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

Indicate by check markwhether registrant is a large accelerated filer, an accelerated filer or non-acceleratedfiler. See definition 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 markwhether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o   No x

Asof July 31, 2006 a total of 17,723,289 shares of the Registrant’s CommonStock, $0.0001 par value, were issued and outstanding.

 

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**DTS, INC.**

**FORM 10-Q**

**TABLEOF CONTENTS**
| **PART I**   | ** ** | **FINANCIAL INFORMATION**                                                                       | ** ** | **3**  |
|-------------------|------------|-------------------------------------------------------------------------------------------------|------------|--------|
| **Item 1.**  | ** ** | **Financial Statements (unaudited):**                                                           | ** ** | **3**  |
|              | ** ** | **Consolidated Balance Sheets**                                                                 | ** ** | **3**  |
|              | ** ** | **Consolidated Statements of  Operations**                                                      | ** ** | **4**  |
|              | ** ** | **Consolidated Statements of  Cash Flows**                                                      | ** ** | **5**  |
|              | ** ** | **Notes to Consolidated Financial  Statements**                                                 | ** ** | **6**  |
| **Item 2.**  | ** ** | **Management’s Discussion and  Analysis of Financial Condition and Results of Operations** | ** ** | **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**                                | ** ** | **43** |
| **Item 3.**  | ** ** | **Defaults Upon Senior  Securities**                                                            | ** ** | **43** |
| **Item 4.**  | ** ** | **Submission of Matters to a  Vote of Security Holders**                                        | ** ** | **43** |
| **Item 5.**  | ** ** | **Other Information**                                                                           | ** ** | **44** |
| **Item 6.**  | ** ** | **Exhibits**                                                                                    | ** ** | **44** |
| **SIGNATURES**    | ** ** | **45**                                                                                          |

 

 

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**DTS, INC.PART IFINANCIAL INFORMATION**

**Item 1.**                        FinancialStatements

**DTS, Inc.**

**ConsolidatedBalance Sheets**

| ** **                                                                                                                                                                                                                                         | ** ** | **As of       December 31,      2005**                   | ** ** | **As of       June 30,       2006** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                                                                         | ** ** | **(Unaudited)  (Amounts in thousands, except  share and per share amounts)** | ** ** |
| ASSETS                                                                                                                                                                                                                                             |       |                                                                                                            |       |                                                                                            |       |   |   |   |   |
| Current assets:                                                                                                                                                                                                                                    |       |                                                                                                            |       |                                                                                            |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                                                                          |       |                                                                                                            | $          | 33,254                                                                                          |       |   |   | $ | 36,517 |   |   |
| Short-term investments                                                                                                                                                                                                                             |       |                                                                                                            | 78,163     |                                                                                            |       |   | 83,149 |   |   |
| Accounts receivable, net of allowance for doubtful  accounts of $370 and $373 at December 31, 2005 and June 30,  2006, respectively                                                                                                 |       |                                                                                                            | 7,311      |                                                                                            |       |   | 7,007 |   |   |
| Inventories                                                                                                                                                                                                                                        |       |                                                                                                            | 3,261      |                                                                                            |       |   | 3,388 |   |   |
| Deferred income taxes                                                                                                                                                                                                                              |       |                                                                                                            | 7,255      |                                                                                            |       |   | 7,687 |   |   |
| Prepaid expenses and other current assets                                                                                                                                                                                                          |       |                                                                                                            | 3,112      |                                                                                            |       |   | 2,096 |   |   |
| Income taxes receivable, net                                                                                                                                                                                                                       |       |                                                                                                            | 2,654      |                                                                                            |       |   | 1,145 |   |   |
| Total current assets                                                                                                                                                                                                                               |       |                                                                                                            | 135,010    |                                                                                            |       |   | 140,989 |   |   |
| Property and equipment, net                                                                                                                                                                                                                        |       |                                                                                                            | 7,375      |                                                                                            |       |   | 9,448 |   |   |
| Goodwill                                                                                                                                                                                                                                           |       |                                                                                                            | 3,585      |                                                                                            |       |   | 3,585 |   |   |
| Intangible assets, net                                                                                                                                                                                                                             |       |                                                                                                            | 11,612     |                                                                                            |       |   | 12,104 |   |   |
| Deferred income taxes                                                                                                                                                                                                                              |       |                                                                                                            | 303        |                                                                                            |       |   | 16 |   |   |
| Other assets                                                                                                                                                                                                                                       |       |                                                                                                            | 369        |                                                                                            |       |   | 766 |   |   |
| Total assets                                                                                                                                                                                                                                       |       |                                                                                                            | $          | 158,254                                                                                         |       |   |   | $ | 166,908 |   |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                                                          |       |                                                                                                            |       |                                                                                            |       |   |   |   |   |
| Current liabilities:                                                                                                                                                                                                                               |       |                                                                                                            |       |                                                                                            |       |   |   |   |   |
| Accounts payable                                                                                                                                                                                                                                   |       |                                                                                                            | $          | 2,634                                                                                           |       |   |   | $ | 2,547 |   |   |
| Accrued expenses                                                                                                                                                                                                                                   |       |                                                                                                            | 6,983      |                                                                                            |       |   | 6,826 |   |   |
| Deferred revenue                                                                                                                                                                                                                                   |       |                                                                                                            | 2,630      |                                                                                            |       |   | 61 |   |   |
| Total current liabilities                                                                                                                                                                                                                          |       |                                                                                                            | 12,247     |                                                                                            |       |   | 9,434 |   |   |
| Deferred income taxes                                                                                                                                                                                                                              |       |                                                                                                            | 1,917      |                                                                                            |       |   | 1,465 |   |   |
| Other liabilities                                                                                                                                                                                                                                  |       |                                                                                                            | —     |                                                                                            |       |   | 208 |   |   |
| Commitments and  contingencies (Note 9)                                                                                                                                                                                                            |       |                                                                                                            |       |                                                                                            |       |   |   |   |   |
| Stockholders’ equity:                                                                                                                                                                                                                         |       |                                                                                                            |       |                                                                                            |       |   |   |   |   |
| Preferred stock—$0.0001 par value, 5,000,000 shares  authorized at December 31, 2005 and June 30, 2006; no shares issued  and outstanding at December 31, 2005  and June 30, 2006                                    |       |                                                                                                            | —     |                                                                                            |       |   | — |   |   |
| Common stock—$0.0001 par value, 70,000,000 shares  authorized at December 31, 2005 and June 30, 2006; 17,472,543 and  17,681,797 shares issued and outstanding at December 31, 2005 and  June 30, 2006, respectively |       |                                                                                                            | 2          |                                                                                            |       |   | 2 |   |   |
| Additional paid-in capital                                                                                                                                                                                                                         |       |                                                                                                            | 122,847    |                                                                                            |       |   | 125,668 |   |   |
| Retained earnings                                                                                                                                                                                                                                  |       |                                                                                                            | 21,241     |                                                                                            |       |   | 30,131 |   |   |
| Total stockholders’ equity                                                                                                                                                                                                                    |       |                                                                                                            | 144,090    |                                                                                            |       |   | 155,801 |   |   |
| Total liabilities  and stockholders’ equity                                                                                                                                                                                                   |       |                                                                                                            | $          | 158,254                                                                                         |       |   |   | $ | 166,908 |   |   |

 

See accompanying notes to consolidated financial statements.

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

| ** **                                                            | ** ** | **For the Three Months Ended  June 30,**                                               | ** ** | **For the Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                                            | ** ** | **2005**                                                                                                        | ** ** | **2006**                                                        | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                                            | ** ** | **(Unaudited)  (Amounts in thousands, except  share and per share amounts)** | ** ** |
| Revenues:                                                             |       |                                                                                                            |       |                                                            |       |   |   |   |   |
| Technology and film licensing                                         |       | $                                                                                                               | 12,835     |                                                            | $          | 11,742 |   | $ | 31,299 |   | $ | 34,587 |   |
| Product sales and other revenues                                      |       | 4,893                                                                                                           |       | 5,155                                                           |       | 8,486 |   | 11,011 |   |
| Total revenues                                                        |       | 17,728                                                                                                          |       | 16,897                                                          |       | 39,785 |   | 45,598 |   |
| Cost of goods sold:                                                   |       |                                                                                                            |       |                                                            |       |   |   |   |   |
| Technology and film licensing                                         |       | 1,035                                                                                                           |       | 1,200                                                           |       | 2,317 |   | 2,478 |   |
| Product sales and other revenues                                      |       | 3,995                                                                                                           |       | 3,834                                                           |       | 7,176 |   | 8,698 |   |
| Total cost of goods sold                                              |       | 5,030                                                                                                           |       | 5,034                                                           |       | 9,493 |   | 11,176 |   |
| Gross profit                                                          |       | 12,698                                                                                                          |       | 11,863                                                          |       | 30,292 |   | 34,422 |   |
| Operating expenses:                                                   |       |                                                                                                            |       |                                                            |       |   |   |   |   |
| Selling, general and administrative                                   |       | 8,080                                                                                                           |       | 10,007                                                          |       | 16,124 |   | 19,905 |   |
| Research and development                                              |       | 2,532                                                                                                           |       | 2,983                                                           |       | 4,626 |   | 5,701 |   |
| In-process research and development                                   |       | —                                                                                                          |       | —                                                          |       | 2,300 |   | — |   |
| Total operating expenses                                              |       | 10,612                                                                                                          |       | 12,990                                                          |       | 23,050 |   | 25,606 |   |
| Income (loss)  from operations                                        |       | 2,086                                                                                                           |       | (1,127                                                          | )          | 7,242 |   | 8,816 |   |
| Interest income,  net                                                 |       | 835                                                                                                             |       | 1,226                                                           |       | 1,189 |   | 2,262 |   |
| Other income  (expense), net                                          |       | (11                                                                                                             | )          | 10                                                              |       | (23 | ) | 50 |   |
| Income before income taxes                                            |       | 2,910                                                                                                           |       | 109                                                             |       | 8,408 |   | 11,128 |   |
| Provision  (benefit) for income taxes                                 |       | 1,094                                                                                                           |       | (1,774                                                          | )          | 3,036 |   | 2,238 |   |
| Net income                                                            |       | 1,816                                                                                                           |       | 1,883                                                           |       | 5,372 |   | 8,890 |   |
| Net income per  common share:                                         |       |                                                                                                            |       |                                                            |       |   |   |   |   |
| Basic                                                                 |       | $                                                                                                               | 0.10       |                                                            | $          | 0.11 |   | $ | 0.31 |   | $ | 0.51 |   |
| Diluted                                                               |       | $                                                                                                               | 0.10       |                                                            | $          | 0.10 |   | $ | 0.30 |   | $ | 0.49 |   |
| Weighted average  shares used to compute net income per common share: |       |                                                                                                            |       |                                                            |       |   |   |   |   |
| Basic                                                                 |       | 17,331,602                                                                                                      |       | 17,547,433                                                      |       | 17,206,415 |   | 17,521,284 |   |
| Diluted                                                               |       | 18,264,458                                                                                                      |       | 18,340,307                                                      |       | 18,180,973 |   | 18,316,120 |   |

 

See accompanying notes to consolidated financial statements.

