**SECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

 

**Form 10-Q**

 

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

 

**For the Quarterly Period Ended March 31, 2004**

 

**Commission File Number 000-50335**

 

**Digital Theater Systems, Inc.**

(Exact name of registrant as 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) |

 

Indicateby check mark whether the registrant: (1) has filed all reports requiredto be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.     Yes ý          No o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act).     Yes o          No ý

 

Asof April 30, 2004 a total of 16,802,729 shares of the Registrant’s CommonStock, $0.0001 par value, were issued and outstanding.

 

 

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**DIGITAL THEATER SYSTEMS, INC.**

 

**FORM 10-Q**

 

**TABLE OF CONTENTS**

 
| **PART I**       | **FINANCIAL INFORMATION**                                                                       |
|------------------|-------------------------------------------------------------------------------------------------|
| **Item 1.** | **Financial Statements:**                                                                       |
|             | **Condensed  Consolidated Balance Sheets**                                                      |
|             | **Condensed  Consolidated Statements of Operations**                                            |
|             | **Condensed  Consolidated Statements of Cash Flows**                                            |
|             | **Notes  to Condensed Consolidated Financial Statements**                                       |
| **Item 2.** | **Management’s  Discussion and Analysis of Financial Condition and Results of Operations** |
| **Item 3.** | **Quantitative  and Qualitative Disclosures About Market Risk**                                 |
| **Item 4.** | **Controls and Procedures**                                                                     |
| **PART II.**     | **OTHER  INFORMATION**                                                                          |
| **Item 1.** | **Legal  Proceedings**                                                                          |
| **Item 2.** | **Changes  in Securities, Use of Proceeds and Issuer Purchases of Equity Securities**           |
| **Item 3.** | **Defaults Upon Senior  Securities**                                                            |
| **Item 4.** | **Submission  of Matters to a Vote of Security Holders**                                        |
| **Item 5.** | **Other  Information**                                                                          |
| **Item 6.** | **Exhibits and Reports on  Form 8-K**                                                      |
| **SIGNATURES**   |

 

2

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**DIGITAL THEATER SYSTEMS, INC.**

 

**PART I**

**FINANCIAL INFORMATION**

 

**Item 1.****     *Financial Statements***

 

**Digital Theater Systems, Inc.**

**Condensed Consolidated Balance Sheets**

 
|                                                                                                                                                                                                                                              |   | **As of  December 31,  2003**                               |    | **As of  March 31,  2004** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------|---------|---------------------------------|--------|
|                                                                                                                                                                                                                                              |   |                                                             |    | **(Unaudited)**                 |   |
|                                                                                                                                                                                                                                              |   | **(Amounts  in thousands, except  share and per share amounts)** |    |
| ASSETS                                                                                                                                                                                                                                            |   |                                                             |    |                            |   |
| Current assets:                                                                                                                                                                                                                                   |   |                                                             |    |                            |   |
| Cash and cash equivalents                                                                                                                                                                                                                         |   | $                                                                | 89,341  |                            | $      | 69,965 |   |
| Short-term investments                                                                                                                                                                                                                            |   | 10,048                                                           |    | 25,587                          |   |
| Accounts receivable, net of allowance for doubtful  accounts of $429 and $430 at December 31, 2003 and March 31, 2004,  respectively                                                                                                    |   | 3,962                                                            |    | 4,771                           |   |
| Inventories                                                                                                                                                                                                                                       |   | 7,552                                                            |    | 9,119                           |   |
| Deferred tax assets, net                                                                                                                                                                                                                          |   | 6,025                                                            |    | 5,904                           |   |
| Prepaid expenses and other                                                                                                                                                                                                                        |   | 1,846                                                            |    | 1,779                           |   |
| Income tax receivable                                                                                                                                                                                                                             |   | 660                                                              |    | —                          |   |
|                                                                                                                                                                                                                                              |   |                                                             |    |                            |   |
| Total current assets                                                                                                                                                                                                                              |   | 119,434                                                          |    | 117,125                         |   |
| Long-term investments                                                                                                                                                                                                                             |   | 2,998                                                            |    | 10,519                          |   |
| Property and equipment, net                                                                                                                                                                                                                       |   | 3,092                                                            |    | 3,353                           |   |
| Patents and trademarks                                                                                                                                                                                                                            |   | 424                                                              |    | 422                             |   |
| Deferred tax assets                                                                                                                                                                                                                               |   | 1,527                                                            |    | 2,778                           |   |
| Other assets                                                                                                                                                                                                                                      |   | 20                                                               |    | 109                             |   |
|                                                                                                                                                                                                                                              |   |                                                             |    |                            |   |
| Total assets                                                                                                                                                                                                                                      |   | $                                                                | 127,495 |                            | $      | 134,306 |   |
|                                                                                                                                                                                                                                              |   |                                                             |    |                            |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                                                         |   |                                                             |    |                            |   |
| Current liabilities:                                                                                                                                                                                                                              |   |                                                             |    |                            |   |
| Accounts payable                                                                                                                                                                                                                                  |   | $                                                                | 2,829   |                            | $      | 4,235 |   |
| Accrued expenses                                                                                                                                                                                                                                  |   | 5,795                                                            |    | 6,037                           |   |
| Income tax payable                                                                                                                                                                                                                                |   | —                                                           |    | 446                             |   |
|                                                                                                                                                                                                                                              |   |                                                             |    |                            |   |
| Total current liabilities                                                                                                                                                                                                                         |   | 8,624                                                            |    | 10,718                          |   |
| Commitments and contingencies (Note 6)                                                                                                                                                                                                            |   |                                                             |    |                            |   |
| Stockholders’ equity:                                                                                                                                                                                                                        |   |                                                             |    |                            |   |
| Preferred stock — $0.0001 par value, 5,000,000  shares authorized at December 31, 2003 and March 31, 2004; no  shares outstanding at December 31, 2003 and March 31, 2004                                                |   | —                                                           |    | —                          |   |
| Common stock — $0.0001 par value, 70,000,000 shares  authorized at December 31, 2003 and March 31, 2004; 16,512,885 and  16,681,393 shares issued and outstanding at December 31, 2003 and  March 31, 2004, respectively |   | 2                                                                |    | 2                               |   |
| Additional paid-in capital                                                                                                                                                                                                                        |   | 115,512                                                          |    | 116,789                         |   |
| Retained earnings                                                                                                                                                                                                                                 |   | 3,357                                                            |    | 6,797                           |   |
|                                                                                                                                                                                                                                              |   |                                                             |    |                            |   |
| Total stockholders’ equity                                                                                                                                                                                                                   |   | 118,871                                                          |    | 123,588                         |   |
|                                                                                                                                                                                                                                              |   |                                                             |    |                            |   |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                   |   | $                                                                | 127,495 |                            | $      | 134,306 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

3

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**Digital Theater Systems, Inc.**

 

**Condensed Consolidated Statements of Operations**

 
|                                                                                                      |   | **For the  Three Months Ended  March 31,**                 |   |
|-----------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------|--------|
|                                                                                                      |   | **2003**                                                        |   | **2004** |   |
|                                                                                                      |   | **(Amounts  in thousands, except share and per share amounts)** |   |
|                                                                                                      |   | **(Unaudited)**                                                 |   |
| Revenues:                                                                                                 |   |                                                            |   |   |   |
| Technology and film licensing                                                                             |   | $                                                               | 10,124 |   | $ | 12,497 |   |
| Product sales and other revenues                                                                          |   | 1,632                                                           |   | 3,100 |   |
|                                                                                                      |   |                                                            |   |   |   |
| Total revenues                                                                                            |   | 11,756                                                          |   | 15,597 |   |
| Cost of goods sold:                                                                                       |   |                                                            |   |   |   |
| Technology and film licensing                                                                             |   | 840                                                             |   | 980 |   |
| Product sales and other revenues                                                                          |   | 1,573                                                           |   | 1,912 |   |
|                                                                                                      |   |                                                            |   |   |   |
| Total cost of goods sold                                                                                  |   | 2,413                                                           |   | 2,892 |   |
|                                                                                                      |   |                                                            |   |   |   |
| Gross profit                                                                                              |   | 9,343                                                           |   | 12,705 |   |
| Operating expenses:                                                                                       |   |                                                            |   |   |   |
| Selling, general and administrative                                                                       |   | 4,991                                                           |   | 6,440 |   |
| Research and development                                                                                  |   | 1,170                                                           |   | 1,332 |   |
|                                                                                                      |   |                                                            |   |   |   |
| Total operating expenses                                                                                  |   | 6,161                                                           |   | 7,772 |   |
|                                                                                                      |   |                                                            |   |   |   |
| Income from operations                                                                                    |   | 3,182                                                           |   | 4,933 |   |
| Interest (income) expense, net                                                                       |   | (13                                                             | )      | (439 | ) |
| Other (income) expense, net                                                                          |   | 80                                                              |   | 14 |   |
|                                                                                                      |   |                                                            |   |   |   |
| Income before provision for income taxes                                                                  |   | 3,115                                                           |   | 5,358 |   |
| Provision for income taxes                                                                                |   | 1,086                                                           |   | 1,918 |   |
|                                                                                                      |   |                                                            |   |   |   |
| Net income                                                                                                |   | 2,029                                                           |   | 3,440 |   |
| Accretion and accrued dividends on preferred stock                                                        |   | (468                                                            | )      | — |   |
|                                                                                                      |   |                                                            |   |   |   |
| Net income attributable to common stockholders                                                            |   | $                                                               | 1,561  |   | $ | 3,440 |   |
|                                                                                                      |   |                                                            |   |   |   |
| Net income attributable to common stockholders per  common share:                                         |   |                                                            |   |   |   |
| Basic                                                                                                     |   | $                                                               | 0.35   |   | $ | 0.21 |   |
|                                                                                                      |   |                                                            |   |   |   |
| Diluted                                                                                                   |   | $                                                               | 0.15   |   | $ | 0.19 |   |
|                                                                                                      |   |                                                            |   |   |   |
| Weighted average shares used to compute net income  attributable to common stockholders per common share: |   |                                                            |   |   |   |
| Basic                                                                                                     |   | 4,424,071                                                       |   | 16,578,942 |   |
|                                                                                                      |   |                                                            |   |   |   |
| Diluted                                                                                                   |   | 10,633,577                                                      |   | 18,219,289 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

