**SECURITIES AND EXCHANGE COMMISSION**

**Washington,DC 20549**

**Form 10-Q**

**QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

**Forthe Quarterly Period Ended March 31, 2005**

**CommissionFile Number 000-50335**

**Digital Theater Systems, Inc.**

(Exact name of registrantas specified in its charter)
| **Delaware**                                                     | **77-0467655**                                              |
|------------------------------------------------------------------|-------------------------------------------------------------|
| (State  or other jurisdiction of  incorporation or organization) | (I.R.S.  employer  identification number)                   |
| **5171 Clareton Drive  Agoura Hills, California 91301**          | **(818) 706-3525**                                          |
| (Address  of principal executive  offices and zip code)          | (Registrant’s  telephone number,  Including area code) |

 

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Indicate by check mark whetherthe registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.    Yes  x     No  o

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act).    Yes  x     No  o

As of April 30, 2005a total of 17,303,563 shares of the Registrant’s Common Stock, $0.0001 parvalue, were issued and outstanding.

 

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**DIGITAL THEATERSYSTEMS, INC.FORM 10-QTABLE OF CONTENTS**
| **PART I**   | ** ** | **FINANCIAL  INFORMATION**                                                                      | ** ** | **3**  |
|-------------------|------------|-------------------------------------------------------------------------------------------------|------------|--------|
| **Item 1.**  | ** ** | **Financial  Statements:**                                                                      | ** ** | **3**  |
|              | ** ** | **Condensed Consolidated  Balance Sheets**                                                      | ** ** | **3**  |
|              | ** ** | **Condensed Consolidated  Statements of Operations**                                            | ** ** | **4**  |
|              | ** ** | **Condensed Consolidated  Statements of Cash Flows**                                            | ** ** | **5**  |
|              | ** ** | **Notes to Condensed  Consolidated Financial Statements**                                       | ** ** | **6**  |
| **Item 2.**  | ** ** | **Management’s Discussion and  Analysis of Financial Condition and Results of Operations** | ** ** | **16** |
| **Item 3.**  | ** ** | **Quantitative and  Qualitative Disclosures About Market Risk**                                 | ** ** | **36** |
| **Item 4.**  | ** ** | **Controls and Procedures**                                                                     | ** ** | **37** |
| **PART II.** | ** ** | **OTHER INFORMATION**                                                                           | ** ** | **38** |
| **Item 1.**  | ** ** | **Legal  Proceedings**                                                                          | ** ** | **38** |
| **Item 2.**  | ** ** | **Unregistered Sales of Equity  Securities and Use of Proceeds**                                | ** ** | **38** |
| **Item 3.**  | ** ** | **Defaults Upon Senior  Securities**                                                            | ** ** | **38** |
| **Item 4.**  | ** ** | **Submission of Matters to a  Vote of Security Holders**                                        | ** ** | **38** |
| **Item 5.**  | ** ** | **Other  Information**                                                                          | ** ** | **38** |
| **Item 6.**  | ** ** | **Exhibits**                                                                                    | ** ** | **39** |
| **SIGNATURES**    | ** ** | **40**                                                                                          |

 

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**DIGITAL THEATERSYSTEMS, INC.**

**PART I**

**FINANCIALINFORMATION**

**Item 1.**                     *Financial Statements*

**DigitalTheater Systems, Inc.Condensed ConsolidatedBalance Sheets**
| ** **                                                                                                                                                                                                                                      | ** ** | **As of   December 31,  2004**                                                      | ** ** | **As of   March 31,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                                                                                                                                      | ** ** | ** **                                                                                         | ** ** | **  (Unaudited)  **    | ** ** |
| ** **                                                                                                                                                                                                                                      | ** ** | **(Amounts in thousands, except  share and per share amounts)** | ** ** |
| ASSETS                                                                                                                                                                                                                                          |       |                                                                                               |       |                                       |       |   |   |   |   |
| Current assets:                                                                                                                                                                                                                                 |       |                                                                                               |       |                                       |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                                                                       |       |                                                                                               | $          | 21,271                                     |       |   |   | $ | 31,892 |   |   |
| Short-term investments                                                                                                                                                                                                                          |       |                                                                                               | 93,040     |                                       |       |   | 74,303 |   |   |
| Accounts receivable, net of allowance for doubtful  accounts of $402 and $406 at December 31, 2004 and March 31, 2005,  respectively                                                                                                  |       |                                                                                               | 4,649      |                                       |       |   | 10,664 |   |   |
| Inventories                                                                                                                                                                                                                                     |       |                                                                                               | 3,669      |                                       |       |   | 3,320 |   |   |
| Deferred tax assets                                                                                                                                                                                                                             |       |                                                                                               | 9,144      |                                       |       |   | 9,090 |   |   |
| Prepaid expenses and other                                                                                                                                                                                                                      |       |                                                                                               | 3,651      |                                       |       |   | 2,713 |   |   |
| Income tax receivable                                                                                                                                                                                                                           |       |                                                                                               | 72         |                                       |       |   | — |   |   |
| Total current assets                                                                                                                                                                                                                            |       |                                                                                               | 135,496    |                                       |       |   | 131,982 |   |   |
| Long-term investments                                                                                                                                                                                                                           |       |                                                                                               | 2,657      |                                       |       |   | — |   |   |
| Property and equipment, net                                                                                                                                                                                                                     |       |                                                                                               | 3,539      |                                       |       |   | 5,722 |   |   |
| Goodwill                                                                                                                                                                                                                                        |       |                                                                                               | —     |                                       |       |   | 3,853 |   |   |
| Intangible assets, net                                                                                                                                                                                                                          |       |                                                                                               | 1,779      |                                       |       |   | 12,369 |   |   |
| Deferred tax assets                                                                                                                                                                                                                             |       |                                                                                               | 500        |                                       |       |   | 1,903 |   |   |
| Other assets                                                                                                                                                                                                                                    |       |                                                                                               | 718        |                                       |       |   | 727 |   |   |
| Total assets                                                                                                                                                                                                                                    |       |                                                                                               | $          | 144,689                                    |       |   |   | $ | 156,556 |   |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                                                       |       |                                                                                               |       |                                       |       |   |   |   |   |
| Current  liabilities:                                                                                                                                                                                                                           |       |                                                                                               |       |                                       |       |   |   |   |   |
| Accounts payable                                                                                                                                                                                                                                |       |                                                                                               | $          | 3,716                                      |       |   |   | $ | 4,609 |   |   |
| Accrued expenses                                                                                                                                                                                                                                |       |                                                                                               | 5,688      |                                       |       |   | 6,138 |   |   |
| Deferred revenue                                                                                                                                                                                                                                |       |                                                                                               | 519        |                                       |       |   | 2,275 |   |   |
| Income tax payable                                                                                                                                                                                                                              |       |                                                                                               | —     |                                       |       |   | 656 |   |   |
| Total current liabilities                                                                                                                                                                                                                       |       |                                                                                               | 9,923      |                                       |       |   | 13,678 |   |   |
| Deferred tax liability                                                                                                                                                                                                                          |       |                                                                                               | —     |                                       |       |   | 4,307 |   |   |
| Commitments and  contingencies (Note 9)                                                                                                                                                                                                         |       |                                                                                               |       |                                       |       |   |   |   |   |
| Stockholders’  equity:                                                                                                                                                                                                                     |       |                                                                                               |       |                                       |       |   |   |   |   |
| Preferred stock—$0.0001 par value, 5,000,000 shares  authorized at December 31, 2004 and March 31, 2005; no shares  outstanding at December 31, 2004 and March 31, 2005                                                |       |                                                                                               | —     |                                       |       |   | — |   |   |
| Common stock—$0.0001 par value, 70,000,000 shares  authorized at December 31, 2004 and March 31, 2005; 17,067,573 and  17,091,980 shares issued and outstanding at December 31, 2004 and  March 31, 2005, respectively |       |                                                                                               | 2          |                                       |       |   | 2 |   |   |
| Additional paid-in capital                                                                                                                                                                                                                      |       |                                                                                               | 121,431    |                                       |       |   | 121,680 |   |   |
| Retained earnings                                                                                                                                                                                                                               |       |                                                                                               | 13,333     |                                       |       |   | 16,889 |   |   |
| Total stockholders’ equity                                                                                                                                                                                                                 |       |                                                                                               | 134,766    |                                       |       |   | 138,571 |   |   |
| Total liabilities  and stockholders’ equity                                                                                                                                                                                                |       |                                                                                               | $          | 144,689                                    |       |   |   | $ | 156,556 |   |   |

 

See accompanying notes to condensed consolidated financial statements.

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**Digital Theater Systems, Inc.**

**Condensed Consolidated Statementsof Operations**
| ** **                                                            | ** ** | **For the Three Months Ended  March 31,**                                 | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|
| ** **                                                            | ** ** | **2004**                                                                                           | ** ** | **2005** | ** ** |
| ** **                                                            | ** ** | **(Amounts in thousands, except  share and per share amounts)** | ** ** |
| ** **                                                            | ** ** | **(Unaudited)**                                                                                    | ** ** |
| Revenues:                                                             |       |                                                                                               |       |   |   |
| Technology and film licensing                                         |       | $                                                                                                  | 12,497     |   | $ | 18,464 |   |
| Product sales and other revenues                                      |       | 3,100                                                                                              |       | 3,593 |   |
| Total revenues                                                        |       | 15,597                                                                                             |       | 22,057 |   |
| Cost of goods sold:                                                   |       |                                                                                               |       |   |   |
| Technology and film licensing                                         |       | 980                                                                                                |       | 1,282 |   |
| Product sales and other revenues                                      |       | 1,912                                                                                              |       | 3,181 |   |
| Total cost of goods sold                                              |       | 2,892                                                                                              |       | 4,463 |   |
| Gross profit                                                          |       | 12,705                                                                                             |       | 17,594 |   |
| Operating expenses:                                                   |       |                                                                                               |       |   |   |
| Selling, general and administrative                                   |       | 6,440                                                                                              |       | 8,044 |   |
| Research and development                                              |       | 1,332                                                                                              |       | 2,094 |   |
| In-process research and development                                   |       | —                                                                                             |       | 2,300 |   |
| Total operating expenses                                              |       | 7,772                                                                                              |       | 12,438 |   |
| Income from operations                                                |       | 4,933                                                                                              |       | 5,156 |   |
| Interest income,  net                                                 |       | 439                                                                                                |       | 354 |   |
| Other expense,  net                                                   |       | (14                                                                                                | )          | (12 | ) |
| Income before provision for income taxes                              |       | 5,358                                                                                              |       | 5,498 |   |
| Provision for  income taxes                                           |       | 1,918                                                                                              |       | 1,942 |   |
| Net income                                                            |       | 3,440                                                                                              |       | 3,556 |   |
| Net income per  common share:                                         |       |                                                                                               |       |   |   |
| Basic                                                                 |       | $                                                                                                  | 0.21       |   | $ | 0.21 |   |
| Diluted                                                               |       | $                                                                                                  | 0.19       |   | $ | 0.19 |   |
| Weighted average  shares used to compute net income per common share: |       |                                                                                               |       |   |   |
| Basic                                                                 |       | 16,578,942                                                                                         |       | 17,080,005 |   |
| Diluted                                                               |       | 18,219,289                                                                                         |       | 18,266,094 |   |

 

See accompanying notes to condensed consolidated financial statements.

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**Digital Theater Systems, Inc.**

**CondensedConsolidated Statements of Cash Flows**
| ** **                                                                          | ** ** | **For the Three Months  Ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                          | ** ** | **2004**                                                           | ** ** | **2005** | ** ** |
| ** **                                                                          | ** ** | **(Unaudited)**                                                    | ** ** |
| ** **                                                                          | ** ** | **(Amounts in thousands)**                               | ** ** |
| Cash flows from  operating activities:                                              |       |                                                               |       |   |   |
| Net income                                                                          |       | $                                                                  | 3,440      |   | $ | 3,556 |   |
| Adjustments to reconcile  net income to net cash provided by operating activities:  |       |                                                               |       |   |   |
| Depreciation and amortization                                                       |       | 279                                                                |       | 809 |   |
| Stock-based compensation charges                                                    |       | 139                                                                |       | 5 |   |
| Allowance for doubtful accounts                                                     |       | 2                                                                  |       | 5 |   |
| Deferred income taxes                                                               |       | (1,130                                                             | )          | (43 | ) |
| Tax benefit from employee stock plans                                               |       | 1,060                                                              |       | 169 |   |
| In-process research and development                                                 |       | —                                                             |       | 2,300 |   |
| Changes in  operating assets and liabilities:                                       |       |                                                               |       |   |   |
| Accounts receivable                                                                 |       | (811                                                               | )          | (5,816 | ) |
| Inventories                                                                         |       | (1,567                                                             | )          | 349 |   |
| Prepaid expenses and other assets                                                   |       | (23                                                                | )          | (233 | ) |
| Accounts payable and accrued expenses                                               |       | 1,647                                                              |       | (966 | ) |
| Deferred revenue                                                                    |       | —                                                             |       | 829 |   |
| Income taxes                                                                        |       | 1,107                                                              |       | 728 |   |
| Net cash provided by operating activities                                           |       | 4,143                                                              |       | 1,692 |   |
| Cash flows from  investing activities:                                              |       |                                                               |       |   |   |
| Sales (purchases) of investments, net                                               |       | (29,485                                                            | )          | 21,394 |   |
| Cash paid for acquisitions                                                          |       | —                                                             |       | (10,954 | ) |
| Purchase of property and equipment                                                  |       | (521                                                               | )          | (1,517 | ) |
| Payment for patents and trademarks in process                                       |       | (16                                                                | )          | (70 | ) |
| Net cash provided by (used in) investing activities                                 |       | (30,022                                                            | )          | 8,853 |   |
| Cash flows from  financing activities:                                              |       |                                                               |       |   |   |
| Follow-on public offering costs                                                     |       | (52                                                                | )          | — |   |
| Proceeds from the issuance of common stock upon  exercise of employee stock options |       | 130                                                                |       | 76 |   |
| Net cash provided by financing activities                                           |       | 78                                                                 |       | 76 |   |
| Net increase (decrease) in cash and cash equivalents                                |       | (25,801                                                            | )          | 10,621 |   |
| Cash and cash  equivalents, beginning of period                                     |       | 39,243                                                             |       | 21,271 |   |
| Cash and cash  equivalents, end of period                                           |       | $                                                                  | 13,442     |   | $ | 31,892 |   |

 

See accompanying notes to condensed consolidated financial statements.

