**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,DC 20549**

**Form 10-Q**

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

**Forthe Quarterly Period Ended September 30, 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  No.)                  |
|                                |   |                                  |
| **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 mark whether the registrant:(1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past90 days. Yes x   No o

Indicate by check mark whether registrant is a largeaccelerated filer, an accelerated filer or non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act.
| Large accelerated  filer  o | Accelerated  filer  x | Non-accelerated filer  o |
|---------------------------------------|---------------------------------|------------------------------------|

 

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

Asof October 31, 2006 a total of 17,818,708 shares of the Registrant’sCommon Stock, $0.0001 par value, were issued and outstanding.

 

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**DTS, INC.**

**FORM 10-Q**

**TABLE OF 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** | **18** |
| **Item 3.**  | **Quantitative  and Qualitative Disclosures About Market Risk**                                 | **27** |
| **Item 4.**  | **Controls and  Procedures**                                                                    | **28** |
| **PART II.** | **OTHER  INFORMATION**                                                                          | **29** |
| **Item 1.**  | **Legal Proceedings**                                                                           | **29** |
| **Item 1A.**      | **Risk Factors**                                                                                | **29** |
| **Item 2.**  | **Unregistered  Sales of Equity Securities and Use of Proceeds**                                | **42** |
| **Item 3.**  | **Defaults Upon  Senior Securities**                                                            | **42** |
| **Item 4.**  | **Submission of  Matters to a Vote of Security Holders**                                        | **42** |
| **Item 5.**  | **Other Information**                                                                           | **42** |
| **Item 6.**  | **Exhibits**                                                                                    | **43** |
| **SIGNATURES**    | **44**                                                                                          |

 

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**DTS,INC.PART IFINANCIAL INFORMATION**

**Item 1.**                          FinancialStatements

**DTS, Inc.**

**ConsolidatedBalance Sheets**
| ** **                                                                                                                                                                                                                                                    | ** ** | **As of**                                       | ** ** | **As of**         | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                                                                                    | ** ** | **December 31,**                                | ** ** | **September 30,** | ** ** |
| ** **                                                                                                                                                                                                                                                    | ** ** | **2005**                                             | ** ** | **2006**               | ** ** |
| ** **                                                                                                                                                                                                                                                    | ** ** | **(Unaudited)**                                      | ** ** |
| ** **                                                                                                                                                                                                                                                    | ** ** | **(Amounts in thousands, except**     | ** ** |
| ** **                                                                                                                                                                                                                                                    | ** ** | **share and per share amounts)** | ** ** |
| ASSETS                                                                                                                                                                                                                                                        |       |                                                 |       |                   |       |
| Current assets:                                                                                                                                                                                                                                               |       |                                                 |       |                   |       |
| Cash and cash  equivalents                                                                                                                                                                                                                                    |       | $                                                    | 33,254     |                   | $          | 43,328 |   |
| Short-term  investments                                                                                                                                                                                                                                       |       | 78,163                                               |       | 75,610                 |       |
| Accounts  receivable, net of allowance for doubtful accounts of $370 and $295 at  December 31, 2005 and September 30, 2006, respectively                                                                                                       |       | 7,311                                                |       | 6,734                  |       |
| Inventories                                                                                                                                                                                                                                                   |       | 3,261                                                |       | 3,587                  |       |
| Deferred income  taxes                                                                                                                                                                                                                                        |       | 7,255                                                |       | 7,687                  |       |
| Prepaid expenses  and other current assets                                                                                                                                                                                                                    |       | 3,112                                                |       | 2,307                  |       |
| Income taxes  receivable, net                                                                                                                                                                                                                                 |       | 2,654                                                |       | 3,012                  |       |
| Total current  assets                                                                                                                                                                                                                                         |       | 135,010                                              |       | 142,265                |       |
| Property and equipment,  net                                                                                                                                                                                                                                  |       | 7,375                                                |       | 9,929                  |       |
| Goodwill                                                                                                                                                                                                                                                      |       | 3,585                                                |       | 3,585                  |       |
| Intangible assets, net                                                                                                                                                                                                                                        |       | 11,612                                               |       | 11,766                 |       |
| Deferred income taxes                                                                                                                                                                                                                                         |       | 303                                                  |       | 16                     |       |
| Other assets                                                                                                                                                                                                                                                  |       | 369                                                  |       | 580                    |       |
| Total assets                                                                                                                                                                                                                                                  |       | $                                                    | 158,254    |                   | $          | 168,141 |   |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                                                                                                    |       |                                                 |       |                   |       |
| Current liabilities:                                                                                                                                                                                                                                          |       |                                                 |       |                   |       |
| Accounts payable                                                                                                                                                                                                                                              |       | $                                                    | 2,634      |                   | $          | 3,104 |   |
| Accrued expenses                                                                                                                                                                                                                                              |       | 6,983                                                |       | 6,800                  |       |
| Deferred revenue                                                                                                                                                                                                                                              |       | 2,630                                                |       | 126                    |       |
| Total current  liabilities                                                                                                                                                                                                                                    |       | 12,247                                               |       | 10,030                 |       |
| Deferred income taxes                                                                                                                                                                                                                                         |       | 1,917                                                |       | 1,218                  |       |
| Other liabilities                                                                                                                                                                                                                                             |       | —                                               |       | 211                    |       |
| Commitments and  contingencies (Note 11)                                                                                                                                                                                                                      |       |                                                 |       |                   |       |
| Stockholders’ equity:                                                                                                                                                                                                                                    |       |                                                 |       |                   |       |
| Preferred  stock—$0.0001 par value, 5,000,000 shares authorized at December 31,  2005 and September 30, 2006; no shares issued and outstanding at  December 31, 2005  and September 30, 2006                                    |       | —                                               |       | —                 |       |
| Common  stock—$0.0001 par value, 70,000,000 shares authorized at December 31,  2005 and September 30, 2006; 17,472,543 and 17,812,733 shares issued and  outstanding at December 31, 2005 and September 30, 2006,  respectively |       | 2                                                    |       | 2                      |       |
| Additional  paid-in capital                                                                                                                                                                                                                                   |       | 122,847                                              |       | 127,447                |       |
| Retained  earnings                                                                                                                                                                                                                                            |       | 21,241                                               |       | 29,233                 |       |
| Total  stockholders’ equity                                                                                                                                                                                                                              |       | 144,090                                              |       | 156,682                |       |
| Total liabilities and  stockholders’ equity                                                                                                                                                                                                              |       | $                                                    | 158,254    |                   | $          | 168,141 |   |

 

See accompanyingnotes to consolidated financial statements.

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**DTS, Inc.Consolidated Statements of Operations**
| ** **                                                                   | ** ** | **For the Three Months Ended  September 30,**                                          | ** ** | **For the Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                                                                                                        | ** ** | **2006**                                                              | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                                                   | ** ** | **(Unaudited)  (Amounts in thousands, except  share and per share amounts)** | ** ** |
| Revenues:                                                                    |       |                                                                                                            |       |                                                                  |       |   |   |   |   |
| Technology and film licensing                                                |       | $                                                                                                               | 12,611     |                                                                  | $          | 11,727 |   | $ | 43,910 |   | $ | 46,314 |   |
| Product sales and other revenues                                             |       | 4,942                                                                                                           |       | 3,526                                                                 |       | 13,428 |   | 14,537 |   |
| Total revenues                                                               |       | 17,553                                                                                                          |       | 15,253                                                                |       | 57,338 |   | 60,851 |   |
| Cost of goods  sold:                                                         |       |                                                                                                            |       |                                                                  |       |   |   |   |   |
| Technology and film licensing                                                |       | 1,194                                                                                                           |       | 1,050                                                                 |       | 3,511 |   | 3,528 |   |
| Product sales and other revenues                                             |       | 3,450                                                                                                           |       | 3,272                                                                 |       | 10,626 |   | 11,970 |   |
| Total cost of goods sold                                                     |       | 4,644                                                                                                           |       | 4,322                                                                 |       | 14,137 |   | 15,498 |   |
| Gross profit                                                                 |       | 12,909                                                                                                          |       | 10,931                                                                |       | 43,201 |   | 45,353 |   |
| Operating  expenses:                                                         |       |                                                                                                            |       |                                                                  |       |   |   |   |   |
| Selling, general and administrative                                          |       | 8,971                                                                                                           |       | 10,374                                                                |       | 25,095 |   | 30,279 |   |
| Research and development                                                     |       | 2,612                                                                                                           |       | 3,300                                                                 |       | 7,238 |   | 9,001 |   |
| In-process research and development                                          |       | —                                                                                                          |       | —                                                                |       | 2,300 |   | — |   |
| Separation costs                                                             |       | —                                                                                                          |       | 396                                                                   |       | — |   | 396 |   |
| Total operating expenses                                                     |       | 11,583                                                                                                          |       | 14,070                                                                |       | 34,633 |   | 39,676 |   |
| Income (loss)  from operations                                               |       | 1,326                                                                                                           |       | (3,139                                                                | )          | 8,568 |   | 5,677 |   |
| Interest income,  net                                                        |       | 635                                                                                                             |       | 1,376                                                                 |       | 1,824 |   | 3,638 |   |
| Other income,  net                                                           |       | 123                                                                                                             |       | 14                                                                    |       | 100 |   | 64 |   |
| Income (loss)  before income taxes                                           |       | 2,084                                                                                                           |       | (1,749                                                                | )          | 10,492 |   | 9,379 |   |
| Provision  (benefit) for income taxes                                        |       | 890                                                                                                             |       | (851                                                                  | )          | 3,926 |   | 1, 387 |   |
| Net income  (loss)                                                           |       | 1,194                                                                                                           |       | (898                                                                  | )          | 6,566 |   | 7,992 |   |
|                                                                         |       |                                                                                                            |       |                                                                  |       |   |   |   |   |
| Net income  (loss) per common share:                                         |       |                                                                                                            |       |                                                                  |       |   |   |   |   |
| Basic                                                                        |       | $                                                                                                               | 0.07       |                                                                  | $          | (0.05 | ) | $ | 0.38 |   | $ | 0.45 |   |
| Diluted                                                                      |       | $                                                                                                               | 0.07       |                                                                  | $          | (0.05 | ) | $ | 0.36 |   | $ | 0.44 |   |
|                                                                         |       |                                                                                                            |       |                                                                  |       |   |   |   |   |
| Weighted average  shares used to compute net income (loss) per common share: |       |                                                                                                            |       |                                                                  |       |   |   |   |   |
| Basic                                                                        |       | 17,411,461                                                                                                      |       | 17,653,865                                                            |       | 17,275,515 |   | 17,565,963 |   |
| Diluted                                                                      |       | 18,342,186                                                                                                      |       | 17,653,865                                                            |       | 18,194,333 |   | 18,342,678 |   |

 

See accompanyingnotes to consolidated financial statements.

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**DTS, Inc.Consolidated Statements of Cash Flows**
| ** **                                                                               | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
|------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                               | ** ** | **2005**                                                              | ** ** | **2006** | ** ** |
| ** **                                                                               | ** ** | **(Unaudited)**                                                       | ** ** |
| ** **                                                                               | ** ** | **(Amounts in thousands)**                                  | ** ** |
| Cash flows from  operating activities:                                                   |       |                                                                  |       |   |   |
| Net income                                                                               |       | $                                                                     | 6,566      |   | $ | 7,992 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:       |       |                                                                  |       |   |   |
| Depreciation and amortization                                                            |       | 2,691                                                                 |       | 3,457 |   |
| Stock-based compensation charges                                                         |       | 75                                                                    |       | 2,686 |   |
| Allowance for doubtful accounts                                                          |       | 5                                                                     |       | 10 |   |
| Loss on disposal of property and equipment                                               |       | —                                                                |       | 93 |   |
| Deferred income taxes                                                                    |       | 937                                                                   |       | (845 | ) |
| Excess tax benefits from stock-based compensation                                        |       | 563                                                                   |       | (818 | ) |
| Write-down of inventory                                                                  |       | —                                                                |       | 144 |   |
| In-process research and development                                                      |       | 2,300                                                                 |       | — |   |
| Changes in operating assets and liabilities:                                             |       |                                                                  |       |   |   |
| Accounts receivable                                                                      |       | (3,845                                                                | )          | 566 |   |
| Inventories                                                                              |       | (408                                                                  | )          | (470 | ) |
| Prepaid expenses and other assets                                                        |       | (279                                                                  | )          | 795 |   |
| Accounts payable and accrued expenses                                                    |       | (1,786                                                                | )          | 288 |   |
| Deferred revenue                                                                         |       | 655                                                                   |       | (2,504 | ) |
| Income taxes receivable                                                                  |       | (1,286                                                                | )          | 461 |   |
| Other liabilities                                                                        |       | —                                                                |       | 211 |   |
| Net cash provided by operating activities                                                |       | 6,188                                                                 |       | 12,066 |   |
|                                                                                     |       |                                                                  |       |   |   |
| Cash flows from  investing activities:                                                   |       |                                                                  |       |   |   |
| Purchases of investments                                                                 |       | (80,703                                                               | )          | (101,853 | ) |
| Maturities of investments                                                                |       | 52,277                                                                |       | 50,748 |   |
| Sales of investments                                                                     |       | 45,998                                                                |       | 53,658 |   |
| Cash paid for business and technology acquisitions,  net of cash acquired                |       | (11,000                                                               | )          | (1,379 | ) |
| Purchase of property and equipment                                                       |       | (4,168                                                                | )          | (4,902 | ) |
| Payment for patents and trademarks in process                                            |       | (115                                                                  | )          | (177 | ) |
| Net cash provided by (used in) investing activities                                      |       | 2,289                                                                 |       | (3,905 | ) |
|                                                                                     |       |                                                                  |       |   |   |
| Cash flows from  financing activities:                                                   |       |                                                                  |       |   |   |
| Proceeds from the issuance of common stock upon  exercise of employee stock options |       | 228                                                                   |       | 615 |   |
| Proceeds from the issuance of common stock under  employee stock purchase plan           |       | 430                                                                   |       | 480 |   |
| Excess tax benefits from stock-based compensation                                        |       | —                                                                |       | 818 |   |
| Net cash provided by financing activities                                                |       | 658                                                                   |       | 1,913 |   |
| Net increase in cash and cash equivalents                                                |       | 9,135                                                                 |       | 10,074 |   |
| Cash and cash  equivalents, beginning of period                                          |       | 21,271                                                                |       | 33,254 |   |
| Cash and cash  equivalents, end of period                                                |       | $                                                                     | 30,406     |   | $ | 43,328 |   |

 

See accompanying notes to consolidated financial statements.

