**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, 2006**

**CommissionFile Number 000-50335**

**DTS, Inc.**

(Exact name of registrantas specified in its charter)

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

 

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Indicate by check markwhether the registrant: (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x   No o

Indicate by check markwhether registrant is a large accelerated filer, accelerated filer ornon-accelerated filer. See definition of “accelerated filer” and “largeaccelerated filer” in Rule 12b-2 of the Exchange Act.

Large acceleratedfiler  o                    Acceleratedfiler  x                    Non-acceleratedfiler  o

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

Asof April 30, 2006 a total of 17,581,872 shares of the Registrant’s CommonStock, $0.0001 par value, were issued and outstanding.

 

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**DTS,INC.**

**FORM 10-Q**

**TABLEOF CONTENTS**

| **PART I**   | ** ** | **FINANCIAL  INFORMATION**                                                                      | ** ** | **3**  |
|-------------------|------------|-------------------------------------------------------------------------------------------------|------------|--------|
| **Item 1.**  | ** ** | **Financial Statements (unaudited):**                                                           | ** ** | **3**  |
|              | ** ** | **Consolidated Balance Sheets**                                                                 | ** ** | **3**  |
|              | ** ** | **Consolidated Statements of  Operations**                                                      | ** ** | **4**  |
|              | ** ** | **Consolidated Statements of  Cash Flows**                                                      | ** ** | **5**  |
|              | ** ** | **Notes to 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**                                 | ** ** | **23** |
| **Item 4.**  | ** ** | **Controls and Procedures**                                                                     | ** ** | **24** |
| **PART II.** | ** ** | **OTHER  INFORMATION**                                                                          | ** ** | **25** |
| **Item 1.**  | ** ** | **Legal Proceedings**                                                                           | ** ** | **25** |
| **Item 1A.**      | ** ** | **Risk Factors**                                                                                | ** ** | **25** |
| **Item 2.**  | ** ** | **Unregistered Sales of Equity  Securities and Use of Proceeds**                                | ** ** | **39** |
| **Item 3.**  | ** ** | **Defaults Upon Senior  Securities**                                                            | ** ** | **39** |
| **Item 4.**  | ** ** | **Submission of Matters to a  Vote of Security Holders**                                        | ** ** | **39** |
| **Item 5.**  | ** ** | **Other Information**                                                                           | ** ** | **39** |
| **Item 6.**  | ** ** | **Exhibits**                                                                                    | ** ** | **40** |
| **SIGNATURES**    | ** ** | **41**                                                                                          |
|                   |            |                                                                                                 |            |        |  |  |

 

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**DTS,INC.**

**PART I**

**FINANCIALINFORMATION**

**Item 1.**                     *Financial Statements*

**DTS, Inc.Consolidated Balance Sheets**

| ** **                                                                                                                                                                                                                                      | ** ** | **As of       December 31,      2005**      | ** ** | **As of       March 31,       2006** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                                                                      | ** ** | **(Unaudited)**                                                                                    | ** ** |
| ** **                                                                                                                                                                                                                                      | ** ** | **(Amounts in thousands, except  share and per share amounts)** | ** ** |
| ASSETS                                                                                                                                                                                                                                          |       |                                                                                               |       |                                                                                             |       |   |   |   |   |
| Current assets:                                                                                                                                                                                                                                 |       |                                                                                               |       |                                                                                             |       |   |   |   |   |
| Cash and cash  equivalents                                                                                                                                                                                                                      |       |                                                                                               | $          | 33,254                                                                                           |       |   |   | $ | 29,767 |   |   |
| Short-term investments                                                                                                                                                                                                                          |       |                                                                                               | 78,163     |                                                                                             |       |   | 89,427 |   |   |
| Accounts receivable, net  of allowance for doubtful accounts of $370 and $375 at December 31,  2005 and March 31, 2006, respectively                                                                                             |       |                                                                                               | 7,311      |                                                                                             |       |   | 6,261 |   |   |
| Inventories                                                                                                                                                                                                                                     |       |                                                                                               | 3,261      |                                                                                             |       |   | 3,215 |   |   |
| Deferred income taxes                                                                                                                                                                                                                           |       |                                                                                               | 7,255      |                                                                                             |       |   | 7,255 |   |   |
| Prepaid expenses and  other current assets                                                                                                                                                                                                      |       |                                                                                               | 3,112      |                                                                                             |       |   | 2,054 |   |   |
| Income taxes receivable,  net                                                                                                                                                                                                                   |       |                                                                                               | 2,654      |                                                                                             |       |   | 1,178 |   |   |
| Total current assets                                                                                                                                                                                                                            |       |                                                                                               | 135,010    |                                                                                             |       |   | 139,157 |   |   |
| Property and equipment,  net                                                                                                                                                                                                                    |       |                                                                                               | 7,375      |                                                                                             |       |   | 8,415 |   |   |
| Goodwill                                                                                                                                                                                                                                        |       |                                                                                               | 3,585      |                                                                                             |       |   | 3,585 |   |   |
| Intangible assets, net                                                                                                                                                                                                                          |       |                                                                                               | 11,612     |                                                                                             |       |   | 11,282 |   |   |
| Deferred income taxes                                                                                                                                                                                                                           |       |                                                                                               | 303        |                                                                                             |       |   | 16 |   |   |
| Other assets                                                                                                                                                                                                                                    |       |                                                                                               | 369        |                                                                                             |       |   | 876 |   |   |
| Total assets                                                                                                                                                                                                                                    |       |                                                                                               | $          | 158,254                                                                                          |       |   |   | $ | 163,331 |   |   |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                                                                                      |       |                                                                                               |       |                                                                                             |       |   |   |   |   |
| Current liabilities:                                                                                                                                                                                                                            |       |                                                                                               |       |                                                                                             |       |   |   |   |   |
| Accounts payable                                                                                                                                                                                                                                |       |                                                                                               | $          | 2,634                                                                                            |       |   |   | $ | 2,919 |   |   |
| Accrued expenses                                                                                                                                                                                                                                |       |                                                                                               | 6,983      |                                                                                             |       |   | 6,236 |   |   |
| Deferred revenue                                                                                                                                                                                                                                |       |                                                                                               | 2,630      |                                                                                             |       |   | 242 |   |   |
| Total current  liabilities                                                                                                                                                                                                                      |       |                                                                                               | 12,247     |                                                                                             |       |   | 9,397 |   |   |
| Deferred income taxes                                                                                                                                                                                                                           |       |                                                                                               | 1,917      |                                                                                             |       |   | 1,752 |   |   |
| Commitments and contingencies (Note 8)                                                                                                                                                                                                          |       |                                                                                               |       |                                                                                             |       |   |   |   |   |
| Stockholders’ equity:                                                                                                                                                                                                                      |       |                                                                                               |       |                                                                                             |       |   |   |   |   |
| Preferred stock—$0.0001  par value, 5,000,000 shares authorized at December 31, 2005 and  March 31, 2006; no shares issued and outstanding at December 31,  2005 and March 31, 2006                                    |       |                                                                                               | —     |                                                                                             |       |   | — |   |   |
| Common stock—$0.0001 par  value, 70,000,000 shares authorized at December 31, 2005 and  March 31, 2006; 17,472,543 and 17,581,872 shares issued and outstanding  at December 31, 2005 and March 31, 2006, respectively |       |                                                                                               | 2          |                                                                                             |       |   | 2 |   |   |
| Additional paid-in  capital                                                                                                                                                                                                                     |       |                                                                                               | 122,847    |                                                                                             |       |   | 123,932 |   |   |
| Retained earnings                                                                                                                                                                                                                               |       |                                                                                               | 21,241     |                                                                                             |       |   | 28,248 |   |   |
| Total stockholders’  equity                                                                                                                                                                                                                |       |                                                                                               | 144,090    |                                                                                             |       |   | 152,182 |   |   |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                 |       |                                                                                               | $          | 158,254                                                                                          |       |   |   | $ | 163,331 |   |   |

 

See accompanying notes to consolidated financial statements.

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**DTS, Inc.Consolidated Statements of Operations**

| ** **                                                            | ** ** | **For the Three Months Ended  March 31,**                                 | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|
| ** **                                                            | ** ** | **2005**                                                                                           | ** ** | **2006** | ** ** |
| ** **                                                            | ** ** | **(Unaudited)**                                                                                    | ** ** |
| ** **                                                            | ** ** | **(Amounts in thousands, except  share and per share amounts)** | ** ** |
| Revenues:                                                             |       |                                                                                               |       |   |   |
| Technology and film licensing                                         |       | $                                                                                                  | 18,464     |   | $ | 22,845 |   |
| Product sales and other revenues                                      |       | 3,593                                                                                              |       | 5,856 |   |
| Total revenues                                                        |       | 22,057                                                                                             |       | 28,701 |   |
| Cost of goods sold:                                                   |       |                                                                                               |       |   |   |
| Technology and film licensing                                         |       | 1,282                                                                                              |       | 1,278 |   |
| Product sales and other revenues                                      |       | 3,181                                                                                              |       | 4,864 |   |
| Total cost of goods sold                                              |       | 4,463                                                                                              |       | 6,142 |   |
| Gross profit                                                          |       | 17,594                                                                                             |       | 22,559 |   |
| Operating expenses:                                                   |       |                                                                                               |       |   |   |
| Selling, general and administrative                                   |       | 8,044                                                                                              |       | 9,898 |   |
| Research and development                                              |       | 2,094                                                                                              |       | 2,718 |   |
| In-process research and development                                   |       | 2,300                                                                                              |       | — |   |
| Total operating expenses                                              |       | 12,438                                                                                             |       | 12,616 |   |
| Income from operations                                                |       | 5,156                                                                                              |       | 9,943 |   |
| Interest income,  net                                                 |       | 354                                                                                                |       | 1,036 |   |
| Other income  (expense), net                                          |       | (12                                                                                                | )          | 40 |   |
| Income before provision for income taxes                              |       | 5,498                                                                                              |       | 11,019 |   |
| Provision for  income taxes                                           |       | 1,942                                                                                              |       | 4,012 |   |
| Net income                                                            |       | 3,556                                                                                              |       | 7,007 |   |
| Net income per  common share:                                         |       |                                                                                               |       |   |   |
| Basic                                                                 |       | $                                                                                                  | 0.21       |   | $ | 0.40 |   |
| Diluted                                                               |       | $                                                                                                  | 0.19       |   | $ | 0.38 |   |
| Weighted average  shares used to compute net income per common share: |       |                                                                                               |       |   |   |
| Basic                                                                 |       | 17,080,005                                                                                         |       | 17,494,844 |   |
| Diluted                                                               |       | 18,266,094                                                                                         |       | 18,291,663 |   |

 

See accompanying notes to consolidated financial statements.

