**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe fiscal year ended December 31, 2004**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe transition periodfrom                           to                           **

**CommissionFile Number 000-50335**

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Digital Theater Systems, Inc.

(Exact name of Registrantas specified in its charter)

| **Delaware**(State or Other Jurisdiction of  Incorporation or Organization)                                                             | **77-0467655**(I.R.S. Employer  Identification Number) |
|-----------------------------------------------------------------------------------------------------------------------------------------|--------------------------------------------------------|
| **5171 Clareton Drive  Agoura Hills, California 91301**(Address, including zip code, of Registrant’s principal  executive offices) |
| Registrant’s  telephone number, including area code: **(818) 706-3525**                                                       |

 

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Securities Registered Pursuantto Section 12(g) of the Act:

**CommonStock, par value $.0001 per share**

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

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. o

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Act). Yes x    No o

The aggregate market valueof the voting stock held by non-affiliates of the registrant, as of June 30,2004 was approximately $441,702,809 (based on the closing price for shares ofthe registrant’s Common Stock as reported by the Nasdaq National Market forthat date). Shares of Common Stock held by each officer and director of theoutstanding Common Stock have been excluded in that such persons may be deemedaffiliates. Exclusion of shares held by any person should not be construed toindicate that such person possesses the power, direct or indirect, to direct orcause the direction of management or policies of the registrant, or that suchperson is controlled by or under common control with the registrant.

As of March 1, 2005,17,086,860 shares of common stock were outstanding.

**DOCUMENTSINCORPORATED BY REFERENCE**

The information requiredby Part III of this Report, to the extent not set forth herein, isincorporated herein by reference to the registrant’s proxy statement relatingto the annual meeting of stockholders to be held on May 19, 2005.

 

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**DIGITAL THEATER SYSTEMS, INC.FORM 10-KFor the Fiscal Year Ended December 31, 2004INDEX**
|                   | ** **                                                                                        | ** ** | **Page** |
|-------------------|---------------------------------------------------------------------------------------------------|------------|----------|
| **PART I**   |
| Item  1.          | Business                                                                                          |       | 3        |
| Item  2.          | Properties                                                                                        |       | 20       |
| Item  3.          | Legal Proceedings                                                                                 |       | 21       |
| Item  4.          | Submission of Matters to a Vote of  Security Holders                                              |       | 21       |
| **PART II**  |
| Item 5.           | Market  for Registrant’s Common Equity and Related Stockholder Matters                       |       | 22       |
| Item 6.           | Selected  Financial Data                                                                          |       | 23       |
| Item 7.           | Management’s  Discussion and Analysis of Financial Condition and Results of Operations  |       | 24       |
| Item 7A.          | Quantitative  and Qualitative Disclosures About Market Risk                                       |       | 53       |
| Item 8.           | Financial Statements and Supplementary Data                                                       |       | 55       |
| Item 9.           | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure        |       | 91       |
| Item 9A.          | Controls  and Procedures                                                                          |       | 91       |
| Item 9B.          | Other  Information                                                                                |       | 91       |
| **PART III** |
| Item 10.          | Directors  and Executive Officers of the Registrant                                               |       | 92       |
| Item 11.          | Executive  Compensation                                                                           |       | 92       |
| Item 12.          | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters  |       | 92       |
| Item 13.          | Certain  Relationships and Related Transactions                                                   |       | 92       |
| Item 14.          | Principal  Accountant Fees and Services                                                           |       | 92       |
| **PART IV**  |
| Item 15.          | Exhibits  and Financial Statement Schedules                                                       |       | 93       |
| SIGNATURES        |                                                                                              | 96         |

 

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**FORWARD-LOOKINGSTATEMENTS**

*This Annual Report on Form 10-K and the documentsincorporated herein by reference contain forward-looking statements based onour current expectations, estimates and projections 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.” Theforward-looking statements contained in this report involve known and unknownrisks, uncertainties and other factors that may cause our actual results to bematerially different from those expressed or implied by these statements. Thesefactors include those listed under the “Risk Factors” section contained inItem 7 and elsewhere in this Form 10-K, and the other documents wefile with the Securities and Exchange Commission, or SEC, including our mostrecent reports on Form 8-K and Form 10-Q. We cannot guarantee futureresults, levels of activity, performance or achievements. We do not undertakeany obligation to revise these forward-looking statements to reflect futureevents or circumstances.*

**PART I**

**Item 1.*Business***

**Company Overview**

We are a leading provider of entertainment technology,historically focused on high-quality digital multi-channel audio technology,products, and services for entertainment markets worldwide. Multi-channelaudio, commonly referred to as surround sound, allows listeners to heardiscrete sounds simultaneously through more than two speakers. Our DTS digitalmulti-channel audio technology delivers compelling surround sound and isfrequently described as the top performing surround sound technology byauthoritative sources such as Widescreen Review and AudioRevolution.com in theirreviews of products featuring multi-channel audio.

We were founded in 1990 and received a key strategicinvestment in 1993 from investors, including Universal City Studios, Inc.The first DTS audio soundtrack was created for the release of Steven Spielberg’s*Jurassic Park* in 1993. From this initialrelease, we established a technical and marketing platform for the developmentof entertainment technology solutions for the motion picture, home theater, andother consumer markets.

We provide products and services to film studios,production companies, and movie theaters to produce, release, and play backdigital multi-channel film soundtracks, pre-show entertainment content,subtitles, captions and descriptive narration. We currently license our soundtechnology to all major film distributors in the United States. Most majorfeature films currently released in the United States include a DTS soundtrack.Our playback systems for DTS- formatted soundtracks have been installed in over24,000 movie screens worldwide.

In 1996, we launched our consumer business, in whichwe license our technology to consumer electronics products manufacturers forinclusion in products such as audio/video receivers, DVD players, and hometheater systems. The consumer products market has since grown to become thelargest segment of our business. To date, we have entered into licensingagreements with substantially all of the major consumer audio electronicsmanufacturers in the world. We also license our technology to many majorconsumer semiconductor manufacturers. Our technology, trademarks, and know-howhave been incorporated in more than 230 million consumer electronicsproducts worldwide.

Our technology andproducts have won awards in each of our markets, including:

·       a*Scientific and Engineering Oscar Award*from the Academy of Motion Picture Arts and Sciences for our DTS playbacksystem;

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·       aBlue Ribbon Award from EQ Magazine voting our Coherent Acoustics algorithm thebest product at the 103rd Audio Engineering Society Convention; and

·       theBest DVD-Audio Release and Best DVD-Audio Disc Award for Queen: The Game fromthe Canadian Entertainment Network Awards and the Fifth Annual DVD Awards,respectively, and Best Orchestral Mix for Porcupine Tree*: In Absentia* from The 3rdAnnual Surround Music Awards.

We develop, market,license, and sell our proprietary technology, products, and services for thefollowing markets:

***Consumer Markets:***

·       Hometheater and consumer electronics entertainment devices such as audio/videoreceivers and DVD players.

·       Emergingmarkets for digital multi-channel audio such as homes, cars, personalcomputers, video games and consoles, portable electronics devices, and digitalsatellite and cable broadcast products.

·       Professionalaudio products and services for encoding and decoding digital multi-channelcontent in our proprietary format.

·       Music titles in our digitalmulti-channel format.

***Cinema Markets:***

·       Audioand video products and services for film producers and distributors to producemovie soundtracks, subtitles, and pre-show or alternative content in ourproprietary format.

·       Systemsfor playback of multi-channel audio soundtracks, pre-show and alternative videocontent, and for subtitling, captioning, and descriptive narration for movietheaters and special venues.

Regardless of theentertainment application that incorporates our technology, we providehigh-quality digital delivery technology and branding for productmanufacturers, content providers, and movie theaters. As the transition fromanalog to digital entertainment technology continues, we believe we arewell-positioned to grow our licensing and product businesses worldwide. Our goalis to become essential to the ultimate entertainment experience byincorporating our technology into every device that manages, controls ordelivers high-quality digital entertainment.

***Imaging Markets:***

In January 2005, weacquired Lowry Digital Images, Inc., or LDI, and changed the name to DTSDigital Images. Through this subsidiary, we now provide restoration andenhancement services for moving pictures captured on film or in digital form.These services enable current or archived content to be restored for highquality, high definition presentations in digital cinema, high definitionoptical media or broadcast applications.

**Industry Background**

Over the past15 years, two trends have greatly impacted the entertainment industry: thetransition from analog to digital entertainment content, and technologicaladvancements in digital coding, transmission, signal processing, and opticalstorage. These trends helped create a technical foundation for the widespreadadoption of digital multi-channel audio for many forms of entertainment.

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***Adoption and Growth of Digital Multi-Channel Audio inthe Motion Picture Industry***

Movie soundtracks were originally presented in mono,or one-channel, audio. In the mid-1970s, stereo was introduced. Stereo consistsof two channels and presents sound through discrete left and right speakers.Stereo was followed by matrix technology that allowed an inexpensive two-tracksystem to bring surround sound to a large number of movie theaters. However,the audio quality and channel separation were limited.

In the early 1990s, the listening experience of movieaudiences was significantly enhanced through the introduction of digitalmulti-channel surround sound technology. This format, commonly known as 5.1,combined high-quality audio with full separation in five channels: left,center, right, left surround, right surround, and a channel dedicated to lowfrequency effects known as a subwoofer. Digital discrete surround sound enablesmovie directors and producers to create a more enveloping and realisticentertainment environment. Many filmmakers recognized the ability ofmulti-channel audio to enhance the entertainment experience and promoted itswidespread adoption.

Digital multi-channel audio is now an industrystandard audio format for feature films. Today, all of the major film studiosin the United States, and an increasing number of international film studios,release their feature films with digital multi-channel soundtracks. In 2004,over 165 major feature films were released in the United States with a DTSdigital multi-channel soundtrack.

Screen Digest Global MediaIntelligence, in its December 2004 Cinema Intelligence report estimatesthat in 2004 there were over 141,000 movie theater screens worldwide, and thatin 2004 there were more than 39,000 screens in the United States and Canada. Asfilm studios have increasingly released films with digital multi-channelsoundtracks, many movie theaters have purchased and installed digitalmulti-channel playback systems and cinema processor equipment for both newlyconstructed and retrofitted movie theaters. A number of other venues alsoutilize digital multi-channel playback systems and cinema processor equipmentto enhance the entertainment experience. These venues include large-screenformat theaters, amusement parks, national parks, and museums.

***Proliferation of Home Theater Systems***

Consumer demand fordigital multi-channel capable home theater systems has been fueled by:

·       theextensive adoption of digital multi-channel audio in movie theaters;

·       decliningprices for DVD players, audio/video receivers, and home-theater-in-a-boxsystems;

·       thesuperior quality and feature sets of DVDs; and

·       thewidespread availability of DVDs released with digital multi-channelsoundtracks.

According to the DVD Entertainment Group website atdvdinformation.com, annual sales of DVDs surpassed annual sales of prerecordedvideocassettes for the first time in 2001. Understanding & Solutions,in its Q1 2005 quarterly briefing, estimated that as of December 31, 2004,64% of U.S. households owned one or more DVD-Video player, a figure that isexpected to grow to nearly 90% by the end of 2008.

Home theater systemsgenerally consist of a DVD-Video player, a digital multi-channel audio/videoreceiver, five speakers, and a subwoofer. Home-theater-in-a-box systems areincreasingly offered to consumers as an all-in-one home theater package forease of use and installation. Understanding & Solutions, in its Q12005 quarterly briefing, estimates that by the end of 2004 38% of U.S.households and 28% of Western European households owned at least one hometheater system and that by the end of 2007 over 55% of U.S. households and over50% of Western European households will own at least one.

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***Development of Robust New Markets for DigitalMulti-Channel Sound***

Digital multi-channel sound is extending into agrowing number of consumer electronics environments, including homes, cars,personal computers, video games and consoles, portable electronics devices, anddigital satellite and cable broadcast products.

Manufacturers of home audio products, music labels,and recording artists have recognized that a substantial market opportunityexists for digital multi-channel home audio systems and digital multi-channelmusic content. Currently, there are multiple formats for CD- and DVD-baseddigital multi-channel audio content, many of which support our format.Understanding & Solutions, in its Q1 2005 quarterly briefing,estimates that the combined U.S. market for high-resolution digital multi-channelaudio content will grow from less than 2 million units in 2002 to approximately40 million units in 2008.

Car audio, personal computer, and video game consolemanufacturers are increasingly incorporating digital multi-channel audiocapability into their products. Surround sound technology is also incorporatedinto portable electronics applications, such as palm-top DVD players, whichallow listeners to enjoy a simulated surround sound experience usingheadphones. These markets represent significant growth opportunities as contentproviders and consumers become familiar with the capability of digitalmulti-channel audio to enhance the entertainment experience.

The digital satellite andcable broadcast markets may represent significant opportunities for digitalmulti-channel audio. Understanding & Solutions, in its Q1 2005quarterly briefing, estimates that digital satellite and/or digital cable wasinstalled in approximately 47% of U.S. households at the end of 2004, projectedto grow to 79% by the end of 2008, and in approximately 22% of Western Europeanhouseholds at the end of 2004, projected to grow to 44% by the end of 2008. Asignificant market opportunity may exist in all sectors of this marketincluding broadcast hardware, television set-top boxes, and televisions.

***Market Opportunity for Digital Multi-Channel MusicContent***

Digital multi-channelmusic can provide an enhanced experience to music listeners, just as hometheater products now provide for home video. With the 360-degree sound-fieldcreated by digital multi-channel technology, musicians and mixing engineers areable to create a far more compelling and realistic listening experience. Withthis technology, an artist can create an audio experience that virtually placesthe listener on stage with the band, in the front rows of the audience, at theconductor’s stand, or in the middle of a concert hall. In addition, digitalmulti-channel music creates new revenue and profit opportunities for artistsand music labels by allowing them to license content to third parties orrelease new or existing content in a digital multi-channel format. The musicindustry has faced many well-publicized challenges in recent years. Theindustry has experienced declining revenues, due in part to piracy, challengesassociated with physical distribution, competition from low-priced alternativeentertainment such as DVDs, and reliance on blockbuster pop acts. Partly as aresult of these business challenges, many music labels are increasingly willingto license their music properties to companies that desire to release digitalmulti-channel music.

***Markets for Other Digital Technologies in the MotionPicture Industry***

The motion picture industry faces growing globaldemand for motion pictures that feature subtitles, captions, or descriptivenarration. This demand is a combined result of the expansion of the motionpicture business in international markets and increasing political and socialpressure to provide access to the motion picture experience for the hearing andvisually impaired. Film distributors and theater owners are increasinglyseeking a means to address this demand in a cost-effective manner.Traditionally, subtitles or captions were permanently imprinted, etched, oroverlayed directly onto the film. These are expensive processes that limit theutility of any individual film print and increases costs as film distributorsare required to produce multiple versions of the same movie to support variouslanguages. Movie theaters also 

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incur additional costsrelated to managing multiple film prints. We believe a significant marketopportunity is developing for digital technologies that provide a flexible,cost-effective solution for subtitling, captioning, and descriptive narration.Advanced solutions can provide for two different delivery methods: closedcaptioning, in which a single moviegoer uses an assistance device to view thetext or hear the narrative audio, and open captioning, which allows everyone inthe theater to view the text or hear the narrative audio.

Motion picture exhibitorscontinue to seek new sources of revenue, independent of feature films. As aresult, there is a growing demand for products and services that facilitate thecreation, distribution, control, and playback of digital pre-show advertising andalternative content. Pre-show and alternative content presentation canrepresent sizable revenue opportunity for exhibitors who have historically beenfinancially challenged by the high cost of modern theater construction and thelimited revenue sources available from theater operation.

**The DTS Solution**

Our proprietary DTS digital audio system providesmoviegoers with a high-quality, digital multi-channel audio experience. Filmstudios and production companies use our technology and services to encode thesoundtracks of their films using our proprietary digital multi-channel soundformat. Theater owners purchase and use our products to play back DTS encodedsoundtracks through six or more discrete speakers.

Our competitors imprint their proprietary digitalmulti-channel audio data directly onto the film. This can result in audiodegradation or failure from repetitive use or handling. By contrast, we use adual-medium system whereby we store audio information on CD-ROM discs, whichare synchronized to the motion picture film by the use of our proprietarytimecode. The timecode is printed on the film, which enables the correlation ofsingle or multiple events, such as audio, light, or motion, to an individualframe of film. By placing audio data on CD-ROM discs rather than directly onfilm, we ensure reliable high-quality playback that is not subject to film wearor subsequent audio degradation. Our system enables theater operators to easilychange audio tracks or languages by swapping the audio discs rather thanchanging film prints—a process that can take several hours. The CD-ROM alsoallows much more data capacity, and consequently higher audio quality, thandata-on-film systems.

In addition, we provide products that enable theplayback of video-based pre-show advertising and alternative content andsystems for the projection and transmission of subtitles, captions, anddescriptive narration. Our product suite allows exhibitors to purchase a singlesystem for multiple solutions, thereby combining incremental revenueopportunities with cost efficient use of cinema hardware.

In 1996, we introduced our Coherent Acousticstechnology to bring advanced digital audio entertainment to the home. CoherentAcoustics is an audio compression/decompression algorithm, or codec, whichenables the encoding and decoding of audio tracks in the DTS digitalmulti-channel sound format. The design architecture of our technology allows usto scale or adapt, adding features or performance while maintaining backwardcompatibility with earlier implementations of the technology. The encodingprocess reduces the storage space or transmission bandwidth required for theaudio information, while maximizing the quality of the sound. The audioinformation can then be stored on a digital medium, such as a DVD, ortransmitted over a broadband connection or broadcast signal. The encodedcontent can be played back on digital audio electronics products equipped witha DTS Coherent Acoustics decoder, such as a DVD-based home theater system.

The performance and flexibility of our CoherentAcoustics technology enables easy implementation in a variety of consumerelectronics products. Our core technology has also been incorporated into soundsystems used in homes, cars, personal computers, video games and consoles,portable electronics devices, and digital satellite and cable broadcastproducts.

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The adoption of digital multi-channel audio depends onthe availability of compelling content, along with the devices required to playit. Accordingly, we provide products and services to filmmakers, recordingartists, producers, and software developers to make it easy to create anddeliver audio content in our proprietary digital multi-channel format. We havealso entered the content-creation market directly through our DTS Entertainmentlabel to further ensure the availability of high-quality digital multi-channelaudio content.

We strive to evolve anddevelop our technology on an ongoing basis. For example, to offer an enhancedexperience for existing and new stereo content, we have developed our Neo:6matrix technology. This technology provides simulated multi-channel playbackfrom stereo content and has been incorporated into home theater, home audio,portable electronics, and our movie theater products. In the future, we expectthis technology to be incorporated into car audio systems as well.

**Products andServices**

We segment our businessinto consumer markets and cinema markets.

***Consumer Markets***

In our consumer business segment, we providetechnology that enables digital multi-channel surround sound for home theater,home audio, and other emerging segments of the consumer markets. Our CoherentAcoustics technology was designed for the consumer electronics market. Thisproprietary technology enables delivery of up to 16 channels of discretedigital audio but typically provides from two to seven channels. CoherentAcoustics enables consumers to experience high-quality surround sound in theirhomes or other listening environments.

We license our Coherent Acoustics technology toconsumer electronics products manufacturers through two licensing channels.First, we license our software developer kits to semiconductor manufacturerswho embed our decoding software into their digital signal processor chips. Inturn, these semiconductor manufacturers sell DTS-enabled chips only to hardwaremanufacturers who have entered into consumer manufacturer licenses with us. Aspart of the licensing terms for both semiconductor and hardware manufacturerlicensees, we typically receive fees for access to our developer kits and forour certification, prior to sale, of the quality and performance of theirproducts. Our business model provides for us to receive a per-unit royalty forhardware products manufactured containing our technology.

Consumer electronics products manufacturers can alsodesign their products to support the passing of a DTS bitstream to anotherdevice, such as an audio/video receiver, that contains a DTS decoder. We referto this pass-through capability as DTS Digital Out. Only devices equipped witha Coherent Acoustics decoder can play back digital multi-channel audio encodedin our format. Like our hardware licensees, our DTS Digital Out trademarklicensees typically pay us fees for access to our developer kits and for ourcertification, prior to sale, of the quality and performance of their products.Our business model provides that we receive per-unit royalties for productsmanufactured containing our trademark.

DTS-enabled audio decoders are embedded in popularhome theater products including audio/video receivers, DVD players, andhome-theater-in-a-box systems. Our technology is also embedded and supported innew and emerging consumer electronics products that use digital multi-channelaudio, including home audio systems, car audio devices, personal computers,video games and consoles, portable electronics devices, and digital satelliteand cable broadcast products. Through December 31, 2004, our decoders havebeen embedded in more than 45 million audio/video devices.

We also market productsand services for the creation of digital multi-channel audio content and weproduce digital multi-channel audio content. We sell professional audioencoding devices to professional audio equipment dealers. We license ourencoding technology to professional and professional/consumer 

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productmanufacturers who in turn sell the products to content owners andpost-production facilities, enabling them to produce and release audio andaudio/video products containing DTS digital multi-channel soundtracks. Thesecontent owners include home video producers and distributors, individual musicartists, and music labels. We also produce digital multi-channel audio contentdirectly through our DTS Entertainment label by licensing popular titles from successfulindustry artists and re-mixing and releasing digital multi-channel versions ofthese music titles.

*Home Theater*

We havehistorically derived nearly all of our consumer market revenue from licensingour technology for incorporation into home theater products. These productsinclude:

·       *Audio and Audio/Video Receivers.*Embedded DTS decodersenable these products to decode digital multi-channel audio.

·       *DVD-Video Players.*Incorporation of DTS Digital Outcapabilities enables these devices to play DTS encoded DVD-Video and 5.1 MusicDiscs. In addition, some DVD players contain DTS decoding capability.

·       *DVD Universal Players.*These products offer the samefunctionality as DVD-Video players but also provide the ability to playDVD-Audio discs.

·       *Home-Theater-in-a-BoxSystems.*All-in-one home theater packages typically consist of a DVDplayer, audio/video receiver, five speakers, and a sub-woofer.

*New and EmergingSegments of the Consumer Market*

The high qualityand flexibility of our Coherent Acoustics algorithm provides for a variety ofalternative applications. We are expanding into new and emerging markets forconsumer electronics and entertainment products that incorporate high-qualitydigital multi-channel audio, including:

·       *Home Audio Systems.*Home-based systems that are designed toplay digital multi-channel music.

·       *Car Audio Systems.*Currently, most major after-market caraudio manufacturers sell, or have products planned for release that include ourdigital multi-channel audio technology. We expect many automobile manufacturersto introduce factory-installed digital multi-channel audio systems within thenext few years. A DTS digital multi-channel sound system is a standard featureon both the 2005 Acura TL and RL models. Lexus, Land Rover, Infinity, Cadillac,Toyota, and Mazda of Japan currently offer a DTS-equipped digital multi-channelsound system as a factory-installed option for certain vehicles. We anticipatethat several other automobile manufacturers will soon release vehicles thatwill incorporate our technology.

·       *Personal Computers.*We have licensed our technology forincorporation into both hardware and software products for the personalcomputer. In the hardware market, we have licensed our decoding technology to anumber of hardware peripherals manufacturers who incorporate our technologyinto sound cards and speaker systems. In the software market, we have licensedour decoding technology to two of the leading software-based DVD playerproviders, Cyberlink Corporation and Intervideo Inc., who haveincorporated our technology into some of their products.

·       *Video Games and Consoles.*We believe that the addition ofinteractive digital multi-channel audio to video games will enable a level ofrealism not provided by conventional audio systems and represents a significantenhancement to the quality of the gaming experience. We intend to license ourtechnology for inclusion into gaming hardware and software applications. In thevideo game hardware market, Sony Corporation’s PlayStation 2 supports ourinteractive digital multi-channel 

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sound technology whenconnected to a DTS-capable audio/video receiver. In the game software market,we have entered into licensing relationships with several major gamepublishers, including Activision, Inc., Atari, Inc., and ElectronicArts, Inc., to incorporate our digital multi-channel encoding technologyinto their PlayStation 2 games.

·       *Portable Electronics Devices.*Our technology is incorporatedinto some portable electronics devices, such as portable DVD players. We intendto aggressively pursue incorporation of our technology into other portableelectronics devices such as camcorders, portable disc players, and musicarchival devices for stereo and simulated multi-channel playback viaheadphones.

·       *Digital Satelliteand Cable Broadcast Products.*Our technology has been adopted by theEuropean Broadcasting Union’s Digital Video Broadcast Project as one of severalformats for digital multi-channel audio delivery. This standards group setsdigital cable, satellite, and terrestrial broadcast standards for internationalmarkets including Europe. We are actively working with other relevant standardsorganizations for the inclusion of our technology. Such inclusion would enableus to pursue the incorporation of our technology into broadcast hardware,set-top-boxes, and televisions. To date, we have licensed our trademarks anddecoding technology for incorporation into television set-top boxes.

*New Technologiesfor Existing and Emerging Consumer Markets*

We continue to evolve and develop our technology forthe consumer market. Our Neo:6 matrix technology provides simulatedmulti-channel play back from stereo, or two-channel, content. This technologyincreasingly is being incorporated into home theater systems, home audiosystems, and portable electronics devices. We expect this technology to beincorporated into car audio systems and broadcast products in the future. Thistechnology provides us with new revenue opportunities from existing and newcustomers.

We continue to develop thesynergies between the various market segments in which we operate, such as theincorporation of our Coherent Acoustics technology into our cinema products toprovide higher quality audio delivery for alternative content presentation inthe cinema market.

*Audio Content*

To support the adoption of our technology, we sell,license, and provide professional audio products and services for encoding anddecoding digital multi-channel content in our format. We also produce, market,and sell music titles in our digital multi-channel format under our DTSEntertainment label.

*ProfessionalAudio Products and Services.  *We sell, license, andprovide a variety of professional audio products and services for contentcreators. The ultimate customers for these products are recording artists,music labels, and post-production facilities. The following table lists theprofessional audio products and services that we currently provide:
| **Product or Service**                  | ** ** | **Description**                                                                                                  |
|-----------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|
| *DTS Pro Series Surround  Encoder* |       | Software based encoder  for Apple or PC digital audio workstations.                                              |
| *DTS Pro Series Network  Encoder*  | ** ** | Software based multi-user network encoder  operating on Apple’s Xserve platform through either a Mac or PC. |
| *DTS Encoding Service*                  |       | Content providers create  a digital multi-channel master audio mix and provide it to us for encoding.            |

 

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*DTS Entertainment Label.  *Were-mix and produce digital multi-channel music content to support technologyoptions, branding and to capitalize on the emerging market for multi-channelmusic. We license this content and pay a royalty based on the number of discssold. We have released over 150 titles from artists in different genres ofmusic including classical, jazz, country, pop, rock, and others. These releasesinclude works from classical composers such as Handel and Tchaikovsky, andtitles by artists such as Diana Krall, The Crystal Method, Vince Gill, LyleLovett, The Eagles, Queen, Sting, and The Blue Man Group.

Under our DTSEntertainment label, we sell the following products:

·       *5.1 Music Discs.*Our 5.1 Music Discs play in DVD playersthat are connected to a DTS-capable 5.1 playback system. Due to our patentcoverage, we are the only company able to produce 5.1 Music Discs, although wehave licensed, and may continue to license, the right to produce 5.1 MusicDiscs in the future. We have released over 115 titles in this format.

·       *DVD-Audio Discs.*DVD-Audio is a relatively new and growingformat for music presentation. Our DVD-Audio discs are fully compatible withboth DVD-Audio players and DVD-Video players. We have released 38 DVD-Audiodiscs.

·       *OEM/Commercial Bundling.*We provide major consumerelectronics products manufacturers targeted digital multi-channel content,which they bundle with their product offerings to highlight a particularfeature or capability and to enhance the perceived value of their product.

*Relationships with Record Labels.*We are pursuing relationships with major record labelswhereby we re-mix and produce titles from the label in our multi-channel formatand the label distributes these titles. We announced our first suchrelationship with EMI Music in August 2003. We produce multi-channelrecordings from various EMI titles, these products carry the DTS logo, and wereceive a per-unit royalty for each unit sold.

***Cinema Markets***

In our cinema businesssegment, which we have previously described as our theatrical business segment,we license technology and sell products and services to producers anddistributors of feature length films and to movie theaters and special venues.

*Products andServices for Film Producers and Distributors*

For film producers anddistributors, we license technology to encode a movie’s audio master into ourdigital multi-channel format and provide audio CD-ROMs for distributionwith film prints to movie theaters. To facilitate synchronization to the filmprint, we provide the studios with equipment and the right to produce atimecode track which is printed on the film. The discs and the film print havecorresponding electronic serial numbers to ensure playback of the correctsoundtrack.

