**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 June 30, 2005**

**CommissionFile Number 000-50335**

**DTS, Inc.**

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

 

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Indicate by check mark whetherthe registrant: (1) has filed all reports required to be filed 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

Asof July 15, 2005 a total of 17,387,153 shares of the Registrant’s CommonStock, $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**                                                   | ** ** | **41** |
| **Item 4.**  | ** ** | **Controls  and Procedures**                                                                                      | ** ** | **42** |
| **PART II.** | ** ** | **OTHER INFORMATION**                                                                                             | ** ** | **43** |
| **Item 1.**  | ** ** | **Legal  Proceedings**                                                                                            | ** ** | **43** |
| **Item 2.**  | ** ** | **Unregistered Sales of Equity  Securities and Use of Proceeds**                                                  | ** ** | **43** |
| **Item 3.**  | ** ** | **Defaults Upon Senior  Securities**                                                                              | ** ** | **43** |
| **Item 4.**  | ** ** | **Submission of Matters to a  Vote of Security Holders**                                                          | ** ** | **43** |
| **Item 5.**  | ** ** | **Other  Information**                                                                                            | ** ** | **44** |
| **Item 6.**  | ** ** | **Exhibits**                                                                                                      | ** ** | **44** |
| **SIGNATURES**    | ** ** | **45**                                                                                                            |

 

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**DTS, INC.**

**PART IFINANCIAL INFORMATION**

**Item 1.**                     *Financial Statements*

**DTS, Inc.Condensed ConsolidatedBalance Sheets**
| ** **                                                                                                                                                                                                                                    | ** ** | **As of   December 31,  2004**                                                      | ** ** | **As of  June 30,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                                                                                                                                                                    | ** ** | ** **                                                                                         | ** ** | **(Unaudited)**                               | ** ** |
| ** **                                                                                                                                                                                                                                    | ** ** | **(Amounts in thousands, except  share and per share amounts)** | ** ** |
| ASSETS                                                                                                                                                                                                                                        |       |                                                                                               |       |                                          |       |   |   |   |   |
| Current assets:                                                                                                                                                                                                                               |       |                                                                                               |       |                                          |       |   |   |   |   |
| Cash and cash  equivalents                                                                                                                                                                                                                    |       |                                                                                               | $          | 21,271                                        |       |   |   | $ | 41,161 |   |   |
| Short-term investments                                                                                                                                                                                                                        |       |                                                                                               | 93,040     |                                          |       |   | 66,449 |   |   |
| Accounts receivable, net  of allowance for doubtful accounts of $402 and $405 at December 31, 2004  and June 30, 2005, respectively                                                                                                 |       |                                                                                               | 4,649      |                                          |       |   | 10,688 |   |   |
| Inventories                                                                                                                                                                                                                                   |       |                                                                                               | 3,669      |                                          |       |   | 3,787 |   |   |
| Deferred tax assets                                                                                                                                                                                                                           |       |                                                                                               | 9,144      |                                          |       |   | 9,157 |   |   |
| Prepaid expenses and  other                                                                                                                                                                                                                   |       |                                                                                               | 3,651      |                                          |       |   | 2,721 |   |   |
| Income tax receivable                                                                                                                                                                                                                         |       |                                                                                               | 72         |                                          |       |   | — |   |   |
| Total current assets                                                                                                                                                                                                                          |       |                                                                                               | 135,496    |                                          |       |   | 133,963 |   |   |
| Long-term investments                                                                                                                                                                                                                         |       |                                                                                               | 2,657      |                                          |       |   | — |   |   |
| Property and equipment,  net                                                                                                                                                                                                                  |       |                                                                                               | 3,539      |                                          |       |   | 6,496 |   |   |
| Intangible assets, net                                                                                                                                                                                                                        |       |                                                                                               | 1,779      |                                          |       |   | 12,040 |   |   |
| Goodwill                                                                                                                                                                                                                                      |       |                                                                                               | —     |                                          |       |   | 3,853 |   |   |
| Deferred tax assets                                                                                                                                                                                                                           |       |                                                                                               | 500        |                                          |       |   | 1,863 |   |   |
| Other assets                                                                                                                                                                                                                                  |       |                                                                                               | 718        |                                          |       |   | 712 |   |   |
| Total assets                                                                                                                                                                                                                                  |       |                                                                                               | $          | 144,689                                       |       |   |   | $ | 158,927 |   |   |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                                                                                    |       |                                                                                               |       |                                          |       |   |   |   |   |
| Current liabilities:                                                                                                                                                                                                                          |       |                                                                                               |       |                                          |       |   |   |   |   |
| Accounts payable                                                                                                                                                                                                                              |       |                                                                                               | $          | 3,716                                         |       |   |   | $ | 4,454 |   |   |
| Accrued expenses                                                                                                                                                                                                                              |       |                                                                                               | 5,688      |                                          |       |   | 6,510 |   |   |
| Deferred revenue                                                                                                                                                                                                                              |       |                                                                                               | 519        |                                          |       |   | 2,643 |   |   |
| Income tax payable                                                                                                                                                                                                                            |       |                                                                                               | —     |                                          |       |   | 7 |   |   |
| Total current  liabilities                                                                                                                                                                                                                    |       |                                                                                               | 9,923      |                                          |       |   | 13,614 |   |   |
| Deferred tax liability                                                                                                                                                                                                                        |       |                                                                                               | —     |                                          |       |   | 4,174 |   |   |
| Commitments and contingencies (Note 9)                                                                                                                                                                                                        |       |                                                                                               |       |                                          |       |   |   |   |   |
| Stockholders’ equity:                                                                                                                                                                                                                    |       |                                                                                               |       |                                          |       |   |   |   |   |
| Preferred stock—$0.0001  par value, 5,000,000 shares authorized at December 31, 2004 and  June 30, 2005; no shares outstanding at December 31, 2004 and  June 30, 2005                                               |       |                                                                                               | —     |                                          |       |   | — |   |   |
| Common stock—$0.0001 par  value, 70,000,000 shares authorized at December 31, 2004 and  June 30, 2005; 17,067,573 and 17,370,368 shares issued and outstanding  at December 31, 2004 and June 30, 2005, respectively |       |                                                                                               | 2          |                                          |       |   | 2 |   |   |
| Additional paid-in  capital                                                                                                                                                                                                                   |       |                                                                                               | 121,431    |                                          |       |   | 122,432 |   |   |
| Retained earnings                                                                                                                                                                                                                             |       |                                                                                               | 13,333     |                                          |       |   | 18,705 |   |   |
| Total stockholders’  equity                                                                                                                                                                                                              |       |                                                                                               | 134,766    |                                          |       |   | 141,139 |   |   |
| Total liabilities and stockholders’ equity                                                                                                                                                                                               |       |                                                                                               | $          | 144,689                                       |       |   |   | $ | 158,927 |   |   |

 

See accompanying notes to condensed consolidated financial statements.

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**DTS, Inc.Condensed ConsolidatedStatements of Operations**
| ** **                                                            | ** ** | **For the Three Months Ended  June 30,**                                  | ** ** | **For the Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                                            | ** ** | **2004**                                                                                           | ** ** | **2005**                                                        | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                                            | ** ** | **(Unaudited)**                                                                                    | ** ** |
| ** **                                                            | ** ** | **(Amounts in thousands, except  share and per share amounts)** | ** ** |
| Revenues:                                                             |       |                                                                                               |       |                                                            |       |   |   |   |   |
| Technology and film licensing                                         |       | $                                                                                                  | 10,720     |                                                            | $          | 12,835 |   | $ | 23,217 |   | $ | 31,299 |   |
| Product sales and other revenues                                      |       | 2,532                                                                                              |       | 4,893                                                           |       | 5,632 |   | 8,486 |   |
| Total revenues                                                        |       | 13,252                                                                                             |       | 17,728                                                          |       | 28,849 |   | 39,785 |   |
| Cost of goods sold:                                                   |       |                                                                                               |       |                                                            |       |   |   |   |   |
| Technology and film licensing                                         |       | 1,166                                                                                              |       | 1,035                                                           |       | 2,146 |   | 2,317 |   |
| Product sales and other revenues                                      |       | 1,755                                                                                              |       | 3,995                                                           |       | 3,667 |   | 7,176 |   |
| Total cost of goods sold                                              |       | 2,921                                                                                              |       | 5,030                                                           |       | 5,813 |   | 9,493 |   |
| Gross profit                                                          |       | 10,331                                                                                             |       | 12,698                                                          |       | 23,036 |   | 30,292 |   |
| Operating expenses:                                                   |       |                                                                                               |       |                                                            |       |   |   |   |   |
| Selling, general and administrative                                   |       | 6,798                                                                                              |       | 8,080                                                           |       | 13,238 |   | 16,124 |   |
| Research and development                                              |       | 1,568                                                                                              |       | 2,532                                                           |       | 2,900 |   | 4,626 |   |
| In-process research and development                                   |       | —                                                                                             |       | —                                                          |       | — |   | 2,300 |   |
| Total operating expenses                                              |       | 8,366                                                                                              |       | 10,612                                                          |       | 16,138 |   | 23,050 |   |
| Income from operations                                                |       | 1,965                                                                                              |       | 2,086                                                           |       | 6,898 |   | 7,242 |   |
| Interest income,  net                                                 |       | 310                                                                                                |       | 835                                                             |       | 749 |   | 1,189 |   |
| Other expense,  net                                                   |       | (17                                                                                                | )          | (11                                                             | )          | (31 | ) | (23 | ) |
| Income from legal  settlement                                         |       | 2,601                                                                                              |       | —                                                          |       | 2,601 |   | — |   |
| Income before provision for income taxes                              |       | 4,859                                                                                              |       | 2,910                                                           |       | 10,217 |   | 8,408 |   |
| Provision for  income taxes                                           |       | 1,740                                                                                              |       | 1,094                                                           |       | 3,658 |   | 3,036 |   |
| Net income                                                            |       | 3,119                                                                                              |       | 1,816                                                           |       | 6,559 |   | 5,372 |   |
| Net income per  common share:                                         |       |                                                                                               |       |                                                            |       |   |   |   |   |
| Basic                                                                 |       | $                                                                                                  | 0.19       |                                                            | $          | 0.10 |   | $ | 0.39 |   | $ | 0.31 |   |
| Diluted                                                               |       | $                                                                                                  | 0.17       |                                                            | $          | 0.10 |   | $ | 0.36 |   | $ | 0.30 |   |
| Weighted average  shares used to compute net income per common share: |       |                                                                                               |       |                                                            |       |   |   |   |   |
| Basic                                                                 |       | 16,830,764                                                                                         |       | 17,331,602                                                      |       | 16,704,490 |   | 17,206,415 |   |
| Diluted                                                               |       | 18,268,283                                                                                         |       | 18,264,458                                                      |       | 18,134,231 |   | 18,180,973 |   |

 

See accompanying notes to condensed consolidated financial statements.