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**DTS, Inc.**

**ConsolidatedStatements of Cash Flows**

| ** **                                                                               | ** ** | **For the Three Months  Ended March 31,** | ** ** |
|------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                               | ** ** | **2005**                                                           | ** ** | **2006** | ** ** |
| ** **                                                                               | ** ** | **(Unaudited)**                                                    | ** ** |
| ** **                                                                               | ** ** | **(Amounts in thousands)**                               | ** ** |
| Cash flows from  operating activities:                                                   |       |                                                               |       |   |   |
| Net income                                                                               |       | $                                                                  | 3,556      |   | $ | 7,007 |   |
| Adjustments to reconcile  net income to net cash provided by operating activities:       |       |                                                               |       |   |   |
| Depreciation and amortization                                                            |       | 809                                                                |       | 1,062 |   |
| Stock-based compensation charges                                                         |       | 5                                                                  |       | 682 |   |
| Allowance for doubtful accounts                                                          |       | 5                                                                  |       | 10 |   |
| Loss on disposal of property and equipment                                               |       | —                                                             |       | 69 |   |
| Deferred income taxes                                                                    |       | (43                                                                | )          | 121 |   |
| Excess tax benefits from stock-based compensation                                        |       | 169                                                                |       | (112 | ) |
| Write-down of inventory                                                                  |       | —                                                             |       | 144 |   |
| In-process research and development                                                      |       | 2,300                                                              |       | — |   |
| Changes in  operating assets and liabilities:                                            |       |                                                               |       |   |   |
| Accounts receivable                                                                      |       | (5,816                                                             | )          | 1,040 |   |
| Inventories                                                                              |       | 349                                                                |       | (99 | ) |
| Prepaid expenses and other assets                                                        |       | (233                                                               | )          | 751 |   |
| Accounts payable and accrued expenses                                                    |       | (966                                                               | )          | (462 | ) |
| Deferred revenue                                                                         |       | 829                                                                |       | (2,388 | ) |
| Income taxes                                                                             |       | 728                                                                |       | 1,588 |   |
| Net cash provided by operating activities                                                |       | 1,692                                                              |       | 9,413 |   |
| Cash flows from  investing activities:                                                   |       |                                                               |       |   |   |
| Purchases of investments                                                                 |       | (29,113                                                            | )          | (48,616 | ) |
| Maturities of investments                                                                |       | 16,307                                                             |       | 26,213 |   |
| Sales of investments                                                                     |       | 34,200                                                             |       | 11,139 |   |
| Cash paid for acquisitions, net of cash acquired                                         |       | (10,954                                                            | )          | (200 | ) |
| Purchase of property and equipment                                                       |       | (1,517                                                             | )          | (1,808 | ) |
| Payment for patents and trademarks in process                                            |       | (70                                                                | )          | (32 | ) |
| Net cash provided by (used in) investing activities                                      |       | 8,853                                                              |       | (13,304 | ) |
| Cash flows from  financing activities:                                                   |       |                                                               |       |   |   |
| Proceeds from the issuance of common stock upon  exercise of employee stock options |       | 76                                                                 |       | 292 |   |
| Excess tax benefits from stock-based compensation                                        |       | —                                                             |       | 112 |   |
| Net cash provided by financing activities                                                |       | 76                                                                 |       | 404 |   |
| Net increase (decrease) in cash and cash equivalents                                     |       | 10,621                                                             |       | (3,487 | ) |
| Cash and cash  equivalents, beginning of period                                          |       | 21,271                                                             |       | 33,254 |   |
| Cash and cash  equivalents, end of period                                                |       | $                                                                  | 31,892     |   | $ | 29,767 |   |

 

See accompanying notes to consolidated financial statements.

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**DTS, INC.**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

**(Amountsin thousands, except share and per share data)**

**Note 1—Basisof Presentation**

The accompanying unaudited consolidated financialstatements of DTS, Inc. (the “Company”) have been prepared in accordancewith accounting principles generally accepted in the United States and with theinstructions to Form 10-Q and Article 10 ofRegulation S-X. Accordingly, they do not include all of the informationand footnotes required by accounting principles generally accepted in theUnited States for complete financial statements. In the opinion of management,the unaudited consolidated financial statements reflect all adjustmentsconsidered necessary for a fair statement of the Company’s financial positionat March 31, 2006, and the results of operations and cash flows for theperiods presented, consisting only of normal and recurring adjustments. Allsignificant intercompany transactions have been eliminated in consolidation.Operating results for the three months ended March 31, 2006 are notnecessarily indicative of the results that may be expected for the fiscal yearending December 31, 2006. For further information, refer to theconsolidated financial statements and footnotes thereto for the year ended December 31,2005 filed on Form 10-K on March 16, 2006.

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.

**Note 2—RecentAccounting Pronouncements**

In June 2005, the Financial Accounting StandardsBoard (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 154,“Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20,Accounting Changes, and Statement No. 3, Reporting Accounting Changes inInterim Financial Statements.” SFAS No. 154 changes the requirementsfor the accounting for, and reporting of, a change in accounting principle.Previously, most voluntary changes in accounting principles were required to berecognized by way of a cumulative effect adjustment within net income duringthe period of the change. SFAS No. 154 requires retrospectiveapplication to prior periods’ financial statements, unless it is impracticableto determine either the period-specific effects or the cumulative effect of thechange. SFAS No. 154 is effective for accounting changes made infiscal years beginning after December 15, 2005; however, the Statementdoes not change the transition provisions of any existing accountingpronouncements. The adoption of SFAS No. 154 did not have a materialeffect on the Company’s consolidated financial position, results of operationsor cash flows.

In December 2004, theFASB finalized SFAS No. 123(R), “Share-Based Payment,” which requirescompanies to measure and recognize compensation costs for all share-basedpayments (including stock options) at fair value, effective for interim orannual periods beginning after June 15, 2005. On April 15, 2005, theU.S. Securities and Exchange Commission (the “SEC”) announced a deferral of theeffective date of SFAS No. 123(R) until the first interim or annualreporting period of the first fiscal year beginning on or after June 15,2005. Effective January 1, 2006, the Company adopted the provisions ofSFAS No. 123(R) as discussed in Footnote 7, Stock-Based Compensation.

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**Note 3—CertainBalance Sheet Items**

Inventoriesconsist of the following:

| ** ** | ** ** | **As of  December 31,  2005** | ** ** | **As of  March 31,  2006** | ** ** |
|------------|------------|-----------------------------------------|------------|--------------------------------------|------------|

| Raw materials     |   |   | $     | 1,062  |   |   |   | $      | 991    |   |   |
|-------------------|--------|--------|-------|--------|--------|--------|--------|--------|--------|--------|--------|
| Finished goods    |   |   | 2,199 |   |   |   | 2,224  |   |   |
| Total inventories |   |   | $     | 3,261  |   |   |   | $      | 3,215  |   |   |

 

Propertyand equipment consist of the following:

| ** **                      | ** ** | **As of  December 31,  2005** | ** ** | **As of  March 31,  2006** | ** ** |
|---------------------------------|------------|-----------------------------------------|------------|--------------------------------------|------------|
| Machinery and  equipment        |       |                                    | $          | 7,437                                |       |   |   | $ | 7,615 |   |   |
| Office furniture  and fixtures  |       |                                    | 3,588      |                                 |       |   | 4,316 |   |   |
| Leasehold  improvements         |       |                                    | 3,697      |                                 |       |   | 3,713 |   |   |
|                            |       |                                    | 14,722     |                                 |       |   | 15,644 |   |   |
| Less: Accumulated  depreciation |       |                                    | (7,347     | )                                    |       |   | (7,229 | ) |   |
| Property and  equipment, net    |       |                                    | $          | 7,375                                |       |   |   | $ | 8,415 |   |   |

 

**Note 4—BusinessCombinations**

In January 2005, the Company completed theacquisition of Lowry Digital Images, Inc, and subsequently changed its name toDTS Digital Images, Inc. (“DTS DI”). DTS DI was acquired for a totalestimated purchase price of $12,249, including $9,642 in cash, forgiveness of aloan and interest of $1,261, and acquisition costs of $1,346. DTS DI providesimage restoration and enhancement services for film producers and distributorsfor home or professional playback of high quality, high definitionpresentations in digital cinema, high definition optical media or broadcastapplications.

The DTS DI acquisition was accounted for as a purchasebusiness combination. The results of operations of DTS DI are included in ourConsolidated Statement of Operations from January 3, 2005. The finalpurchase price is dependent on shares issued, if any, as further discussed. Theformer shareholders of DTS DI are entitled to receive shares of the Company’scommon stock if certain gross profit targets in 2006 are met. In the event thatthe targets are met in full, an aggregate of up to approximately 653,000 sharesof the Company’s common stock will be issued. The value of these shares will beaccounted for as an addition to goodwill.

In July 2004, theCompany completed the acquisition of QDesign Corporation for $1,500 in cash.Under the terms of the acquisition, the Company also contingently agreed to payan additional amount up to a maximum of $450 in cash, which is held by theCompany in a restricted account. The Company classifies the restricted cash inother current and non-current assets. The contingent payment is being accountedfor as compensation expense ratably over the three-year period ending July 2007,and will be paid out if certain criteria are met. The first payment of $150 waspaid in 2005.

**Note 5—Bank Line ofCredit**

We have in place a $10,000 facility that expires on June 30,2006 and is renewable annually. The bank agreement provides for working capitalfinancing and is unsecured. The bank agreement requires the Company to complywith certain covenants including a tangible effective net worth of $60,000,increasing by 50% of net income on an annual basis. The covenants also requirethe Company to keep $2,000 in cash 

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or securities at the bank.At March 31, 2006, the Company was compliant with all covenants under thebank agreement.

At March 31, 2006,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. Theannual commitment fee for this line of credit is not significant.

**Note 6—Income Taxes**

For the three months endedMarch 31, 2006, the Company recorded an income tax provision of $4,012 onpre-tax income of $11,019 resulting in an annualized effective tax rate of36.4%. For the three months ended March 31, 2005, the Company recorded anincome tax provision of $1,942 on pre-tax income of $5,498, resulting in anannualized effective tax rate of 35.3%. These rates differed from the statutoryrates primarily due to state income taxes offset by benefits associated withthe foreign rate differentials.

**Note 7—Stock-BasedCompensation**

Prior to January 1, 2006, the Company accountedfor its employee stock option and stock purchase plans in accordance with theprovisions of Accounting Principles Board Opinion (“APB”) No. 25, “Accountingfor Stock Issued to Employees” and the related FASB Interpretation No. 44,“Accounting for Certain Transactions Involving Stock Compensation,” andcomplied with the disclosure provisions of SFAS No. 123, “Accounting forStock-Based Compensation.” Under the provisions of these pronouncements, alloptions granted under those plans had an exercise price equal to or greaterthan the market value of the underlying common stock on the date of grant,which resulted in no recognition of stock-based compensation expense. For thethree months ended March 31, 2005, the company recognized no stock-basedemployee compensation cost from stock options. Effective January 1, 2006,the Company adopted the provisions of SFAS No. 123(R), using themodified-prospective-transition method. Under the transition method,compensation expense recognized beginning January 1, 2006 includes: (a) compensationcost for all share-based payments granted prior to, but not yet vested as of January 1,2006, based on the grant date fair value estimated in accordance with theoriginal provisions of SFAS No. 123, and (b) compensation cost forall share-based payments granted on or after January 1, 2006, based on thegrant fair value estimated in accordance with the provisions of SFAS No. 123(R).The Company did not restate its results for prior periods.

As a result of adoptingSFAS No. 123(R) on January 1, 2006, the Company’s income beforetaxes and net income for the three months ended March 31, 2006, wereapproximately $619 and $394 lower, respectively, than if it had continued toaccount for share-based compensation under APB No. 25. Basic and dilutedearnings per share for the three months ended March 31, 2006 would havebeen $0.42 and $0.40, respectively, if it had not adopted SFAS No. 123(R),compared to reported basic and diluted earnings per share of $0.40 and $0.38,respectively. The total stock-based compensation cost that has been recognizedin the Consolidated Statements of Operations was $682 and $5 for the threemonths ended March 31, 2006 and 2005, respectively. The total income taxbenefit recognized was $248 and $2 for the three months ended March 31,2006 and 2005, respectively.

