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 provides 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 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, 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 constituted approximately 83% of our revenues in the six months ended December 31, 2012. 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 December 31, 2012 Compared to Three Months Ended December 31, 2011

Revenues. Revenues were $7.7 million for the three months ended December 31, 2012, compared to $8.5 million for the three months ended December 31, 2011. Revenues declined due to lower orders for distribution of older programming and the timing of orders received with respect to seasonal television programming. Our major television customer is tending to spread current new season debuts throughout the year in reaction to audience acceptance. That customer reduced its outsourced requirement for domestic and foreign distribution of non-current programming by $0.7 million when compared to the prior year period, which orders vary from period to period. We continue to have excellent relations with our major customers.

Cost of Services.Costs of services consist principally of wages and benefits, facility costs and depreciation of physical assets. During the three months ended December 31, 2012, total costs of services declined $0.3 million, and were 67% of sales compared to 65% in the prior year. The majority of the decrease was associated with depreciation, facility and material costs. Material costs declined due to the reorganization of functions associated with the shift from physical to file based processes. This also contributed to lower delivery costs. Beginning in the fourth quarter of fiscal 2012, facility costs decreased by approximately $0.3 million per quarter due to the move of one of our Burbank locations to our Media Center facility, which savings is expected to continue. In the current period, outsourced servicing costs increased $0.2 million to complete specific customer tasks, which costs are not expected to continue in future quarters.

Gross Profit. In the three months ended December 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 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 $2.9 million (38% of sales) in the three months ended December 31, 2012 as compared to $3.0 million (35% of sales) in the same period last year. The decrease in SG&A costs was due primarily to lower facility costs in the current period when compared to last year's period.

Operating Income (Loss). Operating loss was $0.4 million in the fiscal 2013 period, compared to a break-even income in the same period last year.

Interest Expense. Net interest expense was $0.1 million in the fiscal 2013 period compared to $0.2 million in the prior year. We expect interest expense to decline during the remainder of fiscal 2013 due to a refinancing of our revolving debt and term loans during the quarter ended September 30, 2012 at lower interest rates. Interest expense for our two term loan mortgages declined by approximately $0.1 million in the quarter ended December 31, 2012 when compared to the prior year period.

Other Income.Other income in both periods represents sublease income and gain on sale of fixed assets.

Net Income (Loss). The net loss was $0.4 million in the fiscal 2013 period, compared to net income of $0.1 million in the 2012 period.

Six Months Ended December 31, 2012 Compared to Six Months Ended December 31, 2011

Revenues. Revenues were $15.4 million for the six months ended December 31, 2012, compared to $17.5 million for the six months ended December 31, 2011. Revenues declined due to lower orders for distribution of older programming and the timing of orders received with respect to seasonal television programming. Our major television customer is tending to spread current new season debuts throughout the year in reaction to audience acceptance. That customer reduced its outsourced requirement for domestic and foreign distribution of non-current programming by $1.8 million when compared to the prior year period, which orders vary from period to period. We continue to have excellent relations with our major customers.

Cost of Services.Costs of services consist principally of wages and benefits, facility costs and depreciation of physical assets. During the dic months ended December 31, 2012, total costs of services declined $0.9 million, and were 66% of sales compared to 63% in the prior year. The majority of the decrease was associated with depreciation, facility and material costs. Material costs declined due to the reorganization of functions associated with the shift from physical to file based processes. This also contributed to lower delivery costs. Beginning in the fourth quarter of fiscal 2012, facility costs decreased by approximately $0.3 million per quarter due to the move of one of our Burbank locations to our Media Center facility, which savings is expected to continue. In the current period, outsourced servicing costs increased $0.2 million to complete specific customer tasks, which costs are not expected to continue in the future.

Gross Profit. In the six months ended December 31, 2012, gross margin was 34% of sales, compared to 37% for the same period last year. The decrease 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 $5.8 million (38% of sales) in the six months ended December 31, 2012 as compared to $6.2 million (35% of sales) in the same period last year. The decrease in SG&A costs was due primarily to lower facility costs in the current period when compared to last year's period.