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**DTS, Inc.Consolidated Statements of Cash Flows**

| ** **                                                                               | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                                                               | ** ** | **2005**                                                        | ** ** | **2006** | ** ** |
| ** **                                                                               | ** ** | **(Unaudited)**                                                 | ** ** |
| ** **                                                                               | ** ** | **(Amounts in thousands)**                            | ** ** |
| Cash flows from  operating activities:                                                   |       |                                                            |       |   |   |
| Net income                                                                               |       | $                                                               | 5,372      |   | $ | 8,890 |   |
| Adjustments to reconcile  net income to net cash provided by operating activities:       |       |                                                            |       |   |   |
| Depreciation and amortization                                                            |       | 1,679                                                           |       | 2,199 |   |
| Stock-based compensation charges                                                         |       | 59                                                              |       | 1,755 |   |
| Allowance for doubtful accounts                                                          |       | 5                                                               |       | 10 |   |
| Loss on disposal of property and equipment                                               |       | —                                                          |       | 79 |   |
| Deferred income taxes                                                                    |       | (202                                                            | )          | (598 | ) |
| Excess tax benefits from stock-based compensation                                        |       | 400                                                             |       | (222 | ) |
| Write-down of inventory                                                                  |       | —                                                          |       | 144 |   |
| In-process research and development                                                      |       | 2,300                                                           |       | — |   |
| Changes in  operating assets and liabilities:                                            |       |                                                            |       |   |   |
| Accounts receivable                                                                      |       | (5,841                                                          | )          | 293 |   |
| Inventories                                                                              |       | (118                                                            | )          | (272 | ) |
| Prepaid expenses and other assets                                                        |       | (225                                                            | )          | 819 |   |
| Accounts payable and accrued expenses                                                    |       | (702                                                            | )          | (239 | ) |
| Deferred revenue                                                                         |       | 1,196                                                           |       | (2,570 | ) |
| Income taxes receivable                                                                  |       | 79                                                              |       | 1,731 |   |
| Other liabilities                                                                        |       | —                                                          |       | 208 |   |
| Net cash provided by operating activities                                                |       | 4,002                                                           |       | 12,227 |   |
| Cash flows from  investing activities:                                                   |       |                                                            |       |   |   |
| Purchases of investments                                                                 |       | (43,870                                                         | )          | (80,057 | ) |
| Maturities of investments                                                                |       | 29,910                                                          |       | 36,238 |   |
| Sales of investments                                                                     |       | 43,208                                                          |       | 38,833 |   |
| Cash paid for business and technology acquisitions,  net of cash acquired                |       | (11,000                                                         | )          | (1,379 | ) |
| Purchase of property and equipment                                                       |       | (2,773                                                          | )          | (3,577 | ) |
| Payment for patents and trademarks in process                                            |       | (129                                                            | )          | (88 | ) |
| Net cash provided by (used in) investing activities                                      |       | 15,346                                                          |       | (10,030 | ) |
| Cash flows from  financing activities:                                                   |       |                                                            |       |   |   |
| Proceeds from the issuance of common stock upon  exercise of employee stock options |       | 112                                                             |       | 364 |   |
| Proceeds from the issuance of common stock under  employee stock purchase plan           |       | 430                                                             |       | 480 |   |
| Excess tax benefits from stock-based compensation                                        |       | —                                                          |       | 222 |   |
| Net cash provided by financing activities                                                |       | 542                                                             |       | 1,066 |   |
| Net increase in cash and cash equivalents                                                |       | 19,890                                                          |       | 3,263 |   |
| Cash and cash  equivalents, beginning of period                                          |       | 21,271                                                          |       | 33,254 |   |
| Cash and cash  equivalents, end of period                                                |       | $                                                               | 41,161     |   | $ | 36,517 |   |

 

See accompanying notes to consolidated financial statements.

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**DTS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)(Amounts in thousands, except share and per share data)**

**Note 1—Basis of Presentation**

The accompanying unauditedconsolidated financial statements of DTS, Inc. (the “Company”) have beenprepared in accordance with accounting principles generally accepted in theUnited States and with the instructions to Form 10-Q and Article 10of Regulation 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 June 30, 2006, andthe results of operations and cash flows for the periods presented. Allsignificant intercompany transactions have been eliminated in consolidation.Operating results for the three and six months ended June 30, 2006 are notnecessarily indicative of the results that may be expected for the fiscal yearending December 31, 2006. The information included in this Form 10-Qshould be read in conjunction with the consolidated financial statements andnotes thereto included in the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2005.

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

**Note 2—Recent Accounting Pronouncements**

In July 2006, the FinancialAccounting Standards Board (“FASB”) issued FASB Interpretation (“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. The Companyis in 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 EmergingIssues Task Force (“EITF”) issued EITF No. 06-3, “How Sales Taxes Collectedfrom Customers and Remitted to Governmental Authorities Should Be Presented inthe Income Statement (That Is, Gross Versus Net Presentation),” which statesthat a company should disclose its accounting policy (i.e., gross or netpresentation) regarding presentation of taxes within the scope of this issue.If taxes included in gross revenues are significant, a company should disclosethe amount of such taxes for each period for which an income statement ispresented. 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. The Company will adopt this interpretationeffective January 1, 2007. Based on the Company’s current evaluation of this issue,the Company does not expect the adoption of EITF No. 06-3 to have a significantimpact on its consolidated results of operations or financial position.

In June 2005, the FASB issued Statement ofFinancial Accounting Standards (“SFAS”) No. 154, “Accounting Changes andError Corrections, a replacement of APB Opinion No. 20, AccountingChanges, 

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

In December 2004, theFASB finalized SFAS No. 123(R), “Share-Based Payment,” which requirescompanies to measure and recognize compensation costs for all share-basedpayments (including stock options) at fair value, effective for interim orannual periods beginning after June 15, 2005. On April 15, 2005, theU.S. Securities and Exchange Commission (the “SEC”) announced a deferral of theeffective date of SFAS No. 123(R) until the first interim or annualreporting period of the first fiscal year beginning on or after June 15,2005. Effective January 1, 2006, the Company adopted the provisions ofSFAS No. 123(R) as discussed in Footnote 8, Stock-BasedCompensation.

**Note 3—CertainBalance Sheet Items**

Inventoriesconsist of the following:

| ** **        | ** ** | **As of  December 31,  2005** | ** ** | **As of  June 30,  2006** | ** ** |
|-------------------|------------|-----------------------------------------|------------|-------------------------------------|------------|
| Raw materials     |       |                                    | $          | 1,062                               |       |   |   | $ | 1,064 |   |   |
| Finished goods    |       |                                    | 2,199      |                                |       |   | 2,324 |   |   |
| Total inventories |       |                                    | $          | 3,261                               |       |   |   | $ | 3,388 |   |   |

 

Propertyand equipment consist of the following:

| ** **                      | ** ** | **As of  December 31,  2005** | ** ** | **As of  June 30,  2006** | ** ** |
|---------------------------------|------------|-----------------------------------------|------------|-------------------------------------|------------|
| Machinery and  equipment        |       |                                    | $          | 6,847                               |       |   | $ | 6,990 |   |
| Office furniture  and fixtures  |       |                                    | 3,588      |                                |       | 4,429 |   |
| Leasehold  improvements         |       |                                    | 3,697      |                                |       | 3,861 |   |
| Software                        |       |                                    | 590        |                                |       | 1,857 |   |
|                            |       |                                    | 14,722     |                                |       | 17,137 |   |
| Less: Accumulated  depreciation |       |                                    | (7,347     | )                                   |       | (7,689 | ) |
| Property and  equipment, net    |       |                                    | $          | 7,375                               |       |   | $ | 9,448 |   |

 

**Note 4—AcquiredTechnology**

On April 17, 2006,the Company acquired for $1,000 the Digital Booking Systems technology (“DBS”)from FilmStew International, Inc. DBS is an application that enablescinema exhibitors and distributors to manage communications via the internet.DBS allows exhibitors and distributors to conduct business online byaccelerating the process of booking playdates, scheduling showtimes,programming trailers, tracking data and facilitating film rental payments.Intangible assets, net includes $929 for the purchase of these assets, whichrepresents the net present value of the total acquisition cost.

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**Note 5—BusinessCombinations**

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

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

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

**Note 6—Bank Line ofCredit**

We have in place a $10,000 facility that expires on June 30,2007 and is renewable annually. The bank agreement provides for working capitalfinancing and is unsecured. The bank agreement requires the Company to complywith certain covenants including a tangible effective net worth of $60,000, increasingby 50% of net income on an annual basis. The covenants also require the Companyto keep $2,000 in cash or securities at the bank. At June 30, 2006, theCompany was compliant with all covenants under the bank agreement.

At June 30, 2006,there were no balances outstanding under this agreement and there was $10,000of available borrowings under this credit facility. Future borrowings will bearinterest based on either of the two options the Company selects at the time ofadvances 1) a rate equal to 2% above the Bank’s LIBOR, or 2) a rateequal to the Base Rate as quoted from the bank less one-half percent. Theannual commitment fee for this line of credit is not material.

**Note 7—Income Taxes**

For the three months endedJune 30, 2006, the Company recorded an income tax benefit of $1,774 onpre-tax income of $109. For the six months ended June 30, 2006, theCompany recorded an income tax provision of $2,238 on pre-tax income of$11,128. This resulted in an annualized effective tax rate of 20.1%. During thesecond quarter of 2006, the Internal Revenue Service (“IRS”) completed anexamination of the federal income tax return filed by the Company for the yearended December 31, 2003. The Company achieved a favorable resolution withthe IRS regarding the Extraterritorial Income Exclusion (“ETI”) that resultedin a tax benefit of $1,710. As a result of this benefit, the current income taxrate differs from the statutory rate. In 2006, excluding this impact of ETIadjustment, the Company’s annualized effective tax rate was approximately34.5%. For the three and six months ended June 30, 2005, the Companyrecorded an income tax provision of $1,094 and $3,036, respectively, on pre-taxincome of $2,910 and $8,408, respectively. This resulted in an annualizedeffective tax rate of 36.1%. These rates 

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differedfrom the statutory rates primarily due to state income taxes offset by benefitsassociated with the foreign rate differentials.

**Note 8—Stock-Based Compensation**

Prior to January 1,2006, the Company accounted for its employee stock option and stock purchaseplans in accordance with the provisions of Accounting Principles Board Opinion(“APB”) No. 25, “Accounting for Stock Issued to Employees” and the relatedFASB Interpretation No. 44, “Accounting for Certain Transactions InvolvingStock Compensation,” and complied with the disclosure provisions of SFAS No. 123,“Accounting for Stock-Based Compensation.” Under the provisions of thesepronouncements, all options granted under those plans had an exercise priceequal to or greater than the market value of the underlying common stock on thedate of grant, which resulted in no recognition of stock-based compensationexpense. For the three and six months ended June 30, 2005, the companyrecognized no stock-based employee compensation cost from stock options.Effective January 1, 2006, the Company adopted the provisions of SFAS No. 123(R),using the modified-prospective-transition method. Under the transition method,compensation expense recognized beginning January 1, 2006 includes: (a) compensationcost for all share-based payments granted prior to, but not yet vested as of January 1,2006, based on the grant date fair value estimated in accordance with theoriginal provisions of SFAS No. 123, and (b) compensation costfor all share-based payments granted on or after January 1, 2006, based onthe grant fair value estimated in accordance with the provisions of SFAS No. 123(R).The Company did not restate its results for prior periods.

As a result of adoptingSFAS No. 123(R) on January 1, 2006, the Company’s income beforetaxes and net income for the three months ended June 30, 2006, wereapproximately $1,073 and $716 lower, respectively, than if it had continued toaccount for share-based compensation under APB No. 25. Basic and dilutedearnings per share for the three months ended June 30, 2006 would havebeen $0.15 and $0.14, respectively, if it had not adopted SFAS No. 123(R),compared to reported basic and diluted earnings per share of $0.11 and $0.10, respectively.The total stock-based compensation cost that has been recognized in theConsolidated Statements of Operations was $1,073 and $54 for the three monthsended June 30, 2006 and 2005, respectively, was recorded to cost of goodssold, and selling, general and administrative expenses, and research anddevelopment expenses. Stock-based compensation cost recorded to cost of goodssold for the three months ended June 30, 2006 and 2005 was $74 and $0,respectively. Stock-based compensation cost recorded to selling, general andadministrative expenses for the three months ended June 30, 2006 and 2005 was$884 and $54, respectively. Stock-based compensation cost recorded to researchand development expenses for the three months ended June 30, 2006 and 2005 was$115 and $0, respectively. The total income tax benefit recognized was $357 and$19 for the three months ended June 30, 2006 and 2005, respectively.