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**DIGITAL THEATER SYSTEMS, INC.NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS(Amounts in thousands, except share and per share data)**

**Note 1—Basisof Presentation**

The accompanying unauditedcondensed consolidated financial statements of Digital Theater Systems, Inc.(the “Company”) have been prepared in accordance with accounting principlesgenerally accepted in the United States and with the instructions to Form 10-Qand Article 10 of Regulation S-X. Accordingly, they do not includeall of the information and footnotes required by accounting principlesgenerally accepted in the United States for complete financial statements. Inthe opinion of management, the unaudited condensed consolidated financialstatements reflect all adjustments considered necessary for fair statements,consisting only of normal and recurring adjustments. All significantintercompany transactions have been eliminated in consolidation. Operatingresults for the three months ended March 31, 2005 are not necessarilyindicative of the results that may be expected for the fiscal year ending December 31,2005. For further information, refer to the consolidated financial statementsand footnotes thereto for the year ended December 31, 2004 filed on Form 10-Kfiled on March 16, 2005.

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities, anddisclosures of contingent assets and liabilities at the date of the financialstatements, and the reported amounts of revenues and expenses during thereporting period. Actual results could differ from those estimates.

**Reclassification**

The Company hasreclassified certain auction rate securities and variable rate demandobligations from cash equivalents to short-term marketable securities. Auctionrate securities are variable rate bonds tied to short-term interest rates withmaturities on the face of the underlying security in excess of 90 days. Auctionrate securities have interest rate resets through a modified Dutch auction atpredetermined short-term intervals, typically every 7, 28 or 35 days.Interest paid during a given period is based upon the interest rate determinedduring the prior auction. Variable rate demand obligations generally provide anoption to tender securities at par on seven days’ notice. The interest rateresets daily, weekly or depending on the mode of the security.

Although these securitiesare issued and rated as long-term bonds, they are priced and traded asshort-term instruments because of the liquidity provided through the interestrate reset. The Company had historically classified these instruments as cashequivalents if the period between interest rate resets was 90 days or less,which was based on our ability to either liquidate our holdings or roll ourinvestment over to the next reset period. The Company’s re-evaluation of thematurity dates and other provisions associated with the underlying bondsresulted in a reclassification from cash and equivalents to short-termmarketable securities of approximately $56,523 on the March 31, 2004balance sheet. As a result of this balance sheet reclassification, certainamounts were reclassified in the accompanying consolidated statement of cashflows for the three months ended March 31, 2004 to reflect the grosspurchases and sales of these securities as investing activities rather than asa component of cash and cash equivalents. This change in classification doesnot affect previously reported cash flows from operating or from financingactivities in the previously reported consolidated statements of cash flows orthe previously reported consolidated statements of operations. As of March 31,2004, before these revisions in classification, $56,523 of these currentinvestments were classified as cash and cash equivalents on the consolidatedbalance sheet. For the three months ended March 31, 2004, before theserevisions in classification, net cash used in investing activities 

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relatedto these current investments of $56,523 were included in cash and cashequivalents in the consolidated statement of cash flows.

**Note 2—Summaryof Significant Accounting** Policies

***RevenueRecognition***

In January 2005, the Company acquired Lowry DigitalImages, Inc. (“LDI”). The Company recognizes revenue when all titles subject toa customer order or contract are delivered and accepted by the customer and nosignificant obligations remain after customer acceptance. The Company typicallybills in advance of services. Prices are established in advance of the workperformed and are generally fixed in nature. If losses are anticipated on acontract, such losses are recognized immediately.

***Acquired In-Process Research and Development***

The value assigned to acquired in-process research anddevelopment (“IPR&D”) is determined by identifying acquired specificin-process research and development projects that would be continued and forwhich (1) technological feasibility has not been established at the acquisitiondate, (2) there is no alternative future use, and (3) the fair value isestimable with reasonable reliability, upon consummation of a business combination.

***Stock-Based Compensation***

The Company accounts forits employee stock option and stock purchase plans in accordance with theprovisions of Accounting Principals Board (“APB”) Opinion No. 25, “Accountingfor Stock Issued to Employees” and the related FASB Interpretation No. 44,“Accounting for Certain Transactions Involving Stock Compensation.”Accordingly, compensation expense related to employee stock options is recordedif, on the date of the grant, the fair value of the underlying stock exceedsthe exercise price.

Todate, options have been granted at exercise prices that equal or exceed themarket value of the underlying common stock on the grant date. The followingtable illustrates the effect on net income per common share if the Company hadapplied the fair value recognition provisions of SFAS No. 123, “Accountingfor Stock-Based Compensation,” to stock-based employee compensation.
| ** **                                                                                                           | ** ** | **For the Three Months  Ended March 31,**   | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                                                                           | ** ** | **     2004     ** | ** ** | **     2005     ** | ** ** |
| ** **                                                                                                           | ** ** | **(Unaudited)**                                                      | ** ** |
| Net income:                                                                                                          |       |                                                                 |       |   |   |   |   |   |   |
| As reported                                                                                                          |       |                                                                 | $          | 3,440 |   |   |   | $3,556 |   |   |
| Additional stock-based  compensation expense determined under the fair value method, net of tax                      |       |                                                                 | (449       | ) |   |   | (489 | ) |   |
| Pro forma                                                                                                            |       |                                                                 | $          | 2,991 |   |   |   | $ | 3,067 |   |   |
| Net income per common  share basic:                                                                                  |       |                                                                 |       |   |   |   |   |   |   |
| As reported                                                                                                          |       |                                                                 | $          | 0.21 |   |   |   | $ | 0.21 |   |   |
| Per share effect of  additional stock-based compensation expense determined under the fair value  method, net of tax |       |                                                                 | (0.03      | ) |   |   | (0.03 | ) |   |
| Pro forma                                                                                                            |       |                                                                 | $          | 0.18 |   |   |   | $ | 0.18 |   |   |
| Net income per common  share—diluted:                                                                           |       |                                                                 |       |   |   |   |   |   |   |
| As reported                                                                                                          |       |                                                                 | $          | 0.19 |   |   |   | $ | 0.19 |   |   |
| Per share effect of  additional stock-based compensation expense determined under the fair value  method, net of tax |       |                                                                 | (0.03      | ) |   |   | (0.03 | ) |   |
| Pro forma                                                                                                            |       |                                                                 | $          | 0.16 |   |   |   | $ | 0.16 |   |   |

 

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The Company accounts forstock, stock options and warrants issued to non-employees in accordance withthe provisions of SFAS No. 123 and EITF Issue No. 96-18 “Accountingfor Equity Instruments That Are Issued to Other Than Employees for Acquiring,or in Conjunction with Selling, Goods and Services.” Under SFAS No. 123and EITF Issue No. 96-18, stock option awards issued to non-employees areaccounted for at fair value using the Black-Scholes pricing model. Managementbelieves that the fair value of the stock options is more reliably measuredthan the fair value of the services received. The fair value of eachnon-employee equity award is remeasured each period until a commitment date isreached, which is generally the vesting date. For non-employee equity awards,deferred stock-based compensation is not reflected in stockholders’ deficituntil a commitment date is reached. For the three months ended March 31,2004 and 2005, the Company recorded stock-based compensation expense of $139and $5, respectively, related to non-employee equity awards.

**Note 3—RecentAccounting Pronouncements**

In November 2004, theFASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43,Chapter 4” (“SFAS 151”). SFAS 151 clarifies the types of costs that should beexpensed rather than capitalized as inventory. SFAS 151 also clarifies thecircumstances under which fixed overhead costs associated with operatingfacilities involved in inventory processing should be capitalized. Thisstatement is effective for fiscal years beginning after June 15, 2005. TheCompany adopted SFAS 151 in the first quarter of fiscal 2005 and the adoptiondid not have a material impact on the Company’s consolidated financial positionor results of operations.

In December 2004, the FASB issued SFAS No. 123R,“Share-Based Payment” (“SFAS 123R”), an amendment to SFAS No. 123, “Accountingfor Stock-Based Compensation.” SFAS 123R requires compensation expenserelated to stock-based awards to be recognized in the financial statements. Theamount of compensation expense will be measured based upon the fair value ofthe stock-based awards at the date of grant. This statement is effective forpublic companies as of the first interim or annual reporting period beginningafter June 15, 2005. In April 2005, the SEC amended the compliancedate for implementing SFAS 123R extending the compliance date to the firstfiscal year that begins after June 15, 2005. The Company plans to adoptSFAS 123R beginning in the first quarter of fiscal 2006. The expected effectsof the adoption of SFAS 123R on the Company’s financial results for the nextfive years, based on stock-based awards granted as of March 31, 2004, areas follows:
| ** **                                                                           | ** ** | **Expenses by Fiscal Year** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                           | ** ** | **Remaining  Nine  Months**                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                           | ** ** | **2005**                                   | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** |
| ** **                                                                           | ** ** | **(unaudited)**                            | ** ** |
| ** **                                                                           | ** ** | **(in thousands)**                    | ** ** |
| Additional  stock-based compensation expense under SFAS 123R before tax benefit |       |                                       | $          | 2,100 |   |   | $ | 1,513 |   | $ | 691 |   | $ | 169 |   | $ | — |   |
|                                                                                      |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

SFAS 123R also affects thepresentation of tax benefits for option exercises in the statement of cashflows. Prior to adoption SFAS 123R, the benefit is classified in cash providedby operating activities. Upon adoption, the tax benefit will be classified incash provided by financing activities. The Company is in the process ofdetermining the impact the adoption will have on the Company’s consolidatedstatement of cash flows.

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**Note 4—CertainBalance Sheet Items**

Inventories consist of thefollowing:
| ** **        | ** ** | **As of  December 31,  2004** | ** ** | **As of  March 31,  2005** | ** ** |
|-------------------|------------|-----------------------------------------|------------|--------------------------------------|------------|
| ** **        | ** ** | ** **                              | ** ** | **(Unaudited)**                      | ** ** |
| Raw materials     |       |                                    | $          | 1,313                                |       |   |   | $ | 1,268 |   |   |
| Work in process   |       |                                    | —     |                                 |       |   | 49 |   |   |
| Finished goods    |       |                                    | 2,356      |                                 |       |   | 2,003 |   |   |
| Total inventories |       |                                    | $          | 3,669                                |       |   |   | $ | 3,320 |   |   |

 

Propertyand equipment consist of the following:
| ** **                     | ** ** | **As of   December 31,   2004** | ** ** | **As of  March 31,  2005** | ** ** |
|--------------------------------|------------|-----------------------------------------------------|------------|--------------------------------------|------------|
| ** **                     | ** ** | ** **                                          | ** ** | **(Unaudited)**                      | ** ** |
| Machinery and  equipment       |       |                                                | $          | 3,036                                |       |   |   | $ | 3,134 |   |   |
| Office furniture  and fixtures |       |                                                | 2,693      |                                 |       |   | 4,838 |   |   |
| Leasehold  improvements        |       |                                                | 2,926      |                                 |       |   | 3,272 |   |   |
|                           |       |                                                | 8,655      |                                 |       |   | 11,244 |   |   |
| Less: Accumulated depreciation |       |                                                | (5,116     | )                                    |       |   | (5,522 | ) |   |
| Property and  equipment, net   |       |                                                | $          | 3,539                                |       |   |   | $ | 5,722 |   |   |

 

**Note 5—BusinessCombinations**

In January 2005, theCompany completed the acquisition of LDI for $9,600 in cash. In late 2004, theCompany loaned LDI a total of $1,250 to enable LDI to satisfy certainliabilities. Neither LDI nor its stockholders were required to repay this loanprior to, or in connection with, the acquisition. The cash portion of theacquisition was funded by working capital. Subsequent to the acquisition, wechanged the name of the business to DTS Digital Images, Inc. (“DDI”).

The Merger Agreement also requires the Company toinvest approximately $3,500 in the business of LDI on or prior to June 30,2005 to enable LDI to make certain capital expenditures and, if and to theextent LDI meets specified gross profit milestones, to invest up to anadditional $1,500 through the end of 2006.

Theestimated total purchase price for the acquisition of all of the outstandingshares of LDI is as follows:
| Cash                                |   | $     | 9,642  |   |
|-------------------------------------|--------|-------|--------|--------|
| Bridge loan,  including interest    |   | 1,261 |   |
| Estimated direct  acquisition costs |   | 1,346 |   |
| Total estimated  purchase price     |   | $     | 12,249 |   |

 

9

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The LDI acquisition wasaccounted for under SFAS 141 “Business Combinations” and certain specifiedprovisions of SFAS 142 “Goodwill and Other Intangible Assets.” The results ofoperations of LDI are included in our Consolidated Statement of Operations fromJanuary 3, 2005. The final purchase price is dependent on the actualdirect acquisition costs and shares issued, if any, as further discussed below.Under the purchase method of accounting, the total estimated purchase price isallocated to LDI’s net tangible and intangible assets based on their estimatedfair value as of the date of completion of the acquisition. Based on theestimated purchase price and the preliminary valuation, the preliminarypurchase price allocation, which is subject to change based on the Company’sfinal analysis, is as follows:
| Accounts receivable                                                          |   | $      | 202    |   |
|------------------------------------------------------------------------------|--------|--------|--------|--------|
| Tangible assets                                                              |   | 1,094  |   |
| Other assets                                                                 |   | 90     |   |
| Deferred tax  assets                                                         |   | 1,441  |   |
| Amortizable intangible  assets:                                              |   |   |   |
| Existing technology                                                          |   | 10,200 |   |
| Non-compete                                                                  |   | 400    |   |
| Backlog                                                                      |   | 100    |   |
| Tradename                                                                    |   | 200    |   |
| In-process  research and development                                         |   | 2,300  |   |
| Goodwill                                                                     |   | 3,853  |   |
| Total assets acquired                                                        |   | 19,880 |   |
| Liabilities  assumed:                                                        |   |   |   |
| Accounts payable                                                             |   | (942   | )      |
| Accrued  liabilities                                                         |   | (952   | )      |
| Notes payable                                                                |   | (368   | )      |
| Deferred revenues                                                            |   | (928   | )      |
| Total liabilities  assumed                                                   |   | (3,190 | )      |
| Net deferred tax liability for acquired intangibles  and purchase accounting |   | (4,441 | )      |
| Total purchase  price                                                        |   | $      | 12,249 |   |

 

A preliminary estimate of$10.9 million has been allocated to amortizable intangible assets consisting ofexisting technology, non-compete, backlog, and tradenames with useful lives ofbetween one and eleven years.