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**DTS, Inc.**

**CondensedConsolidated Statements of Cash Flows**
| ** **                                                                           | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                                                           | ** ** | **2004**                                                        | ** ** | **2005** | ** ** |
| ** **                                                                           | ** ** | **(Unaudited)**                                                 | ** ** |
| ** **                                                                           | ** ** | **(Amounts in thousands)**                            | ** ** |
| Cash flows from  operating activities:                                               |       |                                                            |       |   |   |
| Net income                                                                           |       | $                                                               | 6,559      |   | $ | 5,372 |   |
| Adjustments to reconcile  net income to net cash provided by operating   activities: |       |                                                            |       |   |   |
| Depreciation and amortization                                                        |       | 548                                                             |       | 1,679 |   |
| Stock-based compensation charges                                                     |       | 218                                                             |       | 59 |   |
| Allowance for doubtful accounts                                                      |       | 45                                                              |       | 5 |   |
| Deferred income taxes                                                                |       | (2,027                                                          | )          | (202 | ) |
| Tax benefit from employee stock plans                                                |       | 3,381                                                           |       | 400 |   |
| In-process research and development                                                  |       | —                                                          |       | 2,300 |   |
| Changes in  operating assets and liabilities:                                        |       |                                                            |       |   |   |
| Accounts receivable                                                                  |       | (3,212                                                          | )          | (5,841 | ) |
| Inventories                                                                          |       | (1,155                                                          | )          | (118 | ) |
| Prepaid expenses and other assets                                                    |       | (234                                                            | )          | (225 | ) |
| Accounts payable and accrued expenses                                                |       | (65                                                             | )          | (702 | ) |
| Deferred revenue                                                                     |       | —                                                          |       | 1,196 |   |
| Income taxes                                                                         |       | 719                                                             |       | 79 |   |
| Net cash provided by operating activities                                            |       | 4,777                                                           |       | 4,002 |   |
| Cash flows from  investing activities:                                               |       |                                                            |       |   |   |
| Sales (purchases) of investments, net                                                |       | (28,533                                                         | )          | 29,248 |   |
| Cash paid for acquisitions                                                           |       | —                                                          |       | (11,000 | ) |
| Purchase of property and equipment                                                   |       | (805                                                            | )          | (2,773 | ) |
| Payment for patents and trademarks in process                                        |       | (40                                                             | )          | (129 | ) |
| Net cash provided by (used in) investing activities                                  |       | (29,378                                                         | )          | 15,346 |   |
| Cash flows from  financing activities:                                               |       |                                                            |       |   |   |
| Follow-on public offering costs                                                      |       | (10                                                             | )          | — |   |
| Proceeds from the issuance of common stock upon  exercise of employee stock options  |       | 402                                                             |       | 112 |   |
| Proceeds from the issuance of common stock under  employee stock purchase plan  |       | 473                                                             |       | 430 |   |
| Net cash provided by financing activities                                            |       | 865                                                             |       | 542 |   |
| Net increase (decrease) in cash and cash equivalents                                 |       | (23,736                                                         | )          | 19,890 |   |
| Cash and cash  equivalents, beginning of period                                      |       | 39,243                                                          |       | 21,271 |   |
| Cash and cash  equivalents, end of period                                            |       | $                                                               | 15,507     |   | $ | 41,161 |   |

 

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 of Presentation**

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 June 30, 2005, and the results of operations and cashflows for the periods presented, consisting only of normal and recurringadjustments. All significant intercompany transactions have been eliminated inconsolidation. Operating results for the three and six months ended June 30,2005 are not necessarily indicative of the results that may be expected for thefiscal year ending December 31, 2005. For further information, refer tothe consolidated financial statements and footnotes thereto for the year ended December 31,2004 filed on Form 10-K filed on March 16, 2005.

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities, and disclosures ofcontingent assets and liabilities at the date of the financial statements, andthe reported amounts of revenues and expenses during the reporting period.Actual results could differ from those estimates.

**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 rate bondstied to short-term interest rates with maturities on the face of the underlyingsecurity in excess of 90 days. Auction rate securities have interest rateresets 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 depending on the mode of the security.

Although these securitiesare issued and rated as long-term bonds, they are priced and traded asshort-term instruments because of the liquidity provided through the interestrate reset. The Company had historically classified these instruments as cashequivalents if the period between interest rate resets was 90 days or less,which was based on our ability to either liquidate our holdings or roll ourinvestment over to the next reset period. The Company’s re-evaluation of thematurity dates and other provisions associated with the underlying bondsresulted in a reclassification from cash and equivalents to short-termmarketable securities of approximately $56,662 on the June 30, 2004balance sheet. As a result of this balance sheet reclassification, certainamounts were reclassified in the accompanying consolidated statement of cashflows for the six months ended June 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 or thepreviously reported consolidated statements of operations. For the six monthsended June 30, 2004, before these revisions in classification, net cashused 

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ininvesting activities related to these current investments of $56,662 wereincluded in cash and cash equivalents in the consolidated statement of cashflows.

**Note 2—Summaryof Significant Accounting Policies**

**Revenue Recognition**

In January 2005, theCompany acquired Lowry Digital Images, Inc. (“LDI”). The Companyrecognizes revenue when titles subject to a customer order or contract aredelivered and accepted by the customer and no significant obligations remainafter customer acceptance. In certain instances the Company bills in advance ofservices. Prices are established in advance of the work performed and aregenerally fixed in nature. Revenue related to time and materials contracts isrecognized as services are rendered at contract labor rates plus material andother direct costs incurred. If losses are anticipated on a contract, suchlosses are recognized immediately.

**Acquired In-ProcessResearch and Development**

The value assigned toacquired in-process research and development (“IPR&D”) is determined byidentifying acquired specific in-process research and development projects thatwould be continued and for which (1) technological feasibility has notbeen established at the acquisition date, (2) there is no alternativefuture use, and (3) the fair value is estimable with reasonablereliability, upon consummation of a business combination.

**Stock-BasedCompensation**

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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To date,options have been granted at exercise prices that equal or exceed the marketvalue of the underlying common stock on the grant date. The following tableillustrates 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 June 30,**    | ** ** | **For the Six Months  Ended June 30,**      | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                                                                                | ** ** | **     2004     ** | ** ** | **     2005     ** | ** ** | **      2004      ** | ** ** | **      2005      ** | ** ** |
| ** **                                                                                                                | ** ** | **(Unaudited)**                                                      | ** ** |
| Net income:                                                                                                               |       |                                                                 |       |                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| As reported                                                                                                               |       |                                                                 | $          | 3,119                                                                |       |   |   | $ | 1,816 |   |   |   | $ | 6,559 |   |   |   | $ | 5,372 |   |   |
| Additional stock-based  compensation expense determined under the fair value method, net of tax                      |       |                                                                 | (722       | )                                                                    |       |   | (538 | ) |   |   | (1,171 | ) |   |   | (1,027 | ) |   |
| Pro forma                                                                                                                 |       |                                                                 | $          | 2,397                                                                |       |   |   | 1,278 |   |   |   | $ | 5,388 |   |   |   | $ | 4,345 |   |   |
| Net income per common  share basic:                                                                                       |       |                                                                 |       |                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| As reported                                                                                                               |       |                                                                 | $          | 0.19                                                                 |       |   |   | $ | 0.10 |   |   |   | $ | 0.39 |   |   |   | $ | 0.31 |   |   |
| Per share effect of  additional stock-based compensation expense determined under the fair value  method, net of tax      |       |                                                                 | (0.04      | )                                                                    |       |   | (0.03 | ) |   |   | (0.07 | ) |   |   | (0.06 | ) |   |
| Pro forma                                                                                                                 |       |                                                                 | $          | 0.15                                                                 |       |   |   | $ | 0.07 |   |   |   | $ | 0.32 |   |   |   | $ | 0.25 |   |   |
| Net income per common  share—diluted:                                                                                |       |                                                                 |       |                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| As reported                                                                                                               |       |                                                                 | $          | 0.17                                                                 |       |   |   | $ | 0.10 |   |   |   | $ | 0.36 |   |   |   | $ | 0.30 |   |   |
| Per share effect of  additional stock-based compensation expense determined under the fair  value method, net of tax |       |                                                                 | (0.04      | )                                                                    |       |   | (0.03 | ) |   |   | (0.07 | ) |   |   | (0.06 | ) |   |
| Pro forma                                                                                                                 |       |                                                                 | $          | 0.13                                                                 |       |   |   | $ | 0.07 |   |   |   | $ | 0.29 |   |   |   | $ | 0.24 |   |   |

 

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 “Accounting forEquity Instruments That Are Issued to Other Than Employees for Acquiring, or inConjunction with Selling, Goods and Services.” Under SFAS No. 123 and EITFIssue No. 96-18, stock option awards issued to non-employees are accountedfor at fair value using the Black-Scholes option pricing model. Managementbelieves that the fair value of the stock options is more reliably measuredthan the fair value of the services received. The fair value of eachnon-employee equity award is remeasured each period until a commitment date isreached, which is generally the vesting date. For non-employee equity awards,deferred stock-based compensation is not reflected in stockholders’ deficituntil a commitment date is reached. For the three and six months ended June 30,2005, the Company recorded stock-based compensation expense of $54 and $59,respectively, related to non-employee equity awards. For the three and sixmonths ended June 30, 2004, the Company recorded stock-based compensationexpense of $79 and $218, 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 fair value ofsuch 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 continue the vesting method they have beenusing until adoption of FAS 123R, then apply the accelerated 

