10-Q 1 v057584_10q.htm

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

___________

FORM 10-Q

(Mark One)

x Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

For the quarterly period ended September 30, 2006 or

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 0-21917

Point.360

(Exact Name of Registrant as Specified in Its Charter)

California (State of or other jurisdiction of incorporation or organization)	95-4272619 (I.R.S. Employer Identification No.)

2777 North Ontario Street, Burbank, CA (Address of principal executive offices)	91504 (Zip Code)

(818) 565-1400

(Registrant’s Telephone Number, Including Area Code)

(Former Name, Former Address and Former Fiscal Year,

if Changed Since Last Report)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by 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 o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer __________

Accelerated Filer __________

Non-accelerated filer X

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No x

As of September 30, 2006, there were 9,748,332 shares of the registrant’s common stock outstanding.

PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

POINT.360

CONSOLIDATED BALANCE SHEETS

ASSETS	December 31, 2005		September 30, 2006
Current assets:
Cash and cash equivalents	$	595,000	$	-
Accounts receivable, net of allowances for doubtful
accounts of $563,000 and $708,000 (unaudited), respectively		12,662,000		13,270,000
Inventories		796,000		717,000
Prepaid expenses and other current assets		2,432,000		2,058,000
Deferred income taxes		828,000		828,000
Total current assets		17,313,000		16,873,000
Property and equipment, net		28,079,000		14,854,000
Other assets, net		593,000		1,456,000
Goodwill		29,474,000		29,474,000
Total assets	$	75,459,000	$	62,657,000
Current liabilities:
Accounts payable	$	3,986,000	$	3,540,000
Accrued wages and benefits		1,711,000		1,277,000
Accrued earn-out payments		2,000,000		-
Other accrued expenses		683,000		881,000
Income taxes payable		1,231,000		623,000
Borrowing under revolving line of credit		4,054,000		2,439,000
Current portion of borrowings under notes payable		2,310,000		1,158,000
Current portion of capital lease and other obligations		63,000		32,000
Current portion of deferred gain on sale of real estate		-		178,000
Total current liabilities		16,038,000		10,128,000
Deferred income taxes		6,121,000		6,121,000
Bank notes payable, less current portion		13,744,000		3,763,000
Capital lease and other oblications, less current portion		46,000		8,000
Deferred gain on sale of real estate, less current portion		-		2,407,000
Total long-term liabilities		19,911,000		12,299,000
Total liabilities		35,949,000		22,427,000
Contingencies (Note 5)		-		-
Shareholder' equity
Preferred stock - no par value; 5,000,000 authorized; none outstanding		-		-
Common stock - no par value; 50,000,000 authorized; 9,368,857
and 9,748,332 (unaudited) shares issued and outstanding, respectively		17,971,000		18,601,000
Additional paid - in capital		1,159,000		1,159,000
Retained earnings		20,380,000		20,470,000
Total shareholders' equity		39,510,000		40,231,000
Total liabilities and shareholders' equity	$	75,459,000	$	62,657,000

See accompanying notes to consolidated financial statements.

POINT.360

CONSOLIDATED STATEMENTS OF INCOME (LOSS)

(Unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2005			2006			2005			2006
Revenues	$	16,748,000		$	15,313,000		$	49,821,000		$	47,654,000
Cost of services sold		(10,783,000	)		(10,335,000	)		(32,813,000	)		(31,988,000	)
Gross profit		5,965,000			4,978,000			17,008,000			15,666,000
Selling, general and administrative expense		(5,229,000	)		(4,694,000	)		(15,984,000	)		(14,799,000	)
Operating income (loss)		736,000			284,000			1,024,000			867,000
Interest expense, net		(379,000	)		(147,000	)		(999,000	)		(688,000	)
Income (loss) before income taxes		357,000			137,000			25,000			179,000
(Provision for) benefit from income taxes		(143,000	)		(72,000	)		(10,000	)		(89,000	)
Net income (loss)	$	214,000		$	65,000		$	15,000		$	90,000
Earnings(loss) per share:
Basic:
Net income (loss)	$	0.02		$	0.01		$	-		$	0.01
Weighted average number of shares		9,364,345			9,529,316			9,338,960			9,430,611
Diluted:
Net income (loss)	$	0.02		$	0.01		$	-		$	0.01
Weighted average number of shares
including the dilutive effect
of stock options		9,709,515			9,609,265			9,813,250			9,573,887

See accompanying notes to consolidated financial statements.