A preliminary estimate of$3.9 million has been allocated to goodwill. Goodwill represents the excess ofthe purchase price over the fair market value of the net tangible andamortizable intangible assets acquired. Goodwill will not be amortized and willbe tested for impairment at least annually. The preliminary purchase priceallocation for LDI is subject to revision as more detailed analysis iscompleted and additional information on the fair values of LDI’s assets andliabilities become available.

Any change in the fairvalue of the net assets of LDI will change the amount of the purchase priceallocable to goodwill.

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In-processresearch and development, relating to development projects which had notreached technological feasibility and that were of no future alternative use,was expensed upon consummation of the acquisition. Other identifiableintangible assets are being amortized with the following useful lives:
| ** **           | ** ** | **Estimated Useful  Life (Years)** | ** ** |
|----------------------|------------|----------------------------------------------|------------|
| Existing  technology |       |                                         | 11         |   |   |
| Non-compete          |       |                                         | 3          |   |   |
| Backlog              |       |                                         | 2          |   |   |
| Tradename            |       |                                         | 1          |   |   |

 

Developed technology andin-process research and development were identified and valued throughextensive interviews, analysis of data provided by LDI concerning developmentprojects, their stage of development, the time and resources needed to completethem, if applicable, and their expected income generating ability andassociated risks. Where development projects had reached technologicalfeasibility, they were classified as developed technology and the valueassigned to developed technology was capitalized. The income approach, which includesan analysis of the cash flows and risks associated with achieving such cashflows, was the primary technique utilized in valuing acquired in-processresearch and development. Key assumptions for in-process research anddevelopment included a discount rate of 30% and estimates of revenue growth,cost of sales, operating expenses and taxes.

The former shareholders ofLDI are entitled to receive shares of DTS common stock if certain gross profittargets in 2005 and/or 2006 are met. In the event that the targets are met infull, an aggregate of up to 857,213 shares of DTS common stock will be issued.The value of these shares will be accounted for as an addition to goodwill.

Theresults of operations of LDI are included in our Consolidated Statements of Operationsfrom January 3, 2005, the date of acquisition. For the purposes ofpresenting the unaudited pro forma financial information, the Company used the incomestatements of LDI for the three-months ended March 31, 2004. If theCompany had acquired LDI at the beginning of fiscal year 2004, the Company’sunaudited pro forma net revenues, net income and net income per share for thethree months ended March 31, 2004 would have been as follows:
| ** **                         | ** ** | **Three Months**        | ** ** |
|------------------------------------|------------|------------------------------|------------|
| ** **                         | ** ** | **Ended**                    | ** ** |
| ** **                         | ** ** | **March 31, 2004** | ** ** |
| Revenue                            |       |                         | $          | 16,214 |   |   |
| Net income                         |       |                         | $          | 2,937 |   |   |
| Net income per share—Basic    |       |                         | $          | 0.17 |   |   |
| Net income per  share—Diluted |       |                         | $          | 0.16 |   |   |

 

**Note 6—Goodwilland Intangibles**

In accordance with SFAS 142, our goodwill is notamortized, but is tested for impairment at least annually, or sooner, ifcircumstances indicate its value may no longer be recoverable. SFAS 142prescribes a two-step process for impairment testing of goodwill. For the firststep, we screen for impairment and, if any impairment exists, we undertake asecond step of measuring such impairment. We plan to perform our goodwillimpairment test annually in our fourth fiscal quarter. SFAS 142 requiresimpairment testing based on reporting units. In the period ended March 31,2005, we added $3,853 to goodwill in connection with our acquisition of LDI. TheCompany did not have goodwill prior to the acquisition of LDI.

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Included in cost of salesis $244 of amortization relating to existing technologies and backlog for thethree months ended March 31, 2005. Included in operating expenses is $129of amortization relating to non-compete and tradename. The following tablesummarizes the weighted average lives and the carrying values of our acquiredintangible assets by category:
| ** **           | ** ** | ** **                               | ** **    | **As of March 31, 2005** | ** ** | **As of December 31, 2004** | ** ** |
|----------------------|------------|------------------------------------------|---------------|----------------------------------------------|------------|-------------------------------------------------|------------|
| ** **           | ** ** | **Weighted  Average Life  (Years)** | ** **    | **Gross Amount**                        | ** ** | **Accumulated  Amortization**                   | ** ** | **Net Carrying  Amount** | ** ** | **Gross Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Amount** | ** ** |
| Existing  technology |       |                                     | 10.6          |                                         |       |                                            | $          | 11,627 |   |   |   | $ | (366 | ) |   |   | $ | 11,261 |   |   |   | $ | 1,427 |   |   |   | $ | (89 | ) |   |   | $ | 1,338 |   |   |
| Non-compete          |       |                                     |   3 |                                         |       |                                            | 400        |   |   |   | (33 | ) |   |   | 367 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Backlog              |       |                                     |   2 |                                         |       |                                            | 100        |   |   |   | (13 | ) |   |   | 87 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Tradename            |       |                                     |   1 |                                         |       |                                            | 200        |   |   |   | (50 | ) |   |   | 150 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Total                |       |                                     |          |                                         |       |                                            | $          | 12,327 |   |   |   | $ | (462 | ) |   |   | $ | 11,865 |   |   |   | $ | 1,427 |   |   |   | $ | (89 | ) |   |   | $ | 1,338 |   |   |

 

As of March 31, 2005,we expect the amortization of acquired intangible assets for future periods tobe as follows:
| ** **                                           | ** ** | **Estimated  Amortization  Expense** | ** ** |
|------------------------------------------------------|------------|--------------------------------------|------------|
| Remainder of the year  ending December 31, 2005 |       |                                 | $          | 1,117 |   |   |
| 2006                                                 |       |                                 | 1,289      |   |   |
| 2007                                                 |       |                                 | 1,239      |   |   |
| 2008                                                 |       |                                 | 1,106      |   |   |
| 2009                                                 |       |                                 | 1,106      |   |   |
| Thereafter                                           |       |                                 | 6,008      |   |   |
| Total                                                |       |                                 | $          | 11,865 |   |   |

 

**Note 7—BankLine of Credit**

The Company replaced its prior working capital creditfacility with a new $10,000 facility that expires on June 30, 2005. Thisfacility automatically renews for a one year term. The bank agreement providesfor working capital financing and is unsecured. The bank agreement requires theCompany to comply with certain covenants including a tangible effective networth of $60,000, increasing by 50% of net income on an annual basis. Thecovenants also require the Company to keep $2,000 in cash or securities at thebank.

At March 31, 2005,there were no balances outstanding under this agreement and there was $10,000of available borrowings under this credit facility. Future borrowings will bearinterest based on either of the two options the Company selects at the time ofadvances 1) a rate equal to 2% above the Bank’s LIBOR, or 2) a rateequal to the Base Rate as quoted from the bank less one-half percent. Acommitment fee of $10 was paid for this line of credit.

**Note 8—IncomeTaxes**

Forthe three months ended March 31, 2005, the Company recorded an income taxprovision of $1,942 on pre-tax income of $5,498 resulting in an annualizedeffective tax rate of 35.3%. For the three months ended March 31, 2004,the Company recorded an income tax provision of $1,918 on pre-tax income of$5,358, resulting in an annualized effective tax rate of 35.8%. These ratesdiffered from the statutory rates primarily due to state income taxes offset bybenefits associated with the foreign rate differentials and research anddevelopment credits.

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**Note 9—Commitmentsand Contingencies**

**Indemnities,Commitments and Guarantees**

In the normal course of business, the Company makescertain indemnities, commitments and guarantees under which the Company may berequired to make payments in relation to certain transactions. Theseindemnities, commitments and guarantees include, among others, intellectualproperty indemnities to customers in connection with the sale of products andlicensing of technology, indemnities for liabilities associated with the infringementof other parties’ technology based upon the Company’s products and technology,guarantees of timely performance of the Company’s obligations, and indemnitiesto the Company’ directors and officers to the maximum extent permitted by law.The duration of these indemnities, commitments and guarantees varies, and incertain cases, is indefinite. The majority of these indemnities, commitmentsand guarantees do not provide for any limitation of the maximum potentialfuture payments that the Company could be obligated to make. The Company hasnot recorded a liability for these indemnities, commitments or guarantees inthe accompanying balance sheets, as future payment is not probable.

In March 2005, in connection with the U.S.Internal Revenue Service’s (“IRS”) regular examination of the Company’s taxreturn for the year ended December 31, 2002, the IRS proposed adjustmentsrelated to certain items included in the Company’s return. In March 2005,the Company settled with the IRS and agreed to pay approximately $704,000. Thisamount was paid in April 2005 and did not have a material impact on ourresults of operations for the three months ended March 31, 2005.

In connection with theCompany’s enforcement activities relating to its intellectual property rightsand to stop unauthorized use of its technology and trademarks, the Companyterminated its license agreement with Sunplus Technology Co., Ltd. (“Sunplus”).In response, Sunplus filed suit against the Company alleging breach of contractarising from the Company’s termination of their license agreement. The Companyhas prevailed on several preliminary motions by Sunplus seeking to enjoin theCompany from terminating the license agreement. The Company has filed across-complaint seeking a judicial declaration that the Company properlyterminated the license agreement and to recover damages arising from Sunplus’breach of the agreement. The Company believes Sunplus’ claim is without meritand intends to vigorously defend the case.

**Note 10—OperatingSegment and Geographic Information**

The Company operates its business in three reportablesegments: the Cinema business segment, previously referred to as the Theatricalbusiness, the Consumer business segment and the Digital Images businesssegment. The Cinema business segment provides digital playback systems andcinema processor equipment to movie theaters, and provides film licensingservices to film production and distribution companies. The Company’s Consumerbusiness segment licenses audio technology, trademarks and know-how to consumerelectronics, personal computer, broadcast and professional audio companies, andsells multi-channel audio content and products to consumers. The Company’sDigital Images business provides processing, enhancement and restorationservices for cinema, home video and broadcast television content.

The Company does not separately identify and managecapital expenditures or long-lived assets related to these three businesssegments.

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TheCompany’s reportable segments and geographical information for the three monthsended March 31, 2004 and 2005 are as follows:
| ** **               | ** ** | **Revenues**                                                       | ** ** |
|--------------------------|------------|--------------------------------------------------------------------|------------|
| ** **               | ** ** | **For the Three Months  Ended March 31,** | ** ** |
| ** **               | ** ** | **2004**                                                           | ** ** | **2005** | ** ** |
| ** **               | ** ** | **(Unaudited)**                                                    | ** ** |
| Cinema business          |       | $                                                                  | 4,800      |   | $ | 4,796 |   |
| Consumer business        |       | 10,797                                                             |       | 16,541 |   |
| Digital Images  business |       | —                                                             |       | 720 |   |
| Total revenues           |       | $                                                                  | 15,597     |   | $ | 22,057 |   |

                                                                                                
| ** **               | ** ** | **Gross Profit**                                              | ** ** |
|--------------------------|------------|--------------------------------------------------------------------|------------|
| ** **               | ** ** | **For the Three Months  Ended March 31,** | ** ** |
| ** **               | ** ** | **2004**                                                           | ** ** | **2005** | ** ** |
| ** **               | ** ** | **(Unaudited)**                                                    | ** ** |
| Cinema business          |       | $                                                                  | 2,462      |   | $ | 2,173 |   |
| Consumer business        |       | 10,243                                                             |       | 16,001 |   |
| Digital Images  business |       | —                                                             |       | (580 | ) |
| Total gross  profit      |       | $                                                                  | 12,705     |   | $ | 17,594 |   |

 
| ** **                    | ** ** | **Income (Loss) From  Operations**                       | ** ** |
|-------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                    | ** ** | **For the Three Months  Ended March 31,** | ** ** |
| ** **                    | ** ** | **  2004  **                                   | ** ** | **  2005  ** | ** ** |
| ** **                    | ** ** | **(Unaudited)**                                                    | ** ** |
| Cinema business               |       | $                                                                  | (1,077     | ) | $ | (1,019 | ) |
| Consumer business             |       | 6,010                                                              |       | 10,113 |   |
| Digital Images  business      |       | —                                                             |       | (3,938 | ) |
| Total income from  operations |       | $                                                                  | 4,933      |   | $ | 5,156 |   |

 

Includedin the Digital Images business segment’s loss for the three months ended March 31,2005 is the $2,300 charge related to in-process research and development.
| ** **     | ** ** | **Revenues by Geographic  Region**                                     | ** ** |
|----------------|------------|----------------------------------------------------------------------------------|------------|
| ** **     | ** ** | **For the Three Months  Ended March 31,**               | ** ** |
| ** **     | ** ** | **      2004      ** | ** ** | **      2005      ** | ** ** |
| ** **     | ** ** | **(Unaudited)**                                                                  | ** ** |
| United States  |       |                                                                             | $          | 4,189 |   |   |   | $ | 9,379 |   |   |
| International  |       |                                                                             | 11,408     |   |   |   | 12,678 |   |   |
| Total revenues |       |                                                                             | $          | 15,597 |   |   |   | $ | 22,057 |   |   |

 

The majority of international revenues are generatedfrom Japan and are primarily denominated in United States dollars.