Prior to adoption of SFAS No. 123(R),the Company presented all tax benefits of deductions resulting from theexercise of stock options as operating cash flows in the ConsolidatedStatements of Cash Flows. SFAS No. 123(R) requires the cash flowsresulting from the tax benefits resulting from tax deductions in excess of thecompensation cost recognized for those options (excess tax benefits) to beclassified as financing cash flows. The $112 excess tax benefit classified as afinancing cash inflow would have been 

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classifiedas an operating cash inflow if we had not adopted SFAS No. 123(R). Duringthe three months ended March 31, 2006, the Company received $292 in cashfrom stock option exercises.

If theCompany had elected to recognize compensation cost for stock options based ontheir fair value at the grant dates, consistent with the method prescribed bySFAS No. 123, net income and net income per share for the three monthsended March 31, 2005 would have been as follows:

| ** **                                                                                                                | ** ** | **For the Three  Months  Ended March 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                                                                                                | ** ** | **2005**                                                       | ** ** |
| Net income:                                                                                                               |       |                                                           |       |   |   |
| As reported                                                                                                               |       |                                                           | $          | 3,556 |   |   |
| Additional stock-based  compensation expense determined under the fair value method, net of tax                           |       |                                                           | (489       | ) |   |
| Pro forma                                                                                                                 |       |                                                           | $          | 3,067 |   |   |
| Net income per common  share—basic:                                                                                  |       |                                                           |       |   |   |
| As reported                                                                                                               |       |                                                           | $          | 0.21 |   |   |
| Per share effect of  additional stock-based compensation expense determined under the fair  value method, net of tax |       |                                                           | (0.03      | ) |   |
| Pro forma                                                                                                                 |       |                                                           | $          | 0.18 |   |   |
| Net income per common  share—diluted:                                                                                |       |                                                           |       |   |   |
| As reported                                                                                                               |       |                                                           | $          | 0.19 |   |   |
| Per share effect of  additional stock-based compensation expense determined under the fair  value method, net of tax |       |                                                           | (0.03      | ) |   |
| Pro forma                                                                                                                 |       |                                                           | $          | 0.16 |   |   |

 

The fair value of eachemployee option grant is estimated on the date of the grant using theBlack-Scholes option pricing model with the following weighted average keyassumptions:

| ** **              | ** ** | **Three  Months Ended  March 31,** | ** ** |
|-------------------------|------------|----------------------------------------------|------------|
| ** **              | ** ** | **2005**                                     | ** ** | **2006** | ** ** |
| Risk free interest rate |       |                                         | 3.8        | % |   | 4.4 | % |
| Expected lives (years)  |       |                                         | 4          |   |   | 5.8 |   |
| Dividend yield          |       |                                         | 0          | % |   | 0 | % |
| Expected volatility     |       |                                         | 50         | % |   | 58 | % |

 

The dividend yield was not calculated because theCompany does not currently expect to pay a dividend. The expected life of theoptions granted was derived from the historical activity of the Company’soptions and represented the period of time that options granted were expectedto be outstanding. Expected volatility was based on historical volatility ofthe Company’s common stock. The risk-free interest rate was the averageinterest rates of U.S. government bonds of comparable term to the options on thedates of the option grants.

There were 247,750 and 149,000 options granted duringthe three months ended March 31, 2006 and 2005, respectively. The weightedaverage fair value of options granted during the three months ended March 31,2006 and 2005 was $18.32 and $20.18, respectively. Stock-based compensationexpense for stock options for the three months ended March 31, 2006, wascalculated based on their fair value at the grant dates, consistent with themethod prescribed by SFAS No. 123 adjusted by estimated forfeitures asprescribed by SFAS 123(R). Compensation expense for stock options was $516 forthe three months ended March 31, 2006.

9

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The Company has historically recognized compensationcost over the nominal vesting period, whereby if an employee retired before theend of the vesting period, the Company would recognize any remainingunrecognized compensation cost at the date of retirement. The FASB clarified inSFAS No. 123(R) that the fair value of such stock options should beexpensed based on recognition under a non-substantive vesting period approach,requiring compensation expense recognition when an employee is eligible toretire. Company employees are eligible to retire after age 60. For thoseemployees that retire and are eligible, their options continue to vest upon theoriginal vesting schedules. The SEC recently clarified that companies shouldcontinue the vesting method they have been using until adoption ofFAS 123(R), then apply the accelerated non-substantive vesting approach toall subsequent grants to those employees whose options continue to vest afterthe date of retirement eligibility. For the three months ended March 31,2005, had the Company been accounting for such stock options using thenon-substantive vesting approach for retirement-eligible employees, theCompany would have not recognized additional stock-based compensation expense.

In 1997, the Company adopted a stock option plan (the “1997Plan”) for eligible employees, directors and consultants. In 2002, the Companyadopted a stock option plan (the “2002 Plan”) for management and certain keyemployees. Options granted under the plans may be incentive stock optionsintended to satisfy the requirements of Section 422 of the InternalRevenue Code of 1986, as amended, and the regulations thereunder, ornon-qualified options. Options generally become exercisable over a four-yearperiod and expire in ten years. The total number of shares of common stock thatmay be issued under both plans amounted to a maximum of 2,071,051. Options grantedprior to 2002 were granted at exercise prices equal to the preferred stockfinancing prices, which were in excess of the estimated fair value of theunderlying common stock.

In March 2002, the Company offered a stock optionreplacement program for employees, directors and non-employee consultantsparticipating in the existing plan. Under the stock option replacement program,participants were able to elect to cancel their current options and have thoseoptions replaced after six months and one day with options that will have anexercise price equal to the stock’s then-current fair value. Options topurchase a total of 930,250 shares were cancelled under the stock optionreplacement program. On September 30, 2002, six months and 15 daysafter the cancellation of options exchanged under the option replacementprogram, the Company granted options to purchase a total of 929,250 shares ofcommon stock as replacement awards at an exercise price of $1.02, whichrepresented the fair value of the Company’s common stock on that date.

In April 2003, the Company’s Board adopted the2003 Equity Incentive Plan (the “2003 Plan”) under which an additional 928,949shares were authorized for future issuances of common stock. Additionally, theshares available for issuances of common stock options under the 1997 and 2002Plans were transferred to the 2003 Plan for future issuances of common stockoptions. The 2003 Plan contains a provision for an automatic increase in thenumber of shares available for grant starting January 1, 2004 and each January thereafteruntil and including January 1, 2013, subject to certain limitations, by anumber of shares equal to the lesser of: 1) four percent of the number ofshares issued and outstanding on the immediately preceding December 31,2) 1,500,000 shares, or 3) a number of shares set by the Board ofDirectors.

During 2000 and 2001, options to purchase  50,000 and 5,000 shares, respectively, weregranted to non-employee directors or consultants.

In 2002, the Company granted options to purchase265,500 shares of common stock to non-employee consultants, all of which werere-grants under the stock option replacement program. During the three monthsended March 31, 2005, the Company granted options to purchase 25,000shares of common stock to a non-employee consultant. 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 

10

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Selling, Goods andServices.” Under SFAS No. 123 and EITF Issue No. 96-18, stockoption awards issued to non-employees are accounted for at fair value using theBlack-Scholes pricing model. Management believes that the fair value of thestock options is more reliably measured than the fair value of the servicesreceived. Compensation expense related to the fair value of stock optionsgranted to non-employees is recognized over the service period and was determinedusing the Black-Scholes option pricing model using the following assumptions:risk-free interest rate of 4.4%; contractual life ranging from five to tenyears; dividend yield of 0%; and expected volatility of 58%. At each reportingdate, the Company revalues the stock-based compensation expense related tounvested non-employee options using the Black-Scholes option pricing model. Asa result, stock-based compensation will fluctuate with changes in the fairvalue of the Company’s common stock. For non-employee equity awards, deferredstock-based compensation is not reflected in stockholders’ deficit until acommitment date is reached, which is generally the vesting date. In connectionwith the grant of stock options to consultants, the Company recordedstock-based compensation expense in selling, general and administrative expenseof $5 and $63 for the three months ended March 31, 2005 and 2006,respectively.

In accordance with the evergreen provision in the 2003Plan and as approved by the Board of Directors, effective January 1, 2006,the number of shares reserved under the 2003 Plan was increased by 698,901shares. On February 23, 2006, the Compensation Committee of the Board ofDirectors approved a grant of 68,500 shares of restricted stock to executiveofficers pursuant to the 2003 Plan. The shares of restricted stock generallyvest in equal annual installments on each of the four anniversaries followingthe date of grant. Compensation expense on these shares was $32 for the threemonths ended March 31, 2006.

On April 17,2003, the Company’s board adopted the 2003 Employee Stock Purchase Plan and the2003 Foreign Subsidiary Employee Stock Purchase Plan (“ESPP”), under which,subject to certain limitations, the initial aggregate number of shares of stockthat may be issued is 500,000, cumulatively increased on January 1, 2004and each January 1 thereafter until and including January 1, 2013 bythe lesser of: 1) 500,000 shares, 2) one percent of the number ofshares of all classes of common stock of the Company outstanding on that date,or 3) a lesser amount determined by the Board of Directors. Under theESPP, shares are only issued during the second and fourth quarter of each year.The values were estimated at the date of grant using the Black-Scholes optionpricing model with the following weighted average key assumptions for 2005 and2006:

| ** **               | ** ** | **2005** | ** ** | **2006** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
| Risk free  interest rate |       |     | 2.6        | %        |       |   | 4.3 | % |   |
| Expected lives  (years)  |       |     | 1.3        |     |       |   | .5 |   |   |
| Dividend yield           |       |     | 0          | %        |       |   | 0 | % |   |
| Expected volatility      |       |     | 50         | %        |       |   | 58 | % |   |

 

The dividend yield was not calculated because theCompany does not currently expect to pay a dividend. The expected liferepresented the service period. Expected volatility was based on historicalvolatility of the Company’s common stock. The risk-free interest rate was theaverage interest rates of U.S. government bonds of comparable term to theservice period.

In accordance with the evergreen provision in theESPP, the Board of Directors approved an increase in the number of sharesreserved under the ESPP by 100,000 shares, effective January 1, 2006.Compensation expense under the ESPP was $71 for the three months ended March 31,2006.