The Company’s incomebefore taxes and net income for the six months ended June 30, 2006, wereapproximately $1,692 and $1,110 lower, respectively, than if it had continuedto account for share-based compensation under APB No. 25. Basic anddiluted earnings per share for the six months ended June 30, 2006 wouldhave been $0.57 and $0.55, respectively, if it had not adopted SFAS No. 123(R),compared to reported basic and diluted earnings per share of $0.51 and $0.49,respectively. The total stock-based compensation cost that has been recognizedin the Consolidated Statements of Operations was $1,755 and $59 for the sixmonths ended June 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 six months ended June 30, 2006 and 2005 was $92 and $0,respectively. Stock-based compensation cost recorded to selling, general andadministrative expenses for the six months ended June 30, 2006 and 2005 was$1,443 and $59, respectively. Stock-based compensation cost recorded toresearch and development expenses for the six months ended June 30, 2006 and2005 was $220 and $0, respectively. The total income tax benefit recognized was$604 and $21 for the six months ended June 30, 2006 and 2005, respectively.

9

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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 $222 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 six months ended June 30,2006, the Company received $364 in cash from stock option exercises.

If theCompany had elected to recognize compensation cost for stock options based ontheir fair value at the grant dates, consistent with the method prescribed bySFAS No. 123, net income and net income per share for the three and sixmonths ended June 30, 2005 would have been as follows:

| ** **                                                                                                               | ** ** | **For the Three  Months  Ended June 30,** | ** ** | **For the Six  Months  Ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                                                                                               | ** ** | **2005**                                                      | ** ** | **2005**                                                    | ** ** |
| Net income:                                                                                                              |       |                                                          |       |                                                        |       |   |   |   |   |
| As reported                                                                                                              |       |                                                          | $          | 1,816                                                       |       |   |   | $ | 5,372 |   |   |
| Additional stock-based compensation expense  determined under the fair value method, net of tax                          |       |                                                          | (538       | )                                                           |       |   | (1,027 | ) |   |
| Pro forma                                                                                                                |       |                                                          | $          | 1,278                                                       |       |   |   | $ | 4,345 |   |   |
| Net income per  common share—basic:                                                                                 |       |                                                          |       |                                                        |       |   |   |   |   |
| As reported                                                                                                              |       |                                                          | $          | 0.10                                                        |       |   |   | $ | 0.31 |   |   |
| Per share effect of additional stock-based  compensation expense determined under the fair value method, net of tax |       |                                                          | (0.03      | )                                                           |       |   | (0.06 | ) |   |
| Pro forma                                                                                                                |       |                                                          | $          | 0.07                                                        |       |   |   | $ | 0.25 |   |   |
| Net income per  common share—diluted:                                                                               |       |                                                          |       |                                                        |       |   |   |   |   |
| As reported                                                                                                              |       |                                                          | $          | 0.10                                                        |       |   |   | $ | 0.30 |   |   |
| Per share effect of additional stock-based  compensation expense determined under the fair value method, net of tax |       |                                                          | (0.03      | )                                                           |       |   | (0.06 | ) |   |
| Pro forma                                                                                                                |       |                                                          | $          | 0.07                                                        |       |   |   | $ | 0.24 |   |   |

 

Thefair value of each employee option grant is estimated on the date of the grantusing the Black-Scholes option pricing model with the following weightedaverage key assumptions:

| ** **               | ** ** | **Six  Months Ended  June 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 historical volatility ofthe Company’s common stock. The risk-free interest rate was the averageinterest rates of U.S. government bonds of comparable term to the options onthe dates of the option grants.

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There were 325,750 and591,500 options granted during the six months ended June 30, 2006 and2005, respectively. The weighted average fair value of options granted duringthe six months ended June 30, 2006 and 2005 was $18.68 and $17.46,respectively. Stock-based compensation expense for stock options for the threeand six months ended June 30, 2006, was calculated based on their fairvalue at the grant dates, consistent with the method prescribed by SFAS No. 123adjusted by estimated forfeitures as prescribed by SFAS 123(R). Compensationexpense for stock options was $775 and $1,290 for the three and six monthsended June 30, 2006, respectively.

The Company hashistorically recognized compensation cost over the nominal vesting period,whereby if an employee retired before the end of the vesting period, theCompany would recognize any remaining unrecognized compensation cost at thedate of retirement. The FASB clarified in SFAS No. 123(R) that thefair value of such stock options should be expensed based on recognition undera non-substantive vesting period approach, requiring compensation expenserecognition when an employee is eligible to retire. Company employees areeligible to retire after age 60. For those employees that retire and areeligible, their options may continue to vest upon the original vestingschedules. The SEC recently clarified that companies should continue thevesting method they have been using until adoption of SFAS 123(R), thenapply the accelerated non-substantive vesting approach to all subsequent grantsto those employees whose options continue to vest after the date of retirementeligibility. For the three and six months ended June 30, 2005, had theCompany been accounting for such stock options using the non-substantivevesting approach for retirement-eligible employees, the Company wouldhave not recognized additional stock-based compensation expense.

In 1997, the Companyadopted a stock option plan (the “1997 Plan”) for eligible employees, directorsand consultants. In 2002, the Company adopted a stock option plan (the “2002Plan”) for management and certain key employees. Options granted under theplans may be incentive stock options intended to satisfy the requirements of Section 422of the Internal Revenue Code of 1986, as amended, and the regulationsthereunder, or non-qualified options. Options generally become exercisable overa four-year period and expire in ten years. The total number of shares ofcommon stock that may be issued under both plans amounted to a maximum of2,071,051. Options granted prior to 2002 were granted at exercise prices equalto the preferred stock financing prices, which were in excess of the estimatedfair value of the underlying common stock.

In March 2002, theCompany offered a stock option replacement program for employees, directors andnon-employee consultants participating in the existing plan. Under the stockoption replacement program, participants were able to elect to cancel theircurrent options and have those options replaced after six months and one daywith options that will have an exercise price equal to the stock’s then-currentfair value. Options to purchase a total of 930,250 shares were cancelled underthe stock option replacement program. On September 30, 2002, six monthsand 15 days after the cancellation of options exchanged under the optionreplacement program, the Company granted options to purchase a total of 929,250shares of common stock as replacement awards at an exercise price of $1.02,which represented the fair value of the Company’s common stock on that date.

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

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

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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 anon-employee consultant. The Company accounts for stock, stock options andwarrants issued to non-employees in accordance with the provisions of SFAS No. 123and Emerging Issues Task Force (“EITF”) Issue No. 96-18 “Accountingfor Equity Instruments That Are Issued to Other Than Employees for Acquiring,or in Conjunction with Selling, Goods and Services.” Under SFAS No. 123and EITF Issue No. 96-18, stock option awards issued tonon-employees are accounted for at fair value using the Black-Scholes pricingmodel. Management believes that the fair value of the stock options is morereliably measured than the fair value of the services received. Compensationexpense related to the fair value of stock options granted to non-employees isrecognized over the service period and was determined using the Black-Scholesoption pricing model using the following assumptions: risk-free interest rateof 4.4%; contractual life ranging from five to ten years; dividend yield of 0%;and expected volatility of 58%. At each reporting date, the Company revaluesthe stock-based compensation expense related to unvested non-employee optionsusing the Black-Scholes option pricing model. As a result, stock-basedcompensation will fluctuate with changes in the fair value of the Company’scommon stock. In connection with the grant of stock options to consultants, theCompany recorded stock-based compensation expense in selling, general andadministrative expense of $54 for the three months ended June 30, 2005.The Company recorded stock-based compensation expense in selling, general andadministrative expense of $59 and $63 for the six months ended June 30,2005 and 2006, respectively.

In accordance with the evergreen provision in the 2003Plan and as approved by the Board of Directors, effective January 1, 2006,the number of shares reserved under the 2003 Plan was increased by 698,901shares. On February 23, 2006, the Compensation Committee of the Board ofDirectors approved a grant of 68,500 shares of restricted stock to executiveofficers pursuant to the 2003 Plan. The shares of restricted stock to executiveofficers generally vest in equal annual installments on February 15 of each ofthe four years following the date of grant. On May 18, 2006, in accordancewith the 2003 Plan, 12,500 shares 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.Compensation expense on these shares was $179 and $211 for the three and sixmonths ended June 30, 2006, respectively.

On April 17, 2003,the Company’s board adopted the 2003 Employee Stock Purchase Plan and the 2003Foreign Subsidiary Employee Stock Purchase Plan (“ESPP”), under which, subjectto certain limitations, the initial aggregate number of shares of stock thatmay be issued is 500,000, cumulatively increased on January 1, 2004 andeach January 1 thereafter until and including January 1, 2013 by thelesser of: 1) 500,000 shares, 2) one percent of the number of sharesof all classes of common stock of the Company outstanding on that date, or3) a lesser amount determined by the Board of Directors. Under the ESPP,shares are only issued during the second and fourth quarter of each year. Thevalues were estimated at the date of grant using the Black-Scholes optionpricing model with the following weighted average key assumptions for 2005 and2006:

| ** **               | ** ** | **2005** | ** ** | **2006** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
| Risk free  interest rate |       |     | 2.6        | %        |       |   | 4.5 | % |   |
| 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 historicalvolatility of the Company’s common stock. The risk-free interest rate was theaverage interest rates of U.S. government bonds of comparable term to theservice period.

12

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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 $120 and $191 for the three and sixmonths ended June 30, 2006.

Thefollowing table summarizes information about stock option activity during thesix months ended June 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                                        |       |                     | 325,750    |                                    |       |                                                              | 18.68      |                            |       |   |   |   |   |   |   |
| Exercised                                      |       |                     | (92,266    | )                                       |       |                                                              | 3.95       |                            |       |   |   |   |   |   |   |
| Expired or cancelled                           |       |                     | (19,313    | )                                       |       |                                                              | 17.85      |                            |       |   |   |   |   |   |   |
| Options outstanding  at June 30, 2006     |       |                     | 2,535,723  |                                    |       |                                                              | $          | 13.78                           |       |   |   | 7.75 |   |   | $ | 14,460,000 |   |
| Options  exercisable at June 30, 2006     |       |                     | 1,642,383  |                                    |       |                                                              | $          | 11.85                           |       |   |   | 7.10 |   |   | $ | 12,538,000 |   |

 

| ** **                                                                 | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                         | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------|------------|------------------------------------------------------|------------|
| **Range of Exercise Prices**                                | ** ** | ** **                   | ** ** | **Number  Outstanding at  June 30,  2006** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Number  Exercisable at   June 30,   2006** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| $  1.02 – $  3.07                       |       |                         | 779,961    |                                                 |       |   | 6.25 |   |   |   | $ | 1.02 |   |   |   | 751,137 |   |   |   | $ | 1.02 |   |   |
|     3.08 –     6.16 |       |                         | 7,625      |                                                 |       |   | 2.82 |   |   |   | 4.15 |   |   |   | 7,122 |   |   |   | 4.11 |   |   |
|     6.17 –     9.23 |       |                         | 10,250     |                                                 |       |   | 6.70 |   |   |   | 8.02 |   |   |   | 7,687 |   |   |   | 8.02 |   |   |
|     9.24 –   12.31            |       |                         | 2,750      |                                                 |       |   | 6.80 |   |   |   | 10.59 |   |   |   | 2,687 |   |   |   | 10.57 |   |   |
|   12.32 –   15.40                       |       |                         | 68,250     |                                                 |       |   | 8.21 |   |   |   | 14.16 |   |   |   | 16,187 |   |   |   | 13.42 |   |   |
|   15.41 –   18.47                       |       |                         | 764,000    |                                                 |       |   | 8.91 |   |   |   | 17.08 |   |   |   | 218,998 |   |   |   | 16.46 |   |   |
|   18.48 –   21.55                       |       |                         | 316,387    |                                                 |       |   | 8.98 |   |   |   | 19.89 |   |   |   | 52,065 |   |   |   | 20.16 |   |   |
|   21.56 –   24.63                       |       |                         | 550,500    |                                                 |       |   | 7.63 |   |   |   | 23.10 |   |   |   | 550,500 |   |   |   | 23.10 |   |   |
|   24.64 –   27.71                       |       |                         | 28,500     |                                                 |       |   | 7.43 |   |   |   | 25.94 |   |   |   | 28,500 |   |   |   | 25.94 |   |   |
|   27.72 –   30.79                       |       |                         | 7,500      |                                                 |       |   | 7.27 |   |   |   | 30.79 |   |   |   | 7,500 |   |   |   | 30.79 |   |   |
| $  1.02 – $30.79                                  |       |                         | 2,535,723  |                                                 |       |   | 7.75 |   |   |   | $ | 13.78 |   |   |   | 1,642,383 |   |   |   | $ | 11.85 |   |   |
|                                                                            |            |                              |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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 SFAS No. 123(R).