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non-substantive vesting approach to all subsequentgrants to those employees whose options continue to vest after the date ofretirement eligibility. Had the Company been accounting for such stock optionsusing the non-substantive vesting approach for retirement-eligibleemployees, the Company would have recognized additional stock-basedcompensation expense resulting in the following adjusted proforma dilutedearnings per share.
| ** **                                                                                    | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                                                                    | ** ** | **    2004    **          | ** ** | **    2005    **        | ** ** | **    2004    ** | ** ** | **    2005    ** | ** ** |
| ** **                                                                                    | ** ** | **(unaudited)**                                                   | ** ** |
| Diluted pro forma  earnings per share (from above table)                                      |       |                                                              | $          | 0.13                                                            |       |   |   | $ | 0.07 |   |   |   | $ | 0.29 |   |   |   | $ | 0.24 |   |   |
| Impact of  retirement-eligible                                                                |       |                                                              | —     |                                                            |       |   | (0.01 | ) |   |   | (0.01 | ) |   |   | (0.01 | ) |   |
| Diluted pro forma  earnings per share (adjusted to reflect non-substantive vesting  approach) |       |                                                              | $          | 0.13                                                            |       |   |   | $ | 0.06 |   |   |   | $ | 0.28 |   |   |   | $ | 0.23 |   |   |

 

**Note 3—RecentAccounting Pronouncements**

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

In December 2004, theFASB issued SFAS No. 123R, “Share-Based Payment” (“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. The Company currentlyuses the Black-Scholes option pricing model to value options, and is currentlyassessing which 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 that compensationexpense be recorded for all unvested stock options and restricted stock at thebeginning of 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.The Company plans to adopt SFAS 123R beginning in the first quarter offiscal 2006. If we had adopted SFAS 123R as of June 30, 2005, the effects ofthe adoption of SFAS 123R on the Company’s financial results for the next fiveyears, based on stock-based awards granted as of June 30, 2005, would beas follows:

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| ** **                                                                           | ** ** | **Expenses by Fiscal Year** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                           | ** ** | **Remaining  Six Months**             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                           | ** ** | **2005**                                   | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** |
| ** **                                                                           | ** ** | **(unaudited)**                            | ** ** |
| ** **                                                                           | ** ** | **(in thousands)**                    | ** ** |
| Additional stock-based  compensation expense under SFAS 123R before tax benefit |       |                                       | $          | 2,151 |   |   | $ | 2,464 |   | $ | 1,149 |   | $ | 393 |   | $ | 57 |   |
|                                                                                      |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

SFAS 123R also affects the presentation of tax benefitsfor option exercises in the statement of cash flows. Prior to adoption SFAS123R, the benefit is classified in cash provided by operating activities. Uponadoption, 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 was issuedto assist registrants by simplifying some of the implementation challenges ofSFAS 123R while enhancing the information that investors receive. SAB 107provides guidance regarding valuation models, expected volatility and expectedterm. The Company will apply the guidance of SAB 107 in conjunction with itsadoption of SFAS 123R.

In June 2005, the FASB issued Statement No. 154, “AccountingChanges and Error Corrections, a replacement of APB Opinion No. 20,Accounting Changes, and Statement No. 3, Reporting Accounting Changes inInterim Financial Statements” (“SFAS 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 StaffPosition (“FSP”) 143-1, “Accounting for Electronic Equipment Waste Obligations”was issued. FSP 143-1 addresses 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 transformationinto the respective national laws. Under the Directive, the waste managementobligation remains with the commercial user until the historical wasteequipment (put on the market before August 13, 2005) is replaced. At that timethe waste management obligation for the equipment may be transferred to theproducer of the replacement equipment depending on the transformation of theDirective into national law by the EU-member country. If the commercial userdoes not replace the equipment, the obligation remains with that user until theequipment is disposed. FSP 143-1 requires the commercial user toapply the provisions of SFAS 143, “Accounting for Asset Retirement Obligations”to the obligation 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 Company is currently evaluating theeffect of FSP 143-1 on its consolidated financial statements.

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**Note 4—Certain Balance Sheet Items**

Inventoriesconsist of the following:
| ** **        | ** ** | **As of  December 31,  2004** | ** ** | **As of  June 30,  2005** | ** ** |
|-------------------|------------|-----------------------------------------|------------|-------------------------------------|------------|
| ** **        | ** ** | ** **                              | ** ** | **(Unaudited)**                     | ** ** |
| Raw materials     |       |                                    | $          | 1,313                               |       |   |   | $ | 1,297 |   |   |
| Finished goods    |       |                                    | 2,356      |                                |       |   | 2,490 |   |   |
| Total inventories |       |                                    | $          | 3,669                               |       |   |   | $ | 3,787 |   |   |

 

Propertyand equipment consist of the following:
| ** **                     | ** ** | **As of   December 31,  2004** | ** ** | **As of  June 30,  2005** | ** ** |
|--------------------------------|------------|-----------------------------------------------|------------|-------------------------------------|------------|
| ** **                     | ** ** | ** **                                    | ** ** | **(Unaudited)**                     | ** ** |
| Machinery and  equipment       |       |                                          | $          | 3,036                               |       |   |   | $ | 5,972 |   |   |
| Office furniture  and fixtures |       |                                          | 2,693      |                                |       |   | 3,047 |   |   |
| Leasehold  improvements        |       |                                          | 2,926      |                                |       |   | 3,568 |   |   |
|                           |       |                                          | 8,655      |                                |       |   | 12,587 |   |   |
| Less: Accumulated depreciation |       |                                          | (5,116     | )                                   |       |   | (6,091 | ) |   |
| Property and  equipment, net   |       |                                          | $          | 3,539                               |       |   |   | $ | 6,496 |   |   |

 

**Note 5—Business Combinations**

In January 2005, the Company completed theacquisition of LDI for $9,642 in cash. In late 2004, the Company loaned LDI a totalof $1,250 to enable LDI to satisfy certain liabilities. Neither LDI nor itsstockholders were required to repay this loan prior to, or in connection with,the acquisition. The cash portion of the acquisition was funded by workingcapital. Subsequent to the acquisition, we changed the name of the business toDTS Digital Images, Inc. (“DDI”).

The Merger Agreement also requires, 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 capitalexpenditures and, if and to the extent LDI meets specified gross profitmilestones, to invest up to an additional $1,500 through the end of 2006. As ofJune 30, 2005, the Company has invested $1,135 of the $3,500 described 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 of Operationsfrom January 3, 2005. The final purchase price is dependent on the actualdirect acquisition costs and shares issued, if any, as further discussed below.Under the purchase method of accounting, the total estimated purchase price isallocated to LDI’s net tangible and intangible assets based on their estimatedfair value as of the date of completion 

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                                                         |   | 1,441  |   |
| Amortizable intangible  assets:                                              |   |   |   |
| Existing technology                                                          |   | 10,200 |   |
| Non-compete                                                                  |   | 400    |   |
| Backlog                                                                      |   | 100    |   |
| Tradename                                                                    |   | 200    |   |
| IPR&D                                                                    |   | 2,300  |   |
| Goodwill                                                                     |   | 3,853  |   |
| Total assets acquired                                                        |   | 19,880 |   |
| Liabilities  assumed:                                                        |   |   |   |
| Accounts payable                                                             |   | (942   | )      |
| Accrued  liabilities                                                         |   | (952   | )      |
| Notes payable                                                                |   | (368   | )      |
| Deferred revenues                                                            |   | (928   | )      |
| Total liabilities  assumed                                                   |   | (3,190 | )      |
| Net deferred tax liability for acquired intangibles  and purchase accounting |   | (4,441 | )      |
| Total purchase  price                                                        |   | $      | 12,249 |   |

 

A preliminary estimate of $10.9 million has beenallocated to amortizable intangible assets consisting of existing technology,non-compete, backlog, and tradenames.

A preliminary estimate of $3.9 million has beenallocated to goodwill. Goodwill represents the excess of the purchase priceover the fair market value of the net tangible and amortizable intangibleassets acquired. Goodwill will not be amortized and will be tested forimpairment at least annually. The preliminary purchase price allocation for LDIis subject to revision as more detailed analysis is completed and additionalinformation on the fair values of LDI’s assets and liabilities becomeavailable. The Company expects to complete the evaluation in the fourth quarter2005.

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

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 

12

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resources needed to completethem, if applicable, and their expected income generating ability andassociated risks. Where development projects had reached technologicalfeasibility, they were classified as developed technology and the valueassigned to developed technology was capitalized. The income approach, whichincludes an analysis of the cash flows and risks associated with achieving suchcash flows, was the primary technique utilized in valuing acquired 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. In the event that the targets are met in full, an aggregate of up to857,213 shares of DTS common stock will be issued. The value of these shareswill be accounted for as an addition to goodwill.

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 six months ended June 30,2004. If the Company had acquired LDI at the beginning of fiscal year 2004, theCompany’s unaudited pro forma net revenues, net income and net income per sharefor the three and six months ended June 30, 2004 would have been as follows:
| ** **                         | ** ** | **Three Months**       | ** ** | **Six Months**         | ** ** |
|------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                         | ** ** | **Ended**                   | ** ** | **Ended**                   | ** ** |
| ** **                         | ** ** | **June 30, 2004** | ** ** | **June 30, 2004** | ** ** |
| Revenue                            |       |                        | $          | 14,275                      |       |   |   | $ | 30,489 |   |   |
| Net income                         |       |                        | $          | 2,691                       |       |   |   | $ | 5,628 |   |   |
| Net income per share—Basic    |       |                        | $          | 0.16                        |       |   |   | $ | 0.34 |   |   |
| Net income per  share—Diluted |       |                        | $          | 0.15                        |       |   |   | $ | 0.31 |   |   |

 

**Note 6—Goodwill and Intangibles**

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 six monthperiod ended June 30, 2005, we added $3,853 to goodwill in connection withour acquisition of LDI, which is included in the Digital Images businesssegment. The Company did not have goodwill prior to the acquisition of LDI.