11

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Thefollowing table summarizes information about stock option activity during thethree months ended March 31, 2006: 

| ** **                                     | ** ** | **Options  Outstanding** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Life (Years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|------------------------------------------------|------------|--------------------------|------------|-----------------------------------------|------------|-------------------------------------------------------------------|------------|---------------------------------|------------|
| Options  outstanding at December 31, 2005 |       |                     | 2,321,552  |                                    |       |                                                              | $          | 12.73                           |       |   |   |   |   |   |   |   |
| Granted                                        |       |                     | 247,750    |                                    |       |                                                              | 18.32      |                            |       |   |   |   |   |   |   |
| Exercised                                      |       |                     | (40,829    | )                                       |       |                                                              | 7.14       |                            |       |   |   |   |   |   |   |
| Expired or cancelled                           |       |                     | —     |                                    |       |                                                              | —     |                            |       |   |   |   |   |   |   |
| Options  outstanding at March 31, 2006    |       |                     | 2,528,473  |                                    |       |                                                              | $          | 13.37                           |       |   |   | 7.90 |   |   | $ | 15,903,000 |   |
| Options  exercisable at March 31, 2006    |       |                     | 1,570,512  |                                    |       |                                                              | $          | 11.14                           |       |   |   | 7.17 |   |   | $ | 13,375,000 |   |

 

| ** **                                            | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                          | ** ** |
|-------------------------------------------------------|------------|------------------------------|------------|-------------------------------------------------------|------------|
| **Range of Exercise Prices**           | ** ** | ** **                   | ** ** | **Number  Outstanding at  March 31,  2006** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Number  Exercisable at   March 31,   2006** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| $ 1.02 – $ 3.07                        |       |                         | 830,023    |                                                  |       |   | 6.50 |   |   |   | $ | 1.02 |   |   |   | 801,074 |   |   |   | 1.02 |   |   |
|    3.08  –    6.16      |       |                         | 7,625      |                                                  |       |   | 3.07 |   |   |   | 4.15 |   |   |   | 7,122 |   |   |   | 4.11 |   |   |
|    6.17  –    9.23 |       |                         | 10,250     |                                                  |       |   | 6.95 |   |   |   | 8.02 |   |   |   | 7,687 |   |   |   | 8.02 |   |   |
|    9.24  –  12.31            |       |                         | 2,750      |                                                  |       |   | 7.05 |   |   |   | 10.59 |   |   |   | 2,625 |   |   |   | 10.55 |   |   |
|  12.32 –  15.40                        |       |                         | 73,500     |                                                  |       |   | 8.46 |   |   |   | 14.18 |   |   |   | 14,875 |   |   |   | 13.69 |   |   |
|  15.41 –  18.47                        |       |                         | 771,250    |                                                  |       |   | 9.15 |   |   |   | 17.08 |   |   |   | 99,206 |   |   |   | 16.33 |   |   |
|  18.48 –  21.55                        |       |                         | 245,325    |                                                  |       |   | 8.81 |   |   |   | 19.90 |   |   |   | 50,173 |   |   |   | 20.15 |   |   |
|  21.56 –  24.63                        |       |                         | 550,500    |                                                  |       |   | 7.88 |   |   |   | 23.10 |   |   |   | 550,500 |   |   |   | 23.10 |   |   |
|  24.64 –  27.71                        |       |                         | 29,750     |                                                  |       |   | 7.68 |   |   |   | 25.94 |   |   |   | 29,750 |   |   |   | 25.94 |   |   |
|  27.72 –  30.79                        |       |                         | 7,500      |                                                  |       |   | 7.52 |   |   |   | 30.79 |   |   |   | 7,500 |   |   |   | 30.79 |   |   |
| $ 1.02 – $30.79                             |       |                         | 2,528,473  |                                                  |       |   | 7.90 |   |   |   | $ | 13.37 |   |   |   | 1,570,512 |   |   |   | 11.14 |   |   |
|                                                       |            |                              |            |                                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

On November 17, 2005, the Compensation Committee (the“Committee”) of the Board of Directors of the Company approved the accelerationof the unvested portion of certain stock options held by employees, officersand directors of the Company. The options that were accelerated have exerciseprices greater than $21.00 per share, which is higher than the $14.76 closingprice of the Company’s common stock as quoted on the Nasdaq National Market onNovember 17, 2005. These options would have vested and become exercisable fromtime to time over the next 32 months. As a result of the acceleration, all ofthese options became fully vested and immediately exercisable. All other termsand conditions applicable to outstanding stock option grants remain in effect.Shares received upon the exercise of accelerated options held by members of theCompany’s Board of Directors and by the Company’s President and Chief ExecutiveOfficer and its Executive Vice Presidents may not be sold or otherwisetransferred prior to the earlier of the original vesting date of such optionsor their termination of employment or service. The Committee’s decision toaccelerate the vesting of the affected stock options was based upon therequired adoption of SFAS No. 123(R).

The aggregate intrinsic value of options exercisedduring the three months ended March 31, 2006 was $427. As of March 31,2006, total remaining unearned compensation related to unvested stock optionswas approximately $6,292, which will be amortized over the weighted-averageremaining service period of 2.1 years.

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Thefollowing table summarizes information about restricted stock activity duringthe three months ended March 31, 2006: 

| ** **                              | ** ** | **Number of  Shares** | ** ** | **Weighted-  Average  Grant-Date  Fair Value** | ** ** |
|-----------------------------------------|------------|----------------------------|------------|-----------------------------------------------------|------------|
| Granted                                 |       |                       | 68,500     |                                                |       |   | $ | 18.32 |   |   |
| Vested                                  |       |                       | —     |                                                |       |   | — |   |   |
| Forfeited                               |       |                       | —     |                                                |       |   | — |   |   |
| Nonvested stock at  March 31, 2006 |       |                       | 68,500     |                                                |       |   | $ | 18.32 |   |   |

 

As of March 31, 2006,total remaining unearned compensation related to restricted stock was $1,223,which will be amortized over the weighted-average remaining service period of2.4 years.

**Note 8—Commitmentsand Contingencies**

**Indemnities,Commitments and Guarantees**

In the normal course ofbusiness, the Company makes certain indemnities, commitments and guaranteesunder which the Company may be required to make payments in relation to certaintransactions. These indemnities, commitments and guarantees include, amongothers, intellectual property indemnities to customers in connection with thesale of products and licensing of technology, indemnities for liabilitiesassociated with the infringement of other parties’ technology based upon theCompany’s products and technology, guarantees of timely performance of theCompany’s obligations, and indemnities to the Company’s directors and officersto the maximum extent permitted by law. The duration of these indemnities,commitments and guarantees varies, and in certain cases, is indefinite. Themajority of these indemnities, commitments and guarantees do not provide forany limitation of the maximum potential future payments that the Company couldbe obligated to make. The Company has not recorded a liability for theseindemnities, commitments or guarantees in the accompanying balance sheets, asfuture payment is not probable.

**Note 9—OperatingSegment and Geographic Information**

The Company operates its business in three reportablesegments: the Cinema business segment, the Consumer business segment and theDigital Images business segment. The Cinema business segment licensestechnology and sells products and services to producers and distributors offeature length films and digital content, and to movie theaters and specialvenues. The Company’s Consumer business segment licenses audio technology, trademarksand know-how to consumer electronics, personal computer, broadcast andprofessional audio companies, and sells multi-channel audio content andproducts to consumers. The Company’s Digital Images business segment providesrestoration, enhancement and repair services for moving pictures captured onfilm or in digital form, television content, and other forms of image content.

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

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TheCompany’s reportable segments and geographical information for the three monthsended March 31, 2005 and 2006 are as follows:

| ** **               | ** ** | **Revenues**                                                       | ** ** |
|--------------------------|------------|--------------------------------------------------------------------|------------|
| ** **               | ** ** | **For the Three Months  Ended March 31,** | ** ** |
| ** **               | ** ** | **2005**                                                           | ** ** | **2006** | ** ** |
| Cinema business          |       | $                                                                  | 4,796      |   | $ | 5,427 |   |
| Consumer business        |       | 16,541                                                             |       | 20,682 |   |
| Digital Images  business |       | 720                                                                |       | 2,592 |   |
| Total revenues           |       | $                                                                  | 22,057     |   | $ | 28,701 |   |

 

| ** **               | ** ** | **Gross Profit**                                              | ** ** |
|--------------------------|------------|--------------------------------------------------------------------|------------|
| ** **               | ** ** | **For the Three Months  Ended March 31,** | ** ** |
| ** **               | ** ** | **2005**                                                           | ** ** | **2006** | ** ** |
| Cinema business          |       | $                                                                  | 2,173      |   | $ | 2,375 |   |
| Consumer business        |       | 16,001                                                             |       | 20,324 |   |
| Digital Images  business |       | (580                                                               | )          | (140 | ) |
| Total gross  profit      |       | $                                                                  | 17,594     |   | $ | 22,559 |   |

 

| ** **                    | ** ** | **Income (Loss) From  Operations**                       | ** ** |
|-------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                    | ** ** | **For the Three Months  Ended March 31,** | ** ** |
| ** **                    | ** ** | **2005**                                                           | ** ** | **2006** | ** ** |
| Cinema business               |       | $                                                                  | (1,019     | ) | $ | (1,718 | ) |
| Consumer business             |       | 10,113                                                             |       | 13,153 |   |
| Digital Images  business      |       | (3,938                                                             | )          | (1,492 | ) |
| Total income from  operations |       | $                                                                  | 5,156      |   | $ | 9,943 |   |

 

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,** | ** ** |
| ** **     | ** ** | **    2005    **           | ** ** | **    2006    ** | ** ** |
| United States  |       | $                                                                  | 9,379      |   | $ | 6,735 |   |
| International  |       | 12,678                                                             |       | 21,966 |   |
| Total revenues |       | $                                                                  | 22,057     |   | $ | 28,701 |   |

 

Thefollowing table sets forth, for the periods indicated, long-lived tangibleassets by geographic area in which the Company holds assets at December 31,2005 and March 31, 2006:

| ** **               | ** ** | **Long-Lived Assets**              | ** ** |
|--------------------------|------------|-----------------------------------------|------------|
| ** **               | ** ** | **As of  December 31,  2005** | ** ** | **As of  March 31,  2006** | ** ** |
| United States            |       |                                    | $          | 5,859 |   |   |   | $ | 6,917 |   |   |
| International            |       |                                    | 1,516      |   |   |   | 1,498 |   |   |
| Total long-lived  assets |       |                                    | $          | 7,375 |   |   |   | $ | 8,415 |   |   |

 

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**Note 10—Net IncomePer Common Share**

Basic net income per common share is calculated bydividing net income by the weighted average number of common shares outstandingduring the period. Diluted net income per common share is calculated bydividing net income by the sum of the weighted average number of common sharesoutstanding plus the dilutive effect of unvested restricted stock, outstandingstock options, and common stock warrants using the “treasury stock” method.

Thefollowing table sets forth the computation of basic and diluted net income percommon share:

| ** **                                 | ** ** | **For the Three Months  Ended March 31,** | ** ** |
|--------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                 | ** ** | **2005**                                                           | ** ** | **2006** | ** ** |
| Basic net income  per common share:        |       |                                                               |       |   |   |
| Numerator:                                 |       |                                                               |       |   |   |
| Net income                                 |       | $                                                                  | 3,556      |   | $ | 7,007 |   |
| Denominator:                               |       |                                                               |       |   |   |
| Weighted average common shares outstanding |       | 17,080,005                                                         |       | 17,494,844 |   |
| Basic net income per common share          |       | $                                                                  | 0.21       |   | $ | 0.40 |   |
| Diluted net income per common share:       |       |                                                               |       |   |   |
| Numerator:                                 |       |                                                               |       |   |   |
| Net income                                 |       | $                                                                  | 3,556      |   | $ | 7,007 |   |
| Denominator:                               |       |                                                               |       |   |   |
| Weighted average shares outstanding        |       | 17,080,005                                                         |       | 17,494,844 |   |
| Effect of dilutive securities:             |       |                                                               |       |   |   |
| Common stock options                       |       | 946,957                                                            |       | 775,674 |   |
| Common stock warrants                      |       | 239,132                                                            |       | 21,145 |   |
| Diluted shares  outstanding                |       | 18,266,094                                                         |       | 18,291,663 |   |
| Diluted net  income per common share       |       | $                                                                  | 0.19       |   | $ | 0.38 |   |

 

For the three months endedMarch 31, 2005 and 2006, 738,268 and 1,144,075 shares, respectively, ofthe Company’s stock options and restricted stock were excluded from thecalculation of diluted earnings per share because their inclusion would havebeen anti-dilutive.

