-
 
 
-
 
 
(841
)
 
(841
)
                                       
Balance on August 13, 2007
 
 
24,035
 
 
-
 
 
-
 
 
-
 
 
(841
)
 
23,194
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Formation of New 360
 
 
(24,035
)
 
10,554
 
 
21,080
 
 
2,114
 
 
841
 
 
-
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Recognition of Ne