*Products for MovieTheaters and Special Venues*

*Digital Audio Playback Systems.  *Inorder for a movie theater to play a DTS-encoded soundtrack, the theater mustuse one of our audio playback systems. These systems are rack-mounted productsinstalled in movie theater projection booths. These playback systems are soldin several configurations that support analog and digital audio play back, andother audio management and theater automation functions.

We sell similar products and services to specialvenues such as large-format theaters, amusement parks, national parks, andmuseums. We believe we are a leading supplier in this market due to our highquality and reliability and because we have the only commercially availabletechnology that supports all film sizes and speeds from 8 millimeter to 70millimeter.

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*Systems for Subtitling, Captioning, and DescriptiveNarration.  *We also sell our DTS-CSS system to movietheaters. This system delivers feature-film subtitles, captions, anddescriptive narration for foreign language and hearing and visually impairedaudiences. We believe this proprietary digital system is a cost-effectivemethod to provide subtitles, captions, and descriptive narration for a filmbecause it eliminates the need to permanently imprint, etch, or overlay thesubtitles or captions directly onto the film. The DTS-CSS system enables thedelivery of open or closed captioning, depending on the output device utilized.For open captions, the DTS-CSS system uses a separate video projector to rendersubtitles or captions; for closed captions, the system is utilized inconjunction with a rear-wall display device. This product is designed toaddress the increasing political and social pressure to provide access to themotion picture experience for the hearing and visually impaired.

This same family of products is also being used foralternative content presentations and for pre-show advertising. These productsenable a theater owner to extend its range of revenue opportunities, but alsohelp to maximize the utility of equipment in theater projection rooms, savingexpense and space. In the pre-show advertising area, both the CSS system andthe DTS XD10 Cinema Media player can be used when coupled with a colorprojector. The DTS XD10 has an extensive feature set, which includes networkingcapability to facilitate its integration into a content distribution system.

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The chart below lists theproducts that we sell to movie theaters and special venues:
| **Product or Service**                | ** ** | **Description**                                                                                                                                                                                                                                                                              |
|---------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| *DTS XD10 Cinema Media Player*        |       | The DTS XD10 is a DVD  and hard-drive based multi-function playback device for movie theaters. DTS  XD10 supports up to ten channels of audio, digital video playback capability,  and can be upgraded to support DTS-CSS applications and/or pre-show  advertising and alternative content. |
| *DTS XD10 Cinema Audio Processor*     |       | The recently introduced  DTS XD10P is a standalone digital and analog cinema audio processor. The  XD10P provides up to eight channels of audio output and interfaces with the  XD10 Cinema Media Player and other digital sources as well as theater  automation systems.                   |
| *DTS-6D Digital Playback System*      |       | A digital multi-channel  audio playback unit for movie theaters.                                                                                                                                                                                                                             |
| *DTS-6AD Cinema Processor*            |       | An integrated DTS-6D  playback unit with a cinema processor, providing audio playback management  and control as well as theater automation functions.                                                                                                                                       |
| *DTS-ES Extended Surround Decoder*    |       | A decoding device which  derives a center surround channel from extended surround tracks, providing  6.1 audio for theaters.                                                                                                                                                                 |
| *DTS-6SV Special Venue*               |       | A modified DTS-6D  playback unit for special venue customers, providing six full bandwidth audio  channels and a time code reader for use with non-standard film sizes.                                                                                                                      |
| *DTS-ECP Expandable Cinema Processor* |       | An entry-level analog  cinema processor and booth monitor that can be upgraded for DTS digital play  back.                                                                                                                                                                                   |
| *DTS Digital Playback Package*        |       | A digital playback  upgrade kit for the DTS-ECP, providing the functionality of our DTS-6AD  Cinema Processor.                                                                                                                                                                               |
| *DTS-CSS System*                      |       | A digital subtitling,  captioning, and descriptive narration system consisting of a processing unit,  time code reader, and a digital projector.                                                                                                                                             |

 

**ImageRestoration and Enhancement Services**

In January 2005, weacquired Lowry Digital Images, Inc. and changed the name to DTS DigitalImages. Through this subsidiary, we now provide restoration and enhancementservices for moving pictures captured on film or in digital form. Theseservices enable current or archived content to be restored for high quality,high definition presentations in digital cinema, high definition optical mediaor broadcast applications.

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**DTS Technology Platform**

Our core audio technology platform is designed tocapture, store, and reproduce audio signals. There are several technicalconsiderations involved in this process, including the frequency of datasampling, the word length, and the bit rate. These factors can control thequality of audio presentation and are commonly managed through compressiontechniques.

A fundamental challenge with digital audiodistribution is that capturing analog signal representations in digital formrequires a tremendous amount of data. Therefore, the storage and subsequenttransmission of that data presents physical space, efficiency, and economicchallenges. We address this challenge by developing coding technology andproducts that reduce the amount of data required to store and transmit an audiosignal and to subsequently reproduce the data.

The design, architecture, and implementation of thiscoding solution are complex. Signal coding requires a thorough and combinedunderstanding of the disciplines of electrical engineering, computer science,and psychoacoustics, coupled with significant practical experience. One of ourkey technical strengths has been our ability to develop a system that enablesthe transparent reproduction of an original audio signal, meaning that thereproduction sounds indistinguishable from its source.

Emerging applications for digital multi-channel audio,such as video games, the Internet, and recordable media, have limitedbandwidth. Our technology architecture is flexible enough to accommodate theseneeds and optimize quality within the constraints of the application.

Thefollowing chart compares our audio technology against the two other predominanttechnologies used on DVD-Video—Dolby AC-3, and MPEG-2, Layer 2.
| **Comparison of Technologies Used in DVD-Video** | ** ** | **DTS**        | ** ** | **Dolby  AC-3** | ** ** | **MPEG-2,  Layer 2** | ** ** |
|---------------------------------------------------------------------------|------------|----------------|------------|-----------------|------------|---------------------------|------------|
| Range of  Operation (Bit Rates)                                           |       | 32-9,216  kbps |       | 32-640  kbps    |       | 32-920  kbps              |       |
| Range of Sample  Rates                                                    |       | 8-192  kHz     |       | 32-48  kHz      |       | 8-148  kHz                |       |
| Number of  Channels                                                       |       | 16 +           |       | 5.1             |       | 7                         |       |
| Scalability:                                                              |       |           |       |            |       |                      |       |
| Sampling frequency                                                        |       | Yes            |       | No              |       | Yes                       |       |
| Channels                                                                  |       | Yes            |       | No              |       | Partly                    |       |
| Bit Rate                                                                  |       | Yes            |       | Partly          |       | No                        |       |

 

We have designedthe following attributes into the basic architecture of our technology:

·       *scalable,* meaning that parameters such as data rate can beset over a very wide range, as applications require;

·       *extensible,* meaning that the structure itself accommodatesadditional data for enhancements both anticipated and unknown; and

·       *backwardcompatible,* meaning that extensions and enhancements do not precludethe ability of earlier decoders to play the core signal.

**Intellectual Property**

We have a substantial base of intellectual propertyassets covering patents, trademarks, copyrights, and trade secrets. We have 21individual patent families resulting in more than 123 individual patents andmore than 55 patent applications throughout the world. We have more than 70trademarks and more than 45 trademark applications pending worldwide withadditional marks in the pre-application phase. We also have a number offederally registered copyrights and maintain a sizeable library of copyrightedsoftware 

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and other technicalmaterials as well as numerous trade secrets. We have targeted our intellectualproperty coverage to provide protection in the major manufacturing andcommercial centers of the world.

We pursue a general practice of filing patentapplications for our technology in the United States and various foreigncountries where our customers manufacture, distribute, or sell licensedproducts. We actively pursue new applications to expand our patent portfolio toaddress new technological innovations. Most of the patents in our patentportfolio have an average life of 20 years from their date of filing withsome beginning to expire between 2005 and 2009. However, many of our moresubstantive patents are relatively young and have expiration dates ranging from2015 to 2018. We have multiple patents covering unique aspects and improvementsfor many of our technologies. Accordingly, we do not believe that theexpiration of any single patent is likely to significantly affect ourintellectual property position or our ability to generate licensing revenues.

Thefollowing table lists our key patents and patent applications and theinventions they cover:
| **Key Patent Titles**                                                                                                                     | ** ** | **Coverage**                                                       |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|
| *Consumer Markets*                                                                                                                        |       |                                                               |
| Multi-Channel Predictive  Subband Audio Coder Using Psychoacoustic Adaptive Bit Allocation in  Frequency, Time and over Multiple Channels |       | Coherent Acoustics  Algorithm—Encoder & Decoder      |
| Improving Sound  Quality of Established Low Bit-Rate Audio Coding Systems Without Loss of  Decoder Compatibility                          |       | Core + Extension  Architecture, 96 kHz/24 Bit Structure            |
| Method of  Decoding Two-Channel Matrix Encoded Audio to Reconstruct Multi-Channel Audio                                                   |       | Neo:6 (stereo to  multi-channel) and DTS-ES (6.1 channel)          |
| Digitally Encoded  Machine Readable Storage Media Using Adaptive Bit Allocation in Frequency,  Time and over Multiple Channels            |       | Coherent Acoustics  Algorithm—Article of Manufacture     |
| Method and  Apparatus for Multiplexed Encoding of Digital Audio Information onto a  Digital Storage Medium                                |       | Multi-Channel CD—5.1  Music Disc (applicable to cinema discs) |
| *Cinema Markets*                                                                                                                          |       |                                                               |
| Motion Picture  Digital Sound System and Method with Primary Sound Storage Edit Capability                                                |       | Cinema Synchronization  and Play Back                              |
| Motion Picture  Digital Sound System & Method                                                                                    |       | DTS Time Code on Film                                              |
| Motion Picture  Subtitling System and Method Using an Electro-Optical Dowser                                                              |       | Subtitling System Using  an Optical Dowser                         |

 

We generally license ourtechnology on standard terms through a two-tiered structure: first tointegrated circuit semiconductor manufacturers and then to consumer electronicsproduct manufacturers. We generally license on a non-exclusive, perpetual,worldwide basis. Our business model provides for hardware manufacturers to payus for each unit they produce that contains our technology or trademarks. Werequire that all licensees have their integrated circuits or hardware devicescertified by us prior to distribution. We reserve the right to audit theirrecords and quality standards. Licensees are required to use the appropriateDTS trademark on the products they manufacture.

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In the consumer products market, we have 52 patentsissued and 39 patents pending worldwide spanning the entire spectrum of ourtechnology including the encoding and decoding process, the structure of theDTS audio stream, and media containing DTS encoded material. In addition, wehave a number of patents and applications covering extensions of our coretechnology architecture as well as unique implementation approaches for variousproduct applications.

In the cinema market, we have 47 patents issued and sevenpatents pending worldwide covering our cinema system, the DTS time code, andour subtitling method. These patents cover the technology that is utilized inour various cinema products as well as our film license rights.

We also have 24 patents and nine patent applicationsthat span across both the consumer products and cinema sectors of our business.These rights primarily cover the process of producing media containing DTS anddigital multi-channel audio as well as the individual finished product.

We have licensed from Audio Processing TechnologyLimited the rights to the apt-X algorithm on a perpetual, worldwide,non-exclusive basis. The apt-X algorithm is the audio algorithm used by ourcinema products to encode and play back our audio tracks.

Our trademarks consist of over 20 individual wordmarks, logos, and slogans filed throughout the world. The marks cover ourvarious products, technology, improvements, and features as well as theservices that we provide. Our trademarks are an integral part of our licensingprogram and are required to be used on licensed products to identify theexistence of the technology and to provide greater consumer awareness. Ourtrademarks include the following:

We have a significantamount of copyright protected materials including software, textual materials,and master audio materials used to produce our DTS Entertainment products. Anumber of these products have been federally registered.

**Customers**

***Consumer Markets***

*ConsumerElectronics Products Manufacturers.  *We have licensedour Coherent Acoustics technology to over 250 consumer electronics productsmanufacturers for use in hundreds of consumer audio products. Collectively,these manufacturers have sold over 45 million products with DTS digitalsound decoding technology. The following list sets forth some of the consumerelectronics products manufacturers that have licensed our technology.
| Audio & Audio/Video Receivers                                          | ** ** | **DVD Players**                                                      |
|---------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|
| Koninklijke Philips Electronics

LG Electronics, Inc.  Pioneer Corporation |       | Samsung  Electronics Co., Ltd.

Sony Corporation  Yamaha Corporation |   | Funai Electric  Co., Ltd.

Orion Electric  Co., Ltd.

Samsung  Electronics Co., Ltd. |   | Sanyo Technosound  Co. Ltd.

Sony Corporation  Thomson |
|                                                                                 |            |                                                                      |  |  |  |  |

 

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| Car Audio Systems     |
|-----------------------|
| Fujitsu Ten Co., Ltd. |   | Hyundai Autonet |   | Kenwood Corporation |   | Matsushita  Electric Industrial Co., Ltd. |

 

*SemiconductorManufacturers.  *We have licensed to over 40semiconductor manufacturers the right to incorporate our technology in theirsemiconductors and to sell semiconductors with DTS technology to our hardwaremanufacturer licensees. Our major semiconductor-manufacturing customers includethe following:
| Cirrus Logic, Inc. |   | LSI Logic Corporation                      |   | Yamaha Corporation |
|-------------------------|--------|--------------------------------------------|--------|--------------------|
| Fujitsu Limited         |   | Matsushita Electrical Industrial Co., Ltd. |   |               |

 

*Content Providers.  *We havealso provided our Coherent Acoustics technology to many of the leading homevideo and music content providers including DreamWorks Home Entertainment, NewLine Home Entertainment, Inc., and Warner Bros. Records, Inc. Todate, over 5,000 DVD titles, over 155 CD titles, and over 38 DVD-Audio titleshave been produced with DTS digital multi-channel audio tracks.

*DTS Entertainment.  *Majorretail customers who sell DTS Entertainment labeled music content to consumersinclude Amazon.com, Best Buy, Musicland, and Tower Records.

***Cinema Markets***

Thenine major film studios in the United States are all customers of ours.According to Exhibitor Relations, these film studios accounted forapproximately 84% of admission revenues and 83 of the 100 highest grossing filmsin the United States in 2004. These studios, which released most of their majorfeature films in the DTS format in 2004, are listed below.
| 20th Century Fox      |   | DreamWorks SKG        |   | Paramount Pictures    |
|-----------------------|--------|-----------------------|--------|-----------------------|
| Buena Vista  Pictures |   | MGM Pictures          |   | Universal Pictures    |
| Columbia Pictures     |   | New Line Cinema Corp. |   | Warner Bros. Pictures |

 

Inaddition, we sell our playback equipment to movie theaters, including thefollowing:
| Jack Loeks    |   | Rave Theatres       |   | Wallace Theatres |
|---------------|--------|---------------------|--------|------------------|
| Odeon Cinemas |   | Regal Entertainment |   |             |

 

**Sales, Marketing, and Support**

***Consumer Products***

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 believe that by locating staffnear the leading consumer electronics and semiconductor manufacturers we canenhance our sales and business development efforts.

We market our digitalsound encoding equipment directly to the content providers and audioprofessionals serving the consumer electronics market. We believe that allowingeasy access to encoders will result in more DTS content, which we believe willdrive consumer demand for DTS-enabled electronics products.

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***Film Producers and Distributors***

Our post-productiondepartment, senior management, and liaison offices market our products andservices directly to individual film producers and distributors worldwide.

***Movie Theaters***

We sell our cinemaplayback 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, Western Europe, and in targeted markets inAsia and Latin America. We have also begun to focus our efforts on pursuingtheater companies that have a large concentration of movie theaters in selectedforeign countries such as India, China, and Eastern Europe.

***DTS Entertainment***

We sell music contentreleased under our DTS Entertainment label through distributors. In the UnitedStates, Navarre Corporation is our exclusive distributor of DTS Entertainmentlabel products to major national retail accounts. In addition to our in-housestaff, we also employ consultants to coordinate sales to independent retailers.We are in the process of establishing distribution channels internationally.Cadiz Music Limited serves as our exclusive distributor of DTS Entertainmentlabel products in Europe and Disc Union serves as our exclusive distributor inJapan. We intend to engage one or more additional distributors with anestablished presence in Asia to handle distribution in other Asian territories.We also sell this music directly to consumers through an online store and otherweb-based retailers. We intend to expand the number of retail outlets thatcarry our products and broaden our distribution network worldwide.

**Research and Development**

We have a group of 46 engineers and scientists,including seven PhDs, focused on research and development. This group overseesour product development efforts and is responsible for implementing ourtechnology into our existing and emerging products. We carry out research anddevelopment activities at our corporate headquarters in Agoura Hills,California and at our facility in Bangor, Northern Ireland.

Our research and development expenses totaledapproximately $3.8 million during 2002, $5.0 million during 2003, and$6.1 million during 2004. We expect that we will continue to commit significantresources to applications engineering efforts, particularly in support of thenew high definition disc standards, and to research and development in thefuture.

In December of 2003we entered into a collaborative research agreement with Sonic Arts ResearchCentre, or SARC, located at Queen’s University in Belfast, Northern Ireland.The research is focused on the development of new multi-channel audiotechnologies and is jointly funded by DTS and Invest NI, a development agencyin Northern Ireland.

**Governmentaland Industry Standards**

There are a variety of governmental andindustry-related organizations that are responsible for adopting system andproduct standards. Standards are important in many technology-focusedindustries as they help to assure compatibility across a system or series ofproducts. Generally, standards adoption occurs on either a mandatory basis,requiring the existence of a particular technology or feature, or an optionalbasis, meaning that a particular technology or feature may be, but is notrequired to be, utilized.

We actively participate in a variety of standardsorganizations worldwide, including the DVD Forum, Blu-ray Disc Association,Digital Video Broadcast Project, International Engineering Consortium,High-Definition Multimedia Interface Standard, Media Oriented Systems TransportBus, Audio Engineering 

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Society, and Society forMotion Picture and Television Engineers. We anticipate being involved in anumber of other standards organizations as appropriate to facilitate the implementationof our technology.

We believe the market for audio and audio/videoproducts is very standards driven and our active participation with standardsorganizations is important as we work to include our technology in standards orchange our status from optional to mandatory where possible. We believe ourstandards involvement also provides us early visibility into futureopportunities.

In the consumer products area, we are members of theDVD Forum and Blu-ray Disc Association. In both organizations we arespecifically involved in several working groups and expert groups. ForDVD-Video, we have obtained optional status for our core Coherent Acousticstechnology. Through our participation, we have expanded the supportedspecification of our codec, increasing the quality and number of channels. Ourtechnology has been selected as mandatory in the future high definition opticaldisc standards. Our technology has been accepted as an optional format in theDVD-Audio Recordable specification and we are currently involved in the workinggroups for Interactive DVD and DVD recording specifications for both audio andhigh definition video.

In the digital broadcast area, we participate in theDigital Video Broadcast Project, or DVB, and the Advanced Television SystemsCommittee, or ATSC. In late 2002 our technology was accepted as an optionalaudio format in the DVB Specification.

We actively participate in the major industryassociations that publish research and establish standards. These include theSociety of Motion Picture and Television Engineers and, in particular, thecommittees relating to digital cinema, and the Audio Engineering Society.

We have six employees andconsultants focused on standards activities, including one in Europe, one inJapan, and four in the United States. We also employ additional resources asnecessary to assist with specific standards-related tasks.

**Competition**

We face intense competition in each of our markets andexpect competition to intensify in the future. Our primary competitor is DolbyLaboratories, who develops and markets digital multi-channel audio products andservices. Except for image restoration and enhancement, we compete with Dolbyin nearly all of our markets and product categories.

Dolby was founded more than 35 years ago and formany years was the only significant provider of audio technologies. Dolby’slong-standing market position, brand, business relationships, and inclusion invarious industry standards provide it with a strong competitive position.

In addition to Dolby Laboratories, we also compete inspecific product markets with Coding Technologies, Fraunhofer InstitutIntegrierte Schaltungen, Koninklijke Philips Electronics N.V., MicrosoftCorporation, Smart Devices, Inc., Sony Corporation, Thomson, Ultra StereoLabs, Inc., and various consumer electronics products manufacturers. Manyof these competitors have longer operating histories and significantly greaterresources or greater name recognition than we do.

We believe that theprincipal competitive factors in each of our markets include some or all of thefollowing:

·       technologyperformance, flexibility, and range of application;

·       qualityand reliability of products and services;

·       brandrecognition and reputation;

·       inclusionin industry standards;

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·       price;

·       relationshipswith film producers and distributors and with semiconductor and consumerelectronics manufacturers;

·       availabilityof compatible high-quality audio content; and

·       timelinessand relevance of new product introductions.

We have been successful in penetrating the consumerand cinema markets and building and maintaining significant market share. Mostmajor feature-film releases in the United States are encoded in our format,many top selling and premier edition DVDs contain digital multi-channelsoundtracks in our format, and a substantial majority of consumer electronicsproducts with digital multi-channel capability incorporate our technology,trademarks, or know-how. Our success has been due in large part to our abilityto position our brand as a premium offering that contains superior proprietarytechnology, the quality of our customer service, our inclusion in industrystandards, and our industry relationships.

We believe there aresignificant barriers to entry in our key markets. In the cinema market, thereare three well-established formats—DTS, Dolby, and Sony—and we believe it wouldbe very difficult for a new entrant to penetrate the market. Key barriers toentry include physical limitations on the film, intellectual property coverage,and the reluctance of the film studios to pay additional license fees andtheater operators to purchase additional playback equipment. In the consumerelectronics products market, the standards relating to DVD-Video are wellestablished and support a limited number of technologies including DTS CoherentAcoustics.

**Employees**

As of December 31,2004, we had 174 employees, which includes 46 employees in engineering,technical services, and research and development, 12 employees in productionand operations, 69 employees in sales, marketing, service, and support, 22employees in accounting and information technology, and 25 employees in seniormanagement and administration. Of the 174 total employees, 121 work in theUnited States and 53 work in our various international locations, including 38in the United Kingdom. None of our employees is subject to a collectivebargaining agreement, and we have never experienced a work stoppage. We believeour relations with our employees are good. Our future success depends on ourability to attract, motivate, and retain highly-qualified technical andmanagement personnel. From time to time, we also employ independent contractorsto support our product development, sales, marketing, business development, andadministration organizations.

**Website Access to SEC Filings**

We maintain an Internetwebsite at *www.dtsonline.com.* We make availablefree of charge through our Internet website our annual report on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-K,and amendments to those reports filed or furnished pursuant to Section 13(a) or15(d) of the Exchange Act as soon as reasonably practicable after weelectronically file such material with, or furnish it to, the SEC.

**Item 2. *Properties***

Our corporate headquartersand principal offices are located in Agoura Hills, California, where we leaseapproximately 42,000 square feet. This space is leased under two leases whichexpire in May 2007 and October 2007. We also lease smaller facilitiesin other locations including the United States of America, England, NorthernIreland, Japan, Canada, China, and Hong Kong. We believe that our existingspace is adequate for our current operations. We believe that suitablereplacement and additional space will be available in the future oncommercially reasonable terms.

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**Item 3. *Legal Proceedings***

In the ordinary course of our business, we activelypursue legal remedies to enforce our intellectual property rights and to stopunauthorized use of our technology and trademarks.

In connection with such activities against SunplusTechnology Co., Ltd., or Sunplus, we terminated Sunplus’ license agreement withus. In response, Sunplus filed suit against us alleging breach of contractarising from our termination of their license agreement. We have prevailed onseveral preliminary motions by Sunplus seeking to enjoin us from terminatingthe license agreement. We have filed a cross-complaint seeking a judicialdeclaration that we properly terminated the license agreement and to recoverdamages arising from Sunplus’ breach of the agreement. We believe Sunplus’claim is without merit and we intend to vigorously defend the case.

We are not a party to anyother material legal proceedings. We may, however, become subject to lawsuitsfrom time to time in the course of our business.

**Item 4. *Submission of Matters to aVote of Security Holders***

We did not submit any matters to a vote of securityholders during the fourth quarter of the year ended December 31, 2004.

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**PART II**

**Item5. *Market for Registrant’s Common Equity and RelatedStockholder Matters***

**PRICE RANGE OF COMMON STOCK**

Ourcommon stock has been traded on the Nasdaq National Market under the symbol “DTSI”since our initial public offering on July 10, 2003. The following tablesets forth, for the periods indicated, the high and low sales prices for ourcommon stock as reported by the Nasdaq National Market:
| ** **                               | ** ** | **High** | ** ** | **Low** | ** ** |
|------------------------------------------|------------|----------|------------|---------|------------|
| **2003:**                                |       |     |       |    |       |
| Third Quarter  (from July 10, 2003) |       | $        | 31.31      |    | $          | 19.50 |   |
| Fourth Quarter                           |       | $        | 34.28      |    | $          | 24.05 |   |
| **2004:**                                |       |     |       |    |       |
| First Quarter                            |       | $        | 27.15      |    | $          | 20.08 |   |
| Second Quarter                           |       | $        | 28.00      |    | $          | 19.87 |   |
| Third Quarter                            |       | $        | 26.27      |    | $          | 12.56 |   |
| Fourth Quarter                           |       | $        | 21.30      |    | $          | 15.14 |   |

 

As of March 1, 2005there were approximately 1,700 stockholders of record of our common stock. Webelieve that the number of beneficial owners is substantially greater than thenumber of record holders because a large portion of our common stock is held ofrecord through brokerage firms in “street name.”

**DIVIDEND POLICY**

We have never declared orpaid any cash dividends on our common stock. We currently intend to retain allavailable funds to support our operations and to finance the growth anddevelopment of our business. We do not anticipate paying any cash dividends inthe foreseeable future. Any future determination relating to dividend policywill be made at the discretion of our board of directors and will depend on anumber of factors, including our future earnings, capital requirements,financial condition, future prospects, and other factors as the board ofdirectors may deem relevant.

**USE OF INITIAL PUBLIC OFFERING PROCEEDS**

On July 15, 2003, we completed our initial publicoffering for the sale of 4,091,410 shares of common stock at a price to thepublic of $17.00 per share, which resulted in net proceeds of approximately $63.0million after payment of the underwriters’ commissions and deductions ofoffering expenses. All of the shares of Common Stock sold in the offering wereregistered under the 1933 Act on a Registration Statement on Form S-1(Reg. No. 333-104761) that was declared effective by the SEC on July 9,2003 and a Registration Statement filed pursuant to Rule 462(b) underthe Securities Act that was filed on July 10, 2003 (Reg. No. 333-106920).Subsequent to the offering, we used approximately $22.5 million of our netproceeds to redeem all outstanding shares of redeemable preferred stock and topay all accrued but unpaid dividends on such shares through the date ofredemption. The remaining proceeds to us have conformed with our intended useoutlined in the prospectus related to the offering. As of December 31,2004, we have approximately $40.5 million remaining from the proceeds ofthe offering.