**Note 11—SubsequentEvent**

On April 17, 2006, the Company acquired for$1,000 Digital Booking Systems (“DBS”) from FilmStew International, Inc.DBS is an application service provider that enables cinema exhibitors anddistributors to manage communications via the internet. DBS allows exhibitorsand distributors to conduct business online by accelerating the process ofbooking playdates, scheduling showtimes, programming trailers, tracking dataand facilitating film rental payments.

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**Item 2.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations

**Forward-Looking Statements May Prove Inaccurate**

This Form 10-Qand the 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 theother documents we file with the Securities and Exchange Commission, or SEC,including our most recent reports on Form 8-K and Form 10-K.We cannot 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 DTS DI, we have expanded our business into high quality digital imageprocessing, enhancement and restoration for motion pictures, digital cinema,and television content.

We manage our businessthrough three reportable segments—our consumer business, our cinema business,and our digital images business.

In our consumer business,we derive revenues from licensing our audio technology, trademarks, andknow-how under agreements with substantially all of the major consumer audioelectronics manufacturers. Our business model provides for these manufacturersto pay us a per-unit amount for DTS-enabled products that they manufacture. Wealso derive revenues from licensing our technology to consumer semiconductormanufacturers. Through our DTS Entertainment label, we derive revenues from thesale of multi-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 Digital Cinema,pre-show advertising, alternative content, subtitling, captioning, anddescriptive narration.

In our digital imagesbusiness, we derive revenues from the processing, enhancement and restorationof cinema, home video and broadcast television content. We provide theseservices to motion picture and 

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televisionstudios and other content owners. We offer our services on either a fixed feeor 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 our digitalmulti-channel format and sales of our professional audio products and services.Revenues from product sales and other revenues in connection with our cinemabusiness segment include revenues derived from sales of our digital playbacksystems, cinema processor equipment, and systems for subtitling, captioning,and descriptive narration to movie theaters and special venues. Revenues fromproduct sales and other revenues in connection with our digital images businesssegment include fees for processing, enhancing and restoring cinema, home videoand 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 revenue from our intellectual property. 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 occur in subsequent periods. While we considersuch revenues to be a regular part our normal operations, we cannot predict theamount or timing of such revenues.

Our cost of goods soldconsists primarily of amounts paid for products and materials, salaries andrelated benefits for production personnel, depreciation of productionequipment, amortization of acquired intangibles and payments to third partiesfor licensing technology and copyrighted 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, HongKong and Northern Ireland. We sell music content released under our DTSEntertainment label through exclusive distribution arrangements in 

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theUnited States, Europe and Japan. We employ consultants to coordinate sales toindependent retailers and we sell this music directly to consumers through anonline store and other web-based retailers.

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 independentdealers. To date, most of our sales and marketing efforts have been focused inthe United States and Canada, Western Europe, and in targeted markets in Asiaand Latin 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, China, and 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. Our digital images services enable current orarchived film content to be enhanced or restored for high quality, highdefinition presentation in digital cinema, high definition optical media orbroadcast applications.

**Management Discussion Regarding Trends, Opportunities,and Challenges**

Consumer Segment

Revenue from our consumersegment constitutes the majority of our total revenue, representing 72% and75% of total revenues for the quarters ended March 31, 2006 and 2005,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 recently experienced softness in our DVD playertrademark licensing program, and expect growth rates in this area to declinefrom recent levels. The success of DVD-Video-based systems and products hasfueled a demand for higher quality entertainment in the home, and this demandis extending to the car audio and personal computer markets as well. Inaddition, we expect the recent acceleration of the market for high definitiontelevisions to drive demand for high definition optical disc players beginningin 2006. Because we have been selected as a mandatory technology for nextgeneration players, our consumer revenue growth should more closely track thegrowth rate of these players over the next several years. We expect that themarket for high definition players will yield new growth that provides anoffset to the expected decline in the overall growth in DVD player shipments.Further, we believe that expected mandatory inclusion in next generationoptical disc standards will help to improve the adoption rate of ourtechnologies in other consumer products such as next generation video gameconsoles, personal audio and video players, personal computers and in-carentertainment systems. If we are removed from mandatory status in nextgeneration high definition optical disc standards, it would cause revenuegrowth in our consumer business to be significantly lower than expected andwould 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 existingresearch and development efforts and the intellectual property acquired in theQDesign acquisition, we launched our DTS-HD initiative. This technology is a scalablecoding system that will allow content to be played in home and portabledevices. We believe that the broad and robust nature of this offering improvesthe probability of inclusion of our technologies in next generation products.

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Cinema Segment

Revenue from our cinemasegment represented 19% and 22% of total revenues for the quarters ended March 31,2006 and 2005, respectively. We expect growth in our cinema audio hardwarebusiness to continue at a modest pace throughout the remainder of 2006. We alsobelieve that the cinema exhibition community has recognized that pre-showentertainment represents a significant revenue growth opportunity that willlead to investment in pre-show solutions over the next several years. Becauseour XD10 Cinema Media Player can be configured to perform audio playback alongwith pre-show and subtitling presentation, we believe that we arewell-positioned to participate in the anticipated growth in this market.

A trend 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, our current digital cinema offeringsare limited and we may not be successful in developing or selling competitiveproduct offerings. We believe that the addition of our Cinema Media Network andvariable bit rate JPEG 2000 encoding tools, along with the services provided byour digital images business, and the pre-show and alternative contentcapabilities of our XD10 Cinema Media Player, will enhance our ability toparticipate 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 a result of the closures, sales of our playbacksystems and cinema processors suffered. As the theater industry has regainedhealth in the last several years, sales of our DTS playback systems and cinemaprocessors have improved. Our film licensing revenues are also subject tofluctuations based on industry trends, most significantly, the number of filmsbeing made by studios and independent filmmakers.

Digital Images Segment

Revenue from our digitalimages segment represented 9% and 3% of total revenues for the quarters ended March 31,2006 and 2005, respectively. We believe that the growing market for highresolution and high definition content in the cinema and the home will create asubstantial demand for the type of services provided by DTS DI. We believe thatwe have a technological advantage over many of our competitors based on thesophistication of our processes and level of automation used to enhance theimage quality of entertainment content. Revenues in this business totaled $2.6million and $720,000 for the three months ended March 31, 2006 and 2005,respectively. To date, this business has restored and/or enhanced over 100feature films, including such major DVD releases as Star Wars and IndianaJones. Major motion picture and television studios possess libraries containingthousands of titles, which we believe represent a sizable market opportunityfor the services performed by DTS DI.

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**Critical Accounting 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 these estimates.There has been no material change to our critical accounting policies andestimates from the information provided in our Form 10-K filed on March 16,2006, except for the adoption of SFAS No. 123(R).

**Results of Operations**

***Revenues***

*Technology and Film Licensing*

Technology and filmlicensing revenues for the three months ended March 31, 2006 increased 24%to $22.8 million from $18.5 million for the three months ended March 31,2005. The increase in revenues from technology and film licensing was primarilyattributable to an increase in royalty recoveries of $3.6 million fromintellectual property compliance and enforcement activities. These activities,which include audits of shipments by certain of our licensees and legal actionstaken against licensees and parties who are not our licensees, resulted inrecoveries of royalty payments relating to prior periods. We are experiencingstrong growth in the personal computer and car audio systems markets, whichposted quarter over quarter growth totals of 32% and 63%, respectively, duringthe first quarter of 2006. We remain cautious in our outlook due touncertainties surrounding the consumer electronics market. Overall, we continueto expect technology licensing revenues to grow modestly for 2006, based primarilyon the expected continuation of growth in our decoder licensing program andfrom our license enforcement activities. Our film licensing revenues increasedslightly for the three months ended March 31, 2006 compared to the prioryear due to additional releases in the DTS format and the timing of majorfeature film releases. Film licensing is expected to grow modestly throughoutthe remainder of 2006.

*Product Sales and Other*

Product sales and otherrevenues increased 63% to $5.9 million for the three months ended March 31,2006 from $3.6 million for the three months ended March 31, 2005.This increase was primarily attributable to growth in revenues generated by DTSDI, which we acquired in January 2005, along with an increase in Cinemahardware sales resulting in part from the recognition of deferred revenuerelated to our arrangement with Cinecom. Product sales and other revenue isexpected to grow at a modest rate throughout the remainder of 2006, as wecontinue to expect market interest in multi-function playback devices todevelop at a measured pace.

*Segment Sales*

Revenues from our consumerbusiness totaled $20.7 million for the three months ended March 31, 2006,an increase of 25% from $16.5 million for the three months ended March 31,2005. The increase in revenues was driven primarily by an increase in royaltyrecoveries mentioned above as well as the overall growth in our personalcomputer and car audio markets. Cinema revenues totaled $5.4 million for the 

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threemonths ended March 31, 2006, an increase of 13% from $4.8 million forthe three months ended March 31, 2005. The increase in revenue wasprimarily due to the increase in Cinema hardware sales mentioned above.Revenues from our digital images business totaled $2.6 million for the threemonths ended March 31, 2006, a significant increase from revenues of$720,000 for the three months ended March 31, 2005. The increase inrevenues was primarily due to the recognition of $1.4 million in deferredrevenue and ongoing improvements in the Company’s digital restoration andenhancement process.

***Gross Profit***

Consolidated gross profitdecreased to 79% of revenues for the three months ended March 31, 2006,from 80% for the three months ended March 31, 2005. We expect consolidatedgross margins in the 70% to 75% range for 2006 primarily as a result of theincorporation of DTS DI into our consolidated results of operations.

*Technology and Film Licensing*

Gross profit associatedwith technology and film licensing revenues increased slightly to 94% for thethree months ended March 31, 2006 from 93% of related revenues for thesame period in the prior year.

*Product Sales and Other*

Gross profit associatedwith product sales and other revenues increased to 17% of related revenues forthe three months ended March 31, 2006 from 11% in the prior year periodprimarily as a result of a reduction in the magnitude of the negative marginsgenerated by our digital images business.

*Segment Gross Profit*

Gross profit for ourconsumer business increased slightly to 98% of related revenues for the quarterended March 31, 2006 from 97% in the prior year period. Our cinemabusiness gross profit decreased slightly to 44% of related revenues for thequarter ended March 31, 2006 from 45% in the prior year period primarilydue to the continued change in mix to lower margin product sales from thehigher margin film licensing. Our digital images business experienced negativegross margins as we continue to be affected by the cost impact of certainlegacy projects, and the amortization of acquired intangibles of $244,000. Weexpect margins in the digital images business to improve throughout theremainder of the year as revenues continue to increase and as the businessfocuses on more financially attractive segments of the image restoration andenhancement market.

***Selling,General and Administrative***

Selling, general andadministrative expenses increased 23% to $9.9 million for the three monthsended March 31, 2006, compared to $8.0 million in the prior year period.The increase is primarily due to an increase in compensation expense of $1.7million due to additional employees and the inclusion of $496,000 related toSFAS No. 123(R).

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, 2006, research and development expenses were $2.7 million,compared to $2.1 million for the three months ended March 31, 2005.The change is primarily due to increased labor costs associated with newproduct and technology initiatives, the optimization of our Coherent Acousticstechnology, and the development of tools associated with next generationoptical disc standards and additional expense of $105,000 related to SFAS No. 123(R).