The aggregate intrinsic value of options exercisedduring the six months ended June 30, 2006 was $1,347. As of June 30,2006, total remaining unearned compensation related to unvested stock optionswas 

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approximately $6,540,which will be amortized over the weighted-average remaining service period oftwo years.

Thefollowing table summarizes information about restricted stock activity duringthe six months ended June 30, 2006: 

| ** **                             | ** ** | **Number of  Shares** | ** ** | **Weighted-  Average  Grant-Date  Fair Value** | ** ** |
|----------------------------------------|------------|----------------------------|------------|-----------------------------------------------------|------------|
| Granted                                |       |                       | 81,000     |                                                |       |   | $ | 18.47 |   |   |
| Vested                                 |       |                       | (5,000     | )                                                   |       |   | 18.32 |   |   |
| Forfeited                              |       |                       | —     |                                                |       |   | — |   |   |
| Nonvested stock at  June 30, 2006 |       |                       | 76,000     |                                                |       |   | $ | 18.48 |   |   |

 

As of June 30, 2006,total remaining unearned compensation related to restricted stock was $1,190,which will be amortized over the weighted-average remaining service period oftwo years.

**Note 9—Commitmentsand Contingencies**

**Indemnities,Commitments and Guarantees**

In the normal course ofbusiness, the Company makes certain indemnities, commitments and guaranteesunder which the Company may be required to make payments in relation to certaintransactions. These indemnities, commitments and guarantees include, among others,intellectual property indemnities to customers in connection with the sale ofproducts and licensing of technology, indemnities for liabilities associatedwith the infringement of other parties’ technology based upon the Company’sproducts and technology, guarantees of timely performance of the Company’sobligations, and indemnities to the Company’s directors and officers to themaximum extent permitted by law. The duration of these indemnities, commitmentsand guarantees varies, and in certain cases, is indefinite. The majority ofthese indemnities, commitments and guarantees do not provide for any limitationof the maximum potential future payments that the Company could be obligated tomake. The Company has not recorded a liability for these indemnities,commitments or guarantees in the accompanying balance sheets, as future paymentis not probable.

**Note 10—OperatingSegment and Geographic Information**

The Company operates its business in three reportablesegments: the Cinema business segment, the Consumer business segment and theDigital Images business segment. The Cinema business segment licensestechnology and sells products and services to producers and distributors offeature length films and digital content, and to movie theaters and special venues.The Company’s Consumer business segment licenses audio technology, trademarksand know-how to consumer electronics, personal computer, broadcast andprofessional audio companies, and sells multi-channel audio content andproducts to consumers. The Company’s Digital Images business segment provides enhancement,restoration and repair services for moving pictures captured on film or indigital 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.

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TheCompany’s reportable segments and geographical information for the three andsix months ended June 30, 2005 and 2006 are as follows:

| ** **               | ** ** | **Revenues**                                                      | ** ** |
|--------------------------|------------|-------------------------------------------------------------------|------------|
| ** **               | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
| ** **               | ** ** | **2005**                                                          | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** |
| Cinema business          |       | $                                                                 | 5,138      |   | $ | 4,900 |   | $ | 9,934 |   | $ | 10,327 |   |
| Consumer business        |       | 10,974                                                            |       | 9,580 |   | 27,515 |   | 30,262 |   |
| Digital Images  business |       | 1,616                                                             |       | 2,417 |   | 2,336 |   | 5,009 |   |
| Total revenues           |       | $                                                                 | 17,728     |   | $ | 16,897 |   | $ | 39,785 |   | $ | 45,598 |   |

 

| ** **               | ** ** | **Gross Profit**                                             | ** ** |
|--------------------------|------------|-------------------------------------------------------------------|------------|
| ** **               | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
| ** **               | ** ** | **2005**                                                          | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** |
| Cinema business          |       | $                                                                 | 2,235      |   | $ | 2,428 |   | $ | 4,408 |   | $ | 4,803 |   |
| Consumer business        |       | 10,484                                                            |       | 9,177 |   | 26,485 |   | 29,501 |   |
| Digital Images  business |       | (21                                                               | )          | 258 |   | (601 | ) | 118 |   |
| Total gross  profit      |       | $                                                                 | 12,698     |   | $ | 11,863 |   | $ | 30,292 |   | $ | 34,422 |   |

 

| ** **                           | ** ** | **Income (Loss) From Operations**                  | ** ** |
|--------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                           | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
| ** **                           | ** ** | **2005**                                                          | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** |
| Cinema business                      |       | $                                                                 | (1,604     | ) | $ | (2,028 | ) | $ | (2,623 | ) | $ | (3,746 | ) |
| Consumer business                    |       | 4,534                                                             |       | 2,041 |   | 14,647 |   | 15,194 |   |
| Digital Images  business             |       | (844                                                              | )          | (1,140 | ) | (4,782 | ) | (2,632 | ) |
| Total income  (loss) from operations |       | $                                                                 | 2,086      |   | $ | (1,127 | ) | $ | 7,242 |   | $ | 8,816 |   |

 

Includedin the Digital Images business segment’s loss for the six months ended June 30,2005 is the $2,300 charge related to in-process research and development.

| ** **     | ** ** | **Revenues by Geographic  Region**                      | ** ** |
|----------------|------------|-------------------------------------------------------------------|------------|
| ** **     | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
| ** **     | ** ** | **2005**                                                          | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** |
| United States  |       | $                                                                 | 5,664      |   | $ | 6,194 |   | $ | 15,043 |   | $ | 12,929 |   |
| International  |       | 12,064                                                            |       | 10,703 |   | 24,742 |   | 32,669 |   |
| Total revenues |       | $                                                                 | 17,728     |   | $ | 16,897 |   | $ | 39,785 |   | $ | 45,598 |   |

 

Thefollowing table sets forth, for the periods indicated, long-lived tangibleassets by geographic area in which the Company holds assets at December 31,2005 and June 30, 2006:

| ** **                        | ** ** | **Long-Lived Assets**              | ** ** |
|-----------------------------------|------------|-----------------------------------------|------------|
| ** **                        | ** ** | **As of  December 31,  2005** | ** ** | **As of  June 30,  2006** | ** ** |
| United States                     |       |                                    | $          | 5,859 |   |   |   | $ | 7,880 |   |   |
| International                     |       |                                    | 1,516      |   |   |   | 1,568 |   |   |
| Total long-lived tangible  assets |       |                                    | $          | 7,375 |   |   |   | $ | 9,448 |   |   |

 

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**Note 11—Net IncomePer Common Share**

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

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

| ** **                                   | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|----------------------------------------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                   | ** ** | **2005**                                                          | ** ** | **2006**                                                        | ** ** | **2005** | ** ** | **2006** | ** ** |
| Basic net income  per common share:          |       |                                                              |       |                                                            |       |   |   |   |   |
| Numerator:                                   |       |                                                              |       |                                                            |       |   |   |   |   |
| Net income                                   |       | $                                                                 | 1,816      |                                                            | $          | 1,883 |   | $ | 5,372 |   | $ | 8,890 |   |
| Denominator:                                 |       |                                                              |       |                                                            |       |   |   |   |   |
| Weighted average common   shares outstanding |       | 17,331,602                                                        |       | 17,547,433                                                      |       | 17,206,415 |   | 17,521,284 |   |
| Basic net income per common   share          |       | $                                                                 | 0.10       |                                                            | $          | 0.11 |   | $ | 0.31 |   | $ | 0.51 |   |
| Diluted net income per common   share:       |       |                                                              |       |                                                            |       |   |   |   |   |
| Numerator:                                   |       |                                                              |       |                                                            |       |   |   |   |   |
| Net income                                   |       | $                                                                 | 1,816      |                                                            | $          | 1,883 |   | $ | 5,372 |   | $ | 8,890 |   |
| Denominator:                                 |       |                                                              |       |                                                            |       |   |   |   |   |
| Weighted average shares outstanding          |       | 17,331,602                                                        |       | 17,547,433                                                      |       | 17,206,415 |   | 17,521,284 |   |
| Effect of dilutive securities:               |       |                                                              |       |                                                            |       |   |   |   |   |
| Common stock options                         |       | 912,479                                                           |       | 763,456                                                         |       | 953,047 |   | 769,532 |   |
| Common stock warrants                        |       | 20,377                                                            |       | 22,204                                                          |       | 21,511 |   | 21,677 |   |
| Restricted stock                             |       | —                                                            |       | 7,214                                                           |       | — |   | 3,627 |   |
| Diluted shares outstanding                   |       | 18,264,458                                                        |       | 18,340,307                                                      |       | 18,180,973 |   | 18,316,120 |   |
| Diluted net  income per common share         |       | $                                                                 | 0.10       |                                                            | $          | 0.10 |   | $ | 0.30 |   | $ | 0.49 |   |

 

For thethree months ended June 30, 2005 and 2006, 773,250 and 1,642,512 shares,respectively, of the Company’s stock options and restricted stock were excludedfrom the calculation of diluted earnings per share because their inclusionwould have been anti-dilutive. For the six months ended June 30, 2005 and2006, 773,250 and 1,394,670 shares, respectively, of the Company’s stock optionsand restricted stock were excluded from the calculation of diluted earnings pershare because their inclusion would have been anti-dilutive.

**Note 12—SubsequentEvents**

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. 

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In August 2006, as part of the Company’s strategy toposition itself to pursue opportunities in the emerging digital cinema market,the Company entered into an exclusive license agreement and an option agreementwith Avica Technology Corporation, a provider of products and services for thedigital cinema market. Under the exclusive license agreement, the Company willacquire a worldwide, exclusive license (even as to Avica) to substantially allof Avica’s intellectual property in all fields of use other than with respectto military applications. The Company may be obligated to make certainmilestone payments to Avica under the exclusive license agreement, but will notbe obligated to pay any on-going royalties. Under the option agreement, theCompany may elect, in its sole discretion, to acquire all or substantially allof the assets of Avica.

