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, 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, including the Risk Factors section of the Company's most recent annual report on Form 10-K, 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

Point.360 is 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. The Company also rents and sells DVDs and video games directly to consumers through its Movie>Q retail stores.

We operate in a highly competitive environment in which customers desire a broad range of services 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 Point.360. We attract and retain customers by maintaining a high service level at reasonable prices.

The market for our services is primarily dependent on our customers' desire and ability to monetize their entertainment content. The major studios derive revenues from re-releases and/or syndication of motion pictures and television content. While the size of this market is not quantifiable, we believe studios will continue to repurpose library content to augment uncertain revenues from new releases. The current uncertain economic environment has negatively impacted the ability and willingness of independent producers to create new content.

The demand for entertainment content should continue to expand through web-based applications. We believe long and short form content will be sought by users of personal computers, hand-held devices and home entertainment technology. Additionally, changing formats from standard definition, to high definition, to Blu-Ray and perhaps to 3D will continue to give us the opportunity to provide new services with respect to library content. We also believe that a potentially large consumer market exists for the rental of DVDs and video games, which market is being abandoned by "big box" DVD rental stores.

To meet these needs, we must be prepared to invest in technology and equipment, and attract the talent needed to serve our client needs. Labor, facility and depreciation expenses constitute approximately 85% of our revenues. Our goals include maximizing facility and labor usage, and maintaining sufficient cash flow for capital expenditures and acquisitions of complementary businesses to enhance our service offerings.

We have an opportunity to expand our business by establishing closer relationships with our customers through excellent service at a competitive price and adding to 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 acquisitions of IVC in July 2004, Eden FX in March 2007 and others) that can increase revenues by adding new customers, or expanding current services to existing customers. Additionally, we are looking to capitalize on the Movie>Q retail opportunity.

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.

Three Months Ended March 31, 2012 Compared to Three Months Ended March 31, 2011

Revenues. Revenues were $8.5 million for the three months ended March 31, 2012, compared to $9.3 million for the three months ended March 31, 2011. The decrease was due principally to the timing of orders for our major customers. We are continuing to invest in file-based capabilities where demand is expected to grow. We completed our move of one of our Burbank operations into newly renovated space in our Media Center facility in the third quarter of fiscal 2012, and to date the move has not adversely impacted revenues.

Cost of Services.Costs of services consist principally of wages and benefits, facility costs and depreciation of physical assets. During the quarter ended March 31, 2012, total costs of services declined by $0.3 million, and were 67% of sales compared to 65% in the prior year. Wages and benefits declined due to the reorganization of functions associated with the shift from physical to file based processes. This also contributed to a lesser demand for tape stock material. Beginning in the fourth quarter of fiscal 2012, we expect facility costs to decrease by approximately $0.3 million per quarter due to the move of one of our Burbank locations to our Media Center facility.

Gross Profit. In the three months ended March 31, 2012, gross margin was 33% of sales, compared to 35% for the same period last year. The decrease in gross profit percentage is due to lower sales. From time to time, we will increase or decrease staff capabilities to satisfy potential customer service demand. We expect gross margins to fluctuate in the future as the sales mix changes.

Selling, General and Administrative Expense. SG&A expense was $3.0 million (36% of sales) in the three months ended March 31, 2012 as compared to $3.2 million (35% of sales) in the same period last year. SG&A personnel costs and depreciation expense decreased $0.1 million and $0.1 million, respectively, in the current period when compared to last year's period.

Research and Development Expense. During the fiscal year ended June 30, 2010, the Company undertook a research and development project to evaluate, develop and commercialize "automated" stores to rent and sell digital video discs (DVDs). The Movie>Q stores will contain up to 10,000 DVDs for rent or sale via a software-controlled automated inventory management (AIM) system contained in 1,200 to 1,600 square feet of retail space for each store. As of March 31, 2012, three Movie>Q stores were completed. Expenses associated with R&D activities were $18,000 for the quarter ended March 31, 2011.

Impairment of Long Lived Assets. During the period ended March 31, 2011, the Movie>Q R&D proof of concept was completed. With the selection of the AIM system as the operative DVD distribution method, we determined that the kiosk assets were impaired for accounting purposes, resulting in an impairment charge of $684,000.

Operating Loss. Operating loss was $0.2 million in the fiscal 2012 period, compared to a $0.7 million loss in the same period last year.