POINT.360

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	Nine Months Ended
	September 30,
	2005			2006
Cash flows from operating activities:
Net income (loss)	$	15,000		$	90,000
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization		4,652,000			4,132,000
Provision for doubtful accounts		71,000			145,000
Other non cash items		183,000			-
Changes in assets and liabilities:
(Increase) decrease in accounts receivable		(766,000	)		(753,000	)
Decrease in inventories		120,000			79,000
(Increase) decrease in prepaid expenses and
other current assets		(179,000	)		375,000
(Increase) decrease in other assets		(68,000	)		6,000
Increase (decrease) in accounts payable		(123,000	)		(446,000	)
(Decrease) in accrued expenses		(1,898,000	)		(2,236,000	)
Increase (Decrease) in income taxes		143,000			(608,000	)
(Decrease) in deferred taxes		(780,000	)		(870,000	)
Increase in other current liabilities		-			33,000
Net cash provided by (used in) operating activities		1,370,000			(53,000	)
Cash used in investing activities:
Capital expenditures		(1,688,000	)		(2,248,000	)
Proceeds from sale of Media Center real estate		-			13,893,000
Amount paid for acquisitions		(25,000	)		-
Net cash used in investing activities		(1,713,000	)		11,645,000
Cash flows provided by (used in) financing activities:
Exercise of stock options		55,000			630,000
Change in revolving credit agreement		1,666,000			(1,615,000	)
Proceeds from bank note		1,007,000			-
Shares issued for an acquisition		(400,000	)		-
Repayment of notes payable		(2,150,000	)		(11,133,000	)
Repayment of capital lease and other obligations		(72,000	)		(69,000	)
Net cash provided by (used in) financing activities		106,000			(12,187,000	)
Net increase (decrease) in cash		(237,000	)		(595,000	)
Cash and cash equivalents at beginning of period		668,000			595,000
Cash and cash equivalents at end of period	$	431,000			-
Supplemental disclosure of cash flow information -
Cash paid for:
Interest	$	999,000		$	657,000
Income tax	$	866,000		$	1,116,000

See accompanying notes to consolidated financial statements.

POINT.360

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

September 30, 2006

NOTE 1 - THE COMPANY

Point.360 (“Point.360” or the “Company”) provides video and film asset management services to owners, producers and distributors of entertainment and advertising content. The Company provides the services necessary to edit, master, reformat, archive and distribute its clients’ video content, including television programming, spot advertising and movie trailers. The Company provides worldwide electronic distribution, using fiber optics and satellites. The Company delivers commercials, movie trailers, electronic press kits, infomercials and syndicated programming, by both physical and electronic means, to thousands of broadcast outlets worldwide. The Company operates in one reportable segment.

The Company seeks to capitalize on growth in demand for the services related to the distribution of advertising and entertainment content, without assuming the production or ownership risk of any specific television program, feature film or other form of content. The primary users of the Company’s services are entertainment studios and advertising agencies that choose to outsource such services due to the sporadic demand of any single customer for such services and the fixed costs of maintaining a high-volume physical plant.

Since January 1, 1997, the Company has successfully completed ten acquisitions of companies providing similar services. The Company will continue to evaluate acquisition opportunities to enhance its operations and profitability. As a result of these acquisitions, the Company believes it is one of the largest and most diversified providers of technical and distribution services to the entertainment and advertising industries, and is therefore able to offer its customers a single source for such services at prices that reflect the Company’s scale economies.

The accompanying unaudited financial statements have been prepared in accordance with generally accepted accounting principles and the Securities and Exchange Commission’s rules and regulations for reporting interim financial statements and footnotes. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three and nine-month periods ended September 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006. These financial statements should be read in conjunction with the financial statements and related notes contained in the Company’s Form 10-K for the year ended December 31, 2005.

NOTE 2 - LONG TERM DEBT AND NOTES PAYABLE

On December 30, 2005, the Company entered into a new $10 million term loan agreement. The term loan provides for interest at LIBOR (5.4% as of September 30, 2006) plus 3.15% and is secured by the Company’s equipment. The term loan will be repaid in 60 equal monthly principal payments plus interest. Proceeds of the term loan were used to repay a previously existing term loan. In March 2006, the Company prepaid $4 million of the term loan with proceeds from the sale of real estate (see Note 3). Monthly principal payments were subsequently reduced pro rata.

In January 2006, the due date of the then existing credit facility was extended to March 31, 2006. As of December 30, 2005, the Company did not meet certain financial covenants contained in the credit facility and received a compliance waiver from the bank.