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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 or implied by these statements. Thesefactors include those listed under the “Risk Factors” section contained belowand elsewhere in this Form 10-Q, and the other documents we filewith the Securities and Exchange Commission, or SEC, including our most recentreports on Form 8-K and Form 10-K. We cannot guaranteefuture results, levels of activity, performance, or achievements. We do notintend to update these forward-looking statements to reflect future eventsor circumstances.

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

**Overview**

We are a leading 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 Digital Images, Inc.,now DTS Digital Images, Inc., or DTS DI, we have expanded our businessinto high quality digital image processing, enhancement and restoration formotion pictures, digital cinema, and television content.

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 from licensingour technology to consumer semiconductor manufacturers. Through our DTSEntertainment label, we derive revenues from the sale of multi-channel musictitles 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.

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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 know-how to consumer electronics, personalcomputer, video game and console, digital satellite and cable broadcast, andprofessional audio companies as well as to semiconductor manufacturers.Revenues from technology and film licensing in connection with our cinemabusiness segment include revenues derived from film licensing and services thatwe provide to film studios for the production of soundtracks in our digitalmulti-channel format. Our product sales and other revenues are derived from ourconsumer, cinema and digital images business segments. Revenues from productsales and other revenues in connection with our consumer business segmentinclude revenues derived from sales of music titles that we produce in ourdigital multi-channel format and sales of our professional audio products andservices. Revenues from product sales and other revenues in connection with ourcinema business segment include revenues derived from sales of our digitalplayback systems, cinema processor equipment, and systems for subtitling,captioning, and descriptive narration to movie theaters and special venues.Revenues from product sales and other revenues in connection with our digitalimages business segment include fees for processing, enhancing and restoringcinema, 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 to us the amount of royalties owed under license agreementswith us. We continue to invest in our compliance and enforcement infrastructureto support the value of our intellectual property to us and our licensees andto improve the long-term realization of revenue from our intellectual property.As a result of these activities, from time to time, we recognize royaltyrevenues that relate to consumer electronics manufacturing activities fromprior periods. These royalty recoveries may cause revenues to be higher thanexpected during a particular reporting period and may not occur in subsequentperiods. While we consider such revenues to be a regular part our normaloperations, we cannot 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, informationsystems, legal, and operations, and costs associated with promotional and otherselling activities. Selling, general, and administrative expenses also includeprofessional fees, facility-related expenses, and other general corporateexpenses.

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 andJapan. We employ consultants to coordinate sales to independent retailers andwe sell this music directly to consumers through an online store and otherweb-based retailers.

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

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

***New Strategic Initiatives***

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. In August 2006, as part of our strategy to pursueopportunities in the digital cinema market, we signed an exclusive licenseagreement and an option agreement with Avica Technology Corporation, a providerof products and services for the digital cinema market. Under the exclusivelicense agreement we will acquire a worldwide, exclusive license (even as toAvica) to substantially all of Avica’s intellectual property in all fields ofuse other than with respect to military applications. Under the optionagreement, we may elect, in our sole discretion, to acquire all orsubstantially all of the assets of Avica for a fixed purchase price. Theclosing under these agreements is subject to the satisfaction of certainconditions precedent. We believe Avica’s suite of digital cinema technologies,products and services complements our existing cinema product offerings andwill accelerate our entry into the digital cinema market.

Additionally, we intend tostudy the potential separation of our businesses in order to better addressrapidly evolving markets, meet the needs of customers and increase shareholdervalue.

***Trends, Opportunities, and Challenges by BusinessSegment***

*Consumer Segment*

Revenue from our consumersegment constitutes the majority of our total revenue, representing57% and 62% of total revenues for the quarters ended June 30, 2006and 2005, respectively. Our consumer revenue is primarily dependent upon thehome theater and DVD player markets, which have experienced rapid growth overthe past several years. However, we have recently experienced softness in ourDVD player trademark licensing program, and expect growth rates in this area todecline from recent levels. The success of DVD-Video-based systems and productshas fueled a demand for higher quality entertainment in the home, and thisdemand is extending to the car audio and personal computer markets as well. Inaddition, we expect the recent acceleration of the market for high definitiontelevisions to drive demand for high definition optical disc players beginningin late 2006, although revenues from these high definition players will beminimal for the year. Because we have been selected as a mandatory technologyfor next generation players, our consumer revenue growth should more closelytrack the growth rate of these players over the next several years. We expectthat the market for high definition players will yield new growth that providesan offset to the expected decline in the overall growth in DVD playershipments. Further, we believe that expected mandatory inclusion in nextgeneration optical disc standards will help to 

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improvethe adoption 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 than expectedand would have a material adverse effect on our business.

In July 2004, weacquired QDesign Corporation, or QDesign, a company focused on lower bit-rateaudio delivery technology. The market for higher quality entertainment isexpanding into portable devices that require the use of low-bit rate audiocoding systems including portable audio players, PDAs and wireless handsetapplications. Concurrent with this trend, there is a growing need for a goodlink between home and portable devices that preserves as much quality aspossible and allows consumers a seamless technology solution for the storageand playback of their content. In October 2004, leveraging our existingresearch and development efforts and the intellectual property acquired in theQDesign acquisition, we launched our DTS-HD initiative. This technology is ascalable coding system that will allow content to be played in home andportable devices. We believe that the broad and robust nature of this offeringimproves the probability of inclusion of our technologies in next generationproducts.

*Cinema Segment*

Revenue from our cinemasegment represented 29% of total revenues for the quarters ended June 30, 2006and 2005. 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 digital cinemamarket as discussed below. We also believe that the cinema exhibition communityhas recognized that pre-show entertainment represents a significant revenuegrowth opportunity that will lead to investment in pre-show solutions over thenext several years. Because our XD10 Cinema Media Player can be configured toperform audio playback along with pre-show and subtitling presentation, webelieve that we are well-positioned to participate in the anticipated growth inthis market.

A trend that we believewill affect our cinema business segment is the long-term trend toward digitaldistribution of content. We believe this trend will involve the near-termadoption of digital pre-show and/or electronic cinema solutions, followed bylonger-term adoption of higher quality digital cinema. Digital distribution ofcontent offers the motion picture industry a means to achieve substantial costsavings, including the printing and distribution of movies, help in combatingpiracy, and will enable movies to be played repeatedly without degradation. Italso provides additional revenue opportunities for cinema operators, as digitalcontent such as advertisements, concerts and sporting events could be shown inor broadcast to digitally equipped theaters. In recent months, there has beenincreasing momentum in the digital cinema industry, as product and servicevendors attempt to find a viable business model. We believe that these activitiesare primarily vendor-financed trials at this point, but represent an importantand significant step in the transition. We believe the widespread adoption ofdigital cinema will be longer-term because of the significant capitalinvestment that will be required by cinema operators to purchase new equipmentand solutions. We believe this represents an opportunity for us as we seek toprovide products and services in support of the transition from film-basedcontent towards digital cinema. However, our current digital cinema offeringsare limited and we may not be successful in developing or selling competitiveproduct offerings. We believe that the addition of our Cinema Media Network andvariable bit rate JPEG 2000 encoding tools, along with the services provided byour digital images business, and the pre-show and alternative contentcapabilities of our XD10 Cinema Media Player, combined with the addition of theproducts, technologies and know-how obtained under our exclusive licenseagreement with Avica Technology Corporation, will enhance our ability toparticipate in the industry transition to high definition sound and images for digitalcinema.

Sales of cinema productsand film licensing tend to fluctuate based on the underlying trends in themotion picture industry. For instance, in the late 1990s various cinemaoperators aggressively built 

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megaplexes,which resulted in an oversupply of screens in some domestic and internationalmarkets. The resulting oversupply of screens led to significant declines inrevenues per screen, and eventually, many theaters were closed. As a result ofthe closures, sales of our playback systems and cinema processors suffered. Asthe theater industry has regained health in the last several years, sales ofour DTS playback systems and cinema processors have improved. Our filmlicensing revenues are also subject to fluctuations based on industry trends, mostsignificantly, the number of films being made by studios and independentfilmmakers.

*Digital Images Segment*

Revenue from our digitalimages segment represented 14% and 9% of total revenues for the quarters endedJune 30, 2006 and 2005, respectively. We believe that the growing market forhigh resolution and high definition content in the cinema and the home willcreate a substantial demand for the type of services provided by DTS DI. Arelatively new application for our process is the correction of problemsencountered with the use of digital cameras, enabling our involvement at theearliest stages of digital content development. We believe that we provideleading digital lab capabilities, including digital enhancement, restorationand other pre-compression services and that we have a technological advantageover many of our competitors based on the sophistication of our processes andlevel of automation used to enhance the image quality of entertainment content.Revenues of our digital images segment totaled $2.4 million and $1.6million for the three months ended June 30, 2006 and 2005, respectively. Todate, this business has enhanced and/or restored over 100 feature films,including such major DVD releases as Star Wars and Indiana Jones. Major motionpicture and television studios possess libraries containing thousands oftitles, which we believe represent a sizable market opportunity for theservices performed by DTS DI.

**Critical Accounting Policies and Estimates**

Management’s Discussionand Analysis of Financial Condition and Results of Operations is based upon ourconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States. The preparationof our financial statements requires us to make estimates and judgments thataffect the reported amounts of assets, liabilities, revenues, and expenses, andrelated disclosure of contingent assets and liabilities. On an on-going basis,estimates are evaluated, including those related to revenue recognition,allowance for doubtful accounts, inventories, goodwill and intangible assets,taxes, impairment of long-lived assets, product warranty, stock-basedcompensation, and contingencies and litigation. These estimates are based onhistorical experience and on various other assumptions that we believe to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from theseestimates. There has been no material change to our critical accountingpolicies and estimates from the information provided in our Form 10-Kfiled on March 16, 2006, except for the adoption of SFAS No. 123(R).

**Results of Operations**

***Revenues***

*Technology and Film Licensing*

Technology and filmlicensing revenues for the three months ended June 30, 2006 decreased 9%to $11.7 million from $12.8 million for the three months endedJune 30, 2005. The decrease in revenues from technology and film licensingwas primarily attributable to a decrease in royalty recoveries of $1.3 millionfrom intellectual 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 9% and 72%,respectively, during the second quarter of 2006 and are up 23% and 68%,respectively, for 

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the year.However, we remain cautious in our outlook due to uncertainties surrounding theconsumer electronics market. Overall, we continue to expect technologylicensing revenues to grow modestly for 2006, based primarily on the expectedcontinuation of growth in our decoder licensing program and from our licenseenforcement activities. Our film licensing revenues increased 9% for the threemonths ended June 30, 2006 compared to the prior year due to additionalreleases in the DTS format and the timing of major feature film releases. Filmlicensing is expected to remain relatively flat for the remainder of 2006.

Technology and filmlicensing revenues for the six months ended June 30, 2006 increased 11% to$34.6 million from $31.3 million for the six months endedJune 30, 2005. The increase in revenues from technology and film licensingwas primarily attributable to an increase in royalty recoveries of $2.3 millionfrom intellectual property compliance and enforcement activities. Theseactivities, which include audits of shipments by certain of our licensees andlegal actions taken against licensees and parties who are not our licensees,resulted in recoveries of royalty payments relating to prior periods.

*Product Sales and Other*

Product sales and otherrevenues increased 5% to $5.2 million for the three months ended June 30,2006 from $4.9 million for the three months ended June 30, 2005. Thisincrease was primarily attributable to growth in revenues generated by DTS DIoffset by a net decrease in Cinema hardware sales resulting from a slowdown inthe US cinema audio market, as exhibitors evaluate the digital cinemaalternatives to film-based exhibition. Product sales and other revenue isexpected to be essentially flat throughout the remainder of 2006.