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Thefollowing table sets forth, for the periods indicated, long-lived tangible assetsby geographic area in which the Company holds assets at December 31, 2004and March 31, 2005:
| ** **               | ** ** | **Long-Lived Assets**              | ** ** |
|--------------------------|------------|-----------------------------------------|------------|
| ** **               | ** ** | **As of  December 31,  2004** | ** ** | **As of  March 31,  2005** | ** ** |
| ** **               | ** ** | ** **                              | ** ** | **(Unaudited)** | ** ** |
| United States            |       |                                    | $          | 2,657 |   |   |   | $ | 4,640 |   |   |
| International            |       |                                    | 882        |   |   |   | 1,082 |   |   |
| Total long-lived  assets |       |                                    | $          | 3,539 |   |   |   | $ | 5,722 |   |   |

 

**Note11—Net Income Attributable to Common Stockholders Per Common Share**

Thefollowing table sets forth the computation of basic and diluted net incomeattributable to common stockholders per common share:
| ** **                                 | ** ** | **For the Three Months  Ended March 31,** | ** ** |
|--------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                 | ** ** | **  2004  **                                   | ** ** | **  2005  ** | ** ** |
| ** **                                 | ** ** | **(Unaudited)**                                                    | ** ** |
| Basic net income  per common share:        |       |                                                               |       |   |   |
| Numerator:                                 |       |                                                               |       |   |   |
| Net income                                 |       | $                                                                  | 3,440      |   | $ | 3,556 |   |
| Denominator:                               |       |                                                               |       |   |   |
| Weighted average common shares outstanding |       | 16,578,942                                                         |       | 17,080,005 |   |
| Basic net income per common share          |       | $                                                                  | 0.21       |   | $ | 0.21 |   |
| Diluted net income per common share:       |       |                                                               |       |   |   |
| Numerator:                                 |       |                                                               |       |   |   |
| Net income                                 |       | $                                                                  | 3,440      |   | $ | 3,556 |   |
| Denominator:                               |       |                                                               |       |   |   |
| Weighted average shares outstanding        |       | 16,578,942                                                         |       | 17,080,005 |   |
| Effect of dilutive securities:             |       |                                                               |       |   |   |
| Common stock options                       |       | 1,318,156                                                          |       | 946,957 |   |
| Common stock warrants                      |       | 322,191                                                            |       | 239,132 |   |
| Diluted shares outstanding                 |       | 18,219,289                                                         |       | 18,266,094 |   |
| Diluted net  income per common share       |       | $                                                                  | 0.19       |   | $ | 0.19 |   |

 

Weighted average common shares outstanding, assumingdilution, include the incremental shares that would be issued upon the assumedexercise of stock options. For the three months ended March 31, 2004 and2005, 37,250 and 738,268 shares, with a weighted average exercise prices of$26.91 and $22.39 of the Company’s stock options were excluded from thecalculation of diluted earnings per share because the exercise prices of thestock options were greater than or equal to the average price of the commonshares, and therefore their inclusion would have been anti-dilutive. Theseoptions could be dilutive in the future if the average share price increasesand is equal to or greater than the exercise price of these options.

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**Item 2.        Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

**Forward-LookingStatements May Prove Inaccurate**

This Form 10-Q andthe documents incorporated herein by reference contain forward-lookingstatements based on our current beliefs, expectations, estimates andprojections about our industry, and certain assumptions made by us. Words suchas “believes,” “anticipates,” “estimates,” “expects,” “projections,” “may,” “potential,”“plan,” “continue” and words of similar import, constitute “forward-lookingstatements.” The forward-looking statements contained in this report involveknown and unknown risks, uncertainties and other factors that may cause ouractual results to be materially different from those expressed or implied bythese statements. These factors include those listed under the “Risk Factors”section contained below and elsewhere in this Form 10-Q, and the otherdocuments we file with the Securities and Exchange Commission, or SEC,including our most recent reports on Form 8-K and Form 10-K. Wecannot guarantee future results, levels of activity, performance, orachievements. We do not undertake any obligation to revise theseforward-looking statements to reflect future events or circumstances.

You should read thefollowing discussion of our financial condition and results of operations inconjunction with the consolidated financial statements and the notes to thosestatements included elsewhere in this Form 10-Q. This discussion maycontain forward-looking statements that involve risks and uncertainties. Ouractual results may differ materially from those anticipated in theseforward-looking statements as a result of certain factors, such as those setforth under “Risk Factors” and elsewhere in this Form 10-Q.

**Overview**

We are a leading providerof entertainment technology, products and services to the audio and imageentertainment markets worldwide. Historically we have been focused on highquality digital multi-channel audio, commonly referred to as surround sound,which provides more than two-channels of audio, allowing the listener tosimultaneously hear discrete sounds from multiple speakers. Our DTS digitalmulti-channel audio technology delivers compelling surround sound for themotion picture and consumer electronics markets. With our January 2005acquisition of Lowry Digital Images, Inc., now DTS Digital Images, Inc.or DDI, we have expanded our business into high quality digital imageprocessing, enhancement and restoration for the cinema, home video, andbroadcast television markets.

We manage our businessthrough three reportable segments—our consumer business, our cinema business,which we previously described as our theatrical business and our digital imagesbusiness. Prior to 2001, we derived a majority of our revenues from the cinemabusiness. Beginning in 2001, however, we have derived a majority of ourrevenues from our consumer business.

In our consumer business,we derive revenues from licensing our audio technology, trademarks, and know-howunder agreements with substantially all major consumer audio electronicsmanufacturers. Our business model provides for these manufacturers to pay us aper-unit amount for DTS-enabled products that they manufacture. We also deriverevenues from licensing our technology to consumer semiconductor manufacturers.Through our DTS Entertainment label, we derive revenues from the sale ofmulti-channel music titles in our digital multi-channel format.

In our cinema business, wederive revenues from sales of our playback equipment and cinema processors tomovie theaters and special venues. In addition, we license technology and sellencoding and duplication services to film producers and distributors for thecreation of digital multi-channel motion picture soundtracks. We also deriverevenues from the sale of systems and encoding services for pre-showadvertising, alternative content, subtitling, captioning, and descriptivenarration.

In our recently acquireddigital images business, we derive revenues from the  processing, enhancement and restoration ofcinema, home video and broadcast television content. We provide these 

16

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servicesto motion picture and television studios and other content owners. We offer ourservices on either a fixed fee or time and materials basis.

We present revenues in ourconsolidated financial statements and in this “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” as derived from (1) technologyand film licensing and (2) product sales and other revenues. Ourtechnology and film licensing revenues are derived from each of our consumerand cinema business segments. Revenues from technology licensing in connectionwith our consumer business segment include revenues derived from licensing ouraudio technology, trademarks, and know-how to consumer electronics, personalcomputer, video game and console, digital satellite and cable broadcast, andprofessional audio companies as well as to semiconductor manufacturers.Revenues from technology and film licensing in connection with our cinemabusiness segment include revenues derived from film licensing and services thatwe provide to film studios for the production of soundtracks in our digitalmulti-channel format. Our product sales and other revenues are derived from ourconsumer, cinema and digital images business segments. Revenues from productsales and other revenues in connection with our consumer business segmentinclude revenues derived from sales of music titles that we produce in ourdigital multi-channel format and sales of our professional audio products andservices. Revenues from product sales and other revenues in connection with ourcinema business segment include revenues derived from sales of our digitalplayback systems, cinema processor equipment, and systems for subtitling,captioning, and descriptive narration to movie theaters and special venues. Revenuesfrom product sales and other revenues in connection with our digital imagesbusiness segment include fees for processing, enhancing and restoring cinema,home video and broadcast television content.

We actively engage inintellectual property compliance and enforcement activities focused onidentifying third parties who have either incorporated our technology,trademarks, or know-how without a license or who have under-reported to us theamount of royalties owed under license agreements with us. We continue toinvest in our compliance and enforcement infrastructure to support the value ofour intellectual property to us and our licensees and to improve the long-termrealization of our intellectual property. As a result of these activities, fromtime to time, we recognize royalty revenues that relate to consumer electronicsmanufacturing activities from prior periods. These royalty recoveries may causerevenues to be higher than expected during a particular reporting period andmay not occur in subsequent periods. While we consider such revenues to be aregular part our normal operations, we cannot predict the amount or timing ofsuch revenues.

Our cost of goods soldconsists primarily of amounts paid for products and materials, salaries andrelated benefits for production personnel, depreciation of productionequipment, and payments to third parties for licensing technology andcopyrighted material.

Our selling, general, andadministrative expenses consist primarily of salaries, commissions, and relatedbenefits for personnel engaged in sales, corporate administration, finance,human resources, information systems, legal, and operations, and costsassociated with promotional and other selling activities. Selling, general, andadministrative expenses also include professional fees, facility-relatedexpenses, and other general corporate expenses.

Our research anddevelopment costs consist primarily of salaries and related benefits forresearch and development personnel, engineering consulting expenses associatedwith new product and technology development, and quality assurance and testingcosts. Research and development costs are expensed as incurred.

In our consumer business,we have a licensing team that markets our technology directly to large consumerelectronics products manufacturers and semiconductor manufacturers. This teamincludes employees located in the United States, China, England, Japan, andNorthern Ireland. We sell music content released under our DTS Entertainmentlabel through distributors. In the United States and 

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Canada,Navarre Corporation is our exclusive distributor of DTS Entertainment labelproducts to major national retail accounts and in Europe, Cadiz Music Limitedis our exclusive distributor of DTS Entertainment label products. Disc Unionserves as our exclusive distributor in Japan. We also employ consultants tocoordinate sales to independent retailers. We are in the process ofestablishing distribution channels in other international territories. Weintend to engage one or more additional distributors with an establishedpresence in Asia to handle distribution in other Asian territories. We alsosell this music directly to consumers through an online store and otherweb-based retailers. We intend to expand the number of retail outlets thatcarry our products and broaden our distribution network worldwide.

In our cinema business,our post-production department, senior management, and liaison offices marketour products and services directly to individual film producers anddistributors worldwide. We sell our digital multi-channel playback systems tomovie theaters through a direct sales force and a network of independent dealers.To date, most of our sales and marketing efforts have been focused in theUnited States and Canada, Western Europe, and in targeted markets in Asia andLatin America. We have also begun to focus our efforts on pursuing theatercompanies that have a large concentration of movie theaters in selected foreigncountries such as India and China, and in Eastern Europe.

In our digital imagesbusiness, our senior management team markets our services directly todirectors, producers and content owners. The sales process typically involvesan evaluation of the cinema, home video or broadcast television content to beenhanced or restored and a determination of the scope of services required toachieve the desired result.  This enablescurrent or archived content to be enhanced or restored for high quality, highdefinition presentation in digital cinema, high definition optical media orbroadcast applications.

**ManagementDiscussion Regarding Trends, Opportunities, and Challenges**

**ConsumerSegment**

Revenue from our consumersegment constitutes the majority of our total revenue, representing 75% and 69%of total revenues for the quarters ended March 31, 2005 and 2004,respectively. Our consumer revenue is primarily dependent upon the home theaterand DVD player markets, which have experienced rapid growth over the pastseveral years, however, we have begun to experience softness in our DVD playertrademark licensing program, which may cause growth rates in this area todecline from recent levels. The success of DVD-Video-based systems and productshas fueled a demand for ever-higher quality entertainment in the home, and thisdemand is extending to the car and PC markets as well. We expect the recentacceleration of the market for high definition televisions to drive demand forhigh definition optical disc players beginning in 2006. Because we expect to bea mandatory technology for the next generation players, our consumer revenuegrowth should more closely track the growth rate of these players over the nextseveral years. We expect that the market for high definition players will yieldnew growth that provides an offset to the expected decline in the overallgrowth in DVD player shipments. Further, we believe that expected mandatoryinclusion in next generation optical disc standards will help to improve theadoption rate of our technologies in other consumer products such as nextgeneration video game consoles, personal audio and video players, personalcomputers and in-car entertainment systems. Failure to attain mandatory statusin next generation high definition optical disc standards could cause revenuegrowth in our consumer business to be significantly lower than expected andcould have a material adverse effect on our business.

In July 2004, weacquired QDesign Corporation, or QDesign, a company focused on lower-bit rateaudio delivery technology. The market for higher quality entertainment isexpanding into portable devices that require the use of low-bit rate audiocoding systems including portable audio players, PDAs and wireless handsetapplications. Concurrent with this trend, there is a growing need for a goodlink between home and portable devices that preserves as much quality aspossible and allows consumers a seamless technology solution for the storageand playback of their content. In October 2004, leveraging our existing 

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researchand development efforts and the intellectual property acquired in the QDesignacquisition, we launched DTS-HD, a scalable coding system. This technologyallows content to be played in home and portable devices. We believe that thebroad and robust nature of this offering improves the probability of inclusionof our technologies in next generation products.

**Cinema Segment**

Revenue from our cinemasegment represented 22% and 31% of total revenues for the quarters ended March 31,2005 and 2004, respectively. In our cinema business, 2004 was a solid year forsales of our playback hardware, marking a return to growth for cinema productsales. We expect growth in our cinema audio hardware to continue at a modestpace in 2005. We also believe that the cinema exhibition community hasrecognized that pre-show entertainment represents a significant revenue growthopportunity that will lead to investment in pre-show solutions over the nextseveral years. Because our XD10 Cinema Media Player can be configured toperform audio playback along with pre-show and subtitling presentation, webelieve that we are well-positioned to participate in the growth in thismarket.

A factor that we believewill affect our cinema business segment is the long-term trend toward digitaldistribution of content. We believe this trend will involve the near-termadoption of digital pre-show and/or electronic cinema solutions, followed bylonger-term adoption of higher quality digital cinema. Digital distribution ofcontent offers the motion picture industry a means to achieve substantial costsavings, including the printing and distribution of movies, help in combatingpiracy, and will enable movies to be played repeatedly without degradation. Italso provides additional revenue opportunities for cinema operators, as digitalcontent such as advertisements, concerts and sporting events could be shown inor broadcast to digitally equipped theaters. We believe the widespread adoptionof digital cinema will be longer-term because of the significant capitalinvestment that will be required by cinema operators to purchase new equipmentand solutions. We believe this represents an opportunity for us as we seek toprovide products and services in support of the transition from film-basedcontent towards digital cinema. However, we do not currently offer digitalcinema products and may not be successful in developing or selling competitiveproduct offerings. We believe that the addition of the services provided by ourdigital images business, coupled with the pre-show and alternative contentcapabilities of our XD10 Cinema Media Player, will enhance our ability to playa role in the industry transition to high definition sound and images fordigital cinema.