4

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**Digital Theater Systems, Inc.**

 

**Condensed Consolidated Statements of Cash Flows**

 
|                                                                                |   | **For the  Three Months  Ended March 31,** |   |
|-------------------------------------------------------------------------------------|--------|-------------------------------------------------|--------|
|                                                                                |   | **2003**                                        |   | **2004** |   |
|                                                                                |   | **(Unaudited)**                                 |   |
|                                                                                |   | **(Amounts  in thousands)**                     |   |
| Cash flows from operating activities:                                               |   |                                            |   |   |   |
| Net income                                                                          |   | $                                               | 2,029  |   | $ | 3,440 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities:  |   |                                            |   |   |   |
| Depreciation and amortization                                                       |   | 258                                             |   | 279 |   |
| Stock-based compensation charges                                                    |   | 403                                             |   | 139 |   |
| Allowance for doubtful accounts                                                     |   | 100                                             |   | 2 |   |
| Deferred income taxes                                                               |   | —                                          |   | (1,130 | ) |
| Tax benefit from employee stock plans                                               |   | —                                          |   | 1,060 |   |
| Changes in operating assets and liabilities:                                        |   |                                            |   |   |   |
| Accounts receivable                                                                 |   | 2,281                                           |   | (811 | ) |
| Inventories                                                                         |   | (655                                            | )      | (1,567 | ) |
| Prepaid expenses and other assets                                                   |   | 19                                              |   | (23 | ) |
| Accounts payable and accrued expenses                                               |   | (849                                            | )      | 1,647 |   |
| Income taxes                                                                        |   | (128                                            | )      | 1,107 |   |
|                                                                                |   |                                            |   |   |   |
| Net cash provided by operating activities                                           |   | 3,458                                           |   | 4,143 |   |
|                                                                                |   |                                            |   |   |   |
| Cash flows from investing activities:                                               |   |                                            |   |   |   |
| Purchase of investments                                                             |   | (7                                              | )      | (23,060 | ) |
| Purchase of property and equipment                                                  |   | (247                                            | )      | (521 | ) |
| Payment for patents and trademarks in process                                       |   | (4                                              | )      | (16 | ) |
|                                                                                |   |                                            |   |   |   |
| Net cash used in investing activities                                               |   | (258                                            | )      | (23,597 | ) |
|                                                                                |   |                                            |   |   |   |
| Cash flows from financing activities:                                               |   |                                            |   |   |   |
| Payment of dividends to preferred stockholders                                      |   | (1,318                                          | )      | — |   |
| Follow-on public offering costs                                                     |   | —                                          |   | (52 | ) |
| Proceeds from the issuance of common stock upon  exercise of employee stock options |   | 1                                               |   | 130 |   |
| Proceeds from the issuance of common stock upon  exercise of warrants               |   | 1                                               |   | — |   |
|                                                                                |   |                                            |   |   |   |
| Net cash provided by (used in) financing activities                                 |   | (1,316                                          | )      | 78 |   |
|                                                                                |   |                                            |   |   |   |
| Net increase (decrease) in cash and cash  equivalents                               |   | 1,884                                           |   | (19,376 | ) |
| Cash and cash equivalents, beginning of period                                      |   | 1,907                                           |   | 89,341 |   |
|                                                                                |   |                                            |   |   |   |
| Cash and cash equivalents, end of period                                            |   | $                                               | 3,791  |   | $ | 69,965 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

5

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**DIGITAL THEATER SYSTEMS, INC.**

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Amounts in thousands, except share and per share data)**

 

**Note 1 — Basis of Presentation**

 

Theaccompanying unaudited condensed consolidated financial statements of DigitalTheater Systems, Inc. (the “Company”) have been prepared in accordance withaccounting principles generally accepted in the United States of America andwith 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 of America for complete financial statements. In the opinion ofmanagement, the unaudited condensed consolidated financial statements reflectall adjustments considered necessary for a fair presentation, consisting onlyof normal and recurring adjustments. All significant intercompany transactionshave been eliminated in consolidation. Operating results for the three monthsended March 31, 2004 are not necessarily indicative of the results thatmay be expected for the fiscal year ending December 31, 2004. For furtherinformation, refer to the consolidated financial statements and footnotesthereto for the year ended December 31, 2003 filed on Form 10-K filed onMarch 30, 2004.

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities, and disclosures of contingent assets and liabilities at the dateof the financial statements, and the reported amounts of revenues and expensesduring the reporting period. Actual results could differ from those estimates.

 

**Note 2 — Recent Accounting Pronouncements**

 

In November 2003, the EITF reached a consensus on IssueNo. 03-10, “Application of EITF 02-16 by Resellers to Sales IncentivesOffered to Consumers by Manufacturers.” EITF No. 03-10 addresses theaccounting for manufacturer sales incentives offered directly to consumers,including manufacturer coupons. EITF No. 03-10 is effective for the firstinterim period beginning after November 25, 2003. Adoption of theprovisions of EITF No. 03-10 did not have a material impact on theCompany’s financial position, results of operations, or cash flows for thethree months ended March 31, 2004.

 

**Note 3 — Certain Balance Sheet Items**

 

Inventoriesconsist of the following:

 
|              |   | **As of  December 31,  2003** |       | **As of  March 31,  2004** |       |
|-------------------|--------|------------------------------------|------------|---------------------------------|------------|
|              |   |                               | ** ** | **(Unaudited)**                 | ** ** |
| Raw materials     |   | $                                  | 1,370      |                            | $          | 1,793 |   |
| Work in process   |   | 8                                  |       | 2                               |       |
| Finished goods    |   | 6,174                              |       | 7,324                           |       |
|              |   |                               |       |                            |       |
| Total inventories |   | $                                  | 7,552      |                            | $          | 9,119 |   |

 

Propertyand equipment consist of the following:

 
|                           |   | **As of  December 31,  2003** |   | **As of  March 31,  2004** |   |
|--------------------------------|--------|------------------------------------|--------|---------------------------------|--------|
|                           |   |                               |   | **(Unaudited)**                 |   |
| Machinery and equipment        |   | $                                  | 2,511  |                            | $      | 2,666 |   |
| Office furniture and fixtures  |   | 1,963                              |   | 2,175                           |   |
| Leasehold improvements         |   | 2,599                              |   | 2,753                           |   |
|                           |   |                               |   |                            |   |
|                           |   | 7,073                              |   | 7,594                           |   |
| Less: Accumulated depreciation |   | (3,981                             | )      | (4,241                          | )      |
|                           |   |                               |   |                            |   |
| Property and equipment, net    |   | $                                  | 3,092  |                            | $      | 3,353 |   |

 

**Note 4 — Bank Line of Credit**

 

TheCompany has a $10,000 working capital credit facility with a bank that matureson June 30, 2004. The bank agreement provides for working capitalfinancing and is collateralized by substantially all of the Company’s assets.The bank agreement requires the Company to comply with certain restrictivecovenants including maintenance of certain working capital, tangible net worthand profitability levels.

 

AtDecember 31, 2003 and March 31, 2004, there were no balancesoutstanding under this agreement and there was $10,000 and $10,000,respectively, of available borrowings under this credit facility pursuant to anavailability formula based on cash, cash equivalents, short-term investments,80% of eligible accounts receivable and 20% of inventory (up to a maximum of$1,000). Future borrowings will bear interest at rates ranging from the primerate, as defined, minus 0.5% to the prime rate plus 1% (3.5% to 5.0% atDecember 31, 2003 and March 31, 2004). A commitment fee of 0.25% perannum is paid on the daily unused balance under the line of credit.

 

**Note 5 — Income Taxes**

 

Forthe three months ended March 31, 2004, the Company recorded an income taxprovision of  $1,918 on pre-tax incomeof  $5,358 resulting in an annualizedeffective tax rate of 35.8%.  For thethree months ended March 31, 2003, the Company recorded an income taxprovision of $1,086 on pre-tax income of $3,115, resulting in an annualizedeffective tax rate of 35.0%.  These ratesdiffered from the statutory rates primarily due to state income taxes offset bybenefits associated with the foreign rate differentials and research anddevelopment credits.

 

6

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**Note 6 — Commitments and Contingencies**

 

**Indemnities, Commitments and Guarantees**

 

Inthe normal course of business, the Company makes certain indemnities,commitments and guarantees under which the Company may be required to makepayments in relation to certain transactions. These indemnities, commitmentsand guarantees include, among others, intellectual property indemnities tocustomers in connection with the sale of products and licensing of technology,indemnities for liabilities associated with the infringement of other parties’ technologybased upon the Company’s products and technology, guarantees of timelyperformance of the Company’s obligations, and indemnities to the Company’directors and officers to the maximum extent permitted by law. The duration ofthese indemnities, commitments and guarantees varies, and in certain cases, isindefinite. The majority of these indemnities, commitments and guarantees donot provide for any limitation of the maximum potential future payments thatthe Company could be obligated to make. The Company has not recorded aliability for these indemnities, commitments or guarantees in the accompanyingbalance sheets, as future payment is not probable.