Product sales and otherrevenues increased 30% to $11.0 million for the six months endedJune 30, 2006 from $8.5 million for the six months endedJune 30, 2005. This increase was primarily attributable to growth inrevenues generated by DTS DI along with an increase in Cinema hardware salesresulting in part from the recognition of deferred revenue related to ourarrangement with Cinecom.

*Segment Sales*

Revenues from our consumerbusiness totaled $9.6 million for the three months ended June 30, 2006, adecrease of 13% from $11.0 million for the three months ended June 30, 2005.The decrease in revenues was primarily attributable to a decrease in royaltyrecoveries of $1.3 million from intellectual property compliance andenforcement activities. Cinema revenues totaled $4.9 million for the threemonths ended June 30, 2006, a decrease of 5% from $5.1 million forthe three months ended June 30, 2005. The decrease in revenue wasprimarily due to a slowdown in US hardware sales, as described above. Revenuesfrom our digital images business totaled $2.4 million for the three monthsended June 30, 2006, a significant increase from revenues of $1.6 millionfor the three months ended June 30, 2005. The increase in revenues wasprimarily due to ongoing improvements in the Company’s digital enhancement andrestoration process, which have resulted in significant improvements inthroughput.

Revenuesfrom our consumer business totaled $30.3 million for the six months endedJune 30, 2006, an increase of 10% from $27.5 million for the six monthsended June 30, 2005. The increase in revenues was driven primarily by anincrease in royalty recoveries mentioned above as well as the overall growth inour personal computer and car audio markets. Cinema revenues totaled $10.3million for the six months ended June 30, 2006, an increase of 4% from$9.9 million for the six months ended June 30, 2005. The increase inrevenue was primarily due to strong sales of Cinema hardware products duringthe first quarter of 2006, partially offset by the hardware sales slowdown inthe second described above. Revenues from our digital images business totaled$5.0 million for the six months ended June 30, 2006, a significantincrease from revenues of $2.3 million for the six months ended June 30,2005. The increase in revenues was primarily due to the recognition of $1.5million in deferred revenue, and ongoing improvements in the Company’s digital enhancementand restoration process.

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***Gross Profit***

Consolidated gross profitdecreased to 70% of revenues for the three months ended June 30, 2006,from 72% for the three months ended June 30, 2005. Consolidated grossprofit decreased slightly to 75% of revenues for the six months ended June 30,2006, from 76% for the six months ended June 30, 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 FilmLicensing*

Gross profit associated with technology and filmlicensing revenues decreased slightly to 90% for the three months ended June 30,2006 from 92% of related revenues for the same period in the prior year.

Gross profit associatedwith technology and film licensing revenues remained consistent at 93% for thesix months ended June 30, 2006 and 2005.

*Product Sales andOther*

Gross profit associated with product sales and otherrevenues increased to 26% of related revenues for the three months ended June 30,2006 from 18% in the prior year period primarily as a result of volume-basedmargin improvements in our digital images business.

Gross profit associatedwith product sales and other revenues increased to 21% of related revenues forthe six months ended June 30, 2006 from 15% in the prior year periodprimarily as a result of volume-based margin improvements in our digital imagesbusiness.

*Segment GrossProfit*

Gross profit for our consumer business remainedconsistent at 96% of related revenues for the quarter ended June 30, 2006and 2005. Our cinema business gross profit increased to 50% of related revenuesfor the quarter ended June 30, 2006 from 43% in the prior year periodprimarily due to a favorable mix of higher margin XD10 products and filmlicensing revenues. Our digital images business gross profit was 11% of relatedrevenues for the quarter ended June 30, 2006 compared to a negative grossprofit for the quarter ended June 30, 2005.

Gross profit for ourconsumer business increased slightly to 97% of related revenues for the sixmonths ended June 30, 2006 compared to 96% for the same period in 2005.Our cinema business gross profit increased to 47% of related revenues for thesix months ended June 30, 2006 from 44% in the prior year period primarilydue to the mix effects mentioned above. Our digital images business grossprofit was 2% of related revenues for the six months ended June 30, 2006compared to a negative gross profit for the six months ended June 30,2005.

***Selling, General and Administrative***

Selling, general and administrative expenses increased24% to $10.0 million for the three months ended June 30, 2006,compared to $8.1 million in the prior year period. The increase is primarilydue to an increase in compensation expense of $552,000 due to additionalemployees and the inclusion of $884,000 related to SFAS No. 123(R).

Selling, general and administrative expenses increased23% to $19.9 million for the six months ended June 30, 2006, comparedto $16.1 million in the prior year period. The increase is primarily due to anincrease in compensation expense of $1.7 million due to additional employeesand the inclusion of $1.4 million related to SFAS No. 123(R).

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We expect selling, generaland administrative expenses to increase as a whole to support our growthinitiatives including acquisitions, international expansion and intellectualproperty enforcement activities.

***Research and Development***

For the three months ended June 30, 2006,research and development expenses were $3.0 million, compared to $2.5 millionfor the three months ended June 30, 2005. For the six months ended June 30,2006, research and development expenses were $5.7 million, compared to$4.6 million for the six months ended June 30, 2005. The increase forboth periods is primarily due to increased labor costs associated with newproduct and technology initiatives, the optimization of our Coherent Acousticstechnology, and the development of tools associated with next generationoptical disc standards. In addition, SFAS No. 123(R) related researchand development expenses totaled $115,000 and $220,000 for the three and sixmonths ended June 30, 2006, respectively.

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

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

In-process research anddevelopment of $2.3 million for the six months ended June 30, 2005 relatesto development projects that had not reached technological feasibility and wereof no future alternative use and expensed upon consummation of the acquisitionof DTS DI. Developed technology and in-process research and development wereidentified and valued through extensive interviews, analysis of data providedby DTS DI concerning development projects, their stage of development, the timeand resources 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-process research and development. Key assumptions for in-processresearch and development included a discount rate of 30% and estimates ofrevenue growth, cost of sales, operating expenses and taxes.

***Interest Income, Net***

Interest income, net, forthe three and six months ended June 30, 2006 increased due to the increasein interest rates in 2006 and higher average investment balances.

***Income Taxes***

For the three months ended June 30, 2006, werecorded an income tax benefit of $1.8 million on pre-tax income of $109,000.For the three months ended June 30, 2005, we recorded an income taxprovision of $1.1 million on pre-tax income of $2.9 million.

For the six months ended June 30,2006, we recorded an income tax provision of $2.2 million on pre-tax income of$11.1 million. This resulted in an annualized effective tax rate of 20.1%.During the second quarter of 2006, the Internal Revenue Service (“IRS”)completed an examination of the federal income tax return filed by the Companyfor the year ended December 31, 2003. The Company achieved a favorableresolution with the IRS regarding the Extraterritorial Income Exclusion (“ETI”)that resulted in a tax benefit of $1.7 million. As a result of this benefit,the current income tax rate differs from the statutory rate. In 2006, excludingthis impact of ETI adjustment, the Company’s annualized effective tax rate wasapproximately 34.5%. For the six months ended June 30, 2005, we recordedan income tax provision of 

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$3.0million on pre-tax income of $8.4 million. This resulted in an annualizedeffective tax rate of 36.1%. These rates differed from the statutory ratesprimarily due to state income taxes offset by benefits associated with theforeign rate differentials. We expect the effective tax rate for 2006 will beapproximately 26% to 27%.

**Liquidity andCapital Resources**

At June 30, 2006, we had cash, cash equivalentsand short-term investments of $119.7 million, compared to $111.4 million at December 31,2005.

Net cash provided by operating activities was$12.2 million for the six months ended June 30, 2006, compared to$4.0 million for the six months ended June 30, 2005. The primary source ofoperating cash flow for the six months ended June 30, 2006 was net incomeof $8.9 million, adjusted for non-cash items including depreciation andamortization expense and stock-based compensation charges.

Net cash used in investing activities totaled $10.0million for the six months ended June 30, 2006, compared to net cashprovided by investing activities of $15.3 million for the six months ended June 30,2005. Cash used in investing activities for the six months ended June 30,2006 primarily consists of net purchases of investments of $5.0 million andpurchases of property and equipment of $3.6 million.

Net cash provided by financing activities totaled $1.1million and $542,000 for the six months ended June 30, 2006 and 2005,respectively, and consists of the exercise of stock options and related excesstax benefits and purchases of stock under our employee stock purchase plan.Prior to adoption of SFAS No. 123(R), excess tax benefits from exercise ofstock options were shown as 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 $747,000. We expect that we will incur additional costs in therange of $2 million to $4 million over the next several years in connectionwith our ERP implementation. Through June 30, 2006, we incurredapproximately $1.2 million, which has been capitalized to software.

On August 1, 2006, our Board of Directorsauthorized, subject to certain business and market conditions, the purchase ofup to one million shares of our common stock in the open market or in privatelynegotiated transactions.

We believe that our cash,cash equivalents, short-term investments, funds available under our existingbank line of credit facility, and cash flows from operations will be sufficientto satisfy our working capital and capital expenditure requirements for atleast the next twelve months. Beyond the next twelve months, additionalfinancing may be required to fund working capital and capital expenditures.Changes in our operating plans including lower than anticipated revenues,increased expenses, acquisition of companies, products or technologies or otherevents, including those described in “Risk Factors” included elsewhere herein,in our Form 10-K filed on March 16, 2006 and in other filingsmay cause us to seek additional debt or equity financing on an acceleratedbasis. Financing may not be available on acceptable terms, or at all, and ourfailure to raise capital when needed could negatively impact our growth plansand our financial condition and results of operations. Additional equityfinancing may be dilutive to the holders of our common stock and debtfinancing, if available, may involve significant cash payment obligations andfinancial or operational covenants that restrict our ability to operate ourbusiness.

**Recently IssuedAccounting Standards**

In July 2006, the FIN No. 48, “Accounting forUncertainty in Income Taxes,” which prescribes a comprehensive model for how acompany 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 

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FIN No. 48 are effectivefor fiscal years beginning after December 15, 2006. The Company is in theprocess of determining the effect, if any, the adoption of FIN No. 48 willhave on its financial statements.

In June 2006, the EITF issued EITF No. 06-3, “HowSales Taxes Collected from Customers and Remitted to Governmental AuthoritiesShould Be Presented in the Income Statement (That Is, Gross Versus NetPresentation),” which states that a company should disclose its accountingpolicy (i.e., gross or net presentation) regarding presentation of taxes withinthe scope of this Issue. If taxes included in gross revenues are significant, acompany should disclose the amount of such taxes for each period for which anincome statement is presented. The consensus would be effective for the firstannual or interim reporting period beginning after December 15, 2006. Thedisclosures are required for annual and interim financial statements for eachperiod for which an income statement is presented. The Company will adopt thisInterpretation effective January 1, 2007. Based on the Company’s currentevaluation of this Issue, the Company does not expect the adoption of EITF No.06-3 to have a significant impact on its consolidated results of operations orfinancial 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 during theperiod of the change. SFAS No. 154 requires retrospective applicationto prior periods’ financial statements, unless it is impracticable to determineeither the period-specific effects or the cumulative effect of the change.SFAS No. 154 is effective for accounting changes made in fiscal yearsbeginning after December 15, 2005; however, the Statement does not changethe transition provisions of any existing accounting pronouncements. Theadoption of SFAS No. 154 did not have a material effect on the Company’sconsolidated financial position, results of operations or cash flows.

In December 2004, the FASB finalized SFAS No. 123(R),“Share-Based Payment,” which requires companies to measure and recognizecompensation costs for all share-based payments (including stock options) atfair value, effective for interim or annual periods beginning after June 15,2005. On April 15, 2005, the U.S. Securities and Exchange Commission (the “SEC”)announced a deferral of the effective date of SFAS No. 123(R) untilthe first interim or annual reporting period of the first fiscal year beginningon or after June 15, 2005. Effective January 1, 2006, the Companyadopted the provisions of SFAS No. 123(R) as discussed inFootnote 8, Stock-Based Compensation.

