DGIT Digital Generation, Inc. (MM)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2013

or

For the transition period from              to

Commission File Number: 1-35643

Digital Generation, Inc.

(Exact name of registrant as specified in its charter)

750 West John Carpenter Freeway, Suite 700

Irving, Texas 75039

(Address of principal executive offices) (Zip Code)

(972) 581-2000

(Registrant’s telephone number, including area code)

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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  x   No  o

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.

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 November 6, 2013, the registrant had 27,985,957 shares of Common Stock, par value $0.001, outstanding.

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DIGITAL GENERATION, INC.

Cautionary Note Regarding Forward-Looking Statements

The Securities and Exchange Commission (“SEC”) encourages companies to disclose forward-looking information so that investors can better understand a company’s future prospects and make informed investment decisions. Certain statements contained herein may be deemed to constitute “forward-looking statements.”

Words such as “may,” “anticipate,” “estimate,” “expects,” “projects,” “future,” “intends,” “will,” “plans,” “believes” and words and terms of similar substance used in connection with any discussion of future operating or financial performance, identify forward-looking statements. All forward-looking statements are management’s present expectations of future events and are subject to a number of risks and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. These risks and uncertainties include, among other things:

·                   whether or not the pending transactions with Extreme Reach regarding the sale of the television business will be completed including:

·                   the ability of NewCo to achieve the benefits of the transactions or that such benefits may take longer to realize than expected; and

·                   the potential impact the announcement of the transactions or consummation of the transactions may have on relationships with employees, suppliers, customers and competitors;

·                   our ability to further identify, develop and achieve commercial success for new products;

·                   delays in product development;

·                   the development of competing distribution and online services and products, and the pricing of competing services and products;

·                   our ability to protect our proprietary technologies;

·                   the shift of advertising spending by our customers to online and non-traditional media from television and radio;

·                   the demand for High Definition (HD) ad delivery by our customers;

·                   integrating MediaMind and other acquisitions with our operations, systems, personnel and technologies;

·                   our ability to successfully transition customers from our previous online acquisitions to our MediaMind digital platform for ad delivery;

·                   operating in a variety of foreign jurisdictions;

·                   fluctuations in currency exchange rates;

·                   adaption to new, changing, and competitive technologies;

·                   potential additional impairment of our goodwill and potential impairment of our other long-lived assets; and

·                   other factors discussed elsewhere under the heading “Risk Factors” in Part II, Item 1A included in this Form 10-Q and in Part I, Item 1A of the Annual Report on Form 10-K for the year ended December 31, 2012.

In light of these assumptions, risks and uncertainties, the results and events discussed in the forward-looking statements contained herein might not occur. You are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date of this filing. We are not under any obligation, and we expressly disclaim any obligation, to update or alter any forward-looking statements, whether as a result of new information, future events or otherwise, except as may be required by applicable law. All subsequent forward-looking statements attributable to management or to any person authorized to act on our behalf are expressly qualified in their entirety by the cautionary statements contained or referred to in this section.

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

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

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

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

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DIGITAL GENERATION, INC. AND SUBSIDIARIES

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and optimize digital media campaigns. We also offer a variety of other ancillary products and services to the advertising industry. Our business has grown largely from acquisitions.

We market our services directly in the United States and through our subsidiaries in several countries, including Canada, Israel, the United Kingdom, France, Germany, Australia, Ireland, Spain, Japan, China, Mexico and Brazil. See Note 12.

Basis of Presentation

The consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) and include the accounts of our subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

These financial statements have been prepared by us without audit, pursuant to the rules and regulations of the SEC.  Certain information and disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations.  However, we believe the disclosures are adequate to make the information presented not misleading.  The unaudited consolidated financial statements reflect all adjustments, which are, in the opinion of management, of a normal and recurring nature and necessary for a fair presentation of our financial position as of the balance sheet dates, and the results of operations and cash flows for the periods presented.  These unaudited consolidated financial statements should be read in conjunction with the financial statements and the notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2012 (“Annual Report”).

Seasonality and Political Advertising

Our business is seasonal.  Revenues tend to be the highest in the fourth quarter as a large portion of our revenues follow the advertising patterns of our customers.  Further, our revenues are affected by political advertising, which peaks every other year consistent with the national, state and local election cycles in the United States.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate our estimates, including those related to the recoverability and useful lives of our long-lived assets, the adequacy of our allowance for doubtful accounts and credit memo reserves, office closure exit costs, contingent consideration and income taxes. We base our estimates on historical experience, future expectations and on other relevant assumptions that are believed 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 could differ from those estimates.