Sales of cinema productsand film licensing tend to fluctuate based on the underlying trends in themotion picture industry. For instance, in the late 1990s various cinemaoperators aggressively built megaplexes, which resulted in an oversupply ofscreens in some domestic and international markets. The resulting oversupply ofscreens led to significant declines in revenues per screen, and eventually,many theaters were closed. As the theater industry has regained health in thelast several years, sales of our DTS playback systems and cinema processorshave improved. Our film licensing revenues are also subject to fluctuationsbased on industry trends, most significantly, the number of films being made bystudios and independent filmmakers.

**Digital Images Segment**

 Revenue from our digital images segmentrepresented 3% of total revenues for the quarter ended March 31, 2005. Webelieve that the growing market for high resolution and high definition contentin the cinema and the home will create a substantial demand for the servicesprovided by DDI. We believe that we have a technological advantage over many ofour competitors based on the sophistication of our processes and level ofautomation used to enhance the image quality of entertainment content. Revenuesin this business totaled $720,000 for the three months ended March 31, 2005.This was lower than originally anticipated, as distractions related to theacquisition and integration of this business, coupled with certain processdevelopment initiatives, slowed the pace of selected larger projects during thequarter. To date, 

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thisbusiness has restored and/or enhanced over 100 feature films, including suchrecent major DVD releases as Star Wars and Indiana Jones. Major motion pictureand television studios possess libraries containing thousands of titles, whichwe believe represent a sizable market opportunity for DDI’s service.

**CriticalAccounting Policies and Estimates**

Management’s Discussionand Analysis of Financial Condition and Results of Operations is based upon ourconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States. The preparationof our financial statements requires us to make estimates and judgments thataffect the reported amounts of assets, liabilities, revenues, and expenses, andrelated disclosure of contingent assets and liabilities. On an on-going basis,estimates are evaluated, including those related to revenue recognition,allowance for doubtful accounts, inventories, goodwill and intangible assets,taxes, impairment of long-lived assets, product warranty, stock-basedcompensation, and contingencies and litigation. These estimates are based onhistorical experience and on various other assumptions that we believe to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from theseestimates. With the exceptions of the revenue recognition and in-processresearch and development in connection with the recent acquisition of LDI, nowDDI, as described below, there has been no material change to our criticalaccounting policies and estimates from the information provided in our Form10-K filed on March 16, 2005.

**DDI Revenue Recognition**

Revenue is recognized whenall titles subject to a customer order or contract are delivered and acceptedby the customer and no significant obligations remain after customeracceptance. We typically bill in advance of services. Prices are established inadvance of the work performed and are generally fixed in nature.  Iflosses are anticipated on a contract, such losses are recognized immediately. 

**Acquired In-Process Research and Development**

The value assigned toacquired in-process research and development, or IPR&D, is determined byidentifying acquired specific in-process research and development projects thatwould be continued and for which (1) technological feasibility has not beenestablished at the acquisition date, (2) there is no alternative future use,and (3) the fair value is estimable with reasonable reliability, uponconsummation of a business combination.

**Results ofOperations**

***Revenues***

*Technology and Film Licensing*

Technology and filmlicensing revenues for the three months ended March 31, 2005 increased 48%to $18.5 million from $12.5 million for the three months ended March 31,2004. The increase in revenues from technology and film licensing was primarilyattributable to an increase in royalty recoveries of $5.0 million fromintellectual property compliance and enforcement activities. These activities,which included audits of shipments by certain of our licensees of productscontaining our technology, trademarks and/or know-how and legal actions takenagainst licensees and parties who are not our licensees, resulted in recoveriesof royalty payments relating to prior periods. We expect such royaltyrecoveries to continue and that this activity will continue to improve revenuerealization in our licensing business going forward. Also contributing to theincrease is the continued growth in consumer electronics licensing, particularlyin the car and personal computer markets. Overall, we expect technologylicensing revenues to continue to grow in 2005, based primarily on the expectedcontinuation of growth in the home theater market. Our film 

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licensingrevenues decreased slightly for the three months ended March 31, 2005compared to the prior year period due to fewer international releases in theDTS format and changes in the timing of major feature film releases. Filmlicensing is expected to to grow modestly in 2005.

*Product Sales and Other*

Product sales and otherrevenues increased 16% to $3.6 million for the three months ended March 31,2005 from $3.1 million for the three months ended March 31, 2004.This increase was primarily attributable to revenues generated by DDI, which weacquired in January 2005. Cinema hardware sales were up slightly from astrong performance in the first quarter of 2004. Interest in our XD10 Cinema MediaPlayer continued to build during the first quarter of 2005, with revenue fromshipments totalling approximately $417,000 deferred pending completion of asoftware deliverable, which we expect to be completed by the third quarter of2005. The adoption of our multi-channel music continues to be slower thanexpected. Product sales and other revenue is expected to grow at a modest rate,as we continue to expect the market for pre-show entertainment to develop at ameasured pace throughout the rest of 2005.

*Segment Sales*

Revenues from our consumerbusiness totaled $16.5 million for the three months ended March 31, 2005,an increase of 53% from $10.8 million for the three months ended March 31,2004. The increase in revenues was driven primarily by royalty recoveries andthe growth in consumer electronics technology licensing as mentioned above.Cinema revenues were $4.8 million for the three months ended March 31,2005, essentially unchanged from the same period last year as a slight increasein hardware revenues was offset by a slight decrease in film licensing revenues.Revenues from our digital images business were $720,000 for the three monthsended March 31, 2005, the first quarter these revenues have been includedin our results of operations. Revenues from this business segment were lowerthan anticipated due to normal distractions related to this acquisition andrevenue deferrals under the completed contract methodology.

***GrossProfit***

Consolidated gross profitdecreased to 80% of revenues for the three months ended March 31, 2005,from 81% for the three months ended March 31, 2004. We expect consolidatedgross margins in the 70% to 75% range in 2005 primarily as a result of theincorporation of DDI into our consolidated results of operations.

*Technology and Film Licensing*

Gross profit associatedwith technology and film licensing revenues increased slightly to 93% for thethree months ended March 31, 2005 from 92% of related revenues for theprior year same period.

*Product Sales and Other*

Gross profit associatedwith product sales and other revenues decreased to 11% of related revenues forthe three months ended March 31, 2005 from 38% in the prior year periodprimarily as a result of negative margins relating to our digital imagesbusiness.

*Segment Gross Profit*

Gross profit for ourconsumer business increased to 97% of related revenues for the quarter ended March 31,2005 from 95% in the prior year period. Our cinema business gross profitdecreased to 45% of related revenues for the quarter ended March 31, 2005from 51% in the prior year period primarily due the change in mix to lowermargin product sales from the higher margin film licensing. Our digital imagesbusiness experienced negative gross margins due to lower than anticipatedrevenues and the amortization 

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ofacquired intangibles of $244,000. We expect margins in the digital imagesbusiness to improve as revenues increase throughout the remainder of the year.

***Selling, Generaland Administrative***

Selling, general andadministrative expenses increased 25% to $8.0 million for the three monthsended March 31, 2005, compared to $6.4 million in the prior year period.The increase is primarily due to increases in professional services of $1.1million, which includes costs associated with our increased intellectualproperty compliance and enforcement activities, Sarbanes-Oxley relatedcosts and other costs associated with operating as a public company. Alsocontributing to the increase was $503,000 relating to the inclusion of DDI inour results of operations. Included in the increase related to DDI isamortization of acquired intangibles of $83,000.

We expect selling, generaland administrative expenses to increase as a whole to support our growth initiativesincluding acquisitions, international expansion and intellectual propertyenforcement activities.

***Research andDevelopment***

For the three months endedMarch 31, 2005, research and development expenses were $2.1 million,compared to $1.3 million for the three months ended March 31, 2004.The change is primarily due to increased labor costs associated with newproduct initiatives, the optimization of our Coherent Acoustics technology, andthe development of tools associated with next generation optical discstandards. Also contributing to the increase was the inclusion of DDI researchand development activities totaling $179,000.

We expect to continue toincrease our investment in applications engineering and research anddevelopment activities overall and will accelerate those initiatives in futurequarters to support the roll out of next generation optical disc standards andthe continued optimization of our Coherent Acoustics technology.

***In-Process Researchand Development***

In-process research anddevelopment of $2.3 million relates to development projects that had notreached technological feasibility and were of no future alternative use andexpensed upon consummation of the acquisition of LDI. Developed technology andin-process research and development were identified and valued throughextensive interviews, analysis of data provided by LDI concerning developmentprojects, their stage of development, the time and resources needed to completethem, if applicable, and their expected income generating ability andassociated risks. Where development projects had reached technologicalfeasibility, they were classified as developed technology and the valueassigned to developed technology was capitalized. The income approach, whichincludes an analysis of the cash flows and risks associated with achieving suchcash flows, was the primary technique utilized in valuing acquired in-processresearch and development. Key assumptions for in-process research anddevelopment included a discount rate of 30% and estimates of revenue growth,cost of sales, operating expenses and taxes.

***Interest (Income)Expense, Net***

Interest income, net, forthe three months ended March 31, 2005 decreased due to the inclusion ofinterest income related to a royalty settlement in the first quarter of 2004,partially offset by increasing interest rates in 2005.

***Income Taxes***

For the three months endedMarch 31, 2005, we recorded an income tax provision of $1.9 million onpre-tax income of $5.5 million. This resulted in an annualized effective taxrate of 35.3%. For the three months ended March 31, 2004, we recorded anincome tax provision of $1.9 million on pre-tax income of 

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$5.4million. This resulted in an annualized effective tax rate of 35.8%. Theserates differed from the statutory rates primarily due to state income taxesoffset by benefits associated with the foreign rate differentials and researchand development credits. We expect the effective tax rate for 2005 will beapproximately 35%.

**Liquidity andCapital Resources**

At March 31, 2005, wehad cash, cash equivalents and short- and long-term investments of $106.2million, compared to $117.0 million at December 31, 2004.

Net cash provided byoperating activities was $1.7 million for the three months ended March 31,2005, compared to $4.1 million for the three months ended March 31, 2004.The decrease in cash flows from operations was primarily a result of anincrease in accounts receivable and a reduced tax benefit relating to options.Accounts receivable, net of acquired accounts receivable, increased $5.8million for the three months ended March 31, 2005 due primarily to accruedconsumer license fees, $4.7 million of which was collected by April 2005. Our taxbenefit from the exercise of options decreased $891,000 for the three monthsended March 31, 2005 as a result of the decrease in the market value ofour common stock relative to the same period in the prior year.

Net cash provided byinvesting activities totaled $8.9 million for the three months ended March 31,2005. Net cash used in investing activities totaled $30.0 million for the threemonths ended 2004. The increase in cash used in investing activities for thethree months ended March 31, 2005 is primarily a result of the net salesof investments of $21.4 million, offset by the acquisition of LDI of $11.0million and purchases of property and equipment of $1.5 million.

Net cash provided byfinancing activities totaled $76,000 and $78,000 for the three months ended March 31,2005 and 2004, respectively, and primarily consists of the exercise of stockoptions.

We believe that our cash,cash equivalents, short-term investments, funds available under our existingbank line of credit facility, and cash flows from operations will be sufficientto satisfy our working capital and capital expenditure requirements for atleast the next twelve months. Beyond the next twelve months, additionalfinancing may be required to fund working capital and capital expenditures.Changes in our operating plans, lower than anticipated revenues, increasedexpenses, acquisition of companies, products or technologies or other events,including those described in “Risk Factors” included in our Form 10-Kfiled on March 16, 2005 and in and other filings may cause us to seekadditional debt or equity financing on an accelerated basis. Financing may notbe available on acceptable terms, or at all, and our failure to raise capitalwhen needed could negatively impact our growth plans and our financialcondition and results of operations. Additional equity financing may bedilutive to the holders of our common stock and debt financing, if available,may involve significant cash payment obligations and financial or operationalcovenants that restrict our ability to operate our business.

**Recently Issued AccountingStandards**

In November 2004, theFinancial Accounting Standards Board, or FASB issued Statement of FinancialAccounting Standards, or SFAS, No. 151, “Inventory Costs, an amendment ofARB No. 43, Chapter 4”, or SFAS 151. SFAS 151 clarifies the types of coststhat should be expensed rather than capitalized as inventory. SFAS 151 alsoclarifies the circumstances under which fixed overhead costs associated withoperating facilities involved in inventory processing should be capitalized.This statement is effective for fiscal years beginning after June 15,2005. We adopted SFAS 151 in the three months ended 2005 and the adoption didnot have a material impact on our consolidated financial position or results ofoperations.

In December 2004,the FASB issued SFAS No. 123R, “Share-Based Payment”, or SFAS 123R, anamendment to SFAS No. 123, “Accounting for Stock-Based Compensation.”SFAS 123R requires 

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compensation expense related to stock-based awards tobe recognized in the financial statements. The amount of compensation expensewill be measured based upon the fair value of the stock-based awards at thedate of grant. This statement is effective for public companies as of the firstinterim or annual reporting period beginning after June 15, 2005. In April 2005,the SEC amended the compliance date for implementing SFAS 123R extending thecompliance date to the first fiscal year that begins after June 15, 2005.We plan to adopt SFAS 123R beginning in the first quarter of fiscal 2006. Theexpected effects of the adoption of SFAS 123R on our financial results for thenext five years, based on stock-based awards granted as of March 31, 2004,are as follows:
| ** **                                                                           | ** ** | **Expenses by Fiscal Year** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                           | ** ** | **Remaining**                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                           | ** ** | **Nine**                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                           | ** ** | **Months**                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                           | ** ** | **2005**                                   | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** |
| ** **                                                                           | ** ** | **(unaudited)**                            | ** ** |
| ** **                                                                           | ** ** | **(In thousands)**                         | ** ** |
| Additional stock-based  compensation expense under SFAS 123R before tax benefit |       |                                       | $          | 2,100 |   |   | $ | 1,513 |   | $ | 691 |   | $ | 169 |   | $ | — |   |
|                                                                                      |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

SFAS 123R also affects thepresentation of tax benefits for option exercises in the statement of cashflows. Prior to adoption SFAS 123R, the benefit is classified in cash providedby operating activities. Upon adoption, the tax benefit will be classified incash provided by financing activities. We are in the process of determining theimpact the adoption will have on our consolidated statement of cash flows.