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**DTS,INC.NOTES TO CONSOLIDATED 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 adjustments,consisting only of normal recurring adjustments, considered necessary for afair statement of the Company’s financial position at September 30, 2006,and the results of operations and cash flows for the periods presented. Allsignificant intercompany transactions have been eliminated in consolidation.Operating results for the three and nine months ended September 30, 2006are not necessarily indicative of the results that may be expected for thefiscal year ending December 31, 2006. The information included in thisForm 10-Q should be read in conjunction with the consolidated financialstatements and notes thereto included in the Company’s Annual Report onForm 10-K for the year ended December 31, 2005.

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities, and disclosures of contingent assets and liabilitiesat the date of the financial statements, and the reported amounts of revenuesand expenses during the reporting period. Actual results could differ fromthose estimates.

The Company intends to proceed with the separation ofits Cinema and Digital Images businesses from its Consumer licensingbusiness.  The Company believes thisseparation will enhance stockholder value and better position each business toserve its customer base, go-to-market more rapidly, and be more flexible inthis dynamic environment.

**Note 2—RecentAccounting Pronouncements**

In September 2006, the Financial Accounting StandardsBoard (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No.157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes aframework for measuring fair value and expands disclosures about fair valuemeasurements. This statement is effective for financial statements issued forfiscal years beginning after November 15, 2007. The Company plans to adopt SFASNo. 157 effective January 1, 2008. The Company is in the process of determiningthe effect, if any, the adoption of SFAS No. 157 will have on its financialstatements.

In September 2006, the Securities and ExchangeCommission (“SEC”) staff issued Staff Accounting Bulletin (“SAB”) No. 108, “Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements in CurrentYear Financial Statements.” SAB No. 108 provides guidance on how prior yearmisstatements should be taken into consideration when quantifying misstatementsin current year financial statements for purposes of determining whether thecurrent year’s financial statements are materially misstated. SAB No. 108 iseffective for fiscal years ending after November 15, 2006. The Company plans toadopt SAB No. 108 during the fourth quarter of 2006. The Company is in theprocess of determining the effect, if any, the adoption of SAB No. 108 willhave on its financial statements.

In July 2006, the FASB issued FASB Interpretation (“FIN”)No. 48, “Accounting for Uncertainty in Income Taxes,” which prescribes acomprehensive model for how a company should recognize, measure, present anddisclose in its financial statements uncertain tax positions that the companyhas taken or expects to take on a tax return (including a decision whether tofile or not to file a return in a particular jurisdiction). The accounting provisionsof FIN No. 48 are effective for fiscal years beginning after December 15, 2006.The Company plans to adopt FIN No. 48 effective January 1, 2007. The Company isin the process of determining the effect, if any, the adoption of FIN No.48 will have on its financial statements.

In June 2006, the FASB Emerging Issues Task Force (“EITF”)issued EITF Issue No. 06-3, “How Sales Taxes Collected from Customers andRemitted to Governmental Authorities Should Be Presented in the Income

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Statement (That Is, GrossVersus Net Presentation),” which states that a company should disclose itsaccounting policy (i.e., gross or net presentation) regarding presentation oftaxes within the scope of this issue. If taxes included in gross revenues aresignificant, a company should disclose the amount of such taxes for each periodfor which an income statement is presented. The consensus would be effectivefor the first annual or interim reporting period beginning after December 15,2006. The disclosures are required for annual and interim financial statementsfor each period for which an income statement is presented. The Company plansto adopt this issue effective January 1, 2007. Based on the Company’s currentevaluation of this issue, the Company does not expect the adoption of EITFIssue No. 06-3 to have a significant impact on its consolidated results ofoperations or financial position.

In June 2005, the FASB issued SFAS No. 154, “AccountingChanges 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, the FASB finalized SFASNo. 123(R), “Share-Based Payment,” which requires companies to measure andrecognize compensation costs for all share-based payments (including stockoptions) at fair value, effective for interim or annual periods beginning afterJune 15, 2005. On April 15, 2005, 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 10, Stock-BasedCompensation.

**Note 3—SeparationCosts**

In August 2006, the Company announced that it wasstudying the potential separation of the Cinema and Digital Images businessesfrom the Consumer business in order to better address rapidly evolving markets,meet the needs of customers and increase shareholder value. As of September 30,2006, the Company had incurred approximately $396 in separation costs,consisting primarily of legal and accounting expenses relating to the separationof its business.

**Note 4—CertainBalance Sheet Items**

Inventoriesconsist of the following:
|                    | ** ** | **As of  December 31,  2005** | ** ** | **As of  September 30,  2006** | ** ** |
|--------------------|------------|-----------------------------------------|------------|------------------------------------------|------------|
| Raw materials      |       | $                                       | 1,062      |                                     | $          | 1,133 |   |
| Finished goods     |       | 2,199                                   |       | 2,454                                    |       |
| Total  inventories |       | $                                       | 3,261      |                                     | $          | 3,587 |   |

 

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Property andequipment consist of the following:
|                                 | ** ** | **As of  December 31,  2005** | ** ** | **As of  September 30,  2006** | ** ** |
|---------------------------------|------------|-----------------------------------------|------------|------------------------------------------|------------|
| Machinery and  equipment        |       | $                                       | 6,847      |                                     | $          | 8,370 |   |
| Office furniture  and fixtures  |       | 3,588                                   |       | 3,281                                    |       |
| Leasehold  improvements         |       | 3,697                                   |       | 3,903                                    |       |
| Software                        |       | 590                                     |       | 2,837                                    |       |
|                            |       | 14,722                                  |       | 18,391                                   |       |
| Less:  Accumulated depreciation |       | (7,347                                  | )          | (8,462                                   | )          |
| Property and  equipment, net    |       | $                                       | 7,375      |                                     | $          | 9,929 |   |

 

**Note 5—CapitalizedSoftware Costs**

**TheCompany capitalizes the costs of computer software developed or obtained forinternal use in accordance with Statement of Position 98-1, “Accounting for theCosts of Computer Software Developed or Obtained for Internal Use.” Capitalizedcomputer software costs consist of purchased software licenses, implementationcosts, consulting costs and payroll-related costs for certain projects thatqualify for capitalization. The Company expenses costs related to preliminaryproject assessment, training and application maintenance as incurred, andamortizes the capitalized computer software costs on a straight-line basis overthe estimated useful life of the software upon being placed in service.**

**Note 6—AcquiredTechnology**

On April 17, 2006, the Company acquired for$1,000 the Digital Booking Systems technology (“DBS”) from FilmStewInternational, Inc. DBS is an application that enables cinema exhibitorsand distributors to manage entertainment content via the internet. DBS allowsexhibitors and distributors to conduct business online by accelerating theprocess of booking playdates, scheduling showtimes, programming trailers,tracking data and facilitating film rental payments. Intangible assets, net,includes $929 for the purchase of this asset, which represents the net presentvalue of the total acquisition cost.

**Note 7—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 total estimatedpurchase price of $12,249, including $9,642 in cash, forgiveness of a loan andinterest of $1,261 and acquisition costs of $1,346. DTS DI provides imageenhancement and restoration services for film producers and distributors forhome or professional playback of high quality, high definition presentations indigital cinema, high definition optical media or broadcast applications.

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 will be dependent on shares issued, if any, as furtherdiscussed. The former shareholders of DTS DI are entitled to receive shares ofthe Company’s common stock if certain gross profit targets in 2006 are met. Inthe event that the targets are met in full, an aggregate of up to approximately653,000 shares of the Company’s common stock will be issued. The value of theseshares will be accounted for as an addition to goodwill.

In July 2004, the Company completed theacquisition of QDesign Corporation for $1,500 in cash. Under the terms of theacquisition, the Company also contingently agreed to pay an additional amountup to a maximum of $450 in cash, which is held by the Company in a restrictedaccount. The Company classifies the restricted cash in other current andnon-current assets. The contingent payment is being accounted for ascompensation expense ratably over the three-year period ending July 2007,and will be paid out if certain criteria are met. Two payments of $150 eachwere made, one in 2005 and the other in 2006.

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**Note 8—Bank Lineof Credit**

The Company has a $10,000 unsecured working capitalfacility that expires on June 30, 2007, and is renewable annually. Thebank agreement requires the Company to comply with certain covenants includinga tangible effective net worth of $60,000, increasing by 50% of net income onan annual basis. The covenants also require the Company to keep $2,000 in cashor securities at the issuing bank. At September 30, 2006, the Company wascompliant with all covenants under the bank agreement.

At September 30, 2006, there was no balanceoutstanding and $10,000 of available borrowings under this credit facility.Future borrowings will bear interest based on either of the two options theCompany selects at the time of advances 1) a rate equal to 2% above thebank’s LIBOR, or 2) a rate equal to the Base Rate as quoted from the bankless one-half percent. The annual commitment fee for this line of credit is notmaterial.

**Note 9—IncomeTaxes**

For the three months ended September 30, 2006,the Company recorded an income tax benefit of $851 on pre-tax loss of $1,749.For the nine months ended September 30, 2006, the Company recorded an incometax provision of $1,387 on pre-tax income of $9,379. This resulted in anannualized effective tax rate of 14.8%. During the second quarter of 2006, theInternal Revenue Service (“IRS”) completed an examination of the federal incometax return filed by the Company for the year ended December 31, 2003. TheCompany achieved a favorable resolution with the IRS regarding theExtraterritorial Income Exclusion (“ETI”) that resulted in a tax benefit of$1,710. As a result of these items, the current income tax rate differs fromthe statutory rate. At September 30, 2006, the Company’s annualizedeffective tax rate was approximately 42.4%, which included approximately 5.0%for non-deductible costs related to the separation of its business. For thethree and nine months ended September 30, 2005, the Company recorded anincome tax provision of $890 and $3,926, respectively, on pre-tax income of$2,084 and $10,492, respectively. This resulted in an annualized effective taxrate of 37.4%. These rates differed from the statutory rates primarily due tostate income taxes offset by benefits associated with the foreign ratedifferentials.

**Note 10—Stock-BasedCompensation**

***Adoption of SFAS No. 123(R)***

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 FIN No. 44, “Accounting forCertain Transactions Involving Stock Compensation,” and complied with thedisclosure provisions of SFAS No. 123, “Accounting for Stock-BasedCompensation.” Under the provisions of these pronouncements, all optionsgranted under those plans had an exercise price equal to or greater than themarket value of the underlying common stock on the date of grant, whichresulted in no recognition of stock-based compensation expense. For the threeand nine months ended September 30, 2005, the company recognized nostock-based employee compensation cost from stock options or employee stockpurchase plans.

Effective January 1, 2006, the Company adoptedthe provisions of SFAS No. 123(R), using themodified-prospective-transition method. Under the transition method,compensation expense recognized beginning January 1, 2006 includes:(a) compensation cost for all share-based payments granted prior to, butnot yet vested as of January 1, 2006, based on the grant date fair valueestimated in accordance with the original provisions of SFAS No. 123,and (b) compensation cost for all share-based payments granted on or afterJanuary 1, 2006, based on the grant date fair value estimated inaccordance with the provisions of SFAS No. 123(R). The Company did notrestate its results for prior periods.

As a result of adopting SFAS No. 123(R) onJanuary 1, 2006, the Company’s loss before taxes and net loss for thethree months ended September 30, 2006, were approximately $847 and $394higher, respectively, than if

9

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it had continued toaccount for share-based compensation under APB No. 25. Basic and dilutedloss per share for the three months ended September 30, 2006 would havebeen $(0.03), if it had not adopted SFAS No. 123(R), compared to reportedbasic and diluted loss per share of $(0.05). The total stock-based compensationcost that has been recognized in the Consolidated Statements of Operations was$931 and $16 for the three months ended September 30, 2006 and 2005,respectively, was recorded to cost of goods sold, and selling, general andadministrative expenses, and research and development expenses. Stock-basedcompensation cost recorded to cost of goods sold for the three months endedSeptember 30, 2006 and 2005 was $17 and $0, respectively. Stock-basedcompensation cost recorded to selling, general and administrative expenses forthe three months ended September 30, 2006 and 2005 was $794 and $16,respectively. Stock-based compensation cost recorded to research anddevelopment expenses for the three months ended September 30, 2006 and 2005 was$120 and $0, respectively. The total income tax benefit recognized was $498 and$7 for the three months ended September 30, 2006 and 2005, respectively.

The Company’s income before taxes and net income forthe nine months ended September 30, 2006, were approximately $2,539 and$1,504 lower, respectively, than if it had continued to account for share-basedcompensation under APB No. 25. Basic and diluted earnings per share forthe nine months ended September 30, 2006 would have been $0.54 and $0.52,respectively, if it had not adopted SFAS No. 123(R), compared to reportedbasic and diluted earnings per share of $0.45 and $0.44, respectively. Thetotal stock-based compensation cost that has been recognized in theConsolidated Statements of Operations was $2,686 and $75 for the nine monthsended September 30, 2006 and 2005, respectively, was recorded to cost ofgoods sold, and selling, general and administrative expenses, and research anddevelopment expenses. Stock-based compensation cost recorded to cost of goodssold for the nine months ended September 30, 2006 and 2005 was $109 and $0,respectively. Stock-based compensation cost recorded to selling, general andadministrative expenses for the nine months ended September 30, 2006 and 2005was $2,237 and $75, respectively. Stock-based compensation cost recorded toresearch and development expenses for the nine months ended September 30, 2006and 2005 was $340 and $0, respectively. The total income tax benefit recognizedwas $1,096 and $28 for the nine months ended September 30, 2006 and 2005,respectively.

Prior to adoption of SFAS No. 123(R), the Companypresented all tax benefits of deductions resulting from the exercise of stockoptions as operating cash flows in the Consolidated Statements of Cash Flows.SFAS No. 123(R) requires the cash flows resulting from the taxbenefits resulting from tax deductions in excess of the compensation costrecognized for those options (excess tax benefits) to be classified asfinancing cash flows. The $818 excess tax benefit classified as a financingcash inflow would have been classified as an operating cash inflow if we hadnot adopted SFAS No. 123(R). During the nine months endedSeptember 30, 2006, the Company received $615 in cash from stock optionexercises.