In March 2006, the Company entered into a new credit agreement which provides up to $10 million of revolving credit. The two-year agreement provides for interest of LIBOR plus 1.85% for the first six months of the agreement, and thereafter at either (i) prime (8.25% as of September 30, 2006) minus 0% - 1.00% or (ii) LIBOR plus 1.50% - 2.5%, depending on the level of the Company’s ratio of outstanding debt to fixed charges (as defined). The facility is secured by all of the Company’s assets, except for equipment securing the term loan. The revolving credit agreement requires the Company to comply with various financial and business covenants. There are cross default provisions contained in both the revolving and term loan agreements.

NOTE 3 - SALE OF REAL ESTATE

On March 29, 2006, the Company entered into a sale and leaseback transaction with respect to its Media Center vaulting real estate. The real estate was sold for approximately $14.0 million resulting in a $1.2 million after tax gain. Additionally, the Company received $0.5 million from the purchaser for improvements. In accordance with SFAS No. 28, Accounting for Sales with Leasebacks, the gain, related deferred taxes of $870,000 and improvement allowance will be amortized over the initial 15-year lease term as reduced rent. Such amounts are included in deferred gain on sale of real estate on the balance sheet. Net proceeds at the closing of the sale and the improvement advance (approximately $13.9 million) were used to pay off the mortgage and other outstanding debt. The lease provides for base rental payments during the initial 15-year term of $1,111,000 per year (aggregating $16,665,000 over 15 years) plus annual cost of living increases beginning in year six. There are four five-year renewal options. The lease is accounted for as an operating lease.

The following table presents an unaudited pro forma summary balance sheet as of December 31, 2005 as if the sale and leaseback had occurred on that date (in thousands):


		As Reported	Adjustments					Pro Forma
Current assets	$	17,313	152		(1	)	$	17,465
Property and equipment, net		28,079	(11,249	)	(2	)		16,830
Goodwill and other assets		30,067	870		(3	)		30,937
Total assets	$	75,459					$	65,232
Accounts payable and accrued expenses	$	8,380	870		(4	)	$	9,250
Deferred income taxes		1,231						1,231
Short-term debt		2,373	(310	)	(5	)		2,063
Borrowings under revolving credit		4,054	(3,735	)	(5	)		319
Current liabilities		16,038						12,863
Deferred gain on sale		-	2,175		(6	)		2,175
Deferred income taxes and other		6,121	500		(7	)		6,621
Long-term notes payable		13,790	(9,727	)	(5	)		4,063
Shareholders’ equity		39,510						39,510
Total liabilities and shareholders’ equity	$	75,459					$	65,232

(1) Prepaid rent & property taxes

(2) Net book value of assets sold

(3) Deferred taxes associated with gain on sale

(4) Current tax liability

(5) Pay-down of debt with net proceeds

(6) Deferred gain on sale to be amortized over life of lease

(7) Non-refundable advance from purchaser for improvements

NOTE 4 - STOCK-BASED COMPENSATION

On January 1, 2006, we adopted Statements of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, (SFAS 123(R)) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values. SFAS 123(R) supersedes our previous accounting under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) for periods beginning in fiscal 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (SAB 107) relating to SFAS 123(R). We have applied the provisions of SAB 107 in its adoption of SFAS 123(R).

SFAS 123(R) requires companies to estimate the fair value of share-based payment awards to employees and directors on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s Consolidated Statements of Income (Loss). Stock-based compensation expense recognized in the Consolidated Statements of Income (Loss) for the three and nine month periods ended September 30, 2006 included compensation expense for the share-based payment awards granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). There were no outstanding uninvested share-based payment awards as of January 1, 2006. For stock-based awards issued to employees and directors, stock-based compensation is attributed to expense using the straight-line single option method, which is consistent with how the prior-period pro formas were provided. As stock-based compensation expense recognized in the Statements of Consolidated Income (Loss) for 2006 is based on awards expected to vest, SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. For the three and nine months ended September 30, 2006, expected forfeitures are immaterial and as such the Company is recognizing forfeitures as they occur. In the pro-forma information provided under SFAS 123 for the periods prior to fiscal 2006, the Company accounted for forfeitures as they occurred.

We adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Company’s fiscal year 2006. Our consolidated financial statements as of and for the three and nine-month periods ended September 30, 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, our consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). Stock-based compensation expense related to employee or director stock options recognized for the three and nine-month periods ended September 30, 2006 was $23,000 ($16,000 net of tax benefit) and $60,000 ($42,000 net of tax benefit), respectively.