Interest Expense. Net interest expense was $0.2 million in both quarterly periods.

Other Income.Other income in the current year period represents principally sublease income. In last year's period, other income included a $1.0 million settlement.

Net Income (Loss). Net loss was $0.3 million in the fiscal 2012 period, compared to a net income of $0.2 million in the 2011 period. Excluding the impairment charge and settlement income, the Company incurred a $0.1 loss in the quarter ended March 31, 2011.

Nine Months Ended March 31, 2012 Compared to Nine Months Ended March 31, 2011

Revenues. Revenues were $26.0 million for the nine months ended March 31, 2012, compared to $26.6 million for the nine months ended March 31, 2012. Service revenues remained consistent between the periods. We are continuing to invest in file-based capabilities where demand is expected to grow. We completed the move of one of our Burbank operations into newly renovated space in our Media Center facility in the third quarter of fiscal 2012.

Cost of Services.Costs of services consist principally of wages and benefits, facility costs and depreciation of physical assets. During the nine months ended March 31, 2012, total costs of services declined $1.8 million, and were 64% of sales compared to 70% in the prior year. The majority of the decrease was associated with wages and benefits and material costs. Wages and benefits declined due to the reorganization of functions associated with the shift from physical to file based processes. This also contributed to a lesser demand for tape stock material. Beginning in the fourth quarter of fiscal 2012, we expect facility costs to decrease by approximately $0.3 million per quarter due to the move of one of our Burbank locations to our Media Center facility.

Gross Profit. In the nine months ended March 31, 2012, gross margin was 36% of sales, compared to 31% for the same period last year. The increase in gross profit percentage is due to the factors cited above. From time to time, we will increase or decrease staff capabilities to satisfy potential customer service demand. We expect gross margins to fluctuate in the future as the sales mix changes.

Selling, General and Administrative Expense. SG&A expense was $9.2 million (35% of sales) in the nine months ended March 31, 2012 as compared to $10.2 million (38% of sales) in the same period last year. SG&A personnel costs, professional fees, and depreciation decreased $0.6 million $0.3 million and $0.3 million, respectively, in the current period when compared to last year's period.

Research and Development Expense. During the fiscal year ended June 30, 2010, the Company undertook a research and development project to evaluate, develop and commercialize "automated" stores to rent and sell digital video discs (DVDs). The Movie>Q stores can contain up to 10,000 DVDs for rent or sale via a software-controlled automated inventory management (AIM) system contained in 1,200 to 1,600 square feet of retail space for each store. As of March 31, 2012, three Movie>Q stores were completed. Expenses associated with R&D activities were $0.4 million for the nine months ended March 31, 2011.

Impairment of Long Lived Assets. During the period ended March 31, 2011, the Movie>Q R&D proof of concept was completed. With the selection of the AIM system as the operative DVD distribution method, we determined that the kiosk assets were impaired for accounting purposes, resulting in an impairment charge of $684,000.

Operating Income (Loss). Operating income was $0.1 million in the fiscal 2012 period, compared to a $3.1 million loss in the same period last year.

Interest Expense. Net interest expense was $0.6 million in both quarterly periods.

Other Income.Other income in the current year period represents principally sublease income. In last year's period, other income included a $1.0 million settlement.

Net Loss. Net loss was $0.2 million in the fiscal 2012 period, compared to a net loss of $2.4 million in the 2011 period. Excluding the impairment charge and settlement income, the loss for the nine months ended march 31, 2011 was $2.7 million.

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-Q.

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 (the total purchase price was approximately $8.1 million). Pursuant to the Note, the Company borrowed $6,000,000 payable in monthly installments of principal and interest on a fully amortized basis over 30 years at an initial five-year interest rate of 7.1% and thereafter at a variable rate equal to LIBOR plus 3.6% (6.4% as of the purchase date). The mortgage debt is secured by the land and building.

In June 2009, the Company entered into a $3,562,500 million Purchase Money Promissory Note secured by a Deed of Trust for the purchase of land and a building ("Vine Property"). The note bears interest at 7% fixed for ten years. The principal amount of the note is payable on June 12, 2019. The note is secured by the property.