In November 2005, the FASB issued FASB Staff PositionNo. FAS 123(R)-3, “Transition Election Related to Accounting for Tax Effects ofShare-Based Payment Awards,” (“FSP 123(R)-3”). The Company has elected to adoptthe alternative transition method provided in FSP 123(R)-3 for calculating thetax effects of stock-based compensation pursuant to SFAS No. 123(R). Thealternative transition method includes a simplified method to establish thebeginning balance of the additional paid-in capital (“APIC pool”) related tothe tax effects of employee and director stock-based compensation, and todetermine the subsequent impact on the APIC pool and the consolidatedstatements of cash flows of the tax effects of employee and directorstock-based awards that are outstanding upon adoption of SFAS No. 123(R).

10

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If the Company hadelected to recognize compensation cost for stock options based on their fairvalue at the grant dates, consistent with the method prescribed by SFASNo. 123, net income and net income per share for the three and nine monthsended September 30, 2005 would have been as follows:
|                                                                                                                          | ** ** | **For the Three** | ** ** | **For the Nine** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                                                                                                               | ** ** | **Months Ended**       | ** ** | **Months Ended**      | ** ** |
| ** **                                                                                                               | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| ** **                                                                                                               | ** ** | **2005**                    | ** ** | **2005**                   | ** ** |
| Net income:                                                                                                              |       |                        |       |                       |       |
| As reported                                                                                                              |       | $                           | 1,194      |                       | $          | 6,566 |   |
| Additional stock-based compensation expense  determined under the fair value method, net of tax                          |       | (680                        | )          | (1,707                     | )          |
| Pro forma                                                                                                                |       | $                           | 514        |                       | $          | 4,859 |   |
|                                                                                                                     |       |                        |       |                       |       |
| Net income per  common share—basic:                                                                                 |       |                        |       |                       |       |
| As reported                                                                                                              |       | $                           | 0.07       |                       | $          | 0.38 |   |
| Per share effect of additional stock-based  compensation expense determined under the fair value method, net of tax |       | (0.04                       | )          | (0.10                      | )          |
| Pro forma                                                                                                                |       | $                           | 0.03       |                       | $          | 0.28 |   |
| Net income per  common share—diluted:                                                                               |       |                        |       |                       |       |
| As reported                                                                                                              |       | $                           | 0.07       |                       | $          | 0.36 |   |
| Per share effect of additional stock-based  compensation expense determined under the fair value method, net of tax |       | (0.04                       | )          | (0.09                      | )          |
| Pro forma                                                                                                                |       | $                           | 0.03       |                       | $          | 0.27 |   |

 

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 may continue to vest uponthe original vesting schedules. The SEC recently clarified that companiesshould continue the vesting method they have been using until adoption ofSFAS 123(R), then apply the accelerated non-substantive vesting approachto all subsequent grants to those employees whose options continue to vestafter the date of retirement eligibility. For the three and nine months endedSeptember 30, 2005, had the Company been accounting for such stock optionsusing the non-substantive vesting approach for retirement-eligibleemployees, the Company would have not recognized additional stock-basedcompensation expense.

**Various Stock Plans**

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

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Company granted optionsto purchase a total of 929,250 shares of common stock as replacement awards atan exercise price of $1.02, which represented the fair value of the Company’scommon 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 eachJanuary thereafter until and including January 1, 2013, subject tocertain limitations, by a number of shares equal to the lesser of: 1) fourpercent of the number of shares issued and outstanding on the immediately precedingDecember 31, 2) 1,500,000 shares, or 3) a number of shares setby the Board of Directors.

The fair value ofeach employee option grant is estimated on the date of the grant using theBlack-Scholes option pricing model with the following weighted average keyassumptions:
|                          | ** ** | **Nine  Months Ended  September 30,** | ** ** |
|--------------------------|------------|-------------------------------------------------|------------|
| ** **               | ** ** | **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 a blend of the historicalvolatility of the Company’s common stock and publicly traded peer companies.The risk-free interest rate was the average interest rates of U.S. governmentbonds of comparable term to the options on the dates of the option grants.

There were 352,000 and669,400 options granted during the nine months ended September 30, 2006and 2005, respectively. The weighted average fair value of options grantedduring the nine months ended September 30, 2006 and 2005 was $18.69 and$17.70, respectively. Stock-based compensation expense for stock options forthe three and nine months ended September 30, 2006, was calculated basedon their fair value at the grant dates, consistent with the method prescribedby SFAS No. 123 adjusted by estimated forfeitures as prescribed by SFAS123(R). Compensation expense for stock options was $614 and $1,904 for thethree and nine months ended September 30, 2006, respectively.

The followingtable summarizes information about stock option activity during the nine monthsended September 30, 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                                         |       | 352,000                  |       | 18.69                                   |       |                                                              |       |                            |       |
| Exercised                                       |       | (190,466                 | )          | 3.23                                    |       |                                                              |       |                            |       |
| Expired or cancelled                            |       | (47,968                  | )          | 19.10                                   |       |                                                              |       |                            |       |
| Options  outstanding at September 30, 2006 |       | 2,435,118                |       | $                                       | 14.21      |                                                              | 7.56       |                            | $          | 17,620,000 |   |
| Options exercisable at  September 30, 2006 |       | 1,627,090                |       | $                                       | 12.39      |                                                              | 6.91       |                            | $          | 14,302,000 |   |

 

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|                                             | ** ** | **Options Outstanding**                              | ** ** | **Options Exercisable**                            | ** ** |
|---------------------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| **Range of Exercise Prices** | ** ** | **Number  Outstanding at  September 30,  2006** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Number  Exercisable at   September 30,   2006** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| $                                           | 1.02       | –                                                    | $          | 3.07                                                    |       | 690,048 |   | 5.99 |   | $ | 1.02 |   | 688,798 |   | $ | 1.02 |   |
|                                        | 3.08       | –                                                    |       | 6.16                                                    |       | 7,625 |   | 2.57 |   | 4.15 |   | 7,122 |   | 4.11 |   |
|                                        | 6.17       | –                                                    |       | 9.23                                                    |       | 10,250 |   | 6.45 |   | 8.02 |   | 7,687 |   | 8.02 |   |
|                                        | 9.24       | –                                                    |       | 12.31                                                   |       | 2,750 |   | 6.55 |   | 10.59 |   | 2,687 |   | 10.57 |   |
|                                        | 12.32      | –                                                    |       | 15.40                                                   |       | 66,500 |   | 7.91 |   | 14.15 |   | 29,559 |   | 13.89 |   |
|                                        | 15.41      | –                                                    |       | 18.47                                                   |       | 758,875 |   | 8.68 |   | 17.08 |   | 239,185 |   | 16.47 |   |
|                                        | 18.48      | –                                                    |       | 21.55                                                   |       | 315,070 |   | 8.82 |   | 19.75 |   | 68,052 |   | 19.91 |   |
|                                        | 21.56      | –                                                    |       | 24.63                                                   |       | 548,000 |   | 7.37 |   | 23.11 |   | 548,000 |   | 23.11 |   |
|                                        | 24.64      | –                                                    |       | 27.71                                                   |       | 28,500 |   | 7.17 |   | 25.94 |   | 28,500 |   | 25.94 |   |
|                                        | 27.72      | –                                                    |       | 30.79                                                   |       | 7,500 |   | 7.02 |   | 30.79 |   | 7,500 |   | 30.79 |   |
| $                                           | 1.02       | –                                                    | $          | 30.79                                                   |       | 2,435,118 |   | 7.56 |   | $ | 14.21 |   | 1,627,090 |   | $ | 12.39 |   |

 

On November 17, 2005, the Compensation Committee(the “Committee”) of the Board of Directors of the Company approved theacceleration of the unvested portion of certain stock options held byemployees, officers and directors of the Company. The options that wereaccelerated have exercise prices greater than $21.00 per share, which is higherthan the $14.76 closing price of the Company’s common stock as quoted on theNasdaq National Market on November 17, 2005. These options would havevested and become exercisable from time to time over the next 32 months. As aresult of the acceleration, all of these options became fully vested andimmediately exercisable. All other terms and conditions applicable tooutstanding stock option grants remain in effect. Shares received upon theexercise of accelerated options held by members of the Company’s Board ofDirectors and by the Company’s President and Chief Executive Officer and itsExecutive Vice Presidents may not be sold or otherwise transferred prior to theearlier of the original vesting date of such options or their termination ofemployment or service. The Committee’s decision to accelerate the vesting ofthe affected stock options was based upon the required adoption of SFASNo. 123(R).

The aggregate intrinsic value of options exercisedduring the nine months ended September 30, 2006 was $3,049. As ofSeptember 30, 2006, total remaining unearned compensation related tounvested stock options was approximately $5,922, which will be amortized overthe weighted-average remaining service period of two years.

In accordance with the evergreen provision in the 2003Plan and as approved by the Board of Directors, effectiveJanuary 1, 2006, the number of shares reserved under the 2003 Planwas increased by 698,901 shares.

On April 17, 2003, the Company’s board adoptedthe 2003 Employee Stock Purchase Plan and the 2003 Foreign Subsidiary EmployeeStock Purchase Plan (“ESPP”), under which, subject to certain limitations, theinitial aggregate number of shares of stock that may be issued is 500,000,cumulatively increased on January 1, 2004 and each January 1thereafter until and including January 1, 2013 by the lesser of:1) 500,000 shares, 2) one percent of the number of shares of allclasses of common stock of the Company outstanding on that date, or 3) alesser amount determined by the Board of Directors. Under the ESPP, shares areonly issued during the second and fourth quarter of each year. The values wereestimated at the date of grant using the Black-Scholes option pricing modelwith the following weighted average key assumptions for 2005 and 2006:
|                          | ** ** | **2005** | ** ** | **2006** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
| Risk free  interest rate |       | 2.6      | %          | 4.5      | %          |
| Expected lives  (years)  |       | 1.3      |       | 0.7      |       |
| Dividend yield           |       | 0        | %          | 0        | %          |
| Expected volatility      |       | 50       | %          | 63       | %          |

 

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 a blend of thehistorical volatility of the

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Company’s common stockand publicly traded peer companies. The risk-free interest rate was the averageinterest rates of U.S. government bonds of comparable term to the serviceperiod.

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 $103 and $294 for the three and ninemonths ended September 30, 2006.

On February 23, 2006, the Committee approved agrant of 68,500 shares of restricted stock to executive officers pursuant tothe 2003 Plan. The shares of restricted stock to executive officers generallyvest in equal annual installments on February 15 of each of the four yearsfollowing the date of grant. On May 18, 2006, in accordance with the 2003Plan, 12,500 shares, in total, of restricted stock were automaticallyissued to the outside directors. The shares of restricted stock to outsidedirectors generally vest on May 15 of the year following the date of grant. OnAugust 16, 2006, the Committee approved a grant of 17,500 shares of restrictedstock to employees pursuant to the 2003 Plan. The shares of restricted stock toemployees vest in equal annual installments on August 15 of each of the fouryears following the date of grant. Compensation expense on these shares was$130 and $341 for the three and nine months ended September 30, 2006,respectively.

The followingtable summarizes information about restricted stock activity during the ninemonths ended September 30, 2006: 
|                                             | ** ** | **Number of  Shares** | ** ** | **Weighted-  Average  Grant-Date  Fair Value** | ** ** |
|---------------------------------------------|------------|----------------------------|------------|-----------------------------------------------------|------------|
| Granted                                     |       | 98,500                     |       | $                                                   | 18.53      |   |
| Vested                                      |       | (5,000                     | )          | 18.32                                               |       |
| Forfeited                                   |       | —                     |       | —                                              |       |
| Nonvested stock at  September 30, 2006 |       | 93,500                     |       | $                                                   | 18.54      |   |

 

As of September 30, 2006, total remainingunearned compensation related to restricted stock was $1,217, which will beamortized over the weighted-average remaining service period of two years.

**Non-Employee Equity Awards**

During 2000 and 2001, options to purchase 50,000 and5,000 shares, respectively, were granted to non-employee directors orconsultants.

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. In February, 2005, theCompany granted options to purchase 25,000 shares of common stock to a non-employeeconsultant. The Company accounts for stock, stock options and warrants issuedto non-employees in accordance with the provisions of SFAS No. 123 andEITF Issue No. 96-18 “Accounting for Equity Instruments That AreIssued to Other Than Employees for Acquiring, or in Conjunction with Selling,Goods and Services.” Under SFAS No. 123 and EITF Issue No. 96-18,stock option awards issued to non-employees are accounted for at fair valueusing the Black-Scholes pricing model. Management believes that the fair valueof the stock options is more reliably measured than the fair value of theservices received. Compensation expense related to the fair value of stockoptions granted to non-employees is recognized over the service period and wasdetermined using the Black-Scholes option pricing model using the followingassumptions: risk-free interest rate of 4.4%; contractual life ranging fromfive to ten years; dividend yield of 0%; and expected volatility of 58%. Ateach reporting date, the Company revalues the stock-based compensation expenserelated to unvested non-employee options using the Black-Scholes option pricingmodel. As a result, stock-based compensation will fluctuate with changes in thefair value of the Company’s common stock. In connection with the grant of stockoptions and restricted stock to consultants, the Company recorded stock-basedcompensation expense in selling, general and administrative expense of $16 and$84 for the three months ended September 30, 2005 and 2006, respectively.The Company recorded stock-based compensation expense in selling, general andadministrative expense of $75 and $147 for the nine months endedSeptember 30, 2005 and 2006, respectively.

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**Note 11—Commitmentsand Contingencies**

**Indemnities,Commitments and Guarantees**

In the normal course of business, the Company makescertain indemnities, commitments and guarantees under which the Company may berequired to make payments in relation to certain transactions. Theseindemnities, commitments and guarantees include, among others, intellectualproperty indemnities to customers in connection with the sale of products andlicensing of technology, indemnities for liabilities associated with theinfringement of other parties’ technology based upon the Company’s products andtechnology, guarantees of timely performance of the Company’s obligations, andindemnities to the Company’s directors and officers to the maximum extentpermitted by law. The duration of these indemnities, commitments and guaranteesvaries, and in certain cases, is indefinite. The majority of these indemnities,commitments and guarantees do not provide for any limitation of the maximumpotential future payments that the Company could be obligated to make. TheCompany has not recorded a liability for these indemnities, commitments orguarantees in the accompanying balance sheets, as future payment is notprobable.