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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 for the three months ended March 31, 2005relates to development projects that had not reached technological feasibilityand were of no future alternative use and expensed upon consummation of theacquisition of DTS DI. Developed technology and in-process research anddevelopment were identified and valued through extensive interviews, analysisof data provided by DTS DI concerning development projects, their stage ofdevelopment, the time and resources needed to complete them, if applicable, andtheir expected income generating ability and associated risks. Wheredevelopment projects had reached technological feasibility, they wereclassified as developed technology and the value assigned to developedtechnology was capitalized. The income approach, which includes an analysis ofthe cash flows and risks associated with achieving such cash flows, was theprimary technique utilized in valuing acquired in-process research anddevelopment. Key assumptions for in-process research and development included adiscount rate of 30% and estimates of revenue growth, cost of sales, operatingexpenses and taxes.

***Interest Income,Net***

Interest income, net, forthe three months ended March 31, 2006 increased due to the increase ininterest rates in 2006 and additional funds invested.

***Income Taxes***

For the three months endedMarch 31, 2006, we recorded an income tax provision of $4.0 million onpre-tax income of $11.0 million. This resulted in an annualized effective taxrate of 36.4%. For the three months ended March 31, 2005, we recorded anincome tax provision of $1.9 million on pre-tax income of $5.5 million. Thisresulted in an annualized effective tax rate of 35.3%. These rates differedfrom the statutory rates primarily due to state income taxes offset by benefitsassociated with the foreign rate differentials. We expect the effective taxrate for 2006 will be approximately 36% to 37%.

**Liquidity and Capital Resources**

At March 31, 2006, wehad cash, cash equivalents and short-term investments of $119.2 million,compared to $111.4 million at December 31, 2005.

Net cash provided byoperating activities was $9.4 million for the three months ended March 31,2006, compared to $1.7 million for the three months ended March 31, 2005.The primary source of operating cash flow for the three months ended March 31,2006 was net income of $7.0 million adjusted for non-cash items includingdepreciation and amortization expense and stock-based compensation charges.

Net cash used in investingactivities totaled $13.3 million for the three months ended March 31,2006, compared to net cash provided by investing activities of $8.9 million forthe three months ended March 31, 2005. Cash used in investing activitiesfor the three months ended March 31, 2006 primarily consists of netpurchases of investments of $11.3 million and purchases of property andequipment of $1.8 million.

Net cash provided byfinancing activities totaled $404,000 and $76,000 for the three months endedMarch 31, 2006 and 2005, respectively, and consists of the exercise ofstock options and related excess tax benefits. Prior to adoption of SFASNo. 123(R), excess tax benefits from exercise of stock options were shownas an operating cash inflow.

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In 2005, we entered intoan agreement for the purchase and implementation of a new enterprise resourceplanning system, or ERP, for approximately $747,000. We expect that we willincur additional costs in the range of $2 to $4 million over the next severalyears in connection with our ERP implementation.

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. We anticipate renewing our $10 millionexisting bank line of credit facility, which expires on June 30, 2006.Beyond the next twelve months, additional financing may be required to fundworking capital and capital expenditures. Changes in our operating plans, lowerthan anticipated revenues, increased expenses, acquisition of companies,products or technologies or other events, including those described in “RiskFactors” included elsewhere herein, in our Form 10-K filed on March 16,2006 and in other filings may cause us to seek additional debt or equityfinancing on an accelerated basis. Financing may not be available on acceptableterms, or at all, and our failure to raise capital when needed could negativelyimpact our growth plans and our financial condition and results of operations.Additional equity financing may be dilutive to the holders of our common stockand debt financing, if available, may involve significant cash paymentobligations and financial or operational covenants that restrict our ability tooperate our business.

**Recently Issued Accounting Standards**

In June 2005, theFASB issued SFAS No. 154, “Accounting Changes and Error Corrections, areplacement of APB Opinion No. 20, Accounting Changes, and Statement No. 3,Reporting Accounting Changes in Interim Financial Statements.” SFAS No. 154changes the requirements for the accounting for, and reporting of, a change inaccounting principle. Previously, most voluntary changes in accountingprinciples were required to be recognized by way of a cumulative effectadjustment within net income during the period of the change. SFAS No. 154requires retrospective application to prior periods’ financial statements,unless it is impracticable to determine either the period-specific effects orthe cumulative effect of the change. SFAS No. 154 is effective foraccounting changes made in fiscal years beginning after December 15, 2005;however, the Statement does not change the transition provisions of anyexisting accounting pronouncements. The adoption of SFAS No. 154 didnot have a material effect on the Company’s consolidated financial position,results of operations or cash flows.

In December 2004, theFASB finalized SFAS No. 123(R), “Share-Based Payment,” which requirescompanies to measure and recognize compensation costs for all share-basedpayments (including stock options) at fair value, effective for interim orannual periods beginning after June 15, 2005. On April 15, 2005, theU.S. Securities and Exchange Commission (the “SEC”) announced a deferral of theeffective date of SFAS No. 123(R) until the first interim or annualreporting period of the first fiscal year beginning on or after June 15,2005. Effective January 1, 2006, the Company adopted the provisions ofSFAS No. 123(R) as discussed in Footnote 7, Stock-BasedCompensation.

Prior to adoption of SFAS No. 123(R),the Company presented all tax benefits of deductions resulting from theexercise of stock options as operating cash flows in the ConsolidatedStatements of Cash Flows. SFAS No. 123(R) requires the cash flowsresulting from the tax benefits resulting from tax deductions in excess of thecompensation cost recognized for those options (excess tax benefits) to beclassified as financing cash flows.

**Item 3.**                        Quantitativeand Qualitative Disclosures About Market Risk

Market risk represents therisk of loss arising from adverse changes in market rates and foreign exchangerates. At March 31, 2006, 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.

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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-termmarketable securities, U.S. government securities and corporate bonds. Due tothe nature and maturity of our short-term investments, we have concluded thatthere is no material market risk exposure to our principal. The averagematurity of our investment portfolio is less than one month. As of March 31,2006, a 1% change in interest rates throughout a one-year period would have anannual effect of approximately $1.2 million on our income.

We derive in the range ofhalf to two-thirds of our revenues from sales outside the United States, andmaintain research, sales, marketing, or business development offices in ninecountries. Therefore, our results could be negatively affected by such factorsas changes in foreign currency exchange rates, trade protection measures,longer accounts receivable collection patterns, and changes in regional orworldwide economic or political conditions. The risks of our internationaloperations are mitigated in part by the extent to which our revenues aredenominated in U.S. dollars and, accordingly, we are not exposed to significantforeign currency risk on these items. We do have limited foreign currency riskon certain revenues and operating expenses such as salaries and overhead costsof our foreign operations and a small amount of cash maintained by theseoperations. Revenues denominated in foreign currencies accounted forapproximately 6.2% of total revenues during the first quarter of 2006.Operating expenses, including cost of sales, for our foreign subsidiaries wereapproximately $4.4 million in the first quarter of 2006. Based upon theexpenses for the first quarter of 2006, a 1% change in foreign currency ratesthroughout a one-year period would have an annual effect of approximately$176,000.

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 byexchange rate fluctuations as the financial statements of our foreignsubsidiaries are translated into the United States dollar in consolidation. Asexchange rates vary, these results, when translated, may vary from expectationsand could adversely or positively impact overall profitability. During thefirst quarter of 2006, the positive impact of foreign exchange ratefluctuations related to translation of our foreign subsidiaries’ financialstatements was $46,000.

**Item 4.**                        Controlsand Procedures

**Disclosure Controls and Procedures**

We maintain disclosurecontrols and procedures (as defined in Rules 13a-l5(e) and 15(d)-15(c) ofthe Securities Exchange Act of 1934, as amended (the “Exchange Act”)) that aredesigned to ensure that information required to be disclosed in the reports wefile or submit under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in the rules and forms of theSecurities and Exchange Commission and that such information is accumulated andcommunicated to our management, including our chief executive officer and chieffinancial officer, as appropriate, to allow for timely decisions regardingrequired disclosure.

We carried out anevaluation, under the supervision and with the participation of our management,including our chief executive officer and chief financial officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures as of the end of the quarter covered by this report. Based on theforegoing, our chief executive officer and chief financial officer concludedthat our disclosure controls and procedures were effective.

There has been no changein our internal controls over financial reporting during our most recent fiscalquarter that has materially affected, or is reasonably likely to materiallyaffect, our internal controls over financial reporting.

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**PART IIOTHER INFORMATION**

**Item 1.**                        LegalProceedings

None.

**Item 1A.**                RiskFactors

Set forth below and elsewhere in this report and inother documents we file with the SEC are risks and uncertainties that couldcause our actual results to differ materially from the results contemplated bythe forward-looking statements contained in this report and other publicstatements we make. If any of the following risks actually occurs, ourbusiness, financial condition, or results of operations could suffer. In that case,the trading price of our common stock could decline, and you may lose all orpart of your investment.

The risk factorsdescribed below do not contain any material changes from the Risk Factorsdescribed under Item 1A of Part I of our Annual Report on Form 10-Kfiled on March 16, 2006, except as follows:

·       wehave added a new risk factor below under the heading “Issues arising from theimplementation of our new enterprise resource planning system could affect ouroperating results and ability to manage our business effectively” and

·       following our adoption ofSFAS 123(R) on January 1, 2006, we have deleted the risk factor thatwas titled “Accounting for employee stock options using the fair value methodwill reduce our net income.”

**RisksRelated to Our Business**

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

The digital audio,digital imaging, 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., Ultra Stereo Labs, Inc.,Eastman Kodak Company, Screenvision Cinema Network LLC, National CineMedia LLC,and Unique Digital Ltd.;

·       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 WarnerBros. Entertainment, Inc.; and

·       productsfor image processing including da Vinci Systems, LLC, Digital Vision AB,Mathematical Technologies, Inc., Pixel Farm Ltd., Snell and Wilcox,Teranex Incorporated, and The Foundry Visionmongers Ltd.

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

·       greatername recognition;

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·       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 productcategories that DTS has not, including DVD-Video and DVD-Audio Recordable, forits stereo technology and terrestrial digital television broadcasts in theUnited States. As a result of these factors, Dolby has a competitive advantagein selling its digital multi-channel audio technology to consumer electronicsproducts manufacturers.

Sony Corporation is both acompetitor and a significant customer in most of our markets. If Sony decidesto eliminate the use of our technology in its products or to compete with usmore aggressively in our markets, the revenues that we derive from Sony wouldbe 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 Standard andHigh-Definition DVD and Blu-ray. In the emerging standards for highdefinition-DVD and Blu-ray, both DTS and Dolby technologies have been selectedas mandatory standards for two-channel output. However, if either or both ofthese standards are re-examined or a new standard is developed, we maynot be included as mandatory in any such new or revised standard.

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 andentertainment media emerge, new standards relating to these technologies ormedia may develop. New standards may also emerge in existing markets that arecurrently characterized 

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by competingformats, such as the market for personal computers. We may not be successful inour efforts to include our technology in any such standards.