In November 2010, the Company converted approximately $1 million of accounts payable into a note secured by a lien of all the Company's assets, which security interest was subordinated to that of the $3 million credit agreement and other term and mortgage debt. The note was due in 48 monthly installments of $20,000 plus interest at 3% per annum and could be prepaid at any time. The total amount due under the note is subject to a 12.5% or 6% discount if totally paid within 12 months or 18 months, respectively. In April 2011, the Company received $1 million in settlement of a claim, and prepaid $333,000 of the above $1 million note. The remaining amount due under the note was paid in October, 2011, at a 12.5% discount.

Monthly and annual principal and interest payments due under the term debt and mortgages are approximately $264,000 and $3.1 million, respectively, assuming no change in interest rates.

In January 2011, the Company entered into a credit agreement which provides $1 million of credit based on 85% of acceptable accounts receivable, as defined. The loan and security agreement provides for interest at prime rate plus 2% with an interest floor of 5.25%. In addition, the Company paid a monthly "maintenance" fee of 0.6% of the outstanding daily loan balance (an equivalent annual fee of 7.2%), and an annual commitment fee of 1% of the amount of the credit facility. Amounts outstanding under the agreement are secured by all of the Company's assets other than real estate and are payable on demand. In March 2011, the credit limit was increased to $3 million based on 80% of acceptable accounts receivable, as defined. In November 2011, the credit limit was reduced to 80% of acceptable accounts receivable less $300,000, the interest rate was reduced to prime plus 0.5% (currently 3.75%) with an interest floor of 3.75%, and the monthly maintenance fee was reduced to 0.4% (an equivalent annual fee of 4.8%). As of March 31, 2012, the Company owed $1.3 million under the credit agreement.

The following table summarizes the March 31, 2012 amounts outstanding under our line of credit, note payable, and term (including capital lease obligations) and mortgage loans:

Line of credit                        $  1,267,000

Current portion of notes payable,
  capital leases and mortgages             271,000
Long-term portion of notes payable,
  capital leases and mortgages           9,302,000

Total                                 $ 10,840,000

The Company's cash balance decreased from $355,000 on July 1, 2011 to $42,000 on March 31, 2012, due to the following:

Balance July 1, 2011                              $    355,000
Increase in accounts receivable                       (808,000 )
Increase in accounts payable                           171,000
Increase in accrued expenses                           378,000
Cash provided by other operating activities          2,088,000
Capital expenditures for property and equipment     (3,175,000 )
Decrease in notes payable                             (675,000 )
Line of credit borrowings                               94,000
Changes in other assets and liabilities (A)          1,614,000
Balance March 31, 2012                            $     42,000

(A) Includes changes in liabilities related to deferred lease incentive.

Cash generated by operating activities is directly dependent upon sales levels and gross margins achieved. We generally receive payments from customers in 60-120 days after services are performed. The larger payroll and facilities components of our cost structure must be paid currently. Payment terms of other liabilities vary by vendor and type. 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.

In fiscal 2012 and 2011, the underlying drivers of operating cash flows (sales, receivable collections, the timing of vendor payments, facility costs and employment levels) have been consistent. Sales outstanding in accounts receivable have increased from approximately 71 days to 80 days within the last 12 months. We do not expect days sales outstanding to materially fluctuate in the future.

As of March 31, 2012, our facility costs consisted of building rent, maintenance and communication expenses. In July 2008, rents were reduced by the purchase of our Hollywood Way facility in Burbank, CA, eliminating approximately $625,000 of annual rent expense. The real estate purchase involved a down payment of $2.1 million and $6 million of mortgage debt. The mortgage payments are approximately $489,000 per year.

In March 2009, the lease on one of our facilities in Hollywood, CA ("Highland") expired and the Company became a holdover tenant. The landlord issued a Notice to Quit which required us to move out of the facility. The Highland operations have been housed at another Company facility. Our Eden FX facility was moved to our West Los Angeles location in September 2010.

The Company purchased the Vine Property in June 2009. The purchase price of the Vine Property was $4.75 million, $1.2 million of which was paid in cash with the balance being financed by the seller over ten years, interest only at 7% for the entire term, with the principal amount being due at the end of the term. Building renovations, which are currently being evaluated, will cost about $1.5 million.

In June 2011, the Company entered into a lease amendment with respect to the Company's Media Center facility. The amendment provides that the landlord would reimburse the Company for up to $2 million of improvements to be made to the premises. The amendment also provides that the Company's monthly rent cost would increase approximately $14,000 on July 1, 2011, and an additional $13,000 to approximately $27,000 on April 1, 2012.