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**Item 6. *Selected Financial Data***

**SELECTED CONSOLIDATED FINANCIAL DATA**

In thetable below, we provide you with historical selected consolidated financialdata of Digital Theater Systems, Inc. The consolidated statement ofoperations data for the years ended December 31, 2000 and 2001 andthe consolidated balance sheet data as of December 31, 2000, 2001, and2002 are derived from our audited consolidated financial statements for suchperiods and dates, which are not included in this Form 10-K. Theconsolidated statement of operations data for the years ended December 31,2002, 2003, and 2004 and the consolidated balance sheet data as of December 31,2003 and 2004 are derived from, and qualified by reference to, our auditedconsolidated financial statements for such periods and dates, which appearelsewhere in this Form 10-K. It is important that you read the selectedconsolidated financial data set forth below in conjunction with ourconsolidated financial statements and related notes and “Management’s Discussionand Analysis of Financial Condition and Results of Operations” includedelsewhere in this Form 10-K. Our historical results are not necessarilyindicative of the operating results that may be expected in the future.
| ** **                                                                                                            | ** ** | **Years Ended December 31,**                                            | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|
| ** **                                                                                                            | ** ** | **2000**                                                                               | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                                                                                            | ** ** | **(In thousands, except share and per share data)** | ** ** |
| **Consolidated Statement of Operations Data**                                                                         |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Revenues:                                                                                                             |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Technology and film  licensing                                                                                        |       | $                                                                                      | 14,605     |   | $ | 19,615 |   | $ | 31,906 |   | $ | 42,229 | ** ** | **$** | **49,920** | ** ** |
| Product sales and other  revenues                                                                                     |       | 10,457                                                                                 |       | 9,133 |   | 9,150 |   | 9,473 | ** ** | **11,511** | ** ** |
| Total revenues                                                                                                        |       | 25,062                                                                                 |       | 28,748 |   | 41,056 |   | 51,702 | ** ** | **61,431** | ** ** |
| Cost of goods sold:                                                                                                   |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Technology and film  licensing                                                                                        |       | 2,901                                                                                  |       | 3,007 |   | 3,687 |   | 4,281 | ** ** | **4,451** | ** ** |
| Product sales and other  revenues                                                                                     |       | 5,988                                                                                  |       | 7,045 |   | 6,949 |   | 6,751 | ** ** | **11,711** | ** ** |
| Total cost of goods sold                                                                                              |       | 8,889                                                                                  |       | 10,052 |   | 10,636 |   | 11,032 | ** ** | **16,162** | ** ** |
| Gross profit                                                                                                          |       | 16,173                                                                                 |       | 18,696 |   | 30,420 |   | 40,670 | ** ** | **45,269** | ** ** |
| Operating expenses:                                                                                                   |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Selling, general and  administrative                                                                                  |       | 12,819                                                                                 |       | 13,336 |   | 16,379 |   | 20,473 | ** ** | **27,644** | ** ** |
| Research and development                                                                                              |       | 2,984                                                                                  |       | 3,603 |   | 3,754 |   | 4,987 | ** ** | **6,131** | ** ** |
| Total operating expenses                                                                                              |       | 15,803                                                                                 |       | 16,939 |   | 20,133 |   | 25,460 | ** ** | **33,775** | ** ** |
| Income (loss) from  operations                                                                                        |       | 370                                                                                    |       | 1,757 |   | 10,287 |   | 15,210 | ** ** | **11,494** | ** ** |
| Interest income  (expense), net                                                                                       |       | (338                                                                                   | )          | (278 | ) | (94 | ) | 271 | ** ** | **1,447** | ** ** |
| Other expense, net                                                                                                    |       | (131                                                                                   | )          | (302 | ) | (255 | ) | (214 | ) | **(31** | **)** |
| Income from legal  settlement                                                                                         |       | —                                                                                 |       | — |   | — |   | — | ** ** | **2,601** | ** ** |
| Income (loss) before  provision (benefit) for income taxes                                                       |       | (99                                                                                    | )          | 1,177 |   | 9,938 |   | 15,267 | ** ** | **15,511** | ** ** |
| Provision (benefit) for  income taxes                                                                                 |       | —                                                                                 |       | (2,731 | ) | 3,688 |   | 5,368 | ** ** | **5,535** | ** ** |
| Net income (loss)                                                                                                     |       | (99                                                                                    | )          | 3,908 |   | 6,250 |   | 9,899 | ** ** | **9,976** | ** ** |
| Accretion and accrued  dividends on preferred stock                                                                   |       | (1,783                                                                                 | )          | (1,813 | ) | (1,848 | ) | (1,234 | ) | — |   |
| Net income (loss)  attributable to common stockholders                                                                |       | $                                                                                      | (1,882     | ) | $ | 2,095 |   | $ | 4,402 |   | $ | 8,665 | ** ** | **$** | **9,976** | ** ** |
| Net income (loss) attributable to common  stockholders per common share:                                              |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Basic                                                                                                                 |       | $                                                                                      | (0.44      | ) | $ | 0.49 |   | $ | 0.99 |   | $ | 0.95 | ** ** | **$** | **0.59** | ** ** |
| Diluted                                                                                                               |       | $                                                                                      | (0.44      | ) | $ | 0.23 |   | $ | 0.47 |   | $ | 0.80 | ** ** | **$** | **0.55** | ** ** |
| Weighted average shares used to compute net income  (loss) attributable to common stockholders per common share: |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Basic                                                                                                                 |       | 4,294,378                                                                              |       | 4,295,419 |   | 4,432,408 |   | 9,166,389 | ** ** | **16,865,805** | ** ** |
| Diluted                                                                                                               |       | 4,294,378                                                                              |       | 9,054,843 |   | 9,329,278 |   | 10,764,867 | ** ** | **18,143,114** | ** ** |

 

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Seeour consolidated financial statements and related notes for a description ofthe calculation of the historical net income (loss) attributable to commonstockholders per common share and the weighted average number of shares used incomputing the historical per common share data.
| ** **                                          | ** ** | **As of December 31,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                          | ** ** | **2000**                              | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                          | ** ** | **(In thousands)**               | ** ** |
| **Consolidated Balance Sheet Data**                 |       |                                  |       |   |   |   |   |   |   |   |   |
| Cash, cash  equivalents, and short-term investments |       | $                                     | 4,152      |   | $ | 6,858 |   | $ | 4,051 |   | $ | 99,389 | ** ** | **$** | **114,311** | ** ** |
| Working capital                                     |       | 7,815                                 |       | 9,452 |   | 9,381 |   | 110,810 | ** ** | **125,573** | ** ** |
| Total assets                                        |       | 15,176                                |       | 21,707 |   | 25,779 |   | 127,495 | ** ** | **144,689** | ** ** |
| Long-term  obligations, less current portion        |       | 6,403                                 |       | 6,303 |   | — |   | — |   | — |   |
| Mandatorily  redeemable preferred stock             |       | 17,641                                |       | 19,454 |   | 21,302 |   | — |   | — |   |
| Total stockholders’  equity (deficit)          |       | (12,950                               | )          | (10,855 | ) | (6,315 | ) | 118,871 | ** ** | **134,766** | ** ** |
|                                                     |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Item 7. *Management’s Discussionand Analysis of Financial Condition and Results of Operations***

This Annual Report on Form 10-K and the documentsincorporated herein by reference contain forward-looking statements based onour current expectations, estimates and projections 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.” Theforward-looking statements contained in this report involve known and unknownrisks, uncertainties and other factors that may cause our actual results to bematerially different from those expressed or implied by these statements. Thesefactors include those listed under the “Risk Factors” section contained belowand elsewhere in this Form 10-K, and the other documents we file with theSecurities and Exchange Commission, or SEC, including our most recent reportson Form 8-K and Form 10-Q. We cannot guarantee future results, levelsof activity, performance or achievements. We do not undertake any obligation torevise these forward-looking statements to reflect future events orcircumstances.

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

**Overview**

We are a leading provider of entertainment technology,historically focused on high-quality digital multi-channel audio technology,products, and services for entertainment markets worldwide. Multi-channelaudio, commonly referred to as surround sound, provides more than two-channelsof audio, allowing the listener to simultaneously hear discrete sounds frommultiple speakers. Our DTS digital multi-channel audio technology delivers compellingsurround sound for the motion picture and consumer electronics markets.

We manage our business through two reportablesegments—our consumer business and our cinema business, which we havepreviously described as our theatrical business. Historically, we have deriveda majority of our revenues from the cinema business. Beginning in 2001,however, we have derived a majority of our revenues from our consumer business.In connection with our acquisition of Lowry Digital Images, Inc., or LDI,we will have a third reportable segment in the first quarter of 2005.

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

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

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

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

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

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

Our research and development costs consist primarilyof salaries and related benefits for research and development personnel,engineering consulting expenses associated with new product and technology 

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development, and qualityassurance and testing costs. Research and development costs are expensed asincurred.

In our consumer business, we have a licensing teamthat markets our technology directly to large consumer electronics productsmanufacturers and semiconductor manufacturers. This team includes employeeslocated in the United States, China, England, Japan, and Northern Ireland. Wesell music content released under our DTS Entertainment label throughdistributors. In the United States and Canada, Navarre Corporation is ourexclusive distributor of DTS Entertainment label products to major nationalretail accounts and in Europe, Cadiz Music Limited is our exclusive distributorof DTS Entertainment label products. Disc Union serves as our exclusivedistributor in Japan. We also employ consultants to coordinate sales toindependent retailers. We are in the process of establishing distributionchannels in other international territories. We intend to engage one or moreadditional distributors with an established presence in Asia to handledistribution other Asian territories. We also sell this music directly toconsumers through an online store and other web-based retailers. We intend toexpand the number of retail outlets that carry our products and broaden ourdistribution network worldwide.

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

With our recentacquisition of LDI, we now provide restoration and enhancement services formoving pictures captured on film or in digital form. These services enablecurrent or archived content to be restored for high quality, high definitionpresentations in digital cinema, high definition optical media or broadcastapplications.

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

**Consumer Segment**

Revenue from our consumer segment constitutes themajority of our total revenue, representing 62%, 68%, and 68% of total revenuesin fiscal years ended December 31, 2002, 2003, and 2004, respectively. Ourconsumer revenue is primarily dependent upon the home theater and DVD playermarkets, which have experienced rapid growth over the past several years. Thesuccess of DVD-Video-based systems and products has fueled a demand forever-higher quality entertainment in the home, and this demand is extending tothe car and PC markets as well. We expect the recent acceleration of the marketfor high definition televisions to drive demand for high definition opticaldisc players beginning in late 2005. Because we expect to be a mandatorytechnology for the next generation players, our consumer revenue growth shouldmore closely track the growth rate of these players over the next several years.We expect that the market for high definition players will yield new growththat provides an offset to the expected decline in the overall growth in DVDplayer shipments. Further, we believe that expected mandatory inclusion in nextgeneration optical disc standards will help to improve the adoption rate of ourtechnologies in other consumer products such as next generation video gameconsoles, personal audio and video players, personal computers and in-carentertainment systems. Failure to attain mandatory status in next generationhigh definition optical disc standards could cause revenue growth in ourconsumer business to be significantly lower than expected and could have amaterial adverse effect on our business.

In July 2004, weacquired QDesign Corporation, or QDesign, a company focused on lower-bit rateaudio delivery technology. The market for higher quality entertainment isexpanding into portable devices that require the use of low-bit rate audiocoding systems including portable audio players, PDAs and 

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wirelesshandset applications. Concurrent with this trend, there is a growing need for agood link between home and portable devices that preserves as much quality aspossible and allows consumers a seamless technology solution for the storageand playback of their content. In October 2004, leveraging our existingresearch and development efforts and the intellectual property acquired in theQDesign acquisition, we launched DTS-HD, a scalable coding system. Thistechnology allows content to be played in home and portable devices. We believethat the broad and robust nature of this offering improves the probability ofinclusion of our technologies in next generation products.

**Cinema Segment**

Revenue from our cinema segment represented 38%, 32%,and 32% of total revenues for the years ended December 31 2002, 2003, and2004, respectively. In our cinema business, 2004 was a solid year for sales ofour playback hardware, marking a return to growth for cinema product sales. Weexpect growth in our cinema audio hardware to continue at a modest pace in 2005.We also believe that the cinema exhibition community has recognized thatpre-show entertainment represents a significant revenue growth opportunity thatwill lead to investment in pre-show solutions over the next several years.  Because our XD-10 Cinema Media Player can beconfigured to perform audio playback along with pre-show or subtitlingpresentation, we believe that we are well-positioned to participate in thegrowth in this market.

In January 2005 we acquired Lowry Digital Images, Inc.,or LDI, a company focused in high quality image restoration and enhancement. Webelieve that the growing market for televisions capable of playing highresolution or high definition content will create a substantial demand for suchcontent. We believe that LDI has a technological advantage over many of itscompetitors based on the sophistication of its processes and level ofautomation used to restore or enhance the image quality of entertainmentcontent. To date, LDI has restored and/or enhanced over 100 feature films,including such recent major DVD releases as *Star Wars* and *Indiana Jones.* Major motion picture and television studiospossess libraries containing thousands of titles, which we believe represents asizable market opportunity for LDI’s service.

Another trend that we believe will affect our cinemabusiness segment is the the long-term trend toward digital media. We believethis trend will involve the near term adoption of digital pre-show and/orelectronic cinema solutions, followed by longer term adoption of higher qualitydigital cinema. Digital media offers the motion picture industry a means toachieve substantial cost savings, including the printing and distribution ofmovies, help in combating piracy, and will enable movies to be playedrepeatedly without degradation. It also provides additional revenueopportunities for cinema operators, as digital content such as advertisements,concerts and sporting events could be shown in or broadcast to digitallyequipped theaters. We believe the widespread adoption of digital cinema will belonger term because of the significant capital investment that will be requiredby cinema operators to purchase new equipment and solutions. We believe thisrepresents an opportunity for us as we seek to provide products and services insupport of the transition from film-based content towards digital cinema.However, we do not currently offer digital cinema products and may not besuccesful in developing or selling competitive product offerings. We believethat our recent acquisition of LDI, coupled with the pre-show and alternativecontent capabilities of our XD10 Cinema Media Player, will enable us to play arole in the industry transition to high definition sound and images for digitalcinema.

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

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**CriticalAccounting Policies and Estimates**

Management’s Discussion and Analysis of FinancialCondition and Results of Operations is based upon our consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States. The preparation of our financial statementsrequires us to make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues, and expenses, and related disclosure ofcontingent assets and liabilities. On an on-going basis, estimates areevaluated, including those related to revenue recognition, allowance fordoubtful accounts, inventories, goodwill and intangible assets, impairment oflong-lived assets, product warranty, taxes, and contingencies and litigation.These estimates are based on historical experience and on various otherassumptions that are believed to be reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from other sources.Actual results may differ from these estimates.

We apply thefollowing critical accounting policies in the preparation of our consolidatedfinancial statements:

·       *Revenue Recognition.*We recognize revenues in accordancewith the guidelines of the SEC Staff Accounting Bulletin, or SAB, No. 101as amended by SAB No. 104 “Revenue recognition in Financial Statements.”Revenues from the sale of cinema hardware products are recorded upon shipment,assuming title and risk of loss has transferred to the customer, we have nosignificant obligations remaining, prices are fixed or determinable, andcollection of the related receivable is reasonably assured. The licensing,encoding and duplication of motion picture soundtracks for use in our playbacksystems is undertaken under arrangements with major film studios. Revenuesarising from the licensing and duplication of soundtracks are recognized uponcompletion, assuming prices are fixed or determinable, we have no significantobligations remaining, and collection of the related receivable is reasonablyassured. Direct costs associated with deferred revenue are deferred and includedin other assets. Included in the balance sheet are $519,000 and $296,000 ofdeferred revenue and costs, respectively, at December 31, 2004.

·  Revenues from licensing audio technology,trademarks, and know-how are generated from licensing agreements with consumerelectronics products manufacturers that generally pay a per-unit license feefor products manufactured under those license agreements. Licensees generallyreport manufacturing information within 30 to 60 days after the end of thequarter in which such activity takes place. Consequently, we recognize revenuefrom these licensing agreements on a three-month lag basis, generally in thequarter following the quarter of manufacture, provided amounts are fixed ordeterminable and collection is reasonably assured. Use of this lag methodallows for the receipt of licensee royalty reports prior to the recognition ofrevenue. Revenues from the sale of digital multi-channel audio and videocontent are recorded upon shipment to retail accounts or end customers,assuming title and risk of loss has transferred, prices are fixed ordeterminable, we have no significant obligations remaining, and collection ofthe related receivable is reasonably assured. We provide for returns on productsales based on historical experience and adjust such reserves as considerednecessary. To date, there have been no significant sales returns.

·       *Allowance for Doubtful Accounts.*An allowance for doubtfulaccounts is maintained for estimated losses resulting from the inability of ourcustomers to make required payments. If the financial condition of ourcustomers were to deteriorate, resulting in an impairment of their ability tomake payments, additional allowances may be required. In determining thereserve, we evaluate the collectibility of our accounts receivable based upon avariety of factors. In cases where we become aware of circumstances that mayimpair a specific customer’s ability to meet its financial obligations, werecord a specific allowance against amounts due. For all other customers, werecognize allowances for doubtful accounts based on its historical write-offexperience in conjunction with the 

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length of time thereceivables are past due, customer creditworthiness, geographic risk and thecurrent business environment. Our allowances for doubtful accounts at December 31,2003 and 2004 amounted to $429,000 and $402,000, respectively.

·       *Inventories.*Inventory levels are based on projections offuture demand and market conditions. Any sudden decline in demand and/or rapidproduct improvements and technological changes can result in excess and/orobsolete inventories. On an ongoing basis, inventories are reviewed and writtendown for estimated obsolescence or unmarketable inventories equal to thedifference between the costs of inventories and the estimated net realizablevalue based upon forecasts for future demand and market conditions. If actualmarket conditions are less favorable than our forecasts, additional inventoryreserves may be required. Estimates could be influenced by sudden declines indemand due to economic downturns, rapid product improvements, and technologicalchanges. During the fourth quarter of 2004, we recorded a write-down ofapproximately $3.9 million related to our monochrome projector inventory as aresult of our revised outlook based on declines in future demand andtechnological obsolescence.

·       *Goodwill and Intangible Assets.*We account for goodwill inaccordance with Statement of Financial Accounting Standards, or SFAS, No. 142,“Goodwill and Other Intangible Assets,” or SFAS 142, which, among other things,establishes new standards for goodwill acquired in a business combination,eliminates the amortization of goodwill and requires the carrying value ofgoodwill and certain non-amortizing intangibles to be evaluated for impairmenton an annual basis. As required by SFAS 142, we perform an impairment test onrecorded goodwill by comparing the estimated fair value of each of ourreporting units to the carrying value of the assets and liabilities of eachunit, including goodwill. We determine fair value of the reporting unitsprincipally based upon our management’s determination of the value of DTS as awhole. This value is determined by considering a number of factors, includingour historical and projected financial results, valuation analyses, risksfacing us and the liquidity of our common stock. If the carrying value of theassets and liabilities of the reporting units, including goodwill, were toexceed our estimation of the fair value of the reporting units, we would recordan impairment charge in an amount equal to the excess of the carrying value ofgoodwill over the implied fair value of the goodwill. We did not have anygoodwill at December 31, 2004. We expect to record goodwill in connectionwith our acquisition of LDI, which occurred in January 2005.

We account for intangibleassets in accordance with SFAS 144. This standard requires that intangibleassets with definite lives be amortized over their estimated useful lives andreviewed for impairment whenever events or changes in circumstances indicate anasset’s carrying value many not be recoverable. Recoverability of an asset ismeasured by comparison of its carrying amount to the expected futureundiscounted cash flows that the asset is expected to generate. If it isdetermined that an asset is not recoverable, an impairment loss is recorded inthe amount by which the carrying amount of the asset exceeds its fair value.Our intangible assets principally consist of acquired technology, which isbeing amortized over eight years. No intangible or long-lived assets wereimpaired as of December 31, 2004. We expect to record intangible assets inconnection with our acquisition of LDI.

·       *Impairment of Long-Lived Assets.*We periodically assesspotential impairments of our long-lived assets in accordance with theprovisions of SFAS, No. 144, “Accounting for the Impairment or Disposal ofLong-lived Assets.” An impairment review is performed whenever events orchanges in circumstances indicate that the carrying value may not berecoverable. Factors considered by us include, but are not limited to,significant underperformance relative to expected historical or projectedfuture operating results; significant changes in the manner of use of theacquired assets or the strategy for our overall business; and significantnegative industry or economic trends. When we determine that the carrying valueof a long-lived asset may not be recoverable based upon the 

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existence of one or moreof the above indicators of impairment, we estimate the future undiscounted cashflows expected to result from the use of the asset and its eventualdisposition. If the sum of the expected future undiscounted cash flows andeventual disposition is less than the carrying amount of the asset, werecognize an impairment loss. An impairment loss is reflected as the amount bywhich the carrying amount of the asset exceeds the fair value of the asset,based on the fair market value if available, or discounted cash flows, if not.To date, we have not had an impairment of long-lived assets.

·       *Product Warranty.*We generally warrant our products againstdefects in materials and workmanship for either a one or three year term aftersale and provide for estimated future warranty costs at the time revenues arerecognized. Our warranty obligation is affected by the length of productwarranties, product failure rates, material usage, and service delivery costsincurred in correcting product failures. Should actual product failure rates,material usage, or service delivery costs differ from our estimates, revisionsto the estimated warranty liability would be required. Our warranty reserves atDecember 31, 2003 and 2004 amounted to $81,000, and $162,000,respectively.

·       *Stock-based Compensation.*We account for employee stockoption and purchase plans in accordance with the provisions of AccountingPrincipals Board, or APB, Opinion No. 25, “Accounting for Stock Issued toEmployees” and the related interpretations of the Financial AccountingStandards Board, or FASB, “Accounting for Certain Transactions Involving StockCompensation.” Accordingly, compensation expense related to employee stockoptions is recorded, if on the date of the grant, the fair value of theunderlying stock exceeds the exercise price. Upon adoption of SFAS 123R in thethird quarter of 2005, mentioned in Recently Issued Accounting Standardsincluded elsewhere in this document, we expect to incur significant charges tothe statement of operations.

·       *Taxes.*We must make certain estimates and judgments indetermining income tax expense for financial statement purposes. Theseestimates and judgments occur in the calculation of certain tax assets andliabilities, which arise from differences in the timing of recognition ofrevenue and expense for tax and financial statement purposes.

We must assess thelikelihood that we will be able to recover our deferred tax assets. If recoveryis not likely, we must increase our provision for taxes by recording avaluation allowance against the deferred tax assets that we estimate will notultimately be recoverable. As of December 31, 2004, we believe that all ofthe deferred tax assets recorded on our balance sheet would ultimately berecovered. However, should there be a change in our ability to recover ourdeferred tax assets, our tax provision would increase in the period in which wedetermine that the recovery is not probable.

In March 2005, in connectionwith the U.S. Internal Revenue Service’s, or IRS, regular examination of ourtax return for the year ended December 31, 2002, the IRS proposedadjustments related to certain items included in our return. We do not agreewith the proposed adjustments and intend to appeal these adjustments. If theIRS prevails in its position, our federal income tax due for 2002 wouldincrease by approximately $1.9 million, plus interest. The IRS could makesimilar claims for years subsequent to 2002 in future audits.

Although the finalresolution of the adjustments is uncertain, based on currently availableinformation, we believe that the ultimate outcome will not have a materialadverse effect on our financial position, cash flows or overall trends in the resultsof operations. There is the possibility of a material adverse impact on theresults of operations in the period in which the matter is ultimately resolved,if it is resolved unfavorably, or in the period in which an unfavorable outcomebecomes probable and reasonably estimable.

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·       *Contingenciesand Litigation.* We evaluate contingent liabilities includingthreatened or pending litigation in accordance with SFAS No. 5, “Accountingfor Contingencies,” and record accruals when the outcome of these matters isdeemed probable and the liability is reasonably estimable. We make theseassessments based on the facts and circumstances and in some instances based inpart on the advice of outside legal counsel.

**Segment and Geographic Information**

Our reportable segment andgeographic information is as follows (in thousands):
| ** **        | ** ** | **Revenues by Segment**                         | ** ** |
|-------------------|------------|-----------------------------------------------------------|------------|
| ** **        | ** ** | **For the Years Ended  December 31,** | ** ** |
| ** **        | ** ** | **2002**                                                  | ** ** | **2003** | ** ** | **2004 ** | ** ** |
| Cinema business   |       | $                                                         | 15,399     |   | $ | 16,328 | ** ** | **$** | **19,545** | ** ** |
| Consumer business |       | 25,657                                                    |       | 35,374 | ** ** | **41,886** | ** ** |
| Total revenues    |       | $                                                         | 41,056     |   | $ | 51,702 | ** ** | **$** | **61,431** | ** ** |

 
| ** **          | ** ** | **Gross Profit by Segment**                | ** ** |
|---------------------|------------|-----------------------------------------------------------|------------|
| ** **          | ** ** | **For the Years Ended  December 31,** | ** ** |
| ** **          | ** ** | **2002**                                                  | ** ** | **2003** | ** ** | **2004** | ** ** |
| Cinema business     |       | $                                                         | 6,517      |   | $ | 7,190 | ** ** | **$** | **5,448** | ** ** |
| Consumer business   |       | 23,903                                                    |       | 33,480 | ** ** | **39,821** | ** ** |
| Total gross  profit |       | $                                                         | 30,420     |   | $ | 40,670 | ** ** | **$** | **45,269** | ** ** |

 
| ** **                    | ** ** | **Income (Loss) From Operations  by Segment** | ** ** |
|-------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                    | ** ** | **For the Years Ended  December 31,**         | ** ** |
| ** **                    | ** ** | **2002**                                                          | ** ** | **2003** | ** ** | **2004** | ** ** |
| Cinema business               |       | $                                                                 | (2,425     | ) | $ | (3,504 | ) | **$** | **(8,475** | **)** |
| Consumer business             |       | 12,712                                                            |       | 18,714 | ** ** | **19,969** | ** ** |
| Total income from  operations |       | $                                                                 | 10,287     |   | $ | 15,210 | ** ** | **$** | **11,494** | ** ** |

 
| ** **     | ** ** | **Revenues by Geographic Region**          | ** ** |
|----------------|------------|-----------------------------------------------------------|------------|
| ** **     | ** ** | **For the Years Ended  December 31,** | ** ** |
| ** **     | ** ** | **2002**                                                  | ** ** | **2003** | ** ** | **2004** | ** ** |
| United States  |       | $                                                         | 10,224     |   | $ | 15,837 | ** ** | **$** | **17,830** | ** ** |
| International  |       | 30,832                                                    |       | 35,865 | ** ** | **43,601** | ** ** |
| Total revenues |       | $                                                         | 41,056     |   | $ | 51,702 | ** ** | **$** | **61,431** | ** ** |

 

Thefollowing table sets forth, for the periods indicated, long-lived assets bygeographic region in which we hold assets (in thousands):
| ** **              | ** ** | **Long-Lived Assets**            | ** ** |
|-------------------------|------------|---------------------------------------|------------|
| ** **              | ** ** | **As of December 31,** | ** ** |
| ** **              | ** ** | **2002**                              | ** ** | **2003** | ** ** | **2004** | ** ** |
| United States           |       | $                                     | 3,244      |   | $ | 3,150 | ** ** | **$** | **3,099** | ** ** |
| International           |       | 297                                   |       | 366 | ** ** | **2,219** | ** ** |
| Total long-lived assets |       | $                                     | 3,541      |   | $ | 3,516 | ** ** | **$** | **5,318** | ** ** |

 

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**Results of Operations**

Thefollowing table sets forth our results of operations expressed as a percentageof total revenues:
| ** **                                | ** ** | **For the Years Ended  December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                | ** ** | **2002**                                                  | ** ** | **2003** | ** ** | **2004** | ** ** |
| Revenues:                                 | ** ** | ** **                                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Technology and film licensing             |       | 77.7                                                      | %          | 81.7 | % | **81.3** | **%** |
| Product sales and other revenues          |       | 22.3                                                      |       | 18.3 | ** ** | **18.7** | ** ** |
| Total revenues                            |       | 100.0                                                     |       | 100.0 | ** ** | **100.0** | ** ** |
| Cost of goods sold:                       | ** ** | ** **                                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Technology and film licensing             |       | 9.0                                                       |       | 8.3 | ** ** | **7.2** | ** ** |
| Product sales and other revenues          |       | 16.9                                                      |       | 13.0 | ** ** | **19.1** | ** ** |
| Total cost of goods sold                  |       | 25.9                                                      |       | 21.3 | ** ** | **26.3** | ** ** |
| Gross profit                              |       | 74.1                                                      |       | 78.7 | ** ** | **73.7** | ** ** |
| Operating expenses:                       | ** ** | ** **                                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Selling, general and administrative       |       | 39.9                                                      |       | 39.7 | ** ** | **45.0** | ** ** |
| Research and development                  |       | 9.1                                                       |       | 9.6 | ** ** | **10.0** | ** ** |
| Total operating expenses                  |       | 49.0                                                      |       | 49.3 | ** ** | **55.0** | ** ** |
| Income from  operations                   |       | 25.1                                                      |       | 29.4 | ** ** | **18.7** | ** ** |
| Interest income,  net                     |       | (0.2                                                      | )          | 0.5 | ** ** | **2.4** | ** ** |
| Other expense,  net                       |       | (0.7                                                      | )          | (0.4 | ) | **(0.1** | **)** |
| Income from legal  settlement             |       | —                                                    |       | — | ** ** | **4.2** | ** ** |
| Income before  provision for income taxes |       | 24.2                                                      |       | 29.5 | ** ** | **25.2** | ** ** |
| Provision for  income taxes               |       | 9.0                                                       |       | 10.4 | ** ** | **9.0** | ** ** |
| Net income                                |       | 15.2                                                      | %          | 19.1 | % | **16.2** | **%** |

 

**Comparisonof Years Ended December 31, 2004 and 2003**

***Revenues***

*Technology and Film Licensing.*Technologyand film licensing revenues for the year ended December 31, 2004 increased18% to $49.9 million from $42.2 million for the year ended December 31,2003. The increase in revenues from technology and film licensing was primarilyattributable to continued growth in consumer electronics licensing, driven byan increase in the number of DVD-based home entertainment systems that incorporateDTS technology, such as audio/video receivers, DVD players, andhome-theater-in-a-box systems. The increase also related to revenues recognizedas a result of intellectual property compliance and enforcement activities. Theseactivities, which included audits of shipments by certain of our licensees ofproducts containing our technology, trademarks and/or know-how and legalactions taken against licensees and parties who are not our licensees, resultedin recoveries of royalty payments relating to prior periods. We expect suchroyalty recoveries to continue and that this activity will continue to improverevenue realization in our licensing business going forward. Overall, we expecttechnology licensing revenues to continue to grow in 2005, based primarily onthe expected continuation of growth in the home theater and DVD player markets.In addition, our film licensing revenues increased moderately due to revenuesgenerated from increases in the number of U.S. films released, foreign languagedubbed versions of major films, and foreign original-version films releasedwith a DTS soundtrack. Film licensing is expected to grow modestly again in2005.