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

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

Market risk represents the risk of loss arising fromadverse changes in market rates and foreign exchange rates. At June 30,2006, we did not have any balances outstanding under our bank line of creditarrangement; however, the amount of outstanding debt at any time may fluctuateand we may from time to time be subject to refinancing risk.

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 June 30, 2006, a 1% change ininterest rates 

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throughout a one-yearperiod would have an annual effect of approximately $1.2 million on our incomebefore income taxes.

We derive in the range of half to three-quarters of ourrevenues from sales outside the United States, and maintain research, sales,marketing, or business development offices in nine countries. Therefore, ourresults 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 foreign operationsand a small amount of cash maintained by these operations. Revenues denominatedin foreign currencies accounted for approximately 7.2% of total revenues duringthe six months ended June 30, 2006. Operating expenses, including cost ofsales, for our foreign subsidiaries were approximately $7.5 million in the sixmonths ended June 30, 2006. Based upon the expenses for the six monthsended June 30, 2006, a 1% change in foreign currency rates throughout aone-year period would have an annual effect of approximately $149,000 onoperating 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 byexchange rate fluctuations as the financial statements of our foreign subsidiariesare translated into the United States dollar in consolidation. As exchangerates vary, these results, when translated, may vary from expectations andcould adversely or positively impact overall profitability. During the sixmonths ended June 30, 2006, the positive impact of foreign exchange ratefluctuations related to translation of our foreign subsidiaries’ financialstatements was $49,000 on retained earnings.

**Item 4.**                        Controlsand Procedures

**Disclosure Controlsand Procedures**

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

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**

**OTHER INFORMATION**

**Item 1.**                        LegalProceedings

None.

**Item 1A.**                RiskFactors

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

The risk factorsdescribed below do not contain any material changes from the Risk Factorsdescribed under Item 1A of Part I of our Annual Report on Form 10-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:

·        “Ourstudy of the potential separation of our businesses and/or any failure tosuccessfully manage and complete an undertaken separation transaction couldadversely affect our business and operating results.”

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

·       Following our adoption ofSFAS 123(R) on January 1, 2006, we have deleted the risk factor that was titled“Accounting for employee stock options using the fair value method will reduceour net income.”

**Risks Related toOur Business**

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

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

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

·                    productsfor cinema markets, such as Smart Devices, Inc., Ultra Stereo Labs, Inc.,Eastman Kodak Company, Screenvision Cinema Network LLC, National CineMedia LLC,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

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

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

·                    greatername recognition;

·                    alonger operating history;

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

·                    amore extensive customer base;

·                    digitaltechnologies that provide features that ours do not;

·                    broaderproduct and service offerings;

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

·                    moretechnicians and engineers.

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

In addition to the competitive advantages describedabove, Dolby also enjoys other unique competitive strengths relative to us. Forexample, it introduced multi-channel audio technology before we did. It has alarger base of installed movie theaters for its cinema playback equipment. Itstechnology has been incorporated in significantly more DVD-Video films than ourtechnology. It has also achieved mandatory standard status in productcategories that DTS has not, including DVD-Video and DVD-Audio Recordable, forits stereo technology and terrestrial digital television broadcasts in theUnited States. As a result of these factors, Dolby has a competitive advantagein selling its digital multi-channel audio technology to consumer electronicsproducts manufacturers.

Sony Corporation is both acompetitor and a significant customer in most of our markets. If Sony decidesto eliminate the use of our technology in its products or to compete with usmore aggressively in our markets, the revenues that we derive from Sony wouldbe lower than expected.

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

Technology standards are important in the audio andvideo industry as they help to assure compatibility across a system or seriesof products. Generally, standards adoption occurs on either a mandatory basis,requiring a particular technology to be available in a particular product ormedium, or an optional basis, meaning that a particular technology may be, butis not required to be, utilized. For example, both our digital multi-channelaudio technology and Dolby’s have optional status in Standard andHigh-Definition DVD and Blu-ray. In the emerging standards for highdefinition-DVD and Blu-ray, both DTS and Dolby technologies have been selectedas mandatory standards for two-channel output. However, if either or both ofthese standards are re-examined or a new standard is developed, we maynot be included as mandatory in any such new or revised standard.

Various national governments have adopted or are inthe process of adopting standards for all digital television broadcasts,including cable, satellite, and terrestrial. In the United States, Dolby’saudio technology has been selected as the sole, mandatory audio standard forterrestrial digital television 

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broadcasts. As a result,the audio for all digital terrestrial television broadcasts in the UnitedStates must include Dolby’s technology and must exclude any other format,including ours. We do not know whether this standard will be reopened oramended. If it is not, our audio technology may never be included in thatstandard. Certain large and developing markets, such as China, have not fullydeveloped their digital television standards. Our technology may or may notultimately be included in these standards.

As new technologies andentertainment media emerge, new standards relating to these technologies ormedia may develop. New standards may also emerge in existing markets that arecurrently characterized by competing formats, such as the market for personalcomputers. We may not be successful in our efforts to include our technology inany such standards.

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

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

·                    rapidtechnological change;

·                    newand improved product introductions;

·                    changingcustomer demands;

·                    evolvingindustry standards; and

·                    productobsolescence.

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

***Declining retailprices for consumer electronics products or video content could force us tolower the license orother fees we charge our customers.***

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

The market for consumervideo products is also intensely competitive and price sensitive. Retail pricesfor consumer video products that have been processed, enhanced or restored byus, such as movies, concerts or animated content released on DVD or othermedia, have experienced price pressure and we 

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expectthis price pressure to continue for the foreseeable future. Declining pricesfor such video products could create downward pressure on the fees we currentlycharge our customers for the image processing, enhancement and restorationservices we provide. If the motion picture studios, content owners, producersor distributors were to believe that the existing image quality is satisfactoryor that the pricing for our services is too high, they could decide to not useour services altogether.

***Our study of thepotential separation of our businesses and/or any failure to successfullymanage and complete an undertaken separation transaction could adversely affectour business and operating results.***

In order tobetter address rapidly evolving markets, meet the needs of customers and increaseshareholder value, we are evaluating the benefits, challenges andstructural options with respect to a potential separation of our businesses.This evaluation process may require significant time and attention from ourmanagement team, which could disrupt our day-to-day operations. In addition,implementing any potential transaction would involve a number of operational,legal and, possibly, regulatory steps. Furthermore, implementation could becostly, cause further disruption to our day-to-day operations, and result inthe loss of customers and/or sales revenue, which could cause our business andoperating results to suffer.

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

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

·                    ourpatents may be challenged or invalidated by our competitors;

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

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

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

·                    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;

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

·                    we may beunable to successfully identify or prosecute unauthorized uses of ourtechnology.

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

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

Companies that participatein the digital audio, digital image processing, consumer electronics, andentertainment industries hold a large number of patents, trademarks, andcopyrights, and are frequently 

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involvedin litigation based on allegations of patent infringement or other violationsof intellectual property rights. Intellectual property disputes frequentlyinvolve highly complex and costly scientific matters, and each party generallyhas 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 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 operating results may be adversely affected as aresult of required compliance with the recently adopted European Union Directiveson Waste Electrical and Electronic Equipment and the Restriction of the Use ofHazardous Substances in electrical and electronic equipment.***

In February 2003, theEuropean Union enacted Directive 2002/96/EC on Waste Electrical and ElectronicEquipment Directive, known as the WEEE Directive. The WEEE Directive requiresproducers of certain electrical and electronic equipment to be financiallyresponsible for the future disposal costs of this equipment. Our cinemaproducts may fall within the scope of this Directive and as such we may incursome financial responsibility for the collection, recycling, treatment anddisposal of both new products sold, and products already sold prior to the WEEEDirective’s enforcement date, to customers within the European Union. TheDirective potentially increases our financial liabilities by requiringproducers to adopt new approaches for improving sustainable product design andfor encouraging recycling 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 Unionmember states are required to transpose the Directives into nationallegislation. Although not all European Union member states have enactedlegislation to implement these two directives, we continue to review theapplicability and impact of both directives on the sale of our cinema productswithin the European Union.

We may incur increasedmanufacturing costs or production delays to comply with future legislationwhich implements these directives, but we cannot currently estimate the extentof such increased costs or production delays. However, to the extent that suchcost increases or delays are substantial, our operating results could bematerially adversely affected. In addition, we are aware of similar legislationwhich may be enacted in other countries, such as China, and possible newfederal and state legislation in the United States, the cumulative impact ofwhich could significantly increase our operating costs and adversely affect ouroperating results.

The WEEE Directive and theRoHS Directive are aimed mainly at mass market consumer electronics and thus,will impact many of our customers who license our technology and pay us royaltiesupon the manufacture of electronic products. If the directives result in fewerlicensed consumer electronics products being sold, whether due to priceincreases, production delays, compromised product performance due toreformulation or redesign, or for other reasons, then we will receive lessrevenue in royalties. If the 

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directivesmaterially impair or inhibit such sales, the reduction in licensing revenuecould adversely affect our operating results.

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

We expect to derive asignificant percentage of our revenues from the technology, products, andservices that we offer to manufacturers of consumer electronics products. Todate, the most significant driver for the use of our technology in the hometheater market has been the release of major movie titles with DTS audiosoundtracks. We also believe that demand for our DTS audio technology inemerging markets for multi-channel audio, including homes, cars, personalcomputers, and video games and consoles, will be based on the number, quality,and popularity of the audio DVDs, computer software programs, and video gamesreleased with DTS audio soundtracks. Although we have existing relationshipswith many leading providers of movie, music, computer, and video game content,we do not have contracts that require any of these parties to develop andrelease content with DTS audio soundtracks. In addition, we may not besuccessful in maintaining existing relationships or developing relationshipswith other existing providers or new market entrants that provide content. As aresult, we cannot assure you that a significant amount of content in movies,audio DVDs, computer software programs, video games, or other entertainmentmediums will be released with DTS audio soundtracks. If the amount, variety,and popularity of entertainment content released with DTS audio soundtracks donot increase, consumer electronics products manufacturers that pay us per-unitlicensing fees may discontinue offering DTS playback capabilities in theconsumer electronics products that they sell.

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

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

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

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

***We have limitedexperience in image processing, enhancement and restoration.***

Although we haveestablished relationships with a number of motion picture studios, contentowners, producers and distributors, we do not have any contractual agreementsthat require them to provide us image content for processing. Further, thedemand for image processing, enhancement and restoration of cinema, home videoor broadcast television content may not materialize or accelerate as weanticipate, which would have a negative impact on our business.

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

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

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

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

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***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 industrymay transition from film-based media to electronic-based, or digital, media. Ifthis transition occurs, we may be unable to meaningfully respond withcompetitive product offerings. In addition, if the film industry broadly adoptsdigital cinema, our technology and current product and service offerings couldbe rendered obsolete. In such an event, demand by movie theaters for ourplayback systems, cinema processors, and systems for subtitling, captioning,and descriptive narration as well as film licensing revenue would decline.

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

Our cinema businessdepends in part on the construction of new screens and the renovation of existingtheaters that install our DTS playback systems and cinema processors. In recentyears, aggressive building of megaplexes by companies that operate movietheaters has generated significant competition and resulted in an oversupply ofscreens in some domestic and international markets. The resulting oversupply ofscreens led to significant declines in revenues per screen and, eventually, toan inability by many major film exhibitors to satisfy their financialobligations. Several major movie theater operators have reorganized throughbankruptcy proceedings, and many movie theaters have closed. As a result, ourplayback systems and cinema processors that we previously sold to movietheaters that have reorganized and closed have been relocated to other theatersor have been available for resale in the secondary market to movie theatersthat might otherwise have purchased these products directly from us. Morerecently, the industry has experienced a decline in movie theater attendance.If this decline were to continue, exhibitors could see a decline in revenue perscreen and, potentially, an inability to satisfy their financial obligationsresulting in the closure of screens. If movie theater operators decide to closea significant number of screens in the future or cut their capital spending,demand for our playback systems and cinema processors will decline.

