**SECURITIES AND EXCHANGE COMMISSION**

**Washington,DC 20549**

**Form 10-Q**

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

**Forthe Quarterly Period Ended September 30, 2005**

**CommissionFile Number 000-50335**

**DTS, Inc.**

(Exact name of registrantas specified in its charter)

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

 

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

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act). Yes  x   No  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 October 31, 2005 a total of 17,440,217 shares of the Registrant’sCommon Stock, $0.0001 par value, were issued and outstanding.

 

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**DTS, INC.FORM 10-QTABLE OF CONTENTS**

| **PART I**   | ** ** | **FINANCIAL  INFORMATION**                                                                      | ** ** | **3**  |
|-------------------|------------|-------------------------------------------------------------------------------------------------|------------|--------|
| **Item 1.**  | ** ** | **Financial  Statements:**                                                                      | ** ** | **3**  |
|              | ** ** | **Condensed Consolidated Balance Sheets**                                                       | ** ** | **3**  |
|              | ** ** | **Condensed Consolidated Statements of Operations**                                             | ** ** | **4**  |
|              | ** ** | **Condensed Consolidated Statements of Cash Flows**                                             | ** ** | **5**  |
|              | ** ** | **Notes to Condensed Consolidated Financial Statements**                                        | ** ** | **6**  |
| **Item 2.**  | ** ** | **Management’s Discussion and Analysis of Financial  Condition and Results of Operations** | ** ** | **18** |
| **Item 3.**  | ** ** | **Quantitative and Qualitative Disclosures About Market  Risk**                                 | ** ** | **42** |
| **Item 4.**  | ** ** | **Controls and Procedures**                                                                     | ** ** | **43** |
| **PART II.** | ** ** | **OTHER  INFORMATION**                                                                          | ** ** | **44** |
| **Item 1.**  | ** ** | **Legal  Proceedings**                                                                          | ** ** | **44** |
| **Item 2.**  | ** ** | **Unregistered Sales of Equity Securities and Use of  Proceeds**                                | ** ** | **44** |
| **Item 3.**  | ** ** | **Defaults Upon Senior Securities**                                                             | ** ** | **44** |
| **Item 4.**  | ** ** | **Submission of Matters to a Vote of Security Holders**                                         | ** ** | **44** |
| **Item 5.**  | ** ** | **Other  Information**                                                                          | ** ** | **44** |
| **Item 6.**  | ** ** | **Exhibits**                                                                                    | ** ** | **44** |
| **SIGNATURES**    | ** ** | **45**                                                                                          |

 

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**DTS,INC.**

**PART IFINANCIAL INFORMATION**

**Item 1.   *Financial Statements***

**DTS, Inc.Condensed ConsolidatedBalance Sheets**

| ** **                                                                                                                                                                                                                                              | ** ** | **As of   December 31,  2004**                                                      | ** ** | **As of   September 30,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                                                                                                                                                                                              | ** ** | ** **                                                                                         | ** ** | **(Unaudited)**                                | ** ** |
| ** **                                                                                                                                                                                                                                              | ** ** | **(Amounts in thousands, except  share and per share amounts)** | ** ** |
| ASSETS                                                                                                                                                                                                                                                  |       |                                                                                               |       |                                           |       |   |   |   |   |
| Current assets:                                                                                                                                                                                                                                         |       |                                                                                               |       |                                           |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                                                                               |       |                                                                                               | $          | 21,271                                         |       |   |   | $ | 30,406 |   |   |
| Short-term investments                                                                                                                                                                                                                                  |       |                                                                                               | 93,040     |                                           |       |   | 78,124 |   |   |
| Accounts receivable, net of allowance for doubtful  accounts of $402 and $398 at December 31, 2004 and September 30, 2005,  respectively                                                                                                      |       |                                                                                               | 4,649      |                                           |       |   | 8,692 |   |   |
| Inventories                                                                                                                                                                                                                                             |       |                                                                                               | 3,669      |                                           |       |   | 4,077 |   |   |
| Deferred tax assets                                                                                                                                                                                                                                     |       |                                                                                               | 9,144      |                                           |       |   | 8,023 |   |   |
| Prepaid expenses and other                                                                                                                                                                                                                              |       |                                                                                               | 3,651      |                                           |       |   | 2,946 |   |   |
| Income tax receivable                                                                                                                                                                                                                                   |       |                                                                                               | 72         |                                           |       |   | 1,358 |   |   |
| Total current assets                                                                                                                                                                                                                                    |       |                                                                                               | 135,496    |                                           |       |   | 133,626 |   |   |
| Long-term investments                                                                                                                                                                                                                                   |       |                                                                                               | 2,657      |                                           |       |   | — |   |   |
| Property and equipment, net                                                                                                                                                                                                                             |       |                                                                                               | 3,539      |                                           |       |   | 7,267 |   |   |
| Intangible assets, net                                                                                                                                                                                                                                  |       |                                                                                               | 1,779      |                                           |       |   | 11,672 |   |   |
| Goodwill                                                                                                                                                                                                                                                |       |                                                                                               | —     |                                           |       |   | 3,640 |   |   |
| Deferred tax assets                                                                                                                                                                                                                                     |       |                                                                                               | 500        |                                           |       |   | 1,762 |   |   |
| Other assets                                                                                                                                                                                                                                            |       |                                                                                               | 718        |                                           |       |   | 541 |   |   |
| Total assets                                                                                                                                                                                                                                            |       |                                                                                               | $          | 144,689                                        |       |   |   | $ | 158,508 |   |   |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                                                                                              |       |                                                                                               |       |                                           |       |   |   |   |   |
| Current liabilities:                                                                                                                                                                                                                                    |       |                                                                                               |       |                                           |       |   |   |   |   |
| Accounts payable                                                                                                                                                                                                                                        |       |                                                                                               | $          | 3,716                                          |       |   |   | $ | 3,445 |   |   |
| Accrued expenses                                                                                                                                                                                                                                        |       |                                                                                               | 5,688      |                                           |       |   | 6,437 |   |   |
| Deferred revenue                                                                                                                                                                                                                                        |       |                                                                                               | 519        |                                           |       |   | 2,102 |   |   |
| Total current liabilities                                                                                                                                                                                                                               |       |                                                                                               | 9,923      |                                           |       |   | 11,984 |   |   |
| Deferred tax liability                                                                                                                                                                                                                                  |       |                                                                                               | —     |                                           |       |   | 3,897 |   |   |
| Commitments and  contingencies (Note 9)                                                                                                                                                                                                                 |       |                                                                                               |       |                                           |       |   |   |   |   |
| Stockholders’ equity:                                                                                                                                                                                                                              |       |                                                                                               |       |                                           |       |   |   |   |   |
| Preferred stock—$0.0001 par value, 5,000,000 shares  authorized at December 31, 2004 and September 30, 2005; no shares  outstanding at December 31, 2004 and September 30, 2005                                                |       |                                                                                               | —     |                                           |       |   | — |   |   |
| Common stock—$0.0001 par value, 70,000,000 shares  authorized at December 31, 2004 and September 30, 2005; 17,067,573  and 17,434,882 shares issued and outstanding at December 31, 2004 and  September 30, 2005, respectively |       |                                                                                               | 2          |                                           |       |   | 2 |   |   |
| Additional paid-in capital                                                                                                                                                                                                                              |       |                                                                                               | 121,431    |                                           |       |   | 122,726 |   |   |
| Retained earnings                                                                                                                                                                                                                                       |       |                                                                                               | 13,333     |                                           |       |   | 19,899 |   |   |
| Total stockholders’ equity                                                                                                                                                                                                                         |       |                                                                                               | 134,766    |                                           |       |   | 142,627 |   |   |
| Total liabilities  and stockholders’ equity                                                                                                                                                                                                        |       |                                                                                               | $          | 144,689                                        |       |   |   | $ | 158,508 |   |   |

 

See accompanying notes to condensed consolidated financial statements.

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**DTS, Inc.**

**CondensedConsolidated Statements of Operations**

| ** **                                                            | ** ** | **For the Three Months Ended  September 30,**                             | ** ** | **For the Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                            | ** ** | **2004**                                                                                           | ** ** | **2005**                                                              | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                                            | ** ** | **(Unaudited)**                                                                                    | ** ** |
| ** **                                                            | ** ** | **(Amounts in thousands, except  share and per share amounts)** | ** ** |
| Revenues:                                                             |       |                                                                                               |       |                                                                  |       |   |   |   |   |
| Technology and film licensing                                         |       | $                                                                                                  | 13,058     |                                                                  | $          | 12,611 |   | $ | 36,275 |   | $ | 43,910 |   |
| Product sales and other revenues                                      |       | 2,894                                                                                              |       | 4,942                                                                 |       | 8,526 |   | 13,428 |   |
| Total revenues                                                        |       | 15,952                                                                                             |       | 17,553                                                                |       | 44,801 |   | 57,338 |   |
| Cost of goods sold:                                                   |       |                                                                                               |       |                                                                  |       |   |   |   |   |
| Technology and film licensing                                         |       | 1,199                                                                                              |       | 1,194                                                                 |       | 3,345 |   | 3,511 |   |
| Product sales and other revenues                                      |       | 1,911                                                                                              |       | 3,450                                                                 |       | 5,578 |   | 10,626 |   |
| Total cost of goods sold                                              |       | 3,110                                                                                              |       | 4,644                                                                 |       | 8,923 |   | 14,137 |   |
| Gross profit                                                          |       | 12,842                                                                                             |       | 12,909                                                                |       | 35,878 |   | 43,201 |   |
| Operating expenses:                                                   |       |                                                                                               |       |                                                                  |       |   |   |   |   |
| Selling, general and administrative                                   |       | 6,746                                                                                              |       | 8,971                                                                 |       | 19,984 |   | 25,095 |   |
| Research and development                                              |       | 1,501                                                                                              |       | 2,612                                                                 |       | 4,401 |   | 7,238 |   |
| In-process research and development                                   |       | —                                                                                             |       | —                                                                |       | — |   | 2,300 |   |
| Total operating expenses                                              |       | 8,247                                                                                              |       | 11,583                                                                |       | 24,385 |   | 34,633 |   |
| Income from  operations                                               |       | 4,595                                                                                              |       | 1,326                                                                 |       | 11,493 |   | 8,568 |   |
| Interest income,  net                                                 |       | 373                                                                                                |       | 635                                                                   |       | 1,122 |   | 1,824 |   |
| Other expense,  net                                                   |       | 31                                                                                                 |       | 123                                                                   |       | — |   | 100 |   |
| Income from legal  settlement                                         |       | —                                                                                             |       | —                                                                |       | 2,601 |   | — |   |
| Income before  provision for income taxes                             |       | 4,999                                                                                              |       | 2,084                                                                 |       | 15,216 |   | 10,492 |   |
| Provision for  income taxes                                           |       | 1,774                                                                                              |       | 890                                                                   |       | 5,432 |   | 3,926 |   |
| Net income                                                            |       | 3,225                                                                                              |       | 1,194                                                                 |       | 9,784 |   | 6,566 |   |
| Net income per  common share:                                         |       |                                                                                               |       |                                                                  |       |   |   |   |   |
| Basic                                                                 |       | $                                                                                                  | 0.19       |                                                                  | $          | 0.07 |   | $ | 0.58 |   | $ | 0.38 |   |
| Diluted                                                               |       | $                                                                                                  | 0.18       |                                                                  | $          | 0.07 |   | $ | 0.54 |   | $ | 0.36 |   |
| Weighted average shares  used to compute net income per common share: |       |                                                                                               |       |                                                                  |       |   |   |   |   |
| Basic                                                                 |       | 17,005,750                                                                                         |       | 17,411,461                                                            |       | 16,805,643 |   | 17,275,515 |   |
| Diluted                                                               |       | 18,217,995                                                                                         |       | 18,342,186                                                            |       | 18,129,068 |   | 18,194,333 |   |

 

See accompanying notes to condensed consolidated financial statements.