**Note 12—OperatingSegment and Geographic Information**

The Company operates its business in three reportablesegments: the Consumer business segment, the Cinema business segment and theDigital Images business segment. The Company’s Consumer business segmentlicenses audio technology, trademarks and know-how to consumer electronics,personal computer, broadcast and professional audio companies, and sellsmulti-channel audio content and products to consumers. The Cinema businesssegment licenses technology and sells products and services to producers anddistributors of feature length films and digital content, and to movie theatersand special venues. The Company’s Digital Images business segment providesenhancement, restoration 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 businesssegments.

The Company’sreportable segments and geographical information for the three and nine monthsended September 30, 2005 and 2006 are as follows:
|                          | ** ** | **Revenues**                                                           | ** ** |
|--------------------------|------------|------------------------------------------------------------------------|------------|
| ** **               | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
| ** **               | ** ** | **2005**                                                               | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** |
| Consumer  business       |       | $                                                                      | 10,213     |   | $ | 9,514 |   | $ | 37,728 |   | $ | 39,776 |   |
| Cinema business          |       | 5,742                                                                  |       | 4,768 |   | 15,676 |   | 15,095 |   |
| Digital Images  business |       | 1,598                                                                  |       | 971 |   | 3,934 |   | 5,980 |   |
| Total revenues           |       | $                                                                      | 17,553     |   | $ | 15,253 |   | $ | 57,338 |   | $ | 60,851 |   |

 
|                          | ** ** | **Gross Profit**                                                  | ** ** |
|--------------------------|------------|------------------------------------------------------------------------|------------|
| ** **               | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
| ** **               | ** ** | **2005**                                                               | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** |
| Consumer  business       |       | $                                                                      | 9,799      |   | $ | 9,129 |   | $ | 36,284 |   | $ | 38,630 |   |
| Cinema business          |       | 3,089                                                                  |       | 2,372 |   | 7,497 |   | 7,175 |   |
| Digital Images  business |       | 21                                                                     |       | (570 | ) | (580 | ) | (452 | ) |
| Total gross  profit      |       | $                                                                      | 12,909     |   | $ | 10,931 |   | $ | 43,201 |   | $ | 45,353 |   |

 

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|                                      | ** ** | **Income (Loss) From Operations**                       | ** ** |
|--------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                           | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
| ** **                           | ** ** | **2005**                                                               | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** |
| Consumer  business                   |       | $                                                                      | 3,282      |   | $ | 1,708 |   | $ | 17,929 |   | $ | 16,902 |   |
| Cinema business                      |       | (742                                                                   | )          | (2,730 | ) | (3,365 | ) | (6,476 | ) |
| Digital Images  business             |       | (1,214                                                                 | )          | (2,117 | ) | (5,996 | ) | (4,749 | ) |
| Total income  (loss) from operations |       | $                                                                      | 1,326      |   | $ | (3,139 | ) | $ | 8,568 |   | $ | 5,677 |   |

 

Included in theCinema business segment’s loss for the three and nine months endedSeptember 30, 2006 is the $396 of separation costs. Included in theDigital Images business segment’s loss for the nine months endedSeptember 30, 2005 is the $2,300 charge related to in-process research anddevelopment.
|                | ** ** | **Revenues by Geographic  Region**                           | ** ** |
|----------------|------------|------------------------------------------------------------------------|------------|
| ** **     | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
| ** **     | ** ** | **2005**                                                               | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** |
| United States  |       | $                                                                      | 6,101      |   | $ | 4,336 |   | $ | 21,144 |   | $ | 17,265 |   |
| International  |       | 11,452                                                                 |       | 10,917 |   | 36,194 |   | 43,586 |   |
| Total revenues |       | $                                                                      | 17,553     |   | $ | 15,253 |   | $ | 57,338 |   | $ | 60,851 |   |

 

The followingtable sets forth, for the periods indicated, long-lived tangible assets bygeographic area in which the Company holds assets at December 31, 2005 andSeptember 30, 2006:
|                                   | ** ** | **Long-Lived Assets**              | ** ** |
|-----------------------------------|------------|-----------------------------------------|------------|
| ** **                        | ** ** | **As of  December 31,  2005** | ** ** | **As of  September 30,  2006** | ** ** |
| United States                     |       | $                                       | 5,859      |   | $ | 8,358 |   |
| International                     |       | 1,516                                   |       | 1,571 |   |
| Total long-lived  tangible assets |       | $                                       | 7,375      |   | $ | 9,929 |   |

 

**Note 13—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, common stock warrants, and the ESPP using the “treasury stock”method. Due to the net loss for the three months ended September 30, 2006, allpotential common shares are excluded from the diluted shares outstanding forthe three months ended September 30, 2006.

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The followingtable sets forth the computation of basic and diluted net income (loss) percommon share:
|                                              | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **2005**                                                               | ** ** | **2006**                                                              | ** ** | **2005** | ** ** | **2006** | ** ** |
| Basic net income  (loss) per common share:   |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Numerator:                                   |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Net income (loss)                            |       | $                                                                      | 1,194      |                                                                  | $          | (898 | ) | $ | 6,566 |   | $ | 7,992 |   |
| Denominator:                                 |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Weighted average common shares outstanding   |       | 17,411,461                                                             |       | 17,653,865                                                            |       | 17,275,515 |   | 17,565,963 |   |
| Basic net income (loss) per common share     |       | $                                                                      | 0.07       |                                                                  | $          | (0.05 | ) | $ | 0.38 |   | $ | 0.45 |   |
| Diluted net  income (loss) per common share: |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Numerator:                                   |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Net income (loss)                            |       | $                                                                      | 1,194      |                                                                  | $          | (898 | ) | $ | 6,566 |   | $ | 7,992 |   |
| Denominator:                                 |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Weighted average shares outstanding          |       | 17,411,461                                                             |       | 17,653,865                                                            |       | 17,275,515 |   | 17,565,963 |   |
| Effect of dilutive securities:               |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Common stock options                         |       | 908,720                                                                |       | —                                                                |       | 897,136 |   | 748,375 |   |
| Common stock warrants                        |       | 22,005                                                                 |       | —                                                                |       | 21,682 |   | 16,978 |   |
| Restricted stock                             |       | —                                                                 |       | —                                                                |       | — |   | 6,436 |   |
| ESPP                                         |       | —                                                                 |       | —                                                                |       | — |   | 4,926 |   |
| Diluted shares  outstanding                  |       | 18,342,186                                                             |       | 17,653,865                                                            |       | 18,194,333 |   | 18,342,678 |   |
| Diluted net  income (loss) per common share  |       | $                                                                      | 0.07       |                                                                  | $          | (0.05 | ) | $ | 0.36 |   | $ | 0.44 |   |

 

For the three monthsended September 30, 2005 and 2006, 817,150 and 2,528,618 shares, respectively,of the Company’s stock options and restricted stock were excluded from thecalculation of diluted earnings per share because their inclusion would havebeen anti-dilutive. For the nine months ended September 30, 2005 and 2006,845,150 and 1,314,263 shares, respectively, of the Company’s stock options andrestricted stock were excluded from the calculation of diluted earnings pershare because their inclusion would have been anti-dilutive.

**Note 14—StockRepurchase Plan**

In August 2006, the Company’s Board of Directorsauthorized, subject to certain business and market conditions, the purchase ofup to one million shares of the Company’s common stock in the open market or inprivately negotiated transactions. At September 30, 2006, there were no sharespurchased under this authorization. Any shares repurchased would be consideredtreasury stock.

**Note 15—SubsequentEvents**

In November 2006,the Company announced that it intends to proceed with the separation of itsCinema and Digital Images businesses from its Consumer licensing business.

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

**Forward-LookingStatements May Prove Inaccurate**

This Form 10-Q and the documentsincorporated herein by reference contain forward-looking statements based onour current beliefs, expectations, estimates and projections about ourindustry, and certain assumptions made by us. Words such as “believes,” “anticipates,”“estimates,” “expects,” “projections,” “may,” “potential,” “plan,” “continue”and words of similar import, constitute “forward-looking statements.” Theforward-looking statements contained in this report involve known and unknownrisks, uncertainties and other factors that may cause our actual results to bematerially different from those expressed in or implied by these statements.These factors include those listed under the “Risk Factors” section containedbelow and elsewhere in this Form 10-Q, and the other documents wefile with the SEC, including our most recent reports on Form 8-K andForm 10-K. We cannot guarantee future results, levels of activity,performance, or achievements. We do not intend to update these forward-lookingstatements to reflect future events or circumstances.

You should read the following discussion of ourfinancial condition and results of operations in conjunction with theconsolidated financial statements and the notes to those statements includedelsewhere in this Form 10-Q. This discussion may containforward-looking statements that involve risks and uncertainties. Our actualresults may differ materially from those anticipated in these forward-lookingstatements as a result of certain factors, such as those set forth under “RiskFactors” and elsewhere in this Form 10-Q.

**Overview**

We are a leading provider of entertainment technology,products and services to the audio and image entertainment markets worldwide.Historically we have been focused on high quality digital multi-channel audio,commonly referred to as surround sound, which provides more than two-channelsof audio, allowing the listener to simultaneously hear discrete sounds frommultiple speakers. Our DTS digital multi-channel audio technology deliverscompelling surround sound for the motion picture and consumer electronicsmarkets. With our January 2005 acquisition of Lowry DigitalImages, Inc., now DTS Digital Images, Inc., or DTS DI, we haveexpanded our business into high quality digital image processing, enhancementand restoration services for motion pictures, digital cinema, and televisioncontent.

We intend to proceed with the separation of our Cinemaand Digital Images businesses from our Consumer licensing business.  We believe this separation will enhancestockholder value and better position each business to serve its customer base,go-to-market more rapidly, and be more flexible in this dynamic environment.

We manage our business through three reportablesegments—our consumer business, our cinema business, and our digital imagesbusiness.

In our consumer business, we derive revenues fromlicensing our audio technology, trademarks, and know-how under agreements withsubstantially all of the major consumer audio electronics manufacturers. Ourbusiness model provides for these manufacturers to pay us a per-unit amount forDTS-enabled products that they manufacture. We also derive revenues fromlicensing our technology to consumer semiconductor manufacturers. Through ourDTS Entertainment label, we derive revenues from the sale of multi-channelmusic titles in our digital multi-channel format.

In our cinema business, we derive revenues from salesof our playback equipment and cinema processors to movie theaters and specialvenues. In addition, we license technology and sell encoding and duplicationservices to film producers and distributors for the creation of digitalmulti-channel motion picture soundtracks. We also derive revenues from the saleof systems and encoding services for Digital Cinema, pre-show advertising,alternative content, subtitling, captioning, and descriptive narration.

In our digital images business, we derive revenuesfrom the processing, enhancement and restoration of cinema, home video andbroadcast television content. We provide these services to motion picture andtelevision studios and other content owners. We offer our services on either afixed fee or time and materials basis.

We present revenues in our consolidated financialstatements and in this “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” as derived from (1) technology andfilm licensing and (2) product sales and other revenues. Our technologyand film licensing revenues are derived from each of our consumer and cinemabusiness segments. Revenues from technology licensing in connection with ourconsumer business segment include revenues derived from licensing our audiotechnology, trademarks, and

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know-how to consumerelectronics, personal computer, video game and console, digital satellite andcable broadcast, and professional audio companies as well as to semiconductormanufacturers. Revenues from technology and film licensing in connection withour cinema business segment include revenues derived from film licensing andservices that we provide to film studios for the production of soundtracks inour digital multi-channel format. Our product sales and other revenues arederived from our consumer, cinema and digital images business segments.Revenues from product sales and other revenues in connection with our consumerbusiness segment include revenues derived from sales of music titles that weproduce in our digital multi-channel format and sales of our professional audioproducts and services. Revenues from product sales and other revenues inconnection with our cinema business segment include revenues derived from salesof our digital playback systems, cinema processor equipment, and systems forsubtitling, captioning, and descriptive narration to movie theaters and specialvenues. Revenues from product sales and other revenues in connection with ourdigital images business segment include fees for processing, enhancing andrestoring cinema, home video and broadcast television content.

We actively engage in intellectual property complianceand enforcement activities focused on identifying third parties who have eitherincorporated our technology, trademarks, or know-how without a license or whohave under-reported the amount of royalties owed under license agreements withus. We continue to invest in our compliance and enforcement infrastructure tosupport the value of our intellectual property to us and our licensees and toimprove the long-term realization of revenue from our intellectual property. Asa result of these activities, from time to time, we recognize royalty revenuesthat relate to consumer electronics manufacturing activities from priorperiods. These royalty recoveries may cause revenues to be higher than expectedduring a particular reporting period and may not occur in subsequent periods.While we consider such revenues to be a regular part our normal operations, wecannot predict the amount or timing of such revenues.

Our cost of goods sold consists primarily of amountspaid for products and materials, salaries and related benefits for productionpersonnel, depreciation of production equipment, amortization of acquiredintangibles and payments to third parties for licensing technology andcopyrighted material.

Our selling, general, and administrative expensesconsist primarily of salaries, commissions, and related benefits for personnelengaged in sales, corporate administration, finance, human resources,information systems, legal, and operations, and costs associated withpromotional and other selling activities. Selling, general, and administrativeexpenses also include professional fees, facility-related expenses, and other generalcorporate expenses.

Our research and development costs consist primarilyof salaries and related benefits for research and development personnel,engineering consulting expenses associated with new product and technologydevelopment, and quality assurance and testing costs. Research and developmentcosts are expensed as incurred.

In our consumer business, we have a licensing teamthat markets our technology directly to large consumer electronics productsmanufacturers and semiconductor manufacturers. This team includes employeeslocated in the United States, China, England, Japan, Hong Kong and NorthernIreland. We sell music content released under our DTS Entertainment labelthrough exclusive distribution arrangements in the United States, Europe and Japan.We employ consultants to coordinate sales to independent retailers and we sellthis music directly to consumers through an online store and other web-basedretailers.