Operating Income (Loss). Operating loss was $0.6 million in the fiscal 2013 period, compared to income of $0.3 million in the same period last year.

Interest Expense. Net interest expense was $0.2 million in the current period compared to $0.4 million in the prior year's period. We expect interest expense to decline during the remainder of fiscal 2013 due to a refinancing of our revolving debt and term loans during the quarter ended September 30, 2012 at lower interest rates. Interest expense for our two term loan mortgages declined by approximately $0.2 million in the six months ended December 31, 2012 when compared to the prior year period.

Other Income.Other income in both periods represents sublease income and gain on sale of fixed assets. In the 2012 six month period, other income also included a $0.3 million discount on debt repayment and the write off of $0.1 million deferred financing and other costs associated with the termination of a line of credit and one mortgage loan.

Net Income (Loss). The net loss was $0.5 million in the fiscal 2013 period, compared to net income of $0.2 million in the 2012 period.

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 had 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. The mortgage was paid off in September 2012 and replaced by a new mortgage (see below). The Company received a $332,000 discount in connection with the payoff and wrote off approximately $90,000 of deferred financing costs related to the note, both of which were recorded as other income (expense) in the quarter ended September 30, 2012.

In June 2009, the Company entered into a $3,562,500 Purchase Money Promissory Note secured by a Deed of Trust for the purchase of land and a building. The note was repaid in September 2012 and replaced by a new mortgage (see below).

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. 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.

In January 2011, the Company entered into a credit agreement which provided $1 million of credit. In March 2011, the credit limit was increased to $3 million. In August 2012, the credit agreement was terminated and replaced as discussed below.

In August and September of 2012, the Company entered into revolving credit, equipment financing and two mortgage agreements with a bank as follows:

Revolving Credit Facility. The revolving credit facility provides up to $5 million of credit based on 80% of eligible accounts receivable, as defined. The agreement provides for interest at the lower of (i) Libor plus 2.75% (2.96% as of December 31, 2012) or (ii) the bank's alternative base rate plus 1.75% (5.00% as of December 31, 2012), plus 0.25% per annum assessed on the unused portion of the credit commitment. The maturity date is August 15, 2014 and is renewable for an additional year on each anniversary date upon mutual agreement of the parties.

Equipment Financing Facility. The equipment financing facility provides up to $1.25 million of financing for the cost of new and already-owned or leased equipment. The agreement provides for interest at the bank's cost of funds plus 3% (4.0% as of December 31, 2012). The maturity date for each "schedule" of equipment is up to four years from the borrowing date. Amounts may be borrowed under the facility until August 14, 2013.

Hollywood Way and Vine Street Mortgages. In September 2012, the Company entered into two real estate term loan agreements with respect to its Hollywood Way and Vine Street locations for $5.5 million and $3.1 million, respectively. The loans provide for interest at Libor plus 3% (3.21% as of December 31, 2012). Repayment is based on monthly payments with a 25-year amortization, with all principal due in 10 years.

In connection with the new financing of the Hollywood Way mortgage, the Company received $126,000 (the difference between the new $5,526,000 loan and the $5,400,000 payoff amount of the old loan). The Company used cash of $491,000 (the difference between $3,566,000 payoff of the old loan and $3,075,000 provided by the new loan) in the Vine refinancing. The cash used for both transactions was $365,000, net of transaction costs. We expect annual interest savings on the two new mortgages to be approximately $360,000 based on the new mortgage interest rate as of December 31, 2012 as compared to the rates for the prior mortgages.

General Terms. All amounts due under the revolving credit, equipment financing and term loan facilities are secured by all personal property and real estate of the Company. While amounts are outstanding under the credit arrangements, the Company will be subject to financial covenants as follows:

1. Minimum tangible net worth (TNW) of $8.5 million (the Company's actual TNW was $9.8 million as of December 31, 2012).

2. Minimum quarterly EBITDA (as defined) of $750,000, provided that EBITDA may be a minimum of $500,000 in any one quarter within four consecutive quarters (the Company's EBITDA was $0.6 million for the quarter ended December 31, 2012).