 

**Note 7 — Stock-Based Compensation**

 

TheCompany accounts for its employee stock option and stock purchase plans inaccordance with the provisions of Accounting Principals Board (“APB”) OpinionNo. 25, “Accounting for Stock Issued to Employees” and the related FASBInterpretation No. 44, “Accounting for Certain Transactions InvolvingStock Compensation.” Accordingly, compensation expense related to employeestock options is recorded if, on the date of the grant, the fair value of theunderlying stock exceeds the exercise price.

 

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

 
|                                                                                                                |   | **For the  Three  Months Ended  March 31,** |   |
|---------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------------------|--------|
|                                                                                                                |   | **2003**                                         |   | **2004** |   |
|                                                                                                                |   | **(Unaudited)**                                  |   |
| Net income attributable to common stockholders:                                                                     |   |                                             |   |   |   |
| As reported                                                                                                         |   | $                                                | 1,561  |   | $ | 3,440 |   |
| Additional stock-based compensation expense  determined under the fair value method, net of tax                     |   | (64                                              | )      | (449 | ) |
|                                                                                                                |   |                                             |   |   |   |
| Pro forma                                                                                                           |   | $                                                | 1,497  |   | $ | 2,991 |   |
|                                                                                                                |   |                                             |   |   |   |
| Net income attributable to common stockholders per  common share-basic:                                             |   |                                             |   |   |   |
| As reported                                                                                                         |   | $                                                | 0.35   |   | $ | 0.21 |   |
| Per share effect of additional stock-based  compensation expense determined under the fair value method, net of tax |   | (0.01                                            | )      | (0.03 | ) |
|                                                                                                                |   |                                             |   |   |   |
| Pro forma                                                                                                           |   | $                                                | 0.34   |   | $ | 0.18 |   |
|                                                                                                                |   |                                             |   |   |   |
| Net income attributable to common stockholders per  common share-diluted:                                           |   |                                             |   |   |   |
| As reported                                                                                                         |   | $                                                | 0.15   |   | $ | 0.19 |   |
| Per share effect of additional stock-based  compensation expense determined under the fair value method, net of tax |   | (0.01                                            | )      | (0.03 | ) |
|                                                                                                                |   |                                             |   |   |   |
| Pro forma                                                                                                           |   | $                                                | 0.14   |   | $ | 0.16 |   |

 

TheCompany accounts for stock, stock options and warrants issued to non-employeesin accordance with the provisions of SFAS No. 123 and EITF IssueNo. 96-18 “Accounting for Equity Instruments That Are Issued to Other ThanEmployees for Acquiring, or in Conjunction with Selling, Goods and Services.”Under SFAS No. 123 and EITF Issue No. 96-18, stock option awardsissued to non-employees are accounted for at fair value using the Black-Scholespricing model. Management believes that the fair value of the stock options ismore reliably measured than the fair value of the services received. The fairvalue of each non-employee equity award is remeasured each period until acommitment date is reached, which is generally the vesting date. Fornon-employee equity awards, deferred stock-based compensation is not reflectedin stockholders’ deficit until a commitment date is reached. For the threemonths ended March 31, 2003 and 2004, the Company recorded stock-basedcompensation expense of $403 and $139, respectively, related to non-employee equityawards.

 

**Note 8 — Operating Segment and GeographicInformation**

 

TheCompany operates its business in two reportable segments: the Theatricalbusiness segment and the Consumer business segment. The Theatrical businesssegment provides digital playback systems and cinema processor equipment tomovie theaters, and provides film licensing services to film production anddistribution companies. The Company’s Consumer business segment licenses audiotechnology, trademarks and know-how to consumer electronics, personal computer,broadcast and professional audio companies, and sells multi-channel audiocontent and products to consumers.

 

TheCompany does not have separately identifiable capital expenditures orlong-lived assets related to these two business segments.

 

TheCompany’s reportable segments and geographical information for the three monthsended March 31, 2003 and 2004 are as follows:

 

7

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|                |   | **Revenues**                                   |   |
|---------------------|--------|------------------------------------------------|--------|
|                |   | **For the Three Months  Ended March 31,** |   |
|                |   | **2003**                                       |   | **2004** |   |
|                |   | **(Unaudited)**                                |   |
| Theatrical business |   | $                                              | 3,480  |   | $ | 4,800 |   |
| Consumer business   |   | 8,276                                          |   | 10,797 |   |
|                |   |                                           |   |   |   |
| Total revenues      |   | $                                              | 11,756 |   | $ | 15,597 |   |

 
|                |   | **Gross  Profit**                              |   |
|---------------------|--------|------------------------------------------------|--------|
|                |   | **For the Three Months  Ended March 31,** |   |
|                |   | **2003**                                       |   | **2004** |   |
|                |   | **(Unaudited)**                                |   |
| Theatrical business |   | $                                              | 1,554  |   | $ | 2,462 |   |
| Consumer business   |   | 7,789                                          |   | 10,243 |   |
|                |   |                                           |   |   |   |
| Total gross profit  |   | $                                              | 9,343  |   | $ | 12,705 |   |

 
|                         |   | **Income  (Loss) From Operations**             |   |
|------------------------------|--------|------------------------------------------------|--------|
|                         |   | **For the Three Months  Ended March 31,** |   |
|                         |   | **2003**                                       |   | **2004** |   |
|                         |   | **(Unaudited)**                                |   |
| Theatrical business          |   | $                                              | (1,193 | ) | $ | (1,077 | ) |
| Consumer business            |   | 4,375                                          |   | 6,010 |   |
|                         |   |                                           |   |   |   |
| Total income from operations |   | $                                              | 3,182  |   | $ | 4,933 |   |

 
|           |   | **Revenues  by Geographic Region**             |   |
|----------------|--------|------------------------------------------------|--------|
|           |   | **For the Three Months  Ended March 31,** |   |
|           |   | **2003**                                       |   | **2004** |   |
|           |   | **(Unaudited)**                                |   |
| United States  |   | $                                              | 2,678  |   | $ | 4,189 |   |
| International  |   | 9,078                                          |   | 11,408 |   |
|           |   |                                           |   |   |   |
| Total revenues |   | $                                              | 11,756 |   | $ | 15,597 |   |

 

Thefollowing table sets forth, for the periods indicated, long-lived assets bygeographic area in which the Company holds assets at December 31, 2003 andMarch 31, 2004:

 
|                    |   | **Long-Lived  Assets**             |   |
|-------------------------|--------|------------------------------------|--------|
|                    |   | **As of  December 31,  2003** |   | **As of  March 31,  2004** |   |
|                    |   |                               |   | **(Unaudited)** |   |
| United States           |   | $                                  | 3,150  |   | $ | 3,145 |   |
| International           |   | 366                                |   | 630 |   |
|                    |   |                               |   |   |   |
| Total long-lived assets |   | $                                  | 3,516  |   | $ | 3,775 |   |

 

**Note 9 — Net Income Attributable to CommonStockholders Per Common Share**

 

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

 

8

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|                                                                      |   | **For the  Three Months Ended  March 31,** |   |
|---------------------------------------------------------------------------|--------|-------------------------------------------------|--------|
|                                                                      |   | **2003**                                        |   | **2004** |   |
|                                                                      |   | **(Unaudited)**                                 |   |
| Basic net income attributable to common  stockholders per common share:   |   |                                            |   |   |   |
| Numerator:                                                                |   |                                            |   |   |   |
| Net income                                                                |   | $                                               | 2,029  |   | $ | 3,440 |   |
| Preferred stock dividends accrued                                         |   | (392                                            | )      | — |   |
| Accretion on preferred stock                                              |   | (76                                             | )      | — |   |
|                                                                      |   |                                            |   |   |   |
| Net income attributable to common stockholders                            |   | $                                               | 1,561  |   | $ | 3,440 |   |
|                                                                      |   |                                            |   |   |   |
| Denominator:                                                              |   |                                            |   |   |   |
| Weighted average common shares outstanding                                |   | 4,424,071                                       |   | 16,578,942 |   |
|                                                                      |   |                                            |   |   |   |
| Basic net income attributable to common  stockholders per common share    |   | $                                               | 0.35   |   | $ | 0.21 |   |
|                                                                      |   |                                            |   |   |   |
| Diluted net income attributable to common  stockholders per common share: |   |                                            |   |   |   |
| Numerator:                                                                |   |                                            |   |   |   |
| Net income                                                                |   | $                                               | 2,029  |   | $ | 3,440 |   |
| Preferred stock dividends accrued                                         |   | (392                                            | )      | — |   |
| Accretion on preferred stock                                              |   | (76                                             | )      | — |   |
|                                                                      |   |                                            |   |   |   |
| Net income attributable to common stockholders                            |   | $                                               | 1,561  |   | $ | 3,440 |   |
|                                                                      |   |                                            |   |   |   |
| Denominator:                                                              |   |                                            |   |   |   |
| Weighted average shares outstanding                                       |   | 4,424,071                                       |   | 16,578,942 |   |
| Effect of dilutive securities:                                            |   |                                            |   |   |   |
| Common stock options                                                      |   | 1,406,847                                       |   | 1,318,156 |   |
| Common stock warrants                                                     |   | 4,802,659                                       |   | 322,191 |   |
|                                                                      |   |                                            |   |   |   |
| Diluted shares outstanding                                                |   | 10,633,577                                      |   | 18,219,289 |   |
|                                                                      |   |                                            |   |   |   |
| Diluted net income attributable to common  stockholders per common share  |   | $                                               | 0.15   |   | $ | 0.19 |   |

 

9

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**Item 2.****     *Management’s Discussion and Analysis of FinancialCondition and Results of Operations***

 

**Forward-Looking Statements May Prove Inaccurate**

 

This report and the documents incorporated herein by reference containforward-looking statements based on our current expectations, estimates andprojections about our industry, beliefs, and certain assumptions made by us.Words such as “believes,” “anticipates,” “estimates,” “expects,” “projections,”“may,” “potential,” “plan,” “continue” and words of similar import, constitute“forward-looking statements.” The forward-looking statements contained in thisreport involve known and unknown risks, uncertainties and other factors thatmay cause our actual results to be materially different from those expressed orimplied by these statements. These factors include those listed under the “RiskFactors” section contained below and in our Form 10-K filed onMarch 30, 2004 with the Securities and Exchange Commission, or SEC, andthe other documents we file with the SEC, including our most recent reports onForm 8-K and Form 10-Q. We cannot guarantee future results, levels ofactivity, performance or achievements. We do not undertake any obligation torevise these forward-looking statements to reflect future events or circumstances.