In our cinema business, our post-productiondepartment, senior management, and liaison offices market our products andservices directly to individual film producers and distributors worldwide. Wesell our digital multi-channel playback systems to movie theaters through adirect sales force and a network of independent dealers. To date, most of oursales and marketing efforts have been focused in the United States and Canada,Western Europe, and in targeted markets in Asia and Latin America. We have alsobegun to focus our efforts on pursuing theater companies that have a largeconcentration of movie theaters in selected foreign countries such as India,China, and Eastern Europe.

In our digital images business, our senior managementteam markets our services directly to directors, producers and content owners.The sales process typically involves an evaluation of the cinema, home video orbroadcast television content to be enhanced or restored and a determination ofthe scope of services required to

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achieve the desiredresult. Our digital images services enable current or archived film content tobe enhanced or restored for high quality, high definition presentation indigital cinema, high definition optical media or broadcast applications.

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

***New StrategicInitiatives***

The trend in the motion picture industry and movieexhibition market toward digital delivery of entertainment content continues togain momentum and we believe it presents a long-term opportunity for us toexpand our cinema business. As part of our strategy to pursue opportunities inthe digital cinema market, we signed an exclusive license agreement and anoption agreement with Avica Technology Corporation, a provider of products andservices for the digital cinema market. Under the exclusive license agreementwe will acquire a worldwide, exclusive license (even as to Avica) tosubstantially all of Avica’s intellectual property in all fields of use otherthan with respect to military applications. Under the option agreement, we mayelect, in our sole discretion, to acquire all or substantially all of theassets of Avica for a fixed purchase price. The closing under these agreementshas not yet been consummated and remains subject to the satisfaction or ourwaiver of certain closing conditions. We believe Avica’s suite of digitalcinema technologies, products and services will complement our existing cinemaproduct offerings and will accelerate our entry into the digital cinema market.

Additionally, we intend to proceed with the separationof our Cinema and Digital Images businesses from our Consumer licensingbusiness. We believe this separation will enhance stockholder value and betterposition each business to serve its customer base, go-to-market more rapidly,and be more flexible in this dynamic environment.

***Trends,Opportunities, and Challenges by Business Segment***

*Consumer Segment*

Revenue from our consumer segment constitutes the majorityof our total revenue, representing 62% and 58% of total revenues for thequarters ended September 30, 2006 and 2005, respectively. Our consumerrevenue is primarily dependent upon the home theater and DVD player markets,which have experienced rapid growth over the past several years. However, wehave recently experienced softness in our DVD player trademark licensingprogram, and expect growth rates in this area to decline from recent levels.The success of DVD-Video-based systems and products has fueled a demand forhigher quality entertainment in the home, and this demand is extending to thecar audio and personal computer markets as well. In addition, we expect therecent acceleration of the market for high definition televisions to drivedemand for high definition optical disc players beginning in late 2006,although licensing revenues to us based on sales of these high definitionplayers will be minimal for the year. Because we have been selected as amandatory technology for next generation players, our consumer revenue growthshould more closely track the growth rate for sales of these players over thenext several years. We expect that the market for high definition players willyield new growth that provides an offset to the expected decline in the overallgrowth in DVD player shipments. Further, we believe that expected mandatoryinclusion in next generation optical disc standards will help to improve theadoption rate of our technologies in other consumer products such as nextgeneration video game consoles, personal audio and video players, personalcomputers and in-car entertainment systems. If we are removed from mandatorystatus in next generation high definition optical disc standards, it wouldcause revenue growth in our consumer business to be significantly lower thanexpected and would have a material adverse effect on our business.

In July 2004, we acquired QDesign Corporation, orQDesign, a company focused on lower bit-rate audio delivery technology. Themarket for higher quality entertainment is expanding into portable devices thatrequire the use of low-bit rate audio coding systems including portable audioplayers, PDAs and wireless handset applications. Concurrent with this trend,there is a growing need for a good link between home and portable devices thatpreserves as much quality as possible and allows consumers a seamlesstechnology solution for the storage and playback of their content. InOctober 2004, leveraging our existing research and development efforts andthe intellectual property acquired in the QDesign acquisition, we launched ourDTS-HD initiative. This technology is a scalable coding system that will allowcontent to be played in home and portable devices. We

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believe that the broadand robust nature of this offering improves the probability of inclusion of ourtechnologies in next generation products.

*Cinema Segment*

Revenue from our cinema segment represented 31% and33% of total revenues for the quarters ended September 30, 2006 and 2005,respectively. We expect our cinema audio hardware business to decline slightlythroughout the remainder of 2006 from prior year levels, as the cinemaexhibition community has begun to defer purchases of digital multi channelaudio equipment as they evaluate the pace of progress in the emerging digitalcinema market as discussed below. We also believe that the cinema exhibitioncommunity has recognized that pre-show entertainment represents a significantrevenue growth opportunity that will lead to investment in pre-show solutionsover the next several years. Because our XD10 Cinema Media Player can beconfigured to perform audio playback along with pre-show and subtitlingpresentation, we believe that we are well-positioned to participate in theanticipated growth in this market.

A trend that we believe will affect our cinemabusiness segment is the long-term trend toward digital distribution of content.We believe this trend will involve the near-term adoption of digital pre-showand/or electronic cinema solutions, followed by longer-term adoption of higherquality digital cinema. Digital distribution of content offers the motionpicture industry a means to achieve substantial cost savings, including theprinting and distribution of movies, help in combating piracy, and will enablemovies to be played repeatedly without degradation. It also provides additionalrevenue opportunities for cinema operators, as digital content such asadvertisements, concerts and sporting events could be shown in or broadcast todigitally equipped theaters. In recent months, there has been increasingmomentum in the digital cinema industry, as product and service vendors attemptto find a viable business model. We believe that these activities are primarilyvendor-financed trials at this point, but represent an important andsignificant step in the transition. We believe this represents an opportunityfor us as we seek to provide products and services in support of the transitionfrom film-based content towards digital cinema. However, our current digitalcinema offerings are limited and we may not be successful in developing orselling competitive product offerings. We believe that the addition of ourCinema Media Network and variable bit rate JPEG 2000 encoding tools, along withthe services provided by our digital images business, and the pre-show andalternative content capabilities of our XD10 Cinema Media Player, combined withthe addition of the products, technologies and know-how to be obtained underour exclusive license agreement with Avica, will enhance our ability toparticipate in the industry transition to high definition sound and images fordigital cinema.

Sales of cinema products and film licensing tend tofluctuate based on the underlying trends in the motion picture industry. Forinstance, in the late 1990s various cinema operators aggressively builtmegaplexes, which resulted in an oversupply of screens in some domestic andinternational markets. The resulting oversupply of screens led to significantdeclines in revenues per screen, and eventually, many theaters were closed. Asa result of the closures, sales of our playback systems and cinema processorssuffered. As the theater industry has regained health in the last severalyears, sales of our DTS playback systems and cinema processors have improved.Our film licensing revenues are also subject to fluctuations based on industrytrends, most significantly, the number of films being made by studios andindependent filmmakers.

*Digital Images Segment*

Revenue from our digital images segment represented 6%and 9% of total revenues for the quarters ended September 30, 2006 and 2005,respectively. We believe that the growing market for high resolution and highdefinition content in the cinema and the home will create a substantial demandfor the type of services provided by DTS DI. A relatively new application forour process is the correction of problems encountered with the use of digitalcameras, enabling our involvement at the earliest stages of digital contentdevelopment. We believe that we provide leading digital lab capabilities,including digital enhancement, restoration and other pre-compression servicesand that we have a technological advantage over many of our competitors basedon the sophistication of our processes and level of automation used to enhancethe image quality of entertainment content. Revenues for our digital imagessegment totaled $1.0 million and $1.6 million for the quarter endedSeptember 30, 2006 and 2005, respectively. To date, this business has enhancedand/or restored over 100 feature films, including such

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major DVD releases asStar Wars and Indiana Jones. Major motion picture and television studiospossess libraries containing thousands of titles, which we believe represent asizable market opportunity for the services performed by DTS DI.

**CriticalAccounting Policies and Estimates**

Management’s Discussion and Analysis of FinancialCondition and Results of Operations is based upon our consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States. The preparation of our financialstatements requires us to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenues, and expenses, and related disclosureof contingent assets and liabilities. On an on-going basis, estimates areevaluated, including those related to revenue recognition, allowance fordoubtful accounts, inventories, goodwill and intangible assets, taxes,impairment of long-lived assets, product warranty, stock-based compensation,and contingencies and litigation. These estimates are based on historicalexperience and on various other assumptions that we believe to be reasonableunder the circumstances, the results of which form the basis for making judgmentsabout the carrying values of assets and liabilities that are not readilyapparent 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 onMarch 16, 2006, except for the adoption of SFAS No. 123(R).

**Results ofOperations**

***Revenues***

*Technology and Film Licensing*

Technology and film licensing revenues for the threemonths ended September 30, 2006 decreased 7% to $11.7 million from$12.6 million for the three months ended September 30, 2005. Thedecrease in revenues from technology and film licensing was primarilyattributable to a decrease in royalty recoveries of $1.2 million fromintellectual property compliance and enforcement activities. We areexperiencing strong growth in the personal computer and car audio systemsmarkets, which posted quarter over quarter growth totals of 4% and 90%,respectively, during the third quarter of 2006 and are up 18% and 77%,respectively, for the year. However, 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, basedprimarily on the expected continuation of growth in our decoder licensingprogram and from our license enforcement activities. Our film licensingrevenues decreased 6% for the three months ended September 30, 2006compared to the prior year period due primarily to the timing of major featurefilm releases. Film licensing is expected to remain relatively flat for theremainder of 2006.

Technology and film licensing revenues for the ninemonths ended September 30, 2006 increased 5% to $46.3 million from$43.9 million for the nine months ended September 30, 2005. Theincrease in revenues from technology and film licensing was primarilyattributable to strong growth in the personal computer and car audio systemsmarkets, as described above. Also, royalty recoveries increased $0.9 millionover the prior year period from intellectual property compliance andenforcement activities. These activities, which include audits of shipments bycertain of our licensees and legal actions taken against licensees and partieswho are not our licensees, resulted in recoveries of royalty payments relatingto prior periods.

*Product Sales and Other*

Product sales and other revenues decreased 29% to$3.5 million for the three months ended September 30, 2006 from$4.9 million for the three months ended September 30, 2005. Thisdecrease was primarily attributable to deferred revenue of approximately $0.8million being recognized during the third quarter of 2005 which was notrecognized during the current quarter. Also, revenue from our Digital Imagessegment declined 39% for the three months ended September 30, 2006, to $1.0million as a result of process improvements implemented in the prior quarter,which resulted in an acceleration of certain restoration projects into oursecond quarter and corresponding reduction of backlog for the third quarter. Weexpect product sales and other revenue to improve in the fourth quarter of2006.

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Product sales and other revenues increased 8% to$14.5 million for the nine months ended September 30, 2006 from$13.4 million for the nine months ended September 30, 2005. Thisincrease was primarily attributable to growth in revenues generated by DTS DI,partially offset by a decrease in Cinema hardware sales resulting in part fromthe recognition of deferred revenue related to our arrangement with Cinecomduring 2005.

*Segment Sales*

Revenues from our consumer business totaled $9.5million for the three months ended September 30, 2006, a decrease of 7%from $10.2 million for the three months ended September 30, 2005. Thedecrease in revenues was primarily attributable to a decrease in royaltyrecoveries of $1.2 million from intellectual property compliance andenforcement activities. Cinema revenues totaled $4.8 million for the threemonths ended September 30, 2006, a decrease of 17% from $5.7 millionfor the three months ended September 30, 2005. The decrease in revenue wasprimarily due to a slowdown in U.S. hardware sales, as described above.Revenues from our digital images business totaled $1.0 million for the threemonths ended September 30, 2006, a significant decrease from revenues of$1.6 million for the three months ended September 30, 2005. The decreasein revenues was primarily due to the completion of a significant project in theprior year, coupled with ongoing improvements in our digital enhancement andrestoration processes, which resulted in significant improvements in throughputduring the prior quarter and the resultant reduction in backlog for the thirdquarter.

Revenues from our consumer business totaled $39.8million for the nine months ended September 30, 2006, an increase of 5%from $37.7 million for the nine months ended September 30, 2005. Theincrease in revenues was driven primarily by an increase in royalty recoveriesmentioned above as well as the overall growth in our personal computer and caraudio markets. Cinema revenues totaled $15.1 million for the nine months endedSeptember 30, 2006, a decrease of 4% from $15.7 million for the ninemonths ended September 30, 2005. The decrease in revenue was primarily dueto a slowdown in Cinema hardware sales during 2006. Revenues from our digitalimages business totaled $6.0 million for the nine months endedSeptember 30, 2006, a significant increase from revenues of $3.9 millionfor the nine months ended September 30, 2005. The increase in revenues wasprimarily due to the completion of certain significant projects, and ongoingimprovements in our digital enhancement and restoration processes.

***Gross Profit***

Consolidated gross profit decreased to 72% of revenuesfor the three months ended September 30, 2006, from 74% for the threemonths ended September 30, 2005. Consolidated gross profit was 75% ofrevenues for the nine months ended September 30, 2006 and 2005. We expectconsolidated gross margins in the 70% to 75% range for 2006 primarily as aresult of the incorporation of DTS DI into our consolidated resultsof operations.

*Technology and Film Licensing*

Gross profit associated with technology and filmlicensing revenues was 91% of related revenues for the three months endedSeptember 30, 2006 and 2005.

Gross profit associated with technology and filmlicensing revenues was 92% of related revenues for the nine months endedSeptember 30, 2006 and 2005.

*Product Sales and Other*

Gross profit associated with product sales and otherrevenues decreased to 7% of related revenues for the three months endedSeptember 30, 2006 from 30% in the prior year period primarily as a resultof a slowdown in U.S. hardware sales and low revenues from our Digital Imagesbusiness, as described above.

Gross profit associated with product sales and otherrevenues decreased to 18% of related revenues for the nine months endedSeptember 30, 2006 from 21% in the prior year period primarily as a resultof a slowdown in U.S. hardware sales, as described above.