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**DTS, Inc.**

**CondensedConsolidated Statements of Cash Flows**

| ** **                                                                           | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                           | ** ** | **2004**                                                              | ** ** | **2005** | ** ** |
| ** **                                                                           | ** ** | **(Unaudited)**                                                       | ** ** |
| ** **                                                                           | ** ** | **(Amounts in thousands)**                                  | ** ** |
| Cash flows from  operating activities:                                               |       |                                                                  |       |   |   |
| Net income                                                                           |       | $                                                                     | 9,784      |   | $ | 6,566 |   |
| Adjustments to reconcile  net income to net cash provided by operating activities:   |       |                                                                  |       |   |   |
| Depreciation and amortization                                                        |       | 919                                                                   |       | 2,691 |   |
| Stock-based compensation charges                                                     |       | 267                                                                   |       | 75 |   |
| Allowance for doubtful accounts                                                      |       | 45                                                                    |       | 5 |   |
| Deferred income taxes                                                                |       | (2,025                                                                | )          | 937 |   |
| Tax benefit from employee stock plans                                                |       | 3,878                                                                 |       | 563 |   |
| In-process research and development                                                  |       | —                                                                |       | 2,300 |   |
| Changes in  operating assets and liabilities:                                        |       |                                                                  |       |   |   |
| Accounts receivable                                                                  |       | (1,389                                                                | )          | (3,845 | ) |
| Inventories                                                                          |       | (723                                                                  | )          | (408 | ) |
| Prepaid expenses and other assets                                                    |       | (884                                                                  | )          | (279 | ) |
| Accounts payable and accrued expenses                                                |       | 1,146                                                                 |       | (1,786 | ) |
| Deferred revenue                                                                     |       | —                                                                |       | 655 |   |
| Income taxes                                                                         |       | 1,634                                                                 |       | (1,286 | ) |
| Net cash provided by operating activities                                            |       | 12,652                                                                |       | 6,188 |   |
| Cash flows from  investing activities:                                               |       |                                                                  |       |   |   |
| Purchases of investments                                                             |       | (91,863                                                               | )          | (80,703 | ) |
| Maturities of investments                                                            |       | 7,130                                                                 |       | 52,277 |   |
| Sales of investments                                                                 |       | 52,112                                                                |       | 45,998 |   |
| Cash paid for acquisitions                                                           |       | (1,384                                                                | )          | (11,000 | ) |
| Purchase of property and equipment                                                   |       | (1,036                                                                | )          | (4,168 | ) |
| Payment for patents and trademarks in process                                        |       | (57                                                                   | )          | (115 | ) |
| Net cash provided by (used in) investing activities                                  |       | (35,098                                                               | )          | 2,289 |   |
| Cash flows from  financing activities:                                               |       |                                                                  |       |   |   |
| Follow-on public offering costs                                                      |       | (30                                                                   | )          | — |   |
| Proceeds from the issuance of common stock upon  exercise of employee stock options  |       | 470                                                                   |       | 228 |   |
| Proceeds from the issuance of common stock under  employee stock purchase plan  |       | 473                                                                   |       | 430 |   |
| Net cash provided by financing activities                                            |       | 913                                                                   |       | 658 |   |
| Net increase (decrease) in cash and cash equivalents                                 |       | (21,533                                                               | )          | 9,135 |   |
| Cash and cash  equivalents, beginning of period                                      |       | 39,243                                                                |       | 21,271 |   |
| Cash and cash  equivalents, end of period                                            |       | $                                                                     | 17,710     |   | $ | 30,406 |   |

 

See accompanying notes to condensed consolidated financial statements.

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

**Note 1—Basis ofPresentation**

The accompanying unaudited condensed consolidatedfinancial statements of DTS, Inc. (the “Company”) have been prepared inaccordance with accounting principles generally accepted in the United Statesand with the instructions to Form 10-Q and Article 10 ofRegulation S-X. Accordingly, they do not include all of the informationand footnotes required by accounting principles generally accepted in theUnited States for complete financial statements. In the opinion of management,the unaudited condensed consolidated financial statements reflect alladjustments considered necessary for a fair statement of the Company’sfinancial position at September 30, 2005, and the results of operationsand cash flows for the periods presented, consisting only of normal andrecurring adjustments. All significant intercompany transactions have beeneliminated in consolidation. Operating results for the three and nine monthsended September 30, 2005 are not necessarily indicative of the resultsthat may be expected for the fiscal year ending December 31, 2005. Forfurther information, refer to the consolidated financial statements andfootnotes thereto for the year ended December 31, 2004 filed on Form 10-Kon March 16, 2005.

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

In the third quarter of2005, the Company’s management identified an error in its calculation ofcommission expense that was corrected during the third quarter of 2005. Thecorrection had the effect of increasing selling, general and administrativeexpenses and operating expenses by $287 for the three months ended September 30,2005. This correction also decreased income from operations and income beforeprovision for income taxes by $287 and decreased net income by $180. Althoughthis correction was an out-of-period adjustment, the Company’s managementdetermined that the effect on previously filed reports was not material.

**Reclassification**

The Company has reclassified certain auction ratesecurities and variable rate demand obligations from cash equivalents toshort-term marketable securities. Auction rate securities are variable ratebonds tied to short-term interest rates with maturities on the face of theunderlying security in excess of 90 days. Auction rate securities have interestrate resets through a modified Dutch auction at predetermined short-termintervals, typically every 7, 28 or 35 days. Interest paid during a givenperiod is based upon the interest rate determined during the prior auction.Variable rate demand obligations generally provide an option to tendersecurities at par on seven days’ notice. The interest rate resets daily, weeklyor at longer intervals as set forth in each instrument.

Although these securitiesare issued and rated as long-term bonds, they are priced and traded asshort-term instruments because of the liquidity provided through the interestrate reset. The Company had historically classified these instruments as cashequivalents if the period between interest rate resets was 90 days or less,which was based on our ability to either liquidate our holdings or roll ourinvestment over to the next reset period. The Company’s re-evaluation of thematurity dates and other provisions associated 

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with theunderlying bonds resulted in a reclassification from cash and equivalents toshort-term marketable securities of approximately $51,848 on the September 30,2004 balance sheet. As a result of this balance sheet reclassification, certainamounts were reclassified in the accompanying consolidated statement of cashflows for the nine months ended September 30, 2004 to reflect the grosspurchases and sales of these securities as investing activities rather than asa component of cash and cash equivalents. This change in classification doesnot affect previously reported cash flows from operating or from financingactivities in the previously reported consolidated statements of cash flows orthe previously reported consolidated statements of operations. For the ninemonths ended September 30, 2004, before these revisions in classification,net cash used in investing activities related to these current investments of$51,848 was included in cash and cash equivalents in the consolidated statementof cash flows.

**Note 2—Summary ofSignificant Accounting Policies**

**Revenue Recognition**

In January 2005, theCompany acquired Lowry Digital Images, Inc. (“LDI”). The Company recognizesrevenue when titles subject to a customer order or contract are delivered andaccepted by the customer and no significant obligations remain after customeracceptance. In certain instances the Company bills in advance of services.Prices are established in advance of the work performed and are generally fixedin nature. Revenue related to time and materials contracts is recognized asservices are rendered at contract labor rates plus material and other directcosts incurred. If losses are anticipated on a contract, such losses arerecognized immediately.

**Acquired in-ProcessResearch and Development**

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

**Stock-Based Compensation**

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

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Todate, options have been granted at exercise prices that equal or exceed themarket value of the underlying common stock on the grant date. The followingtable illustrates the effect on net income per common share if the Company hadapplied the fair value recognition provisions of Statement of FinancialAccounting Standards (“SFAS”) No. 123, “Accounting for Stock-BasedCompensation,” to stock-based employee compensation.

| ** **                                                                                                                     | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                                                                     | ** ** | **2004**                                                               | ** ** | **2005**                                                              | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                                                                                                     | ** ** | ** **                                                             | ** ** | **(Unaudited)**                                                       | ** ** | ** ** | ** ** |
| Net income:                                                                                                                    |       |                                                                   |       |                                                                  |       |   |   |   |   |
| As reported                                                                                                                    |       | $                                                                      | 3,225      |                                                                  | $          | 1,194 |   | $ | 9,784 |   | $ | 6,566 |   |
| Additional stock-based compensation expense  determined under the fair value method, net of tax                           |       | 117                                                                    |       | (680                                                                  | )          | (1,054 | ) | (1,707 | ) |
| Pro forma                                                                                                                      |       | $                                                                      | 3,342      |                                                                  | 514        |   | $ | 8,730 |   | $ | 4,859 |   |
| Net income per common share basic:                                                                                             |       |                                                                   |       |                                                                  |       |   |   |   |   |
| As reported                                                                                                                    |       | $                                                                      | 0.19       |                                                                  | $          | 0.07 |   | $ | 0.58 |   | $ | 0.38 |   |
| Per share effect of additional stock-based  compensation expense determined under the fair value method, net of tax       |       | 0.01                                                                   |       | (0.04                                                                 | )          | (0.06 | ) | (0.10 | ) |
| Pro forma                                                                                                                      |       | $                                                                      | 0.20       |                                                                  | $          | 0.03 |   | $ | 0.52 |   | $ | 0.28 |   |
| Net income per  common share—diluted:                                                                                     |       |                                                                   |       |                                                                  |       |   |   |   |   |
| As reported                                                                                                                    |       | $                                                                      | 0.18       |                                                                  | $          | 0.07 |   | $ | 0.54 |   | $ | 0.36 |   |
| Per share effect of additional stock-based  compensation expense determined under the fair value method, net of tax  |       | 0.01                                                                   |       | (0.04                                                                 | )          | (0.06 | ) | (0.09 | ) |
| Pro forma                                                                                                                      |       | $                                                                      | 0.19       |                                                                  | $          | 0.03 |   | $ | 0.48 |   | $ | 0.27 |   |

 

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 optionpricing model. Management believes that the fair value of the stock options ismore reliably measured than the fair value of the services received. The fairvalue of each non-employee equity award is remeasured each period until acommitment date is reached, which is generally the vesting date. Fornon-employee equity awards, deferred stock-based compensation is not reflectedin stockholders’ deficit until a commitment date is reached. For the three andnine months ended September 30, 2005, the Company recorded stock-basedcompensation expense of $16 and $75, respectively, related to non-employeeequity awards. For the three and nine months ended September 30, 2004, theCompany recorded stock-based compensation expense of $49 and $267,respectively, related to non-employee equity awards.