Includedin cost of sales are $244 and $488 of amortization relating to existingtechnologies and backlog for the three and six months ended June 30, 2005,respectively. Included in operating expenses are $129 and $258 of amortizationrelating to non-compete and tradename for the three and six months ended June 30,2005, respectively. The following table summarizes the weighted average livesand the carrying values of our acquired intangible assets by category:
| ** **           | ** ** | ** **                               | ** ** | **As of June 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     |   |   | $ | (642 | ) |   | $ | 10,985 |   | $ | 1,427 |   |   | $ | (89 | ) |   |   | $ | 1,338 |   |   |
| Non-compete          |       |                                     | 3          |                                        |       | 400                                             |       |   | (67 | ) |   | 333 |   | — |   |   | — |   |   |   | — |   |   |
| Backlog              |       |                                     | 2          |                                        |       | 100                                             |       |   | (25 | ) |   | 75 |   | — |   |   | — |   |   |   | — |   |   |
| Tradename            |       |                                     | 1          |                                        |       | 200                                             |       |   | (100 | ) |   | 100 |   | — |   |   | — |   |   |   | — |   |   |
| Total                |       |                                     |       |                                        |       | $                                               | 12,327     |   |   | $ | (834 | ) |   | $ | 11,493 |   | $ | 1,427 |   |   | $ | (89 | ) |   |   | $ | 1,338 |   |   |

 

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As of June 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 |       |                                 | $          | 744 |   |   |
| 2006                                                 |       |                                 | 1,289      |   |   |
| 2007                                                 |       |                                 | 1,239      |   |   |
| 2008                                                 |       |                                 | 1,106      |   |   |
| 2009                                                 |       |                                 | 1,106      |   |   |
| Thereafter                                           |       |                                 | 6,009      |   |   |
| Total                                                |       |                                 | $          | 11,493 |   |   |

 

**Note 7—Bank Line of Credit**

We have in place a $10,000 facility that expires onJune 30, 2006. The bank agreement provides for working capital financing and isunsecured. The bank agreement requires the Company to comply with certain covenantsincluding a tangible effective net worth of $60,000, increasing by 50% of netincome on an annual basis. The covenants also require the Company to keep$2,000 in cash or securities at the bank. At June 30, 2005, the Company was compliantwith all covenants under the bank agreement.

At June 30, 2005,there were no balances outstanding under this agreement and there was $10,000of available borrowings under this credit facility. Future borrowings will bearinterest based on either of the two options the Company selects at the time ofadvances 1) a rate equal to 2% above the Bank’s LIBOR, or 2) a rateequal to the Base Rate as quoted from the bank less one-half percent. An annualcommitment fee of $10 will be paid in July 2005 for this line of credit.

**Note 8—Income Taxes**

For the three and six months ended June 30, 2005,the Company recorded an income tax provision of $1,094 and $3,036,respectively, on pre-tax income of $2,910 and $8,408, respectively. Thisresulted in an annualized effective tax rate of 36.1%. For the three and sixmonths ended June 30, 2004, the Company recorded an income tax provisionof $1,740 and $3,658, respectively, on pre-tax income of $4,859 and $10,217,respectively. This resulted in an annualized effective tax rate of 35.8%. Theserates differed from the statutory rates primarily due to state income taxesoffset by benefits associated with the foreign rate differentials and researchand development credits.

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**Note 9—Commitmentsand Contingencies**

**Indemnities,Commitments and Guarantees**

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

In March 2005, in connection with the U.S.Internal Revenue Service’s (“IRS”) regular examination of the Company’s taxreturn for the year ended December 31, 2002, the IRS proposed adjustmentsrelated to certain items included in the Company’s return. In March 2005,the Company settled with the IRS and agreed to pay approximately $704. Thisamount was paid in April 2005 and did not have a material impact on ourresults of operations for the three or six months ended June 30, 2005.

In connection with theCompany’s enforcement activities relating to its intellectual property rightsand to stop unauthorized use of its technology and trademarks, the Company hassettled its dispute with Sunplus Technology Co., Ltd. (“Sunplus”).

**Note 10—OperatingSegment and Geographic Information**

The Company operates its business in three reportable segments:the Cinema business segment, previously referred to as the Theatrical business,the Consumer business segment and the Digital Images business segment. TheCinema business segment provides digital playback systems and cinema processorequipment to movie theaters, and provides film licensing services to filmproduction and distribution companies. The Company’s Consumer business segmentlicenses audio technology, trademarks and know-how to consumerelectronics, personal computer, broadcast and professional audio companies, andsells multi-channel audio content and products to consumers. The Company’sDigital Images business provides processing, enhancement and restorationservices for cinema, home video and broadcast television content.

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

TheCompany’s reportable segments and geographical information for the three andsix months ended June 30, 2004 and 2005 are as follows:
| ** **              | ** ** | **Revenues**                                                      | ** ** |
|-------------------------|------------|-------------------------------------------------------------------|------------|
| ** **              | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
| ** **              | ** ** | **2004**                                                          | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **              | ** ** | **(Unaudited)**                                                   | ** ** |
| Cinema business         |       | $                                                                 | 4,503      |   | $ | 5,138 |   | $ | 9,303 |   | $ | 9,934 |   |
| Consumer business       |       | 8,749                                                             |       | 10,974 |   | 19,546 |   | 27,515 |   |
| Digital Images business |       | —                                                            |       | 1,616 |   | — |   | 2,336 |   |
| Total revenues          |       | $                                                                 | 13,252     |   | $ | 17,728 |   | $ | 28,849 |   | $ | 39,785 |   |

                                                                                                

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| ** **               | ** ** | **Gross Profit**                                             | ** ** |
|--------------------------|------------|-------------------------------------------------------------------|------------|
| ** **               | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
| ** **               | ** ** | **2004**                                                          | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **               | ** ** | **(Unaudited)**                                                   | ** ** |
| Cinema business          |       | $                                                                 | 1,850      |   | $ | 2,235 |   | $ | 4,312 |   | $ | 4,408 |   |
| Consumer business        |       | 8,481                                                             |       | 10,484 |   | 18,724 |   | 26,485 |   |
| Digital Images  business |       | —                                                            |       | (21 | ) | — |   | (601 | ) |
| Total gross  profit      |       | $                                                                 | 10,331     |   | $ | 12,698 |   | $ | 23,036 |   | $ | 30,292 |   |

 
| ** **                    | ** ** | **Income (Loss) From Operations**                  | ** ** |
|-------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                    | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
| ** **                    | ** ** | **2004**                                                          | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                    | ** ** | **(Unaudited)**                                                   | ** ** |
| Cinema business               |       | $                                                                 | (1,729     | ) | $ | (1,604 | ) | $ | (2,806 | ) | $ | (2,623 | ) |
| Consumer business             |       | 3,694                                                             |       | 4,534 |   | 9,704 |   | 14,647 |   |
| Digital Images  business      |       | —                                                            |       | (844 | ) | — |   | (4,782 | ) |
| Total income from  operations |       | $                                                                 | 1,965      |   | $ | 2,086 |   | $ | 6,898 |   | $ | 7,242 |   |

 

Includedin the Digital Images business segment’s loss for the six months ended June 30,2005 is the $2,300 charge related to in-process research and development.
| ** **     | ** ** | **Revenues by Geographic Region**                  | ** ** |
|----------------|------------|-------------------------------------------------------------------|------------|
| ** **     | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
| ** **     | ** ** | **2004**                                                          | ** ** | **2005** | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **     | ** ** | **(Unaudited)**                                                   | ** ** | **(Unaudited)** | ** ** |
| United States  |       | $                                                                 | 4,401      |   | $ | 5,664 |   | $ | 8,590 |   | $ | 15,043 |   |
| International  |       | 8,851                                                             |       | 12,064 |   | 20,259 |   | 24,742 |   |
| Total revenues |       | $                                                                 | 13,252     |   | $ | 17,728 |   | $ | 28,849 |   | $ | 39,785 |   |

 

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

The following table sets forth, for the periodsindicated, long-lived tangible assets by geographic area in which the Companyholds assets at December 31, 2004 and June 30, 2005:
| ** **               | ** ** | **Long-Lived Assets**              | ** ** |
|--------------------------|------------|-----------------------------------------|------------|
| ** **               | ** ** | **As of  December 31,  2004** | ** ** | **As of  June 30,  2005** | ** ** |
| ** **               | ** ** | ** **                              | ** ** | **(Unaudited)** | ** ** |
| United States            |       |                                    | $          | 2,657 |   |   |   | $ | 5,079 |   |   |
| International            |       |                                    | 882        |   |   |   | 1,417 |   |   |
| Total long-lived  assets |       |                                    | $          | 3,539 |   |   |   | $ | 6,496 |   |   |

 

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

Thefollowing table sets forth the computation of basic and diluted net incomeattributable to common stockholders per common share:
| ** **                                 | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|--------------------------------------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                 | ** ** | **2004**                                                          | ** ** | **2005**                                                        | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                 | ** ** | **(Unaudited)**                                                   | ** ** |
| Basic net income per  common share:        |       |                                                              |       |                                                            |       |   |   |   |   |
| Numerator:                                 |       |                                                              |       |                                                            |       |   |   |   |   |
| Net income                                 |       | $                                                                 | 3,119      |                                                            | $          | 1,816 |   | $ | 6,559 |   | $ | 5,372 |   |
| Denominator:                               |       |                                                              |       |                                                            |       |   |   |   |   |
| Weighted average common shares outstanding |       | 16,830,764                                                        |       | 17,331,602                                                      |       | 16,704,490 |   | 17,206,415 |   |
| Basic net income per common share          |       | $                                                                 | 0.19       |                                                            | $          | 0.10 |   | $ | 0.39 |   | $ | 0.31 |   |
| Diluted net  income per common share:      |       |                                                              |       |                                                            |       |   |   |   |   |
| Numerator:                                 |       |                                                              |       |                                                            |       |   |   |   |   |
| Net income                                 |       | $                                                                 | 3,119      |                                                            | $          | 1,816 |   | $ | 6,559 |   | $ | 5,372 |   |
| Denominator:                               |       |                                                              |       |                                                            |       |   |   |   |   |
| Weighted average shares outstanding        |       | 16,830,764                                                        |       | 17,331,602                                                      |       | 16,704,490 |   | 17,206,415 |   |
| Effect of  dilutive securities:            |       |                                                              |       |                                                            |       |   |   |   |   |
| Common stock options                       |       | 1,109,896                                                         |       | 912,479                                                         |       | 1,104,810 |   | 953,047 |   |
| Common stock warrants                      |       | 327,623                                                           |       | 20,377                                                          |       | 324,931 |   | 21,511 |   |
| Diluted shares outstanding                 |       | 18,268,283                                                        |       | 18,264,458                                                      |       | 18,134,231 |   | 18,180,973 |   |
| Diluted net  income per common share       |       | $                                                                 | 0.17       |                                                            | $          | 0.10 |   | $ | 0.36 |   | $ | 0.30 |   |

 

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 six months ended June 30, 2005, therewere 773,250 anti-dilutive common stock equivalents, with a weighted averageexercise prices of $22.54. For the three and six months ended June 30,2004, there were 133,750 anti-dilutive common stock equivalents, with aweighted average exercise prices of $26.34. These options could be dilutive inthe future if the average share price increases and is equal to or greater thanthe exercise price of these 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-Q and the documents incorporatedherein by reference contain forward-looking statements based on our currentbeliefs, expectations, estimates and projections about our industry, andcertain assumptions made by us. Words such as “believes,” “anticipates,” “estimates,”“expects,” “projections,” “may,” “potential,” “plan,” “continue” and words ofsimilar import, constitute “forward-looking statements.” Theforward-looking statements contained in this report involve known and unknownrisks, uncertainties and other factors that may cause our actual results to bematerially different from those expressed or implied by these statements. Thesefactors include those listed under the “Risk Factors” section contained belowand elsewhere in this Form 10-Q, and the other documents we file with theSecurities and Exchange Commission, or SEC, including our most recent reportson Form 8-K and Form 10-K. We cannot guarantee future results, levelsof activity, performance, or achievements. We do not undertake any obligationto revise these forward-looking statements to reflect future events orcircumstances.