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*Segment Gross Profit*

Gross profit for our consumer business was 96% ofrelated revenues for the three months ended September 30, 2006 and 2005.Our cinema business gross profit decreased to 50% of related revenues for thethree months ended September 30, 2006 from 54% in the prior year periodprimarily due to a slowdown in U.S. hardware sales, as described above, and aless favorable mix of hardware sales and film licensing. Our digital imagesbusiness gross profit was negative for the three months endedSeptember 30, 2006 compared to 1% of related revenues in the prior year.

Gross profit for our consumer business increasedslightly to 97% of related revenues for the nine months endedSeptember 30, 2006 compared to 96% for the same period in 2005. Our cinemabusiness gross profit was 48% of related revenues for the nine months endedSeptember 30, 2006 and 2005. Our digital images business gross profit wasnegative for the nine months ended September 30, 2006 and 2005.

***Selling, Generaland Administrative***

Selling, general and administrative expenses increased16% to $10.4 million for the three months ended September 30, 2006,compared to $9.0 million in the prior year period. The increase is primarilydue to an increase in compensation expense of $1.4 million due to additionalemployees and the inclusion of $0.7 million in stock based compensation costsunder SFAS No. 123(R).

Selling, general and administrative expenses increased21% to $30.3 million for the nine months ended September 30, 2006,compared to $25.1 million in the prior year period. The increase is primarilydue to an increase in compensation expense of $4.6 million due to additionalemployees and the inclusion of $2.1 million in stock based compensationcosts under SFAS No. 123(R).

We expect selling, general and administrative expensesto increase due to our separation activities and to support our growthinitiatives including acquisitions, international expansion and intellectualproperty enforcement activities related to the launch of our DTS-HD initiative.

***Research andDevelopment***

For the three months ended September 30, 2006,research and development expenses were $3.3 million, compared to$2.6 million for the three months ended September 30, 2005. For thenine months ended September 30, 2006, research and development expenseswere $9.0 million, compared to $7.2 million for the nine months endedSeptember 30, 2005. The increase for both periods is primarily due toincreased labor costs associated with new product and technology initiatives,the optimization of our Coherent Acoustics technology, and the development oftools associated with next generation optical disc standards. In addition,SFAS No. 123(R) related compensation expenses totaled $0.1million and $0.3 million for the three and nine months ended September 30,2006, respectively.

We expect to continue to increase our investment inapplications engineering and research and development activities in futurequarters to support the roll out of next generation optical disc standards andthe continued optimization of our Coherent Acoustics technology.

***In-ProcessResearch and Development***

In-process research and development of $2.3 millionfor the nine months ended September 30, 2005 relates to developmentprojects that had not reached technological feasibility and were of no futurealternative use and expensed upon consummation of the acquisition of DTS DI.Developed technology and in-process research and development were identifiedand valued through extensive interviews, analysis of data provided by DTS DIconcerning development projects, their stage of development, the time andresources needed to complete them, if applicable, and their expected incomegenerating ability and associated risks. Where development projects had reachedtechnological feasibility, they were classified as developed technology and thevalue assigned to developed technology was capitalized. The income approach,which includes an analysis of the cash flows and risks associated withachieving such cash flows, was the primary technique utilized in valuingacquired in-

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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.

***Separation Costs***

Separation costs for the three and nine months endedSeptember 30, 2006 were $0.4 million. In August 2006, we announced that weintend to study the potential separation of the Cinema and Digital Imagesbusinesses from the Consumer business in order to better address rapidlyevolving markets, meet the needs of customers and increase shareholder value.The separation costs consist primarily of legal and accounting expensesrelating to the separation of our business. We will continue to incur thesecosts as we proceed with the separation of the business.

***Interest Income,Net***

Interest income, net, for the three and nine monthsended September 30, 2006 increased due to the increase in interest ratesin 2006 and higher average investment balances.

***Income Taxes***

For the three months ended September 30, 2006, werecorded an income tax benefit of $0.9 million on pre-tax loss of $1.7 million.For the three months ended September 30, 2005, we recorded an income taxprovision of $0.9 million on pre-tax income of $2.1 million.

For the nine months ended September 30, 2006, werecorded an income tax provision of $1.4 million on pre-tax income of $9.4million. This resulted in an annualized effective tax rate of 14.8%. During thesecond quarter of 2006, the Internal Revenue Service, or IRS, completed anexamination of the federal income tax return filed by us for the year endedDecember 31, 2003. We achieved a favorable resolution with the IRSregarding the Extraterritorial Income Exclusion, or ETI, that resulted in a taxbenefit of $1.7 million.  As a result ofthese items, the current income tax rate differs from the statutory rate. AtSeptember 30, 2006, our annualized effective tax rate was approximately 42.4%,which included approximately 5.0% for non-deductible costs related to the separationof the business. For the nine months ended September 30, 2005, we recordedan income tax provision of $3.9 million on pre-tax income of $10.5 million,representing an annualized effective tax rate of 37.4%. 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 to be 17% to 19%. However, we expect future tax rates to moreclosely approximate the statutory rates.

**Liquidity andCapital Resources**

At September 30, 2006, we had cash, cashequivalents and short-term investments of $118.9 million, compared to $111.4million at December 31, 2005.

Net cash provided by operating activities was$12.1 million for the nine months ended September 30, 2006, comparedto $6.2 million for the nine months ended September 30, 2005. The primarysource of operating cash flow for the nine months ended September 30, 2006was net income of $8.0 million, adjusted for non-cash items includingdepreciation and amortization expense and stock-based compensation charges.

Net cash used in investing activities totaled $3.9million for the nine months ended September 30, 2006, compared to net cashprovided by investing activities of $2.3 million for the nine months endedSeptember 30, 2005. Cash used in investing activities for the nine monthsended September 30, 2006 primarily consists of purchases of property andequipment of $4.9 million offset by net sales of investments of $2.6 million.

Net cash provided by financing activities totaled $1.9million and $0.7 million for the nine months ended September 30, 2006 and2005, respectively, and consists of the exercise of stock options and relatedexcess tax

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benefits and purchases ofstock under our employee stock purchase plan. Prior to adoption of SFASNo. 123(R), excess tax benefits from exercise of stock options were shownas an operating cash inflow.

In 2005, we entered into an agreement for the purchaseand implementation of a new enterprise resource planning system, or ERP, forapproximately $0.7 million. We expect that we will incur additional costs inthe range of $2 million to $4 million over the next several years in connectionwith our ERP implementation. Through September 30, 2006, we incurredapproximately $2.1 million, which has been capitalized to software.

On August 1, 2006, our Board of Directors authorized,subject to certain business and market conditions, the purchase of up to onemillion shares of our common stock in the open market or in privatelynegotiated transactions. At September 30, 2006, there were no shares purchasedunder this authorization. Any shares repurchased would be considered treasurystock.

In August 2006, we announced that we were studying thepotential separation of our business and in November 2006, we announced ourintent to proceed with the separation of our Cinema and Digital Images businessesfrom our Consumer licensing business. Through September 30, 2006, we incurredapproximately $0.4 million in separation costs, consisting primarily of legaland accounting expenses relating to the separation of our business. Theseparation of our business may require us to allocate a significant portion ofour cash to the Cinema and Digital Images business.

On August 8, 2006,we entered into an Exclusive License Agreement and an Option Agreement withAvica. The closing under these agreements has not yet been consummated andremains subject to the satisfaction or our waiver of certain closingconditions. Under the Exclusive License Agreement, Avica will grant to us anexclusive license to all or substantially all of Avica’s intellectual propertyand technology in all fields of use other than military applications. Toacquire the exclusive license under the Exclusive License Agreement, we will berequired to pay initial aggregate consideration of $5 million. Thereafter, wewill be required to pay up to an additional $2.9 million to Avica in the eventthat we recognize revenues with respect to the sale of certain Avica productsto third parties during the three-year period following the date of theExclusive License Agreement. The term of Exclusive License Agreement willcommence when we complete the license closing upon payment of the initialaggregate consideration of $5 million (the “License Closing”) and will lastuntil three years following completion by Avica of certain clean-up conditionsidentified in the Exclusive License Agreement to our reasonable satisfaction.Under the Option Agreement, we will acquire the exclusive option to acquire theassets of Avica during the period beginning upon the License Closing and endingon the expiration or earlier termination of the license term. In the event thatwe exercise our exclusive option under the Option Agreement, we will berequired to pay up to $1.5 million to Avica, which may be payable in cash or inrestricted common stock pursuant to the terms set forth in the OptionAgreement.

We believe that our cash, cash equivalents, short-terminvestments, funds available under our existing bank line of credit facility,and cash flows from operations will be sufficient to satisfy our workingcapital and capital expenditure requirements for at least the next twelvemonths. Beyond the next twelve months, additional financing may be required tofund working capital and capital expenditures. Changes in our operating plansincluding lower than anticipated revenues, increased expenses, acquisition ofcompanies, products or technologies or other events, including those describedin “Risk Factors” included elsewhere herein, in our Form 10-K filedon March 16, 2006 and in other filings may cause us to seek additionaldebt or equity financing on an accelerated basis. Financing may not beavailable on acceptable terms, or at all, and our failure to raise capital whenneeded could negatively impact our growth plans and our financial condition andresults of operations. Additional equity financing may be dilutive to theholders of our common stock and debt financing, if available, may involvesignificant cash payment obligations and financial or operational covenantsthat restrict our ability to operate our business.

**Recently IssuedAccounting Standards**

In September 2006, the FASB issued SFAS No. 157, “FairValue Measurements.” SFAS No. 157 defines fair value, establishes a frameworkfor measuring fair value, and expands disclosures about fair valuemeasurements. This statement is effective for financial statements issued forfiscal years beginning after November 15, 2007. We plan to adopt SFAS No. 157effective January 1, 2008. We are in the process of determining the effect, ifany, the adoption of SFAS No. 157 will have on our financial statements.

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In September 2006, the SEC staff issued SAB No. 108, “Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements.” SAB 108 provides guidance on how prior yearmisstatements should be taken into consideration when quantifying misstatementsin current year financial statements for purposes of determining whether thecurrent year’s financial statements are materially misstated. SAB No. 108 iseffective for fiscal years ending after November 15, 2006. We plan to adopt SABNo. 108 during the fourth quarter of 2006. We are in the process of determiningthe effect, if any, the adoption of SAB No. 108 will have on our financialstatements.

In July 2006, the FASB issued FIN No. 48, “Accountingfor Uncertainty in Income Taxes,” which prescribes a comprehensive model forhow a company should recognize, measure, present and disclose in its financialstatements uncertain tax positions that the company has taken or expects totake on a tax return (including a decision whether to file or not to file areturn in a particular jurisdiction). The accounting provisions of FIN No. 48are effective for fiscal years beginning after December 15, 2006. We plan toadopt FIN No. 48 effective January 1, 2007. We are in the process ofdetermining the effect, if any, the adoption of FIN No. 48 will have onour financial statements.

In June 2006, the EITF issued EITF Issue No. 06-3, “HowSales Taxes Collected from Customers and Remitted to Governmental AuthoritiesShould Be Presented in the Income Statement (That Is, Gross Versus Net Presentation),”which states that a company should disclose its accounting policy (i.e., grossor net presentation) regarding presentation of taxes within the scope of thisIssue. If taxes included in gross revenues are significant, a company shoulddisclose the amount of such taxes for each period for which an income statementis presented. The consensus would be effective for the first annual or interimreporting period beginning after December 15, 2006. The disclosures arerequired for annual and interim financial statements for each period for whichan income statement is presented. We plan to adopt EITF Issue No. 06-3effective January 1, 2007. Based on our current evaluation, we do not expectthe adoption of EITF Issue No. 06-3 to have a significant impact on ourconsolidated results of operations or financial position.

In June 2005, the FASB issued SFAS No. 154, “AccountingChanges 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 our consolidated financial position, results of operations or cashflows.

In December 2004, the FASB finalized SFASNo. 123(R), “Share-Based Payment,” which requires companies to measure andrecognize compensation costs for all share-based payments (including stockoptions) at fair value, effective for interim or annual periods beginning afterJune 15, 2005. On April 15, 2005, 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, we adopted the provisions ofSFAS No. 123(R) as discussed in Footnote 10, Stock-BasedCompensation.

Prior to adoption of SFAS No. 123(R), wepresented all tax benefits of deductions resulting from the exercise of stockoptions as operating cash flows in the Consolidated Statements of Cash Flows.SFAS No. 123(R) requires the cash flows resulting from the taxbenefits resulting from tax deductions in excess of the compensation costrecognized for those options (excess tax benefits) to be classified asfinancing cash flows.

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

Market risk represents the risk of loss arising fromadverse changes in market rates and foreign exchange rates. AtSeptember 30, 2006, we did not have any balances outstanding under ourbank line of credit arrangement; however, the amount of outstanding debt at anytime may fluctuate and we may from time to time be subject to refinancing risk.

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Our interest income is sensitive to changes in thegeneral level of U.S. interest rates, particularly since a significant portionof our investments are and will be in short-term marketable securities, U.S.government securities and corporate bonds. Due to the nature and maturity ofour short-term investments, we have concluded that there is no material marketrisk exposure to our principal. The average maturity of our investmentportfolio is less than one month. As of September 30, 2006, a 1% change ininterest rates throughout a one-year period would have an annual effect ofapproximately $1.2 million on our income before income taxes.

We derive in the range of half to three-quarters ofour revenues from sales outside the United States, and maintain research,sales, marketing, or business development offices in nine countries. Therefore,our results could be negatively affected by such factors as changes in foreigncurrency exchange rates, trade protection measures, longer accounts receivablecollection patterns, and changes in regional or worldwide economic or politicalconditions. The risks of our international operations are mitigated in part bythe extent to which our revenues are denominated in U.S. dollars and,accordingly, we are not exposed to significant foreign currency risk on theseitems. We do have limited foreign currency risk on certain revenues andoperating expenses such as salaries and overhead costs of our foreignoperations and a small amount of cash maintained by these operations. Revenuesdenominated in foreign currencies accounted for approximately 8% of totalrevenues during the nine months ended September 30, 2006. Operatingexpenses, including cost of sales, for our foreign subsidiaries wereapproximately $10.0 million in the nine months ended September 30, 2006.Based upon the expenses for the nine months ended September 30, 2006, a 1%change in foreign currency rates throughout a one-year period would havean annual effect of approximately $0.1 million on operating income.