The Company’s determination of fair value of share-based payment awards to employees and directors on the date of grant uses the Black-Scholes model, which is affected by the Company’s stock price as well as assumptions regarding a number of complex and subjective variables. These variables include, but are not limited to, the expected stock price volatility over the expected term of the awards, and actual and projected employee stock option exercise behaviors. The Company estimates expected volatility using historical data. The expected term is estimated using the “safe harbor" provisions under SAB 107.

The following table illustrates the effect on net income (loss) and income (loss) per share if we had applied the fair value recognition provisions of SFAS 123 to stock-based awards granted under the company’s stock option plans for the three and nine-month periods ended September 30, 2005. For purposes of this pro-forma disclosure, the fair value of the options is estimated using the Black-Scholes-Merton option-pricing formula (Black-Scholes model) and amortized to expense over the options’ contractual term.

Net income (loss):	Three Months Ended September 30, 2005			Nine Months Ended September 30, 2005
As reported	$	214,000		$	15,000
Deduct: Total stock-based employee
compensation expense determined
under fair value based method fo r
all awards, net of related tax effects		(61,000	)		(158,000	)
Pro forma		153,000			(143,000	)
Basic earnings (loss) per share of
common stock:
As reported	$	0.02		$	-
Pro forma	$	0.02		$	(0.02	)
Diluted earnings (loss) per share of
common stock:
As reported	$	0.02			-
Pro forma	$	0.02		$	(0.01	)

During the quarter ended September 30, 2006, the Company did not grant any stock-based awards to employees or non-employees. During the nine months ended September 30, 2006, the Company granted awards of stock options for 400,000 shares at an average market price of $2.25 per share. At September 30, 2006, there were options outstanding to acquire 2,485,000 shares at an average exercise price of $2.88 per share. The estimated fair value of all awards granted during the nine months ended September 30, 2006 was $397,000. The total fair value of options vested during 2006 was $60,000. The fair value of each option was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions:

	Three months ended						Nine months ended
	September 30						September 30
	2005			2006			2005			2006
Risk-free interest rate		3.54	%		5.23	%		3.02	%		4.85	%
Expected term (years)		5.00			5.00			5.00			5.00
Volatility		43	%		42	%		43	%		42	%
Expected annual dividends		0.00	%		0.00	%		0.00	%		0.00	%

At September 30, 2006, the Company had outstanding options under three stock options plans: the 1996 Stock Incentive Plan, the 2000 Nonqualified Stock Option Plan, and the 2005 Equity Incentive Plan. The 1996 and 2000 Plans were terminated in May 2005 upon shareholder approval of the 2005 Plan, except that outstanding options under the 1996 and 2000 Plans were not terminated. The 2005 Plan provides for the award of options to purchase up to 2,000,000 shares of common stock, as well as stock appreciation rights and restricted stock awards.

The following table summarizes the status of these plans as of September 30, 2006:

	1996 Plan		2000 Plan		2005 Plan
Options originally available		3,800,000		1,500,000		2,000,000
Stock options outstanding		1,314,000		632,000		539,000
Options available for grant		-		-		1,461,000

Under all plans, the stock option price per share for options granted is determined by the Board of Directors and is based on the market price of the Company’s common stock on the date of grant, and each option is exercisable within the period and in the increments as determined by the Board, except that no option can be exercised later than ten years from the date it was granted. The stock options generally vest over one to five years.

A summary of the status of stock options as of September 30, 2005 and 2006, and changes during the three and nine-month periods then ended, is as follows.

	2005				2006
	Shares			Wtd. Avg. Exercise Price	Shares			Wtd. Avg. Exercise Price
Outstanding at beginning of the year	2,352,947		$	2.82	2,665,797		$	2.79
Granted	5,000		$	3.81	20,000		$	2.40
Exercised	(4,400	)	$	2.47	(3,400	)	$	1.35
Canceled	(64,447	)	$	2.50	(7,303	)	$	2.73

Outstanding at March 31	2,289,100		$	2.88	2,675,094		$	2.78
Granted	501,400		$	2.95	379,950		$	2.25
Exercised	(12,000	)	$	1.93	(49,725	)	$	1.55
Canceled	(18,780	)	$	2.42	(110,503	)	$	3.22

Outstanding at June 30	2,759,720		$	2.86	2,894,816		$	2.73
Granted	-			-	-			-
Exercised	(11,325	)	$	1.81	(326,350	)	$	1.54
Canceled	(45,382	)	$	2.64	(83,515	)	$	2.90

Outstanding at September 30	2,703,013		$	2.87	2,484,951		$	2.88

As of September 30, 2006, the total compensation costs related to non-vested awards yet to be expensed was approximately $0.3 million to be amortized over the next four years.