**RISK FACTORS**

Set forth below andelsewhere in this report and in other documents we file with the SEC are risksand uncertainties that could cause our actual results to differ materially fromthe results contemplated by the forward-looking statements contained in thisreport and other public statements we make. If any of the following risksactually occurs, our business, financial condition, or results of operationscould suffer. In that case, the trading price of our common stock coulddecline, and you may lose all or part of your investment.

**Risks Related to Our Business**

***We face intense competition from companies withgreater brand recognition and resources.***

The digital audio, digitalimaging, consumer electronics, and entertainment markets are intenselycompetitive, subject to rapid change, and significantly affected by new productintroductions and other market activities of industry participants. Ourprincipal competitor is Dolby Laboratories, Inc., who competes with us inmost of our markets. We also compete with other companies offering:

·       digitalaudio technology incorporated into consumer electronics products andentertainment mediums, including Coding Technologies, Fraunhofer InstitutIntegrierte Schaltungen, Koninklijke Philips Electronics N.V. (Philips),Meridian Audio Limited, Microsoft Corporation, Sony Corporation, and Thomson;

·       productsfor cinema markets, such as Smart Devices, Inc., Sony Corporation, andUltra Stereo Labs, Inc., and

·       digitalimage processing, enhancement and restoration services, including Ascent MediaGroup, EFILM LLC, Imax Corporation, Laser Pacific Media Corporation, ModernVideo Film, Inc., Sunset Digital, Technicolor Media Services, and Warner Bros.Entertainment, Inc.

·       products for imageprocessing including da Vinci Systems, LLC, Digital Vision AB, MathematicalTechnologies, Inc., Pixel Farm Ltd., Snell and Wilcox, Teranex Incorporated,and The Foundry Visionmongers Ltd.

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Many of our currentand potential competitors, including Dolby, enjoy substantial competitiveadvantages, including:

·       greatername recognition;

·       alonger operating history;

·       moredeveloped distribution channels and deeper relationships with our commoncustomer base;

·       amore extensive customer base;

·       digitaltechnologies that provide features that ours do not;

·       broaderproduct and service offerings;

·       greaterresources for competitive activities, such as research and development,strategic acquisitions, alliances, joint ventures, sales and marketing, andlobbying industry and government standards; and

·       moretechnicians and engineers.

As a result, these current and potential competitorsmay be able to respond more quickly and effectively than we can to new orchanging opportunities, technologies, standards, or customer requirements.

In addition to the competitive advantages describedabove, Dolby also enjoys other unique competitive strengths relative to us. Forexample, it introduced multi-channel audio technology before we did. It has alarger base of installed movie theaters for its cinema playback equipment. Itstechnology has been incorporated in significantly more DVD-Video films than ourtechnology. It has also achieved mandatory standard status in a few productcategories, including DVD-Video and DVD-Audio Recordable, for its stereotechnology and terrestrial digital television broadcasts in the United States.As a result of these factors, Dolby has a competitive advantage in selling itsdigital multi-channel technology to consumer electronics productsmanufacturers.

Sony Corporation is both a competitor and asignificant customer in all of our markets. If Sony decides to eliminate theuse of our technology in its products or to compete with us more aggressivelyin our markets, the revenues that we derive from Sony would be lower thanexpected.

Warner Bros. is both acompetitor and a significant customer in the image processing, enhancement andrestoration markets. If Warner Bros. decides to compete directly with us in theimage processing, enhancement and restoration market, the revenues that wederive from Warner Bros. would be lower than expected.

***Current and future governmental and industry standardsmay significantly limit our business opportunities.***

Technology standards are important in the audio andvideo industry as they help to assure compatibility across a system or seriesof products. Generally, standards adoption occurs on either a mandatory basis,requiring a particular technology to be available in a particular product ormedium, or an optional basis, meaning that a particular technology may be, butis not required to be, utilized. For example, both our digital multi-channelaudio technology and Dolby’s have optional status in the HD-DVD standard. Inthe emerging standard for HD-DVD, both DTS and Dolby technologies have beenselected as mandatory standards. Recently, however, there has been discussionregarding merging the two competing next generation optical disc HD-DVDstandards. If either or both of these standards are re-examined as a result ofthese discussions or a new standard is developed, we may not be included asmandatory in any new or revised standard.

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Various national governments have adopted or are inthe process of adopting standards for all digital television broadcasts,including cable, satellite, and terrestrial. In the United States, Dolby’saudio technology has been selected as the sole, mandatory audio standard forterrestrial digital television broadcasts. As a result, the audio for alldigital terrestrial television broadcasts in the United States must includeDolby’s technology and must exclude any other format, including ours. We do notknow whether this standard will be reopened or amended. If it is not, our audiotechnology may never be included in that standard. Certain large and developingmarkets, such as China, have not fully developed their digital televisionstandards. Our technology may or may not ultimately be included in thesestandards.

As new technologies and entertainment mediums emerge,new standards relating to these technologies or mediums may develop. Newstandards may also emerge in existing markets that are currently characterizedby competing formats, such as the market for personal computers. We may not besuccessful in our efforts to include our technology in any such standards.

***We may not be able to evolve our technology, products,and services or develop new technology, products, and services that areacceptable to our customers or the changing market.***

The market for ourtechnology, products, and services is characterized by:

·       rapidtechnological change;

·       newand improved product introductions;

·       changingcustomer demands;

·       evolvingindustry standards; and

·       productobsolescence.

Our future success will depend on our ability toenhance our existing technology, products, and services and to developacceptable new technology, products, and services on a timely basis. Thedevelopment of enhanced and new technology, products, and services is a complexand uncertain process requiring high levels of innovation, highly-skilledengineering and development personnel, and the accurate anticipation oftechnological and market trends. We may not be able to identify, develop,market, or support new or enhanced technology, products, or services on atimely basis, if at all. Furthermore, our new technology, products, andservices may never gain market acceptance, and we may not be able to respondeffectively to evolving consumer demands, technological changes, productannouncements by competitors, or emerging industry standards. For example, wemay not be able to effectively address concerns in the film and music industriesrelating to piracy in our current or future products. Any failure to respond tothese changes or concerns would likely prevent our technology, products, andservices from gaining market acceptance or maintaining market share.

***If we fail to protect our intellectual propertyrights, our ability to compete could be harmed.***

Protection of our intellectual property is critical toour success. Patent, trademark, copyright, and trade secret laws andconfidentiality and other contractual provisions afford only limited protectionand may not adequately protect our rights or permit us to gain or keep anycompetitive advantage. We face numerous risks in protecting our intellectualproperty rights, including the following:

·       ourpatents may be challenged or invalidated by our competitors;

·       ourpending patent applications may not issue, or, if issued, may not providemeaningful protection for related products or proprietary rights;

·       wemay not be able to prevent the unauthorized disclosure or use of our technicalknowledge or other trade secrets by employees, consultants, and advisors;

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·       wemay not be able to practice our trade secrets as a result of patent protectionafforded a third-party for such product, technique or processes;

·       thelaws of foreign countries may not protect our intellectual property rights tothe same extent as the laws of the United States, and mechanisms forenforcement of intellectual property rights may be inadequate in foreigncountries;

·       ourcompetitors may produce competitive products or services that do not unlawfullyinfringe upon our intellectual property rights; and

·       wemay be unable to successfully identify or prosecute unauthorized uses of ourtechnology.

As a result, our means of protecting our intellectualproperty rights and brands may not be adequate. Furthermore, despite ourefforts, third parties may violate, or attempt to violate, our intellectualproperty rights. Infringement claims and lawsuits would likely be expensive toresolve and would require management’s time and resources. In addition, we havenot sought, and do not intend to seek, patent and other intellectual propertyprotections in all foreign countries. In countries where we do not have suchprotection, products incorporating our technology may be lawfully produced andsold without a license.

***We may be sued by third parties for allegedinfringement of their proprietary rights.***

Companies that participate in the digital audio,digital image processing, consumer electronics, and entertainment industrieshold a large number of patents, trademarks, and copyrights, and are frequentlyinvolved in litigation based on allegations of patent infringement or otherviolations of intellectual property rights. Intellectual property disputesfrequently involve highly complex and costly scientific matters, and each partygenerally has the right to seek a trial by jury which adds additional costs anduncertainty. Accordingly, intellectual property contests, with or withoutmerit, could be costly and time consuming to litigate or settle, and coulddivert management’s attention from executing our business plan. In addition,our technology and products may not be able to withstand any third-party claimsor rights against their use. If we were unable to obtain any necessary licensefollowing a determination of infringement or an adverse determination inlitigation or in interference or other administrative proceedings, we may needto redesign some of our products to avoid infringing a third party’s rights andcould be required to temporarily or permanently discontinue licensing ourproducts.

***If we are unable to maintain and increase the amountof entertainment content released with DTS audio soundtracks, demand for thetechnology, products, and services that we offer to consumer electronicsproducts manufacturers may significantly decline.***

We expect to derive a significant percentage of ourrevenues from the technology, products, and services that we offer tomanufacturers of consumer electronics products. To date, the most significantdriver for the use of our technology in the home theater market has been therelease of major movie titles with DTS audio soundtracks. We also believe thatdemand for our DTS audio technology in emerging markets for multi-channelaudio, including homes, cars, personal computers, and video games and consoles,will be based on the number, quality, and popularity of the audio DVDs,computer software programs, and video games released with DTS audiosoundtracks. Although we have existing relationships with many leadingproviders of movie, music, computer, and video game content, we do not havecontracts that require any of these parties to develop and release content withDTS audio soundtracks. In addition, we may not be successful in maintainingexisting relationships or developing relationships with other existingproviders or new market entrants that provide content. As a result, we cannotassure you that a significant amount of content in movies, audio DVDs, computersoftware programs, video games, or other entertainment mediums will be releasedwith DTS audio soundtracks. If the amount, variety, and popularity ofentertainment content released with DTS audio soundtracks do not increase,consumer electronics products manufacturers that pay us per-unit licensing feesmay discontinue offering DTS playback capabilities in the consumer electronicsproducts that they sell.

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***If our independent registered public accounting firm isunable to provide us with an unqualified report as to the adequacy of ourinternal controls over financial reporting for future year-ends as required by Section 404of the Sarbanes-Oxley Act of 2002, investors could lose confidence in thereliability of our financial statements, which could result in a decrease inthe value of our shares.***

As directed by Section 404 of the Sarbanes-OxleyAct of 2002, the SEC adopted rules requiring all public companies,including us, to include a report by management on internal control overfinancial reporting in all annual reports on Form 10-K that containsan assessment by management of the effectiveness of internal control overfinancial reporting. In addition, the public accounting firm auditing ourfinancial statements must attest to and report on our management’s assessmentof the effectiveness of internal control over financial reporting and theeffectiveness of internal control over financial reporting. While we conductrigorous reviews of our internal control over financial reporting in order to complywith the Section 404 requirements, our registered public accounting firmmay interpret the Section 404 requirements and the related rules andregulations differently from us, or our registered public accounting firm ormanagement may not be satisfied with our internal control over financialreporting or with the level at which these controls are documented, executed orreviewed. In addition, many uncertainties remain regarding the requirements forauditor attestation, and guidance provided by the public accounting professionhas changed frequently and materially to date and may continue to change suchthat we may not be able to comply with these new requirements. Further, thedemand for competent audit resources has grown dramatically as a result of therequirements of Section 404, and such demand may exceed available supply. Inaddition, in January 2005, we acquired Lowry Digital Images, Inc., or LDI, aprivately held company with limited financial resources that had notimplemented sufficient internal control over financial reporting. We may in thefuture make additional acquisitions which may be significant to our operationseither individually or in the aggregate. We may face significant challenges inimplementing the required processes and procedures in the acquired operationsof LDI or any other businesses that we may acquire. As a result, our registeredpublic accounting firm may issue an adverse report or a disclaimer onmanagements assesment of internal control over financial reporting. Managementmay also identify material weaknesses which would cause management to concludeinternal control over financial reporting is not effective. This could resultin an adverse reaction in the financial markets due to a loss of confidence inthe reliability of our financial statements, which could cause the market priceof our shares to decline.

***We have limited experience in licensing, re-mixing,marketing, and directly selling multi-channel audio content.***

Although we have established relationships with anumber of artists and music labels, we do not have any contractual agreementsthat require artists or music labels to provide us with music content to re-mixand release in our proprietary DTS audio format. Music companies may in thefuture be unwilling to license titles from their music catalogs to us. Inaddition, our audio content competes with other multi-channel formats,including Super Audio CD, which is a format developed jointly by Philips andSony Corporation. As a result, we may have difficulty in obtaining rights torelease a significant amount of audio content, and any content that we dorelease may not be commercially successful.

***We have limited experience in image processing,enhancement and restoration***

Although we have established relationships with anumber of motion picture studios, content owners, producers and distributors,we do not have any contractual agreements that require them to provide us imagecontent for processing. Further, the demand for image processing, enhancementand restoration of cinema, home video or broadcast television content may not materializeor accelerate as we anticipate, which would have a negative impact on ourbusiness.

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***Declining retail prices for consumer electronicsproducts or video content could force us to lower the license or other fees wecharge our customers.***

The market for consumer electronics products isintensely competitive and price sensitive. Retail prices for consumerelectronics products that include our DTS audio technology, such as DVD playersand home theater systems, have decreased significantly and we expect prices tocontinue to decrease for the foreseeable future. Declining prices for consumerelectronics products could create downward pressure on the licensing fees wecurrently charge our customers who integrate our technology into the consumerelectronics products that they sell and distribute. Most of the consumerelectronics products that include our audio technology also include Dolby’smulti-channel audio. As a result of pricing pressure, consumer electronicsproducts manufacturers could decide to exclude our DTS audio technology fromtheir products altogether.

The market for consumer video products is also intenselycompetitive and price sensitive. Retail prices for consumer video products thatthat have been processed, enhanced or restored by us, such as movies, concertsor animated content released on DVD or other media, have experienced pricepressure and we expect this price pressure to continue for the foreseeablefuture. Declining prices for such video products could create downward pressureon the fees we currently charge our customers for the image processing,enhancement and restoration services we provide. If the motion picture studios,content owners, producers or distributors were to believe that the existing imagequality is satisfactory or that the pricing for our services are too high, theycould decide to not use our services altogether.