TheCompany has historically recognized compensation cost over the nominal vestingperiod, whereby if an employee retired before the end of the vesting period,the Company would recognize any remaining unrecognized compensation cost at thedate of retirement. The FASB clarified in SFAS No. 123R that the fairvalue of such stock options should be expensed based on recognition under anon-substantive vesting period approach, requiring compensation expenserecognition when an employee is eligible to retire. DTS employees are eligibleto retire after age 60. For those employees that retire and are eligible, theiroptions continue to vest upon the original vesting schedules. The SEC recentlyclarified that companies should 

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continue the vesting method they have been using untiladoption of FAS 123R, then apply the accelerated non-substantive vestingapproach to all subsequent grants to those employees whose options continue to vestafter the date of retirement eligibility. Had the Company been accounting forsuch stock options using the non-substantive vesting approach for retirement-eligibleemployees, the Company would have recognized additional stock-basedcompensation expense resulting in the following adjusted pro forma dilutedearnings per share.

| ** **                                                                                    | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                                    | ** ** | **2004**                                                               | ** ** | **2005**                                                              | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                                                                    | ** ** | ** **                                                             | ** ** | **(unaudited)**                                                       | ** ** | ** ** | ** ** |
| Diluted pro forma  earnings per share (from above table)                                      |       | $                                                                      | 0.19       |                                                                  | $          | 0.03 |   | $ | 0.48 |   | $ | 0.27 |   |
| Impact of  retirement-eligible                                                                |       | —                                                                 |       | —                                                                |       | (0.01 | ) | (0.01 | ) |
| Diluted pro forma  earnings per share (adjusted to reflect non-substantive vesting  approach) |       | $                                                                      | 0.19       |                                                                  | $          | 0.03 |   | $ | 0.47 |   | $ | 0.26 |   |

 

**Note 3—RecentAccounting Pronouncements**

In November 2004, the FASB issued SFAS No. 151,“Inventory Costs, an amendment of ARB No. 43, Chapter 4” (“SFAS 151”).SFAS 151 clarifies the types of costs that should be expensed rather thancapitalized as inventory. SFAS 151 also clarifies the circumstances under whichfixed overhead costs associated with operating facilities involved in inventoryprocessing should be capitalized. This statement is effective for fiscal yearsbeginning after June 15, 2005. The Company adopted SFAS 151 in the firstquarter of fiscal 2005 and the adoption did not have a material impact on theCompany’s consolidated financial position or results of operations.

In December 2004,the FASB issued SFAS No. 123R, “Share-Based Payment” (“SFAS 123R”), an amendmentto SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS 123Rrequires compensation expense related to stock-based awards to be recognized inthe financial statements. The amount of compensation expense will be measuredbased upon the fair value of the stock-based awards at the date of grant. SFAS123R also requires an enterprise to assess the most appropriate model tocalculate the value of the options. The Company currently uses theBlack-Scholes option pricing model to value options, and is currently assessingwhich model it may use in the future under SFAS 123R and may deem analternative model to be the most appropriate. The use of a different model tovalue options may result in a different fair value than the use of theBlack-Scholes option pricing model. In addition, there are a number of otherrequirements under the new standard that will result in differing accountingtreatment than currently required. These differences include, but are notlimited to, the accounting for the tax benefit on employee stock options. Inaddition to the appropriate fair value model to be used for valuing share-basedpayments, the Company will also be required to determine the transition methodto be used at the date of adoption. The allowed transition methods includeprospective and retroactive adoption methods. Under the retroactive method,prior periods may be restated either as of the beginning of the year ofadoption or for all periods presented. The prospective method requires thatcompensation expense be recorded for all unvested stock options and restrictedstock at the beginning of the first quarter of adoption of SFAS 123R while theretroactive method would record compensation expense for all unvested stockoptions and restricted stock beginning with the first period restated. Thisstatement was to have become effective for public companies as of the firstinterim or annual reporting period beginning after June 15, 2005. In April 2005,the SEC amended the compliance date for implementing SFAS 123R extending the compliancedate to the first fiscal year that begins after June 15, 2005. The Companyplans to adopt SFAS 123R beginning in the first quarter of fiscal 2006. Ifwe had adopted SFAS 123R as of September 30, 2005, using the Black-Scholesmethod, the effects of the adoption of SFAS 123R on the Company’s 

9

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financial results for the next five years, based onstock-based awards granted as of September 30, 2005, would be as follows:

| ** **                                                                           | ** ** | **Expenses by Fiscal Year** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                           | ** ** | **Remaining  Three  Months**     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                           | ** ** | **2005**                                   | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** |
| ** **                                                                           | ** ** | **(unaudited)**                            | ** ** |
| ** **                                                                           | ** ** | **(in thousands)**                    | ** ** |
| Additional  stock-based compensation expense under SFAS 123R before tax benefit |       |                                       | $          | 832 |   |   | $ | 3,036 |   | $ | 2,659 |   | $ | 1,410 |   | $ | 314 |   |
|                                                                                      |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

SFAS 123R also affects the presentation of taxbenefits for option exercises in the statement of cash flows. Prior to adoptionSFAS 123R, the benefit is classified in cash provided by operating activities.Upon adoption, the tax benefit will be classified in cash provided by financingactivities. The Company is in the process of determining the impact theadoption will have on the Company’s consolidated statement of cash flows.

In March 2005, the SEC issued Staff AccountingBulletin (“SAB”) No. 107 to provide guidance on SFAS 123R. SAB 107 wasissued to assist registrants by simplifying some of the implementationchallenges of SFAS 123R while enhancing the information that investors receive.SAB 107 provides guidance regarding valuation models, expected volatility andexpected term. The Company will apply the guidance of SAB 107 in conjunctionwith its adoption of SFAS 123R.

In June 2005, the FASB issued Statement No. 154,“Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20,Accounting Changes, and Statement No. 3, Reporting Accounting Changes inInterim Financial Statements” (“SFAS 154”). SFAS 154 changes therequirements for the accounting for, and reporting of, a change in accountingprinciple. Previously, most voluntary changes in accounting principles wererequired to be recognized by way of a cumulative effect adjustment within netincome during the period of the change. SFAS 154 requires retrospectiveapplication to prior periods’ financial statements, unless it is impracticableto determine either the period-specific effects or the cumulative effect of thechange. SFAS 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. TheCompany does not believe adoption of SFAS 154 will have a material effecton the Company’s consolidated financial position, results of operations or cashflows.

In June 2005 FASB Staff Position (“FSP”) 143-1,“Accounting for Electronic Equipment Waste Obligations” was issued. FSP 143-1addresses the accounting for obligations associated withDirective 2002/96/EC on Waste Electrical and Electronic Equipment (the “Directive”)of the European Union (“EU”) which is subject to transformation into therespective national laws. Under the Directive, the waste management obligationremains with the commercial user until the historical waste equipment (put onthe market before August 13, 2005) is replaced. At that time the wastemanagement obligation for the equipment may be transferred to the producer ofthe replacement equipment depending on the transformation of the Directive intonational law by the EU-member country. If the commercial user does not replacethe equipment, the obligation remains with that user until the equipment isdisposed. FSP 143-1 requires the commercial user to apply theprovisions of SFAS 143, “Accounting for Asset Retirement Obligations” to theobligation associated with historical waste. FSP 143-1 will have to beapplied in the first reporting period ending after the date the law is adoptedby the applicable EU-member countries. The adoption of FSP 143-1 did nothave a material impact on the Company’s consolidated financial statements.

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**Note 4—CertainBalance Sheet Items**

Inventories consist of the following:

| ** **        | ** ** | **As of  December 31,  2004** | ** ** | **As of  September 30,  2005** | ** ** |
|-------------------|------------|-----------------------------------------|------------|------------------------------------------|------------|
| ** **        | ** ** | ** **                              | ** ** | **(Unaudited)**                          | ** ** |
| Raw materials     |       |                                    | $          | 1,313                                    |       |   |   | $ | 1,246 |   |   |
| Finished goods    |       |                                    | 2,356      |                                     |       |   | 2,831 |   |   |
| Total inventories |       |                                    | $          | 3,669                                    |       |   |   | $ | 4,077 |   |   |

 

Propertyand equipment consist of the following:

| ** **                      | ** ** | **As of   December 31,  2004** | ** ** | **As of  September 30,  2005** | ** ** |
|---------------------------------|------------|-----------------------------------------------|------------|------------------------------------------|------------|
| ** **                      | ** ** | ** **                                    | ** ** | **(Unaudited)**                          | ** ** |
| Machinery and  equipment        |       |                                          | $          | 3,036                                    |       |   |   | $ | 6,969 |   |   |
| Office furniture  and fixtures  |       |                                          | 2,693      |                                     |       |   | 3,287 |   |   |
| Leasehold  improvements         |       |                                          | 2,926      |                                     |       |   | 3,680 |   |   |
|                            |       |                                          | 8,655      |                                     |       |   | 13,936 |   |   |
| Less: Accumulated  depreciation |       |                                          | (5,116     | )                                        |       |   | (6,669 | ) |   |
| Property and  equipment, net    |       |                                          | $          | 3,539                                    |       |   |   | $ | 7,267 |   |   |

 

**Note 5—BusinessCombinations**

In January 2005, the Company completed theacquisition of LDI for $9,642 in cash. In late 2004, the Company loaned LDI atotal of $1,250 to enable LDI to satisfy certain liabilities. Neither LDI norits stockholders were required to repay this loan prior to, or in connectionwith, the acquisition. The cash portion of the acquisition was funded byworking capital. Subsequent to the acquisition, we changed the name of thebusiness to DTS Digital Images, Inc. (“DTS DI”).

The merger agreement also required, under certainconditions, the Company to invest approximately $3,500 in the business of LDIon or prior to June 30, 2005 to enable LDI to make certain capital expendituresand, if and to the extent LDI meets specified gross profit milestones, toinvest up to an additional $1,500 through the end of 2006. Based upon theconditions met as of June 30, 2005 the Company invested $1,813 of the $3,500described above.

Theestimated total purchase price for the acquisition of all of the outstandingshares of LDI is as follows:

| Cash                                |   | $     | 9,642  |   |
|-------------------------------------|--------|-------|--------|--------|
| Bridge loan,  including interest    |   | 1,261 |   |
| Estimated direct  acquisition costs |   | 1,346 |   |
| Total estimated purchase  price     |   | $     | 12,249 |   |

 

TheLDI acquisition was accounted for as a purchase business combination. Theresults of operations of LDI are included in our Consolidated Statement ofOperations from January 3, 2005. The final purchase price is dependent onthe actual direct acquisition costs and shares issued, if any, as furtherdiscussed below. Under the purchase method of accounting, the total estimatedpurchase price is allocated to LDI’s net tangible and intangible assets basedon their estimated fair value as of the date of completion 

11

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of the acquisition. Based on the estimated purchaseprice and the valuation, the preliminary purchase price allocation, which issubject to change based on the Company’s final analysis, is as follows:

| Accounts  receivable                                                         |   | $      | 202    |   |
|------------------------------------------------------------------------------|--------|--------|--------|--------|
| Tangible assets                                                              |   | 1,094  |   |
| Other assets                                                                 |   | 90     |   |
| Deferred tax  assets                                                         |   | 1,356  |   |
| Amortizable  intangible assets:                                              |   |   |   |
| Existing technology                                                          |   | 10,200 |   |
| Non-compete                                                                  |   | 400    |   |
| Backlog                                                                      |   | 100    |   |
| Tradename                                                                    |   | 200    |   |
| IPR&D                                                                    |   | 2,300  |   |
| Goodwill                                                                     |   | 3,640  |   |
| Total assets  acquired                                                       |   | 19,582 |   |
| Liabilities assumed:                                                         |   |   |   |
| Accounts payable                                                             |   | (942   | )      |
| Accrued  liabilities                                                         |   | (919   | )      |
| Notes payable                                                                |   | (368   | )      |
| Deferred revenues                                                            |   | (928   | )      |
| Total liabilities  assumed                                                   |   | (3,157 | )      |
| Net deferred tax  liability for acquired intangibles and purchase accounting |   | (4,176 | )      |
| Total purchase  price                                                        |   | $      | 12,249 |   |

 

A preliminary estimate of $10,900 has been allocatedto amortizable intangible assets consisting of existing technology,non-compete, backlog, and tradenames.