The weighted average exercise prices for options granted and exercisable and the weighted average remaining contractual life for options outstanding as of December 31, 2005 and September 30, 2006 was as follows:

As of December 31, 2005	Number of Shares		Weighted Average Exercise Price	Weighted Average Remaining Contractual Life (Years)		Intrinsic Value
Employees - Outstanding	2,300,797	$	2.69	3.33	$	116,000
Employees - Expected to Vest	2,300,797	$	2.69	3.33	$	116,000
Employees - Exercisable	2,300,797	$	2.69	3.33	$	116,000

Non-Employees - Outstanding	365,000	$	3.44	3.87	$	1,000
Non-Employees - Expected to Vest	365,000	$	3.44	3.87	$	1,000
Non-Employees - Exercisable	365,000	$	3.44	3.87	$	1,000
As of September 30, 2006
Employees - Outstanding	2,119,951	$	2.79	3.35	$	16,000
Employees - Expected to Vest	2,082,956	$	2.80	3.33	$	16,000
Employees - Exercisable	1,750,501	$	2.90	3.07	$	16,000

Non-Employees - Outstanding	365,000	$	3.44	3.52		-
Non-Employees - Expected to Vest	365,000	$	3.44	3.52		-
Non-Employees - Exercisable	365,000	$	3.44	3.52		-

Additional information with respect to outstanding options as of September 30, 2006 is as follows (shares in thousands):

Options Outstanding					Options Exercisable
Option Exercise Price Range	Number of Shares	Weighted Average Remaining Contractual Life		Weighted Average Exercise Price	Number of Shares		Weighted Average Exercise Price
$ 1.20 - $5.38	2,479,000	3.38 yrs.	$	2.87	2,110,000	$	2.98
$ 7.00 - $10.00	6,000	.41 yrs.	$	7.00	6,000	$	7.00

We have elected to adopt the detailed method provided in SFAS 123(R) for calculating the beginning balance of the additional paid-in capital pool (APIC pool) related to the tax effects of employee stock-based compensation, and to determine the subsequent impact on the APIC pool and Consolidated Statements of Cash Flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS 123(R).

NOTE 5 - CONTINGENCIES

On July 10, 2006, Digital Generation Systems, Inc. (“DG”) filed a claim in the District Court of Dallas County, Texas, alleging that the Company interfered with a contract between DG and Pathfire, Inc. (Pathfire), which contract provided that DG was granted exclusive use of Pathfire’s network for the distribution of advertising content. The DG/Pathfire exclusivity excluded the distribution of certain other types of content (other than advertising content) to be distributed by Pathfire for CBS/Viacom. The claim alleges that the Company was aware of the exclusivity provision during its negotiations with CBS Worldwide Distribution, CBS Broadcasting, Inc. (“CBS”), which resulted in a January 2006 contract between the Company and CBS (“CBS Contract”). Under the CBS Contract, the Company licensed advertising content distribution services from CBS, which services were to be performed utilizing Pathfire’s IP-Multicast Format Store & Forward technology. DG alleges that the Company’s knowledge of the exclusivity provision during the Company’s negotiations with CBS and the resulting use of Pathfire’s technology for distribution of ads caused damage to DG. The claim seeks unspecified actual and punitive damages and other costs of prosecution.

If DG is successful in its claim, the possibility exists that the Pathfire distribution technology will become unavailable to the Company, through which the Company currently distributes a portion of its commercial spots. If that occurs, the Company believes it has alternative means to fulfill customer needs.

The Company believes the complaint is without merit and will not have a material effect on the Company’s financial position. Regardless, CBS has agreed to indemnify the Company pursuant to the CBS Contract to the extent permitted by law or otherwise.

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.

NOTE 6 - SHAREHOLDERS’ EQUITY

During the nine-month period ended September 30, 2006, the number of outstanding shares of the Company’s common stock increased by 379,475 shares due to the exercise of employee stock options for $571,000 in cash.

POINT.360

MANAGEMENT’S DISCUSSION AND ANALYSIS

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

Except for the historical information contained herein, certain statements in this quarterly 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, dependence 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 Part II of this Form 10-Q, for a further discussion of these and other risks and uncertainties applicable to the Company's business.