***We have limited control over existing and potentialcustomers’ and licensees’ decision to include our technology in their productofferings.***

We are dependent on our customers andlicensees—including consumer electronics products manufacturers, semiconductormanufacturers, movie theaters, producers and distributors of content for music,films, videos, and games—to incorporate our technology in their products,purchase our products and services, or release their content in our proprietaryDTS audio format. Although we have contracts and license agreements with manyof these companies, these agreements do not require any minimum purchasecommitments, and are on a non-exclusive basis, and do not require incorporationor use of our technology, trademarks or services. Our customers, licensees andother manufacturers might not utilize our technology or services in the future.

***Our revenues from film producers and distributors andfrom the products and services that we offer to movie theaters would decline ifthe major U.S. film producers and distributors decrease the number of filmsthey release using DTS technology or services.***

Although all nine major film producers anddistributors are customers of ours, we generally do not have contractualarrangements that require them to use our DTS audio technology or our imageservices. Our cinema and images business depends on our having good relationswith these film studios and other content owners. A deterioration in ourrelationship with any of these customers could cause them to stop using our DTSaudio technology or our image enhancement services. Any significant decline inthe release of motion pictures with DTS audio soundtracks would decrease thedemand for and revenues from the playback products and services that we offerto movie theaters. In addition, other motion picture studios, content owners,producers, and distributors throughout the world generally adopt and use theprocesses and the technologies used by the major U.S. film studios. Therefore,if the major U.S. motion picture studios, content owners, producers ordistributors stop using our technology, we would not only lose the per-movielicensing fee we receive from these customers, but may also lose per-movielicensing fees from other film studios throughout the world.

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***If the movie industry adopts new digital cinematechnology in place of current film technology, demand for our cinema productsand services could decline.***

The movie theater industrymay transition from film-based media to electronic-based, or digital, media. Ifthis transition occurs, we may be unable to meaningfully respond withcompetitive product offerings. In addition, if the film industry broadly adoptsdigital cinema, our technology and current product offerings could be renderedobsolete. In such an event, demand by movie theaters for our playback systems,cinema processors, and systems for subtitling, captioning, and descriptivenarration would decline.

***The movie theaterindustry has suffered and may continue to suffer from an oversupply of screens,which has affected and may continue to affect demand for the products andservices we offer to movie theaters.***

Our cinema businessdepends in part on the construction of new screens and the renovation ofexisting theaters that install our DTS playback systems and cinema processors.In recent years, aggressive building of megaplexes by companies that operatemovie theaters has generated significant competition and resulted in anoversupply of screens in some domestic and international markets. The resultingoversupply of screens led to significant declines in revenues per screen and,eventually, to an inability by many major film exhibitors to satisfy theirfinancial obligations. Several major movie theater operators have reorganizedthrough bankruptcy proceedings, and many movie theaters have closed. As aresult, our playback systems and cinema processors that we previously sold tomovie theaters that have reorganized and closed have been relocated to othertheaters or have been available for resale in the secondary market to movietheaters that might otherwise have purchased these products directly from us.If movie theater operators decide to close a significant number of screens inthe future or cut their capital spending, demand for our playback systems and cinemaprocessors will decline.

***We are dependent onour management team and key technical employees, and the loss of any of themcould harm our business.***

Our success depends, inpart, upon the continued availability and contributions of our management team,particularly Jon Kirchner, our President and Chief Executive Officer, W. PaulSmith, our Senior Vice President, Research and Development, and John Lowry, ourChief Technologist of DTS Digital Images who became an employee upon our acquisitionof LDI. We also rely on the skills and talents of our engineering and technicalpersonnel because of the complexity of our products and services. Several ofour key engineers have been instrumental in the development of our technology.Important factors that could cause the loss of key personnel include:

·       ourexisting employment agreements with the members of our management team allowsuch persons to terminate their employment with us at any time;

·       wedo not have employment agreements with a majority of our key engineering andtechnical personnel;

·       wehave key-man life insurance only for a limited numbers of our employees;

·       significantportions of the stock options held by the members of our management team arevested; and

·       manyof the stock options held by our executive officers provide for acceleratedvesting in the event of a sale or change of control of our company.

The loss of key personnel or an inability to attractqualified personnel in a timely manner could slow our technology and productdevelopment and harm our ability to execute our business plan.

***We have a limitedoperating history in many of our key markets.***

Although the first movie with a DTS audio soundtrackwas released in 1993, we did not enter the home theater market until 1996, andour technology has only recently been incorporated into other 

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consumerelectronics markets, such as car audio, personal computers, video games andconsoles, portable electronics devices, and digital satellite and cablebroadcast products. In addition, while we have completed over 100 digital imageprocessing, enhancement and restoration film projects, it is only recently thata large number of these projects have been completed. As a result, the demandfor our technology, products, and services and the income potential of thesebusinesses are unproven. In addition, because the market for digital audiotechnology and image services are relatively new and rapidly evolving, we havelimited insight into trends that may emerge and affect our business. We maymake errors in predicting and reacting to relevant business trends, which couldharm our business. Before investing in our common stock, you should considerthe risks, uncertainties, and difficulties frequently encountered by companiesin new and rapidly evolving markets such as ours. We may not be able tosuccessfully address any or all of these risks.

***Our technology andproducts are complex and may contain errors that could cause us to losecustomers, damage our reputation, or incur substantial costs.***

Our technology or products could contain errors thatcould cause our products or technology to operate improperly and could causeunintended consequences. If our products or technology contain errors we couldbe required to replace them, and if any such errors cause unintendedconsequences we could face claims for product liability. Although we generallyattempt to contractually limit our exposure to incidental and consequentialdamages, if these contract provisions are not enforced or are unenforceable forany reason, or if liabilities arise that are not effectively limited, we couldincur substantial costs in defending and/or settling product liability claims.

***Because we expectour operating expenses to increase in the future, we may not be able to sustainor increase our profitability.***

Although we have been inbusiness since 1990, we have only achieved profits from our business operationsin the last fifteen fiscal quarters. We expect our operating expenses toincrease as we, among other things:

·       expandour domestic and international sales and marketing activities;

·       acquirebusinesses or technologies and integrate them into our existing organization;

·       increaseour research and development efforts to advance our existing technology,products, and services and develop new technology, products, and services;

·       hireadditional personnel, including engineers and other technical staff;

·       upgradeour operational and financial systems, procedures, and controls; and

·       continueto assume the responsibilities of being a public company.

As a result, we will need to grow our revenues inorder to maintain and increase our profitability. In addition, we may fail toaccurately estimate and assess our increased operating expenses as we grow.

***We are subject to additional risks associated with ourinternational operations.***

We market and sell ourproducts and services outside the United States, and currently have employeeslocated in Canada, China, England, Japan, Mexico, Northern Ireland, and Spain.Many of our customers and licensees are located outside the United States. As akey component of our business strategy, we intend to expand our internationalsales. We face numerous risks in doing business outside the United States,including:

·       unusualor burdensome foreign laws or regulatory requirements or unexpected changes tothose laws or requirements;

·       tariffs,trade protection measures, import or export licensing requirements, tradeembargos, and other trade barriers;

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·       difficultiesin staffing and managing foreign operations;

·       dependenceon foreign distributors and their sales channels;

·       longeraccounts receivable collection cycles and difficulties in collecting accountsreceivable;

·       lesseffective and less predictable protection of intellectual property;

·       changesin the political or economic condition of a specific country or region,particularly in emerging markets;

·       fluctuationsin the value of foreign currency versus the U.S. dollar and the cost ofcurrency exchange; and

·       potentiallyadverse tax consequences.

Such factors could cause our future internationalsales to decline.

***Our businesspractices in international markets are also subject to the requirements of theForeign Corrupt Practices Act. If any of our employees is found to haveviolated these requirements, we could be subject to significant fines and otherpenalties.***

Our international revenue is mostly denominated inU.S. dollars. As a result, fluctuations in the value of the U.S. dollar andforeign currencies may make our technology, products, and services more expensivefor international customers, which could cause them to decrease their purchasesfrom us. Expenses for our subsidiaries are denominated in their respectivelocal currencies. Significant fluctuations in the value of the U.S. dollar andforeign currencies could have a material impact on our consolidated financialstatements. We do not currently engage in currency hedging activities to limitthe risk of exchange rate fluctuations.

***We face risks in expanding our business operations inChina.***

One of our key strategies is to expand our businessoperations in China. However, we may be unsuccessful in implementing thisstrategy as planned or at all. Factors that could inhibit our successfulexpansion into China include its historically poor recognition of intellectualproperty rights and poor performance in stopping counterfeiting and piracyactivity. If we are unable to successfully stop unauthorized use of ourintellectual property and assure compliance by our Chinese licensees, we couldexperience increased operational and enforcement costs both inside and outsideChina.

Even if we are successful in expanding into China, wemay be greatly impacted by the political, economic, and military conditions inChina, Taiwan, North Korea, and South Korea. These countries have recentlyconducted military exercises in or near the other’s territorial waters andairspace. Such disputes may continue or escalate, resulting in economicembargos, disruptions in shipping, or even military hostilities. This couldseverely harm our business by interrupting or delaying production or shipmentof our products or products that incorporate our technology.

***We depend on several suppliers, manufacturers, anddistributors for some of our products, and the loss of any of these suppliers,manufacturers, or distributors could harm our business.***

We purchase a small number of parts from sole-sourcesuppliers. In addition, our professional audio encoding devices and movietheater playback systems are manufactured according to our specifications bysingle third-party manufacturers. Because we have no direct control over thesethird-party suppliers and manufacturers, interruptions or delays in theproducts and services provided by these third parties may be difficult toremedy in a timely fashion. In addition, if such suppliers or manufacturers areincapable of or unwilling to deliver the necessary parts or products, we may beunable to redesign our technology to work without such parts or findalternative suppliers or manufacturers. In such events, we could experienceinterruptions, delays, increased costs, or quality control problems.

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In addition, we haveentered into agreements with three companies to serve as our sole distributorsfor our DTS Entertainment products in the United States and Canada, Europe andJapan. We have no direct control over these distributors and any problems withtheir performance may take time to identify and/or remedy, and any remedialmeasures that we take may be unsuccessful. In addition, if any of thesedistributors were to go out of business, as one of our previous distributorsdid, or otherwise becomes incapable of continuing as our distributor, we couldexperience delays in distributing our DTS Entertainment products to the retailmarket, loss of inventory, and loss of revenue.

***We rely on the accuracy of our customers’manufacturing reports for reporting and collecting our revenues, and if thesereports are untimely or incorrect, our revenues could be delayed orinaccurately reported.***

A significant percentageof our revenues are generated from our consumer electronics productsmanufacturer customers who license and incorporate our technology in theirconsumer electronics products. Under our existing arrangements, these customerspay us a per-unit licensing fee based on the number of consumer electronicsproducts manufactured that incorporate our technology. We rely on our customersto accurately report the number of units manufactured in collecting our licensefees, preparing our financial reports, projections, budgets, and directing oursales and product development efforts. Most of our license agreements permit usto audit our customers, but audits are generally expensive and time consumingand could harm our customer relationships. If any of our customer reportsunderstate the number of products they manufacture, we may not collect andrecognize revenues to which we are entitled.

***A prolonged economic downturn could materially harmour business.***

Negative trends in thegeneral economy, including trends resulting from actual or threatened militaryaction by the United States and threats of terrorist attacks on the UnitedStates and abroad, could cause a decrease in consumer spending on entertainmentin general. Any reduction in consumer confidence or disposable income ingeneral may affect the demand for consumer electronics products thatincorporate our digital audio technology, audio DVDs that we produce anddistribute through our DTS Entertainment label, and demand by film studios andmovie theaters for our cinema products and services.

***We may not successfully address problems encounteredin connection with any acquisitions.***

We acquired LDI inJanuary 2005, and we expect to consider additional opportunities to acquire ormake investments in other technologies, products, and businesses that couldenhance our technical capabilities, complement our current products andservices, or expand the breadth of our markets. We have a limited history ofacquiring and integrating businesses. Acquisitions and strategic investmentsinvolve numerous risks, including:

·       problemsassimilating the purchased technologies, products, or business operations;

·       significantfuture charges relating to in-process research and development and theamortization of intangible assets;

·       significantamount of goodwill that is not amortizable and is subject to annual impairmentreview;

·       problemsmaintaining uniform standards, procedures, controls, and policies;

·       unanticipatedcosts associated with the acquisition, including accounting charges, capitalexpenditures, and transaction expenses;

·       diversionof management’s attention from our core business;

·       adverseeffects on existing business relationships with suppliers and customers;

·       risksassociated with entering markets in which we have no or limited priorexperience; and

·       potentialloss of key employees of acquired organizations.

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If we fail to properlyevaluate and execute acquisitions and strategic investments, our managementteam may be distracted from our day-to-day operations, our business may bedisrupted, and our operating results may suffer. In addition, if we financeacquisitions by issuing equity or convertible debt securities, our existingstockholders would be diluted.

***We may have difficulty managing any growth that wemight experience.***

Weexpect to continue to experience growth in the scope of our operations and thenumber of our employees. If this growth continues, it will place a significantstrain on our management team and on our operational and financial systems,procedures, and controls. Our future success will depend in part on the abilityof our management team to manage any growth effectively. This will require ourmanagement to:

·       hireand train additional personnel in the United States and internationally;

·       implementand improve our operational and financial systems, procedures, and controls;

·       maintainour cost structure at an appropriate level based on the revenues we generate;

·       managemultiple, concurrent development projects; and

·       manageoperations in multiple time zones with different cultures and languages.

Any failure tosuccessfully manage our growth could distract management’s attention, andresult in our failure to execute our business plan. For instance, ouracquisition of LDI has required significant time and attention from ourmanagement team. Any future growth could cause similar management challenges orcreate distractions.