*Product Sales and Other.*Productsales and other revenues increased 22% to $11.5 million for the year endedDecember 31, 2004 from $9.5 million for the year ended December 31,2003. This increase was primarily attributable to increased purchases bytheater operators of our cinema processors and playback 

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equipment by theateroperators as a result of the film exhibition industry’s return to growth aswell as solid interest in our XD10 Cinema Media Player. The adoption of ournewer technologies for pre-show, subtitling and multi-channel music continuesto be slower than expected. Product sales and other revenue is expected to growat a modest rate, as we expect the market for pre-show entertainment to developat a measured pace in 2005.

*SegmentSales.*Revenues from our consumer business totaled$41.9 million for the year ended December 31, 2004, an increase of18% from $35.4 million for the year ended December 31, 2003. Theincrease in revenues was driven by the growth in consumer electronicstechnology licensing as mentioned above. Cinema revenues were$19.5 million for the year ended December 31, 2004, up 20% from thesame period last year due primarily to growth in the sales of our cinema audioproducts, driven by the film exhibition industry return to growth, as mentionedabove.

***Gross Profit***

Consolidated gross profit decreased to 74% of revenuesfor the year ended December 31, 2004, from 79% for the year ended December 31,2003. The decrease is primarily due to the write-down of our monochromeprojector inventory of approximately $3.9 million that was a result of ourrevised outlook based on declines in future demand and technologicalobsolescence. We expect consolidated gross margins in the 70% to 75% range in2005, as we incorporate the activities of LDI into our consolidated results.

*Technology and Film Licensing.*Grossprofit associated with technology and film licensing revenues increasedslightly to 91% from 90% of related revenues for the year ended December 31,2004 and 2003, respectively and we expect this rate to increase slightly during2005 due to a higher mix of technology licensing relative to film licensing.

*Product Sales and Other.*Grossprofit associated with product sales and other revenues decreased to (2)% ofrelated revenues for the year ended December 31, 2004 from 29% in theprior year period due to the write-down discussed above and we expect this rateto recover to its historical levels and range from the low to mid thirties in2005.

*SegmentGross Profit.*Gross profit for our consumer business remainedconsistent between years at 95% and we expect this trend to continue into 2005.Our cinema business gross profit decreased to 28% of related revenues for thequarter ended December 31, 2004 from 44% in the prior year periodprimarily due to the write-down of the monochrome projector inventory discussedabove. The impact of this write-down on gross profit was partially offset bythe increase in revenue for our cinema business year-over-year relative tofixed costs. We expect the gross profit from the cinema business to recover toits historical levels

***Selling, General and Administrative***

Selling, general and administrative expenses increased35% to $27.7 million for the year ended December 31, 2004, comparedto $20.5 million in the prior year period. The increase is primarily dueto increases in professional services of $2.5 million, which includes costsassociated with our increased intellectual property compliance and enforcementactivities, Sarbanes-Oxley related costs and other costs associated withoperating as a public company. Also contributing to the increase is an increaseof $2.2 million in salaries and related costs as we increased headcount tosupport our growth. The increase also includes increases in advertising andpromotion costs related to new product introductions, and insurance costs.Salaries and related costs include stock-based compensation, whichdecreased to $273,000 for the year ended December 31, 2004 from $497,000in the prior year period. Stock-based compensation for the prior periodprimarily consists of a charge related to the issuance of a warrant. Includedin professional services for the year ended December 31, 2004 isapproximately $300,000 in legal costs related to our settlement with Mintekthat was reached in May 2004.

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Costs of compliance with the Sarbanes-Oxley Actwere approximately $899,000 for the year ended December 31, 2004. Weexpect Sarbanes-Oxley Act costs to decrease in 2005 to approximately $500,000.

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

***Research and Development***

For the year ended December 31, 2004, researchand development expenses were $6.1 million, compared to $5.0 million forthe year ended December 31, 2003. The increase is primarily due toincreased labor costs associated with new product initiatives and theoptimization of our Coherent Acoustics technology for new consumer electronicsapplications and development of tools associated with next generation opticaldisc standards.

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

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

Interest income, net, forthe year ended December 31, 2004 increased significantly over the previousyear due to increased investment income relating to proceeds from our initialand follow-on public offerings in July and November of 2003.

***Income From Legal Settlement***

In May 2004, wereached a settlement with Mintek for $3.5 million for TrademarkInfringement, False Designation of Origin, Trademark Dilution, and UnfairCompetition relating to Mintek’s distribution of DVD players bearing ourregistered trademarks without obtaining a license from us. In the year ended December 31,2004, we recognized $899,000 in revenue under the settlement agreement forroyalties due on known units that could be identified as using our trademarkand accounted for the remaining $2.6 million as other income. Selling,general and administrative expenses for the year ended December 31, 2004included approximately $300,000 in legal fees related to the Mintek case. Legalfees related to Mintek were approximately $200,000 for 2003.

***Income Taxes***

For the year ended December 31,2004, we recorded an income tax provision of $5.5 million on pre-tax income of$15.6 million. This resulted in an annualized effective tax rate of 36%. Forthe year ended December 31, 2003, we recorded an income tax provision of$5.4 million on pre-tax income of $15.3 million. This resulted in anannualized effective tax rate of 35%. These rates differed from the statutoryrates primarily due to state income taxes offset by benefits associated withthe foreign rate differentials and research and development credits. We expectthe effective tax rate for 2005 will be approximately 36%.

**Comparisonof Years Ended December 31, 2003 and 2002**

***Revenues***

Total revenues for the year ended December 31,2003 increased 26% to $51.7 million from $41.1 million for the yearended December 31, 2002, due primarily to the increase in technology andfilm licensing revenues. Technology and film licensing revenues totaled$42.2 million for 2003, compared to $31.9 million in 2002, anincrease of 32%. Technology licensing revenues posted growth of 36% for theperiod, driven primarily by the rapid increase in sales by our licensees ofDVD-based home entertainment 

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systems that incorporateDTS technology, such as audio/video receivers, DVD players, andhome-theater-in-a-box systems. Film and other content licensing grew by 21% dueprimarily to revenues generated from increases in the number of U.S. filmsreleased in the DTS format, foreign language dubbed versions of major U.S.films, and foreign original-version films released with a DTS soundtrack.Product sales and other revenues totaled $9.5 million for 2003, comparedto $9.2 million in 2002.

In the consumer business,revenues for the year ended December 31, 2003 were $35.4 million, a38% increase over the $25.7 million recorded in the year ended December 31,2002, due to the strength of the consumer electronics licensing activitiesdiscussed above. Cinema revenues were $16.3 million for the year ended December 31,2003, a 6% increase over 2002, as growth in film licensing revenues more thanoffset a decline in product-related revenues.

***Gross Profit***

Consolidated gross profit improved to 79% of revenuesfor the year ended December 31, 2003, from 74% for 2002. The increase isdue to changes in the mix of licensing and product revenues, as higher-margintechnology and film licensing comprised 82% of revenues in the year ended December 31,2003, up from 78% of revenues in the prior year period.

Gross profit associated with technology and filmlicensing revenues improved slightly to 90% of related revenues for the yearended December 31, 2003 from 88% in the prior year period. This increaseis primarily due to a favorable mix of technology licensing, which carries verylittle cost, relative to film licensing, which typically carries cost of 25% to30%.

Gross profit for ourconsumer business improved to 95% of related revenues for the year ended December 31,2003, from 93% in the prior year. The increase is due to the rapid growth ofhigher margin technology licensing revenues. Cinema business gross profitincreased slightly to 44% of related revenues for the year ended December 31,2003 from 42% in the prior year due to the higher revenues achieved in 2003,which allowed certain fixed overhead costs to be spread over a larger revenuebase.

***Selling, General, and Administrative***

Selling, general, andadministrative expenses increased 25% to $20.5 million for the year ended December 31,2003, from $16.4 million for the prior year. The increase is primarily dueto increases in salaries and related costs of $1.8 million as we increasedheadcount to support our growth and professional services of $1.3 million,which includes costs associated with our increased intellectual propertycompliance and enforcement activities and additional costs associated withoperating as a public company. The year-to-year increase also includesincreases in advertising and promotion costs related to new product introductions,and insurance costs. In addition to these growth factors, the 2003 amountincludes $497,000 in expenses related to stock-based compensation for optionsand warrants to purchase common stock.

***Research and Development***

Research and developmentexpenses for the year ended December 31, 2003 increased to$5.0 million compared to $3.8 million for the same period in theprior year. The increase is primarily due to increased labor costs caused byincreased headcount associated with new product initiatives and expensesassociated with the optimization of our Coherent Acoustics technology for newconsumer electronics applications. Research and development headcount increasedfrom 32 at December 31, 2002 to 41 at December 31, 2003.

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

Interest (income) expense,net, for the year ended December 31, 2003 was $(271,000) compared to$94,000 for the same period in the prior year. The increase was primarily dueto increased investment 

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incomeon higher average cash and investment balances arising from our initial publicoffering in July 2003 and our follow-on public offering in November 2003.

***Other Expense, Net***

Other expense, net,decreased slightly for the year ended December 31, 2003 to $214,000 from$255,000 in the prior year. Other expense, net, for 2002 primarily consisted offinancing commitment fees. Other expense, net, for 2003 primarily consisted oftranslation losses related to foreign currency fluctuations when consolidatingour foreign subsidiaries.

***Income Taxes***

Income tax expense totaled$5.4 million for the year ended December 31, 2003, representing aneffective tax rate of 35%, down from 37% for year ended December 31, 2002.Our effective tax rate reflects the full federal and state statutory rates onU.S. taxable income net of available tax credits, combined with taxes expectedto be paid by our wholly owned subsidiaries in lower tax jurisdictions such asthe United Kingdom, China, and the British Virgin Islands. The reduction in oureffective tax rate in 2003 versus 2002 was due to an increase in taxable incomeof our non-U.S. subsidiaries as a percentage of consolidated taxable income.

**Liquidity and Capital Resources**

At December 31, 2004, we had cash, cashequivalents, and short-term investments of $114.3 million, compared to $99.4 millionat December 31, 2003. In addition, we had long-term investments of $3.0 and$2.7 at December 31, 2003 and 2004, respectively, and we view these long-terminvestments as part of our overall cash and liquidity management.

Since our inception, we have financed our operationsthrough sales of redeemable preferred stock, borrowings under bank line ofcredit arrangements, internally generated cash flows and proceeds from ourinitial and follow-on public offerings. At December 31, 2004, we had nooutstanding borrowings under our bank facility, which expires on June 30,2005 and automatically renews for one year. The bank facility provides forworking capital financing and is unsecured. The bank agreement requires us tocomply with certain covenants including a tangible effective net worth of $60.0million increasing by 50% of net income on an annual basis. The covenants alsorequire us to keep $2.0 million in cash or securities at the bank. Availabilityunder this facility was $10.0 million at December 31, 2004. Futureborrowings will bear interest based on either of the two options selected atthe time of advances 1) a rate equal to 2% above the Bank’s LIBOR, or2) a rate equal to the Base Rate as quoted from the bank less one-halfpercent.

Through December 31, 2004, we have raised$14.7 million in cash through the sale of mandatorily redeemable preferredstock, net proceeds of $63.0 million from our initial public offering andnet proceeds of $48.9 million from our follow-on public offering. Thepreferred stock was redeemable at the original issuance price of $2.019 pershare plus dividends accumulating at 8% per annum through October 24, 2002and 10% per annum from October 25, 2002 through the date of redemption. Weused approximately $22.5 million from the proceeds of our initial publicoffering to redeem all shares of the preferred stock and to pay all accrued butunpaid dividends on such shares through the date of redemption.

Net cash provided by operating activities was $4.6 million,$9.2 million and $17.6 million for the years ended December 31,2002, 2003 and 2004, respectively. For the year ended December 31, 2004,increased net income, adjusted for the $4.0 million tax benefit related toemployee stock plans and the $3.9 million write-down of inventory, was theprimary reason for the increase in cash provided from operating activities overthe prior years. Accounts receivable increased $748,000 for the year ended December 31,2004 due to increases in receivables related to consumer license fees, offsetby improved collections. Prepaid expenses and other assets increased $1.3million for the year ended December 31, 2004 primarily as result of 

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acquisition related items,including restricted cash in connection with the QDesign Corporation, orQDesign, acquisition and direct costs associated with the LDI acquisition. Alsocontributing to the increase in prepaid expenses and other assets was anincrease in deferred costs associated with deferred revenues. Upon the adoptionof SFAS 123R, the tax benefits for employee benefit plans will be included as afinancing activity.

We use cash in investing activities primarily topurchase office equipment, fixtures, computer hardware and software,engineering and manufacturing test and certification equipment, for securingpatent and trademark protection for our proprietary technology and brand name,and to purchase short-term investments such as bank certificates of deposit,municipal bonds and auction rate securities. Cash used in investing activitiestotaled $3.2 million, $62.0 million, and $36.8 million, respectively,in the years ended December 31, 2002, 2003, and 2004. In 2002, 2003 and2004, $2.1 million, $61.0 and $32.6 million, respectively, was used forthe purchase of short- and long-term investments. In December 2004, inadvance of our acquisition of LDI in January 2005, we provided bridgefinancing of approximately $1.3 million to LDI and acquired QDesign for netcash of $1.4 million. The principal and interest outstanding under the bridgeloan reduced the price we paid to acquire LDI by the aggregate amount due. Wecontinue to invest in property and equipment, including office equipment andfixtures, engineering and manufacturing test equipment, and computer hardwareand software.

Net cash flows used infinancing activities totaled $6.3 million for the year ended December 31,2002. For the years ended December 31, 2003 and 2004, cash provided byfinancing activities were $90.1 million and $1.3 million, respectively.For the year ended December 31, 2002, cash used by financing activitiesconsisted of the repayments under the bank line of credit. For the year ended December 31,2003, cash provided by financing activities was $90.1 million representingnet proceeds of $63.0 million from our initial public offering andproceeds of $48.9 million from our follow-on public offering. These cashinflows were partially offset by cash dividends paid to our preferredstockholders totaling $6.8 million as well as payments of $15.8 millionto redeem the principal value of our mandatorily redeemable preferred stock. Forthe year ended December 31, 2004, cash provided by financing activitiesprimarily consisted of proceeds from the issuance of common stock under ouroption and employee stock purchase plans.

**ContractualObligations and Commitments**

Futurepayments due under non-cancelable lease obligations and commitments at of December 31,2004 are described below (in thousands):
| ** **                 | ** ** | **2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010 and  thereafter** | ** ** | **Total** | ** ** |
|----------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|-------------------------------|------------|-----------|------------|
| Operating leases           |       | $        | 903        |     | $          | 750      |       | $        | 559        |     | $          | 333                           |       | $         | 292        |   |   | $ | 870 |   |   | $ | 3,707 |   |
| Acquisition  consideration |       | 150      |       | 150      |       | 150      |       | —   |       | —   |       |                          | —     |      |       | 450 |   |
| Total                      |       | $        | 1,053      |     | $          | 900      |       | $        | 709        |     | $          | 333                           |       | $         | 292        |   |   | $ | 870 |   |   | $ | 4,157 |   |

 

Purchase orders or contracts for the purchase of rawmaterials and other goods and services are not included in the table above. Weare not able to determine the aggregate amount of such purchase orders thatrepresent contractual obligations, as purchase orders may representauthorizations to purchase rather than binding agreements. Our purchase ordersare typically based on our current needs and are typically fulfilled by ourvendors within short time horizons.

We also enter into contracts with manufacturers toprovide certain manufacturing services. If we were to have terminated thesecontracts at December 31, 2004, we would have to make payments ofapproximately $1.6 million.

As part of the acquisition of LDI, in January 2005,we agreed to invest $3.5 million in the business of LDI on or prior to June 30,2005 to enable LDI to make certain capital expenditures and, if and to the 

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extent LDI meets specifiedgross profit milestones, to invest up to an additional $1.5 million through theend of 2006.

We believe that our cashand cash equivalents, short-term investments, funds available under ourexisting bank line of credit facility, and cash flows from operations will besufficient to satisfy our working capital and capital expenditure requirementsfor at least the next twelve months. We used a portion of the proceeds from ourinitial public offering to redeem all outstanding shares of our redeemablepreferred stock. Beyond the next twelve months, additional financing may berequired to fund working capital and capital expenditures. Changes in ouroperating plans, lower than anticipated revenues, increased expenses,acquisitions of companies, products or technologies or other events, includingthose described in “Risk Factors,” may cause us to seek additional debt orequity financing on an accelerated basis. Financing may not be available onacceptable terms, or at all, and our failure to raise capital when needed couldnegatively impact our growth plans and our financial condition and results ofoperations. Additional equity financing may be dilutive to the holders of ourcommon stock and debt financing, if available, may involve significant cashpayment obligations and covenants and/or financial ratios that restrict ourability to operate our business.

**Quarterly Results of Operations**

The following table sets forth the unaudited quarterlyresults of operations for each of the eight quarters ended December 31,2004, as well as the same data expressed as a percentage of our total revenuesfor the periods indicated. This information includes all adjustments managementconsiders necessary for the fair presentation of such data. The information foreach quarter is unaudited and we have prepared it on the same basis as theaudited consolidated financial statements appearing elsewhere in this Form 10-K.In the opinion of management, all necessary adjustments, consisting only ofnormal recurring adjustments, have been included to present fairly theunaudited quarterly results. The results of historical periods are notnecessarily indicative of results for any future period.

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Generally,consumer electronics manufacturing activities are lowest in the first calendarquarter of each year, and increase progressively throughout the remainder ofthe year. The third and fourth quarters are typically the strongest in termsmanufacturing output as our technology licensees increase their manufacturingoutput to prepare for the holiday buying season. Since recognition of revenuesin our consumer business generally lags manufacturing activity by one quarter,our revenues and earnings are generally lowest in the second quarter. Filmlicensing revenues are typically strongest in the second and fourth quartersdue to the abundance of movies typically released during the summer andyear-end holiday seasons. In general, the introduction of new products andinclusion of DTS technologies in new and rapidly growing markets can have amaterial effect on quarterly revenues and profits, and can distort the moderateseasonality described above.
| ** **                                 | ** ** | **For the Three Months Ended** | ** ** |
|--------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                 | ** ** | ** Mar. 31,   2003**                | ** ** | **  Jun. 30,    2003** | ** ** | **Sep. 30,  2003** | ** ** | **Dec. 31,  2003** | ** ** | ** Mar. 31,   2004** | ** ** | **Jun. 30,  2004** | ** ** | **Sep. 30,  2004** | ** ** | **Dec. 31,  2004** | ** ** |
| ** **                                 | ** ** | **(Unaudited, in thousands)**            | ** ** |
| Revenues:                                  |       |                                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Technology and  film licensing             |       |                                               | $          | 10,124 |   |   |   | $ | 9,554 |   |   | $ | 10,632 |   | $ | 11,919 |   |   | $ | 12,497 |   |   | $ | 10,720 |   | $ | 13,058 |   | $ | 13,645 |   |
| Product sales and  other revenues          |       |                                               | 1,632      |   |   |   | 2,147 |   |   | 2,702 |   | 2,992 |   |   | 3,100 |   |   | 2,532 |   | 2,894 |   | 2,985 |   |
| Total revenues                             |       |                                               | 11,756     |   |   |   | 11,701 |   |   | 13,334 |   | 14,911 |   |   | 15,597 |   |   | 13,252 |   | 15,952 |   | 16,630 |   |
| Cost of goods sold:                        |       |                                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Technology and  film licensing             |       |                                               | 840        |   |   |   | 1,045 |   |   | 1,294 |   | 1,102 |   |   | 980 |   |   | 1,166 |   | 1,199 |   | 1,106 |   |
| Product sales and  other revenues          |       |                                               | 1,573      |   |   |   | 1,744 |   |   | 1,596 |   | 1,838 |   |   | 1,912 |   |   | 1,755 |   | 1,911 |   | 6,133 |   |
| Total cost of  goods sold                  |       |                                               | 2,413      |   |   |   | 2,789 |   |   | 2,890 |   | 2,940 |   |   | 2,892 |   |   | 2,921 |   | 3,110 |   | 7,239 |   |
| Gross profit                               |       |                                               | 9,343      |   |   |   | 8,912 |   |   | 10,444 |   | 11,971 |   |   | 12,705 |   |   | 10,331 |   | 12,842 |   | 9,391 |   |
| Operating expenses:                        |       |                                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general  and administrative       |       |                                               | 4,991      |   |   |   | 4,865 |   |   | 5,092 |   | 5,525 |   |   | 6,440 |   |   | 6,798 |   | 6,746 |   | 7,660 |   |
| Research and  development                  |       |                                               | 1,170      |   |   |   | 1,174 |   |   | 1,304 |   | 1,339 |   |   | 1,332 |   |   | 1,568 |   | 1,501 |   | 1,730 |   |
| Total operating  expenses                  |       |                                               | 6,161      |   |   |   | 6,039 |   |   | 6,396 |   | 6,864 |   |   | 7,772 |   |   | 8,366 |   | 8,247 |   | 9,390 |   |
| Income from  operations                    |       |                                               | 3,182      |   |   |   | 2,873 |   |   | 4,048 |   | 5,107 |   |   | 4,933 |   |   | 1,965 |   | 4,595 |   | 1 |   |
| Interest income,  net                      |       |                                               | 13         |   |   |   | 10 |   |   | 116 |   | 132 |   |   | 439 |   |   | 310 |   | 373 |   | 325 |   |
| Other income  (expense), net               |       |                                               | (80        | ) |   |   | 3 |   |   | (65 | ) | (72 | ) |   | (14 | ) |   | (17 | ) | 31 |   | (31 | ) |
| Income from legal  settlement              |       |                                               | —     |   |   |   | — |   |   | — |   | — |   |   | — |   |   | 2,601 |   | — |   | — |   |
| Income before  provision for income  taxes |       |                                               | 3,115      |   |   |   | 2,886 |   |   | 4,099 |   | 5,167 |   |   | 5,358 |   |   | 4,859 |   | 4,999 |   | 295 |   |
| Provision for  income taxes                |       |                                               | 1,086      |   |   |   | 1,041 |   |   | 1,407 |   | 1,834 |   |   | 1,918 |   |   | 1,740 |   | 1,774 |   | 103 |   |
| Net income                                 |       |                                               | $          | 2,029 |   |   |   | $ | 1,845 |   |   | $ | 2,692 |   | $ | 3,333 |   |   | $ | 3,440 |   |   | $ | 3,119 |   | $ | 3,225 |   | $ | 192 |   |

 

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| ** **                                | ** ** | **For the Three Months Ended** | ** ** |
|-------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                | ** ** | ** Mar. 31,   2003**                | ** ** | ** Jun. 30,   2003** | ** ** | **Sep. 30,  2003** | ** ** | **Dec. 31,  2003** | ** ** | ** Mar. 31,   2004** | ** ** | **Jun. 30,  2004** | ** ** | **Sep. 30,  2004** | ** ** | **Dec. 31,  2004** | ** ** |
| Revenues:                                 |       |                                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Technology and  film licensing            |       |                                               | 86.1       | % |   |   | 81.7 | % |   |   | 79.7 | % |   |   | 79.9 | % |   |   | 80.1 | % |   |   | 80.9 | % |   |   | 81.9 | % |   |   | 82.1 | % |   |
| Product sales and  other revenues         |       |                                               | 13.9       |   |   |   | 18.3 |   |   |   | 20.3 |   |   |   | 20.1 |   |   |   | 19.9 |   |   |   | 19.1 |   |   |   | 18.1 |   |   |   | 17.9 |   |   |
| Total revenues                            |       |                                               | 100.0      |   |   |   | 100.0 |   |   |   | 100.0 |   |   |   | 100.0 |   |   |   | 100.0 |   |   |   | 100.0 |   |   |   | 100.0 |   |   |   | 100.0 |   |   |
| Cost of goods sold:                       |       |                                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Technology and  film licensing            |       |                                               | 7.1        |   |   |   | 8.9 |   |   |   | 9.7 |   |   |   | 7.4 |   |   |   | 6.3 |   |   |   | 8.8 |   |   |   | 7.5 |   |   |   | 6.7 |   |   |
| Product sales and  other revenues         |       |                                               | 13.4       |   |   |   | 14.9 |   |   |   | 12.0 |   |   |   | 12.3 |   |   |   | 12.3 |   |   |   | 13.2 |   |   |   | 12.0 |   |   |   | 36.9 |   |   |
| Total cost of  goods sold                 |       |                                               | 20.5       |   |   |   | 23.8 |   |   |   | 21.7 |   |   |   | 19.7 |   |   |   | 18.6 |   |   |   | 22.0 |   |   |   | 19.5 |   |   |   | 43.6 |   |   |
| Gross profit                              |       |                                               | 79.5       |   |   |   | 76.2 |   |   |   | 78.3 |   |   |   | 80.3 |   |   |   | 81.4 |   |   |   | 78.0 |   |   |   | 80.5 |   |   |   | 56.4 |   |   |
| Operating expenses:                       |       |                                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general  and administrative      |       |                                               | 42.4       |   |   |   | 41.6 |   |   |   | 38.2 |   |   |   | 37.1 |   |   |   | 41.3 |   |   |   | 51.3 |   |   |   | 42.3 |   |   |   | 46.1 |   |   |
| Research and  development                 |       |                                               | 10.0       |   |   |   | 10.0 |   |   |   | 9.7 |   |   |   | 9.0 |   |   |   | 8.5 |   |   |   | 11.8 |   |   |   | 9.4 |   |   |   | 10.4 |   |   |
| Total operating  expenses                 |       |                                               | 52.4       |   |   |   | 51.6 |   |   |   | 47.9 |   |   |   | 46.1 |   |   |   | 49.8 |   |   |   | 63.1 |   |   |   | 51.7 |   |   |   | 56.5 |   |   |
| Income from  operations                   |       |                                               | 27.1       |   |   |   | 24.6 |   |   |   | 30.4 |   |   |   | 34.2 |   |   |   | 31.6 |   |   |   | 14.9 |   |   |   | 28.8 |   |   |   | (0.1 | ) |   |
| Interest income,  net                     |       |                                               | 0.1        |   |   |   | 0.1 |   |   |   | 0.9 |   |   |   | 0.9 |   |   |   | 2.8 |   |   |   | 2.3 |   |   |   | 2.3 |   |   |   | 2.0 |   |   |
| Other income  (expense), net              |       |                                               | (0.7       | ) |   |   | 0.0 |   |   |   | (0.5 | ) |   |   | (0.4 | ) |   |   | (0.1 | ) |   |   | (0.1 | ) |   |   | 0.2 |   |   |   | (0.2 | ) |   |
| Income from legal  settlement             |       |                                               | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 19.6 |   |   |   | — |   |   |   | — |   |   |
| Income before  provision for income taxes |       |                                               | 26.5       |   |   |   | 24.7 |   |   |   | 30.8 |   |   |   | 34.7 |   |   |   | 34.3 |   |   |   | 36.7 |   |   |   | 31.3 |   |   |   | 1.7 |   |   |
| Provision for  income taxes               |       |                                               | 9.2        |   |   |   | 8.9 |   |   |   | 10.6 |   |   |   | 12.3 |   |   |   | 12.3 |   |   |   | 13.1 |   |   |   | 11.1 |   |   |   | .6 |   |   |
| Net income                                |       |                                               | 17.3       | % |   |   | 15.8 | % |   |   | 20.2 | % |   |   | 22.4 | % |   |   | 22.0 | % |   |   | 23.6 | % |   |   | 20.2 | % |   |   | 1.1 | % |   |

 

Revenues for the quarterspresented above were impacted by the seasonality factors noted above and havegenerally increased quarter to quarter primarily as a result of continuinggrowth in our consumer electronics licensing revenues. This continuing growthis a result of increases in manufacturing activity, including increasedconsumer demand for home theater products, use of our technology in new productcategories, and increases in the number of consumer electronics licensees.

Gross profit for thequarter ended December 31, 2004 was impacted by the write-down ofapproximately $3.9 million of our monochrome projector inventory.

Interest and other(income) expense, net, increased in the quarter ended December 31, 2002 asa result of increased financing commitment fees expensed in the fourth quarter.