Overview

We are one of the largest providers of video and film asset management services to owners, producers and distributors of entertainment and advertising content. We provide the services necessary to edit, master, reformat, archive and ultimately distribute our clients’ film and video content, including television programming, spot advertising, feature films and movie trailers using electronic and physical means. We deliver commercials, movie trailers, electronic press kits, infomercials and syndicated programming to hundreds of broadcast outlets worldwide. Our interconnected facilities in Los Angeles, New York, Chicago, Dallas and San Francisco provide service coverage in each of the major U.S. media centers. Clients include major motion picture studios, advertising agencies and corporations.

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 the Company. 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 Point.360. We attract and retain customers by maintaining a high service level at reasonable prices.

In recent years, electronic delivery services have grown while physical duplication and delivery have been declining. We expect this trend to continue for the foreseeable future. All of our electronic, fiber optics, satellite and Internet deliveries are made using third party vendors, which eliminates our need to invest in such capability. However, the use of others to deliver our services poses the risk that costs may rise in certain situations that cannot be passed on to customers, thereby lowering gross margins. There is also the risk that third party vendors who directly compete with us will succeed in taking away business or refuse to allow us to use their distribution channels. In fact, in June 2005, one such vendor/competitor notified us that its electronic distribution channel would not be available to us except in very limited circumstances, or unless we entered certain “preferred vendor” arrangements that we believed would not be in the best long-term interests of Point.360. While curtailment of these services has not materially affected our ability to deliver commercial spots, we have not been able to pass on increased alternative delivery costs to our customers since June 2005. While we are exploring other lower cost alternatives, gross margins related to spot delivery revenues will be lower until such alternatives become available.

The Company has an opportunity to expand its business by establishing closer relationships with our customers through excellent service at a competitive price and maintaining adequate third party distribution channels. 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 International Video Conversions, Inc. (“IVC”) in July 2004) which 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 nationwide interconnected facilities provide the ability to better service national 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.

Statistical Analysis

The table below summarizes pro forma results for the three and nine-month periods ended September 30, 2005 and 2006, isolating the effects of the March 29, 2006 sale/leaseback transaction for the 2006 periods: (in thousands except per share amounts)

	Quarter Ended
	September 30, 2005			September 30, 2006
	GAAP			Pro forma			(1)			GAAP

Revenues	$	16,748		$	15,313		$	-		$	15,313
Cost of services		(10,783	)		(10,162	)		(173	)		(10,335	)
Gross profit		5,965			5,151			(173	)		4,978
Selling, general and
administrative expense		(5,229	)		(4,680	)		(14	)		(4,694	)
Operating income		736			471			(187	)		284
Interest expense, net		(379	)		(413	)		266			(147	)
Income
before income taxes		357			58			79			137
Provision for
income taxes		(143	)		(31	)		(41	)		(72	)
Net income	$	214		$	27		$	38		$	65
Earnings per share:
Basic:	$	0.02		$	-		$	0.01		$	0.01
Diluted:	$	0.02		$	-		$	0.01		$	0.01

	Nine Months Ended
	September 30, 2005			September 30, 2006
	GAAP			Pro forma			(1)			GAAP
Revenues	$	49,821		$	47,654		$	-		$	47,654
Cost of services		(32,813	)		(31,642	)		(346	)		(31,988	)
Gross profit		17,008			16,012			(346	)		15,666
Selling, general and
administrative expense		(15,984	)		(14,771	)		(28	)		(14,799	)
Operating income		1,024			1,241			(374	)		867
Interest expense, net		(999	)		(1,212	)		524			(688	)
Income
before income		25			29			150			179
Provision for
from income taxes		(10	)		(14	)		(75	)		(89	)
Net income	$	15		$	15		$	75		$	90
Earnings per share:
Basic:	$	-		$	-		$	0.01		$	0.01
Diluted:	$	-		$	-		$	0.01		$	0.01

(1)	Effect of sale/leaseback transaction. The adjustments reflect the decrease in depreciation and the increase in rent associated with the real estate and lower interest expense resulting from the pay off of approximately $13.9 million of mortgage and other debt with the sale proceeds.

Three Months Ended September 30, 2006 Compared To Three Months Ended September 30, 2005.

Revenues. Revenues were $15.3 million for the three-month period ended September 30, 2006, compared to $16.7 million for the three-month period ended September 30, 2005. Revenues declined in 2006 due to a number of factors including: (i) price compression due to competition in post production and spot advertising distribution, (ii) consolidation among some customers that has resulted in less business being available to Point.360, and (iii) the continuing trend toward electronic distribution of commercial spots as opposed to physical duplication and distribution which results in lower revenues. Billings to customers for sending commercial spots physically, has declined to about 4.6% of sales in the third quarter of 2006 from 5.1% in the prior year period. These factors have been somewhat offset by acquiring new customers and adding new service offerings. We expect the negative trends to continue at a slower pace in the future, and we will 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.