A preliminary estimate of $3,640 has been allocated togoodwill. Goodwill represents the excess of the purchase price over the fairmarket value of the net tangible and amortizable intangible assets acquired.Goodwill will not be amortized and will be tested for impairment at leastannually. The preliminary purchase price allocation for LDI is subject torevision as more detailed analysis is completed and additional information onthe fair values of LDI’s assets and liabilities become available. Goodwilldecreased $213 in the third quarter of this year as a result of additionalinformation relating to the fair value of certain assets and liabilities. TheCompany expects to complete the evaluation in the fourth quarter of 2005.

Any change in the fair value of the net assets of LDIwill change the amount of the purchase price allocable to goodwill.

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IPR&D,relating to development projects which had not reached technologicalfeasibility and that were of no future alternative use, was expensed uponconsummation of the acquisition. Other identifiable intangible assets are beingamortized with the following estimated economic useful lives:

| ** **           | ** ** | **Estimated Useful  Life (Years)** | ** ** |
|----------------------|------------|----------------------------------------------|------------|
| Existing  technology |       |                                         | 11         |   |   |
| Non-compete          |       |                                         | 3          |   |   |
| Backlog              |       |                                         | 2          |   |   |
| Tradename            |       |                                         | 1          |   |   |

 

Developed technology and IPR&D were identified andvalued through extensive interviews, analysis of data provided by LDIconcerning development projects, their stage of development, the time and resourcesneeded to complete them, if applicable, and their expected income generatingability and associated risks. Where development projects had reached technologicalfeasibility, they were classified as developed technology and the valueassigned to developed technology was capitalized. The income approach, whichincludes an analysis of the cash flows and risks associated with achieving suchcash flows, was the primary technique utilized in valuing acquired IPR&D.Key assumptions for IPR&D included a discount rate of 30% and estimates ofrevenue growth, cost of sales, operating expenses and taxes.

The former shareholders of LDI are entitled to receiveshares of DTS common stock if certain gross profit targets in 2005 and/or 2006are met. The target for 2005 has not been met. In the event that the targetsare met in full, an aggregate of up to 857,213 shares of DTS common stock willbe issued. The value of these shares will be accounted for as an addition togoodwill.

Theresults of operations of LDI are included in our Consolidated Statements ofOperations from January 3, 2005, the date of acquisition. For the purposesof presenting the unaudited pro forma financial information, the Company usedthe income statements of LDI for the three and nine months endedSeptember 30, 2004. If the Company had acquired LDI at the beginning offiscal year 2004, the Company’s unaudited pro forma net revenues, net incomeand net income per share for the three and nine months ended September 30,2004 would have been as follows:

| ** **                         | ** ** | **Three Months  Ended  September 30,  2004** | ** ** | **Nine Months  Ended  September 30,  2004** | ** ** |
|------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Revenue                            |       |                                                   | $          | 18,169                                                |       |   |   | $ | 48,658 |   |   |
| Net income                         |       |                                                   | $          | 3,389                                                 |       |   |   | $ | 9,013 |   |   |
| Net income per  share—Basic   |       |                                                   | $          | 0.20                                                  |       |   |   | $ | 0.54 |   |   |
| Net income per  share—Diluted |       |                                                   | $          | 0.19                                                  |       |   |   | $ | 0.50 |   |   |

 

**Note 6—Goodwill andIntangibles**

Goodwill is not amortized, but is tested forimpairment at least annually, or sooner, if circumstances indicate its valuemay no longer be recoverable. A two-step process for impairment testing ofgoodwill is used. For the first step, we screen for impairment and, if anyimpairment exists, we undertake a second step of measuring such impairment. Weplan to perform our goodwill impairment test annually in our fourth fiscalquarter. Impairment testing is based on reporting units. In the nine monthperiod ended September 30, 2005, we added $3,640 to goodwill in connectionwith our acquisition of LDI, which is included in the Digital Images businesssegment. The Company did not have goodwill prior to the acquisition of LDI.

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Included in cost of salesare $244 and $732 of amortization relating to existing technologies and backlogfor the three and nine months ended September 30, 2005, respectively.Included in operating expenses are $129 and $387 of amortization relating tonon-compete and tradename for the three and nine months endedSeptember 30, 2005, respectively. The following table summarizes the weightedaverage lives and the carrying values of our acquired intangible assets bycategory:

| ** **           | ** ** | ** **                               | ** ** | **As of September 30, 2005** | ** ** | **As of December 31, 2004** | ** ** |
|----------------------|------------|------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **           | ** ** | **Weighted  Average Life  (Years)** | ** ** | **Gross  Amount**                                | ** ** | **Accumulated  Amortization**                   | ** ** | **Net  Carrying  Amount** | ** ** | **Gross  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net   Carrying   Amount** | ** ** |
| Existing  technology |       |                                     | 10.6       |                                             |       | $                                               | 11,627     |   |   | $ | (918 | ) |   | $ | 10,709 |   |   | $ | 1,427 |   |   |   | $ | (89 | ) |   |   | $ | 1,338 |   |   |
| Non-compete          |       |                                     | 3          |                                             |       | 400                                             |       |   | (100 | ) |   | 300 |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Backlog              |       |                                     | 2          |                                             |       | 100                                             |       |   | (38 | ) |   | 62 |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Tradename            |       |                                     | 1          |                                             |       | 200                                             |       |   | (150 | ) |   | 50 |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Total                |       |                                     |       |                                             |       | $                                               | 12,327     |   |   | $ | (1,206 | ) |   | $ | 11,121 |   |   | $ | 1,427 |   |   |   | $ | (89 | ) |   |   | $ | 1,338 |   |   |

As of September 30,2005, we expect the amortization of acquired intangible assets for futureperiods to be as follows:

| ** **                                           | ** ** | **Estimated  Amortization  Expense** | ** ** |
|------------------------------------------------------|------------|--------------------------------------|------------|
| Remainder of the  year ending December 31, 2005 |       |                                 | $          | 372 |   |   |
| 2006                                                 |       |                                 | 1,289      |   |   |
| 2007                                                 |       |                                 | 1,239      |   |   |
| 2008                                                 |       |                                 | 1,106      |   |   |
| 2009                                                 |       |                                 | 1,106      |   |   |
| Thereafter                                           |       |                                 | 6,009      |   |   |
| Total                                                |       |                                 | $          | 11,121 |   |   |

 

**Note 7—Bank Line of Credit**

We have in place a $10,000 facility that expires on June 30,2006. The bank agreement provides for working capital financing and isunsecured. The bank agreement requires the Company to comply with certaincovenants including a tangible effective net worth of $60,000, increasing by50% of net income on an annual basis. The covenants also require the Company tokeep $2,000 in cash or securities at the bank. At September 30, 2005, theCompany was compliant with all covenants under the bank agreement.

At September 30,2005, there were no balances outstanding under this agreement and there was$10,000 of available borrowings under this credit facility. Future borrowingswill bear interest based on either of the two options the Company selects atthe time of advances 1) a rate equal to 2% above the Bank’s LIBOR, or 2) arate equal to the Base Rate as quoted from the bank less one-half percent. Anannual commitment fee of $10 was paid in July 2005 for this line ofcredit.

**Note 8—Income Taxes**

For the three and ninemonths ended September 30, 2005, the Company recorded an income taxprovision of $890 and $3,926, respectively, on pre-tax income of $2,084 and$10,492, respectively. This resulted in an annualized effective tax rate of37.4%. For the three and nine months ended September 30, 2004, the Companyrecorded an income tax provision of $1,774 and $5,432, respectively, on pre-taxincome of $4,999 and $15,216, respectively. This resulted in an annualizedeffective tax rate of 35.7%. These rates differed from the statutory ratesprimarily due to state income taxes offset by benefits associated with theforeign tax rate differentials and research and development credits.

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

**Note 10—OperatingSegment and Geographic Information**

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

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

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TheCompany’s reportable segments and geographical information for the three andnine months ended September 30, 2004 and 2005 are as follows:

| ** **               | ** ** | **Revenues**                                                           | ** ** |
|--------------------------|------------|------------------------------------------------------------------------|------------|
| ** **               | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
| ** **               | ** ** | **2004**                                                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **               | ** ** | **(Unaudited)**                                                        | ** ** |
| Cinema business          |       | $                                                                      | 5,135      |   | $ | 5,742 |   | $ | 14,438 |   | $ | 15,676 |   |
| Consumer business        |       | 10,817                                                                 |       | 10,213 |   | 30,363 |   | 37,728 |   |
| Digital Images  business |       | —                                                                 |       | 1,598 |   | — |   | 3,934 |   |
| Total revenues           |       | $                                                                      | 15,952     |   | $ | 17,553 |   | $ | 44,801 |   | $ | 57,338 |   |

 

 

| ** **               | ** ** | **Gross Profit**                                                  | ** ** |
|--------------------------|------------|------------------------------------------------------------------------|------------|
| ** **               | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
| ** **               | ** ** | **2004**                                                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **               | ** ** | **(Unaudited)**                                                        | ** ** |
| Cinema business          |       | $                                                                      | 2,443      |   | $ | 3,089 |   | $ | 6,755 |   | $ | 7,497 |   |
| Consumer business        |       | 10,399                                                                 |       | 9,799 |   | 29,123 |   | 36,284 |   |
| Digital Images  business |       | —                                                                 |       | 21 |   | — |   | (580 | ) |
| Total gross  profit      |       | $                                                                      | 12,842     |   | $ | 12,909 |   | $ | 35,878 |   | $ | 43,201 |   |

 

| ** **                    | ** ** | **Income (Loss) From Operations**                       | ** ** |
|-------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                    | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
| ** **                    | ** ** | **2004**                                                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                    | ** ** | **(Unaudited)**                                                        | ** ** |
| Cinema business               |       | $                                                                      | (898       | ) | (742 | ) | $ | (3,704 | ) | $ | (3,365 | ) |
| Consumer business             |       | 5,493                                                                  |       | 3,282 |   | 15,197 |   | 17,929 |   |
| Digital Images  business      |       | —                                                                 |       | (1,214 | ) | — |   | (5,996 | ) |
| Total income from  operations |       | $                                                                      | 4,595      |   | $ | 1,326 |   | $ | 11,493 |   | $ | 8,568 |   |
|                               |            |                                                                        |            |  |  |  |  |  |  |  |  |  |  |

 