Interest and other (income) expense, net, for thequarters ended September 30 and December 31, 2003 and for thequarterly periods in 2004 were favorably impacted by increased interest incomeearned as a result of increased cash, cash equivalent, and short-terminvestment balances during these periods.

Income from legal settlement for the quarter ended June 30,2004, consists of a settlement with Mintek.

Fluctuations in theprovision for income taxes between the quarters are a result of changes in ourincome before income taxes for the corresponding quarter.

**RecentlyIssued Accounting Standards**

In November 2004, theFASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43,Chapter 4”. SFAS 151 clarifies the types of costs that should be expensedrather than capitalized as inventory. SFAS 151 also clarifies the circumstancesunder which fixed overhead costs associated with operating facilities involvedin inventory processing should be capitalized. This statement is effective forfiscal years beginning after June 15, 2005. We plan to adopt SFAS 151 inthe first quarter of fiscal 2005. 

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We havenot determined the impact, if any, that this statement will have on ourconsolidated financial position or results of operations.

In December 2004,the FASB issued SFAS No. 123R, “Share-Based Payment”, an amendment to SFASNo. 123, “Accounting for Stock-Based Compensation.” SFAS 123R requirescompensation expense related to stock-based awards to be recognized in thefinancial statements. The amount of compensation expense will be measured basedupon the fair value of the stock-based awards at the date of grant. Thisstatement is effective for public companies as of the first interim or annualreporting period beginning after June 15, 2005. We plan to adopt SFAS 123Rbeginning in the third quarter of fiscal 2005. The expected effects of theadoption of SFAS 123R on our financial results for the next five years, basedon stock-based awards granted as of December 31, 2004, is as follows:
| ** **                                                                           | ** ** | **Expenses by Fiscal Year** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                           | ** ** | **2005**                                   | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** |
| ** **                                                                           | ** ** | **(unaudited)**                            | ** ** |
| ** **                                                                           | ** ** | **(in thousands)**                    | ** ** |
| Additional  stock-based compensation expense under SFAS 123R before tax benefit |       | $                                          | 933        |   | $ | 1,161 |   | $ | 503 |   | $ | 88 |   | $ | — |   |
|                                                                                      |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

This statement alsoaffects the presentation of tax benefits for option exercises in the statementof cash flows. Prior to adoption SFAS 123R, the benefit is classified in cashprovided by operating activities. Upon adoption, the tax benefit will beclassified in cash provided by financing activities. We are in the process ofdetermining the impact the adoption will have on our consolidated statement ofcash flows.

**RISK FACTORS**

*Set forth below and elsewhere in this report and inother documents we file with the SEC are risks and uncertainties that couldcause our actual results to differ materially from the results contemplated bythe forward-looking statements contained in this report and other public statementswe make. If any of the following risks actually occurs, our business, financialcondition, or results of operations could suffer. In that case, the tradingprice of our common stock could decline, and you may lose all or part of yourinvestment.*

**Risks Related toOur Business**

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

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

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

·       productsfor cinema markets, such as Smart Devices, Inc., Sony Corporation, andUltra Stereo Labs, Inc.

Manyof our current and potential competitors, including Dolby, enjoy substantialcompetitive advantages, including:

·       greatername recognition;

·       alonger operating history;

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

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·       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 potential competitorsmay be able to respond more quickly and effectively than we can to new orchanging opportunities, technologies, standards, or customer requirements.

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

Sony Corporation is both acompetitor and a significant customer in all of our markets. If Sony decides toeliminate the use of our technology in its products or to compete with us moreaggressively in our markets, the revenues that we derive from Sony would belower than expected.

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

Technology standards are important in the audioindustry as they help to assure compatibility across a system or series ofproducts. 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, our technology for stereoplayback has been selected as a mandatory standard for HD-DVD. Both our digitalmulti-channel technology and Dolby’s have optional status in the HD-DVDstandard. In the standard for HD-DVD, both DTS and Dolby technologies have beenselected as mandatory standards.

Various national governments have adopted or are inthe process of adopting standards for all digital television broadcasts,including cable, satellite, and terrestrial. In the United States, Dolby’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 be includedin that standard. Certain large and developing markets, such as China, have notfully developed their digital television standards. Our technology may or maynot ultimately be included in these standards.

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

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

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

·       rapidtechnological change;

·       newand improved product introductions;

·       changingcustomer demands;

·       evolvingindustry standards; and

·       productobsolescence.

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

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

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

·       ourpatents may be challenged or invalidated by our competitors;

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

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

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

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

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

As a result, we cannotassure you that our means of protecting our intellectual property rights andbrands will be adequate. Furthermore, despite our efforts, third parties mayviolate, or attempt to violate, our intellectual property rights. Infringementclaims and lawsuits would likely be expensive to resolve and would requiremanagement’s time and resources. In addition, we have not sought, and do notintend to seek, patent and other intellectual property protections in allforeign countries. In countries where we do 

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not havesuch protection, products incorporating our technology may be lawfully producedand sold without a license.

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

Companies that participatein the digital audio, consumer electronics, and entertainment industries hold alarge number of patents, trademarks, and copyrights, and are frequentlyinvolved in litigation based on allegations of patent infringement or otherviolations of intellectual property rights. Intellectual property disputesfrequently involve highly complex and costly scientific matters, and each partygenerally has the right to seek a trial by jury which adds additional costs anduncertainty. Accordingly, intellectual property contests, with or withoutmerit, could be costly and time consuming to litigate or settle, and coulddivert management’s attention from executing our business plan. In addition,our technology and products may not be able to withstand any third-party claimsor rights against their use. If we were unable to obtain any necessary licensefollowing a determination of infringement or an adverse determination inlitigation or in interference or other administrative proceedings, we may needto redesign some of our products to avoid infringing a third party’s patent andcould be required to temporarily or permanently discontinue licensing ourproducts.

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

We expect to derive asignificant percentage of our revenues from the technology, products, andservices that we offer to manufacturers of consumer electronics products. Todate, the most significant driver for the use of our technology in the hometheater market has been the release of major movie titles with DTS audiosoundtracks. We also believe that demand for our DTS audio technology inemerging markets for multi-channel audio, including homes, cars, personalcomputers, and video games and consoles, will be based on the number, quality,and popularity of the audio DVDs, computer software programs, and video gamesreleased with DTS audio soundtracks. Although we have existing relations withmany leading providers of movie, music, computer, and video game content, noneof our existing contracts require these parties to develop and release contentwith DTS audio soundtracks. In addition, we may not be successful inmaintaining existing relationships or developing relationships with otherexisting providers or new market entrants that provide content. As a result, wecannot assure you that a significant amount of content in movies, audio DVDs,computer software programs, video games, or other entertainment mediums will bereleased with DTS audio soundtracks. If the amount, variety, and popularity ofentertainment content released with DTS audio soundtracks do not increase,consumer electronics products manufacturers that pay us per-unit licensing feesmay discontinue offering DTS playback capabilities in the consumer electronicsproducts that they sell.

***If our independentauditors are unable to provide us with an unqualified report as to the adequacyof our internal controls over financial reporting for future year-ends asrequired by Section 404 of the Sarbanes-Oxley Act of 2002, investorscould lose confidence in the reliability of our financial statements, whichcould result in a decrease in the value of our shares.***

As directed by Section 404of the Sarbanes-Oxley Act of 2002, the SEC adopted rules requiringall public companies, including us, to include a report by management oninternal controls over financial reporting in all annual reports on Form 10-Kthat contains an assessment by management of the effectiveness of internalcontrols over financial reporting. In addition, the public accounting firmauditing our financial statements must attest to and report on our management’sassessment of the effectiveness of internal controls over financial reporting.This requirement applies to our annual report on Form 10-K. While weconduct rigorous reviews of our internal controls over financial reporting inorder to comply with 

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the Section 404requirements, our independent auditors may interpret the Section 404requirements and the related rules and regulations differently from us, orour independent auditors or management may not be satisfied with our internalcontrols over financial reporting or with the level at which these controls aredocumented, executed or reviewed. In addition, many uncertainties remain regardingthe requirements for auditor attestation, and guidance provided by the publicaccounting profession has changed frequently and materially to date. Further,the demand for competent audit resources has grown dramatically as a result ofthe requirements of Section 404, and such demand may exceed availablesupply. Finally, in the event we make a significant acquisition, or a series ofinsignificant acquisitions, we may face significant challenges in implementingthe required processes and procedures in the acquired operations. As a result,our independent auditors may decline or be unable to attest to management’sassessment or may issue a qualified report or management may identify materialweaknesses. This could result in an adverse reaction in the financial marketsdue to a loss of confidence in the reliability of our financial statements,which could cause the market price of our shares to decline.

***If we are unsuccessful in appealing the InternalRevenue Service’s proposed adjustments, there exists the possibility of amaterial adverse impact on the future results of operations.***

In March 2005, in connection with the U.S.Internal Revenue Service’s, or IRS, regular examination of our tax return forthe year ended December 31, 2002, the IRS proposed adjustments related tocertain items included in our return. We do not agree with the proposedadjustments and intend to appeal these adjustments. If the IRS prevails in itsposition, our federal income tax due for 2002 would increase by approximately $1.9million, plus interest. The IRS could make similar claims for years subsequentto 2002 in future audits.

Although the finalresolution of the adjustments is uncertain, based on currently availableinformation, we believe that the ultimate outcome will not have a materialadverse effect on our financial position, cash flows or overall trends in theresults of operations. There is the possibility of a material adverse impact onthe results of operations in the period in which the matter is ultimately resolved,if it is resolved unfavorably, or in the period in which an unfavorable outcomebecomes probable and reasonably estimable.

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

Although we haveestablished relations with a number of artists and music labels, we do not haveany contractual agreements that require artists or music labels to provide uswith music content to re-mix and release in our proprietary DTS audio format.Music companies may in the future be unwilling to license titles from theirmusic catalogs to us. In addition, our audio content competes with othermulti-channel formats, including Super Audio CD, which is a format developedjointly by Philips and Sony Corporation. As a result, we may have difficulty inobtaining rights to release a significant amount of audio content, and anycontent that we do release may not be commercially successful.

***Declining retailprices for consumer electronics products could force us to lower the licensefees we charge our customers.***

The market for consumerelectronics products is intensely competitive and price sensitive. Retailprices for consumer electronics products that include our DTS audio technology,such as DVD players and home theater systems, have decreased significantly andwe expect prices to continue to decrease for the foreseeable future. Decliningprices for consumer electronics products could create downward pressure on thelicensing fees we currently charge our customers who integrate our technologyinto the consumer electronics products that they sell and distribute. Most ofthe consumer electronics products that include our audio technology alsoinclude Dolby’s multi-channel audio. As a result of pricing pressure, consumer 

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electronicsproducts manufacturers could decide to exclude our DTS audio technology fromtheir products altogether.

***We have limitedcontrol over existing and potential customers’ and licensees’ decision toinclude our technology in their product offerings.***

We are dependent on ourcustomers and licensees—including consumer electronics products manufacturers,semiconductor manufacturers, movie theaters, and producers and distributors ofcontent for music, films, videos, and games—to incorporate our technology in theirproducts, purchase our products and services, or release their content in ourproprietary DTS audio format. Although we have license agreements with many ofthese companies, these license agreements do not require any minimum purchasecommitments, and are on a non-exclusive basis, and do not require incorporationof our technology or trademarks in their products. Our licensees and othermanufacturers might not utilize our technology in the future.

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

Although all nine majorfilm producers and distributors are customers of ours, we generally do not havecontractual arrangements that require them to use our DTS audio technology. Ourcinema business 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 movieindustry adopts new digital cinema technology in place of current filmtechnology, demand for our cinema products and services could decline.***

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

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

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operatorsdecide to close a significant number of screens in the future or cut theircapital spending, demand for our playback systems and cinema processors willdecline.

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

Our successdepends, in part, upon the continued availability and contributions of ourmanagement team, particularly Jon Kirchner, our President and Chief ExecutiveOfficer, W. Paul Smith, our Senior Vice President, Research and Development andJohn Lowry, our Chief Technologist of DTS Digital Images who became an employeeupon the acquisition of LDI. We also rely on the skills and talents of ourengineering and technical personnel because of the complexity of our productsand services. Several of our key engineers have been instrumental in thedevelopment of our technology. Important factors that could cause the loss ofkey 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;

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

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

The loss of key personnelor an inability to attract qualified personnel in a timely manner could slowour technology and product development and harm our ability to execute ourbusiness plan.

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

Although the first moviewith a DTS audio soundtrack was released in 1993, we did not enter the hometheater market until 1996, and our technology has only recently beenincorporated into other consumer electronics markets, such as car audio,personal computers, video games and consoles, portable electronics devices, anddigital satellite and cable broadcast products. As a result, the demand for ourtechnology, products, and services and the income potential of these businessesare unproven. In addition, because the market for digital audio technology isrelatively new and rapidly evolving, we have limited insight into trends thatmay emerge and affect our business. We may make errors in predicting andreacting to relevant business trends, which could harm our business. Beforeinvesting in our common stock, you should consider the risks, uncertainties,and difficulties frequently encountered by companies in new and rapidlyevolving markets such as ours. We may not be able to successfully address anyor all of these risks.

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

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

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***Because we expectour operating expenses to increase in the future, we may not be able to sustainor increase our profitability.***

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

·       expandour domestic and international sales and marketing activities;

·       acquirebusinesses or technologies;

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

·       hireadditional personnel, including engineers and other technical staff;

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

·       continueto assume the responsibilities of being a public company.

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

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

We market and sellour products and services outside the United States, and currently haveemployees located in Canada, China, England, Japan, Mexico, Northern Ireland,and Spain. Many of our customers and licensees are located outside the UnitedStates. As a key component of our business strategy, we intend to expand ourinternational sales. We face numerous risks in doing business outside theUnited States, including:

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

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

·       difficultiesin staffing and managing foreign operations;

·       dependenceon foreign distributors and their sales channels;

·       longeraccounts receivable collection cycles and difficulties in collecting accountsreceivable;

·       lesseffective and less predictable protection of intellectual property;

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

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

·       potentiallyadverse tax consequences.

Such factors could cause our future internationalsales to decline.

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

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

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

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

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

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

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

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

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

A significant percentageof our revenues are generated from our consumer electronics productsmanufacturer customers who license and incorporate our technology in theirconsumer electronics products. Under our existing arrangements, these customerspay us a per-unit licensing fee based on the number of consumer electronicsproducts manufactured that incorporate our technology. We rely on our customersto accurately report the number of units manufactured in collecting our licensefees, preparing our financial reports, projections, budgets, and directing oursales and product development efforts. Most 

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

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

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

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

We expect toconsider opportunities to acquire or make investments in other technologies,products, and businesses that could enhance our technical capabilities,complement our current products and services, or expand the breadth of ourmarkets. We have a limited history of acquiring and integrating businesses.Acquisitions and strategic investments involve numerous risks, including:

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

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

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

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

·       unanticipatedcosts associated with the acquisition, including accounting charges 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 priorexperience; and

·       potentialloss of key employees of acquired organizations.

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

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

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

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

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

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

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·       managemultiple, concurrent development projects; and

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

Any failure tosuccessfully manage our growth could distract management’s attention, andresult in our failure to execute our business plan. For instance, the LDI acquisitionin 2005 has required significant time and attention from our management team.Any future growth could cause similar management challenges or createdistractions.

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

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

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

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

There has been ongoingpublic debate whether stock options granted to employees should be treated ascompensation expense and, if so, how to properly value such charges. Currently,we account for options using the intrinsic value method, which results in nocompensation expense, since we granted employee options with exercise pricesequal to the fair market value of the underlying stock at the time of grant.If, however, we had used the fair value method of accounting for stock optionsgranted to employees using a Black-Scholes option valuation formula, our netincome for the year ended December 31, 2004, would have been reduced by$1.5 million, from $10.0 million to $8.5 million for the year ended December 31,2004. When we adopt FAS 123R in the third quarter of 2005, we will haveon-going accounting charges significantly greater than those we would haverecorded under our current method of accounting for stock options, which couldhave a material adverse affect on our operating results.

**Risks Related to Our Common Stock**

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

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

·       actualor anticipated fluctuations in our results of operations;

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·       announcementsof technological innovations or technology standards;

·       announcementsof significant contracts by us or our competitors;

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

·       developmentswith respect to intellectual property rights;

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

·       thecommencement of or our involvement in litigation;

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

·       conditionsand trends in technology industries;

·       changesin market valuation or earnings of our competitors;

·       thetrading volume of our common stock;

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

·       generaleconomic conditions.

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

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

As of December 31,2004, we have 17,067,573 shares of common stock outstanding. As a result of ourrelatively small public float, our common shares may be less liquid than thecommon shares of companies with broader public ownership. Among other things,trading of a relatively small volume of our common shares may have a greaterimpact on the trading price for our shares than would be the case if our publicfloat were larger.

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

Our capitalrequirements will depend on many factors, including:

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

·       thecosts of developing new products or technology;

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

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

·       thecosts associated with our expansion, if any.

In the future, we may needto raise additional funds, and such funds may not be available on favorableterms, or at all. Furthermore, if we issue equity or debt securities to raiseadditional funds, our existing stockholders may experience dilution, and thenew equity or debt securities may have rights, preferences, 

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andprivileges senior to those of our existing stockholders. If we cannot raisefunds on acceptable terms, we may not be able to develop or enhance ourproducts and services, execute our business plan, take advantage of futureopportunities, or respond to competitive pressures or unanticipated customerrequirements. This may materially harm our business, results of operations, andfinancial condition.

***Anti-takeoverprovisions under our charter documents and Delaware law could delay or preventa change of control and could also limit the market price of our stock.***

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

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

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

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

·       requireadvance written notice of stockholder proposals and director nominations.

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

**Item 7A. *Quantitative andQualitative Disclosure About Market Risk***

Market risk represents the risk of loss arising fromadverse changes in market rates and foreign exchange rates. At December 31,2004, we did not have any balances outstanding under our bank line of creditarrangement; however, the amount of outstanding debt at any time may fluctuateand we may from time to time be subject to refinancing risk.

Our interest income is sensitive to changes in thegeneral level of U.S. interest rates, particularly since a significant portionof our investments are and will be in short-term marketable securities, U.S.government securities and corporate bonds. Due to the nature and maturity ofour short-term investments, we have concluded that there is no material marketrisk exposure to our principal. The average maturity of our investmentportfolio is less than one month. As of December 31, 2004, a 1% change ininterest rates throughout a one-year period would have an annual effect ofapproximately $1.2 million on our income.

We derive more than half of our revenues from salesoutside the United States, and maintain research, sales, marketing, or businessdevelopment offices in six countries. Therefore, our results could benegatively affected by such factors as changes in foreign currency exchangerates, trade protection measures, longer accounts receivable collectionpatterns, and changes in regional or worldwide economic or politicalconditions. The risks of our international operations are mitigated in part bythe extent to which our revenues are denominated in U.S. dollars and,accordingly, we are not exposed to significant foreign currency risk on theseitems. We do have limited foreign currency risk on certain revenues andoperating expenses such as salaries and overhead costs of our foreignoperations and a small amount of cash maintained by these operations. Revenuesdenominated in foreign currencies accounted for 

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approximately 13% of totalrevenues during 2004. Operating expenses, including cost of sales, for ourforeign subsidiaries were approximately $5.7 million in 2004. Based upon theexpenses for 2004, a 1% change in foreign currency rates throughout a one-yearperiod would have an annual effect of approximately $57,000.

Our international business is subject to risks,including, but not limited to, differing economic conditions, changes in politicalclimate, differing tax structures, other regulations and restrictions, andforeign exchange rate volatility when compared to the United States dollar.Accordingly, our future results could be materially impacted by changes inthese or other factors.

We are also affected by exchange rate fluctuations asthe financial statements of our foreign subsidiaries are translated into theUnited States dollar in consolidation. As exchange rates vary, these results,when translated, may vary from expectations and could adversely impact overallprofitability. During 2004, the impact of foreign exchange rate fluctuationsrelated to translation of our foreign subsidiaries’ financial statements were$119,000.

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**Item 8**.*Financial Statements and Supplementary Data*

**DIGITAL THEATERSYSTEMS, INC.INDEX TO CONSOLIDATED FINANCIAL STATEMENTS**
| **Consolidated Financial Statements:**                                                                                               | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|
| Report of Independent Registered  Public Accounting Firm                                                                             | 56         |
| Consolidated  Balance Sheets as of December 31, 2003 and 2004                                                                   | 58         |
| Consolidated Statements of Operations for the  years ended December 31, 2002, 2003 and 2004                           | 59         |
| Consolidated Statements of  Stockholders’ Equity (Deficit) for the years ended December 31,  2002, 2003 and 2004 | 60         |
| Consolidated Statements of Cash Flows for the  years ended December 31, 2002, 2003 and 2004                           | 61         |
| Notes  to Consolidated Financial Statements                                                                                          | 62         |
| **Financial  Statement Schedule:**                                                                                                   | ** ** |
| Schedule II—Valuation and  Qualifying Accounts for the years ended December 31, 2002, 2003  and 2004                  | 90         |

 

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**Report of Independent Registered Public AccountingFirm**

To the Board of Directors and Shareholders of DigitalTheater Systems, Inc.:

We have completed anintegrated audit of Digital Theater Systems, Inc.’s 2004 consolidated financialstatements and of its internal control over financial reporting as of December31, 2004 and audits of its 2003 and 2002 consolidated financial statements inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Our opinions, based on our audits, are presented below.

*Consolidatedfinancial statements and financial statement schedule*

In our opinion, theconsolidated financial statements listed in the accompanying index presentfairly, in all material respects, the financial position of Digital TheaterSystems, Inc. and its subsidiaries at December 31, 2004 and 2003, and theresults of their operations and their cash flows for each of the three years inthe period ended December 31, 2004 in conformity with accounting principlesgenerally accepted in the United States of America. In addition, in ouropinion, the financial statement schedule listed in the accompanying indexpresent fairly, in all material respects, the information set forth thereinwhen read in conjunction with the related consolidated financial statements.These financial statements and financial statement schedule are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements and financial statement schedule based onour audits. We conducted our audits of these statements in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit of financial statements includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statementpresentation. We believe that our audits provide a reasonable basis for ouropinion.

*Internal control overfinancial reporting*

Also, in our opinion, management’s assessment,included in the Company’s Form 10-K appearing in Item 9A. *Controls andProcedures*entitled “Managements Report on Internal Control OverFinancial Reporting”, that the Company maintained effective internal control overfinancial reporting as of December 31, 2004 based on criteria establishedin *Internal Control—Integrated Framework*issuedby the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”),is fairly stated, in all material respects, based on those criteria. Furthermore,in our opinion, the Company maintained, in all material respects, effective internalcontrol over financial reporting as of December 31, 2004, based oncriteria established in *InternalControl—Integrated Framework*issued by the COSO. The Company’s managementis responsible for maintaining effective internal control over financialreporting and for its assessment of the effectiveness of internal control overfinancial reporting. Our responsibility is to express opinions on management’sassessment and on the effectiveness of the Company’s internal control overfinancial reporting based on our audit. We conducted our audit of internalcontrol over financial reporting in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects. An audit of internal control over financial reportingincludes obtaining an understanding of internal control over financialreporting, evaluating management’s assessment, testing and evaluating thedesign and operating effectiveness of internal control, and performing suchother procedures as we consider necessary in the circumstances. We believe thatour audit provides a reasonable basis for our opinions.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for 

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external purposes inaccordance with generally accepted accounting principles. A company’s internalcontrol over financial reporting includes those policies and procedures that(i) pertain to the maintenance of records that, in reasonable detail,accurately and fairly reflect the transactions and dispositions of the assetsof the company; (ii) provide reasonable assurance that transactions arerecorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that receipts andexpenditures of the company are being made only in accordance withauthorizations of management and directors of the company; and (iii) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the company’s assets that could have amaterial effect on the financial statements.

Because of its inherent limitations, internal control overfinancial reporting may not prevent or detect misstatements. Also, projectionsof any evaluations of effectiveness to future periods are subject to the riskthat controls may become inadequate because of changes in conditions, or thatthe degree of compliance with the policies or procedures may deteriorate.
| /s/ PricewaterhouseCoopers LLP |
|--------------------------------|
| Los Angeles, CA                |
| March 15, 2005                 |

 

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**DIGITAL THEATERSYSTEMS, INC.CONSOLIDATED BALANCE SHEETS**
|                                                                                                                                                                                                                   | ** ** | **As of  December 31,**                                                              | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                                        | ** ** | **2003**                                                                                       | ** ** | **2004** | ** ** |
| ** **                                                                                                                                                                                                        | ** ** | **(Amounts in thousands,  except share and per  share amounts)** | ** ** |
| **ASSETS**                                                                                                                                                                                                        | ** ** |
| Current assets:                                                                                                                                                                                                   |       |                                                                                           |       |   |   |
| Cash and cash equivalents                                                                                                                                                                                         |       | $                                                                                              | 39,243     | ** ** | **$** | **21,271** | ** ** |
| Short-term investments                                                                                                                                                                                            |       | 60,146                                                                                         | ** ** | **93,040** | ** ** |
| Accounts receivable, net of  allowance for doubtful accounts of $429 and $402  at December 31, 2003 and 2004, respectively                                                                                   |       | 3,962                                                                                          | ** ** | **4,649** | ** ** |
| Inventories                                                                                                                                                                                                       |       | 7,552                                                                                          | ** ** | **3,669** | ** ** |
| Deferred tax assets, net                                                                                                                                                                                          |       | 6,025                                                                                          | ** ** | **9,144** | ** ** |
| Prepaid expenses and other                                                                                                                                                                                        |       | 1,846                                                                                          | ** ** | **3,651** | ** ** |
| Income tax receivable                                                                                                                                                                                             |       | 660                                                                                            | ** ** | **72** | ** ** |
| Total current assets                                                                                                                                                                                              |       | 119,434                                                                                        | ** ** | **135,496** | ** ** |
| Long-term investments                                                                                                                                                                                             |       | 2,998                                                                                          | ** ** | **2,657** | ** ** |
| Property and  equipment, net                                                                                                                                                                                      |       | 3,092                                                                                          | ** ** | **3,539** | ** ** |
| Intangible assets, net                                                                                                                                                                                            |       | 424                                                                                            | ** ** | **1,779** | ** ** |
| Deferred tax  assets                                                                                                                                                                                              |       | 1,527                                                                                          | ** ** | **500** | ** ** |
| Other assets                                                                                                                                                                                                      |       | 20                                                                                             | ** ** | **718** | ** ** |
| Total assets                                                                                                                                                                                                      |       | $                                                                                              | 127,495    | ** ** | **$** | **144,689** | ** ** |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                     | ** ** |
| Current  liabilities:                                                                                                                                                                                             | ** ** | ** **                                                                                     | ** ** | ** ** | ** ** |
| Accounts payable                                                                                                                                                                                                  |       | $                                                                                              | 2,829      | ** ** | **$** | **3,716** | ** ** |
| Accrued expenses                                                                                                                                                                                                  |       | 5,795                                                                                          | ** ** | **5,688** | ** ** |
| Deferred revenue                                                                                                                                                                                                  |       | —                                                                                         | ** ** | **519** | ** ** |
| Total current liabilities                                                                                                                                                                                         |       | 8,624                                                                                          | ** ** | **9,923** | ** ** |
| Commitments and  contingencies (Note 10)                                                                                                                                                                     |       |                                                                                           |       |   |   |
| Stockholders’ equity:                                                                                                                                                                                        |       |                                                                                           |       |   |   |
| Preferred stock—$0.0001 par  value, 5,000,000 shares authorized at December 31, 2004; no shares issued  and outstanding                                                                                 |       | —                                                                                         | ** ** | **—** | ** ** |
| Common stock—$0.0001 par value, 70,000,000 shares  authorized at December 31, 2003 and 2004; 16,512,885 and 17,067,573  shares issued and outstanding at December 31, 2003 and 2004,  respectively |       | 2                                                                                              | ** ** | **2** | ** ** |
| Additional paid-in capital                                                                                                                                                                                        |       | 115,512                                                                                        | ** ** | **121,431** | ** ** |
| Retained earnings                                                                                                                                                                                                 |       | 3,357                                                                                          | ** ** | **13,333** | ** ** |
| Total stockholders’ equity                                                                                                                                                                                   |       | 118,871                                                                                        | ** ** | **134,766** | ** ** |
| Total liabilities  and stockholders’ equity                                                                                                                                                                  |       | $                                                                                              | 127,495    | ** ** | **$** | **144,689** | ** ** |

 

See accompanying notes to consolidated financial statements.