 

You should read the following discussion of our financial condition andresults of operations in conjunction with the Form 10-K filed on March 30,2004. This discussion may contain forward-looking statements that involve risksand uncertainties. Our actual results may differ materially from thoseanticipated in these forward-looking statements as a result of certain factors,such as those set forth under “Risk Factors” contained below and in our Form10-K filed on March 30, 2004.

 

**Overview**

 

Weare a leading provider of entertainment technology, historically focused onhigh-quality digital multi-channel audio technology, products, and services forentertainment markets worldwide. Multi-channel audio, commonly referred to assurround sound, provides more than two-channels of audio, allowing the listenerto simultaneously hear discrete sounds from multiple speakers. Our DTS digitalmulti-channel audio technology delivers compelling surround sound for themotion picture and consumer electronics markets.

 

Wemanage our business through two reportable segments — our theatricalbusiness and our consumer business. Historically, we have derived a majority ofour revenues from the theatrical business. Beginning in 2001, however, we havederived a majority of our revenues from our consumer business.

 

Inour consumer business, we derive revenues from licensing our audio technology,trademarks, and know-how under agreements with substantially all of the majorconsumer audio electronics manufacturers. Our business model provides for thesemanufacturers to pay us a per-unit amount for DTS-enabled products that theymanufacture. We also derive revenues from licensing our technology to consumersemiconductor manufacturers. Through our DTS Entertainment label, we deriverevenues from the sale of music titles in our digital multi-channel format.

 

Inour theatrical business, we derive revenues from sales of our playbackequipment and cinema processors to movie theaters and special venues. Inaddition, we sell encoding and duplication services to film producers anddistributors for the creation of digital multi-channel motion picturesoundtracks. We also derive revenues from the sale of systems and encodingservices for pre-show advertising, alternative content, subtitling, captioning,and descriptive narration.

 

Wepresent revenues in our consolidated financial statements and in this“Management’s Discussion and Analysis of Financial Condition and Results ofOperations” as derived from (1) technology and film licensing and(2) product sales and other revenues. Our technology and film licensingrevenues are derived from each of our consumer and theatrical businesssegments. Revenues from technology licensing in connection with our consumerbusiness segment include revenues derived from licensing our audio technology,trademarks, and know-how to consumer electronics, personal computer, video gameand console, digital satellite and cable broadcast, and professional audiocompanies as well as to semiconductor manufacturers. Revenues from technologyand film licensing in connection with our theatrical business segment includerevenues derived from film licensing and services that we provide to filmstudios for the production of soundtracks in our digital multi-channel format.Our product sales and other revenues also are derived from each of our consumerand theatrical business segments. Revenues from product sales and otherrevenues in connection with our consumer business segment include revenuesderived from sales of music titles that we produce in our digital multi-channelformat and sales of our professional audio products and services. Revenues fromproduct sales and other revenues in connection with our theatrical businesssegment include revenues derived from sales of our digital playback systems,cinema processor equipment, and systems for subtitling, captioning, anddescriptive narration to movie theaters and special venues.

 

Weactively engage in intellectual property compliance and enforcement activitiesfocused on identifying third parties who have either incorporated ourtechnology, trademarks, or know-how without a license or who haveunder-reported to us the amount of royalties owed under license agreements withus. As a result of these activities, from time to time, we recognize royaltyrevenues that relate to consumer electronics manufacturing activities fromprior periods. These royalty recoveries may cause revenues to be higher thanexpected during a particular reporting period and may not occur in subsequentperiods. We cannot predict the amount or timing of such revenues.

 

Ourcost of goods sold consists primarily of amounts paid for products andmaterials, salaries and related benefits for production personnel, depreciationof production equipment, and payments to third parties for licensing technologyand copyrighted material.

 

Ourselling, general, and administrative expenses consist primarily of salaries,commissions, and related benefits for personnel engaged in sales, corporateadministration, finance, human resources, information systems, legal, andoperations, and costs associated with promotional and other selling activities.Selling, general, and administrative expenses also include professional fees,facility-related expenses, and other general corporate expenses.

 

Ourresearch and development costs consist primarily of salaries and relatedbenefits for research and development personnel, engineering consultingexpenses associated with new product and technology development, and qualityassurance and testing costs. Research and development costs are expensed asincurred.

 

Inour consumer business, we have a licensing team that markets our technologydirectly to large consumer electronics products manufacturers and semiconductormanufacturers. This team includes employees located in the United States,China, England, Japan, and Northern Ireland. We sell music content releasedunder our DTS Entertainment label through distributors. In the United Statesand Canada, Navarre Corporation is our exclusive distributor of DTS Entertainmentlabel products to major national retail accounts and in Europe, Cadiz MusicLimited is our exclusive distributor of DTS Entertainment label products. Wealso employ consultants to coordinate sales to independent retailers. We are inthe process of establishing distribution channels in other internationalterritories. We expect that distribution in Asia will be handled throughestablished distributors located in Asia. We also sell this music directly to consumers through an online storeand other web-based retailers. We intend to expand the number of retail outletsthat carry our products and broaden our distribution network worldwide.

 

Inour theatrical business, our post-production department, senior management, andliaison offices market our products and services directly to individual filmproducers and distributors worldwide. We sell our digital multi-channelplayback systems to movie theaters through a direct sales force and a networkof independent dealers. To date, most of our sales and marketing efforts havebeen focused in the United States and Canada, Western Europe, and in targetedmarkets in Asia and Latin America. We have also begun to focus our efforts onpursuing theater companies that have a large concentration of movie theaters inselected foreign countries such as India, China, and in Eastern Europe.

 

10

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**Critical Accounting Policies and Estimates**

 

Management’sDiscussion and Analysis of Financial Condition and Results of Operations is basedupon our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United States.The preparation of our financial statements requires us to make estimates andjudgments that affect the reported amounts of assets, liabilities, revenues,and expenses, and related disclosure of contingent assets and liabilities. Onan on-going basis, estimates are evaluated, including those related to revenuerecognition, allowance for doubtful accounts, inventories, deferred taxes,impairment of long-lived assets, product warranty, stock-based compensation,and contingencies and litigation. These estimates are based on historicalexperience and on various other assumptions that we believe to be reasonableunder the circumstances, the results of which form the basis for makingjudgments about the carrying values of assets and liabilities that are notreadily apparent from other sources. Actual results may differ from theseestimates.  There has been no materialchange to our critical accounting policies and estimates from the informationprovided in our Form 10-K filed on March 30, 2004.

 

**Results of Operations**

 

***Revenues***

 

Totalrevenues for the three months ended March 31, 2004 increased 33% to $15.6million from $11.8 million for the three months ended March 31, 2003.The increase in revenues in 2004 resulted from a 23% increase in technology andfilm licensing revenues to $12.5 million for the three months endedMarch 31, 2004 from $10.1 million for the three months endedMarch 31, 2003 and a 90% increase in our product sales and other revenuesto $3.1 million for the three months ended March 31, 2004 from $1.6million for the three months ended March 31, 2003. The increase inrevenues from technology and film licensing was primarily attributable tocontinued growth in consumer electronics licensing, driven by an increase inthe number of DVD-based home entertainment systems that incorporate DTStechnology, such as audio/video receivers, DVD players, and home-theater-in-a-boxsystems, and by revenues recognized as a result of intellectual propertycompliance and enforcement activities. In addition, our film licensing revenues increased moderately due torevenues generated from increases in the number of U.S. films released, foreignlanguage dubbed versions of major U.S. films, and foreign original-versionfilms released with a DTS soundtrack. Shipments of our XD-10 Cinema Media Player contributed to theincrease in revenues from product sales quarter over quarter, as did anincrease in sales by our DTS Entertainment label.

 

Revenuesfrom our consumer business totaled $10.8 million for the three monthsended March 31, 2004, an increase of 30% from $8.3 million in the firstquarter of the prior year. The increase in revenues was driven by the growth inconsumer electronics technology licensing as mentioned above. Theatricalrevenues were $4.8 million for the three months ended March 31, 2004, up38% from the same period last year due primarily to growth in product sales,primarily the XD-10 Cinema Media Player.

 

***Gross Profit***

 

Consolidatedgross profit improved to 81% of revenues for the three months endedMarch 31, 2004, from 79% for the three months ended March 31, 2003.The increase is due to an increase in gross profit in product sales and otherrevenues.