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

| ** **     | ** ** | **Revenues by Geographic Region**                       | ** ** |
|----------------|------------|------------------------------------------------------------------------|------------|
| ** **     | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
| ** **     | ** ** | **2004**                                                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **     | ** ** | **(Unaudited)**                                                        | ** ** |
| United States  |       | $                                                                      | 5,045      |   | $ | 6,101 |   | $ | 13,635 |   | $ | 21,144 |   |
| International  |       | 10,907                                                                 |       | 11,452 |   | 31,166 |   | 36,194 |   |
| Total revenues |       | $                                                                      | 15,952     |   | $ | 17,553 |   | $ | 44,801 |   | $ | 57,338 |   |

 

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

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The following table setsforth, for the periods indicated, long-lived tangible assets by geographic areain which the Company holds assets at December 31, 2004 and September 30,2005:

| ** **               | ** ** | **Long-Lived Assets**              | ** ** |
|--------------------------|------------|-----------------------------------------|------------|
| ** **               | ** ** | **As of  December 31,  2004** | ** ** | **As of  September 30,  2005** | ** ** |
| ** **               | ** ** | ** **                              | ** ** | **(Unaudited)** | ** ** |
| United States            |       |                                    | $          | 2,657 |   |   |   | $ | 5,772 |   |   |
| International            |       |                                    | 882        |   |   |   | 1,495 |   |   |
| Total long-lived  assets |       |                                    | $          | 3,539 |   |   |   | $ | 7,267 |   |   |

 

**Note 11—Net IncomeAttributable to Common Stockholders Per Common Share**

Thefollowing table sets forth the computation of basic and diluted net incomeattributable to common stockholders per common share:

| ** **                                 | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
|--------------------------------------------|------------|------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                 | ** ** | **2004**                                                               | ** ** | **2005**                                                              | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                 | ** ** | **(Unaudited)**                                                        | ** ** |
| Basic net income  per common share:        |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Numerator:                                 |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Net income                                 |       | $                                                                      | 3,225      |                                                                  | $          | 1,194 |   | $ | 9,784 |   | $ | 6,566 |   |
| Denominator:                               |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Weighted average common shares outstanding |       | 17,005,750                                                             |       | 17,411,461                                                            |       | 16,805,643 |   | 17,275,515 |   |
| Basic net income per common share          |       | $                                                                      | 0.19       |                                                                  | $          | 0.07 |   | $ | 0.58 |   | $ | 0.38 |   |
| Diluted net income per common share:       |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Numerator:                                 |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Net income                                 |       | $                                                                      | 3,225      |                                                                  | $          | 1,194 |   | $ | 9,784 |   | $ | 6,566 |   |
| Denominator:                               |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Weighted average shares outstanding        |       | 17,005,750                                                             |       | 17,411,461                                                            |       | 16,805,643 |   | 17,275,515 |   |
| Effect of dilutive securities:             |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Common stock options                       |       | 994,463                                                                |       | 908,720                                                               |       | 1,034,550 |   | 897,135 |   |
| Common stock warrants                      |       | 217,782                                                                |       | 22,005                                                                |       | 288,875 |   | 21,682 |   |
| Diluted shares  outstanding                |       | 18,217,995                                                             |       | 18,342,186                                                            |       | 18,129,068 |   | 18,194,333 |   |
| Diluted net  income per common share       |       | $                                                                      | 0.18       |                                                                  | $          | 0.07 |   | $ | 0.54 |   | $ | 0.36 |   |

 

Weighted average common shares outstanding, assumingdilution, include the incremental shares that would be issued upon the assumedexercise of stock options. Certain common stock equivalents were excluded fromthe calculation of diluted EPS because the exercise price of these common stockequivalents was greater than the average market price of common stock for therespective period, and, therefore, their inclusion would have beenanti-dilutive. For the three and nine months ended September 30, 2005,there were 817,150 and 845,150, respectively, anti-dilutive common stockequivalents, with weighted average exercise prices of $22.41 and $22.28,respectively. For the three and nine months ended September 30, 2004,there were 611,000 and 378,500, respectively, anti-dilutive common stockequivalents, with weighted average exercise prices of $23.62 and $24.47,respectively. These options could be dilutive in the future if the averageshare price increases and is equal to or greater than the exercise price ofthese options.

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

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

**Overview**

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

In the third quarter of2005, we identified an error in our calculation of commission expense that wascorrected during the third quarter of 2005. The correction had the effect ofincreasing selling, general and administrative expenses and operating expensesby $287,000 for the three months ended September 30, 2005. This correctionalso decreased income from operations and income before provision for incometaxes by $287,000 and decreased net income by $180,000. Although thiscorrection was an out-of-period adjustment, we determined that the effect onpreviously filed reports was not material.

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

In our consumer business,we derive revenues from licensing our audio technology, trademarks, andknow-how under agreements with substantially all major consumer audioelectronics manufacturers. Our business model provides for these manufacturersto pay us a per-unit amount for DTS-enabled products that they manufacture. Wealso derive revenues from licensing our technology to consumer semiconductormanufacturers. Through our DTS Entertainment label, we derive revenues from thesale of multi-channel music titles in our digital multi-channel format.

In our cinema business, wederive revenues from sales of our playback equipment and cinema processors tomovie theaters and special venues. In addition, we license technology and sellencoding and 

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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 pre-show advertising, alternative content,subtitling, captioning, and descriptive narration.

In our digital imagesbusiness, we derive revenues from the processing, enhancement and restorationof cinema, home video and broadcast television content. We provide theseservices to motion picture and television studios and other content owners. Weoffer our services on either a fixed fee or time and materials basis.

We present revenues in our consolidated financialstatements and in this “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” as derived from (1) technology andfilm licensing and (2) product sales and other revenues. Our technologyand film licensing revenues are derived from each of our consumer and cinemabusiness segments. Revenues from technology licensing in connection with ourconsumer business segment include revenues derived from licensing our audiotechnology, trademarks, and 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 inintellectual property compliance and enforcement activities focused onidentifying third parties who have either incorporated our technology,trademarks, or know-how without a license or who have under-reported to us theamount of royalties owed under license agreements with us. We continue toinvest in our compliance and enforcement infrastructure to support the value ofour intellectual property to us and our licensees and to improve the long-termrealization of revenue from our intellectual property. As a result of theseactivities, from time to time, we recognize royalty revenues that relate toconsumer electronics manufacturing activities from prior periods. These royaltyrecoveries may cause revenues to be higher than expected during a particularreporting period and may not occur in subsequent periods. While we considersuch revenues to be a regular part our normal operations, we cannot predict theamount or timing of such revenues.

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

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

Our research anddevelopment costs consist primarily of salaries and related benefits forresearch and development personnel, engineering consulting expenses associatedwith new product and technology 

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development,and quality assurance and testing costs. Research and development costs areexpensed as incurred.

In our consumer business,we have a licensing team that markets our technology directly to large consumerelectronics products manufacturers and semiconductor manufacturers. This teamincludes employees located in the United States, China, England, Japan, HongKong and Northern Ireland. We sell music content released under our DTSEntertainment label through exclusive distribution arrangements in the UnitedStates, Europe and Japan. We employ consultants to coordinate sales toindependent retailers and we sell this music directly to consumers through anonline store and other web-based retailers.

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

In our digital imagesbusiness, our senior management team markets our services directly todirectors, producers and content owners. The sales process typically involvesan evaluation of the cinema, home video or broadcast television content to beenhanced or restored and a determination of the scope of services required toachieve the desired result. 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**

*Consumer Segment*

Revenue from our consumersegment constitutes the majority of our total revenue, representing 58% and 68%of total revenues for the quarters ended September 30, 2005 and 2004,respectively. Our consumer revenue is primarily dependent upon the home theaterand DVD player markets, which have experienced rapid growth over the pastseveral years. However, we have recently experienced softness in our DVD playertrademark licensing program, and expect growth rates in this area to declinefrom recent levels. The success of DVD-Video-based systems and products hasfueled a demand for higher quality entertainment in the home, and this demandis extending to the car and PC markets as well. We expect the recentacceleration of the market for high definition televisions to drive demand forhigh definition optical disc players beginning in 2006. Because we expect to bea mandatory technology for next generation players, our consumer revenue growthshould more closely track the growth rate of these players over the nextseveral years. We expect that the market for high definition players will yieldnew growth that provides an offset to the expected decline in the overallgrowth in DVD player shipments. Further, we believe that expected mandatoryinclusion in next generation optical disc standards will help to improve theadoption rate of our technologies in other consumer products such as nextgeneration video game consoles, personal audio and video players, personalcomputers and in-car entertainment systems. Failure to attain mandatory statusin next generation high definition optical disc standards could cause revenuegrowth in our consumer business to be significantly lower than expected andcould have a material adverse effect on our business.

In July 2004, we acquired QDesign Corporation, orQDesign, a company focused on lower-bit rate audio delivery technology. Themarket for higher quality entertainment is expanding into portable devices suchas portable audio players, PDAs, and wireless handset applications that requirethe use of low-bit rate audio coding systems. Concurrent with this trend, thereis a growing need for a good link between home and portable devices thatpreserves as much quality as possible and allows consumers a seamlesstechnology solution for the storage and playback of their content. In October 2004,leveraging our existing 

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research and developmentefforts and the intellectual property acquired in the QDesign acquisition, welaunched DTS-HD, a scalable coding system. This technology allows content to beplayed in home and portable devices. We believe that the broad and robustnature of this offering improves the probability of inclusion of ourtechnologies in next generation products.

*Cinema Segment*

Revenue from our cinemasegment represented 33% and 32% of total revenues for the quarters ended September 30,2005 and 2004, respectively. In our cinema business, 2004 was a solid year forsales of our playback hardware, marking a return to growth for cinema productsales. We expect growth in our cinema audio hardware to continue at a modestpace in 2005. We also believe that the cinema exhibition community hasrecognized that pre-show entertainment represents a significant revenue growth opportunitythat will lead to investment in pre-show solutions over the next several years.Because our XD10 Cinema Media Player can be configured to perform audioplayback along with pre-show and subtitling presentation, we believe that weare well-positioned to participate in the growth in this market.

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

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

*Digital Images Segment*

Revenue from our digital images segment represented 9%of total revenues for the quarter ended September 30, 2005. We believethat the growing market for high resolution and high definition content in thecinema and the home will create a substantial demand for the type of servicesprovided by DTS DI. We believe that we have a technological advantage over manyof our competitors based on the sophistication of our processes and level ofautomation used to enhance the image quality of entertainment content. Revenuesin this business totaled $1.6 million for the three months ended September 30,2005. To date, this business has restored and/or enhanced over 100 featurefilms, including such major DVD releases as Star Wars and Indiana Jones. Majormotion picture and television studios possess libraries containing thousands oftitles, which we believe represent a sizable market opportunity for DTS DI’sservices.

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**CriticalAccounting Policies and Estimates**

Management’s Discussionand Analysis of Financial Condition and Results of Operations is based upon ourconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States. The preparationof our financial statements requires us to make estimates and judgments thataffect the reported amounts of assets, liabilities, revenues, and expenses, andrelated disclosure of contingent assets and liabilities. On an on-going basis,estimates are evaluated, including those related to revenue recognition,allowance for doubtful accounts, inventories, goodwill and intangible assets,taxes, impairment of long-lived assets, product warranty, stock-based compensation,and contingencies and litigation. These estimates are based on historicalexperience and on various other assumptions that we believe to be reasonableunder the circumstances, the results of which form the basis for makingjudgments about the carrying values of assets and liabilities that are notreadily apparent from other sources. Actual results may differ from theseestimates. With the exceptions of the revenue recognition and in-processresearch and development in connection with the recent acquisition of LDI, nowDTS DI, as described below, there has been no material change to our criticalaccounting policies and estimates from the information provided in our Form 10-Kfiled on March 16, 2005.