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

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

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

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

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

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

The loss of key personnelor an inability to attract qualified personnel in a timely manner could slowour technology and product development and harm our ability to execute ourbusiness plan. We do not 

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generallycarry key-man life insurance on any of our employees, with the exception thatwe are the beneficiary of a $10 million key-man life insurance policy for JohnLowry.

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

Although the first moviewith a DTS audio soundtrack was released in 1993, we did not enter the hometheater market until 1996, and our technology has only recently beenincorporated into other consumer electronics markets, such as car audio,personal computers, video games and consoles, portable electronics devices, anddigital satellite and cable broadcast products. In addition, while we havecompleted over 100 digital image processing, enhancement and restoration filmprojects, it is only recently that a large number of these projects have beencompleted. As a result, the demand for our technology, products, and servicesand the income potential of these businesses are unproven. In addition, becausethe market for digital audio technology and image services is relatively newand rapidly evolving, we have limited insight into trends that may emerge andaffect our business. We may make errors in predicting and reacting to relevantbusiness trends, which could harm our business. Before investing in our commonstock, you should consider the risks, uncertainties, and difficultiesfrequently encountered by companies in new and rapidly evolving markets such asours. We may not be able to successfully address any or all of these risks.

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

Our technology or productscould contain errors that could cause our products or technology to operateimproperly and could cause unintended consequences. If our products ortechnology contain errors we could be required to replace them, and if any sucherrors cause unintended consequences we could face claims for productliability. Although we generally attempt to contractually limit our exposure toincidental and consequential damages, if these contract provisions are notenforced or are unenforceable for any reason, or if liabilities arise that arenot effectively limited, we could incur substantial costs in defending and/orsettling product liability claims.

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

We recently began toimplement an enterprise resource planning, or ERP, system to enhance operatingefficiencies and provide more effective management of our business operations.Implementing a new ERP system is costly and involves risks inherent in theconversion to a new computer system, including disruption to our normalaccounting procedures and problems achieving accuracy in the conversion ofelectronic data. Failure to properly or adequately address these issues couldresult in increased costs, the diversion of management’s attention andresources and could materially adversely affect our operating results andability 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:

·       expandour domestic and international sales and marketing activities;

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

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

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·       hireadditional personnel, including engineers and other technical staff;

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

·       continueto assume the responsibilities of being a public company.

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

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

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

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

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

·       difficultiesin staffing and managing foreign operations;

·       dependenceon foreign distributors and their sales channels;

·       longeraccounts receivable collection cycles and difficulties in collecting accountsreceivable;

·       lesseffective and less predictable protection of intellectual property;

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

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

·       potentiallyadverse tax consequences.

Such factors could cause our future internationalsales to decline.

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

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

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

One of our key strategies is to expand our businessoperations in China. However, we may be unsuccessful in implementing thisstrategy as planned or at all. Factors that could inhibit our successfulexpansion into China include its historically poor recognition of intellectualproperty rights and poor performance in stopping counterfeiting and piracyactivity. If we are unable to successfully stop 

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

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

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

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

***We rely on theaccuracy of our customers’ manufacturing reports for reporting and collectingour revenues, and if these reports are untimely or incorrect, our revenuescould be delayed or inaccurately reported.***

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

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

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

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

We acquired DTS DIin January 2005, and we expect to consider additional opportunities toacquire or make investments in other technologies, products, and businesses thatcould enhance our technical capabilities, complement our current products andservices, or expand the breadth of our markets. We have a limited history ofacquiring and integrating businesses. Acquisitions and strategic investmentsinvolve numerous risks, including:

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

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

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

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

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

·       diversionof management’s attention from our core business;

·       adverseeffects on existing business relationships with suppliers and customers;

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

·       potentialloss of key employees of acquired organizations.

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

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

We expect 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:

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

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

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

·       managemultiple concurrent development projects; and

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

Any failure tosuccessfully manage our growth could distract management’s attention, andresult in our failure to execute our business plan. For instance, ouracquisition of DTS DI has required significant time and attention from our managementteam. Any future growth could cause similar management challenges or createdistractions.

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

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

**Risks Related toOur Common Stock**

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

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

·       actualor anticipated fluctuations in our results of operations;

·       announcementsof technological innovations or technology standards;

·       announcementsof significant contracts by us or our competitors;

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

·       developmentswith respect to intellectual property rights;

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

·       thecommencement of or our involvement in litigation;

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

·       conditionsand trends in technology industries;

·       changesin market valuation or earnings of our competitors;

·       thetrading volume of our common stock;

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

·       generaleconomic conditions.

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

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

As of June 30, 2006,we had 17,681,797 shares of common stock outstanding. As a result of ourrelatively small public float, our common shares may be less liquid than thecommon shares of companies with broader public ownership. Among other things,trading of a relatively small volume of our common shares may have a greaterimpact on the trading price for our shares than would be the case if our publicfloat were larger.

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

Our capitalrequirements will depend on many factors, including:

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

·       thecosts of developing new products or technology;

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

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

·       thecosts associated with our expansion, if any.

In the future, we may needto raise additional funds, and such funds may not be available on favorableterms, or at all. Furthermore, if we issue equity or debt securities to raiseadditional funds, our existing stockholders may experience dilution, and thenew equity or debt securities may have rights, preferences, and privilegessenior to those of our existing stockholders. If we cannot raise funds on acceptableterms, we may not be able to develop or enhance our products and services,execute our business plan, take advantage of future opportunities, or respondto competitive pressures or unanticipated customer requirements. This maymaterially 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 are governed by the provisions of Section 203of the Delaware General Corporate Law, which may prohibit certain businesscombinations with stockholders owning 15% or more of our outstanding votingstock. These and other provisions in our Restated Certificate of Incorporation,Restated Bylaws and Delaware law could make it more difficult for stockholdersor potential acquirors to obtain control of our Board or initiate actions thatare opposed by the then-current Board, including delay or impede amerger, tender offer, or proxy contest involving our company. Any delay orprevention of a change of control transaction or changes in our Board couldcause the market price of our common stock to decline.

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

On July 15, 2003, wecompleted our initial public offering for the sale of 4,091,410 shares ofcommon stock at a price to the public of $17.00 per share, which resulted innet proceeds of approximately $63.0 million after payment of the underwriters’commissions and deductions of offering expenses. All of the shares of commonstock sold in the offering were registered under the Securities Act of 1933, asamended (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 Registration Statement filed pursuant to Rule 462(b) underthe Securities Act that was filed on July 10, 2003 (Reg. No. 333-106920).Subsequent to the offering, we used approximately $22.5 million of our netproceeds to redeem all outstanding shares of redeemable preferred stock and topay all accrued but unpaid dividends on such shares through the date ofredemption. The remaining proceeds to us have conformed with our intended useoutlined in the prospectus related to the offering. As of June 30, 2006,we have approximately $40.5 million remaining from the proceeds of theoffering.

**Item 3.**                        DefaultsUpon Senior Securities

None.

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

The Annual Meeting of Stockholders of DTS, Inc.was held on May 18, 2006. The following matters were voted upon and wereapproved as set forth below.

Thestockholders elected three Class III directors to hold office until the2009 Annual Meeting of Stockholders by the following votes:

| ** **                                   | ** ** | **Number of Shares** | ** ** |
|----------------------------------------------|------------|--------------------------------|------------|
| **Name of Directors Elected** | ** ** | ** **                     | ** ** | **For** | ** ** | **Withheld** | ** ** |
| Jon E. Kirchner                              |       | 16,048,312                     |       | 142,094 |   |
| James B. McElwee                             |       | 15,453,458                     |       | 736,948 |   |
| Ronald N. Stone                              |       | 15,448,934                     |       | 741,472 |   |
|                                              |            |                                |            |  |  |  |  |

 

The following individuals are continuing directorswith terms expiring upon the 2007 Annual Meeting of Stockholders: Daniel E.Slusser and Joseph A. Fischer.

The following individuals are continuing directorswith terms expiring upon the 2008 Annual Meeting of Stockholders: Joerg D. Aginand C. Ann Busby.

Thestockholders ratified PricewaterhouseCoopers LLP as the independent registeredpublic accounting firm of DTS, Inc. by the following vote:

| Number of Shares | ** ** |
|----------------------------|------------|
| **For**                    | ** ** | **Against** | ** ** | **Abstain** | ** ** |
| 15,696,458                 |       | 493,438 |   | 510 |   |

 

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**Item 5.**                        OtherInformation

**New Forms of Restricted Stock Grant Notice andRestricted Stock Agreement under 2003 Equity Incentive Plan**

On June 5, 2006, the Compensation Committee ofour Board of Directors adopted two new forms of restricted stock grant noticeand restricted stock agreement for stock awards granted under our 2003 EquityIncentive Plan, as amended (the “Plan”). These new forms have replaced the formpreviously approved by our Board of Directors and filed with the SEC on June 5,2003 as Exhibit 10.16 to Amendment No. 1 to our registration statement on FormS-1 (File No. 333-104761). The new forms are filed as Exhibit 10.16.1 and10.16.2 to this report. The form filed as Exhibit 10.16.1 to this report is forthe automatic annual stock awards to our non-employee directors under the Planand the form filed as Exhibit 10.16.2 to this report is for stock awardsgranted to our employees and consultants.

**Stock RepurchaseProgram**

***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.***

**Item 6.**                        Exhibits
| Exhibit  Number | ** ** | ** **                                                                                                                                             | ** ** | **Exhibit Description** |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|
| 10.16.1         |       | Form of Restricted  Stock Grant Notice and Restricted Stock Agreement under 2003 Equity Incentive  Plan (for annual non-employee director grants) |
| 10.16.2         |       | Form of Restricted  Stock Grant Notice and Restricted Stock Agreement under 2003 Equity Incentive  Plan (for employee and consultant grants)      |
| 31.1            |       | Certification of the  Chief Executive Officer under Securities Exchange Act Rules 13a-14(a) or 15d-14(a)                                |
| 31.2            |       | Certification of the  Chief Financial Officer under Securities Exchange Act Rules 13a-14(a) or 15d-14(a)                                |
| 32.1            |       | Certification of the  Chief Executive Officer under Securities Exchange Act Rules 13a-14(b) or 15d-14(b) and  18 U.S.C. 1350       |
| 32.2            |       | Certification of the Chief Financial Officer under  Securities Exchange Act Rules 13a-14(b) or 15d-14(b) and  18 U.S.C. 1350  |

 

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
|                            |   |   | DTS, INC. |
|----------------------------|--------|--------|----------------|
|                       |   |   | by:            | /s/ JON E. KIRCHNER |
|                       |   |   |           | Jon E. Kirchner |
|                       |   |   | * *       | *President and Chief Executive Officer* |
|                       |   |   | * *       | *(Duly Authorized Officer)* |
| Date: August 9,  2006 |   |   |           |   |
|                       |   |   | by:            | /s/ MELVIN L. FLANIGAN |
|                       |   |   |           | Melvin L. Flanigan |
|                       |   |   | * *       | *Executive Vice President, Finance and* |
|                       |   |   | * *       | *Chief Financial Officer* |
|                       |   |   | * *       | *(Principal Financial and Accounting Officer)* |
| Date: August 9,  2006 |   |   |           |   |

 

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