 

Grossprofit associated with technology and film licensing revenues remained constantat 92% of related revenues for the three months ended March 31, 2004 and2003. Gross profit associated with product sales and other revenues improved to38% of related revenues for the three months ended March 31, 2004 from 4%in the prior year period due primarily to increased shipment volumes.

 

Grossprofit for our consumer business improved to 95% of related revenues for thethree months ended March 31, 2004, from 94% in the prior year period. Theincrease is due to the growth of our higher margin technology licensingrevenues. Theatrical business gross profit increased to 51% of related revenuesfor the quarter ended March 31, 2004 from 45% in the prior year period dueto the growth in sales of our XD-10 Cinema Media Player mentioned above.

 

We expect our consolidated gross profit as a percentage of sales todecrease to between 70% and 75% for the full fiscal year 2004 as we expect thatthe sales growth rate in our theatrical business will exceed that of our highermargin consumer business.

 

***Selling, General and Administrative***

 

Selling,general and administrative expenses increased 29% to $6.4 million for thequarter ended March 31, 2004, compared to $5.0 million in the prioryear quarter. The increase is primarily due to increases in salaries andrelated costs of $776,000 as we increased headcount to support our growth, andprofessional services of $380,000 which includes costs associated with ourincreased intellectual property compliance and enforcement activities andadditional costs associated with operating as a public company. The quarter toquarter increase also includes increases in advertising and promotion costs relatedto new product introductions, and insurance costs.  Salaries and related costs includes stock-based compensation.

 

Costs of compliance with the Sarbanes-Oxley Act, particularlySection 404 of that Act, are anticipated to cause an estimated increase inadministration costs of between $700,000 and $900,000 during 2004, up to halfof which represents recurring costs for compliance.

 

***Research and Development***

 

Researchand development expenses increased to $1.3 million for the three monthsended March 31, 2004, compared to $1.2 million for the three months endedMarch 31, 2003. The increase is primarily due to increased labor costsassociated with new product initiatives and the optimization of our CoherentAcoustics technology for new consumer electronics applications.

 

Weexpect quarterly research and development expenses in 2004 to increase inabsolute dollars relative to the prior year.

 

11

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

 

Interestincome, net, for the three months ended March 31, 2004 increased to$439,000 from $13,000 for the prior year same period. This favorable increasewas due to increased investment income subsequent to the initial and follow-onpublic offerings along with the recognition of $164,000 in interest for latepayment of royalties from a licensee that covered the period of July 2000through September 2003.

 

***Income Taxes***

 

For the three months ended March 31, 2004, the Company recorded anincome tax provision of $1,918 on per-tax income of $5,358 resulting in anannualized effective tax rate of 35.8%. This rate differs from the Company’s statutory rate primarily due tostate income taxes offset by benefits associated with the foreign ratedifferential and research and development credits.

 

**Liquidity and Capital Resources**

 

AtMarch 31, 2004, we had cash, cash equivalents and short-term investmentsof $95.6 million, compared to $99.4 million at December 31,2003.

 

Netcash provided by operating activities was $4.1 million for the threemonths ended March 31, 2004, compared to $3.5 million for the three monthsended March 31, 2003. The improvement in cash flows from operations wasprimarily a result of increased net income generated in the first three monthsof 2004 relative to the same period in the prior year. Accounts receivableincreased $811,000 for the three months ended March 31, 2004 due toaccruals related to consumer license fees. Inventory increased $1.6 million forthe three months ended March 31, 2004 as a result of inventory purchasesrelated to our new product offerings. Accounts payable and accrued expenses increased $1.6 million primarilyrelated to the timing of inventory purchases, an unusually large proportion ofwhich occurred very late in first quarter of 2004.

 

Netcash used in investing activities totaled $23.6 million and $258,000 for thethree months ended March 31, 2004 and 2003, respectively. The increase incash used in investing activities for the three months ended March 31,2004 is primarily a result of the purchases of investment instruments withmaturities greater than 90 days of $23.1 million and purchases of property andequipment related to the establishment of an office in Japan.

 

Netcash provided by financing activities totaled $78,000 for the three monthsended March 31, 2004 and net cash used by financing activities was$1.3 million for the three months ended March 31, 2003.  Net cash provided by financing activitiesfor the three months ended March 31, 2004 primarily consisted of cashreceived from option exercises, partially offset by cash paid for offeringcosts related to the follow-on public offering in 2003.  Net cash used by financing activities forthe three months ended March 31, 2003 consisted of payments of dividendsto preferred stockholders.  The preferredstock was redeemed in the third quarter of 2003.

 

Webelieve that our cash, cash equivalents, short-term investments, fundsavailable under our existing bank line of credit facility, and cash flows fromoperations will be sufficient to satisfy our working capital and capitalexpenditure requirements for at least the next twelve months. Beyond the nexttwelve months, additional financing may be required to fund working capital andcapital expenditures. Changes in our operating plans, lower than anticipatedrevenues, increased expenses, acquisition of companies, products ortechnologies or other events, including those described in “Risk Factors”included in our Form 10-K filed on March 30, 2004 and in and other filingsmay cause us to seek additional debt or equity financing on an acceleratedbasis. Financing may not be available on acceptable terms, or at all, and ourfailure to raise capital when needed could negatively impact our growth plansand our financial condition and results of operations. Additional equityfinancing may be dilutive to the holders of our common stock and debtfinancing, if available, may involve significant cash payment obligations andfinancial or operational covenants that restrict our ability to operate ourbusiness.

 

**Recently Issued Accounting Standards**

 

In November 2003, the EITF reached a consensus on IssueNo. 03-10, “Application of EITF 02-16 by Resellers to Sales Incentives Offered to Consumers by Manufacturers.”EITF No. 03-10 addresses the accounting for manufacturer sales incentivesoffered directly to consumers, including manufacturer coupons. EITFNo. 03-10 is effective for the first interim period beginning afterNovember 25, 2003. Adoption of the provisions of EITF No. 03-10 didnot have a material impact on our financial position, results of operations, orcash flows for the three months ended March 31, 2004.

 

**RISK FACTORS**

 

*Set forth below and elsewhere in this reportand in other documents we file with the Securities and Exchange Commission arerisks and uncertainties that could cause our actual results to differmaterially from the results contemplated by the forward-looking statementscontained in this report and other public statements we make. If any of thefollowing risks actually occurs, our business, financial condition, or resultsof operations could suffer. In that case, the trading price of our common stockcould decline, and you may lose all or part of your investment.*

 

**Risks Related to Our Business**

 

***We face intensecompetition from companies with greater brand recognition and resources.***

 

The digital audio, consumer electronics, andentertainment markets are intensely competitive, subject to rapid change, andsignificantly affected by new product introductions and other market activitiesof industry participants. Our principal competitor is DolbyLaboratories, Inc., who competes with us in most of our markets. We alsocompete with other companies offering:

 

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

 

•              productsfor theatrical markets, such as Smart Devices, Inc., Sony Corporation, andUltra Stereo Labs, Inc.

 

Many of our current and potentialcompetitors, including Dolby, enjoy substantial competitive advantages,including:

 

•              greatername recognition;

 

•              alonger operating history;

 

•              moredeveloped distribution channels and deeper relationships with semiconductor andconsumer electronics products manufacturers;

 

•              amore extensive customer base;

 

•              digitaltechnologies that offer greater compression and require less storage capacity;

 

•              broaderproduct and service offerings;

 

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

 

•              moretechnicians and engineers.

 

As a result, these current and potentialcompetitors may be able to respond more quickly and effectively than we can tonew or changing opportunities, technologies, standards, or customerrequirements.

 

In addition to the competitive advantagesdescribed above, Dolby also enjoys other unique competitive strengths relativeto us. For example, it introduced multi-channel audio technology before we did.It has a larger base of installed movie theaters for its cinema playbackequipment. Its technology has been incorporated in significantly more DVD-Videofilms than our technology. It has also achieved mandatory standard status in afew product categories, including DVD-Video and DVD-Audio Recordable, for itsstereo technology and terrestrial digital television broadcasts in the UnitedStates. As a result of these factors, Dolby has a competitive advantage inselling its digital multi-channel technology to consumer electronics productsmanufacturers.

 

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

 

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

 

Technology standards are important in theaudio 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 audio technology to be available in a particular productor medium, or an optional basis, meaning that a particular audio technology maybe, but is not required to be, utilized. For example, Dolby’s technology forstereo playback has been selected as a mandatory standard for DVD-Video andDVD-Audio Recordable. Both Dolby’s and our digital multi-channel technologyhave optional status in the DVD-Video standard.

 

12

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Various national governments have adopted orare in the process of adopting standards for all digital television broadcasts,including cable, satellite, and terrestrial. In the United States, Dolby’stechnology has been selected as the sole, mandatory standard for terrestrialdigital television broadcasts. As a result, all digital terrestrial televisionbroadcasts in the United States must include Dolby’s technology and mustexclude any other format, including ours. We do not know whether this standardwill be reopened or amended. If it is not, our technology may never beincluded. Certain large and developing markets, such as China, have not fullydeveloped their digital television standards. Our technology may or may notultimately be included in these standards.

 

Adoption of our technology is not mandatoryas part of any governmental or industry accepted standards in any specificentertainment medium or format. As such, there can be no assurance that ourtechnology will continue to be used in current and future applications.