Gross Profit. In the third quarter of 2006, gross margin was 33 % of sales, compared to 36% for the quarter ended September 30, 2005. The sale/leaseback penalized third quarter gross margin by 1% of sales (i.e., lease costs increased $0.2 million in the 2006 quarter 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 lower sales offset by declining wages and benefits. Gross margins have been historically higher as a percentage of sales for advertising related revenue as compared to post production, the latter requiring a larger investment in equipment (greater depreciation) and higher personnel costs when compared to duplication and distribution of advertising content. We expect gross margins to fluctuate in the future as the sales mix changes.

Selling, General and Administrative Expense. SG&A expense was $4.7 million (31% of sales) in the third quarter of 2006 as compared to $5.2 million (31% of sales) in the same period of 2005.

Interest Expense. Interest expense for the three-month period ended September 30, 2006 was $0.1 million, a decrease of $0.2 million over the three-month period ended September 30, 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.

Nine Months Ended September 30, 2006 Compared to Nine Months Ended September 30, 2005.

Revenues. Revenues were $47.7 million for the nine-month period ended September 30, 2006, compared to $49.8 million for the nine-month period ended September 30, 2005. Revenues declined in 2006 due to a number of factors including: (i) price compression due to competition in post production and spot advertising distribution, (ii) consolidation among some customers that has resulted in less business being available to Point.360, and (iii) the continuing trend toward electronic distribution of commercial spots as opposed to physical duplication and distribution which results in lower revenues. Revenue from freight, the charge to customers for sending commercial spots physically, has declined to about 4.6% of sales in the third quarter of 2006 from 5.2% in the prior year period. These factors have been somewhat offset by acquiring new customers and adding new service offerings. We expect the negative trends to continue at a slower pace in the future, and we will 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.

Gross Profit. In the first nine months of 2006, gross margin was 33 % of sales, compared to 34% for the same period last year. The sale/leaseback penalized third quarter gross margin by 1% of sales (i.e., lease costs increased $0.4 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 decrease in gross profit percentage is due to lower sales offset by declining wages and benefits. Gross margins have been historically higher as a percentage of sales for advertising related revenue as compared to post production, the latter requiring a greater investment in equipment (greater depreciation) and higher personnel costs when compared to duplication and distribution of advertising content. We expect gross margins to fluctuate in the future as the sales mix changes.

Selling, General and Administrative Expense. SG&A expense was $14.8 million (31% of sales) in the first nine months of 2006 as compared to $16.0 million (32% of sales) in the same period of 2005.

Interest Expense. Interest expense for the nine-month period ended September 30, 2006 was $0.7 million, a decrease of $0.3 million over the nine-month period ended September 30, 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.

LIQUIDITY AND CAPITAL RESOURCES

On December 30, 2005, the Company entered a new $10 million term loan agreement. The term loan provides for interest at LIBOR (5.4% at September 30, 2006) plus 3.15% and is secured by the Company’s equipment. The term loan will be repaid in 60 equal principal payments plus interest. Proceeds of the loan were used to pay off our previously existing term loan.

In March 2006, the Company entered into a new credit agreement which provides up to $10 million of revolving credit. The two-year agreement provides for interest of LIBOR plus 1.85% for the first six months of the agreement, and thereafter either (i) prime (8.25% at September 30, 2006) 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). The facility is secured by all of the Company’s assets, except for equipment securing a new term loan as described above.

In March 2006, the Company 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 $1.2 million after tax gain. Additionally, we received $500,000 from the purchaser for improvements. In accordance with SFAS No. 28, Accounting for Sales with Leasebacks (“SFAS 28”), the gain and the improvement allowance will be amortized over the initial 15-year lease term as reduced rent. Net proceeds at the closing of the sale and the improvement advance (approximately $13.9 million) were used to pay off the mortgage and other outstanding debt. In accordance with our agreement with the revolving credit lender, we prepaid $4 million of the term loan. As a result of the prepayment, monthly principal payments on the term loan were reduced by approximately $70,000 per month ($840,000 per year).