***We may not be ableto evolve our technology, products, and services or develop new technology,products, and services that are acceptable to our customers or the changingmarket.***

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 willdepend on our ability to enhance our existing technology, products, andservices and to develop acceptable new technology, products, and services on atimely basis. The development of enhanced and new technology, products, andservices is a complex and uncertain process requiring high levels ofinnovation, highly-skilled engineering and development personnel, and theaccurate anticipation of technological and market trends. We may not be able toidentify, develop, market, or support new or enhanced technology, products, orservices on a timely basis, if at all. Furthermore, our new technology,products, and services may never gain market acceptance, and we may not be ableto respond effectively to evolving consumer demands, technological changes,product announcements by competitors, or emerging industry standards. Forexample, we may not be able to effectively address concerns in the film andmusic industries relating to piracy in our current or future products. Anyfailure to respond to these changes or concerns would likely prevent ourtechnology, products, and services from gaining market acceptance ormaintaining market share.

***Declining retailprices for consumer electronics products or video content could force us tolower the license or other fees we charge 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 consumervideo products is also intensely competitive and price sensitive. Retail pricesfor consumer video products that have been processed, enhanced or restored byus, such as movies, concerts or animated content released on DVD or othermedia, have experienced price pressure and we expect this price pressure tocontinue for the foreseeable future. Declining prices for such video productscould create downward pressure on the fees we currently charge our customersfor the image processing, enhancement and restoration services we provide. Ifthe motion picture studios, content owners, producers or distributors were tobelieve that the existing image quality is satisfactory or that the pricing forour services is too high, they could decide to not use our services altogether.

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

Protection of ourintellectual property is critical to our success. Patent, trademark, copyright,and trade secret laws and confidentiality and other contractual provisionsafford only limited protection and may not adequately protect our rights orpermit us to gain or keep any competitive advantage. We face numerous risks inprotecting our intellectual property 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;

·       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 ofprotecting our intellectual property rights and brands may not be adequate.Furthermore, despite our efforts, third parties may violate, or attempt toviolate, our intellectual property rights. Infringement claims and lawsuitswould likely be expensive to resolve and would require management’s time andresources. In addition, we have not sought, and do not intend to seek, patentand other intellectual property protections in all foreign countries. Incountries where we do not have such protection, products incorporating ourtechnology may be lawfully produced and sold without a license.

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

Companies that participatein the digital audio, digital image processing, consumer electronics, andentertainment industries hold a large number of patents, trademarks, andcopyrights, and are frequently involved in litigation based on allegations ofpatent infringement or other violations of intellectual property rights.Intellectual property disputes frequently involve highly complex and costlyscientific matters, and each party generally has the right to seek a trial byjury which adds additional costs and uncertainty. Accordingly, intellectualproperty disputes, with or without merit, could be costly and time consuming tolitigate or settle, and could divert management’s attention from executing ourbusiness plan. In addition, our technology and products may not be able towithstand any third-party claims or rights against their use. If we were unableto obtain any necessary license following a determination of infringement or anadverse determination in litigation or in interference or other administrativeproceedings, we may need to redesign some of our products to avoid infringing athird party’s rights and could be required to temporarily or permanentlydiscontinue licensing our products.

***Our operatingresults may be adversely affected as a result of required compliance with therecently adopted European Union Directives on Waste Electrical and ElectronicEquipment and the Restriction of the Use of Hazardous Substances in electricaland electronic equipment.***

In February 2003, the European Union enactedDirective 2002/96/EC on Waste Electrical and Electronic Equipment Directive,known as the WEEE Directive. The WEEE Directive requires producers 

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of certain electrical and electronicequipment to be financially responsible for the future disposal costs of thisequipment. Our cinema products may fall within the scope of this Directive andas such we may incur some financial responsibility for the collection,recycling, treatment and disposal of both new products sold, and productsalready sold prior to the WEEE Directive’s enforcement date, to customerswithin the European Union. The Directive potentially increases our financialliabilities by requiring producers to adopt new approaches for improvingsustainable product design and for encouraging recycling or re-use at the endof the product’s life.

At the same time, the European Union also enactedDirective 2002/95/EC on the Restriction of the use of Hazardous Substances inelectrical and electronic equipment, known as the RoHS Directive. ThisDirective restricts the use of certain hazardous substances, including mercury,lead, cadmium, hexavalent chromium and certain flame retardants, used in theconstruction of component parts of electrical and electronic equipment. We mayneed to change our manufacturing processes, and to redesign or reformulateproducts regulated under the RoHS Directive to eliminate these hazardoussubstances in our products, in order to be able to continue to offer them forsale within the European Union. For some products, substituting certaincomponents containing regulated hazardous substances may be more difficult orcostly, and the additional redesign efforts could result in production delays.

Individual European Union member states are requiredto transpose the Directives into national legislation. Although not allEuropean Union member states have enacted legislation to implement these twodirectives, we continue to review the applicability and impact of bothdirectives on the sale of our cinema products within the European Union.

We may incur increased manufacturing costs orproduction delays to comply with future legislation which implements thesedirectives, but we cannot currently estimate the extent of such increased costsor production delays. However, to the extent that such cost increases or delaysare substantial, our operating results could be materially adversely affected.In addition, we are aware of similar legislation which may be enacted in othercountries, such as China, and possible new federal and state legislation in theUnited States, the cumulative impact of which could significantly increase ouroperating costs and adversely affect our operating results.

The WEEE Directive and theRoHS Directive are aimed mainly at mass market consumer electronics and thus,will impact many of our customers who license our technology and pay usroyalties upon the manufacture of electronic products. If the directives resultin fewer licensed consumer electronics products being sold, whether due toprice increases, production delays, compromised product performance due toreformulation or redesign, or for other reasons, then we will receive lessrevenue in royalties. If the directives materially impair or inhibit suchsales, the reduction in licensing revenue could adversely affect our operatingresults.

***If we are unable tomaintain and increase the amount of entertainment content released with DTSaudio soundtracks, demand for the technology, products, and services that weoffer to consumer electronics products manufacturers may significantly decline.***

We expect to derive asignificant percentage of our revenues from the technology, products, andservices that we offer to manufacturers of consumer electronics products. Todate, the most significant driver for the use of our technology in the hometheater market has been the release of major movie titles with DTS audiosoundtracks. We also believe that demand for our DTS audio technology inemerging markets for multi-channel audio, including homes, cars, personalcomputers, and video games and consoles, will be based on the number, quality,and popularity of the audio DVDs, computer software programs, and video gamesreleased with DTS audio soundtracks. Although we have existing relationshipswith many leading providers of movie, music, computer, and video game content,we do not have contracts that require any of these parties to develop andrelease content with DTS audio soundtracks. In addition, 

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we maynot be successful in maintaining existing relationships or developingrelationships with other existing providers or new market entrants that providecontent. As a result, we cannot assure you that a significant amount of contentin movies, audio DVDs, computer software programs, video games, or otherentertainment mediums will be released with DTS audio soundtracks. If theamount, variety, and popularity of entertainment content released with DTSaudio soundtracks do not increase, consumer electronics products manufacturersthat pay us per-unit licensing fees may discontinue offering DTS playbackcapabilities in the consumer electronics products that they sell.

***If our independentregistered public accounting firm is unable to provide us with an unqualifiedreport as to the adequacy of our internal controls over financial reporting forfuture year-ends as required by Section 404 of the Sarbanes-OxleyAct of 2002, investors could lose confidence in the reliability of ourfinancial statements, which could result in a decrease in the value of ourshares.***

As directed by Section 404of the Sarbanes-Oxley Act of 2002, the SEC adopted rules requiringall public companies, including us, to include a report by management oninternal control over financial reporting in all annual reports on Form 10-Kthat contains an assessment by management of the effectiveness of internalcontrol over financial reporting. In addition, the independent registeredpublic accounting firm auditing our financial statements must attest to and reporton our management’s assessment of the effectiveness of internal control overfinancial reporting and the effectiveness of internal control over financialreporting. While we conduct rigorous reviews of our internal control overfinancial reporting in order to comply with the Section 404 requirements,our independent registered public accounting firm may interpret the Section 404requirements and the related rules and regulations differently from us, orour independent registered public accounting firm or management may not besatisfied with our internal control over financial reporting or with the levelat which these controls are documented, executed or reviewed. In addition, manyuncertainties remain regarding the requirements for auditor attestation, andguidance provided by the public accounting profession has changed frequentlyand materially to date and may continue to change such that we may not be ableto comply with these new requirements. Further, the demand for competent auditresources has grown dramatically as a result of the requirements of Section 404,and such demand may exceed available supply. In addition, in January 2005,we acquired DTS DI, a privately held company with limited financial resourcesthat may not have implemented sufficient internal control over financialreporting. We may in the future make additional acquisitions which may besignificant to our operations either individually or in the aggregate. We mayface significant challenges in implementing the required processes andprocedures in the acquired operations of DTS DI or any other businesses that wemay acquire. As a result, our independent registered public accounting firm mayissue an adverse report or a disclaimer on management’s assessment of internalcontrol over financial reporting. Management may also identify materialweaknesses which would cause management to conclude internal control overfinancial reporting is not effective. This could result in an adverse reactionin the financial markets due to a loss of confidence in the reliability of ourfinancial statements, which could cause the market price of our shares todecline.

***We have limitedexperience in licensing, re-mixing, marketing, and directly sellingmulti-channel audio content.***

Although we haveestablished relationships with a number of artists and music labels, we do nothave any contractual agreements that require artists or music labels to provideus with music content to re-mix and release in our proprietary DTS audioformat. Music companies may in the future be unwilling to license titles fromtheir music catalogs to us. In addition, our audio content competes with othermulti-channel formats, including Super Audio CD, which is a formatdeveloped jointly by Philips and Sony Corporation. As a result, we may havedifficulty in obtaining rights to release a significant amount of audiocontent, and any content that we do release may not be commercially successful.

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

Although we have establishedrelationships with a number of motion picture studios, content owners,producers and distributors, we do not have any contractual agreements thatrequire them to provide us image content for processing. Further, the demandfor image processing, enhancement and restoration of cinema, home video orbroadcast television content may not materialize or accelerate as weanticipate, which would have a negative impact on our business.

***We have limitedcontrol over existing and potential customers’ and licensees’ decisions toinclude our technology in their product offerings.***

We are dependent on ourcustomers and licensees—including consumer electronics products manufacturers,semiconductor manufacturers, movie theaters, producers and distributors ofcontent for music, films, videos, and games—to incorporate our technology intheir products, purchase our products and services, or release their content inour proprietary DTS audio format. Although we have contracts and licenseagreements with many of these companies, these agreements do not require anyminimum purchase commitments, and are on a non-exclusive basis, and do notrequire incorporation or use of our technology, trademarks or services. Ourcustomers, licensees and other manufacturers might not utilize our technologyor services in the future.

***Our revenues fromfilm producers and distributors and from the products and services that weoffer to movie theaters would decline if the major U.S. film producers anddistributors decrease or delay the number of films they release using DTStechnology or services.***

Although all six majorU.S. film producers and distributors are customers of ours, we generally do nothave contractual arrangements that require them to use our DTS audio technologyor our digital image services. Our cinema and digital images business dependson our having good relations with these film studios and other content owners.A deterioration in our relationship with any of these customers could causethem to stop using our DTS audio technology or our digital image enhancementservices. Any significant decline or delay in the release of motion pictureswith DTS audio soundtracks would decrease the demand for and revenues from theplayback products and services that we offer to movie theaters. In addition,other motion picture studios, content owners, producers, and distributorsthroughout the world generally adopt and use the processes and the technologiesused by the major U.S. film studios. Therefore, if the major U.S. motionpicture studios, content owners, producers or distributors stop using ourtechnology, we would not only lose the per-movie licensing fee we receive fromthese customers, but may also lose per-movie licensing fees from other filmstudios throughout the world. Furthermore, poor box-office performancecaused by a weak film release calendar or declining consumer interest in thefilms being released could have a negative impact on the demand for theproducts and services we sell to the motion picture industry.