 

As new technologies and entertainment mediumsemerge, including future generations of DVD technology, new standards relatingto these technologies or mediums may develop. New standards may also emerge inexisting markets that are currently characterized by competing formats, such asthe market for personal computers. We may not be successful in our efforts toinclude 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 thatare acceptable to our customers or the changing market.***

 

The market for our technology, products, andservices is characterized by:

 

•              rapidtechnological change;

 

•              newand improved product introductions;

 

•              changingcustomer demands;

 

•              evolvingindustry standards; and

 

•              productobsolescence.

 

Our future success will depend on our abilityto enhance 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 toprotect our intellectual property rights, our ability to compete could beharmed.***

 

Protection of our intellectual property iscritical to our success. Patent, trademark, copyright, and trade secret lawsand confidentiality and other contractual provisions afford only limitedprotection and may not adequately protect our rights or permit us to gain orkeep any competitive advantage. We face numerous risks in protecting ourintellectual 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;

 

•              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

 

13

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

 

As a result, we cannot assure you that ourmeans of protecting our intellectual property rights and brands will beadequate. Furthermore, despite our efforts, third parties may violate, orattempt to violate, our intellectual property rights. Infringement claims andlawsuits would likely be expensive to resolve and would require management’stime and resources. In addition, we have not sought, and do not intend to seek,patent and other intellectual property protections in all foreign countries. Incountries where we do not have such protection, products incorporating ourtechnology may be lawfully produced and sold without a license.

 

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

 

Companies that participate in the digitalaudio, consumer electronics, and entertainment industries hold a large numberof patents, trademarks, and copyrights, and are frequently involved inlitigation based on allegations of patent infringement or other violations ofintellectual property rights. Intellectual property disputes frequently involvehighly complex and costly scientific matters, and each party generally has theright to seek a trial by jury which adds additional costs and uncertainty.Accordingly, intellectual property contests, with or without merit, could becostly and time consuming to litigate or settle, and could divert management’sattention from executing our business plan. In addition, our technology andproducts may not be able to withstand any third-party claims or rights againsttheir use. If we were unable to obtain any necessary license following adetermination of infringement or an adverse determination in litigation or ininterference or other administrative proceedings, we may need to redesign someof our products to avoid infringing a third party’s patent and could berequired to temporarily or permanently discontinue licensing our products.

 

***If we are unable to maintain and increase theamount of entertainment content released with DTS audio soundtracks, demand forthe technology, products, and services that we offer to consumer electronicsproducts manufacturers may significantly decline.***

 

We expect to derive a significant percentage ofour revenues 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 relations with many leading providers ofmovie, music, computer, and video game content, none of our existing contractsrequire 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 DTS-CSS system for subtitles,captions, and descriptive narration for films is not adopted widely, ourbusiness may be harmed.***

 

Our DTS-CSS system for subtitles, captions,and descriptive narration for films is a key new product. To date, sales andrevenues from this system have been immaterial and we have limited experienceto indicate whether or not this system will be widely adopted. Nonetheless, wehave anticipated significant future sales of this system and our revenue andgrowth projections contemplate that it will generate significant futurerevenues.  If we are unsuccessful inselling our DTS-CSS system, our future revenues will be lower than expected andwe may be required to write-down or reserve against obsolete or excess systemsin inventory.

 

***If our independent auditors are unable toprovide us with an unqualified report as to of the adequacy of our internalcontrols over financial reporting as of December 31, 2004 and future year-endsas required by Section 404 of the Sarbanes-Oxley Act of 2002, investors couldlose confidence in the reliability of our financial statements, which couldresult in a decrease in the value of our shares.***

 

As directed by Section 404 of theSarbanes-Oxley Act of 2002, the SEC adopted rules requiring public companies toinclude a report of management on the company’s internal controls overfinancial reporting in their annual reports on Form 10-K that contains anassessment by our management of the effectiveness of internal controls overfinancial reporting. In addition, the public accounting firm auditing ourfinancial statements must attest to and report on our management’s assessmentof the effectiveness of  internalcontrols over financial reporting. This requirement may apply to our annualreport on Form 10-K for the fiscal year ending December 31, 2004. While weintend to conduct a rigorous review of our internal controls over financialreporting in order to assure compliance with the Section 404 requirements, ourindependent auditors may interpret the Section 404 requirements and the relatedrules and regulations differently from us or our independent auditors may notbe satisfied with our internal controls over financial reporting or with thelevel at which these controls are documented, operated or reviewed. Moreover,in the event we make a significant acquisition, or a series of insignificantacquisitions, we may face significant challenges in implementing the requiredprocesses and procedures in the acquired operations. As a result, ourindependent auditors may decline to attest to management’s assessment or mayissue a qualified report. This could result in an adverse reaction in thefinancial markets due to a loss of confidence in the reliability of ourfinancial statements, which could cause the market price of our shares todecline.

 

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

 

Although we have established relations 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.

 

***Declining retail prices for consumerelectronics products could force us to lower the license fees we charge ourcustomers.***

 

The market for consumer electronics productsis intensely competitive and price sensitive. Retail prices for consumerelectronics products that include our DTS audio technology, such as DVD playersand home theater systems, have decreased significantly and we expect prices tocontinue to decrease for the foreseeable future. Declining prices for consumerelectronics products could create downward pressure on the licensing fees wecurrently charge our customers who integrate our technology into the consumerelectronics products that they sell and distribute. 

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Most of the consumer electronics products that include our audiotechnology also include Dolby’s multi-channel audio. As a result of pricingpressure, consumer electronics products manufacturers could decide to excludeour DTS audio technology from their products altogether.

 

***We have limited control over existing andpotential customers’ and licensees’ decision to include our technology in theirproduct offerings.***

 

We are dependent on our customers and licensees—includingconsumer electronics products manufacturers, semiconductor manufacturers, movietheaters, and producers and distributors of content for music, films, videos,and games—to incorporate our technology in their products, purchase ourproducts and services, or release their content in our proprietary DTS audioformat. Although we have license agreements with many of these companies, theselicense agreements do not require any minimum purchase commitments, and are ona non-exclusive basis, and do not require incorporation of our technology ortrademarks in their products. Our licensees and other manufacturers might notutilize our technology in the future.

 

***Our revenues from film producers anddistributors and from the products and services that we offer to movie theaterswould decline if the major U.S. film producers and distributors decrease thenumber of films they release with DTS audio soundtracks.***

 

Although all nine major film producers anddistributors are customers of ours, we generally do not have contractualarrangements that require them to use our DTS audio technology. Our theatricalbusiness depends on our having good relations with these film studios. Adeterioration in our relationship with any of these film studios could causethese customers to stop using our DTS audio technology. Any significant declinein the release of motion pictures with DTS audio soundtracks would decrease thedemand for and revenues from the playback products and services that we offerto movie theaters. In addition, other film studios throughout the worldgenerally adopt the technologies used by the major U.S. film studios.Therefore, if the major U.S. film studios stop using our technology, we wouldnot only lose the per-movie licensing fee we receive from these customers, butmay also lose per-movie licensing fees from other film studios throughout theworld.

 

***If the movie industry adopts new digitalcinema technology in place of current film technology, demand for ourtheatrical products and services could decline.***

 

The movie theater industry may transitionfrom film-based media to electronic-based, or digital, media. If thistransition occurs, we may be unable to meaningfully respond with competitiveproduct offerings. In addition, if the film industry broadly adopts digitalcinema, our technology and current product 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 would decline.

 

***The movie theater industry has suffered andmay continue to suffer from an oversupply of screens, which has affected andmay continue to affect demand for the products and services we offer to movietheaters.***

 

Our theatrical business depends in part onthe construction 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.

 

***We are dependent on our management team andkey technical employees, and the loss of any of them could harm our business.***

 

Our success depends, in part, upon thecontinued availability and contributions of our management team, particularlyJon Kirchner, our President and Chief Executive Officer, and W. Paul Smith, ourSenior Vice President, Research and Development. We also rely on the skills andtalents of our engineering and technical personnel because of the complexity ofour products and services. Several of our key engineers have been instrumentalin the development of our technology. Important factors that could cause theloss of 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;

 

•              wedo not maintain key-man life insurance on any of our employees;

 

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

 

•               many of the stockoptions held by our executive officers provide for accelerated vesting in theevent of a sale or change of control of our company.

 

The loss of key personnel or an inability toattract qualified personnel in a timely manner could slow our technology andproduct development and harm our ability to execute our business plan.

 

***We have a limited operating history in manyof our key markets.***

 

Although the first movie with a DTS audiosoundtrack was released in 1993, we did not enter the home theater market until1996, and our technology has only recently been incorporated into otherconsumer electronics markets, such as car audio, personal computers, videogames and consoles, portable electronics devices, and digital satellite andcable broadcast products. As a result, the demand for our technology, products,and services and the income potential of these businesses are unproven. Inaddition, because the market for digital audio technology is relatively new andrapidly evolving, we have limited insight into trends that may emerge andaffect our business. We may make errors in predicting and reacting to relevantbusiness trends, which could harm our business. Before investing in our commonstock, you should consider the risks, uncertainties, and difficultiesfrequently encountered by companies in new and rapidly evolving markets such asours. We may not be able to successfully address any or all of these risks.

 

***Our technology and products are complex andmay contain errors that could cause us to lose customers, damage ourreputation, or incur substantial costs.***

 

Our technology or products could containerrors that could cause our products or technology to operate improperly andcould cause unintended consequences. If our products or technology containerrors we could be required to replace them, and if any such errors causeunintended consequences we could face claims for product liability. Although wegenerally attempt 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.