As of March 31, 2012, the Company had incurred $2.0 million of costs for construction, of which $1.7 million had been reimbursed by the landlord. The Company completed the project and vacated one of its Burbank facilities on the February 28, 2012 expiration of the related lease and move to the Media Center space. Total annual savings beginning in March 2012 are expected to be approximately $1.2 million.

We believe our current cash position and a difficult economy may provide us with the opportunity to invest in facility assets that will not only help fix our operating costs, but give us the potential to own appreciating real estate assets. We will continue to evaluate opportunities to reduce facility costs.

The following table summarizes contractual obligations as of March 31, 2012 due in the future:

                                                   Payment due by Period

Contractual                             Less than 1         Years           Years
Obligations               Total             Year           2 and 3         4 and 5        Thereafter
Long-Term Debt
Principal
Obligations            $  9,331,000     $     76,000     $   184,000     $   214,000     $  8,857,000
Long-Term Debt
Interest Obligations
(1)                       8,183,000          662,000       1,246,000       1,201,000        5,074,000
Capital Lease
Obligations                 242,000          195,000          47,000               -                -
Capital Lease
Interest Obligations         13,000           12,000           1,000               -                -
Operating Lease
Obligations              16,682,000        1,971,000       3,730,000       3,835,000        7,146,000
Line of Credit
Obligations               1,267,000        1,267,000               -               -                -
Total                  $ 35,718,000     $  4,183,000     $ 5,208,000     $ 5,250,000     $ 21,077,000

(1) Interest on variable rate debt has been computed using the rate on the latest balance sheet date.

As described elsewhere in this Form 10-Q, the Company began a research and development project in Fiscal 2010 to create "proof of concept" stores to distribute digital video discs (DVDs) to consumers. The Company hopes to capture a portion of the DVD rental market being vacated by the closure of many larger distribution vendors (e.g., Blockbuster and Hollywood Video) locations. The Company has initially issued stock (valued at $500,000) and cash for assets and intellectual property, and spent $3.7 million in Fiscal 2010 and $1.0 million in Fiscal 2011 to test the concept. We finalized the proof-of-concept in March 2011. Since then, the quarterly negative cash flow (defined as earnings before interest, taxes, depreciation and amortization) for each of the three stores has averaged $15,000 on revenues of $47,000. We estimate that cash flow break even can be achieved on revenues of $60,000 per quarter per store, which level may be lower if administrative costs were spread over a larger number of stores. The estimated cost of opening a store (physical build-out and inventory) is approximately $200,000 in the current store configuration. Further expansion of Movie>Q will depend on the availability of additional funding.

During the past year, the Company had generated sufficient cash flow to meet operating, capital expenditure and debt service needs and most of its other obligations. The Company also received in July 2010 a refund of $1.5 million in federal income taxes for the tax year 2006, and a $1 million settlement of a claim in April 2011. 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 and possible real estate transactions. Consummation of any acquisition, real estate or other expansion transaction by the Company may be subject to the Company securing additional financing, perhaps at a cost higher than our existing line of credit and term loans. In the current economic climate, additional financing may not be available. 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 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 (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. At the end of an accounting period, revenue is accrued for un-invoiced but shipped work.

Certain jobs specify that many discrete tasks must be performed which require up to four months to complete. In such cases, we use the proportional performance method for recognizing revenue. Under the proportional performance method, revenue is recognized based on the value of each stand-alone service completed.

In some instances, a client will request that we store (or "vault") an element for a period ranging from a day to indefinitely. The Company attempts to bill customers a nominal amount for storage, but some customers, especially major movie studios, will not pay for this service. In the latter instance, storage is an accommodation to foster additional business with respect to the related element. It is impossible to estimate (i) the length of time we may house the element, or (ii) the amount of additional services we may be called upon to perform on an element. We do not treat vaulting as a separate deliverable in those instances in which the customer does not pay.

The Company records all revenues when all of the following criteria are met: (i) there is persuasive evidence that an arrangement exists; (ii) delivery has occurred or the services have been rendered; (iii) the Company's price to the customer is fixed or determinable; and (iv) collectability is reasonably assured. Additionally, in instances where package services are performed on multiple elements or where the proportional performance method is applied, revenue is recognized based on the value of each stand-alone service completed.

Allowance for doubtful accounts. We are required to make judgments, based on historical experience and future expectations, as to the collectability 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, comprise a . . .