Our international business is subject to risks,including, but not limited to, differing economic conditions, changes inpolitical climate, differing tax structures, other regulations andrestrictions, and foreign exchange rate volatility when compared to the UnitedStates dollar. Accordingly, our future results could be materially impacted bychanges in these or other factors.

We are also affected by exchange rate fluctuations asthe financial statements of our foreign subsidiaries are translated into theUnited States dollar in consolidation. As exchange rates vary, these results,when translated, may vary from expectations and could adversely or positivelyimpact overall profitability. During the nine months ended September 30,2006, the positive impact of foreign exchange rate fluctuations related totranslation of our foreign subsidiaries’ financial statements was $0.1 millionon retained earnings.

**Item 4.**                          Controlsand Procedures

**DisclosureControls and Procedures**

We maintain disclosure controls and procedures (asdefined in Rules 13a-l5(e) and 15d-15(e) of the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”) that are designed toensure that information required to be disclosed in the reports we file or submitunder the Exchange Act is recorded, processed, summarized and reported withinthe time periods specified in the rules and forms of the SEC and that suchinformation is accumulated and communicated to our management, including ourchief executive officer and chief financial officer, as appropriate, to allowtimely decisions regarding required disclosure.

We carried out an evaluation, under the supervisionand with the participation of our management, including our chief executiveofficer and chief financial officer, of the effectiveness of our disclosurecontrols and procedures as of the end of the period covered by this report.Based on such evaluation, our chief executive officer and chief financialofficer concluded that as of the end of the period covered by this report ourdisclosure controls and procedures were effective.

There has been no change in our internal control overfinancial reporting during our most recent fiscal quarter that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

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**PART II**

**OTHERINFORMATION**

**Item 1.**                          LegalProceedings

None.

**Item1A.**                 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-K for thefiscal year ended December 31, 2005, which was filed with the SEC on March16, 2006, except as follows:

·       Wehave added two new risk factors under the following headings:

·        “Theseparation of our businesses and/or any failure to successfully manage andcomplete an undertaken separation transaction could adversely affect ourbusiness and operating results.”

·        “Issuesarising from the implementation of our new enterprise resource planning systemcould affect our operating results and ability to manage our businesseffectively.”

·       Followingour adoption of SFAS 123(R) on January 1, 2006, we have deleted the risk factorthat was titled “Accounting for employee stock options using the fair valuemethod will reduce our net income.”

**Risks Related toOur Business**

***We face intensecompetition from companies with greater 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 StereoLabs, Inc., Eastman Kodak Company, Screenvision Cinema Network LLC,National CineMedia LLC, Doremi Labs, 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.

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Many of ourcurrent and potential competitors, including Dolby, enjoy substantialcompetitive advantages, including:

·                  greatername recognition;

·                  alonger operating history;

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

·                  amore extensive customer base;

·                  digitaltechnologies that provide features that ours do not;

·                  broaderproduct and service offerings;

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

·                  moretechnicians and engineers.

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

In addition to the competitive advantages describedabove, Dolby also enjoys other unique competitive strengths relative to us. Forexample, it introduced multi-channel audio technology before we did. It has alarger base of installed movie theaters for its cinema playback equipment. Itstechnology has been incorporated in significantly more DVD-Video films than ourtechnology. It has also achieved mandatory standard status in 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 a competitor and asignificant customer in most of our markets. If Sony decides to eliminate theuse of our technology in its products or to compete with us more aggressivelyin our markets, the revenues that we derive from Sony would be lower thanexpected.

***Current and futuregovernmental and industry standards may significantly limit our businessopportunities.***

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 and entertainment media emerge,new standards relating to these technologies or media may develop. Newstandards may also emerge in existing markets that are currently characterizedby competing

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

***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 consumer video products is alsointensely competitive and price sensitive. Retail prices for consumer videoproducts that have been processed, enhanced or restored by us, such as movies,concerts or animated content released on DVD or other media, have experiencedprice pressure and we expect this price pressure to continue for theforeseeable future. Declining prices for such video products could createdownward pressure on the fees we currently charge our customers for the imageprocessing, enhancement and restoration services we provide. If the motionpicture studios, content owners, producers or distributors were to believe thatthe existing image quality is satisfactory or that the pricing for our servicesis too high, they could decide to not use our services altogether.

***The separation ofour businesses and/or any failure to successfully manage and complete anundertaken separation transaction could adversely affect our business andoperating results.***

In order to better address rapidly evolving markets,meet the needs of customers and increase shareholder value, we are proceedingwith the separation of our Cinema and Digital Images businesses from ourConsumer licensing business. The separation process may be costly. We mayduring this separation process elect not to

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separate the business.This separation process may require significant time and attention from ourmanagement team, which could disrupt our day-to-day operations. In addition,implementing any transaction would involve a number of operational, legal and,possibly, regulatory steps. Furthermore, implementation could be costly, causefurther disruption to our day-to-day operations, and result in the loss ofcustomers and/or sales revenue, which could cause our business and operatingresults to suffer.

***If the movieindustry adopts new digital cinema technology in place of current filmtechnology, demand for our cinema products and services could decline.***

The movie theater industry may transition fromfilm-based media to electronic-based, or digital, media. If this transitionoccurs, we may be unable to meaningfully respond with competitive productofferings. In addition, if the film industry broadly adopts digital cinema, ourtechnology and current product and service offerings could be renderedobsolete. In such an event, demand by movie theaters for our playback systems,cinema processors, and systems for subtitling, captioning, and descriptivenarration as well as film licensing revenue would decline.

***If we fail toprotect our intellectual property rights, our ability to compete could beharmed.***

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:

·                  our patents maybe challenged or invalidated by our competitors;

·                  our pendingpatent applications may not issue, or, if issued, may not provide meaningfulprotection for related products or proprietary rights;

·                  we may not beable to prevent the unauthorized disclosure or use of our technical knowledgeor other trade secrets by employees, consultants, and advisors;

·                  we may not beable to practice our trade secrets as a result of patent protection afforded athird-party for such product, technique or processes;

·                  the laws offoreign countries may not protect our intellectual property rights to the sameextent as the laws of the United States, and mechanisms for enforcement ofintellectual property rights may be inadequate in foreign countries;

·                  our competitorsmay produce competitive products or services that do not unlawfully infringeupon our intellectual property rights; and

·                  we may be unableto successfully identify or prosecute unauthorized uses of our technology.

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

***We may be sued bythird parties for alleged infringement of their proprietary rights.***

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

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necessary licensefollowing a determination of infringement or an adverse determination inlitigation or in interference or other administrative proceedings, we may needto redesign some of our products to avoid infringing a third party’s rights andcould be required to temporarily or permanently discontinue licensing ourproducts.

***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 of certainelectrical and electronic equipment to be financially responsible for thefuture disposal costs of this equipment. Our cinema products may fall withinthe scope of this Directive and as such we may incur some financialresponsibility for the collection, recycling, treatment and disposal of bothnew products sold, and products already sold prior to the WEEE Directive’senforcement date, to customers within the European Union. The Directivepotentially increases our financial liabilities by requiring producers to adoptnew approaches for improving sustainable product design and for encouragingrecycling or re-use at the end of 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 the RoHS Directive are aimedmainly at mass market consumer electronics and thus, will impact many of ourcustomers who license our technology and pay us royalties upon the manufactureof electronic products. If the directives result in fewer licensed consumerelectronics products being sold, whether due to price increases, productiondelays, compromised product performance due to reformulation or redesign, orfor other reasons, then we will receive less revenue in royalties. If thedirectives materially impair or inhibit such sales, the reduction in licensingrevenue could adversely affect our operating results.

***If we are unableto maintain 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 a significant percentage of ourrevenues from the technology, products, and services that we offer tomanufacturers of consumer electronics products. To date, the most significantdriver for the use of our technology in the home theater market has been therelease of major movie titles with DTS audio soundtracks. We also believe thatdemand for our DTS audio technology in emerging markets for multi-channelaudio, including homes, cars, personal computers, and video games and consoles,will be based on the number,

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quality, and popularityof the audio DVDs, computer software programs, and video games released withDTS audio soundtracks. Although we have existing relationships with manyleading providers of movie, music, computer, and video game content, we do nothave contracts that require any of these parties to develop and release contentwith DTS audio soundtracks. In addition, we may not be successful inmaintaining existing relationships or developing relationships with otherexisting providers or new market entrants that provide content. As a result, wecannot assure you that a significant amount of content in movies, audio DVDs,computer software programs, video games, or other entertainment mediums will bereleased with DTS audio soundtracks. If the amount, variety, and popularity ofentertainment content released with DTS audio soundtracks is not maintained,consumer electronics products manufacturers that pay us per-unit licensing feesmay discontinue offering DTS playback capabilities in the consumer electronicsproducts 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 404 of the Sarbanes-OxleyAct of 2002, the SEC adopted rules requiring all public companies,including us, to include a report by management on internal control overfinancial reporting in all annual reports on Form 10-K that containsan assessment by management of the effectiveness of internal control overfinancial reporting. In addition, the independent registered public accountingfirm auditing our financial statements must attest to and report on ourmanagement’s assessment of the effectiveness of internal control over financialreporting and the effectiveness of internal control over financial reporting.While we conduct rigorous reviews of our internal control over financialreporting in order to comply with the Section 404 requirements, ourindependent registered public accounting firm may interpret theSection 404 requirements and the related rules and regulationsdifferently from us, or our independent registered public accounting firm ormanagement may not be satisfied with our internal control over financialreporting or with the level at which these controls are documented, executed orreviewed. In addition, many uncertainties remain regarding the requirements forauditor attestation, and guidance provided by the public accounting professionhas changed frequently and materially to date and may continue to change suchthat we may not be able to comply with these new requirements. Further, thedemand for competent audit resources has grown dramatically as a result of therequirements of Section 404, and such demand may exceed available supply.In addition, in January 2005, we acquired DTS DI, a privately held companywith limited financial resources that may not have implemented sufficientinternal control over financial reporting. We may in the future make additionalacquisitions which may be significant to our operations either individually orin the aggregate. We may face significant challenges in implementing therequired processes and procedures in the acquired operations of DTS DI or anyother businesses that we may acquire. As a result, our independent registeredpublic accounting firm may issue an adverse report or a disclaimer onmanagement’s assessment of internal control over financial reporting.Management may also identify material weaknesses which would cause managementto conclude internal control over financial reporting is not effective. Thiscould result in an adverse reaction in the financial markets due to a loss ofconfidence in the reliability of our financial statements, which could causethe market price of our shares to decline.

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

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

***We have limited experiencein image processing, enhancement and restoration.***

Although we have established relationships with anumber of motion picture studios, content owners, producers and distributors,we do not have any contractual agreements that require them to provide us image

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content for processing.Further, the demand for image processing, enhancement and restoration ofcinema, home video or broadcast television content may not materialize oraccelerate as we anticipate, 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 our customers andlicensees—including consumer electronics products manufacturers, semiconductormanufacturers, movie theaters, producers and distributors of content for music,films, videos, and games—to incorporate our technology in their products,purchase our products and services, or release their content in our proprietaryDTS audio format. Although we have contracts and license agreements with manyof these companies, these agreements do not require any minimum purchasecommitments, and are on a non-exclusive basis, and do not require incorporationor use of our technology, trademarks or services. Our customers, licensees andother manufacturers might not utilize our technology or services in the future.

***Our revenues 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 major U.S. film producers anddistributors are customers of ours, we generally do not have contractual arrangementsthat require them to use our DTS audio technology or our digital imageservices. Our cinema and digital images business depends on our having goodrelations with these film studios and other content owners. A deterioration inour relationship with any of these customers could cause them to stop using ourDTS audio technology or our digital image enhancement services. Any significantdecline or delay in the release of motion pictures with DTS audio soundtrackswould decrease the demand for and revenues from the playback products andservices that we offer to movie theaters. In addition, other motion picturestudios, content owners, producers, and distributors throughout the worldgenerally adopt and use the processes and the technologies used by the majorU.S. film studios. Therefore, if the major U.S. motion picture studios, contentowners, producers or distributors stop using our technology, we would not onlylose the per-movie licensing fee we receive from these customers, but may alsolose per-movie licensing fees from other film studios throughout the world.Furthermore, poor box-office performance caused by a weak film releasecalendar or declining consumer interest in the films being released could havea negative impact on the demand for the products and services we sell to themotion picture industry.

***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 business depends in part on theconstruction of new screens and the renovation of existing theaters thatinstall our DTS playback systems and cinema processors. In recent years,aggressive building of megaplexes by companies that operate movie theaters hasgenerated significant competition and resulted in an oversupply of screens insome domestic and international markets. The resulting oversupply of screensled to significant declines in revenues per screen and, eventually, to aninability by many major film exhibitors to satisfy their financial obligations.Several major movie theater operators have reorganized through bankruptcyproceedings, and many movie theaters have closed. As a result, our playbacksystems and cinema processors that we previously sold to movie theaters thathave reorganized and closed have been relocated to other theaters or have beenavailable for resale in the secondary market to movie theaters that mightotherwise have purchased these products directly from us. More recently, theindustry has experienced a decline in movie theater attendance. If this declinewere to continue, exhibitors could see a decline in revenue per screen and,potentially, an inability to satisfy their financial obligations resulting inthe closure of screens. If movie theater operators decide to close asignificant number of screens in the future or cut their capital spending,demand for our playback systems and cinema processors will decline.

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***We are dependenton our 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 and W. Paul Smith, our Senior Vice President, Research and Development.We also rely on the skills and talents of our engineering and technicalpersonnel because of the complexity of our products and services. Several ofour key engineers have been instrumental in the development of our technology.Important factors that could cause the loss of key personnel include:

·       our existing employment agreements with themembers of our management team allow such persons to terminate their employmentwith us at any time;

·       we do not have employment agreements with amajority of our key engineering and technical personnel;

·       significant portions of the stock options heldby the members of our management team are vested; and

·       stock options held by certain executive officersprovide for accelerated vesting in the event of a sale or change of control ofour company.

The loss of key personnel or an inability to attractqualified personnel in a timely manner could slow our technology and productdevelopment and harm our ability to execute our business plan. We do notgenerally carry key-man life insurance on any of our employees, with theexception that we are the beneficiary of a $10 million key-man life insurancepolicy for John Lowry, who is Chief Technologist of our DTS Digital Imagesbusiness.