3. Minimum quarterly fixed charge ratio (as defined) of 1.25 (the Company's fixed charge ratio was 1.34 for the quarter ended December 31, 2012).

Amounts Borrowed. As of December 31, 2012, the Company had no outstanding borrowings under the revolving credit facility and $0.3 million borrowed under the equipment financing facility.

In connection with the termination of the prior credit agreement, the Company paid a $30,000 break-up fee, which was reflected in other income/expense in the six months ended December 31, 2012.

Monthly and annual principal and interest payments due under the capital leases and mortgages are approximately $63,000 and $0.8 million, respectively, assuming no change in interest rates.

The following table summarizes the December 31, 2012 amounts outstanding under our line of credit, capital lease obligations and mortgage loans:

Line of credit                                                     $         -
Current portion of, capital leases and mortgages                       466,000
Long-term portion of notes payable, capital leases and mortgages     8,400,000
Total                                                              $ 8,866,000

The Company's cash balance increased from $1,219,000 on July 1, 2012 to $1,285,000 on December 31, 2012, due to the following:

Balance July 1, 2012                              $ 1,219,000
Decrease in accounts receivable                       933,000
Decrease in accrued expenses                         (292,000 )
Capital expenditures for property and equipment      (212,000 )
Decrease in notes payable                            (542,000 )
Changes in other assets and liabilities               177,000
Balance December 31, 2012                         $ 1,285,000

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 2013, 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 decreased from approximately 64 days to 63 days within the last 12 months. We do not expect days sales outstanding to materially fluctuate in the future.

The Company purchased the Vine Property in June 2009. The building is currently being used for storage. Building renovations will cost about $1.0-$1.5 million depending on the expected use of the space. One alternative will be to move our entire West Los Angeles operation to Vine by the May 2014 expiration of the West Los Angles lease if we decide not to exercise our option to extend the lease.

In June 2011, the Company entered into a lease amendment with respect to the Company's Media Center facility. The amendment provided that the landlord would reimburse the Company for up to $2 million of improvements to be made to the premises. The amendment also provided 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.

The Company incurred $2.1 million of costs for the Media Center construction, of which $2.0 million was 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, which began in April 2012, are 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 December 31, 2012 due in the future:

                                                          Payment due by Period

                                               Less than 1         Years           Years
Contractual Obligations          Total             Year           2 and 3         4 and 5        Thereafter
Long-Term Debt Principal
Obligations                   $  8,545,000     $    344,000     $   688,000     $   688,000     $  6,825,000
Long-Term Debt Interest
Obligations (1)                  2,196,000          276,000         519,000         473,000          928,000
Capital Lease Obligations          321,000          122,000         199,000               -                -
Capital Lease Interest
Obligations                         18,000           10,000           8,000               -                -
Operating Lease Obligations     15,380,000        1,955,000       3,878,000       3,848,000        5,699,000
Line of Credit Obligations               -                -               -               -                -
Total                         $ 26,460,000     $  2,707,000     $ 5,292,000     $ 5,009,000     $ 13,452,000

(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 initially issued stock (valued at $500,000) and cash for assets and intellectual property, and spent $4.7 million in Fiscal 2010 and 2011 to test the concept. The plan was to open five test stores, three of which were completed at a cost of approximately $200,000 per store for the physical build-out and inventory. The remaining two of the leased facilities are expected to be completed in the third quarter of fiscal 2013 at a cost of approximately $50,000 per store. Over the last 12 months, the quarterly negative cash flow (defined as earnings before interest, taxes, depreciation and amortization) for each of the three stores operating during that period has averaged $18,000 on revenues of $43,000, including rent for the two previously vacant locations. We estimate that cash flow break even can be achieved on revenues of $61,000 per quarter per store, which level may be lower if administrative costs were spread over a larger number of stores. Further expansion of Movie>Q will depend on the performance of the stores and 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. 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 . . .