**DTS DI RevenueRecognition**

Revenue is recognized whenelements of a customer order or contract are delivered and accepted by thecustomer and no significant obligations remain after customer acceptance. Incertain instances, we bill in advance of services. Prices are established inadvance of the work performed and are generally fixed in nature. Revenuerelated to time and materials contracts is recognized as services are renderedat contract labor rates plus material and other direct costs incurred. Iflosses are anticipated on a contract, such losses are recognized immediately.

**AcquiredIn-Process Research and Development**

The value assigned toacquired in-process research and development is determined by identifyingacquired specific in-process research and development projects that would becontinued and for which (1) technological feasibility has not beenestablished at the acquisition date, (2) there is no alternative futureuse, and (3) the fair value is estimable with reasonable reliability, uponconsummation of a business combination.

**Results of Operations**

***Revenues***

*Technology and Film Licensing*

Technology and filmlicensing revenues for the three months ended September 30, 2005 decreased3% to $12.6 million from $13.1 million for the three months ended September 30,2004. The decrease in revenues from technology and film licensing was primarilyattributable to a decrease in royalty recoveries from intellectual propertycompliance and enforcement activities in the third quarter of 2005 relative tothe same period in the prior year. Our combined home AV/DVD licensing business,excluding royalty recoveries, was down 4% year-to-year in the third quarter dueprimarily to continuing softness in the DVD player market. However, we continueto see good growth in our car and PC licensing, which posted year over yeargrowth totals of 52% and 23%, respectively, in the third quarter of 2005. Weremain cautious in our outlook due to uncertainties surrounding the consumerelectronics market. Overall, we continue to expect technology licensingrevenues to grow modestly for 2005, based primarily on the expectedcontinuation of growth in our decoder licensing program and from our licenseenforcement activities. Our film licensing revenues decreased slightly for thethree months ended September 30, 2005 compared to the prior year perioddue to fewer international releases in the DTS format and changes in the timingof major 

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featurefilm releases. Film licensing is expected to decrease slightly for the fullyear 2005 compared to 2004.

Technology and filmlicensing revenues for the nine months ended September 30, 2005 increased21% to $43.9 million from $36.3 million for the nine months ended September 30,2004. The increase in revenues from technology and film licensing was primarilyattributable to an increase in royalty recoveries of $6.8 million fromintellectual property compliance and enforcement activities during 2005 as wellas an increase in consumer license revenues.

*Product Sales andOther*

Product sales and otherrevenues increased 71% to $4.9 million for the three months ended September 30,2005 from $2.9 million for the three months ended September 30, 2004.This increase was primarily attributable to revenues generated by DTS DI, whichwe acquired in January 2005, and an increase in Cinema hardware sales of$620,000. Interest in our XD10 Cinema Media Player along with the XD10P CinemaAudio Processor was a primary driver of sales. Deferred revenue ofapproximately $828,000 was recognized during the third quarter of 2005, which hadbeen pending the completion of a software deliverable. Product sales and otherrevenue is expected to grow at a modest rate, as we continue to expect marketinterest in multi-function playback devices to develop at a measured pacethroughout the rest of 2005.

Product sales and otherrevenues increased 57% to $13.4 million for the nine months ended September 30,2005 from $8.5 million for the nine months ended September 30, 2004.This increase was primarily attributable to revenues generated by DTS DI aswell as an increase in Cinema hardware sales of approximately $1.4 million dueto the reasons mentioned above.

*Segment Sales*

Revenues from our consumerbusiness totaled $10.2 million for the three months ended September 30,2005, a decrease of 6% from $10.8 million for the three months ended September 30,2004. The decrease in revenues was driven primarily by a decrease in royaltyrecoveries. Cinema revenues were $5.7 million for the three months ended September 30,2005, an increase of 12% from $5.1 million for the three months ended September 30,2004. The increase in revenues was driven primarily by an increase in hardwarerevenues. Revenues from our digital images business were $1.6 million for thethree months ended September 30, 2005, the third quarter these revenueshave been included in our results of operations.

Revenues from our consumerbusiness totaled $37.7 million for the nine months ended September 30,2005, an increase of 24% from $30.4 million for the nine months ended September 30,2004. The increase in revenues was driven primarily by an increase in royaltyrecoveries mentioned above, which was partially offset by softness in DVDtrademark royalties. Cinema revenues were $15.7 million for the nine monthsended September 30, 2005, up 9% from the same period last year dueprimarily to growth in product sales, primarily the XD10 Cinema Media Player.

***Gross Profit***

Consolidated gross profitdecreased to 74% of revenues for the three months ended September 30,2005, from 81% for the three months ended September 30, 2004 due primarilyto the mix of licensing and product sales during the period including theincorporation of DTS DI in our 2005 revenues.

For the nine months ended September 30, 2005,consolidated gross profit decreased to 75% of revenues, compared to 80% for thesame period in 2004 as a result of the incorporation of DTS DI into ourconsolidated results of operations as mentioned above. We expect consolidatedgross margins in the 

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70% to75% range for the 2005 fiscal year primarily as a result of the incorporationof DTS DI into our consolidated results of operations.

*Technology and Film Licensing*

Gross profit associatedwith technology and film licensing revenues remained at 91% of related revenuesfor the three months ended September 30, 2005 compared to the prior yearsame period.

For the nine months ended September 30,2005, technology and film licensing revenues increased to 92% of relatedrevenues, compared to 91% for the same period in 2004 due to the increase inrevenue relative to fixed costs.

*Product Sales and Other*

Gross profit associatedwith product sales and other revenues decreased to 30% of related revenues forthe three months ended September 30, 2005 from 34% in the prior yearperiod primarily as a result of low margins in our digital images business dueto high fixed overhead costs and amortization of acquired intangibles.

For the nine months ended September 30,2005, product sales and other revenues decreased to 21% of related revenues,compared to 35% for the same period in 2004 for the reasons mentioned above andthe negative margins in our digital images business for the first half of theyear.

*Segment Gross Profit*

Gross profit for ourconsumer business remained consistent at 96% of related revenues for thequarter ended September 30, 2005 from the prior year period. Our cinemabusiness gross profit increased to 54% of related revenues for the quarterended September 30, 2005 from 48% in the prior year period primarily dueto a higher margin deal that was recognized during the quarter. Our digitalimages business experienced low gross margins due to lower than anticipatedrevenues and the amortization of acquired intangibles of $244,000. We expect marginsin the digital images business to improve as revenues increase throughout theremainder of the year.

For the nine months ended September 30,2005, our consumer business gross profit remained consistent at 96% of relatedrevenues, compared to the same period in 2004. Our cinema business gross profitincreased slightly to 48% of related revenues, compared to 47% for the sameperiod in 2004. Our digital images business experienced negative gross marginsdue to the reasons mentioned above and the amortization of acquired intangiblesof $732,000.

***Selling, Generaland Administrative***

Selling, general andadministrative expenses increased 33% to $9.0 million for the three monthsended September 30, 2005, compared to $6.7 million in the prior yearperiod. The increase is primarily due to increases in salaries and relatedcosts of $1.4 million, as we increased headcount to support our growth. Alsocontributing to the increase was $230,000 relating to the inclusion of DTS DIin our results of operations.

Selling, general andadministrative expenses increased 26% to $25.1 million for the nine monthsended September 30, 2005, compared to $20.0 million in the prior yearperiod. The increase is primarily due to increases in salaries and relatedcosts of $2.5 million as we increased headcount to support our growth, andprofessional services of $1.1 million which includes costs associated withour increased intellectual property compliance and enforcement activities, andother additional costs associated with operating as a public company. Alsocontributing to the increase was $1.1 million relating to the inclusion of DTSDI in our results of operations.

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

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***Research and Development***

For the three months ended September 30, 2005,research and development expenses were $2.6 million, compared to$1.5 million for the three months ended September 30, 2004. For thenine months ended September 30, 2005, research and development expenseswere $7.2 million, up from $4.4 million for the nine months endedSeptember 30, 2004. The increase for both periods is primarily due toincreased labor costs associated with new product initiatives, the optimizationof our Coherent Acoustics technology, and the development of tools associatedwith next generation optical disc standards. Also contributing to the increasewas the inclusion of DTS DI research and development activities totaling$285,000 and $668,000 for the three and nine months ended September 30,2005, respectively.

We expect to continue toincrease our investment in applications engineering and research anddevelopment activities overall in future quarters, primarily in support of newproduct initiatives, 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 nine months ended September 30, 2005,relates to development projects that had not reached technological feasibility,were of no future alternative use and which were expensed upon consummation ofthe acquisition of LDI. Developed technology and in-process research anddevelopment were identified and valued through extensive interviews, analysisof data provided by LDI concerning development projects, their stage ofdevelopment, the time and resources needed to complete them, if applicable, andtheir expected income generating ability and associated risks. Wheredevelopment projects had reached technological feasibility, they wereclassified as developed technology and the value assigned to developedtechnology was capitalized. The income approach, which includes an analysis ofthe cash flows and risks associated with achieving such cash flows, was theprimary technique utilized in valuing acquired in-process research anddevelopment. Key assumptions for in-process research and developmentincluded a discount rate of 30% and estimates of revenue growth, cost of sales,operating expenses and taxes.

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

Interest income, net, forthe three and nine months ended September 30, 2005 increased significantlyover the same period of the prior year due to the generally improved interestrate environment and a temporary shift away from tax-exempt auction ratesecurities to taxable investments, which generate higher nominal yields.Offsetting the increase for the nine months ended September 30, 2005, isthe inclusion of $164,000 of interest income related to a royalty settlement inthe first quarter of 2004. We re-entered the tax-exempt auction rate securitiesmarket in the third quarter of this year, and expect interest income todecrease in future quarters.

**Income From LegalSettlement**

In May 2004, wereached a settlement with Mintek for $3.5 million for Trademark Infringement,False Designation of Origin, Trademark Dilution, and Unfair Competitionrelating to Mintek’s distribution of DVD players bearing our registeredtrademarks without obtaining a license from us. In the nine months ended September 30,2004 we recognized $899,000 in revenue under the settlement agreement forroyalties due on known units that could be identified as using our trademarkand accounted for the remaining $2.6 million as other income.

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***Income Taxes***

For the three and ninemonths ended September 30, 2005, we recorded an income tax provision of$890,000 and $3.9 million, respectively, on pre-tax income of $2.1 millionand $10.5 million, respectively. This resulted in an annualized effective taxrate of 37.4%. For the three and nine months ended September 30, 2004, werecorded an income tax provision of $1.8 million and $5.4 million,respectively, on pre-tax income of $5.0 million and $15.2 million,respectively. This resulted in an annualized effective tax rate of 35.7%. Theserates differed from the statutory rates primarily due to state income taxesoffset by benefits associated with the foreign tax rate differentials andresearch and development credits. We expect the effective tax rate for 2005will be approximately 38%, slightly higher than our previous estimates dueprimarily to the non-deductibility of in-process research and developmentcharges and changes in our geographic earnings mix expectations as the year hasprogressed.