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

**Overview**

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

We manage our business through three reportablesegments—our consumer business, our cinema business, which we previouslydescribed as our theatrical business, and our digital images business. Prior to2001, we derived a majority of our revenues from the cinema business. Beginningin 2001, however, we have derived a majority of our revenues from our consumerbusiness.

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

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

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In our recently acquired digital images business, wederive revenues from the processing, enhancement and restoration of cinema,home video and broadcast television content. We provide these services tomotion picture and television studios and other content owners. We offer ourservices on either a fixed fee or time and materials basis.

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

We actively engage in intellectual property complianceand enforcement activities focused on identifying third parties who have eitherincorporated our technology, trademarks, or know-how without a license or whohave under-reported to us the amount of royalties owed under license agreementswith us. We continue to invest in our compliance and enforcement infrastructureto support the value of our intellectual property to us and our licensees andto improve the long-term realization of our intellectual property. As a resultof these activities, from time to time, we recognize royalty revenues thatrelate to consumer electronics manufacturing activities from prior periods.These royalty recoveries may cause revenues to be higher than expected during aparticular reporting period and may not occur in subsequent periods. While weconsider such revenues to be a regular part our normal operations, we cannotpredict the amount or timing of such revenues.

Our cost of goods sold consists primarily of amountspaid for products and materials, salaries and related benefits for productionpersonnel, depreciation of production equipment, 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 and development costs consist primarilyof salaries and related benefits for research and development personnel,engineering consulting expenses associated with new product and technologydevelopment, and quality assurance and testing costs. Research and developmentcosts are expensed as incurred.

In our consumer business, we have a licensing teamthat markets our technology directly to large consumer electronics productsmanufacturers and semiconductor manufacturers. This team includes 

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employees located in theUnited States, China, England, Japan, Hong Kong and Northern Ireland. We sellmusic content released under our DTS Entertainment label through exclusivedistribution arrangements in the United States, Europe and Japan. We employconsultants to coordinate sales to independent retailers and we sell this musicdirectly to consumers through an online store and other web-based retailers.

In our cinema business, our post-productiondepartment, senior management, and liaison offices market our products andservices directly to individual film producers and distributors worldwide. Wesell our digital multi-channel playback systems to movie theaters through adirect sales force and a network of independent dealers. To date, most of oursales and marketing efforts have been focused in the United States and Canada,Western Europe, and in targeted markets in Asia and Latin America. We have alsoexpanded our efforts to pursue theater companies that have a largeconcentration of movie theaters in selected foreign countries such as India andChina, 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 consumer segment constitutes themajority of our total revenue, representing 62% and 66% of total revenues forthe quarters ended June 30, 2005 and 2004, respectively. Our consumerrevenue is primarily dependent upon the home theater and DVD player markets,which have experienced rapid growth over the past several years. However, wehave recently experienced softness in our DVD player trademark licensingprogram, and expect growth rates in this area to decline from recent levels.The success of DVD-Video-based systems and products has fueled a demand forhigher quality entertainment in the home, and this demand is extending to thecar and PC markets as well. We expect the recent acceleration of the market forhigh definition televisions to drive demand for high definition optical discplayers beginning in 2006. Because we expect to be a mandatory technology forthe next generation players, our consumer revenue growth should more closelytrack the growth rate of these players over the next several years. We expectthat the market for high definition players will yield new growth that providesan offset to the expected decline in the overall growth in DVD playershipments. Further, we believe that expected mandatory inclusion in nextgeneration optical disc standards will help to improve the adoption rate of ourtechnologies in other consumer products such as next generation video gameconsoles, personal audio and video players, personal computers and in-carentertainment systems. Failure to attain mandatory status in next generationhigh definition optical disc standards could cause revenue growth in ourconsumer business to be significantly lower than expected and could have amaterial adverse effect on our business.

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

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portabledevices. We believe that the broad and robust nature of this offering improvesthe probability of inclusion of our technologies in next generation products.

**Cinema Segment**

Revenue from our cinema segment represented 29% and34% of total revenues for the quarters ended June 30, 2005 and 2004,respectively. In our cinema business, 2004 was a solid year for sales of ourplayback hardware, marking a return to growth for cinema product sales. Weexpect growth in our cinema audio hardware to continue at a modest pace in2005. We also believe that the cinema exhibition community has recognized thatpre-show entertainment represents a significant revenue growth opportunity thatwill 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 believe will affect our cinemabusiness segment is the long-term trend toward digital distribution of content.We believe this trend will involve the near-term adoption of digital pre-showand/or electronic cinema solutions, followed by longer-term adoption of higherquality digital cinema. Digital distribution of content offers the motionpicture industry a means to achieve substantial cost savings, including theprinting and distribution of movies, help in combating piracy, and will enablemovies to be played repeatedly without degradation. It also provides additionalrevenue opportunities for cinema operators, as digital content such asadvertisements, concerts and sporting events could be shown in or broadcast todigitally equipped theaters. We believe the widespread adoption of digitalcinema will be longer-term because of the significant capital investment thatwill be required by cinema operators to purchase new equipment and solutions.We believe this represents an opportunity for us as we seek to provide productsand services in support of the transition from film-based content towardsdigital cinema. However, we do not currently offer digital cinema products andmay not be successful in developing or selling competitive product offerings.We believe that the addition of the services provided by our digital imagesbusiness, coupled with the pre-show and alternative content capabilities of ourXD10 Cinema Media Player, will enhance our ability to play a role in theindustry transition to high definition sound and images for digital 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 digitalimages segment represented 9% of total revenues for the quarter ended June 30,2005. We believe that the growing market for high resolution and highdefinition content in the cinema and the home will create a substantial demandfor the type of services provided by DDI. We believe that we have atechnological advantage over many of our competitors based on thesophistication of our processes and level of automation used to enhance theimage quality of entertainment content. Revenues in this business totaled $1.6million for the three months ended June 30, 2005, up significantly from $720,000in the first quarter of 2005. To date, this business has restored and/orenhanced over 100 feature films, including such recent major DVD releases asStar Wars and Indiana Jones. Major motion picture and television studiospossess libraries containing thousands of titles, which we believe represent asizable market opportunity for DDI’s services.

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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-basedcompensation, and contingencies and litigation. These estimates are based onhistorical experience and on various other assumptions that we believe to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from theseestimates. With the exceptions of the revenue recognition and in-processresearch and development in connection with the recent acquisition of LDI, nowDDI, as described below, there has been no material change to our criticalaccounting policies and estimates from the information provided in our Form 10-Kfiled on March 16, 2005.

**DDI Revenue Recognition**

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. If losses areanticipated 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 ofOperations**

***Revenues***

*Technology and FilmLicensing*

Technology and film licensing revenues for the threemonths ended June 30, 2005 increased 20% to $12.8 million from$10.7 million for the three months ended June 30, 2004. The increasein revenues from technology and film licensing was primarily attributable to growthin our car and PC licensing activities, and an increase in royalty recoveriesfrom intellectual property compliance and enforcement activities. Theseactivities, which included audits of shipments by certain of our licensees ofproducts containing our technology, trademarks and/or know-how and legalactions taken against licensees and parties who are not our licensees, resultedin recoveries of royalty payments relating to prior periods. We expect suchroyalty recoveries to continue and that this activity will continue to improverevenue realization in our licensing business going forward. Our core DVDbusiness was down quarter to quarter, in line with the industry as the industryis experiencing a slowdown in sales of DVD players and certain home theaterequipment. We remain cautious on our outlook due to uncertainties surroundingthe consumer electronics market. Overall, we continue to expect technologylicensing revenues to grow modestly in 2005, based primarily on the expectedcontinuation of growth in the home theater market and from our licenseenforcement activities. However, we believe that the growth rate of ourtechnology licensing business will decline in the second half of the yearrelative to the growth rate in the six months ended June 30, 2005. Ourfilm licensing 

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revenues decreasedslightly for the three months ended June 30, 2005 compared to the prioryear period due to fewer international releases in the DTS format and changesin the timing of major feature film releases. Film licensing is expected todecrease slightly in 2005.

Technology and filmlicensing revenues for the six months ended June 30, 2005 increased 35% to$31.3 million from $23.2 million for the six months ended June 30,2004. The increase in revenues from technology and film licensing was primarilyattributable to an increase in royalty recoveries of $7.1 million fromintellectual property compliance and enforcement activities during the firsttwo quarters of 2005 as well as an increase in consumer license revenues.

*Product Sales andOther*

Product sales and other revenues increased 93% to$4.9 million for the three months ended June 30, 2005 from$2.5 million for the three months ended June 30, 2004. This increasewas primarily attributable to revenues generated by DDI, which we acquired in January 2005,and an increase in Cinema hardware sales of $722,000. Interest in our XD10 CinemaMedia Player along with the recently released XD10P Cinema Audio Processor wasa primary driver of sales. Revenue from shipments during this quarter totallingapproximately $272,000 were deferred pending completion of a softwaredeliverable, which we expect to be completed by the third quarter of 2005.Product sales and other revenue is expected to grow at a modest rate, as wecontinue to expect the market for pre-show entertainment to develop at a measuredpace throughout the rest of 2005.

Product sales and otherrevenues increased 51% to $8.5 million for the six months ended June 30,2005 from $5.6 million for the six months ended June 30, 2004. Thisincrease was primarily attributable to revenues generated by DDI as well as anincrease in Cinema hardware sales of approximately $750,000 due to the reasonsmentioned above.