***If the movie industryadopts new digital cinema technology in place of current film technology,demand for our cinema products and 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 and service offerings couldbe rendered obsolete. In such an event, demand by movie theaters for ourplayback systems, cinema processors, and systems for subtitling, captioning,and descriptive narration as well as film licensing revenue would decline.

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***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.More recently, the industry has experienced a decline in movie theaterattendance. If this decline were to continue, exhibitors could see a decline inrevenue per screen and, potentially, an inability to satisfy their financialobligations resulting in the closure of screens. If movie theater operatorsdecide to close a significant number of screens in the future or cut their capitalspending, demand for our playback systems and cinema processors will decline.

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

Our successdepends, in part, upon the continued availability and contributions of ourmanagement team, particularly Jon Kirchner, our President and Chief ExecutiveOfficer, W. Paul Smith, our Senior Vice President, Research and Development,and John Lowry, our Chief Technologist of DTS Digital Images who became anemployee upon our acquisition of DTS DI. We also rely on the skills and talentsof our engineering and technical personnel because of the complexity of ourproducts and services. Several of our key engineers have been instrumental inthe development of our technology. Important factors that could cause the lossof 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;

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

·       stockoptions held by certain executive officers provide for accelerated vesting inthe event of a sale or change of control of our company.

The loss of key personnelor an inability to attract qualified personnel in a timely manner could slowour technology and product development and harm our ability to execute ourbusiness plan. We do not generally carry key-man life insurance on any of ouremployees, with the exception that we are the beneficiary of a $10 millionkey-man life insurance policy for John Lowry.

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***We have a limited operating history in many of our keymarkets.***

Although the first moviewith a DTS audio soundtrack was released in 1993, we did not enter the hometheater market until 1996, and our technology has only recently beenincorporated into other consumer electronics markets, such as car audio,personal computers, video games and consoles, portable electronics devices, anddigital satellite and cable broadcast products. In addition, while we havecompleted over 100 digital image processing, enhancement and restoration filmprojects, it is only recently that a large number of these projects have beencompleted. As a result, the demand for our technology, products, and servicesand the income potential of these businesses are unproven. In addition, becausethe market for digital audio technology and image services is relatively newand rapidly evolving, we have limited insight into trends that may emerge andaffect our business. We may make errors in predicting and reacting to relevantbusiness trends, which could harm our business. Before investing in our commonstock, you should consider the risks, uncertainties, and difficultiesfrequently encountered by companies in new and rapidly evolving markets such asours. We may not be able to successfully 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 productscould contain errors that could cause our products or technology to operateimproperly and could cause unintended consequences. If our products ortechnology contain errors we could be required to replace them, and if any sucherrors cause unintended consequences we could face claims for product liability.Although we generally attempt to contractually limit our exposure to incidentaland consequential damages, if these contract provisions are not enforced or areunenforceable for any reason, or if liabilities arise that are not effectivelylimited, we could incur substantial costs in defending and/or settling productliability claims.

***Issues arising fromthe implementation of our new enterprise resource planning system could affectour operating results and ability to manage our business effectively.***

We recently began toimplement an enterprise resource planning, or ERP, system to enhance operatingefficiencies and provide more effective management of our business operations. Implementinga new ERP system is costly and involves risks inherent in the conversion to anew computer system, including disruption to our normal accounting proceduresand problems achieving accuracy in the conversion of electronic data. Failureto properly or adequately address these issues could result in increased costs,the diversion of management’s attention and resources and could materiallyadversely affect our operating results and ability to manage our businesseffectively.

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

Although we havebeen in business since 1990, we have only achieved profits from our businessoperations since the third quarter of 2001. 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

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·       continueto assume the responsibilities of being a public company.

As a result, we will needto grow our revenues in order to maintain and increase our profitability. Inaddition, we may fail to accurately estimate and assess our increased operatingexpenses as we grow.

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

We market and sellour products and services outside the United States, and currently haveemployees located in Canada, China, England, France, Japan, Hong Kong, Italy,Northern Ireland, and Spain. Many of our customers and licensees are locatedoutside the United States. As a key component of our business strategy, weintend to expand our international sales. We face numerous risks in doingbusiness 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;

·       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 business practices in international markets arealso subject to the requirements of the Foreign Corrupt Practices Act. If anyof our employees is found to have violated these requirements, we could besubject to significant fines and other penalties.

Our international revenueis mostly denominated in U.S. dollars. As a result, fluctuations in the valueof the U.S. dollar and foreign currencies may make our technology, products,and services more expensive for international customers, which could cause themto decrease their purchases from us. Expenses for our subsidiaries aredenominated in their respective local currencies. Significant fluctuations inthe value of the U.S. dollar and foreign currencies could have a materialimpact on our consolidated financial statements. We do not currently engage incurrency hedging activities to limit the 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.

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Even if we are successfulin expanding into China, we may be greatly impacted by the political, economic,and military conditions in China, Taiwan, North Korea, and South Korea. Thesecountries have periodically conducted military exercises in or near the other’sterritorial waters and airspace. Such disputes may continue or escalate,resulting in economic embargos, disruptions in shipping, or even militaryhostilities. This could severely harm our business by interrupting or delayingproduction or shipment of our products or products that incorporate ourtechnology.

***We depend onseveral suppliers, manufacturers, and distributors for some of our products,and the loss of any of these suppliers, manufacturers, or distributors couldharm 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 to remedyin 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.

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 theretail market, loss of inventory, and loss of revenue.

***We rely on theaccuracy of our customers’ manufacturing reports for reporting and collectingour revenues, and if these reports are untimely or incorrect, our revenuescould be delayed or inaccurately 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 per-unit licensing fees 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 the general economy, including trendsresulting from actual or threatened military action by the United States andthreats of terrorist attacks on the United States and abroad, could cause adecrease in consumer spending on entertainment in general. Any reduction inconsumer confidence or disposable income in general may affect the demand forconsumer electronics products that incorporate our digital audio technology,audio DVDs that we produce and distribute through our DTS Entertainment label,and demand by film studios and movie theaters for our cinema products andservices.

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

We acquired DTS DIin January 2005, and we expect to consider additional opportunities toacquire or make investments in other technologies, products, and businesses thatcould enhance 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.

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.***

We expect tocontinue to experience growth in the scope of our operations and the number ofour employees. If this growth continues, it will place a significant strain onour management team and on our operational and financial systems, procedures,and controls. Our future success will depend in part on the ability of ourmanagement 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 DTS DI has required significant time and attention from our managementteam. Any future growth could cause similar management challenges or createdistractions.

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

We have historically experienced moderate seasonalityin our business due to our business mix and the nature of our products. In ourconsumer business, consumer electronics manufacturing activities are 

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generally lowest in thefirst calendar quarter of each year, and increase progressively throughout theremainder of the year. Manufacturing output is generally strongest in the thirdand fourth quarters as our technology licensees increase manufacturing toprepare for the holiday buying season. Since recognition of revenues in ourconsumer business generally lags manufacturing activity by one quarter, our revenuesand earnings from the consumer business are generally lowest in the secondquarter. Film licensing revenues are generally strongest in the second andfourth quarters due to the abundance of movies typically released during thesummer and year-end holiday seasons. The introduction of new products andinclusion of our technologies in new and rapidly growing markets can distortthe moderate seasonality described above. Our revenues may continue to besubject to seasonal fluctuations in the future. Unanticipated fluctuations inseasonality could cause us to miss our earnings projections which could causeour 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. Such fluctuationsin our revenues and operating results may cause declines in our stock price.

**Risks Related toOur Common Stock**

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

The market price ofour common stock is likely to be highly volatile and may fluctuatesubstantially 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 

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performance.In the past, following periods of volatility in the market price of a company’ssecurities, securities class-action litigation has often been institutedagainst that company. Such litigation, if instituted against us, could resultin substantial costs and a diversion of management’s attention and resources.

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

As of March 31, 2006,we had 17,581,872 shares of common stock outstanding. As a result of ourrelatively small public float, our common shares may be less liquid than thecommon shares of companies with broader public ownership. Among other things,trading of a relatively small volume of our common shares may have a greaterimpact on the trading price for our shares than would be the case if our publicfloat were larger.

***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.***

Our capitalrequirements 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-takeoverprovisions under our charter documents and Delaware law could delay or preventa change of control and could also limit the market price of our stock.***

Our RestatedCertificate of Incorporation and Restated Bylaws contain provisions that coulddelay or prevent a change of control of our company or changes in our Board ofDirectors that our stockholders might consider favorable. Some of theseprovisions:

·       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 aregoverned by the provisions of Section 203 of the Delaware GeneralCorporate Law, which may prohibit certain business combinations withstockholders owning 15% or more of our outstanding voting stock. These andother provisions in our Restated Certificate of Incorporation, Restated Bylawsand Delaware law could make it more difficult for stockholders or potentialacquirors to obtain control of our Board or initiate actions that are opposedby the then-current Board, including delay 

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orimpede a merger, tender offer, or proxy contest involving our company. Anydelay or prevention of a change of control transaction or changes in our Boardcould cause the market price of our common stock to decline.

**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, 2006, we haveapproximately $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

On February 3, 2006, we entered into anemployment agreement with Daniel E. Slusser in connection with the continuedemployment of Mr. Slusser as Chairman of our Board of Directors. The termof this employment agreement is effective as of January 2, 2006 andexpires May 31, 2007.

Pursuant to thisagreement, we will pay Mr. Slusser a base salary of $100,000 per year andannual bonuses as determined by our Board of Directors. In addition, theagreement provides for severance payments to Mr. Slusser (i) upon aChange of Control of the Company (as defined in the agreement), (ii) inthe event Mr. Slusser’s employment is terminated for other than “goodcause” (as defined in the agreement) or (iii) in the event of a ConstructiveTermination of his employment (as defined in the agreement). These severancepayments include a lump sum payment of Mr. Slusser’s base salary duethrough the term of the agreement, continuation of all Company providedbenefits through the term of the agreement, and acceleration of vesting of hisstock options, which shall be exercisable for the period set forth in theappropriate option agreement.

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**Item 6.**                        Exhibits

| Exhibit  Number | ** ** | **Exhibit Description**                                                                                                                     |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.67           |       | Employment Agreement By and Between the Registrant  and Daniel E. Slusser, effective as of January 2, 2006                                  |
| 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.

|                         |   | DTS, INC. |
|-------------------------|--------|----------------|
|                    | by:    |           | /s/ JON E. KIRCHNER |
|                    |   |           | Jon E. Kirchner |
|                    |   |           | *President and Chief Executive Officer* |
|                    |   |           | *(Duly Authorized Officer)* |
| Date: May 10, 2006 |   |           |   |
|                    | by:    |           | /s/ MELVIN L. FLANIGAN |
|                    |   |           | Melvin L. Flanigan |
|                    |   |           | *Executive Vice President, Finance and* |
|                    |   |           | *Chief Financial Officer* |
|                    |   |           | *(Principal Financial and Accounting Officer)* |
| Date: May 10, 2006 |   |           | * * |

 

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