**Liquidity andCapital Resources**

At September 30, 2005, we had cash, cashequivalents and short- and long-term investments of $108.5 million,compared to $117.0 million at December 31, 2004.

Net cash provided by operating activities was$6.2 million for the nine months ended September 30, 2005, comparedto $12.7 million for the nine months ended September 30, 2004. Accountsreceivable, net of acquired accounts receivable, increased $3.8 million for thenine months ended September 30, 2005 due to royalty recoveries and otheraccrued license fees. Our tax benefit from the exercise of options decreased$3.3 million for the nine months ended September 30, 2005, comparedto the same prior period. Included in 2004 was an unusually high volume ofoption exercises during the nine months subsequent to our initial publicoffering lockup release in early 2004. Additionally, lower average marketprices for shares of our common stock in the first nine months of 2005 relativeto the same period in 2004 resulted in lower option exercise activity during2005. As part of the acquisition of LDI, we assumed $1.9 million in liabilitiesand a significant portion of these liabilities were paid during 2005.

Net cash provided by investing activities totaled $2.3million for the nine months ended September 30, 2005. Net cash used ininvesting activities totaled $35.1 million for the nine months ended September 30,2004. The increase in cash provided by investing activities for the nine monthsended September 30, 2005 is primarily a result of the net sales ofinvestments of $17.6 million, offset by the acquisition of LDI of $11.0 millionand purchases of property and equipment of $4.2 million. We shifted ourinvestment focus away from the purchase of auction rate securities that areclassified as short-term investments, which has resulted in an increase in ourcash balance. We started to re-enter the auction rate security market andexpect to see a continued shift of cash to short-term investments.

Net cash provided by financing activities totaled$658,000 and $913,000 for the nine months ended September 30, 2005 and2004, respectively, and primarily consists of the exercise of stock options andpurchases of stock under our employee stock purchase plan.

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

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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 November 2004, the Financial AccountingStandards Board, or FASB, issued Statement of Financial Accounting Standards,or SFAS, No. 151, “Inventory Costs, an amendment of ARB No. 43,Chapter 4”, or SFAS 151. SFAS 151 clarifies the types of costs that should beexpensed rather than capitalized as inventory. SFAS 151 also clarifies thecircumstances under which fixed overhead costs associated with operatingfacilities involved in inventory processing should be capitalized. Thisstatement is effective for fiscal years beginning after June 15, 2005. Weadopted SFAS 151 in the three months ended March 31, 2005 and the adoptiondid not have a material impact on our consolidated financial position orresults of operations.

In December 2004, theFASB issued SFAS No. 123R, “Share-Based Payment”, or SFAS 123R, anamendment to SFAS No. 123, “Accounting for Stock-Based Compensation.”SFAS 123R requires compensation expense related to stock-based awards tobe recognized in the financial statements. The amount of compensation expensewill be measured based upon the fair value of the stock-based awards at thedate of grant. SFAS 123R also requires an enterprise to assess the mostappropriate model to calculate the value of the options. We currently use theBlack-Scholes option pricing model to value options, and we are currentlyassessing which model we will use in the future under SFAS 123R and may deem analternative model to be the most appropriate. The use of a different model tovalue options may result in a different fair value than the use of the Black-Scholesoption pricing model. In addition, there are a number of other requirementsunder the new standard that will result in differing accounting treatment thancurrently required. These differences include, but are not limited to, theaccounting for the tax benefit on employee stock options. In addition to theappropriate fair value model to be used for valuing share-based payments, wewill also be required to determine the transition method to be used at the dateof adoption. The allowed transition methods include prospective and retroactiveadoption methods. Under the retroactive method, prior periods may be restatedeither as of the beginning of the year of adoption or for all periodspresented. The prospective method requires that compensation expense berecorded for all unvested stock options and restricted stock at the beginningof the first quarter of adoption of SFAS 123R, while the retroactivemethod would record compensation expense for all unvested stock options andrestricted stock beginning with the first period restated. This statement wasto have become effective for public companies as of the first interim or annualreporting period beginning after June 15, 2005. In April 2005, theSEC amended the compliance date for implementing SFAS 123R extending thecompliance date to the first fiscal year that begins after June 15, 2005.We plan to adopt SFAS 123R beginning in the first quarter of fiscal 2006. If wehad adopted SFAS 123R as of September 30, 2005, the effects of theadoption of SFAS 123R on our financial results for the next five years, basedon stock-based awards granted as of September 30, 2005, would be asfollows:

| ** **                                                                           | ** ** | **Expenses by Fiscal Year** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                           | ** ** | **Remaining**                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                           | ** ** | **Three**                                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                           | ** ** | **Months**                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                           | ** ** | **2005**                                   | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** |
| ** **                                                                           | ** ** | **(unaudited)**                            | ** ** |
| ** **                                                                           | ** ** | **(In thousands)**                    | ** ** |
| Additional stock-based  compensation expense under SFAS 123R before tax benefit |       |                                       | $          | 832 |   |   | $ | 3,036 |   | $ | 2,659 |   | $ | 1,410 |   | $ | 314 |   |
|                                                                                      |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

SFAS 123R also affects the presentation of taxbenefits for option exercises in the statement of cash flows. Prior to adoptionSFAS 123R, the benefit is classified in cash provided by operating activities.Upon 

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adoption, the tax benefitwill be classified in cash provided by financing activities. We are in theprocess of determining the impact the adoption will have on our consolidatedstatement of cash flows.

In March 2005, the SEC issued Staff AccountingBulletin, or SAB, No. 107 to provide guidance on SFAS 123R. SAB 107 wasissued to assist registrants by simplifying some of the implementationchallenges of SFAS 123R while enhancing the information that investors receive.SAB 107 provides guidance regarding valuation models, expected volatility andexpected term. We will apply the guidance of SAB 107 in conjunction with ouradoption of SFAS 123R.

In June 2005, the FASB issued Statement No. 154,“Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20,Accounting Changes, and Statement No. 3, Reporting Accounting Changes inInterim Financial Statements”, or SFAS 154. SFAS 154 changes therequirements for the accounting for, and reporting of, a change in accountingprinciple. Previously, most voluntary changes in accounting principles wererequired to be recognized by way of a cumulative effect adjustment within netincome during the period of the change. SFAS 154 requires retrospectiveapplication to prior periods’ financial statements, unless it is impracticableto determine either the period-specific effects or the cumulative effect of thechange. SFAS 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. We do notbelieve adoption of SFAS 154 will have a material effect on ourconsolidated financial position, results of operations or cash flows.

In June 2005 FASB Staff Position, or FSP, 143-1,“Accounting for Electronic Equipment Waste Obligations” was issued. FSP 143-1addresses the accounting for obligations associated with Directive 2002/96/ECon Waste Electrical and Electronic Equipment, or the “Directive”, of theEuropean Union, or EU, which is subject to transformation into the respectivenational laws. Under the Directive, the waste management obligation remainswith the commercial user until the historical waste equipment (put on themarket before August 13, 2005) is replaced. At that time the wastemanagement obligation for the equipment may be transferred to the producer ofthe replacement equipment depending on the transformation of the Directive intonational law by the EU-member country. If the commercial user does not replacethe equipment, the obligation remains with that user until the equipment isdisposed. FSP 143-1 requires the commercial user to apply theprovisions of SFAS 143, “Accounting for Asset Retirement Obligations” to theobligation associated with historical waste. FSP 143-1 will have to beapplied in the first reporting period ending after the date the law is adoptedby the applicable EU-member countries. The adoption of FSP 143-1 did nothave a material impact on our consolidated financial statements.

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**RISK FACTORS**

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

**Risks Related 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 and entertainmentmediums, including Coding Technologies, Fraunhofer Institut IntegrierteSchaltungen, Koninklijke Philips Electronics N.V. (Philips), Meridian AudioLimited, Microsoft Corporation, Sony Corporation, and Thomson;

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

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

·       productsfor image processing including da Vinci Systems, LLC, Digital Vision AB, MathematicalTechnologies, Inc., Pixel Farm Ltd., Snell and Wilcox, TeranexIncorporated, 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.

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

Sony Corporation is both 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 futuregovernmental and industry standards may significantly limit our businessopportunities.***

Technology standards are important in the audio andvideo industry as they help to assure compatibility across a system or seriesof products. Generally, standards adoption occurs on either a mandatory basis,requiring a particular technology to be available in a particular product ormedium, or an optional basis, meaning that a particular technology may be, butis not required to be, utilized. For example, both our digital multi-channel audiotechnology and Dolby’s have optional status in Standard and High-DefinitionDVD. In the emerging standards for high definition-DVD, both DTS and Dolbytechnologies have been selected as mandatory standards for two-channel output.Recently, however, there has been discussion regarding merging the twocompeting next generation optical disc standards. If either or both of thesestandards are re-examined as a result of these discussions or a newstandard is developed, we may not be included as mandatory in any new orrevised standard.

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

As new technologies andentertainment mediums emerge, new standards relating to these technologies ormediums 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.

***Our operating results may be adversely affected as aresult of required compliance with the recently adopted European UnionDirectives on Waste Electrical and Electronic Equipment and the Restriction ofthe Use of Hazardous Substances in electrical and electronic equipment.***

In February 2003, the European Union enacted Directive2002/96/EC on Waste Electrical and Electronic Equipment Directive, known as theWEEE Directive. The WEEE Directive requires producers of certain electrical andelectronic equipment to be financially responsible for the future disposalcosts of this equipment. Our cinema products may fall within the scope of thisDirective and as such we may incur some financial responsibility for thecollection, recycling, treatment and disposal of both new products 

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sold, and products alreadysold prior to the WEEE Directive’s enforcement date, to customers within theEuropean Union. The Directive further increases our financial liabilities byrequiring producers to adopt new approaches for improving sustainable productdesign and for encouraging recycling or re-use at the end of the product’slife.

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

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

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

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

***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 the 

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accurateanticipation 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.

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

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

·       ourpatents may be challenged or invalidated by our competitors;

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

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

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

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

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

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

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

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

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

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proceedings,we may need to redesign some of our products to avoid infringing a third party’srights and could be required to temporarily or permanently discontinuelicensing our products.

***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 games releasedwith DTS audio soundtracks. Although we have existing relationships with manyleading providers of movie, music, computer, and video game content, we do nothave contracts that require any of these parties to develop and release contentwith DTS audio soundtracks. In addition, we may not be successful inmaintaining existing relationships or developing relationships with otherexisting providers or new market entrants that provide content. As a result, wecannot assure you that a significant amount of content in movies, audio DVDs,computer software programs, video games, or other entertainment mediums will bereleased with DTS audio soundtracks. If the amount, variety, and popularity ofentertainment content released with DTS audio soundtracks do not increase,consumer electronics products manufacturers that pay us per-unit licensing feesmay discontinue offering DTS playback capabilities in the consumer electronicsproducts that they sell.