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**DIGITAL THEATERSYSTEMS, INC.CONSOLIDATED STATEMENTS OF OPERATIONS**
| ** **                                                                                                 | ** ** | **For the Years Ended December 31,**                                      | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                 | ** ** | **2002**                                                                                           | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                                                                                 | ** ** | **(Amounts in thousands, except share and per  share amounts)** | ** ** |
| Revenues:                                                                                                  |       |                                                                                               |       |   |   | ** ** | ** ** |
| Technology and film licensing                                                                              |       | $                                                                                                  | 31,906     |   | $ | 42,229 |   | **$** | **49,920** | ** ** |
| Product sales and other revenues                                                                           |       | 9,150                                                                                              |       | 9,473 |   | **11,511** | ** ** |
| Total revenues                                                                                             |       | 41,056                                                                                             |       | 51,702 |   | **61,431** | ** ** |
| Cost of goods  sold:                                                                                       | ** ** |                                                                                               |       |   |   | ** ** | ** ** |
| Technology and film licensing                                                                              |       | 3,687                                                                                              |       | 4,281 |   | **4,451** | ** ** |
| Product sales and other revenues                                                                           |       | 6,949                                                                                              |       | 6,751 |   | **11,711** | ** ** |
| Total cost of goods sold                                                                                   |       | 10,636                                                                                             |       | 11,032 |   | **16,162** | ** ** |
| Gross profit                                                                                               |       | 30,420                                                                                             |       | 40,670 |   | **45,269** | ** ** |
| Operating expenses:                                                                                        |       |                                                                                               |       |   |   | ** ** | ** ** |
| Selling, general and administrative                                                                        |       | 16,379                                                                                             |       | 20,473 |   | **27,644** | ** ** |
| Research and development                                                                                   |       | 3,754                                                                                              |       | 4,987 |   | **6,131** | ** ** |
| Total operating expenses                                                                                   |       | 20,133                                                                                             |       | 25,460 |   | **33,775** | ** ** |
| Income from  operations                                                                                    |       | 10,287                                                                                             |       | 15,210 |   | **11,494** | ** ** |
| Interest income  (expense), net                                                                            |       | (94                                                                                                | )          | 271 |   | **1,447** | ** ** |
| Other expense,  net                                                                                        |       | (255                                                                                               | )          | (214 | ) | **(31** | **)** |
| Income from legal  settlement (Note 20)                                                                    |       | —                                                                                             |       | — |   | **2,601** | ** ** |
| Income before  provision for income taxes                                                                  |       | 9,938                                                                                              |       | 15,267 |   | **15,511** | ** ** |
| Provision for  income taxes                                                                                |       | 3,688                                                                                              |       | 5,368 |   | **5,535** | ** ** |
| Net income                                                                                                 |       | 6,250                                                                                              |       | 9,899 |   | **9,976** | ** ** |
| Accretion and accrued dividends on preferred stock                                                         |       | (1,848                                                                                             | )          | (1,234 | ) | — | ** ** |
| Net income  attributable to common stockholders                                                            |       | $                                                                                                  | 4,402      |   | $ | 8,665 |   | **$** | **9,976** | ** ** |
| Net income  attributable to common stockholders per common share:                                          |       |                                                                                               |       |   |   | ** ** | ** ** |
| Basic                                                                                                      |       | $                                                                                                  | 0.99       |   | $ | 0.95 |   | **$** | **0.59** | ** ** |
| Diluted                                                                                                    |       | $                                                                                                  | 0.47       |   | $ | 0.80 |   | **$** | **0.55** | ** ** |
| Weighted average  shares used to compute net income attributable to common stockholders per  common share: |       |                                                                                               |       |   |   | ** ** | ** ** |
| Basic                                                                                                      |       | 4,432,408                                                                                          |       | 9,166,389 |   | **16,865,805** | ** ** |
| Diluted                                                                                                    |       | 9,329,278                                                                                          |       | 10,764,867 |   | **18,143,114** | ** ** |

 

See accompanying notes to consolidated financial statements.

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**DIGITAL THEATERSYSTEMS, INC.CONSOLIDATED STATEMENTS OF STOCKHOLDERS’EQUITY (DEFICIT)**
| ** **                                                                         | ** ** | **Preferred Stock**                                                  | ** ** | **Common Stock** | ** ** | **Additional  Paid-in** | ** ** | **Retained  Earnings  (Accumulated** | ** ** | **Total  Stockholders’** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|--------------------------------------|------------|-------------------------------|------------|
| ** **                                                                         | ** ** | **Shares**                                                                | ** ** | **Amount**            | ** ** | **Shares**              | ** ** | **Amount**                           | ** ** | **Capital**                   | ** ** | **      Deficit)      ** | ** ** | **Equity (Deficit)** | ** ** |
| ** **                                                                         | ** ** | **(Amounts in thousands, except share amounts)** | ** ** |
| Balance at  December 31, 2001                                                 |       |                                                                      | —     |                  |       |                    | —     |                                 |       | 4,413,035                     |       |   | $ | 1 |   |   |   | $ | (1,146 | ) |   |   | $ | (9,710 | ) |   |   | $ | (10,855 | ) |   |
| Exercise of  warrants                                                              |       |                                                                      | —     |                  |       |                    | —     |                                 |       | 116,697                       |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Stock-based  compensation charge for options issued to non-employees               |       |                                                                      | —     |                  |       |                    | —     |                                 |       | —                        |       |   | — |   |   |   | 138 |   |   |   | — |   |   |   | 138 |   |   |
| Shares cancelled  on expiration  of escrow agreement                               |       |                                                                      | —     |                  |       |                    | —     |                                 |       | (117,616                      | )          |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Accretion of  mandatorily redeemable preferred stock redemption value         |       |                                                                      | —     |                  |       |                    | —     |                                 |       | —                        |       |   | — |   |   |   | — |   |   |   | (512 | ) |   |   | (512 | ) |   |
| Cumulative  preferred stock dividends accrued                                      |       |                                                                      | —     |                  |       |                    | —     |                                 |       | —                        |       |   | — |   |   |   | — |   |   |   | (1,336 | ) |   |   | (1,336 | ) |   |
| Net income                                                                         |       |                                                                      | —     |                  |       |                    | —     |                                 |       | —                        |       |   | — |   |   |   | — |   |   |   | 6,250 |   |   |   | 6,250 |   |   |
| Balance at  December 31, 2002                                                 |       |                                                                      | —     |                  |       |                    | —     |                                 |       | 4,412,116                     |       |   | 1 |   |   |   | (1,008 | ) |   |   | (5,308 | ) |   |   | (6,315 | ) |   |
| Exercise of  warrants                                                              |       |                                                                      | —     |                  |       |                    | —     |                                 |       | 5,606,954                     |       |   | — |   |   |   | 4 |   |   |   | — |   |   |   | 4 |   |   |
| Exercise of  options and related tax benefit of $3,384                   |       |                                                                      | —     |                  |       |                    | —     |                                 |       | 369,378                       |       |   | — |   |   |   | 3,875 |   |   |   | — |   |   |   | 3,875 |   |   |
| Issuance of common  stock under employee stock purchase  plan                      |       |                                                                      |       |                  |       |                    |       |                                 |       | 18,327                        |       |   | — |   |   |   | 253 |   |   |   | — |   |   |   | 253 |   |   |
| Issuance of  warrants to purchase common stock                                     |       |                                                                      | —     |                  |       |                    | —     |                                 |       | —                        |       |   | — |   |   |   | 345 |   |   |   | — |   |   |   | 345 |   |   |
| Issuance of common  stock in initial public offering, net of issuance costs   |       |                                                                      | —     |                  |       |                    | —     |                                 |       | 4,091,410                     |       |   | 1 |   |   |   | 63,028 |   |   |   | — |   |   |   | 63,029 |   |   |
| Issuance of common  stock in follow-on public offering, net of issuance costs |       |                                                                      |       |                  |       |                    |       |                                 |       | 2,014,700                     |       |   | — |   |   |   | 48,863 |   |   |   |   |   |   |   | 48,863 |   |   |
| Stock-based  compensation charge for options issued to non-employees               |       |                                                                      | —     |                  |       |                    | —     |                                 |       | —                        |       |   | — |   |   |   | 152 |   |   |   | — |   |   |   | 152 |   |   |
| Accretion of  mandatorily redeemable preferred stock redemption value              |       |                                                                      | —     |                  |       |                    | —     |                                 |       | —                        |       |   | — |   |   |   | — |   |   |   | (390 | ) |   |   | (390 | ) |   |
| Cumulative  preferred stock dividends accrued                                      |       |                                                                      | —     |                  |       |                    | —     |                                 |       | —                        |       |   | — |   |   |   | — |   |   |   | (844 | ) |   |   | (844 | ) |   |
| Net income                                                                         |       |                                                                      | —     |                  |       |                    | —     |                                 |       | —                        |       |   | — |   |   |   | — |   |   |   | 9,899 |   |   |   | 9,899 |   |   |
| Balance at  December 31, 2003                                                 |       |                                                                      | —     |                  |       |                    | —     |                                 |       | 16,512,885                    |       |   | 2 |   |   |   | 115,512 |   |   |   | 3,357 |   |   |   | 118,871 |   |   |
| Exercise of  warrants                                                              |       |                                                                      | —     |                  |       |                    | —     |                                 |       | 48,802                        |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Exercise of  options and related tax benefit of $4,348                        |       |                                                                      | —     |                  |       |                    | —     |                                 |       | 449,085                       |       |   | — |   |   |   | 4,855 |   |   |   | — |   |   |   | 4,855 |   |   |
| Issuance of common  stock under employee stock purchase  plan                      |       |                                                                      | —     |                  |       |                    | —     |                                 |       | 56,801                        |       |   | — |   |   |   | 821 |   |   |   | — |   |   |   | 821 |   |   |
| Issuance costs for  follow-on public offering                                      |       |                                                                      | —     |                  |       |                    | —     |                                 |       | —                        |       |   | — |   |   |   | (30 | ) |   |   | — |   |   |   | (30 | ) |   |
| Stock-based  compensation charge for options issued to non-employees               |       |                                                                      | —     |                  |       |                    | —     |                                 |       | —                        |       |   | — |   |   |   | 273 |   |   |   | — |   |   |   | 273 |   |   |
| Net income                                                                         |       |                                                                      | —     |                  |       |                    | —     |                                 |       | —                        |       |   | — |   |   |   | — |   |   |   | 9,976 |   |   |   | 9,976 |   |   |
| Balance at  December 31, 2004                                                 |       |                                                                      | —     |                  |       |                    | —     |                                 |       | 17,067,573                    |       |   | $ | 2 |   |   |   | $ | 121,431 |   |   |   | $ | 13,333 |   |   |   | $ | 134,766 |   |   |

 

See accompanying notes to consolidated financial statements.

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**DIGITAL THEATERSYSTEMS, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS**
| ** **                                                                                                                    | ** ** | **For the Years Ended  December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                                                                    | ** ** | **2002**                                                  | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                                                                                                    | ** ** | **(Amounts in thousands)**                      | ** ** |
| Cash flows from operating activities:                                                                                         |       |                                                      |       |   |   |   |   |
| Net income                                                                                                                    |       | $                                                         | 6,250      |   | $ | 9,899 | ** ** | **$** | **9,976** | ** ** |
| Adjustments to reconcile net income to net cash  provided by operating activities:                                            |       |                                                      |       |   |   |   |   |
| Depreciation and  amortization                                                                                                |       | 902                                                       |       | 910 | ** ** | **1,298** | ** ** |
| Stock-based compensation  charges                                                                                             |       | 138                                                       |       | 497 | ** ** | **273** | ** ** |
| Allowance for doubtful  accounts                                                                                              |       | 10                                                        |       | 114 | ** ** | **61** | ** ** |
| Loss on disposal of  property and equipment                                                                                   |       | —                                                    |       | 93 |   | — |   |
| Deferred income taxes                                                                                                         |       | (3,141                                                    | )          | (374 | ) | **(2,092** | **)** |
| Tax benefit from employee  stock plans                                                                                        |       | —                                                    |       | 3,384 | ** ** | **4,348** | ** ** |
| Write-down of projector  inventory                                                                                            |       | —                                                    |       | — | ** ** | **3,871** | ** ** |
| Changes in operating assets and liabilities:                                                                                  |       |                                                      |       |   |   |   |   |
| Accounts receivable                                                                                                           |       | (1,855                                                    | )          | 1,542 | ** ** | **(748** | **)** |
| Inventories                                                                                                                   |       | (1,736                                                    | )          | (2,906 | ) | **12** | ** ** |
| Prepaid expenses and  other assets                                                                                            |       | 3                                                         |       | (1,121 | ) | **(1,245** | **)** |
| Accounts payable and  accrued expenses                                                                                        |       | 1,460                                                     |       | 359 | ** ** | **713** | ** ** |
| Deferred revenue                                                                                                              |       | —                                                    |       | — | ** ** | **519** | ** ** |
| Income taxes                                                                                                                  |       | 2,527                                                     |       | (3,187 | ) | **588** | ** ** |
| Net cash provided by  operating activities                                                                                    |       | 4,558                                                     |       | 9,210 | ** ** | **17,574** | ** ** |
| Cash flows from investing activities:                                                                                         |       |                                                      |       |   |   |   |   |
| Purchase of investments                                                                                                       |       | (2,144                                                    | )          | (61,000 | ) | **(32,554** | **)** |
| Purchase of property and  equipment                                                                                           |       | (977                                                      | )          | (892 | ) | **(1,567** | **)** |
| Bridge loan for  acquisition                                                                                                  |       | —                                                    |       | — | ** ** | **(1,250** | **)** |
| Cash paid for  acquistions, net of cash acquired                                                                              |       | —                                                    |       | — | ** ** | **(1,383** | **)** |
| Payment for patents and  trademarks in process                                                                                |       | (85                                                       | )          | (86 | ) | **(90** | **)** |
| Net cash used in  investing activities                                                                                        |       | (3,206                                                    | )          | (61,978 | ) | **(36,844** | **)** |
| Cash flows from financing activities:                                                                                         |       |                                                      |       |   |   |   |   |
| Preferred stock dividend  payments                                                                                            |       | —                                                    |       | (6,758 | ) | **—** | ** ** |
| Redemption of preferred  stock                                                                                                |       | —                                                    |       | (15,778 | ) | **—** | ** ** |
| Proceeds from the sale of  common stock in connection with the initial and follow-on public offerings,  net of issuance costs |       | —                                                    |       | 111,892 | ** ** | **(30** | **)** |
| Proceeds from the  issuance of common stock upon exercise of employee stock options                                           |       | —                                                    |       | 491 | ** ** | **507** | ** ** |
| Proceeds from the  issuance of common stock upon exercise of warrants                                                         |       | —                                                    |       | 4 | ** ** | **—** | ** ** |
| Proceeds from the  issuance of common stock under employee stock purchase plan                                                |       | —                                                    |       | 253 | ** ** | **821** | ** ** |
| Net repayments under bank  line of credit                                                                                     |       | (6,303                                                    | )          | — |   | — |   |
| Net cash provided by  (used in) financing activities                                                                          |       | (6,303                                                    | )          | 90,104 | ** ** | **1,298** | ** ** |
| Net increase  (decrease) in cash and cash equivalents                                                                         |       | (4,951                                                    | )          | 37,336 | ** ** | **(17,972** | **)** |
| Cash and cash  equivalents, beginning of period                                                                               |       | 6,858                                                     |       | 1,907 | ** ** | **39,243** | ** ** |
| Cash and cash  equivalents, end of period                                                                                     |       | $                                                         | 1,907      |   | $ | 39,243 | ** ** | **$** | **21,271** | ** ** |
| Supplemental disclosure of cash flow information:                                                                             |       |                                                      |       |   |   |   |   |
| Cash paid for interest                                                                                                        |       | $                                                         | 181        |   | $ | 2 | ** ** | **$** | **—** | ** ** |
| Cash paid for income  taxes                                                                                                   |       | $                                                         | 2,269      |   | $ | 2,774 | ** ** | **$** | **482** | ** ** |
| Non-cash investing and financing activities:                                                                                  |       |                                                      |       |   |   |   |   |
| Non-cash cumulative preferred dividends accrued and  accretion of preferred stock redemption value                            |       | $                                                         | 1,848      |   | $ | 1,234 | ** ** | **$** | **—** | ** ** |

 

See accompanying notes to consolidated financial statements.

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Amounts in thousands, except share and per share data)**

**Note 1**—The Company

Digital Theater Systems, Inc.(the “Company”) provides digital entertainment technologies, products andservices to the motion picture, consumer electronics, professional audio andrelated industries. The Company’s Cinema business, which was previouslydescribed as the Theatrical business, provides digital playback systems andcinema processor equipment to movie theaters, and licenses and providesservices to film producers and distributors. The Company’s Consumer businesslicenses audio technology to consumer electronics, personal computer, broadcastand professional audio companies, and sells DVD-based entertainment content.

The Company commencedoperations in 1990 as Digital Theater Systems Corporation (“DTS Corp”). In1993, DTS Corp became the general partner of Digital Theater Systems, L.P., aDelaware limited partnership (“the Partnership”). In 1994, the Partnershipformed DTS Technology, LLC (“DTS Technology”) to develop audio technologies forthe consumer electronics and other markets. On October 24, 1997 theCompany completed a reorganization and tax-free exchange with the predecessorentities and was incorporated in Delaware. The reorganization and formation ofthe Company was accounted for as a transaction by entities under common controland was effected by each of the former stockholders and owners of DTS Corp, thePartnership and DTS Technology receiving an ownership interest in the Company,represented by shares of common stock and warrants to acquire shares of commonstock, substantially equivalent to their previous interests in DTS Corp, thePartnership and DTS Technology. Of such shares, a total of 117,616 were held inescrow pursuant to an escrow agreement which called for the shares to be heldin escrow until the earlier of the consummation of an Initial Public Offeringor a Qualified Sale Transaction, as defined, or December 1, 2002. As noneof these events occurred by December 1, 2002, under the terms of theescrow, these shares were returned to the Company for cancellation in December 2002.

**Note 2**—SignificantAccounting Policies

***Principles ofConsolidation***

The consolidated financialstatements include the accounts of the Company and its subsidiaries. Allmaterial intercompany accounts and transactions have been eliminated.

***Reclassification***

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

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

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note2—Significant Accounting Policies (Continued)**

the nextreset period. The Company’s re-evaluation of the maturity dates and otherprovisions associated with the underlying bonds resulted in a reclassificationfrom cash and equivalents to short-term marketable securities of approximately$50,098 on the December 31, 2003 balance sheet. As a result of this balancesheet reclassification, certain amounts were reclassified in the accompanyingconsolidated statement of cash flows for the year ended December 31, 2003 toreflect the gross purchases and sales of these securities as investingactivities rather than as a component of cash and cash equivalents. This changein classification does not affect previously reported cash flows from operatingor from financing activities in the previously reported consolidated statementsof cash flows or the previously reported consolidated statements of operations.As of December 31, 2003, before these revisions in classification, $50,098 ofthese current investments were classified as cash and cash equivalents on theconsolidated balance sheet. For the year ended December 31, 2003, before theserevisions in classification, net cash used in investing activities related tothese current investments of $50,098 were included in cash and cash equivalentsin the consolidated statement of cash flows.

***Use of Estimatesand Critical Accounting Policies***

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

The most significant areasthat require management judgment are revenue recognition, allowance fordoubtful accounts, inventories, deferred taxes, impairment of long-lived assets,product warranty, stock-based compensation, contingencies and litigation. Theaccounting policies for these areas are discussed in this or other footnotes tothese consolidated financial statements.

***Cash and CashEquivalents***

The Company considers allshort-term highly liquid investments with an original maturity of three monthsor less to be cash equivalents. Cash and cash equivalents consist of funds heldin general checking accounts, money market accounts, and bank certificates ofdeposit. Cash and cash equivalents are stated at cost plus accrued interest,which approximates fair value. Cash restricted as to use is classified in othercurrent and non-current assets, as appropriate.

***Short-TermInvestments***

Short-term investmentsconsist of bank certificates of deposit and certain marketable debt securities,which consist primarily of auction rate and variable rate obligation securitiesof short-to intermediate-term fixed income securities issued by U.S. governmentagencies and municipalities. The Company only invests in marketable securitieswith active secondary or resale markets to ensure portfolio liquidity and theability to readily convert investments into cash to fund current operations, orsatisfy other cash requirements as needed. Short-term investments areclassified as available for sale and are carried at fair value whichapproximates amortized cost.

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note2—Significant Accounting Policies (Continued)**

***Long-TermInvestments***

Long-term investmentsconsist of United States government and agency securities as well as municipalsecurities that the Company has classified as long-term investments based onthe intention to hold these investments for at least the next twelve months.These investments are classified as available for sale and are carried at fairvalue, which approximates amortized cost.

***Concentration ofBusiness and Credit Risk***

The Company markets itsproducts and services to major motion picture producers and distributors, movietheaters, and consumer electronics product manufacturers in the United Statesand internationally. Domestic customers accounted for $10,244, $15,837, and$17,830 of revenues for the years ended December 31, 2002, 2003 and 2004,respectively. International customers accounted for $30,832, $35,865 and$43,601 of revenues for the years ended December 31, 2002, 2003 and 2004,respectively. Although the Company is generally subject to the financial wellbeing of the motion picture industry and the consumer electronics business,management does not believe that the Company is subject to significant creditrisk with respect to trade accounts receivable. Additionally, the Companyperforms ongoing credit evaluations of its customers and maintains allowancesfor potential credit losses which, when realized, have generally been withinthe range of management’s expectations.

No customers accounted formore than 10% of revenues for the year ended December 31, 2002. Onecustomer accounted for 11% of revenues for the year ended December 31,2003. There were no customers that accounted for more than 10% of revenues forthe year ended December 31, 2004. Another customer accounted for 20% ofaccounts receivable at December 31, 2003. This receivable was collectedsubsequent to the end of the year. Another customer accounted for 24% ofaccounts receivable at December 31, 2004.

The Company purchases itsprofessional audio encoding devices and movie theater playback systems from severalthird-party manufacturers who manufacture these units according to the Company’sspecifications. Although the Company believes it could find alternativesuppliers if necessary, a lack of key components could cause significantdelays, increased costs, or quality control problems, which could have amaterial adverse effect on the Company’s business and results of operations.

The Company deposits itscash and cash equivalents in accounts with major financial institutions. Attimes, such investments may be in excess of insured limits. The Company investsits short-term and long-term investments in accounts with major financialinstitutions, investment grade municipal securities and United States agencysecurities. The Company has not incurred any related losses on any of itsinvestments.

***Allowance ForDoubtful Accounts***

The Company continuallymonitors customer payments and maintains a reserve for estimated lossesresulting from its customers’ inability to make required payments. Indetermining the reserve, the Company evaluates the collectibility of itsaccounts receivable based upon a variety of factors. In cases where the Companybecomes aware of circumstances that may impair a specific customer’s ability tomeet its financial obligations, the Company records a specific allowanceagainst amounts due. For all other customers, the Company recognizes allowancesfor doubtful accounts based on its historical write-off 

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note2—Significant Accounting Policies (Continued)**

experiencein conjunction with the length of time the receivables are past due, customercreditworthiness, geographic risk and the current business environment. Actualfuture losses from uncollectible accounts may differ from the Company’sestimates. The Company’s allowance for doubtful accounts totaled $429 and $402at December 31, 2003 and 2004, respectively.

***Inventories***

Inventories are stated atthe lower of cost or market. Cost is determined using the first-in, first-outmethod. The Company evaluates its ending inventories for estimated excessquantities and obsolescence. The Company’s evaluation includes the analysis offuture sales demand by product, within specific time horizons. Inventories inexcess of projected future demand are written down to net realizable value. Inaddition, the Company assesses the impact of changing technology on inventorybalances and writes-down inventories that are considered obsolete. The Companyrecorded an inventory write-down of $3,871 related to its monochrome projectorinventory during the year ended December 31, 2004 due to declines infuture demand and technological obsolescence.

***Property andEquipment***

Property and equipment arerecorded at cost. Depreciation is calculated using the straight-line methodover the related assets’ estimated useful lives, which is generally two to fiveyears for machinery and equipment and three to seven years for office furnitureand equipment. Leasehold improvements are amortized over their estimated usefullives, or the lease term, whichever is shorter. Expenditures that materiallyincrease asset life are capitalized, while ordinary maintenance and repairs areexpensed as incurred.

***Long-Lived Assets***

The Company periodicallyassesses potential impairments to its long-lived assets in accordance with theprovisions of Statement of Financial Accounting Standards (“SFAS”) No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets.” An impairmentreview is performed whenever events or changes in circumstances indicate thatthe carrying value may not be recoverable. Factors considered by the Companyinclude, but are not limited to: significant underperformance relative toexpected historical or projected future operating results; significant changesin the manner of use of the acquired assets or the strategy for the Company’soverall business; and significant negative industry or economic trends. Whenthe Company determines that the carrying value of a long-lived asset may not berecoverable based upon the existence of one or more of the above indicators ofimpairment, the Company estimates the future undiscounted cash flows expectedto result from the use of the asset and its eventual disposition. If the sum ofthe expected future undiscounted cash flows and eventual disposition is lessthan the carrying amount of the asset, the Company recognizes an impairmentloss. An impairment loss is reflected as the amount by which the carryingamount of the asset exceeds the fair market value of the asset, based on thefair market value if available, or discounted cash flows if not. To date, therehas been no impairment of long-lived assets.

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note2—Significant Accounting Policies (Continued)**

***Goodwill andIntangible Assets***

The Company accounts forgoodwill in accordance with SFAS No. 142, “Goodwill and Other IntangibleAssets,” (“SFAS 142”), which, among other things, establishes new standards forgoodwill acquired in a business combination, eliminates the amortization ofgoodwill and requires the carrying value of goodwill and certain non-amortizingintangibles to be evaluated for impairment on an annual basis. As required bySFAS 142, the Company performs an impairment test on recorded goodwill bycomparing the estimated fair value of each of the Company’s reporting units tothe carrying value of the assets and liabilities of each unit, includinggoodwill. The Company determines fair value of the reporting units principallybased upon management’s determination of the value of the Company as a whole.This value is determined by considering a number of factors, including theCompany’s historical and projected financial results, valuation analyses, risksfacing the Company and the liquidity of its common stock. If the carrying valueof the assets and liabilities of the reporting units, including goodwill, wereto exceed the Company’s estimation of the fair value of the reporting units,the Company would record an impairment charge in an amount equal to the excessof the carrying value of goodwill over the implied fair value of the goodwill.The Company did not have any goodwill at December 31, 2004. The Companyexpects to record goodwill in connection with the acquisition of Lowry DigitalImages, Inc. (“LDI”) mentioned in Note 22.

The Company accounts forintangible assets in accordance with SFAS No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets,” (“SFAS 144”). This standardrequires that intangible assets with definite lives be amortized over theirestimated useful lives and reviewed for impairment whenever events or changesin circumstances indicate an asset’s carrying value many not be recoverable.Recoverability of an asset is measured by comparison of its carrying amount tothe expected future undiscounted cash flows that the asset is expected togenerate. If it is determined that an asset is not recoverable, an impairmentloss is recorded in the amount by which the carrying amount of the assetexceeds its fair value. The Company’s intangible assets principally consist ofacquired technology and internally developed patents and trademarks, which arebeing amortized over their respective lives. No intangible or long-lived assetswere impaired as of December 31, 2004. The Company expects to recordintangible assets in connection with the acquisition of LDI mentioned in Note22.

***Revenue Recognition***

The Company recognizesrevenue in accordance with the guidelines of the Securities and ExchangeCommission (“SEC”) Staff Accounting Bulletin (“SAB”) No. 101, “RevenueRecognition in Financial Statements,” as amended by SAB No. 104. Revenuefrom the sale of cinema hardware products is recorded upon shipment assuming:title and risk of loss has transferred to the customer; no significant Companyobligations remain; prices are fixed or determinable; and collection of therelated receivable is reasonably assured. The licensing, encoding andduplication of motion picture soundtracks for use in the audio playback systemsmanufactured by the Company is undertaken under arrangements with major filmproducers and distributors. Revenue arising from the licensing and duplication ofsoundtracks is recognized upon completion assuming: prices are fixed ordeterminable; no significant Company obligations remain; and collection of therelated receivable is reasonably assured. Direct costs associated with deferredrevenue are deferred and included in other assets. Included in the balancesheet are $519 and $296 of deferred revenue and costs, respectively, at December 31,2004.

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note2—Significant Accounting Policies (Continued)**

Revenue from licensingaudio technology, trademarks and know-how is generated from licensingagreements with consumer electronics product manufacturers that pay a per-unitlicense fee for products manufactured under those license agreements. Licenseesgenerally report manufacturing information within 30 to 60 days after theend of the quarter in which such activity takes place. Consequently, theCompany recognizes revenue from these licensing agreements on a three-month lagbasis, generally in the quarter following the quarter of manufacture, providedamounts are fixed or determinable and collection is reasonably assured. Use ofthis lag method allows for the receipt of licensee royalty reports prior to therecognition of revenue.