During the three months ended June 30, 2013 we reversed a $0.8 million revenue earnout liability as payment was predicated on collected revenues and collections fell short of the amount requiring an earnout payment.  The reversal was credited to cost of revenues.  The revised estimate increased income from continuing operations, net income and diluted earnings per share by $0.5 million, $0.5 million and $0.02, respectively, during the three months ended June 30, 2013.  See Note 3.

During the three months ended March 31, 2012, we reduced our estimated bonus for 2011 by approximately $1.1 million. The reduction was credited to general and administrative expense during the three months ended March 31, 2012.  The revised estimate increased income from continuing operations, net income and diluted earnings per share by $0.6 million, $0.6 million and $0.02, respectively, during the three months ended March 31, 2012.

See Note 5 for a discussion of the risk of a future impairment of our goodwill.

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Derivative Instruments

We enter into foreign currency forward contracts and options with a single counterparty (i.e., an Israeli bank) to hedge the exposure to the variability in expected future cash flows resulting from changes in related foreign currency exchange rates between the New Israeli Shekel (“NIS”) and the U.S. Dollar. Portions of these transactions are designated as cash flow hedges, as defined by Accounting Standards Codification (“ASC”) Topic 815, “ Derivatives and Hedging. ”

ASC Topic 815 requires that we recognize derivative instruments as either assets or liabilities in our balance sheet at fair value. These contracts are Level 2 fair value measurements in accordance with ASC Topic 820, “ Fair Value Measurements and Disclosures.” For derivative instruments that are designated and qualify as a cash flow hedge (i.e., hedging the exposure to variability in expected future cash flows that is attributable to a particular risk), the effective portion of the gain or loss on the derivative instrument is reported as a component of other comprehensive income (loss), net of taxes, and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Any ineffectiveness, which historically has not been material, is recognized in the statement of operations (interest income and other, net).

Our cash flow hedging strategy is to hedge against the risk of overall changes in cash flows resulting from certain forecasted foreign currency rent and salary payments during the next 12 months. We hedge portions of our forecasted expenses denominated in the NIS with foreign currency forward contracts and options. At September 30, 2013, we had $7.7 million notional amount of foreign currency forward contracts and options outstanding that had a net fair value asset balance of $0.3 million ($0.3 million asset, net of a $0.0 million liability). The net asset is included in “other current assets” and is expected to be recognized in our results of operations in the next 12 months. As a result of our hedging activities we incurred the following gains (losses) in our consolidated results of operations (in thousands):

The vast majority of any gain or loss from hedging activities is included in our various operating expenses.  It is our policy to offset fair value amounts recognized for derivative instruments executed with the same counterparty when we have the right of, or ability to cause, net settlement.  In connection with our foreign currency forward contracts and options and other banking arrangements, we have agreed to maintain $1.7 million of cash in a bank account with our counterparty (an Israeli bank).

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Acquisition, Integration and Other Expenses

Acquisition, integration and other expenses reflect the expenses incurred in acquiring or disposing of a business (e.g., investment banking fees, legal fees), costs to integrate an acquired operation (e.g., severance pay, office closure costs) into the Company and certain other expenses.  Strategic alternatives costs principally relate to the pending transaction with ER.  These costs are ongoing (see Note 1).  A summary of our acquisition, integration and other expenses are as follows (in thousands):

(1)  See Note 1.

Discontinued Operations

In 2011, management committed to a plan to sell certain assets and the operations of our Springbox unit since it was not deemed to be part of our core business going forward.  As a result, the Springbox operating results have been reclassified to discontinued operations in the accompanying consolidated statements of operations.  The Springbox operation was sold on June 1, 2012.  For the five months ended May 31, 2012, Springbox reported revenues, loss from discontinued operations and diluted loss per share from discontinued operations of $1.6 million, $1.1 million and $0.04, respectively.

Recently Adopted Accounting Guidance

Effective January 1, 2013, we adopted ASU 2012-02, “Intangibles—Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment,” which provides entities with the option to assess qualitative factors to determine whether the existence of events and circumstances indicates that it is more likely than not that the indefinite-lived intangible asset is impaired.  If the entity concludes that it is more likely than not that the asset is impaired, it is required to determine the fair value of the intangible asset and perform the quantitative impairment test by comparing the fair value with the carrying value in accordance with Topic 350.  If the entity concludes otherwise, no further quantitative assessment is required.  Presently, our only indefinite long-lived intangible asset is goodwill. The adoption of ASU 2012-02 did not have a material impact on our consolidated financial statements.

Effective January 1, 2013, we adopted ASU 2013-02, “Comprehensive Income (Topic 350)” which requires entities to disclose information showing the effect of items reclassified from accumulated other comprehensive income (loss) to the line items in the statement of operations.  The provisions of this new guidance were effective prospectively beginning January 1, 2013.  Accordingly, we have included enhanced footnote disclosure for the three and nine months ended September 30, 2013 in Note 7.  Other than the additional disclosure, the adoption of ASU 2013-02 did not have a material impact on our consolidated financial statements.