*Segment Sales*

Revenues from our consumer business totaled $11.0million for the three months ended June 30, 2005, an increase of 25% from$8.7 million for the three months ended June 30, 2004. The increase inrevenues was driven primarily by royalty recoveries and the increase in licenserevenue from our car and personal computer markets. Cinema revenues were$5.1 million for the three months ended June 30, 2005, an increase of14% from $4.5 million for the three months ended June 30, 2004. Theincrease in revenues was driven primarily by an increase in hardware revenuesoffset by a slight decrease in film revenues. Revenues from our digital imagesbusiness were $1.6 million for the three months ended June 30, 2005, thesecond quarter these revenues have been included in our results of operations.

Revenues from our consumerbusiness totaled $27.5 million for the six months ended June 30, 2005, anincrease of 41% from $19.5 million for the six months ended June 30, 2004.The increase in revenues was driven primarily by royalty recoveries and thegrowth in consumer electronics technology licensing as mentioned above. Cinemarevenues were $9.9 million for the six months ended June 30, 2005, up 7%from the same period last year due primarily to growth in product sales,primarily the XD10 Cinema Media Player. At the end of the first quarter of2005, we released the XD10P Cinema Audio Processor.

***Gross Profit***

Consolidated gross profit decreased to 72% of revenuesfor the three months ended June 30, 2005, from 78% for the three monthsended June 30, 2004. We expect consolidated gross margins in the 70% to75% range in 2005 primarily as a result of the incorporation of DDI into ourconsolidated results of operations.

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For the six months ended June 30,2005, consolidated gross profit decreased to 76% of revenues, compared to 80%for the same period in 2004 as a result of the incorporation of DDI into ourconsolidated results of operations as mentioned above.

*Technology and FilmLicensing*

Gross profit associated with technology and filmlicensing revenues increased to 92% for the three months ended June 30,2005 from 89% of related revenues for the prior year same period due to theincrease in revenue relative to fixed costs.

For the six months ended June 30,2005, technology and film licensing revenues increased to 93% of relatedrevenues, compared to 91% for the same period in 2004 due to the reasonsmentioned above.

*Product Sales andOther*

Gross profit associated with product sales and otherrevenues decreased to 18% of related revenues for the three months ended June 30,2005 from 31% in the prior year period primarily as a result of negative marginsrelating to our digital images business due to fixed overhead and amortizationof acquired intangibles in excess of revenues.

For the six months ended June 30,2005, product sales and other revenues decreased to 15% of related revenues,compared to 35% for the same period in 2004 due to reasons mentioned above.

*Segment GrossProfit*

Gross profit for our consumer business decreasedslightly to 96% of related revenues for the quarter ended June 30, 2005,from 97% in the prior year period. Our cinema business gross profit increasedto 43% of related revenues for the quarter ended June 30, 2005 from 41% inthe prior year period primarily due to the increase in revenue relative tofixed costs. Our digital images business experienced negative gross margins dueto lower than anticipated revenues and the amortization of acquired intangiblesof $244,000. We expect margins in the digital images business to improve asrevenues increase throughout the remainder of the year.

For the six months ended June 30,2005, our consumer business gross profit remained consistent at 97% of relatedrevenues, compared to the same period in 2004. Our cinema business gross profitdecreased slightly to 44% of related revenues, compared to 46% for the sameperiod in 2004. Our digital images business experienced negative gross marginsdue to the reasons mentioned above and the amortization of acquired intangiblesof $488,000.

***Selling, General and Administrative***

Selling, general and administrative expenses increased19% to $8.1 million for the three months ended June 30, 2005,compared to $6.8 million in the prior year period. The increase is primarilydue to increases in salaries and related costs of $1.2 million, as we increasedheadcount to support our growth. Also contributing to the increase was $366,000relating to the inclusion of DDI in our results of operations. Included in theincrease related to DDI is amortization of acquired intangibles of $96,000.

Selling, general and administrative expenses increased22% to $16.1 million for the six months ended June 30, 2005, comparedto $13.2 million in the prior year period. The increase is primarily due toincreases in salaries and related costs of $1.1 million as we increasedheadcount to support our growth, and professional services of $1.1 millionwhich includes costs associated with our increased intellectual propertycompliance and enforcement activities, and other additional costs associatedwith operating as a public company. Also contributing to the increase was $868,000relating to the inclusion of DDI in our results of operations. Included in theincrease related to DDI is amortization of acquired intangibles of $192,000.

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

***Research and Development***

For the three months ended June 30, 2005,research and development expenses were $2.5 million, compared to$1.6 million for the three months ended June 30, 2004. For the sixmonths ended June 30, 2004, research and development expenses were $4.6million, up from $2.9 million for the six months ended June 30, 2004. Theincrease for both periods is primarily due to increased labor costs associatedwith new product initiatives, the optimization of our Coherent Acousticstechnology, and the development of tools associated with next generationoptical disc standards. Also contributing to the increase was the inclusion ofDDI research and development activities totaling $204,000 and $383,000 for thethree and six months ended June 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 six months ended June 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 six months ended June 30, 2005 increased significantly overthe same period of the prior year due to the generally improved interest rateenvironment and a temporary shift away from tax-exempt auction rate securitiesto taxable investments, which generate higher nominal yields. Offsetting theincrease for the six months ended June 30, 2005, is the inclusion ofinterest income related to a royalty settlement in the first quarter of 2004.

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***IncomeFrom Legal Settlement***

***In May 2004, wereached a settlement with Mintek for $3.5 million for Trademark Infringement,False Designation of Origin, Trademark Dilution, and Unfair Competition relatingto Mintek’s distribution of DVD players bearing our registered trademarkswithout obtaining a license from us. In the six months ended June 30, 2004 werecognized $899,000 in revenue under the settlement agreement for royalties dueon known units that could be identified as using our trademark and accountedfor the remaining $2.6 million as other income.***

***Income Taxes***

For the three and sixmonths ended June 30, 2005, we recorded an income tax provision of $1.1 millionand $3.0 million, respectively, on pre-tax income of $2.9 million and $8.4million, respectively. This resulted in an annualized effective tax rate of36.1%. For the three and six months ended June 30, 2004, we recorded anincome tax provision of $1.7 million and $3.7 million, respectively, on pre-taxincome of $4.9 million and $10.2 million, respectively. This resulted inan annualized effective tax rate of 35.8%. These rates differed from thestatutory rates primarily due to state income taxes offset by benefitsassociated with the foreign rate differentials and research and developmentcredits. We expect the effective tax rate for 2005 will be approximately 36%,slightly higher than our previous estimates due primarily to the non-deductibilityof in-process research and development charges and changes in our geographicearnings mix expectations as the year has progressed.

**Liquidity and Capital Resources**

At June 30, 2005, we had cash, cash equivalentsand short- and long-term investments of $107.6 million, compared to $117.0million at December 31, 2004.

Net cash provided by operating activities was$4.0 million for the six months ended June 30, 2005, compared to $4.8million for the six months ended June 30, 2004. Accounts receivable, netof acquired accounts receivable, increased $5.8 million for the six monthsended June 30, 2005 due to royalty recoveries and other accrued licensefees. Our tax benefit from the exercise of options decreased $3.0 millionfor the six months ended June 30, 2005, compared to the same prior period.Included in 2004 was an unusually high volume of option exercises during thesix months subsequent to our initial public offering lockup release in early2004. Additionally, lower average market prices for shares of our common stockin the first six months of 2005 relative to the same period in 2004 resulted inlower option exercise activity during 2005.

Net cash provided byinvesting activities totaled $15.3 million for the six months ended June 30,2005. Net cash used in investing activities totaled $29.4 million for the sixmonths ended June 30, 2004. The increase in cash provided by investingactivities for the six months ended June 30, 2005 is primarily a result ofthe net sales of investments of $29.2 million, offset by the acquisition of LDIof $11.0 million and purchases of property and equipment of $2.8 million. Wehave shifted our investment focus away from the purchase of auction ratesecurities that are classified as short-term investments, which has resulted inan increase in our cash balance.

Net cash provided byfinancing activities totaled $542,000 and $865,000 for the six months ended June 30,2005 and 2004, respectively, and primarily consists of the exercise of stockoptions and purchases 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 

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ortechnologies or other events, including those described in “Risk Factors”included herein and in our Form 10-K filed on March 16, 2005 and inany other filings may cause us to seek additional debt or equity financing onan accelerated basis. Financing may not be available on acceptable terms, or atall, and our failure to raise capital when needed could negatively impact ourgrowth plans and our financial condition and results of operations. Additionalequity financing may be dilutive to the holders of our common stock and debtfinancing, if available, may involve significant cash payment obligations andfinancial or operational covenants that restrict our ability to operate ourbusiness.

**RecentlyIssued Accounting Standards**

In November 2004, theFinancial Accounting Standards Board, or FASB, issued Statement of FinancialAccounting Standards, or SFAS, No. 151, “Inventory Costs, an amendment ofARB No. 43, Chapter 4”, or SFAS 151. SFAS 151 clarifies the types of coststhat should be expensed rather than capitalized as inventory. SFAS 151 alsoclarifies the circumstances under which fixed overhead costs associated withoperating facilities involved in inventory processing should be capitalized.This statement is effective for fiscal years beginning after June 15,2005. We adopted SFAS 151 in the three months ended March 31, 2005 and theadoption did not have a material impact on our consolidated financial positionor results 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 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, we will also be required to determine the transition method to beused 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 of adoptionor for all periods presented. The prospective method requires that compensationexpense be recorded for all unvested stock options and restricted stock at thebeginning 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 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 June 30, 2005, the effects of the adoption of SFAS123R on our financial results for the next five years, based on stock-basedawards granted as of June 30, 2005, would be as follows:
| ** **                                                                           | ** ** | **Expenses by Fiscal Year** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                           | ** ** | **Remaining**                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                           | ** ** | **Six**                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                           | ** ** | **Months**                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                           | ** ** | **2005**                                   | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** |
| ** **                                                                           | ** ** | **(unaudited)**                            | ** ** |
| ** **                                                                           | ** ** | **(In thousands)**                    | ** ** |
| Additional stock-based  compensation expense under SFAS 123R before tax benefit |       |                                       | $          | 2,151 |   |   | $ | 2,464 |   | $ | 1,149 |   | $ | 393 |   | $ | 57 |   |
|                                                                                      |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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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. We are in the process of determining the impact the adoption willhave on our consolidated statement of cash flows.