Revenue from the sale ofmulti-channel audio content is recorded upon shipment to retail accounts or endcustomers, assuming: title and risk of loss has transferred to the customer;prices are fixed or determinable; no significant Company obligations remain;and collection of the related receivable is reasonably assured. The Company’sshipping terms are customarily FOB shipping point with title transfer and riskof loss transferring to the customer upon shipment.

Management provides forreturns on product sales based on historical experience and adjusts suchreserves as considered necessary.

***Shipping andHandling Costs***

Costs related to theshipment of products to customers are included in cost of goods sold.

***Patents andTrademarks***

Costs incurred in securingpatents and trademarks protecting the Company’s proprietary technology andbrand name are capitalized. Patent and trademark costs are amortized over fiveyears and ten years, respectively. The amortization period commences when thepatent or trademark is issued. Amortization of patent and trademark costsamounted to $73, $103 and $74 for the years ended December 31, 2002, 2003and 2004, respectively. Accumulated amortization at December 31, 2003 and2004 amounted to $501 and $575, respectively.

***Research andDevelopment Costs***

Research and developmentcosts are expensed as incurred.

***In-process Researchand Development***

Costs to acquirein-process research and development (“IPR&D”) projects and technologieswhich have no alternative future use and which have not reached technologicalfeasibility at the date of acquisition are expensed as incurred.

***Provision forWarranty Claims***

The Company offers alimited warranty for product sales that generally provides customers with oneor three year warranty period against defects. Provisions for warranty claimsare recorded at the time products are sold and are reviewed and adjusted bymanagement periodically to reflect actual and anticipated experience.

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note2—Significant Accounting Policies (Continued)**

An analysis of changes inthe liability for product warranty claims is as follows:
| ** **                      | ** ** | **For the Years Ended  December 31,** | ** ** |
|---------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                      | ** ** | **2002**                                                  | ** ** | **2003** | ** ** | **2004** | ** ** |
| Balance at beginning of  period |       | $                                                         | 36         |   | $ | 52 | ** ** | **$** | **81** | ** ** |
| Current year provision          |       | 18                                                        |       | 57 | ** ** | **135** | ** ** |
| Expenditures                    |       | (2                                                        | )          | (28 | ) | **(54** | **)** |
| Balance at end of period        |       | $                                                         | 52         |   | $ | 81 | ** ** | **$** | **162** | ** ** |

 

***Foreign CurrencyTranslation***

The functional currency ofthe Company’s subsidiaries is the United States dollar and accordingly, gainsand losses resulting from the translation of accounts denominated in currenciesother than the functional currency are reflected in the determination of netincome. Translation losses amounted to $1, $191 and $119 for the years ended December 31,2002, 2003 and 2004, respectively.

***AdvertisingExpenses***

Advertising andpromotional costs are expensed as incurred and amounted to $1,771, $2,376 and$2,508 for the years ended December 31, 2002, 2003 and 2004, respectively.

***ComprehensiveIncome***

The Company accounts forcomprehensive income in accordance with SFAS No. 130, “ComprehensiveIncome”, which established standards for reporting comprehensive income and itscomponents in financial statements. Comprehensive income, as defined, includesall changes in stockholders’ equity during a period from non-owner sources. Todate, comprehensive income does not differ from net income for the periodspresented.

***Income Taxes***

The Company accounts forincome taxes using the liability method. Under this method, the deferred taxassets and liabilities are measured each year based on the difference betweenthe financial statement and tax bases of assets and liabilities at theapplicable enacted tax rates. Additionally, a valuation allowance is recordedfor that portion of deferred tax assets for which it is more likely than notthat the assets will not be realized. The deferred tax provision is the resultof changes in the deferred tax assets and liabilities.

***Stock-BasedCompensation***

Since 1997, the Companyhas stock-based employee compensation plans, which are described more fully inNote 13. During 2003, the Company adopted the 2003 Employee Stock PurchasePlan. The Company accounts for its employee stock option and purchase plans inaccordance with the provisions of Accounting Principals Board (“APB”) Opinion No. 25,“Accounting for Stock Issued to Employees” and the related interpretations ofthe Financial Accounting Standards Board (“FASB”), “Accounting for CertainTransactions Involving Stock Compensation.” Accordingly, compensation expenserelated to 

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note2—Significant Accounting Policies (Continued)**

employeestock options is recorded, if on the date of the grant, the fair value of theunderlying stock exceeds the exercise price.

To date, options have beengranted at exercise prices that equal or exceed the market value of theunderlying common stock on the grant date. The following table illustrates theeffect on net income attributable to common stockholders and net income percommon share if the Company had applied the fair value recognition provisionsof SFAS No. 123, “Accounting for Stock-Based Compensation,” to stock-basedemployee compensation.
| ** **                                                                                                           | ** ** | **For the Years Ended  December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                                                           | ** ** | **2002**                                                  | ** ** | **2003** | ** ** | **2004** | ** ** |
| Net income attributable  to common stockholders:                                                                     |       |                                                      |       |   |   |   |   |
| As reported                                                                                                          |       | $                                                         | 4,402      |   | $ | 8,665 | ** ** | **$** | **9,976** | ** ** |
| Additional stock-based  compensation expense determined under the fair value method, net of tax                      |       | (225                                                      | )          | (604 | ) | **(1,465** | **)** |
| Pro forma                                                                                                            |       | $                                                         | 4,177      |   | $ | 8,061 | ** ** | **$** | **8,511** | ** ** |
| Net income attributable  to common stockholders per common share—basic:                                         | ** ** | ** **                                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| As reported                                                                                                          |       | $                                                         | 0.99       |   | $ | 0.95 | ** ** | **$** | **0.59** | ** ** |
| Per share effect of  additional stock-based compensation expense determined under the fair value  method, net of tax |       | (0.05                                                     | )          | (0.07 | ) | **(0.09** | **)** |
| Pro forma                                                                                                            |       | $                                                         | 0.94       |   | $ | 0.88 | ** ** | **$** | **0.50** | ** ** |
| Net income attributable  to common stockholders per common share—diluted:                                       | ** ** | ** **                                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| As reported                                                                                                          |       | $                                                         | 0.47       |   | $ | 0.80 | ** ** | **$** | **0.55** | ** ** |
| Per share effect of  additional stock-based compensation expense determined under the fair value  method, net of tax |       | (0.02                                                     | )          | (0.05 | ) | **(0.08** | **)** |
| Pro forma                                                                                                            |       | $                                                         | 0.45       |   | $ | 0.75 | ** ** | **$** | **0.47** | ** ** |

 

The key assumptions usedfor the determination of the fair value of stock and employee stock purchaseplans are further described in Note 13.

TheCompany accounts for stock issued to non-employees in accordance with theprovisions of SFAS No. 123 and Emerging Issues Task Force (“EITF”) Issue No. 96-18“Accounting for Equity Instruments That Are Issued to Other Than Employees forAcquiring, or in Conjunction with Selling, Goods and Services.” Under SFAS No. 123and EITF Issue No. 96-18, stock option awards issued to non-employees areaccounted for at fair value using the Black-Scholes option pricing model.Management believes that the fair value of the stock options is more reliablymeasured than the fair value of the services received. The fair value of eachnon-employee stock award is remeasured each period until a commitment date isreached, which is generally the vesting date. For non-employee awards, deferredstock-based compensation is not reflected in stockholders’ equity (deficit)until a commitment date is reached. See Recent Accounting Developments belowfor further discussion regarding the impact of adopting SFAS 123R in the thirdquarter of 2005.

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note 2—SignificantAccounting Policies (Continued)**

***Net Income Attributable to Common Stockholders PerCommon Share***

Basic net incomeattributable to common stockholders per common share is calculated by dividingnet income attributable to common stockholders for the period by the weightedaverage common shares outstanding during the period reduced by shares subjectto escrow. Diluted net income per share is calculated by dividing the netincome attributable to common stockholders for the period by the weightedaverage common shares outstanding, adjusted for all dilutive potential commonshare equivalents including shares issuable upon the exercise of stock options,and common stock warrants determined using the treasury stock method. Commonshare equivalents are excluded from the calculation if their effect isanti-dilutive. As the Company’s mandatorily redeemable preferred stock was notconvertible into shares of common stock, the mandatorily redeemable preferredstock was not considered a common share equivalent.

***Accretion of Redemption Value of MandatorilyRedeemable Preferred Stock***

The Company accreted theredemption value of mandatorily redeemable preferred stock ratably over theminimum period such stock is outstanding. In addition, accrued but unpaid dividendswere recorded to increase the carrying value of the mandatorily redeemablepreferred stock to the redemption value at maturity.

***Segment Information***

The Company uses the “managementapproach” in determining reportable business segments. The management approachdesignates the internal organization used by management for making operatingdecisions and assessing performance as the source for determining the Company’sreportable segments.

***Fair Value of Financial Instruments***

The carrying amount ofcash, cash equivalents, short-term investments, long-term investments, accountsreceivable, accounts payable and accrued liabilities approximates fair valuedue to the short-term nature of these instruments. The carrying amount of thebank line of credit approximates fair value based on the then currentincremental borrowing rates for similar types of borrowing arrangements.

***Recent Accounting Pronouncements***

In November 2004, the FASB issued SFAS No. 151,“Inventory Costs, an amendment of ARB No. 43, Chapter 4” (“SFAS 151”).SFAS 151 clarifies the types of costs that should be expensed rather thancapitalized as inventory. SFAS 151 also clarifies the circumstances under whichfixed overhead costs associated with operating facilities involved in inventoryprocessing should be capitalized. This statement is effective for fiscal yearsbeginning after June 15, 2005. The Company plans to adopt SFAS 151 in thefirst quarter of fiscal 2005. The Company has not determined the impact, ifany, that this statement will have on the Company’s consolidated financialposition or results of operations.

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note2—Significant Accounting Policies (Continued)**

In December 2004, theFASB issued SFAS No. 123R, “Share-Based Payment” (“SFAS 123R”), anamendment to SFAS No. 123, “Accounting for Stock-Based Compensation.”SFAS 123R requires compensation expense related to stock-based awards tobe recognized in the financial statements. The amount of compensation expensewill be measured based upon the fair value of the stock-based awards at thedate of grant. This statement is effective for public companies as of the firstinterim or annual reporting period beginning after June 15, 2005. TheCompany plans to adopt SFAS 123R beginning in the third quarter of fiscal 2005.The expected effects of the adoption of SFAS 123R on the Company’s financialresults for the next five years, based on stock-based awards granted as of December 31,2004, is as follows:
| ** **                                                                           | ** ** | **Expenses by Fiscal Year** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                           | ** ** | **2005**                                   | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** |
| ** **                                                                           | ** ** | **(unaudited)**                            | ** ** |
| ** **                                                                           | ** ** | **(in thousands)**                    | ** ** |
| Additional  stock-based compensation expense under SFAS 123R before tax benefit |       | $                                          | 933        |   | $ | 1,161 |   | $ | 503 |   | $ | 88 |   | $ | — |   |
|                                                                                      |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

This statement alsoaffects the presentation of tax benefits for option exercises in the statementof cash flows. Prior to adoption SFAS 123R, the benefit is classified in cashprovided by operating activities. Upon adoption, the tax benefit will beclassified in cash provided by financing activities. The Company is in theprocess of determining the impact the adoption will have on the Company’sconsolidated statement of cash flows.

**Note 3—Cash,Short-term and Long-term Investments**

Cash, short-term and long-term investments consist ofthe following:
| ** **                                     | ** ** | **As of December 31,** | ** ** |
|------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                     | ** ** | **2003**                              | ** ** | **2004** | ** ** |
| Cash and cash  equivalents:                    |       |                                  |       |   |   |
| Cash                                           |       | $                                     | 12,357     | ** ** | **$** | **15,116** | ** ** |
| United States government and agency securities |       | 17,996                                | ** ** | **—** | ** ** |
| Municipal securities                           |       | 8,890                                 | ** ** | **6,155** | ** ** |
| Total cash and cash equivalents                |       | $                                     | 39,243     | ** ** | **$** | **21,271** | ** ** |
| Short-term investments:                        | ** ** | ** **                            | ** ** | ** ** | ** ** |
| Certificates of deposit                        |       | $                                     | 2,192      | ** ** | **$** | **11,787** | ** ** |
| United States government and agency securities |       | —                                | ** ** | **12,086** | ** ** |
| Municipal securities                           |       | 57,954                                | ** ** | **69,167** | ** ** |
| Total short-term investments                   |       | $                                     | 60,146     | ** ** | **$** | **93,040** | ** ** |
| Long-term investments:                         | ** ** | ** **                            | ** ** | ** ** | ** ** |
| United States government and agency securities |       | $                                     | 1,997      | ** ** | **$** | **—** | ** ** |
| Municipal securities                           |       | 1,001                                 | ** ** | **2,657** | ** ** |
| Total long-term  investments                   |       | $                                     | 2,998      | ** ** | **$** | **2,657** | ** ** |

 

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note3—Cash, Short-term and Long-term Investments (Continued)**

The contractual maturitiesof short-term investments at December 31, 2004 are as follows:
| Due within one  year                    |   | $      | 51,099 |   |
|-----------------------------------------|--------|--------|--------|--------|
| Due after one  year through five years  |   | — |   |
| Due after five  years through ten years |   | 1,003  |   |
| Due after ten  years                    |   | 40,938 |   |
| Total short and  long-term investments  |   | $      | 93,040 |   |

 

Thecontractual maturities of long-term investments at December 31, 2004 areas follows:
| Due after one  year through five years |   | 2,657 |   |
|----------------------------------------|--------|-------|--------|
| Total short and  long-term investments |   | $     | 2,657  |   |
|                                        |        |       |        |  |

 

**Note 4—Inventories**

Inventoriesconsist of the following:
| ** **        | ** ** | **As of   December 31,** | ** ** |
|-------------------|------------|-----------------------------------------|------------|
| ** **        | ** ** | **2003**                                | ** ** | **2004** | ** ** |
| Raw materials     |       | $                                       | 1,370      | ** ** | **$** | **1,313** | ** ** |
| Work in process   |       | 8                                       | ** ** | **—** | ** ** |
| Finished goods    |       | 6,174                                   | ** ** | **2,356** | ** ** |
| Total inventories |       | $                                       | 7,552      | ** ** | **$** | **3,669** | ** ** |

 

**Note 5—Property andEquipment**

Propertyand equipment consist of the following:
| ** **                      | ** ** | **As of December 31,** | ** ** |
|---------------------------------|------------|---------------------------------------|------------|
| ** **                      | ** ** | **2003**                              | ** ** | **2004** | ** ** |
| Machinery and  equipment        |       | $                                     | 2,511      | ** ** | **$** | **3,036** | ** ** |
| Office furniture  and fixtures  |       | 1,963                                 | ** ** | **2,693** | ** ** |
| Leasehold  improvements         |       | 2,599                                 | ** ** | **2,926** | ** ** |
|                            | ** ** | 7,073                                 |       | **8,655** |   |
| Less: Accumulated  depreciation |       | (3,981                                | )          | **(5,116** | **)** |
| Property and  equipment, net    |       | $                                     | 3,092      | ** ** | **$** | **3,539** | ** ** |

 

Depreciation expense was$829, $807 and $1,135 for the years ended December 31, 2002, 2003 and2004, respectively.

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note 6—Intangibles**

Intangiblesconsist of the following:
| ** **                                        | ** ** | **As of   December 31,  2003** | ** ** | **As of   December 31,  2004** | ** ** |
|---------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| Acquired  technology                              |       |                                          | $          | —                                        |       |   |   | $ | 1,426 |   |   |
| Patents and  trademarks                           |       |                                          | 925        |                                          |       |   | 1,017 |   |   |
|                                              |       |                                          | 925        |                                          |       |   | 2,443 |   |   |
| Less:                                             |       |                                          |       |                                          |       |   |   |   |   |
| Accumulated  amortization, acquired technology    |       |                                          | —     |                                          |       |   | 89 |   |   |
| Accumulated  amortization, patents and trademarks |       |                                          | 501        |                                          |       |   | 575 |   |   |
| Intangibles, net                                  |       |                                          | $          | 424                                           |       |   |   | $ | 1,779 |   |   |

 

During the third quarter of 2004, the Companycompleted an acquisition (Note 9) for net cash consideration of approximately$1,400, of which approximately $1,426 was allocated to acquired technology withan estimated useful life of eight years. Aggregate amortization expense foracquired technology totaled $89 for the year ended December 31, 2004.

As of December 31,2004, expected future amortization of acquired technology is as follows:
| **Fiscal year:** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------|------------|------------|------------|------------|------------|
| 2005                  |       | $          | 178        |       |
| 2006                  |       | 178        |       |
| 2007                  |       | 178        |       |
| 2008                  |       | 178        |       |
| 2009                  |       | 178        |       |
| Thereafter            |       | 447        |       |
|                  |       | $          | 1,337      |       |

 

**Note 7—AccruedExpenses**

Accruedexpenses consist of the following:
| ** **                            | ** ** | **As of December 31,** | ** ** |
|---------------------------------------|------------|---------------------------------------|------------|
| ** **                            | ** ** | **2003**                              | ** ** | **2004** | ** ** |
| Accrued payroll  and related benefits |       | $                                     | 1,906      | ** ** | **$** | **2,409** | ** ** |
| Production  advance                   |       | 1,446                                 | ** ** | **1,248** | ** ** |
| Accrued royalties                     |       | 692                                   | ** ** | **507** | ** ** |
| Vendor supply  agreement              |       | 450                                   | ** ** | **—** | ** ** |
| Other                                 |       | 1,301                                 | ** ** | **1,524** | ** ** |
| Total accrued  expenses               |       | $                                     | 5,795      | ** ** | **$** | **5,688** | ** ** |

 

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note 8—Bank Line ofCredit**

The Company replaced its prior working capital creditfacility with a new $10,000 facility that expires on June 30, 2005. Thisfacility automatically renews for a one year term. The bank agreement providesfor working capital financing and is unsecured. The bank agreement requires theCompany to comply with certain covenants including a tangible effective networth of $60,000, increasing by 50% of net income on an annual basis. Thecovenants also require the Company to keep $2,000 in cash or securities at thebank.

At December 31,2004,there were no balances outstanding under this agreement and there was $10,000of available borrowings under this credit facility. Future borrowings will bearinterest based on either of the two options the Company selects at the time ofadvances 1) a rate equal to 2% above the Bank’s LIBOR, or 2) a rateequal to the Base Rate as quoted from the bank less one-half percent. Acommitment fee of $10 was paid for this line of credit.

**Note 9—Acquisition**

In July 2004, the Company completed theacquisition of QDesign Corporation for $1,500 in cash. Under the terms of theacquisition, the Company has also contingently agreed to pay an additionalamount up to a maximum of $450 in cash, which is held by the Company in arestricted account. The Company classified the restricted cash in other currentand non-current assets. The contingent payment is being accounted for as compensationexpense ratably over the three-year period ending July 2007, and will bepaid out if certain criteria are met.

The allocation of thepurchase price to the assets acquired and liabilities assumed based on theestimated fair values was as follows:
| Cash acquired           |   | $     | 117    |   |
|-------------------------|--------|-------|--------|--------|
| Property and  equipment |   | 15    |   |
| Acquired  technology    |   | 1,426 |   |
| Other assets            |   | 8     |   |
| Total assets acquired   |   | 1,566 |   |
| Liabilities  assumed    |   | 66    |   |
| Total                   |   | $     | 1,500  |   |

 

Amortizable intangible assets consist of acquiredtechnology with a useful life of eight years.

The results of operationsof this acquisition have been included in the Company’s condensed consolidatedstatements of operations since the completion of the acquisition in July 2004.Results of operations for the acquisition for periods prior to the acquisitionwere not material to the Company and, accordingly, pro forma results ofoperations have not been presented.

**Note 10—Commitmentsand Contingencies**

Warehouse, officefacilities and certain office equipment are leased under operating leasesexpiring in various years through 2007. Some leases contain renewal options andescalation clauses including increases 

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note10—Commitments and Contingencies (Continued)**

in annual rents based upon increases in the consumerprice index. Minimum future rental payments under non-cancelable operatingleases, net of sublease income are as follows:
| **Years Ending December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|------------|------------|
| 2005                                         |       | $          | 903        |       |
| 2006                                         |       | 750        |       |
| 2007                                         |       | 559        |       |
| 2008                                         |       | 333        |       |
| 2009                                         |       | 292        |       |
| 2010 and thereafter                          |       | 870        |       |
|                                         |       | $          | 3,707      |       |

 

Rent expense, net of sublease income amounted to $525,$485 and $883 for the years ended December 31, 2002, 2003 and 2004,respectively.

During its normal course of business, the Company hasmade certain indemnities, commitments and guarantees under which it may berequired to make payments in relation to certain transactions. Thoseindemnities include intellectual property indemnities to the Company’scustomers in connection with the sale of its products and the licensing of itstechnology, indemnities for liabilities associated with the infringement ofother parties’ technology based upon the Company’s products and technology, andindemnities to directors and officers of the Company to the maximum extentpermitted under the laws of the State of Delaware. The duration of theseindemnities, 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. To date, the Company has not beenrequired to make any payments and has not recorded any liability for theseindemnities, commitments and guarantees in the accompanying balance sheets. TheCompany does, however, accrue for losses for any known contingent liability,including those that may arise from indemnification provisions, when futurepayment is probable.

In March 2005, in connection with the U.S.Internal Revenue Service’s (“ IRS”) regular examination of the Company’s taxreturn for the year ended December 31, 2002, the IRS proposed adjustmentsrelated to certain items included in its return. The Company does not agreewith the proposed adjustments and intends to appeal these adjustments. If theIRS prevails in its position, the Company’s federal income tax due for 2002would increase by approximately $1.9 million, plus interest. The IRS could makesimilar claims for years subsequent to 2002 in future audits.

Although the final resolution of the adjustments isuncertain, based on currently available information, the Company believes thatthe ultimate outcome will not have a material adverse effect on the Company’sfinancial position, cash flows or overall trends in the results of operations.There is the possibility of a material adverse impact on the results ofoperations in the period in which the matter is ultimately resolved, if it isresolved unfavorably, or in the period in which an unfavorable outcome becomesprobable and reasonably estimable.

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note10—Commitments and Contingencies (Continued)**

In connection with the Company’s enforcementactivities relating to its intellectual property rights and to stopunauthorized use of its technology and trademarks, the Company terminated itslicense agreement to Sunplus Technology Co., Ltd. (“Sunplus”). In response,Sunplus filed suit against the Company alleging breach of contract arising fromthe Company’s termination of their license agreement. The Company has prevailedon several preliminary motions by Sunplus seeking to enjoin the Company fromterminating the license agreement. The Company has filed a cross-complaintseeking a judicial declaration that the Company properly terminated the licenseagreement and to recover damages arising from Sunplus’ breach of the agreement.The Company believes Sunplus’ claim is without merit and intends to vigorouslydefend the case.

In the normal course of business, the Company issubject to certain claims and litigation, including unasserted claims. TheCompany is of the opinion that, based on information presently available, anysuch legal matters will not have a material adverse effect on the financialposition, results of operations or cash flows of the Company.

As stated in Note 22, theCompany has agreed to invest $3,500 in the business of LDI on or prior to June 30,2005 to enable LDI to make certain capital expenditures and, if and to theextent LDI meets specified gross profit milestones, to invest up to anadditional $1,500 through the end of 2006.

**Note 11—Related PartyTransactions**

One of the Company’s 5% or greater stockholders isboth a customer of and a supplier to the Company. Sales to this stockholdertotaled $569, $615 and $648 for the years ended December 31, 2002, 2003and 2004, respectively. Purchases from the stockholder totaled $0, $0 and $39 forthe years ended December 31, 2002, 2003 and 2004, respectively. Accountsreceivable at December 31, 2003 and 2004 include $102 and $176,respectively, due from this stockholder.

Sales to another 5% or greater stockholder totaled$369 and $369 for the years ended December 31, 2002 and 2003 respectively.Accounts receivable at December 31, 2003 include $129 due from thisstockholder. This entity was not considered a related party in 2004.

The Company had sales of $126, $90 and $219 for theyears ended December 31, 2002, 2003 and 2004, respectively, to a customerwhich is an 18.8% owned affiliate. Accounts receivable at December 31,2003 and 2004 include $25 and $132, respectively, due from this affiliate.

The Company purchased webhosting and graphic design services from an entity controlled by a person whois the son of one of the Company’s former board members and was then also astockholder. The Company paid $85 and $12 for such services during the yearsended December 31, 2002 and 2003, respectively. This entity was notconsidered a related party in 2004.

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note 12—Income Taxes(Continued)**

Theprovision for income taxes consists of the following:
| ** **                        | ** ** | **Years Ended  December 31,** | ** ** |
|-----------------------------------|------------|-----------------------------------------|------------|
| ** **                        | ** ** | **2002**                                | ** ** | **2003** | ** ** | **2004** | ** ** |
| Current:                          |       |                                    |       |   |   |   |   |
| Federal                           |       | $                                       | 3,700      |   | $ | 1,462 | ** ** | **$** | **5,307** | ** ** |
| State                             |       | 965                                     |       | 1,106 | ** ** | **1,358** | ** ** |
| Foreign                           |       | 2,164                                   |       | 3,174 | ** ** | **960** | ** ** |
| Total current                     |       | 6,829                                   |       | 5,742 | ** ** | **7,625** | ** ** |
| Deferred:                         | ** ** | ** **                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Federal                           |       | (2,821                                  | )          | (242 | ) | **(1,774** | **)** |
| State                             |       | (320                                    | )          | (132 | ) | **(316** | **)** |
| Total deferred                    |       | (3,141                                  | )          | (374 | ) | **(2,090** | **)** |
| Total provision for  income taxes |       | $                                       | 3,688      |   | $ | 5,368 | ** ** | **$** | **5,535** | ** ** |

 

The components oftemporary differences that gave rise to deferred income tax are as follows:
| ** **                            | ** ** | **As of  December 31,** | ** ** |
|---------------------------------------|------------|----------------------------------------|------------|
| ** **                            | ** ** | **2003**                               | ** ** | **2004** | ** ** |
| Deferred tax  assets:                 |       |                                   |       |   |   |
| Accrued revenues                      |       | $                                      | 3,986      | ** ** | **$** | **4,650** | ** ** |
| Inventory                             |       | —                                 | ** ** | **1,877** | ** ** |
| Credit carryforwards                  |       | 1,421                                  | ** ** | **1,340** | ** ** |
| Royalty expense                       |       | 1,115                                  | ** ** | **—** | ** ** |
| Depreciation and amortization         |       | 669                                    | ** ** | **500** | ** ** |
| Accrued expenses                      |       | 663                                    | ** ** | **992** | ** ** |
| Other assets                          |       | 260                                    | ** ** | **285** | ** ** |
| Total deferred tax assets             |       | 8,114                                  | ** ** | **9,644** | ** ** |
| Deferred tax liabilities:             | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Depreciation and amortization         |       | (562                                   | )          | **—** | ** ** |
| Total deferred tax liabilities        |       | (562                                   | )          | **—** | ** ** |
| Deferred tax assets, net              |       | 7,552                                  | ** ** | **9,644** | ** ** |
| Current deferred tax assets           |       | 6,025                                  | ** ** | **9,144** | ** ** |
| Non-current  deferred tax assets, net |       | $                                      | 1,527      | ** ** | **$** | **500** | ** ** |

 

There is no valuation allowance for deferred taxassets at December 31, 2004, based on management’s assessment of theCompany’s ability to utilize these deferred tax assets. Realization of the netdeferred tax assets of $9.6 million is dependent on the Company generatingsufficient taxable income in the future. Although realization is not assured,the Company believes it is more likely than not that the deferred tax 

77

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note12—Income Taxes (Continued)**

assets will be realized.The amount of the deferred tax assets considered realizable, however, could bereduced in the future if estimates of future taxable income are reduced.

The income tax provision excludes the current yearincome tax deductions related to the issuance of common stock from the exerciseof stock options for which no compensation expense was recorded for accountingpurposes. The income tax benefit from these deductions resulted in an increaseto additional paid-in capital of approximately $3.4 million and $4.3 million,respectively, for the years ended December 31, 2003 and 2004 and acorresponding decrease in the income taxes payable in the accompanying balancesheets.