 

***Because we expect our operating expenses toincrease in the future, we may not be able to sustain or increase ourprofitability.***

 

Although we have been in business since 1990,we have only achieved profits from our business operations in the last elevenfiscal quarters. We expect our operating expenses to increase as we, amongother things:

 

•              expandour domestic and international sales and marketing activities;

 

•              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;

 

•              continue toimplement the requirements of the Sarbanes-Oxley Act; and

 

•              continueto assume the responsibilities of being a public company.

 

As a result, we will need to grow ourrevenues in order to maintain and increase our profitability. In addition, wemay fail to accurately estimate and assess our increased operating expenses aswe grow.

 

***We are subject to additional risks associatedwith our international operations.***

 

We market and sell our products and servicesoutside the United States, and currently have employees located in China,England, Japan, Mexico, Northern Ireland, and Spain. Many of our customers andlicensees are located outside the United States. As a key component of ourbusiness strategy, we intend to expand our international sales. We facenumerous risks in doing business 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;

 

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•              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 futureinternational sales to decline.

 

Our business practices in internationalmarkets are also subject to the requirements of the Foreign Corrupt PracticesAct. If any of our employees is found to have violated these requirements, wecould be subject to significant fines and other penalties.

 

Our international revenue is mostlydenominated in U.S. dollars. As a result, fluctuations in the value of the U.S.dollar and foreign currencies may make our technology, products, and servicesmore expensive for international customers, which could cause them to decreasetheir purchases 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 businessoperations in China.***

 

One of our key strategies is to expand ourbusiness operations in China. However, we may be unsuccessful in implementingthis strategy 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 intoChina, we may be greatly impacted by the political, economic, and militaryconditions in China, Taiwan, North Korea, and South Korea. These countries haverecently conducted military exercises in or near the other’s territorial watersand airspace. 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.

 

***We depend on single suppliers, manufacturers,and distributors for some of our products, and the loss of any of thesesuppliers, manufacturers, or distributors could harm our business.***

 

We purchase a small number of parts fromsole-source suppliers. In addition, our professional audio encoding devices andmovie theater playback systems are manufactured according to our specificationsby single third-party manufacturers. Because we have no direct control overthese third-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 agreementswith two companies to serve as our sole distributors for our DTS Entertainmentproducts in the United States and Canada and in Europe, respectively. We haveno direct control over these distributors and any problems with theirperformance may take time to identify and/or remedy, and any remedial measuresthat we take may be unsuccessful. In addition, if either or both of thesedistributors were to go out of business, as our last distributor did, orotherwise becomes incapable of continuing as our distributor, we couldexperience delays in distributing our DTS Entertainment products to the retailmarket, loss of inventory, and loss of revenue.

 

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

 

A significant percentage of our revenues aregenerated from our consumer electronics products manufacturer customers wholicense and incorporate our technology in their consumer electronics products.Under our existing arrangements, these customers pay us a per-unit licensingfee based on the number of consumer electronics products manufactured thatincorporate our technology. We rely on our customers to accurately report thenumber of units manufactured in collecting our license fees, preparing ourfinancial reports, projections, budgets, and directing our sales and productdevelopment efforts. Most of our license agreements permit us to audit our

 

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customers, but audits are generally expensive and time consuming andcould harm our customer relationships. If any of our customer reportsunderstate the number of products they manufacture, we may not collect andrecognize revenues to which we are entitled.

 

***A prolonged economic downturn couldmaterially harm our business.***

 

Negative trends in the general economy,including trends resulting from actual or threatened military action by theUnited States and threats of terrorist attacks on the United States and abroad,could cause a decrease in consumer spending on entertainment in general. Anyreduction in consumer confidence or disposable income in general may affect thedemand for consumer electronics products that incorporate our digital audiotechnology, audio DVDs that we produce and distribute through our DTSEntertainment label, and demand by film studios and movie theaters for ourtheatrical products and services.

 

***We may not successfully address problemsencountered in connection with any future acquisitions.***

 

We expect to consider opportunities toacquire or make investments in other technologies, products, and businessesthat could enhance our technical capabilities, complement our current productsand services, or expand the breadth of our markets. We have not made anyacquisitions or strategic investments to date, and therefore our ability as anorganization to make acquisitions or strategic investments is unproven.Acquisitions and strategic investments involve numerous risks, including:

 

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

 

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

 

•              unanticipatedcosts associated with the acquisition, including accounting charges andtransaction 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 prior experience;and

 

•              potentialloss of key employees of acquired organizations.

 

If we fail to properly evaluate and executeacquisitions and strategic investments, our management team may be distractedfrom our day-to-day operations, our business may be disrupted, and ouroperating results may suffer. In addition, if we finance acquisitions byissuing equity or convertible debt securities, our existing stockholders wouldbe diluted.

 

***We may have difficulty managing any growththat we might experience.***

 

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

 

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

 

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

 

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

 

•              managemultiple, concurrent development projects; and

 

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

 

Any failure to successfully manage our growthcould distract management’s attention, and result in our failure to execute ourbusiness plan. For instance, the establishment of our operations in Guangzhou,China has required significant time and attention from our management team. Anyfuture growth could cause similar management challenges or create distractions.

 

***We may experience fluctuations in ouroperating results.***

 

We have historically experienced moderateseasonality in our business due to our business mix and the nature of ourproducts. In our consumer business, consumer electronics manufacturingactivities are generally lowest in the first calendar quarter of each year, andincrease progressively throughout the remainder of the year. Manufacturingoutput is generally strongest in the third and fourth quarters

 

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as our technology licensees increase manufacturing to prepare for theholiday buying season. Since recognition of revenues in our consumer businessgenerally lags manufacturing activity by one quarter, our revenues and earningsfrom the consumer business are generally lowest in the second quarter. Filmlicensing revenues are generally strongest in the second and fourth quartersdue to the abundance of movies typically released during the summer andyear-end holiday seasons. The introduction of new products and inclusion of ourtechnologies in new and rapidly growing markets can distort the moderateseasonality described above. Our revenues may continue to be subject toseasonal fluctuations in the future. Unanticipated fluctuations in seasonalitycould cause us to miss our earnings projections which could cause our stockprice to decline.

 

In addition, we actively engage inintellectual property compliance and enforcement activities focused onidentifying third parties who have either incorporated our technology,trademarks, or know-how without a license or who have underreported to us theamount of royalties owed under license agreements with us. As a result of theseactivities, from time to time, we recognize royalty revenues that relate toconsumer electronics manufacturing activities from prior periods. These royaltyrecoveries may cause revenues to be higher than expected during a particularreporting period and may not recur in future reporting periods. Suchfluctuations in our revenues and operating results may cause declines in ourstock price.

 

**Risks Related to Our Common Stock**

 

***We expect that the price of our common stockwill fluctuate substantially.***

 

The market price of our common stock islikely to be highly volatile and may fluctuate substantially due to manyfactors, including:

 

•              actualor anticipated fluctuations in our results of operations;

 

•              announcementsof technological innovations or technology standards;

 

•              announcementsof significant contracts by us or our competitors;

 

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

 

•              developmentswith respect to intellectual property rights;

 

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

 

•              thecommencement of or our involvement in litigation;

 

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

 

•              conditionsand trends in technology industries;

 

•              changesin market valuation or earnings of our competitors;

 

•              thetrading volume of our common stock;

 

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

 

•              generaleconomic conditions.

 

In addition, the stock market in general, andthe Nasdaq National Market and the market for technology companies inparticular, has experienced extreme price and volume fluctuations that haveoften been unrelated or disproportionate to the operating performance of thosecompanies. Further, the market prices of securities of technology companieshave been particularly volatile. These broad market and industry factors maymaterially harm the market price of our common stock, regardless of ouroperating performance. In the past, following periods of volatility in themarket price of a company’s securities, securities class-action litigation hasoften been instituted against that company. Such litigation, if institutedagainst us, could result in substantial costs and a diversion of management’sattention and resources.

 

***Shares of our common stock are relativelyilliquid.***

 

As of March 31, 2004, we have 16,681,393shares of common stock outstanding. As a result of our relatively small publicfloat, our common shares may be less liquid than the common shares of companieswith broader public ownership. Among other things, trading of a relativelysmall volume of our common shares may have a greater impact on the tradingprice for our shares than would be the case if our public float were larger.

 

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***Our future capital needs are uncertain and wemay need to raise additional funds in the future, and such funds may not beavailable on acceptable terms or at all.***

 

Our capital requirements will depend on manyfactors, 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 raiseadditional funds, and such funds may not be available on favorable terms, or atall. Furthermore, if we issue equity or debt securities to raise additionalfunds, our existing stockholders may experience dilution, and the new equity ordebt securities may have rights, preferences, and privileges senior to those ofour existing stockholders. If we cannot raise funds on acceptable terms, we maynot be able to develop or enhance our products and services, execute ourbusiness plan, take advantage of future opportunities, or respond tocompetitive pressures or unanticipated customer requirements. This maymaterially harm our business, results of operations, and financial condition.

 

***Anti-takeover provisions under our charterdocuments and Delaware law could delay or prevent a change of control and couldalso limit the market price of our stock.***

 

Our Restated Certificate of Incorporation andRestated Bylaws contain provisions that could delay or prevent a change ofcontrol of our company or changes in our Board of Directors that ourstockholders might consider favorable. Some of these provisions:

 

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

 

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

 

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

 

•              requireadvance written notice of stockholder proposals and director nominations.