In March 2005, the SEC issued Staff AccountingBulletin, or SAB, No. 107 to provide guidance on SFAS 123R. SAB 107 was issuedto assist registrants by simplifying some of the implementation challenges ofSFAS 123R while enhancing the information that investors receive. SAB 107provides guidance regarding valuation models, expected volatility and expectedterm. We will apply the guidance of SAB 107 in conjunction with our adoption ofSFAS 123R.

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 waste managementobligation for the equipment may be transferred to the producer of thereplacement 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 be appliedin the first reporting period ending after the date the law is adopted by theapplicable EU-member countries. We are currently evaluating the effect of FSP143-1 on our consolidated financial statements.

OnJune 7, 2005, the FASB issued Statement No. 154, “Accounting Changesand Error Corrections, a replacement of APB Opinion No. 20, AccountingChanges, and Statement No. 3, Reporting Accounting Changes in InterimFinancial Statements”, or SFAS 154. SFAS 154 changes the requirementsfor the accounting for, and reporting of, a change in accounting principle.Previously, most voluntary changes in accounting principles were required to berecognized by way of a cumulative effect adjustment within net income duringthe period of the change. SFAS 154 requires retrospective application toprior periods’ financial statements, unless it is impracticable to determineeither the period-specific effects or the cumulative effect of the change.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.

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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.

**RisksRelated to Our Business**

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

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

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

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

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

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

·       greatername recognition;

·       alonger operating history;

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

·       amore extensive customer base;

·       digitaltechnologies that provide features that ours do not;

·       broaderproduct and service offerings;

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

·       moretechnicians and engineers.

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

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

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

Technology standards are important in the audio andvideo industry as they help to assure compatibility across a system or seriesof products. Generally, standards adoption occurs on either a mandatory basis,requiring a particular technology to be available in a particular product ormedium, or an optional basis, meaning that a particular technology may be, butis not required to be, utilized. For example, both our digital multi-channelaudio technology and Dolby’s have optional status in Standard 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 and entertainment mediums emerge,new standards relating to these technologies or mediums may develop. Newstandards may also emerge in existing markets that are currently characterizedby competing formats, such as the market for personal computers. We may not besuccessful in our efforts to include our technology in any such standards.

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

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

·       rapidtechnological change;

·       newand improved product introductions;

·       changingcustomer demands;

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·       evolving industrystandards; and

·       productobsolescence.

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

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

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

Companies that participate in the digital audio,digital image processing, consumer electronics, and entertainment industrieshold a large number of patents, trademarks, and copyrights, and are frequentlyinvolved in litigation based on allegations of patent infringement or otherviolations of intellectual property rights. Intellectual property disputesfrequently involve highly complex and costly scientific 

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matters, and each partygenerally has the right to seek a trial by jury which adds additional costs anduncertainty. Accordingly, intellectual property disputes, with or withoutmerit, could be costly and time consuming to litigate or settle, and coulddivert management’s attention from executing our business plan. In addition,our technology and products may not be able to withstand any third-party claimsor rights against their use. If we were unable to obtain any necessary licensefollowing a determination of infringement or an adverse determination inlitigation or in interference or other administrative proceedings, we may needto redesign some of our products to avoid infringing a third party’s rights andcould be required to temporarily or permanently discontinue licensing ourproducts.

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

We expect to derive a significant percentage of ourrevenues from the technology, products, and services that we offer tomanufacturers of consumer electronics products. To date, the most significantdriver for the use of our technology in the home theater market has been therelease of major movie titles with DTS audio soundtracks. We also believe thatdemand for our DTS audio technology in emerging markets for multi-channelaudio, including homes, cars, personal computers, and video games and consoles,will be based on the number, quality, and popularity of the audio DVDs,computer software programs, and video games released with DTS audiosoundtracks. Although we have existing relationships with many leading providersof movie, music, computer, and video game content, we do not have contractsthat require any of these parties to develop and release content with DTS audiosoundtracks. In addition, we may not be successful in maintaining existingrelationships or developing relationships with other existing providers or newmarket entrants that provide content. As a result, we cannot assure you that asignificant amount of content in movies, audio DVDs, computer softwareprograms, video games, or other entertainment mediums will be released with DTSaudio soundtracks. If the amount, variety, and popularity of entertainmentcontent released with DTS audio soundtracks do not increase, consumerelectronics products manufacturers that pay us per-unit licensing fees maydiscontinue 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 404 of the Sarbanes-OxleyAct of 2002, the SEC adopted rules requiring all public companies,including us, to include a report by management on internal control overfinancial reporting in all annual reports on Form 10-K that containsan assessment by management of the effectiveness of internal control overfinancial reporting. In addition, the public accounting firm auditing ourfinancial statements must attest to and report on our management’s assessmentof the effectiveness of internal control over financial reporting and theeffectiveness of internal control over financial reporting. While we conductrigorous reviews of our internal control over financial reporting in order tocomply with the Section 404 requirements, our registered public accountingfirm may interpret the Section 404 requirements and the related rules andregulations differently from us, or our registered public accounting firm ormanagement may not be satisfied with our internal control over financialreporting or with the level at which these controls are documented, executed orreviewed. In addition, many uncertainties remain regarding the requirements forauditor attestation, and guidance provided by the public accounting professionhas changed frequently and materially to date and may continue to change suchthat we may not be able to comply with these new requirements. Further, thedemand for competent audit resources has grown dramatically as a result of therequirements of Section 404, and such demand may exceed available supply. Inaddition, in January 2005, we acquired Lowry Digital Images, Inc., orLDI, a privately held company with limited financial resources that had notimplemented sufficient internal control over 

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financial reporting. Wemay in the future make additional acquisitions which may be significant to ouroperations either individually or in the aggregate. We may face significantchallenges in implementing the required processes and procedures in theacquired operations of LDI or any other businesses that we may acquire. As aresult, our registered public accounting firm may issue an adverse report or adisclaimer on management’s assesment of internal control over financialreporting. Management may also identify material weaknesses which would causemanagement to conclude internal control over financial reporting is noteffective. This could result in an adverse reaction in the financial marketsdue to a loss of confidence in the reliability of our financial statements,which could cause the market price of our shares to decline.

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

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

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

Although we have established relationships with anumber of motion picture studios, content owners, producers and distributors,we do not have any contractual agreements that require them to provide us imagecontent for processing. Further, the demand for image processing, enhancementand restoration of cinema, home video or broadcast television content may notmaterialize or accelerate as we anticipate, which would have a negative impacton 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 to continueto decrease for the foreseeable future. Declining prices for consumerelectronics products could create downward pressure on the licensing fees wecurrently charge our customers who integrate our technology into the consumerelectronics products that they sell and distribute. Most of the consumerelectronics products that include our audio technology also include Dolby’smulti-channel audio. As a result of pricing pressure, consumer electronicsproducts manufacturers could decide to exclude our DTS audio technology fromtheir products altogether.

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

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

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

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

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 in the release of motion pictures with DTSaudio soundtracks would decrease the demand for and revenues from the playbackproducts and services that we offer to movie theaters. In addition, othermotion picture studios, content owners, producers, and distributors throughoutthe world generally adopt and use the processes and the technologies used bythe major U.S. film studios. Therefore, if the major U.S. motion picturestudios, content owners, producers or distributors stop using our technology,we would not only lose the per-movie licensing fee we receive from thesecustomers, but may also lose per-movie licensing fees from other film studiosthroughout the world.

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

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

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

Our successdepends, in part, upon the continued availability and contributions of ourmanagement team, particularly Jon Kirchner, our President and Chief ExecutiveOfficer, W. Paul Smith, our Senior Vice President, Research and Development,and John Lowry, our Chief Technologist of DTS Digital Images who became anemployee upon our acquisition of 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

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

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

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

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

***Our technology and products arecomplex and may contain errors that could cause us to lose customers, damageour reputation, or incur substantial costs.***

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

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***Because we expect our operatingexpenses to increase in the future, we may not be able to sustain or increaseour profitability.***

Although we havebeen in business since 1990, we have only achieved profits from our businessoperations in the last sixteen 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 need to grow our revenues inorder to maintain and increase our profitability. In addition, we may fail toaccurately estimate and assess our increased operating expenses as we grow.

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

We market and 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 ofcurrency exchange; and

·       potentiallyadverse tax consequences.

Such factors could cause our future internationalsales to decline.

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

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

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

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

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

***We depend on several suppliers,manufacturers, and distributors for some of our products, and the loss of anyof 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 have entered into agreements withthree companies to serve as our sole distributors for our DTS Entertainmentproducts in the United States and Canada, Europe and Japan. We have no directcontrol over these distributors and any problems with their performance maytake time to identify and/or remedy, and any remedial measures that we take maybe unsuccessful. In addition, if any of these distributors were to go out ofbusiness, as one of our previous distributors did, or otherwise becomesincapable of continuing as our distributor, we could experience delays indistributing our DTS Entertainment products to the retail market, loss ofinventory, and loss of revenue.

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

A significant percentage of our revenues are generatedfrom our consumer electronics products manufacturer customers who license andincorporate our technology in their consumer electronics products. Under ourexisting arrangements, these customers pay us per-unit licensing fees based onthe number of consumer electronics products manufactured that incorporate ourtechnology. We rely on our customers to accurately report the number of unitsmanufactured in collecting our license fees, preparing our financial reports,projections, budgets, and directing our sales and product development efforts.Most of our license agreements permit us to audit our customers, but audits aregenerally expensive and time 

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consuming and could harmour customer relationships. If any of our customer reports understate thenumber of products they manufacture, we may not collect and recognize revenuesto which we are entitled.

***A prolonged economic downturncould materially harm our business.***

Negative trends in the general economy, includingtrends resulting from actual or threatened military action by the United Statesand threats of terrorist attacks on the United States and abroad, could cause adecrease in consumer spending on entertainment in general. Any reduction inconsumer confidence or disposable income in general may affect the demand forconsumer electronics products that incorporate our digital audio technology,audio DVDs that we produce and distribute through our DTS Entertainment label,and demand by film studios and movie theaters for our cinema products andservices.

***We may 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 properly evaluate and execute acquisitionsand strategic investments, our management team may be distracted from ourday-to-day operations, our business may be disrupted, and our operating resultsmay suffer. In addition, if we finance acquisitions by issuing equity orconvertible debt securities, our existing stockholders would be diluted.

***We may have difficulty managingany growth that we might experience.***

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

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

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

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

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·       manage multiple, concurrentdevelopment projects; and

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

Any failure to successfully manage our growth coulddistract management’s attention, and result in our failure to execute ourbusiness plan. For instance, our acquisition of LDI has required significanttime and attention from our management team. Any future growth could causesimilar management challenges or create distractions.