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

Although the first movie with a DTS audio soundtrackwas released in 1993, we did not enter the home theater market until 1996, andour technology has only recently been incorporated into other consumerelectronics markets, such as car audio, personal computers, video games and consoles,portable electronics devices, and digital satellite and cable broadcastproducts. In addition, while we have completed over 100 digital imageprocessing, enhancement and restoration film projects, it is only recently thata large number of these projects have been completed. As a result, the demandfor our technology, products, and services and the income potential of thesebusinesses are unproven. In addition, because the market for digital audiotechnology and image services is relatively new and rapidly evolving, we havelimited insight into trends that may emerge and affect our business. We maymake errors in predicting and reacting to relevant business trends, which couldharm our business. Before investing in our common stock, you should considerthe risks, uncertainties, and difficulties frequently encountered by companiesin new and rapidly evolving markets such as ours. We may not be able tosuccessfully address any or all of these risks.

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

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

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

We recently began to implement an enterprise resourceplanning, or ERP, system to enhance operating efficiencies and provide moreeffective management of our business operations. Implementing a new ERP system

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is costly and involvesrisks inherent in the conversion to a new computer system, including disruptionto our normal accounting procedures and internal control over financialreporting and problems achieving accuracy in the conversion of electronic data.Failure to properly or adequately address these issues could result inincreased costs, the diversion of management’s attention and resources andcould materially adversely affect our operating results, internal control overfinancial reporting and ability to manage our business effectively.

***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:

·       expand our domestic and international sales andmarketing activities;

·       acquire businesses or technologies and integratethem into our existing organization;

·       increase our research and development efforts toadvance our existing technology, products, and services and develop newtechnology, products, and services;

·       hire additional personnel, including engineersand other technical staff;

·       upgrade our operational and financial systems,procedures, and controls; and

·       continue to assume the responsibilities of beinga public company.

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

***We are subject toadditional risks associated with our international 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:

·       unusual or burdensome foreign laws or regulatoryrequirements or unexpected changes to those laws or requirements;

·       tariffs, trade protection measures, import orexport licensing requirements, trade embargos, and other trade barriers;

·       difficulties in staffing and managing foreignoperations;

·       dependence on foreign distributors and theirsales channels;

·       longer accounts receivable collection cycles anddifficulties in collecting accounts receivable;

·       less effective and less predictable protectionof intellectual property;

·       changes in the political or economic conditionof a specific country or region, particularly in emerging markets;

·       fluctuations in the value of foreign currencyversus the U.S. dollar and the cost of currency exchange; and

·       potentially adverse tax consequences.

Such factors could cause our future internationalsales to decline.

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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 revenue is mostly denominated inU.S. dollars. As a result, fluctuations in the value of the U.S. dollar andforeign currencies may make our technology, products, and services moreexpensive for international customers, which could cause them to decrease theirpurchases from us. Expenses for our subsidiaries are denominated in theirrespective local currencies. Significant fluctuations in the value of the U.S.dollar and foreign currencies could have a material impact on our consolidatedfinancial statements. We do not currently engage in currency hedging activitiesto limit the risk of exchange rate fluctuations.

***We face risks inexpanding our business operations in China.***

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

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

***We depend 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 have entered into agreements withthree companies to serve as our sole distributors for our DTS Entertainmentproducts in the United States and Canada, Europe and Japan. We have no directcontrol over these distributors and any problems with their performance maytake time to identify and/or remedy, and any remedial measures that we take maybe unsuccessful. In addition, if any of these distributors were to go out ofbusiness, as one of our previous distributors did, or otherwise becomesincapable of continuing as our distributor, we could experience delays indistributing our DTS Entertainment products to the retail market, loss ofinventory, 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 percentage of our revenues are generatedfrom our consumer electronics products manufacturer customers who license andincorporate our technology in their consumer electronics products. Under ourexisting arrangements, these customers pay us per-unit licensing fees based onthe number of consumer electronics products manufactured that incorporate ourtechnology. We rely on our customers to accurately report the number of unitsmanufactured in collecting our license fees, preparing our financial reports,

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projections, budgets, anddirecting our sales and product development efforts. Most of our licenseagreements permit us to audit our customers, but audits are generally expensiveand time consuming and could harm our customer relationships. If any of ourcustomer reports understate the number of products they manufacture, we may notcollect and recognize revenues to which we are entitled.

***A prolongedeconomic downturn could materially harm our business.***

Negative trends in the general economy, includingtrends resulting from actual or threatened military action by the United Statesand threats 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.

***We may notsuccessfully address problems encountered in 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 businessesthat could enhance our technical capabilities, complement our current productsand services, or expand the breadth of our markets. We have a limited historyof acquiring and integrating businesses. Acquisitions and strategic investmentsinvolve numerous risks, including:

·       problems assimilating the purchasedtechnologies, products, or business operations;

·       significant future charges relating toin-process research and development and the amortization of intangible assets;

·       significant amount of goodwill that is notamortizable and is subject to annual impairment review;

·       problems maintaining uniform standards,procedures, controls, and policies;

·       unanticipated costs associated with theacquisition, including accounting charges, capital expenditures, andtransaction expenses;

·       diversion of management’s attention from ourcore business;

·       adverse effects on existing businessrelationships with suppliers and customers;

·       risks associated with entering markets in whichwe have no or limited prior experience; and

·       potential loss of key employees of acquiredorganizations.

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 havedifficulty managing any growth that we might experience.***

We expect to continue to experience growth in thescope of our operations and the number of our employees. If this growthcontinues, it will place a significant strain on our management team and on ouroperational and financial systems, procedures, and controls. Our future successwill depend in part on the ability of our management team to manage any growtheffectively. This will require our management to:

·       hire and train additional personnel in theUnited States and internationally;

·       implement and improve our operational andfinancial systems, procedures, and controls;

·       maintain our cost structure at an appropriatelevel based on the revenues we generate;

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·       manage multiple concurrent development projects;and

·       manage operations in multiple time zones withdifferent cultures and languages.

Any failure to successfully manage our growth coulddistract management’s attention, and result in our failure to execute ourbusiness plan.

***We may experiencefluctuations in our operating results.***

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 generallylowest in the first calendar quarter of each year, and increase progressivelythroughout the remainder of the year. Manufacturing output is generallystrongest in the third and fourth quarters as our technology licensees increasemanufacturing to prepare for the holiday buying season. Since recognition ofrevenues in our consumer business generally lags manufacturing activity by onequarter, our revenues and earnings from the consumer business are generallylowest in the second quarter. Film licensing revenues are generally strongestin the second and fourth quarters due to the abundance of movies typicallyreleased during the summer and year-end holiday seasons. The introduction ofnew products and inclusion of our technologies in new and rapidly growingmarkets can distort the moderate seasonality described above. Our revenues maycontinue to be subject to seasonal fluctuations in the future. Unanticipatedfluctuations in seasonality could cause us to miss our earnings projectionswhich could cause our stock price to decline.

In addition, we actively engage in intellectualproperty compliance and enforcement activities focused on identifying thirdparties who have either incorporated our technology, trademarks, or know-howwithout a license or who have underreported to us the amount of royalties owedunder license agreements with us. As a result of these activities, from time totime, we recognize royalty revenues that relate to consumer electronicsmanufacturing activities from prior periods. These royalty recoveries may causerevenues to be higher than expected during a particular reporting period andmay not recur in future reporting periods. Such fluctuations in our revenuesand operating results may cause declines in our stock price.

**Risks Related toOur Common Stock**

***We expect that theprice of our common stock will fluctuate substantially.***

The market priceof our common stock is likely to be highly volatile and may fluctuatesubstantially due to many factors, including:

·       actual or anticipated fluctuations in ourresults of operations;

·       announcements of technological innovations ortechnology standards;

·       announcements of significant contracts by us orour competitors;

·       changes in our pricing policies or the pricingpolicies of our competitors;

·       developments with respect to intellectualproperty rights;

·       the introduction of new products or productenhancements by us or our competitors;

·       the commencement of or our involvement inlitigation;

·       our sale of common stock or other securities inthe future;

·       conditions and trends in technology industries;

·       changes in market valuation or earnings of ourcompetitors;

·       the trading volume of our common stock;

·       changes in the estimation of the future size andgrowth rate of our markets; and

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·       general economic conditions.

In addition, the stock market in general, and theNasdaq National Market and the market for technology companies in particular,has experienced extreme price and volume fluctuations that have often beenunrelated or disproportionate to the operating performance of those companies.Further, the market prices of securities of technology companies have beenparticularly volatile. These broad market and industry factors may materiallyharm the market price of our common stock, regardless of our operatingperformance. In the past, following periods of volatility in the market priceof a company’s securities, securities class-action litigation has often beeninstituted against that company. Such litigation, if instituted against us,could result in substantial costs and a diversion of management’s attention andresources.

***Shares of ourcommon stock are relatively illiquid.***

As of September 30, 2006, we had 17,812,733shares of common stock outstanding. As a result of our relatively small publicfloat, our common shares may be less liquid than the common shares of companieswith broader public ownership. Among other things, trading of a relativelysmall volume of our common shares may have a greater impact on the trading pricefor our shares than would be the case if our public float 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 capital requirementswill depend on many factors, including:

·       acceptance of, and demand for, our products andtechnology;

·       the costs of developing new products ortechnology;

·       the extent to which we invest in new technologyand research and development projects;

·       the number and timing of acquisitions and otherstrategic transactions;

·       the costs associated with our expansion, if any;and

·       the separation of our business.

In the future, we may need to raise additional funds,and such funds may not be available on favorable terms, or at all. Furthermore,if we issue equity or debt securities to raise additional funds, our existingstockholders may experience dilution, and the new equity or debt securities mayhave rights, preferences, and privileges senior to those of our existingstockholders. If we cannot raise funds on acceptable terms, we may not be ableto develop or enhance our products and services, execute our business plan,take advantage of future opportunities, or respond to competitive pressures orunanticipated customer requirements. This may materially harm our business,results of operations, and financial condition.

***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.***

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

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

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

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

·       requireadvance written notice of stockholder proposals and director nominations.

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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 or impede a merger, tenderoffer, or proxy contest involving our company. Any delay or prevention of achange of control transaction or changes in our Board could cause the marketprice of our common stock to decline.

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

(b) On July 15, 2003, we completed our initialpublic offering for the sale of 4,091,410 shares of common stock at a price tothe public of $17.00 per share, which resulted in net proceeds of approximately$63.0 million after payment of the underwriters’ commissions and deductions ofoffering expenses. All of the shares of common stock sold in the offering wereregistered under the Securities Act of 1933, as amended (the “Securities Act”)on a Registration Statement on Form S-1 (Reg. No. 333-104761)that was declared effective by the SEC on July 9, 2003 and a RegistrationStatement filed pursuant to Rule 462(b) under the Securities Act thatwas filed on July 10, 2003 (Reg. No. 333-106920). Subsequent tothe offering, 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 September 30, 2006, we haveapproximately $40.5 million remaining from the proceeds of the offering.

(c) In August 2006, our Board of Directors approvedthe repurchase of up to one million shares of our common stock in the openmarket or in privately negotiated transactions, depending upon marketconditions and other factors. We have not made any purchases under this programand did not repurchase any shares under the program during the quarter ended September30, 2006. As of September 30, 2006, we had authority to repurchase up to onemillion shares under that program.

**Item 3.**                          DefaultsUpon Senior Securities

None.

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

None.

**Item 5.**                          OtherInformation

On August 8, 2006,we entered into an Exclusive License Agreement and an Option Agreement withAvica. The closing under these agreements has not yet been consummated andremains subject to the satisfaction or our waiver of certain closingconditions. Under the Exclusive License Agreement, Avica will grant to us anexclusive license to all or substantially all of Avica’s intellectual propertyand technology in all fields of use other than military applications. Toacquire the exclusive license under the Exclusive License Agreement, we will berequired to pay initial aggregate consideration of $5 million. Thereafter, wewill be required to pay up to an additional $2.9 million to Avica in the eventthat we recognize revenues with respect to the sale of certain Avica productsto third parties during the three-year period following the date of theExclusive License Agreement. The term of Exclusive License Agreement willcommence when we complete the license closing upon payment of the initialaggregate consideration of $5 million (the “License Closing”) and will lastuntil three years following completion by Avica of certain clean-up conditionsidentified in the Exclusive License Agreement to our reasonable satisfaction.Under the Option Agreement, we will acquire the exclusive option to acquire theassets of Avica during the period beginning upon the License Closing and endingon the expiration or earlier termination of the license term. In the event thatwe exercise our exclusive option under the Option Agreement, we will berequired to pay up to $1.5 million to Avica, which may be payable in cash or inrestricted common stock pursuant to the terms set forth in the OptionAgreement.

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**Item 6.**                          Exhibits
| Exhibit  Number | ** ** | **Exhibit Description**                                                                                                                                                                                                                                                                                     |
|-----------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.69           |       | Exclusive License Agreement between the Company and  Avica Technology Corporation, dated as of August 8, 2006†                                                                                                                                                                                              |
| 10.70           |       | Option Agreement between the Company and Avica  Technology Corporation, dated as of August 8, 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                                                                                                                                                            |
| †          |       | Certain confidential portions of this Exhibit were  omitted by means of redacting a portion of the text (the “Mark”). This  Exhibit has been filed separately with the Secretary of the Commission  without the Mark pursuant to the Registrant’s Application Requesting  Confidential Treatment. |

 

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|                         | DTS, INC. |
|-------------------------|----------------|
|                    |           |
|                    |           |
|                    | by:            | /s/ JON E. KIRCHNER |   |
|                    |           | Jon E. Kirchner |
|                    | * *       | *President and Chief Executive Officer* |
|                    | * *       | *(Duly Authorized Officer)* |
|                    | * *       | * * |
| Date: November  9, 2006 |           |   |
|                    |           |   |
|                    | by:            | /s/ MELVIN L. FLANIGAN |   |
|                    |           | Melvin L. Flanigan |
|                    | * *       | *Executive Vice President, Finance and* |
|                    | * *       | *Chief Financial Officer* |
|                    | * *       | *(Principal Financial and Accounting Officer)* |
|                    | * *       | * * |
| Date: November  9, 2006 |           |   |

 

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