 

In addition, we are governed by theprovisions of Section 203 of the Delaware General Corporate Law, which mayprohibit certain business combinations with stockholders owning 15% or more ofour outstanding voting stock. These and other provisions in our Restated Certificateof Incorporation, Restated Bylaws and Delaware law could make it more difficultfor stockholders or potential acquirors to obtain control of our Board orinitiate actions that are opposed by the then-current Board, including delay orimpede a merger, tender offer, or proxy contest involving our company. Anydelay or prevention of a change of control transaction or changes in our Boardcould cause the market price of our common stock to decline.

 

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

 

Market risk represents the risk of loss arising from adverse changes inmarket rates and foreign exchange rates. At March 31, 2004, we did not have any balances outstandingunder our bank line of credit arrangement; however, the amount of outstandingdebt at any time may fluctuate and we may from time to time be subject torefinancing risk.

 

Our interest income is sensitive to changes in the general level ofU.S. interest rates, particularly since a significant portion of ourinvestments are and will be in short-term marketable securities, U.S.government securities and corporate bonds. Due to the nature and maturity of our short-term investments,we have concluded that there is no material market risk exposure to ourprincipal. The average maturity of our investment portfolio is less than onemonth. As of March 31, 2004, a 1% change in interest rates throughout aone-year period would have an annual effect of approximately $1.1 millionon our income.

 

We derive more than half of our revenues from sales outside the UnitedStates, and maintain research, sales, marketing, or business developmentoffices in six countries. Therefore, our results could be negatively affectedby such factors as changes in foreign currency exchange rates, trade protectionmeasures, longer accounts receivable collection patterns, and changes inregional or worldwide economic or political conditions. The risks of our internationaloperations are mitigated in part by the extent to which our revenues aredenominated in U.S. dollars and, accordingly, we are not exposed to significantforeign currency risk on these items. We do have limited foreign currency riskon certain revenues and operating expenses such as salaries and overhead costsof our foreign operations and a small amount of cash maintained by theseoperations. Revenues denominated in foreign currencies accounted forapproximately 16% of total revenues during the first quarter of 2004. Operatingexpenses, including cost of sales, for our foreign subsidiaries wereapproximately $1.3 million in the first quarter of 2004. Based upon theexpenses for the first quarter of 2004, a 1% change in foreign currency ratesthroughout a one-year period would have an annual effect of approximately$50,000.

 

Ourinternational business is subject to risks, including, but not limited to,differing economic conditions, changes in political climate, differing taxstructures, other regulations and restrictions, and foreign exchange ratevolatility when compared to the United States dollar. Accordingly, our future results could bematerially impacted by changes in these or other factors.

 

We are also affected by exchange rate fluctuations as the financialstatements of our foreign subsidiaries are translated into the United Statesdollar in consolidation.

 

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As exchange rates vary, these results, when translated, may vary fromexpectations and could adversely impact overall profitability. During the firstquarter of 2004 the impact of foreign exchange rate fluctuations related totranslation of our foreign subsidiaries’ financial statements was notsignificant.

 

**Item 4.*****     Controlsand Procedures***

 

**Disclosure Controls and Procedures**

 

*Evaluation of disclosure controls and procedures.*Under the supervision and with theparticipation of our management, including our Chief Executive Officer andChief Financial Officer, we evaluated the effectiveness of the design andoperation of our disclosure controls and procedures (as defined inRule 13a-15(e) or 15d-15(e) under the Securities Exchange Act of 1934 (the“Exchange Act”)). Based upon that evaluation, the Chief Executive Officer andChief Financial Officer concluded that, as of the end of the period covered bythis Report, our disclosure controls and procedures are adequately designed toensure that information required to be disclosed by us in the reports we fileor submit under the Exchange Act is recorded processed, summarized and reportedwithin the time periods specified in applicable rules and forms.

 

**PART II**

**OTHER INFORMATION**

 

**Item 1.*****     LegalProceedings***

 

None.

 

**Item 2.*****     Changesin Securities, Use of Proceeds and Issuer Purchases of Equity Securities***

 

(a) Duringthe first quarter of 2004, pursuant to the exemption from registration providedin Section 3(a)(9) of the Securities Act, the Registrant issued anaggregate of 40,950 shares of common stock to various holders upon the cashlessexercise of warrants to purchase an aggregate of 70,152 shares of common stock.

 

(b) OnJuly 15, 2003, we closed the sale of an aggregate of 4,091,410 shares ofour Common Stock, $0.0001 par value, in our initial public offering, whichincluded the sale of 251,410 shares of our Common Stock pursuant to theexercise of the underwriters’ overallotment option in the offering. Theoffering also included the sale by certain of our stockholders of an aggregateof 324,590 shares of our Common Stock in connection with the exercise by theunderwriters of their overallotment option. The managing underwriters in theoffering were SG Cowen Securities Corporation, William Blair &Company, L.L.C., and Thomas Weisel Partners LLC. 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 was declaredeffective by the SEC on July 9, 2003 and a Registration Statement filedpursuant to Rule 462(b) under the Securities Act that was filed onJuly 10, 2003 (Reg. No. 333-106920). All 4,416,000 shares of CommonStock registered under the Registration Statement, including shares sold by usand by selling stockholders upon exercise of the overallotment option, weresold at a price per share of $17.00.

 

Theaggregate price of the offering amount registered on our behalf was$69.6 million. In connection with the offering, we paid an aggregate of$4.9 million in underwriting discounts and commissions to the underwritersand incurred approximately $1.7 million in other offering expenses. Afterdeducting the underwriting discounts and commissions and offering expenses, wereceived net proceeds from the offering of approximately $63.0 million.Subsequent to the offering, we used approximately $22.5 million of our netproceeds to redeem all outstanding shares of redeemable preferred stock and topay all accrued but unpaid dividends on such shares through the date ofredemption. The remaining proceeds to us have conformed with our intended useoutlined in the prospectus related to the offering. As of March 31, 2004,we have approximately $41.8 million remaining from the proceeds of theoffering.

 

**Item 3.*****     DefaultsUpon Senior Securities***

 

None.

 

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

 

None.

 

**Item 5.*****     OtherInformation***

 

During the first quarter of 2004, certain of our executives implementedindividual stock selling plans in accordance with SEC Rule 10b5-1 to sell aportion of their company holdings over time as part of their individuallong-term strategy for asset diversification and liquidity, while avoidingconflicts of interest or the appearance of any such conflict that might arisefrom their positions with the company. The executives that have implemented such plans are Chief ExecutiveOfficer Jon Kirchner, Executive Vice President, Finance and Chief FinancialOfficer Melvin Flanigan, Executive Vice President, Operations Andrea Nee,Executive Vice President, Legal and General Counsel, Blake Welcher, Senior VicePresident, Research and Development W. Paul Smith, Senior Vice President,Strategy and Business Development Patrick Watson, Senior Vice President,Engineering and Product Development Jan Wissmuller, Vice President, DTSEntertainment Jeffrey Skillen, Vice President, Consumer/Pro Audio Brian Towneand Chairman of the Board of Directors Dan Slusser.

 

Under the Rule 10b5-1 trading plans, the DTS executives may each sellup to 20% of the stock and exercisable stock options held by such person as ofthe effective date of the plan during the one-year term of the plan; however,the executive shall not sell more than 50% of such shares in any one calendarquarter.  Sales under these plans may beexecuted no more than once per month. Sales under these plans commenced in February 2004.

 

**Item 6.*****     Exhibitsand Reports on Form 8-K***

 

(a) *Exhibits:*

 
| **Exhibit  Number** |   | **Exhibit  Description**                                                                                                                                                                       |
|---------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |   |                                                                                                                                                                                           |
| 10.41+              |   | Letter  Agreement dated March 9, 2004 by and between the Registrant and In Focus  Corporation amending the Purchase-Sales Agreement between such parties dated  as of March 12, 2002 |
| 31.1                |   | Certification  of the Chief Executive Officer under Securities Exchange Act  Rules 13a-14(a) and 15d-14(a)                                                                                |
| 31.2                |   | Certification  of the Chief Financial Officer under Securities Exchange Act  Rules 13a-14(a) and 15d-14(a)                                                                                |
| 32.1                |   | Certification  of the Chief Executive Officer under Securities Exchange Act  Rules 13a-14(b) and 15d-14(b) and Section 1350 of 18 U.S.C. 1350                                        |
| 32.2                |   | Certification  of the Chief Financial Officer under Securities Exchange Act  Rules 13a-14(b) and 15d-14(b) and Section 1350 of 18 U.S.C. 1350                                   |

 

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+      Certain confidential portions of this Exhibitwere omitted by means of reducting a portion of the text (the “Mark”).  This Exhibit has been filed seperately withthe Secretary of the Commission without the Mark pursuant to the RegistrantApplication Requesting Confidential Treatment under Rule 24b-2 under theSecurities Exchange Act of 1934.

 

(b) *Reports on Form 8-K:*

 

On February 12, 2004, we filed on Form 8-K a press releaseannouncing our financial results for the fourth quarter of 2003.

 

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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.

 
|   | DIGITAL  THEATER SYSTEMS, INC. |
|--------|--------------------------------|
|   |                           |
|   |                           |
|   | By:                            | /s/ JON E. KIRCHNER |
|   |                           | Jon E. Kirchner |
|   |                           | *President and Chief Executive Officer* |
|   |                           | *(Duly Authorized Officer)* |

 

 

Date:May 17, 2004

 
|   | By:    | /s/ MELVIN L. FLANIGAN                         |
|--------|--------|------------------------------------------------|
|   |   | Melvin L. Flanigan                             |
|   |   | *Executive Vice President, Finance and*        |
|   |   | *Chief Financial Officer*                      |
|   |   | *(Principal Financial and Accounting Officer)* |

 

 

Date:May 17, 2004

 

23

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