***We may experience fluctuations inour operating results.***

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

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

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

There has been ongoing public debate whether stockoptions granted to employees should be treated as compensation expense and, ifso, how to properly value such charges. Currently, we account for options usingthe intrinsic value method, which results in no compensation expense, since wegrant employee options with exercise prices equal to the fair market value ofthe underlying stock at the time of grant. If, however, we had used the fairvalue method of accounting for stock options granted to employees using aBlack-Scholes option valuation formula, our net income for the six months endedJune 30, 2005, would have been reduced by $1.0 million, from $5.4 millionto $4.4 million for that period. When we adopt FAS 123R in the first quarter of2006, we will have on-going accounting charges significantly greater than thosewe would have recorded under our current method of accounting for stockoptions, which will have a material adverse affect on our operating results.

**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;

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·       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 stock market in general, and theNasdaq National Market and the market for technology companies in particular,has experienced extreme price and volume fluctuations that have often been unrelatedor disproportionate to the operating performance of those companies. Further,the market prices of securities of technology companies have been particularlyvolatile. These broad market and industry factors may materially harm themarket price of our common stock, regardless of our operating performance. Inthe past, following periods of volatility in the market price of a company’ssecurities, securities class-action litigation has often been institutedagainst that company. Such litigation, if instituted against us, could resultin substantial costs and a diversion of management’s attention and resources.

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

As of June 30, 2005, we have 17,370,368 shares ofcommon stock outstanding. As a result of our relatively small public float, ourcommon shares may be less liquid than the common shares of companies withbroader public ownership. Among other things, trading of a relatively smallvolume of our common shares may have a greater impact on the trading price forour shares than would be the case if our public float were larger.

***Our future capital needs areuncertain and we may need to raise additional funds in the future, and suchfunds may not be available on acceptable terms or at all.***

Our capital requirementswill depend on many factors, including:

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

·       thecosts of developing new products or technology;

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

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

·       thecosts associated with our expansion, if any.

In the future, we may need to raise additional funds,and such funds may not be available on favorable terms, or at all. Furthermore,if we issue equity or debt securities to raise additional funds, our existingstockholders may experience dilution, and the new equity or debt securities mayhave rights, preferences, and privileges senior to those of our existingstockholders. If we cannot raise funds on acceptable terms, we 

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may not be able to developor enhance our products and services, execute our business plan, take advantageof future opportunities, or respond to competitive pressures or unanticipatedcustomer requirements. This may materially harm our business, results ofoperations, and financial condition.

***Anti-takeover provisions underour charter documents and Delaware law could delay or prevent a change ofcontrol and could also limit the market price of our stock.***

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

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

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

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

·       requireadvance written notice of stockholder proposals and director nominations.

In addition, we aregoverned by the provisions of Section 203 of the Delaware GeneralCorporate Law, which may prohibit certain business combinations withstockholders owning 15% or more of our outstanding voting stock. These andother provisions in our Restated Certificate of Incorporation, Restated Bylawsand Delaware law could make it more difficult for stockholders or potentialacquirors to obtain control of our Board or initiate actions that are opposedby the then-current Board, including delay 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 June 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 June 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 sales outsidethe 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 measures, longer accounts receivable collectionpatterns, and changes in regional or worldwide economic or politicalconditions. The risks of our international operations are mitigated in part bythe extent to which our revenues are denominated in U.S. dollars and,accordingly, we are not exposed to significant foreign currency risk on theseitems. We do have limited foreign currency risk on certain revenues andoperating expenses such as salaries and overhead costs of our foreignoperations and a small amount of cash maintained by these operations. Revenuesdenominated in foreign currencies accounted for approximately 4% of totalrevenues during the first quarter of 2005. Operating expenses, including costof sales, for our foreign subsidiaries were approximately $3.1 million inthe first six months of 2005. Based 

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upon the expenses for thefirst six months of 2005, a 1% change in foreign currency rates throughout aone-year period would have an annual effect of approximately $124,000.

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 sixmonth periods ended June 30, 2005 of 2005 the impact of foreign exchange ratefluctuations 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 the Securities Exchange Act of1934, as amended (the “Exchange Act”)) that are designed to ensure that informationrequired to be disclosed in the reports we file or submit under the ExchangeAct is recorded, processed, summarized and reported within the time periodsspecified in the rules and forms of the Securities and Exchange Commission andthat such information is accumulated and communicated to our management,including our chief executive officer and chief financial officer, asappropriate, to allow for timely decisions regarding required disclosure.

We carried out an evaluation, under the supervisionand with the participation of our management, including our chief executiveofficer and chief financial officer, of the effectiveness of 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 II**

**OTHER INFORMATION**

**Item 1.**                        LegalProceedings

During the quarter endedJune 30, 2005, we settled our dispute with Sunplus Technology Co., Ltd.

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

(a) During the second quarter of 2005, pursuantto the exemption from registration provided in Section 3(a)(9) of theSecurities Act, the Registrant issued an aggregate of 211,583 shares of commonstock upon the cashless exercise of a warrant to purchase an aggregate of574,825 shares of common stock.

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

The Annual Meeting of Stockholders of DTS, Inc.was held on May 19, 2005. The following matters were voted upon and wereapproved as set forth below.

Thestockholders elected two Class II directors to hold office until the 2008Annual Meeting of Stockholders by the following votes:
| ** **                                   | ** ** | **Number of Shares** | ** ** |
|----------------------------------------------|------------|--------------------------------|------------|
| **Name of Directors Elected** | ** ** | ** **                     | ** ** | **For** | ** ** | **Withheld** | ** ** |
| Joerg D. Agin                                |       | 15,310,389                     |       | 524,583 |   |
| C. Ann Busby                                 |       | 15,733,987                     |       | 100,985 |   |
|                                              |            |                                |            |  |  |  |  |

 

The following individuals are continuing directorswith terms expiring upon the 2006 Annual Meeting of Stockholders: Jon E.Kirchner, James B. McElwee and Ronald N. Stone.

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

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

| **Number of Shares** | ** ** |
|--------------------------------|------------|
| **For**                        | ** ** | **Against** | ** ** | **Abstain** | ** ** |
| 15,816,007                     |       | 15,755 |   | 3,210 |   |

 

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The stockholders approved an amendment to the Company’sRestated Certificate of Incorporation to change the Company’s corporate namefrom “Digital Theater Systems, Inc.” to “DTS, Inc.” by the followingvote:

| **Number of Shares** | ** ** |
|--------------------------------|------------|
| **For**                        | ** ** | **Against** | ** ** | **Abstain** | ** ** |
| 15,374,111                     |       | 454,182 |   | 6,679 |   |

 

Thestockholders approved the Performance Incentive Plan (the “PIP”), pursuant towhich awards of restricted stock that are intended to qualify as “performance-basedcompensation” under Section 162(m) of the Internal Revenue Code of1986, as amended, may be made to eligible Company employees, including each ofthe Company’s named executive officers. The PIP, effective as of January 1,2005, was approved by the following vote:

| **Number of Shares** |
|--------------------------------|
| **For**                        | ** ** | **Against** | ** ** | **Abstain** | ** ** | **No Vote** |
| 10,848,733                     |   | 954,214 |   | 474,360 |   | 3,557,665 |

 

**Item 5.**                        OtherInformation

The Company has enteredinto employment agreements, each effective in May 2005, with each of MelvinFlanigan, Blake Welcher, Andrea Nee, Jan Wissmuller, Mr. William PaulSmith, Don Bird, Brian Towne, Patrick Watson and William Neighbors. The Companyhas filed these agreements as exhibits 10.46 through 10.54 included with thisReport.

**Item 6.**                        Exhibits
| Exhibit  Number | ** ** | **Exhibit Description**                                                                                                                     |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.9             |       | Restated  Certificate of Incorporation, as amended by Amendment dated May 20, 2005                                                          |
| 10.46           |       | Employment  Agreement by and between the Registrant and Melvin Flanigan, effective as of  May 20, 2005                                           |
| 10.47           |       | Employment  Agreement by and between the Registrant and Blake Welcher, effective as of  May 20, 2005                                        |
| 10.48           |       | Employment  Agreement by and between the Registrant and Andrea Nee, effective as of May 20,  2005                                           |
| 10.49           |       | Employment  Agreement by and between the Registrant and Jan Wissmuller, effective as of  May 20, 2005                                       |
| 10.50           |       | Second  Amendment to Service Agreement between the Registrant and Mr. William  Paul Smith, dated June 3, 2005                          |
| 10.51           |       | Employment  Agreement by and between the Registrant and Don Bird, effective as of May 20,  2005                                             |
| 10.52           |       | Employment  Agreement by and between the Registrant and Brian Towne, effective as of May 20,  2005                                          |
| 10.53           |       | Employment  Agreement by and between the Registrant and Patrick Watson, effective as of  May 20, 2005                                       |
| 10.54           |       | Employment  Agreement by and between the Registrant and William Neighbors, effective as  of May 18, 2005                                    |
| 31.1            |       | Certification  of the Chief Executive Officer under Securities Exchange Act  Rules 13a-14(a) or 15d-14(a)                              |
| 31.2            |       | Certification  of the Chief Financial Officer under Securities Exchange Act Rules 13a-14(a) or  15d-14(a)                              |
| 32.1            |       | Certification  of the Chief Executive Officer under Securities Exchange Act Rules 13a-14(b) or  15d-14(b) and 18 U.S.C. 1350      |
| 32.2            |       | Certification  of the Chief Financial Officer under Securities Exchange Act Rules 13a-14(b) or  15d-14(b) and 18 U.S.C. 1350 |

 

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
|                            |     | DTS, INC.                                                                                                 |
|----------------------------|----------|----------------------------------------------------------------------------------------------------------------|
|                       | by:      | /s/ JON E. KIRCHNER                                                                                            |
|                       |     | Jon E. Kirchner                                                                                                |
| * *                   | * * | *President and Chief Executive Officer  (Duly Authorized Officer)*                                             |
| Date: August 5,  2005 |     |                                                                                                           |
|                       | by:      | /s/ MELVIN L. FLANIGAN                                                                                         |
|                       |     | Melvin L. Flanigan                                                                                             |
| * *                   | * * | *Executive Vice President, Finance and  Chief Financial Officer  (Principal Financial and Accounting Officer)* |
| Date: August 5, 2005  |     |                                                                                                           |

 

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