***We may experience fluctuations in our operatingresults.***

We have historicallyexperienced moderate seasonality in our business due to our business mix andthe nature of our products. In our consumer business, consumer electronicsmanufacturing activities are generally lowest in the first calendar quarter ofeach year, and increase progressively throughout the remainder of the year.Manufacturing output is generally strongest in the third and fourth quarters asour technology licensees increase manufacturing to prepare for the holidaybuying season. Since recognition of revenues in our consumer business generallylags manufacturing activity by one quarter, our revenues and earnings from theconsumer business are generally lowest in the second quarter. Film licensingrevenues are generally strongest in the second and fourth quarters due to the abundanceof movies typically released during the summer and year-end holiday seasons.The introduction of new products and inclusion of our technologies in new andrapidly growing markets can distort the moderate seasonality described above.Our revenues may continue to be subject to seasonal fluctuations in the future.Unanticipated fluctuations in seasonality could cause us to miss our earningsprojections which could cause our stock price to decline.

In addition, we activelyengage in intellectual property compliance and enforcement activities focusedon identifying third parties who have either incorporated our technology,trademarks, or know-how without a license or who have underreported to us theamount of royalties owed under license agreements with us. As a result of theseactivities, from time to time, we recognize royalty revenues that relate toconsumer electronics manufacturing activities from prior periods. These royaltyrecoveries may cause revenues to be higher than expected during a particularreporting period and may not recur in future reporting periods. Suchfluctuations in our revenues and operating results may cause declines in ourstock price.

***Accounting for employee stock options using the fairvalue method will reduce our net income.***

There has been ongoingpublic debate whether stock options granted to employees should be treated ascompensation expense and, if so, how to properly value such charges. Currently,we account for options using the intrinsic value method, which results in nocompensation expense, since we grant employee 

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optionswith exercise prices equal to the fair market value of the underlying stock atthe time of grant. If, however, we had used the fair value method of accountingfor stock options granted to employees using a Black-Scholes option valuationformula, our net income for the three months ended March 31, 2005, wouldhave been reduced by $489,000, from $3.5 million to $3.1 million for the threemonths ended March 31, 2005. When we adopt FAS 123R in the first quarterof 2006, we will have on-going accounting charges significantly greater thanthose we would have recorded under our current method of accounting for stockoptions, which will have a material adverse affect on our operating results.

**RisksRelated to Our Common Stock**

***We expect that the price of our common stock willfluctuate substantially.***

Themarket price of our common stock is likely to be highly volatile and mayfluctuate substantially due to many factors, including:

·       actualor anticipated fluctuations in our results of operations;

·       announcementsof technological innovations or technology standards;

·       announcementsof significant contracts by us or our competitors;

·       changesin our pricing policies or the pricing policies of our competitors;

·       developmentswith respect to intellectual property rights;

·       theintroduction of new products or product enhancements by us or our competitors;

·       thecommencement of or our involvement in litigation;

·       oursale of common stock or other securities in the future;

·       conditionsand trends in technology industries;

·       changesin market valuation or earnings of our competitors;

·       thetrading volume of our common stock;

·       changesin the estimation of the future size and growth rate of our markets; and

·       generaleconomic conditions.

In addition, the stockmarket in general, and the Nasdaq National Market and the market for technologycompanies in particular, has experienced extreme price and volume fluctuationsthat have often been unrelated or disproportionate to the operating performanceof those companies. Further, the market prices of securities of technologycompanies have been particularly volatile. These broad market and industryfactors may materially harm the market price of our common stock, regardless ofour operating performance. In the past, following periods of volatility in themarket price of a company’s securities, securities class-action litigation hasoften been instituted against that company. Such litigation, if institutedagainst us, could result in substantial costs and a diversion of management’sattention and resources.

***Shares of our common stock are relatively illiquid.***

As of March 31, 2005, we have 17,091,980 sharesof common stock outstanding. As a result of our relatively small public float,our common shares may be less liquid than the common shares of companies withbroader public ownership. Among other things, trading of a relatively smallvolume of our common shares may have a greater impact on the trading price forour shares than would be the case if our public float were larger.

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***Our future capitalneeds are uncertain and we may need to raise additional funds in the future,and such funds may not be available on acceptable terms or at all.***

Ourcapital requirements will depend on many factors, including:

·       acceptanceof, and demand for, our products and technology;

·       thecosts of developing new products or technology;

·       theextent to which we invest in new technology and research and developmentprojects;

·       thenumber and timing of acquisitions and other strategic transactions; and

·       thecosts associated with our expansion, if any.

In the future, we may needto raise additional funds, and such funds may not be available on favorableterms, or at all. Furthermore, if we issue equity or debt securities to raiseadditional funds, our existing stockholders may experience dilution, and thenew equity or debt securities may have rights, preferences, and privilegessenior to those of our existing stockholders. If we cannot raise funds onacceptable terms, we may not be able to develop or enhance our products andservices, execute our business plan, take advantage of future opportunities, orrespond to competitive pressures or unanticipated customer requirements. Thismay materially harm our business, results of operations, and financialcondition.

***Anti-takeover provisions under our charter documentsand Delaware law could delay or prevent a change of control and could alsolimit the market price of our stock.***

OurRestated Certificate of Incorporation and Restated Bylaws contain provisionsthat could delay or prevent a change of control of our company or changes inour Board of Directors that our stockholders might consider favorable. Some ofthese provisions:

·       authorizethe issuance of preferred stock which can be created and issued by the board ofdirectors without prior stockholder approval, with rights senior to those ofthe common stock;

·       providefor a classified Board of Directors, with each director serving a staggeredthree-year term;

·       prohibitstockholders from filling board vacancies, calling special stockholdermeetings, or taking action by written consent; and

·       requireadvance written notice of stockholder proposals and director nominations.

In addition, we are governed by the provisions of Section 203of the Delaware General Corporate Law, which may prohibit certain businesscombinations with stockholders owning 15% or more of our outstanding votingstock. These and other provisions in our Restated Certificate of Incorporation,Restated Bylaws and Delaware law could make it more difficult for stockholdersor potential acquirors to obtain control of our Board or initiate actions thatare opposed by the then-current Board, including delay or impede amerger, tender offer, or proxy contest involving our company. Any delay orprevention of a change of control transaction or changes in our Board couldcause the market price of our common stock to decline.

**Item 3**.        Quantitative and Qualitative DisclosuresAbout Market Risk

Market risk represents therisk of loss arising from adverse changes in market rates and foreign exchangerates. At March 31, 2005, we did not have any balances outstanding underour bank line of credit arrangement; however, the amount of outstanding debt atany time may fluctuate and we may from time to time be subject to refinancingrisk.

Our interest income issensitive to changes in the general level of U.S. interest rates, particularlysince a significant portion of our investments are and will be in short-term marketablesecurities, U.S. 

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government securities andcorporate bonds. Due to the nature and maturity of our short-term investments,we have concluded that there is no material market risk exposure to ourprincipal. The average maturity of our investment portfolio is less than onemonth. As of March 31, 2005, a 1% change in interest rates throughout aone-year period would have an annual effect of approximately $1.1 millionon our income.

We derive more than halfof our revenues from sales outside the United States, and maintain research,sales, marketing, or business development offices in six countries. Therefore,our results could be negatively affected by such factors as changes in foreigncurrency exchange rates, trade protection measures, longer accounts receivablecollection patterns, and changes in regional or worldwide economic or politicalconditions. The risks of our international operations are mitigated in part bythe extent to which our revenues are denominated in U.S. dollars and,accordingly, we are not exposed to significant foreign currency risk on theseitems. We do have limited foreign currency risk on certain revenues andoperating expenses such as salaries and overhead costs of our foreignoperations and a small amount of cash maintained by these operations. Revenuesdenominated in foreign currencies accounted for approximately 3% of totalrevenues during the first quarter of 2005. Operating expenses, including costof sales, for our foreign subsidiaries were approximately $1.5 million in thefirst quarter of 2005. Based upon the expenses for the first quarter of 2005, a1% change in foreign currency rates throughout a one-year period would have anannual effect of approximately $62,000.

Our international businessis subject to risks, including, but not limited to, differing economicconditions, changes in political climate, differing tax structures, otherregulations and restrictions, and foreign exchange rate volatility whencompared to the United States dollar. Accordingly, our future results could bematerially impacted by changes in these or other factors.

We are also affected by exchange rate fluctuations asthe financial statements of our foreign subsidiaries are translated into theUnited States dollar in consolidation. As exchange rates vary, these results,when translated, may vary from expectations and could adversely impact overallprofitability. During the first quarter of 2005 the impact of foreign exchangerate fluctuations related to translation of our foreign subsidiaries’ financialstatements was not significant.

**Item 4.**        Controls and Procedures

**DisclosureControls and Procedures**

*Evaluation of disclosure controlsand procedures.  *Under the supervision and with theparticipation of our management, including our Chief Executive Officer andChief Financial Officer, we evaluated the effectiveness of the design andoperation of our disclosure controls and procedures (as defined in Rule 13a-15(e) or15d-15(e) under the Securities Exchange Act of 1934 (the “ExchangeAct”)). Based upon that evaluation, the Chief Executive Officer and ChiefFinancial Officer concluded that, as of the end of the period covered by thisReport, our disclosure controls and procedures are adequately designed toensure that information required to be disclosed by us in the reports we fileor submit under the Exchange Act is recorded, processed, summarized andreported appropriately and within the time periods specified in applicable rules andforms.

*Changes in internal controls.**  *Duringthe first quarter of 2005 we began integrating the accounting operations of LDI,now DDI. Prior to our acquisition of LDI in January 2005, LDI was aprivately held company operating with limited financial resources that had notimplemented sufficient internal controls over financial reporting. We are inthe process of implementing changes to improve the internal controls at LDI. Wedo not believe the integration of the accounting operations of LDI hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

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**PART II**

**OTHER INFORMATION**

**Item 1.**                        LegalProceedings

In connection with ourenforcement activities relating to our intellectual property rights and to stopunauthorized use of our technology and trademarks, we terminated our licenseagreement to Sunplus Technology Co., Ltd., or Sunplus. In response, Sunplusfiled suit against us alleging breach of contract arising from our terminationof their license agreement. We prevailed on several preliminary motions bySunplus seeking to enjoin us from terminating the license agreement. We filed across-complaint seeking a judicial declaration that we properly terminated thelicense agreement and to recover damages arising from Sunplus’ breach of theagreement. We believe Sunplus’ claim is without merit and intends to vigorouslydefend the case.

**Item 2.**                        UnregisteredSales of Equity Securities and Use of Proceeds

On July 15, 2003, wecompleted our initial public offering for the sale of 4,091,410 shares ofcommon stock at a price to the public of $17.00 per share, which resulted innet proceeds of approximately $63.0 million after payment of the underwriters’commissions and deductions of offering expenses. All of the shares of CommonStock sold in the offering were registered under the 1933 Act on a RegistrationStatement on Form S-1 (Reg. No. 333-104761) that wasdeclared effective by the SEC on July 9, 2003 and a Registration Statementfiled pursuant to Rule 462(b) under the Securities Act that was filedon July 10, 2003 (Reg. No. 333-106920). Subsequent to theoffering, we used approximately $22.5 million of our net proceeds toredeem all outstanding shares of redeemable preferred stock and to pay allaccrued but unpaid dividends on such shares through the date of redemption. Theremaining proceeds to us have conformed with our intended use outlined in theprospectus related to the offering. As of March 31, 2005, we have approximately$40.5 million remaining from the proceeds of the offering.

**Item 3.**                        DefaultsUpon Senior Securities

None.

**Item 4.**                        Submissionof Matters to a Vote of Security Holders

None.

**Item 5.**                        OtherInformation

In February 2005, several of our executivesimplemented individual stock selling plans in accordance with SEC Rule 10b5-1to sell a portion of their holdings of our common stock over time as part oftheir individual long-term strategy for asset diversification and liquidity,while avoiding conflicts of interest or the appearance of any such conflictthat might arise from their positions with the company. The executives thathave implemented such plans are Chief Executive Officer Jon Kirchner, ExecutiveVice President, Finance and Chief Financial Officer Melvin Flanigan, ExecutiveVice President, Operations Andrea Nee, Executive Vice President, Legal andGeneral Counsel, Blake Welcher, Senior Vice President, Research and DevelopmentW. Paul Smith, Senior Vice President, Strategy and Business Development PatrickWatson, Senior Vice President, Engineering and Product Development JanWissmuller, Senior Vice President, Cinema division Don Bird, Vice President,Consumer/Pro Audio Brian Towne and Chairman of the Board of Directors DanSlusser.

Under the Rule 10b5-1trading plans, the DTS executives may each sell up to 20% of the stock andexercisable stock options held by such person as of the effective date of theplan during the one-year term of the plan; however, the executive shall notsell more than 50% of such shares in any one calendar 

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quarter.Sales under these plans may be executed no more than once per month. Theseplans provide that sales may begin 90 days after the implementation date of theplan.

**Item 6.**                        Exhibits
| Exhibit  Number | ** ** | ** **                                                                                                                                       | ** ** | **Exhibit Description** |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|
| 31.1            |       | Certification of the Chief Executive Officer under  Securities Exchange Act Rules 13a-14(a) or 15d-14(a)                               |
| 31.2            |       | Certification of the Chief Financial Officer under  Securities Exchange Act Rules 13a-14(a) or 15d-14(a)                               |
| 32.1            |       | Certification of the Chief Executive Officer under  Securities Exchange Act Rules 13a-14(b) or 15d-14(b) and 18  U.S.C. 1350           |
| 32.2            |       | Certification of the Chief Financial Officer under  Securities Exchange Act Rules 13a-14(b) or 15d-14(b) and  18 U.S.C. 1350 |

 

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
|                    |   | DIGITAL  THEATER SYSTEMS, INC.                  |
|--------------------|--------|-------------------------------------------------|
|               | by:    | /s/ JON E. KIRCHNER                             |
|               |   | Jon E. Kirchner                                 |
|               |   | *President  and Chief Executive Officer*        |
|               |   | *(Duly  Authorized Officer)*                    |
| Date: May 10, 2005 |   |                                            |
|               | by:    | /s/ MELVIN L. FLANIGAN                          |
|               |   | Melvin L.  Flanigan                             |
|               |   | *Executive  Vice President, Finance and*        |
|               |   | *Chief  Financial Officer*                      |
|               |   | *(Principal  Financial and Accounting Officer)* |
| Date: May 10, 2005 |   |

 

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