***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 public accounting firmauditing our financial statements must attest to and report on our management’sassessment of the effectiveness of internal control over financial reportingand the effectiveness of internal control over financial reporting. While weconduct rigorous reviews of our internal control over financial reporting inorder to comply with the Section 404 requirements, our registered publicaccounting firm may interpret the Section 404 requirements and the relatedrules and regulations differently from us, or our registered publicaccounting firm or management may not be satisfied with our internal controlover financial reporting or with the level at which these controls aredocumented, executed or reviewed. In addition, many uncertainties remainregarding the requirements for auditor attestation, and guidance provided bythe public accounting profession has changed frequently and materially to dateand may continue to change such that we may not be able to comply with thesenew requirements. Further, the demand for competent audit resources has grown dramaticallyas a result of the requirements of Section 404, and such demand may exceedavailable supply. In addition, in January 2005, we acquired Lowry DigitalImages, Inc., or LDI, a privately held company with limited financialresources that had not 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 LDI or any other businesses that wemay acquire. As a result, our registered public accounting firm may issue anadverse report or a disclaimer on management’s assessment of internal controlover financial reporting. Management may also identify 

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materialweaknesses which would cause management to conclude internal control overfinancial reporting is not effective. This could result in an adverse reactionin the financial markets due to a loss of confidence in the reliability of ourfinancial statements, which could cause the market price of our shares todecline.

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

Although we have establishedrelationships with a number of artists and music labels, we do not have anycontractual agreements that require artists or music labels to provide us withmusic content to re-mix and release in our proprietary DTS audio format.Music companies may in the future be unwilling to license titles from theirmusic catalogs to us. In addition, our audio content competes with other multi-channelformats, including Super Audio CD, which is a format developed jointly byPhilips and Sony Corporation. As a result, we may have difficulty in obtainingrights to release a significant amount of audio content, and any content thatwe do release may not be commercially successful.

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

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

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

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

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

***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 

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purchasecommitments, and are on a non-exclusive basis, and do not require incorporationor use of our technology, trademarks or services. Our customers, licensees andother manufacturers might not utilize our technology or services in the future.

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

Although all nine majorfilm producers and distributors are customers of ours, we generally do not havecontractual arrangements that require them to use our DTS audio technology orour digital image services. Our cinema and digital images business depends onour having good relations with these film studios and other content owners. Adeterioration in our relationship with any of these customers could cause themto 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 performance causedby a weak film release calendar or declining consumer interest in the filmsbeing released could have a negative impact on the demand for the products andservices we sell to the motion picture industry.

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

The movie theater industrymay transition from film-based media to electronic-based, or digital, media. Ifthis transition occurs, we may be unable to meaningfully respond withcompetitive product offerings. In addition, if the film industry broadly adoptsdigital cinema, our technology and current product 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 theater industry has suffered and maycontinue to suffer from an oversupply of screens, which has affected and maycontinue to affect demand for the products and services we offer to movietheaters.***

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

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***We are dependent on our management team and keytechnical employees, and the loss of any of them could 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 LDI. We also rely on the skills and talents ofour engineering and technical personnel because of the complexity of ourproducts and services. Several of our key engineers have been instrumental inthe development of our technology. Important factors that could cause the lossof key personnel include:

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

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

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

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

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

***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 difficulties frequentlyencountered by companies in new and rapidly evolving markets such as ours. Wemay not be able to successfully address any or all of these risks.

***Our technology and products are complex and maycontain errors that could cause us to lose customers, damage our reputation, orincur 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.

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***Because we expect our operating expenses to increase inthe future, we may not be able to sustain or increase our profitability.***

Although we havebeen in business since 1990, we have only achieved profits from our businessoperations in the last seventeen fiscal quarters. We expect our operatingexpenses to increase as we, among other things:

·       expandour domestic and international sales and marketing activities;

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

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

·       hireadditional personnel, including engineers and other technical staff;

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

·       continueto assume the responsibilities of being a public company.

As a result, we will 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, Japan, Hong Kong, Italy, Mexico,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 of currencyexchange; 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.

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

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

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

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

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

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

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

A significant percentageof our revenues are generated from our consumer electronics productsmanufacturer customers who license and incorporate our technology in theirconsumer electronics products. Under our existing arrangements, these customerspay us 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 

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of ourlicense agreements permit us to audit our customers, but audits are generallyexpensive and time consuming and could harm our customer relationships. If anyof our customer reports understate the number of products they manufacture, wemay not collect and recognize revenues to which we are entitled.

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

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

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

We acquired LDI in January 2005,and we expect to consider additional opportunities to acquire or makeinvestments in other technologies, products, and businesses that could enhanceour technical capabilities, complement our current products and services, orexpand the breadth of our markets. We have a limited history of acquiring andintegrating businesses. Acquisitions and strategic investments involve numerousrisks, including:

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

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

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

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

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

·       diversionof management’s attention from our core business;

·       adverseeffects on existing business relationships with suppliers and customers;

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

·       potentialloss of key employees of acquired organizations.

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

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

We expect tocontinue to experience growth in the scope of our operations and the number ofour employees. If this growth continues, it will place a significant strain onour management team and on our operational and financial systems, procedures,and controls. Our future success will depend in part on the ability of ourmanagement team to manage any growth effectively. This will require ourmanagement to:

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

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

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·       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 to successfullymanage our growth could distract management’s attention, and result in ourfailure to execute our business plan. For instance, our acquisition of LDI hasrequired significant time and attention from our management team. Any futuregrowth could cause similar management challenges or create distractions.

***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.

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

There has been ongoingpublic debate whether stock options granted to employees should be treated ascompensation expense and, if so, how to properly value such charges. Currently,we account for options using the intrinsic value method, which results in nocompensation expense, since we grant employee options with exercise pricesequal to the fair market value of the underlying stock at the time of grant.If, however, we had used the fair value method of accounting for stock optionsgranted to employees using a Black-Scholes option valuation formula, our netincome for the nine months ended September 30, 2005, would have beenreduced by $1.7 million, from $6.6 million to $4.9 million for that period.When we adopt FAS 123R in the first quarter of 2006, we will have on-goingaccounting charges significantly greater than those we would have recordedunder our current method of accounting for stock options, which will have amaterial adverse affect on our operating results.

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**Risks Related to Our Common Stock**

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

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

·       actualor anticipated fluctuations in our results of operations;

·       announcementsof technological innovations or technology standards;

·       announcementsof significant contracts by us or our competitors;

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

·       developmentswith respect to intellectual property rights;

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

·       thecommencement of or our involvement in litigation;

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

·       conditionsand trends in technology industries;

·       changesin market valuation or earnings of our competitors;

·       thetrading volume of our common stock;

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

·       generaleconomic conditions.

In addition, the stockmarket in general, and the Nasdaq National Market and the market for technologycompanies in particular, has experienced extreme price and volume fluctuationsthat have often been unrelated or disproportionate to the operating performanceof those companies. Further, the market prices of securities of technologycompanies have been particularly volatile. These broad market and industryfactors may materially harm the market price of our common stock, regardless ofour operating 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 September 30,2005, we have 17,434,882 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 capital needs are uncertain and we may needto raise additional funds in the future, and such funds may not be available onacceptable 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;

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

·       thecosts associated with our expansion, if any.

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

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

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

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

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

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

·       requireadvance written notice of stockholder proposals and director nominations.

In addition, we aregoverned by the provisions of Section 203 of the Delaware GeneralCorporate Law, which may prohibit certain business combinations withstockholders owning 15% or more of our outstanding voting stock. These andother provisions in our Restated Certificate of Incorporation, Restated Bylawsand Delaware law could make it more difficult for stockholders or potentialacquirors to obtain control of our Board or initiate actions that are opposedby the then-current Board, including delay or impede a merger, tenderoffer, or proxy contest involving our company. Any delay or prevention of achange of control transaction or changes in our Board could cause the marketprice of our common stock to decline.

**Item 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 September 30,2005, 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 September 30, 2005, a 1% change ininterest rates throughout a one-year period would have an annual effect ofapproximately $1.1 million on our income.

We derive more than half of our revenues from salesoutside the United States, and maintain research, sales, marketing, or businessdevelopment offices in seven countries. Therefore, our results could benegatively affected by such factors as changes in foreign currency exchangerates, trade protection 

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measures, longer accountsreceivable collection patterns, and changes in regional or worldwide economicor political conditions. The risks of our international operations aremitigated in part by the extent to which our revenues are denominated in U.S.dollars and, accordingly, we are not exposed to significant foreign currencyrisk on these items. We do have limited foreign currency risk on certainrevenues and operating expenses such as salaries and overhead costs of ourforeign operations and a small amount of cash maintained by these operations.Revenues denominated in foreign currencies accounted for approximately 8% oftotal revenues during the nine months ended September 30, 2005. Operatingexpenses, including cost of sales, for our foreign subsidiaries wereapproximately $5.1 million in the first nine months of 2005. Based uponthe expenses for the first nine months of 2005, a 1% change in foreign currencyrates throughout a one-year period would have an annual effect of approximately$68,000.

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 foreignsubsidiaries are translated into the United States dollar in consolidation. Asexchange rates vary, these results, when translated, may vary from expectationsand could adversely impact overall profitability. During the three and ninemonth periods ended September 30, 2005, the impact of foreign exchangerate fluctuations related to translation of our foreign subsidiaries’ financialstatements was not significant.

**Item 4.**                        Controlsand Procedures

**Disclosure Controls and Procedures**

We maintain disclosure controls and procedures (asdefined in Rules 13a-l5(e) and 15(d)-15(c) 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 for timely decisions regardingrequired disclosure.

We carried out an evaluation, under the supervisionand with the participation of our management, including our chief executiveofficer and chief financial officer, of the effectiveness of the design andoperation of our disclosure controls and procedures as of the end of thequarter covered by this report. Based on the foregoing, our chief executiveofficer and chief financial officer concluded that our disclosure controls andprocedures were effective.

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

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**PART IIOTHER INFORMATION**

**Item 1.**                        LegalProceedings

None.

**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 theunderwriters’ commissions and deductions of offering expenses. All of theshares of Common Stock sold in the offering were registered under the 1933 Acton a Registration Statement on Form S-1 (Reg. No. 333-104761)that was declared effective by the SEC on July 9, 2003 and a RegistrationStatement filed pursuant to Rule 462(b) under the Securities Act that wasfiled on July 10, 2003 (Reg. No. 333-106920). Subsequent to theoffering, we used approximately $22.5 million of our net proceeds toredeem all outstanding shares of redeemable preferred stock and to pay allaccrued but unpaid dividends on such shares through the date of redemption. Theremaining proceeds to us have conformed with our intended use outlined in theprospectus related to the offering. As of September 30, 2005, we haveapproximately $40.5 million remaining from the proceeds of the offering.

**Item 3.**                        DefaultsUpon Senior Securities

None.

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

None.

**Item 5.**                        OtherInformation

None.

**Item 6.**                        Exhibits

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

 

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

|                              |     |     |     | DTS, Inc.                                                                                                 |
|------------------------------|----------|----------|----------|----------------------------------------------------------------------------------------------------------------|
|                         |     | by:      |     | /s/ JON E. KIRCHNER                                                                                            |
|                         |     |     |     | Jon E. Kirchner                                                                                                |
| * *                     | * * | * * | * * | *President and Chief Executive Officer  (Duly Authorized Officer)*                                             |
| Date: November 9,  2005 |     |     |     |                                                                                                           |
|                         |     | by:      |     | /s/ MELVIN L. FLANIGAN                                                                                         |
|                         |     |     |     | Melvin L. Flanigan                                                                                             |
| * *                     | * * | * * | * * | *Executive Vice President, Finance and Chief  Financial Officer  (Principal Financial and Accounting Officer)* |
| Date: November 9,  2005 |     |     |     |                                                                                                           |

 

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