3.  Fair Value Measurements

ASC 820, Fair Value Measurements and Disclosures, defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date.

ASC 820 establishes a three-level fair value hierarchy that prioritizes the inputs used to measure fair value. This hierarchy requires entities to maximize the use of observable inputs and minimize the use of unobservable inputs. The three levels of inputs used to measure fair value are as follows:

·                   Level 1—Quoted prices in active markets for identical assets or liabilities.

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·                   Level 2—Observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar assets and liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

·                   Level 3—Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. This includes certain pricing models, discounted cash flow methodologies and similar techniques that use significant unobservable inputs.

We have classified our assets and liabilities that are measured at fair value on a recurring basis (at least annually) into the most appropriate level within the fair value hierarchy based on the inputs used to determine the fair value at the measurement date.

The tables below set forth by level, assets and liabilities that were accounted for at fair value as of September 30, 2013 and December 31, 2012.  The tables do not include cash on hand or assets and liabilities that are measured at historical cost or any basis other than fair value (in thousands):

(a) Included in cash and cash equivalents.

(b) Included in other current assets.

(c) Included in other non-current assets.

(d) Included in accrued liabilities.

(e) Included in other non-current liabilities.

The fair value of our money market funds and marketable equity securities were determined based upon quoted market prices. Our marketable equity securities relate to a single issuer with an adjusted cost basis of $0.3

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million.  The currency forwards/options are derivative instruments whose value is based upon quoted market prices from various market participants.

In connection with the sale of Springbox we are entitled to receive a percentage of the revenues collected by the business for three years after the closing date (June 1, 2012). We have estimated the future revenues of Springbox based on the historical revenues and certain other factors, discounted to their present value.  The following table provides a reconciliation of changes in the fair values of our Level 3 assets (in thousands):

In connection with an acquisition of a business, we sometimes include a contingent consideration component of the purchase price based on future revenues. We estimate future revenues based on historical revenues and certain other factors. Each reporting period, we update our estimate of the future revenues of each earnout party and the corresponding earnout levels achieved, discounted to their present values. The change in fair value is recorded in cost of revenues in the accompanying consolidated statements of operations. The following table provides a reconciliation of changes in the fair value of our Level 3 liabilities (in thousands):

The fair value of our debt (see Note 6) at September 30, 2013 was approximately $387.3 million based on the average trading price (a Level 1 fair value measurement).

4.  Acquisitions

During 2012 we completed the following acquisitions:

Each of the acquired businesses has been included in our results of operations since the date of closing.  Accordingly, 2013 and 2012 operating results are not entirely comparable due to these acquisitions and related costs.

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The following unaudited pro forma information presents our results of operations for the three and nine months ended September 30, 2012 as if (i) the acquisitions of North Country and Peer 39 and (ii) the disposition of the Chors assets had occurred on January 1, 2012 (in thousands, except per share amounts).  A table of actual amounts is provided for reference.

5. Goodwill

Changes in the carrying value of our goodwill by reporting unit for the nine months ended September 30, 2013 are as follows (in thousands):

Risk of Future Impairment

We test goodwill for possible impairment each year on December 31 st  and whenever events or changes in circumstances indicate the carrying value of our goodwill may not be recoverable.  As of September 30, 2013, we continue to believe that the fair value of our reporting units exceed their respective carrying values.  Accordingly, we have not performed an interim goodwill impairment test.

During 2012, we recorded a total of $219.6 million of goodwill impairment charges related to our online reporting unit.  The 2012 charges primarily related to reducing our forecasts to address weaker than previously expected operating results, and softer market conditions and trends.  As a result of the charges, the online reporting unit’s goodwill was adjusted to its then implied fair value.  We determine fair value based on a combination of the discounted cash flow methodology (which uses our internal forecasts as to future cash flows by reporting unit) and the guideline public company approach.  If our actual operating results, or our future expected operating results, were to fall sufficiently below our current forecasts, we may be required to record another goodwill impairment charge for the online reporting unit.

Further, at December 31, 2012, the fair value of our television reporting unit only exceeded its carrying value by 13%.  Similar to the online reporting unit, to the extent our actual or future expected operating results of the television reporting unit were to fall sufficiently below our current forecasts, we may be required to record a goodwill impairment charge for the television reporting unit.  The pending transaction with ER (see Note 1) to sell our television business is an indication that the fair value of the television reporting unit continues to exceed its carrying value.  At December 31, 2012, the fair value of our SourceEcreative reporting unit exceeded its carrying value by 977%.

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6.  Long-Term Debt

Long-term debt is summarized as follows (in thousands):