The following table summarizes the September 30, 2006 status of our revolving line of credit and term loans:

Revolving credit	$	2,439,000
Current portion of term loan		1,158,000
Long-term portion of term loan		3,763,000
Total	$	7,360,000

Monthly and annual principal and interest payments due under the term debt are approximately $94,000 and $1.1 million, respectively, assuming no change in interest rates, down from $260,000 and $3,100,000, respectively, from the term loan in existence in 2005. Simultaneously, monthly and annual cash lease costs have increased by $93,000 and $1,111,000, respectively.

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 and freight components of cost of sales must be paid currently and within 30 days, respectively. 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.

We expect that remaining amounts available under the new revolving credit arrangement, 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 $2.5 - 3.5 million of capital expenditures for the next twelve months.

The acquisition of IVC was completed in July 2004 for $2.3 million in cash and $4.7 million in borrowings. The IVC purchase agreement also required payments of $1 million, $2 million and $2 million in 2005, 2006 and 2007, respectively, if certain predetermined earnings levels (as defined) are met. In April 2005, $1 million was paid. $2 million was paid in 2006.

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 complementary to 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.

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 or 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 judgements. 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 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 allowances; 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 independent appraisals and other valuation techniques.

Factors we consider important which could trigger an impairment review include the following:

l	significant underperformance relative to expected historical or projected future operating results;

l	significant changes in the manner of our use of the acquired assets or the strategy for our overall business;

l	significant negative industry or economic trends;

l	significant decline in our stock price for a sustained period; and

l	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 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 $45.8 million as of September 30, 2006.

In 2002, Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”) became effective and as a result, we ceased to amortize approximately $26.3 million of goodwill beginning in 2002. In lieu of amortization, we were required to perform an initial impairment review of our goodwill in 2002 and an annual impairment review thereafter. The initial test on January 1, 2002, and the Fiscal 2002, 2003, 2004 and 2005 tests performed as of September 30, 2002, 2003, 2004 and 2005, respectively, required no goodwill impairment. An additional test was performed as of December 31, 2005 which required no impairment. The discounted cash flow method used to evaluate goodwill impairment included cash flow estimates for 2006 and subsequent years. In the 2006 test performed as of September 30, 2006, we determined the fair value of the enterprise using independent appraisals and other valuation techniques, and there was no impairment indicated. If future appraisals or future performance are affected by the factors cited above, resulting potential impairment could adversely affect the reported goodwill asset value 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 September 30, 2006 was $6.1 million. The Company did not record a valuation allowance against its deferred tax assets as of September 30, 2006.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market Risk. The Company had borrowings of $7.4 million at September 30, 2006 under a term loan and revolving credit agreements. All debt was subject to a variable interest rate. The weighted average interest rate paid during the first nine months of 2006 was 7.7%. For variable rate debt outstanding at September 30, 2006, a .25% increase in interest rates will increase annual interest expense by approximately $18,000. Amounts 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.

ITEM 4. CONTROLS AND PROCEDURES

Pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934 (the “Exchange Act”), the Company’s management, with the participation of the Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the Company’s disclosure controls and procedures, as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in ensuring that information required to be disclosed in reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. No change in the Company’s internal control over financial reporting occurred during the Company’s most recent fiscal quarter that materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

ITEM 1A. RISK FACTORS

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” within the meaning of the Private Securities Litigation Reform Act of 1995. 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. In connection with the “Safe Harbor” provisions of the Private Securities Litigation Reform Act of 1995, 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:

l	Recent history of losses.

l	Prior breach and changes in credit agreements and ongoing liquidity.

l	Our highly competitive marketplace.

l	The risks associated with dependence upon significant customers.

l	Our ability to execute our expansion strategy.

l	The uncertain ability to manage in a changing environment.

l	Our dependence upon and our ability to adapt to technological developments.

l	Dependence on key personnel.

l	Our ability to maintain and improve service quality.

l	Fluctuation in quarterly operating results and seasonality in certain of our markets.

l	Possible significant influence over corporate affairs by significant shareholders.

Investors are encouraged to examine the Company’s 2005 Form 10-K, which more fully describes the risks and uncertainties associated with the Company’s business.

ITEM 6. EXHIBITS

(a)

Exhibits

31.1 Certification of Chief Executive Officer Pursuant to 15 U.S.C. § 7241, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2 Certification of Chief Financial Officer Pursuant to 15 U.S.C. § 7241, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1 Certification of Chief Executive Officer Pursuant to 18 U.S.C. § 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2 Certification of Chief Financial Officer Pursuant to 18 U.S.C. § 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

SIGNATURES

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


	POINT.360

DATE: November 14, 2006	By:	/s/ Alan R. Steel
		Alan R. Steel Executive Vice President, Finance and Administration (duly authorized officer and principal financial officer)