The provision (benefit)for income taxes differs from the amount obtained by applying the federalstatutory income tax rate to income (loss) before provision (benefit) forincome taxes as follows:
|                             | ** ** | **Years Ended  December 31,** | ** ** |
|----------------------------------|------------|-----------------------------------------|------------|
| ** **                       | ** ** | **2002  **                    | ** ** | **  2003  ** | ** ** | **  2004  ** | ** ** |
| Statutory federal  rate          |       |                                    | 34.0       | % |   |   | 34.0 | % |   |   | **35.0** | **%** |   |
| State income  taxes, net         |       |                                    | 4.3        |   |   |   | 4.2 |   |   |   | **4.5** | ** ** |   |
| Valuation  allowance             |       |                                    | (2.2       | ) |   |   | — |   |   |   | — | ** ** |   |
| Effect of varying  foreign rates |       |                                    | (0.3       | ) |   |   | (4.5 | ) |   |   | **(1.5** | **)** |   |
| Other                            |       |                                    | 1.3        |   |   |   | 1.5 |   |   |   | **(2.3** | **)** |   |
| Effective tax rate               |       |                                    | 37.1       | % |   |   | 35.2 | % |   |   | **35.7** | **%** |   |

 

The Company has not provided for U.S. deferred incometaxes or foreign withholding taxes on the undistributed earnings of itsnon-U.S. subsidiaries as of December 31, 2004, since these earnings areintended to be reinvested indefinitely.

As of December 31, 2004, the Company had foreigntax credit carryforwards of approximately $1.3 million, which expire in 2014.

During the years ended December 31,2002, 2003 and 2004, the Company received a tax holiday from the Chinese taxingauthorities. In future periods, the Company expects to be taxed on income inChina at 17%.

**Note 13—Stock OptionPlans**

In 1997, the Company adopted a stock option plan (the “1997Plan”) for eligible employees, directors and consultants. In 2002, the Companyadopted a stock option plan (the “2002 Plan”) for management and certain keyemployees. Options granted under the plans may be incentive stock options intendedto satisfy the requirements of Section 422 of the Internal Revenue Code of1986, as amended, and the regulations thereunder, or non-qualified options.Options generally become exercisable over a four-year period and expire in tenyears. The total number of shares of common stock that may be issued under bothplans amounted to a maximum of 2,071,051. Options granted prior to 2002 weregranted at exercise prices equal to the preferred stock financing prices, whichwere in excess of the estimated fair value of the underlying common stock.

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note13—Stock Option Plans (Continued)**

In March 2002, the Company offered a stock optionreplacement program for employees, directors and non-employee consultantsparticipating in the existing Plan. Under the stock option replacement program,participants were able to elect to cancel their current options and have thoseoptions replaced after six months and one day with options that will have anexercise price equal to the stock’s then-current fair value. Options topurchase a total of 930,250 shares were cancelled under the stock optionreplacement program. On September 30, 2002, six months and 15 daysafter the cancellation of options exchanged under the option replacementprogram, the Company granted options to purchase a total of 929,250 shares ofcommon stock as replacement awards at an exercise price of $1.02, whichrepresented the fair value of the Company’s common stock on that date.

In April 2003, the Company’s Board adopted the2003 Equity Incentive Plan (the “2003 Plan”) under which an additional 928,949shares were authorized for future issuances of common stock options.Additionally, the shares available for issuances of common stock options underthe 1997 and 2002 Plans were transferred to the 2003 Plan for future issuancesof common stock options. The 2003 Plan contains a provision for an automaticincrease in the number of shares available for grant starting January 1,2004 and each January thereafter until and including January 1, 2013,subject to certain limitations, by a number of shares equal to the lesser of:1) four percent of the number of shares issued and outstanding on theimmediately preceding December 31, 2) 1,500,000 shares, or 3) a numberof shares set by the Board of Directors. At December 31, 2003, a total of917,545 shares were available for future grant under the Company’s 2003 Plan.In accordance with the 2003 Plan provisions, there was no increase in thenumber of shares available for future grants on January 1, 2004.

During 2000 and 2001, options to purchase  50,000 and 5,000 shares, respectively, weregranted to non-employee directors or consultants.

In 2002, the Company granted options to purchase265,500 shares of common stock to non-employee consultants, all of which werere-grants under the stock option replacement program. Compensation expenserelated to the fair value of stock options granted to non-employees isrecognized over the service period and was determined using the Black-Scholesoption pricing model using the following assumptions: risk-free interest rateof 4%; contractual life ranging from five to ten years; dividend yield of 0%;and expected volatility of 50%. At each reporting date, the Company revaluesthe stock-based compensation expense related to unvested non-employee optionsusing the Black-Scholes option pricing model. As a result, stock-basedcompensation will fluctuate with changes in the fair value of the Company’scommon stock. In connection with the grant of stock options to consultantsduring 2002, the Company recorded stock-based compensation expense in selling,general and administrative expense of $138, $152 and $273 for the years ended December 31,2002, 2003 and 2004, respectively.

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note13—Stock Option Plans (Continued)**

The following tablesummarizes information about stock option activity: 
| ** **                                                    | ** ** | **Options  Outstanding** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|---------------------------------------------------------------|------------|--------------------------|------------|------------------------------------------------|------------|
| Options  outstanding at December 31, 2001                |       | 1,036,125                |       |                                           | $          | 4.04 |   |   |
| Granted                                                       |       | 1,778,250                |       |                                           | 1.02       |   |   |
| Exercised                                                     |       | —                   |       |                                           | —     |   |   |
| Expired or cancelled                                          |       | (942,750                 | )          |                                           | 4.04       |   |   |
| Options outstanding at December 31, 2002                 |       | 1,871,625                |       |                                           | 4.04       |   |   |
| Granted                                                       |       | 223,205                  |       |                                           | 18.09      |   |   |
| Exercised                                                     |       | (371,883                 | )          |                                           | 1.38       |   |   |
| Expired or cancelled                                          |       | (13,625                  | )          |                                           | 2.56       |   |   |
| Options outstanding at December 31, 2003                 |       | 1,709,322                |       |                                           | 3.32       |   |   |
| Granted                                                       |       | 571,499                  |       |                                           | 22.05      |   |   |
| Exercised                                                     |       | (448,685                 | )          |                                           | 1.13       |   |   |
| Expired or cancelled                                          |       | (28,065                  | )          |                                           | 17.58      |   |   |
| Options  outstanding at December 31, 2004                |       | 1,804,071                |       |                                           | $          | 10.15 |   |   |
| Options available  for future grant at December 31, 2004 |       | 299,920                  |       |                                           |       |   |   |

 
| ** **                                  | ** **  | ** **          | ** ** | **Options Outstanding** | ** **                                               | **Options Exercisable** | ** **                                              |
|---------------------------------------------|-------------|---------------------|------------|------------------------------|----------------------------------------------------------|------------------------------|---------------------------------------------------------|
| **Range of Exercise Prices** | ** **  | ** **          | ** ** | ** **                   | **Number  Outstanding at  December 31,  2004** | ** **                   | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Number  Exercisable at   December 31,   2004** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| $                                           | 1.02        |  –   | $          |   3.07                  |                                                     |                         | 981,271                                                 |   |   |   | 7.70 |   |   |   | $ | 1.02 |   |   |   | 555,021 |   |   |   | $ | 1.02 |   |   |
|                                        | 3.08        |  –        |       |   6.16                  |                                                     |                         | 10,925                                                  |   |   |   | 4.30 |   |   |   | 4.16 |   |   |   | 8,516 |   |   |   | 4.03 |   |   |
|                                        | 6.17        |  –        |       |   9.23                  |                                                     |                         | 10,250                                                  |   |   |   | 8.20 |   |   |   | 8.02 |   |   |   | 2,562 |   |   |   | 8.02 |   |   |
|                                        | 9.24        |  –        |       | 12.31                        |                                                     |                         | 2,750                                                   |   |   |   | 8.30 |   |   |   | 10.59 |   |   |   | 1,312 |   |   |   | 10.55 |   |   |
|                                        | 12.32       |  –        |       | 15.40                        |                                                     |                         | 73,000                                                  |   |   |   | 9.40 |   |   |   | 14.10 |   |   |   | 2,874 |   |   |   | 12.56 |   |   |
|                                        | 15.41       |  –        |       | 18.47                        |                                                     |                         | 91,875                                                  |   |   |   | 8.50 |   |   |   | 16.16 |   |   |   | 30,936 |   |   |   | 16.34 |   |   |
|                                        | 18.48  |  –        |       | 21.55                        |                                                     |                         | 36,250                                                  |   |   |   | 9.60 |   |   |   | 19.17 |   |   |   | 5,312 |   |   |   | 21.30 |   |   |
|                                        | 21.56       |  –        |       | 24.63                        |                                                     |                         | 560,500                                                 |   |   |   | 9.20 |   |   |   | 23.09 |   |   |   | 25,746 |   |   |   | 22.62 |   |   |
|                                        | 24.64       |  –        |       | 27.71                        |                                                     |                         | 29,750                                                  |   |   |   | 8.90 |   |   |   | 25.94 |   |   |   | 6,810 |   |   |   | 26.00 |   |   |
|                                        | 27.72       |  –        |       | 30.79                        |                                                     |                         | 7,500                                                   |   |   |   | 8.80 |   |   |   | 30.79 |   |   |   | 4,375 |   |   |   | 30.79 |   |   |
| $                                           | 1.02        |  –        |       | 30.79                        |                                                     |                         | 1,804,071                                               |   |   |   | 8.32 |   |   |   | $ | 10.15 |   |   |   | 643,464 |   |   |   | $ | 3.39 |   |   |
|                                             |             |                     |            |                              |                                                          |                              |                                                         |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Options exercisable at December 31, 2002 and 2003were 834,375 and 1,431,652, respectively, at weighted average exercise pricesof $1.34 and $1.64 per share, respectively.

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note13—Stock Option Plans (Continued)**

As further described inNote 2, the key assumptions used for determining the fair value of eachemployee option grant is estimated on the date of the grant using theBlack-Scholes option pricing model with the following weighted averageassumptions:
| ** **               | ** ** | **Years Ended  December 31,** | ** ** |
|--------------------------|------------|-----------------------------------------|------------|
| ** **               | ** ** | **  2002  **        | ** ** | **  2003  ** | ** ** | **  2004  ** | ** ** |
| Risk free  interest rate |       |                                    | 4.0        | % |   |   | 3.9 | % |   |   | **3.4** | **%** |   |
| Expected lives  (years)  |       |                                    | 4          |   |   |   | 4 |   |   |   | **4** | ** ** |   |
| Dividend yield           |       |                                    | 0          | % |   |   | 0 | % |   |   | **0** | **%** |   |
| Expected volatility      |       |                                    | 50         | % |   |   | 50 | % |   |   | **50** | **%** |   |

 

The weighted average fair value at grant date for theoptions granted for the years ended December 31, 2002, 2003 and 2004 was$1.02, $18.09, and $22.05, respectively.

In accordance with the evergreen provision in the 2003Plan, the Board of Directors, in January 2005, approved an increase in thenumber of shares reserved under the 2003 Plan by 682,703 shares.

On April 17,2003, the Company’s board adopted the 2003 Employee Stock Purchase Plan and the2003 Foreign Subsidiary Employee Stock Purchase Plan (“ESPP”), under which,subject to certain limitations, the initial aggregate number of shares of stockthat may be issued is 500,000, cumulatively increased on January 1, 2004and each January 1 therafter until and including January 1, 2013 bythe lesser of: 1) 500,000 shares, 2) one percent of the number ofshares of all classes of common stock of the Company outstanding on that date,or 3) a lesser amount determined by the Board of Directors. Under theemployee stock purchase plan, shares are only issued during the second andfourth quarter of each year. The values were estimated at the date of grantusing the following weighted average assumptions for 2003 and 2004:
| ** **              | ** ** | **2003** | ** ** | **2004** | ** ** |
|-------------------------|------------|----------|------------|----------|------------|
| Risk free interest rate |       | 1.2      | %          | 1.4      | %          |
| Expected lives (years)  |       | 1.2      |       | 1.3      |       |
| Dividend yield          |       | 0        | %          | 0        | %          |
| Expected volatility     |       | 50       | %          | 50       | %          |

 

In accordance with theevergreen provision in the ESPP, the Board of Directors approved an increase inthe number of shares reserved under the ESPP by 100,000 shares in January 2005.

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note 14—DefinedContribution Plan**

The Company has savings and investment plans,including a savings plan that qualifies as a defined contribution plan under Section 401(k) ofthe Internal Revenue Code, that allow eligible employees to allocate up to 15%of salary through payroll deductions. Substantially all full-time employees onthe payroll of the Company are eligible to participate in the plans. Prior to2004, the Company matched up to 50% of the employee’s contributions up to 6%.  Effective for 2004, the Company matches 50% ofthe first 4% of salary contributed to the plan and up to 6% if certainfinancial targets are met. For the years ending December 31, 2002, 2003and 2004, the costs of these matches were $160, $156 and $194, respectively.

**Note 15—Mandatorily Redeemable Preferred Stock**

In 1997, the Companyissued 5,943,536 shares of Series A preferred stock, $0.0001 par value pershare, for net proceeds of approximately $11,000 as a result of a completedprivate placement. These shares contained mandatory redemption provisions andwere redeemable at a price of $2.02 each plus accrued and unpaid dividends, 50%of the shares at October 24, 2002, and the remaining 50% at October 24,2003. As further described below, on October 22, 2002, the redemption datewas extended to May 24, 2004. Along with the issuance of the Series Apreferred stock, the Company issued 2,971,768 common stock warrants, each ofwhich entitles the holder to purchase one share of the Company’s common stockfor $0.02 per share. These warrants are further described in Note 16.

Additionally, inconnection with the private placement, the Company issued warrants to theplacement agent to purchase 29,717 shares of common stock at a price of $4.04per share, expiring on December 31, 2007. The estimated fair value ofthese warrants as determined using the Black-Scholes option pricing model wasinsignificant.

In January 2000, theCompany completed the issuance of 1,857,355 shares of Series B redeemablepreferred stock (“Series B preferred stock”) for net proceeds ofapproximately $3,689. These shares contained mandatory redemption provisionsand were redeemable at a price of $2.02 each, 50% of the shares on January 27,2005, and the remaining 50% on January 27, 2006. As further described below,on October 22, 2002, the redemption date was accelerated to May 24,2004. Along with the Series B preferred stock, the Company issued1,857,355 warrants, each of which entitles the holder to purchase one share ofthe Company’s common stock for $0.02 per share. These warrants are furtherdescribed in Note 16.

On October 22, 2002,the terms of the Series A preferred stock were amended to provide for theextension of the redemption from the equal installments due on October 24,2002 and October 24, 2003 to one installment due on May 24, 2004. Atthe same time, the redemption of the Series B preferred stock wasaccelerated to coincide with the Series A redemption on May 24, 2004.In addition, the dividend rate was increased from 8% to 10% per annum for accrualof all dividends after October 24, 2002 through maturity on May 24,2004.

In conjunction with itsinitial public offering, the Company redeemed its preferred stock and paidaccrued dividends. As of December 31, 2003 and 2004, no balances wereoutstanding.

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note15—Mandatorily Redeemable Preferred Stock (Continued)**

Prior to the redemption ofthe mandatorily redeemable preferred stock during 2003, the mandatorilyredeemable preferred stock had the following rights:

***Conversion***

At issuance, the shares ofSeries A preferred stock were automatically convertible into shares of theCompany’s common stock on a one-for-two basis in the event that, on or prior toDecember 31, 1999 the Company consummated a public offering or saletransaction, meeting certain criteria. Upon expiration of the December 31,1999 conversion expiration date, the shares of Series A preferred stockwere no longer convertible into common stock. Accordingly, the Series Aand Series B preferred stock have no conversion features and can only beredeemed.

***Dividend Rights***

Holders of preferred stockwere entitled to receive dividends at the rate of 8% per annum through October 24,2002 and 10% per annum thereafter through maturity when, as and if declared bythe Board of Directors (the “Board”). Dividends not declared and paid wereaccrued and accumulated, resulting in an increase in the liquidation preferenceon the preferred stock.

On each anniversary dateof original issuance of the Series A and Series B preferred stock,respectively, the Company was required to pay all accrued but unpaid dividendson the preferred stock if and to the extent the Company’s net income for theperiod for which such dividends accrued was equal to or greater than twice the amountof the total dividend due on the Series A and Series B preferredstock, respectively (the “Dividend Amount”). If the Dividend Amount was lessthan the amount of all accrued dividends, any dividends not paid would continueto accrue and accumulate. All dividends for Series A and Series Bwere paid during 2003.

***Liquidation Rights***

Upon any liquidation,dissolution or winding-up of the Company, holders of Series B preferredstock had the right to receive an amount equal to their initial purchase priceplus any accrued and unpaid dividends, prior to and in preference over anyliquidation payment on the Company’s Series A preferred stock and commonstock. In addition, holders of Series A preferred stock had the right toreceive an amount equal to their initial purchase price plus any accrued andunpaid dividends, prior to and in preference over any liquidation payment onthe Company’s common stock. A sale of all or substantially all of the Company’sassets, a sale of the Company’s securities representing in excess of 50% of thevoting power of the Company or a merger, consolidation, reorganization or othertransaction that results in the Company’s stockholders immediately prior tosuch transaction not holding more than 50% of the voting power of the survivingentity would have been deemed a liquidation (any of the foregoing, a “Sale”).

***Voting Rights***

Each holder of a share of Series Apreferred stock or Series B preferred stock was entitled to one vote pershare. Except as provided by law or with respect to the election of directors,holders of common stock 

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note15—Mandatorily Redeemable Preferred Stock (Continued)**

andpreferred stock voted together as a single class. The holders of a majority ofthe shares of Series A and Series B preferred stock outstanding,voting separately as one class, had the special and exclusive right to electtwo directors of the Board (the “Preferred Stock Directors”). The PreferredStock Directors collectively had the greater of (i) two or (ii) 28.5%of the aggregate votes represented by all the members of the Board in office atthe time in question. The holders of Series A and Series B preferredstock also had veto rights over certain corporate actions.

Under certaincircumstances, holders of at least 662¤3% of theissued and outstanding shares of Series A and Series B preferredstock could have required the Company to raise additional equity financing orconsummate a sale of the Company.

***MandatoryRedemption***

The Company was requiredto redeem all shares of Series A and Series B preferred stock on May 24,2004 at a price per share equal to $2.02 plus all accrued but unpaid dividends,if any, through the date of redemption. Accordingly, the Series A and Series Bpreferred stock have been accreted to the redemption value, includingcumulative accrued but unpaid dividends with a corresponding charge toaccumulated deficit. The Series A and Series B preferred stock wereredeemed during 2003.

**Note 16—CommonStock Warrants**

In connection with thereorganization as described in Note 1, warrants to acquire 304,119 sharesof common stock at an exercise price of $1.06 per share were granted to twoformer partnership members of the Partnership to replace substantiallyequivalent options previously held by such partners to acquire additionalinterests in the Partnership. In 1996, a charge of $132 was recorded by thepredecessor entity for the issuance of the original options. These warrantswere exercised in October 2002 in a cashless exercise as permitted underthe warrant agreements, resulting in the issuance of 116,697 shares of commonstock.

In connection with thereorganization as described in Note 1, each of the former stockholders andthe Partnership members of the predecessor entities were also granted warrantsto acquire a pro-rata number of 2,126,663 shares of the Company’s common stockat an exercise price of $12.11 per share at any time through December 31,2007. As the reorganization was accounted for as a common control transaction,no additional value was ascribed to these warrants.

In connection with the Series Apreferred stock financing discussed in Note 13, the Company issued2,971,768 warrants to the holders of Series A preferred stock that entitlethe holders to purchase one share each of common stock at a price of $0.02 pershare. At issuance, the warrants were cancelable if the Company was able toconsummate a Qualified Public Offering or Qualified Sales Transaction, asdefined, before January 1, 2000. No such transactions occurred and, assuch, the warrants became exercisable on January 1, 2000 and remainexercisable through December 31, 2007. No proceeds from the Series Afinancing in 1997 were attributable to the common stock warrants as nocommitment date and measurement could occur until the warrants becameexercisable on January 1, 2000, which corresponds to the expiration of theSeries A preferred stock conversion feature as described in Note 13.

Upon the measurement date,the portion of the proceeds attributable to the common stock warrants wasestimated to be $876 and was recorded as a charge to additional paid-incapital. The allocation of 

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note16—Common Stock Warrants (Continued)**

proceedswas based on the relative fair values between the common stock warrants and theSeries A preferred stock. The fair value of the common stock warrant wasdetermined using the Black-Scholes option pricing model using the followingassumptions: risk-free interest rate of 6.4%; contractual life of 7 years;dividend yield of 0%; and expected volatility of 50%.

In connection with the Series Bfinancing discussed in Note 13, the Company issued 1,857,355 warrants tothe holders of Series B preferred stock that entitle the holders topurchase one share each of common stock of the Company at a price of $0.02 pershare. The warrants are exercisable at any time through December 31, 2007.The proceeds attributable to these common stock warrants was estimated to be$514 and was recorded as a charge to additional paid-in capital. The allocationof proceeds was based on the relative fair values between the common stockwarrants and the Series B preferred stock. The fair value of the commonstock warrants was determined using the Black-Scholes option pricing model usingthe following assumptions: risk-free interest rate of 6.4%; contractual life of7 years; dividend yield of 0%; and expected volatility of 50%.

Through 2002, warrantsrelated to the Series A and Series B financings, representing 12,500shares of common stock, were exercised. Concurrent with the initial publicoffering in 2003, the outstanding warrants related to the Series A and Series Bpreferred stock financings were automatically converted into common stockthrough cashless exercise, resulting in the issuance of 4,690,390 shares ofcommon stock.

In March 2003, theCompany issued warrants to a holder of Series A preferred stock topurchase 32,864 shares of the Company’s common stock at an exercise price of$0.02 per share. The warrants are immediately exercisable, non-forfeitable andexpire in 10 years. The fair value ascribed to these warrants amounted to$345 and was determined using the Black-Scholes option pricing model using thefollowing assumptions: risk-free interest rate of 4%; contractual life of tenyears; dividend yield of 0%, expected volatility of 50%; and a fair value of$10.50 per share of common stock. The charge for these warrants was recorded inselling, general and administrative expenses for the year ended December 31,2003. In April 2003, all of these warrants were exercised for proceedstotaling $1.

As of December 31,2004, there were 593,753 and 19,491 warrants exercisable to purchase commonstock outstanding with exercise prices of $12.114 and $4.038 per share,respectively.

**Note 17—CapitalStructure and Sale of Common Stock**

In April 2003, theCompany’s Board approved an increase in the number of authorized shares ofcommon stock to 70,000,000 shares and authorized 5,000,000 shares ofundesignated preferred stock at a $0.0001 par value.

On July 15, 2003, theCompany completed its initial public offering of 3,840,000 shares of its commonstock at $17.00 per share, before underwriting discounts and commissions. Inaddition, the Company sold an additional 251,410 shares of common stock andcertain of the Company’s stockholders sold an aggregate of 324,590 shares ofcommon stock pursuant to the underwriter’s exercise of their option to purchaseadditional shares of common stock to cover over-allotments. The Company raiseda total of $69,600 in gross proceeds from the offering. After deducting theunderwriting fee of approximately $4,900 

85

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note17—Capital Structure and Sale of Common Stock (Continued)**

andapproximately $1,671 of other offering expenses, net proceeds wereapproximately $63,029. Concurrent with the initial public offering, certainwarrants issued in connection with the Series A and Series Bpreferred stock were automatically converted into common stock, resulting inthe issuance of 4,690,390 shares of common stock.

On December 10, 2003,the Company completed its follow-on public offering of 1,500,000 shares of itscommon stock at $25.75 per share, before underwriting discounts andcommissions. In connection with the follow-on public offering, certain of theCompany’s stockholders sold an aggregate of 3,000,000 shares of common stock.In addition, the Company sold an additional 514,700 shares of common stockpursuant to the underwriter’s exercise of their option to purchase additionalshares of common stock to cover over-allotments. The Company raised a total of$51,879 in gross proceeds from the offering. After deducting the underwritingfee of approximately $2,594 and approximately $423 of other offering expenses,net proceeds were approximately $48,863.

**Note 18—OperatingSegment and Geographic Information**

The Company operates itsbusiness in two reportable segments: the Cinema business segment, previouslynamed the Theatrical business segment, and the Consumer business segment. The Cinemabusiness segment provides digital playback systems and cinema processorequipment to movie theaters, and licenses technology and provides services tofilm production and distribution companies. The Company’s Consumer businesssegment licenses audio technology, trademarks and know-how to consumerelectronics, personal computer, broadcast and professional audio companies, andsells multi-channel audio content and products to consumers.

The Company does not haveseparately identifiable capital expenditures or long-lived assets related tothese two business segments.

The Company’s reportablesegments and geographical information are as follows:
| ** **        | ** ** | **Revenues**                                              | ** ** |
|-------------------|------------|-----------------------------------------------------------|------------|
| ** **        | ** ** | **For the Years Ended  December 31,** | ** ** |
| ** **        | ** ** | **2002**                                                  | ** ** | **2003** | ** ** | **2004** | ** ** |
| Cinema business   |       | $                                                         | 15,399     |   | $ | 16,328 | ** ** | **$** | **19,545** | ** ** |
| Consumer business |       | 25,657                                                    |       | 35,374 | ** ** | **41,886** | ** ** |
| Total revenues    |       | $                                                         | 41,056     |   | $ | 51,702 | ** ** | **$** | **61,431** | ** ** |

 

For 2003, sales to a customer accounted for 11% ofconsolidated revenues. This same customer accounted for 4% and 14% of theCinema and Consumer Segment 2003 revenues, respectively. No customers accountedfor more than 10% of revenues for either business segment in 2004.
| ** **          | ** ** | **Gross Profit**                                     | ** ** |
|---------------------|------------|-----------------------------------------------------------|------------|
| ** **          | ** ** | **For the Years Ended  December 31,** | ** ** |
| ** **          | ** ** | **2002**                                                  | ** ** | **2003** | ** ** | **2004** | ** ** |
| Cinema business     |       | $                                                         | 6,517      |   | $ | 7,190 | ** ** | **$** | **5,448** | ** ** |
| Consumer business   |       | 23,903                                                    |       | 33,480 | ** ** | **39,821** | ** ** |
| Total gross  profit |       | $                                                         | 30,420     |   | $ | 40,670 | ** ** | **$** | **45,269** | ** ** |

** **

86

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note18—Operating Segment and Geographic Information (Continued)**

 
| ** **                    | ** ** | **Income (loss) From Operations**          | ** ** |
|-------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                    | ** ** | **For the Years Ended  December 31,** | ** ** |
| ** **                    | ** ** | **2002**                                                  | ** ** | **2003** | ** ** | **2004** | ** ** |
| Cinema business               |       | $                                                         | (2,425     | ) | $ | (3,504 | ) | **$** | **(8,475** | **)** |
| Consumer business             |       | 12,712                                                    |       | 18,714 | ** ** | **19,969** | ** ** |
| Total income from  operations |       | $                                                         | 10,287     |   | $ | 15,210 | ** ** | **$** | **11,494** | ** ** |

 

Included in gross profitand loss from operations for the Cinema business for the year ended December 31,2004 is a $3,871 write-down of the monochrome projector inventory.

The Cinema business lossfrom operations includes tax benefits of $954, $1,208 and $2,752 for the yearsending December 31, 2002, 2003 and 2004, respectively. The Consumerbusiness income from operations includes tax provisions of $4,642, $6,576 and$8,287 for the years ending December 31, 2002, 2003 and 2004,respectively.

The Cinema business lossfrom operations includes depreciation and amortization expense of $408, $326and $545 for the years ending December 31, 2002, 2003 and 2004,respectively. The Consumer business income from operations includesdepreciation and amortization expense of $494, $584 and $753 for the yearsending December 31, 2002, 2003 and 2004, respectively.
| ** **     | ** ** | **Revenues by Geographic Region**          | ** ** |
|----------------|------------|-----------------------------------------------------------|------------|
| ** **     | ** ** | **For the Years Ended  December 31,** | ** ** |
| ** **     | ** ** | **2002**                                                  | ** ** | **2003** | ** ** | **2004** | ** ** |
| United States  |       | $                                                         | 10,224     |   | $ | 15,837 | ** ** | **$** | **17,830** | ** ** |
| International  |       | 30,832                                                    |       | 35,865 | ** ** | **43,601** | ** ** |
| Total revenues |       | $                                                         | 41,056     |   | $ | 51,702 | ** ** | **$** | **61,431** | ** ** |

 

The following table sets forth, for the periodsindicated, long-lived assets by geographic region:
| ** **               | ** ** | **Long-Lived Assets**            | ** ** |
|--------------------------|------------|---------------------------------------|------------|
| ** **               | ** ** | **As of December 31,** | ** ** |
| ** **               | ** ** | **2002**                              | ** ** | **2003** | ** ** | **2004** | ** ** |
| United States            |       | $                                     | 3,244      |   | $ | 3,150 | ** ** | **$** | **3,099** | ** ** |
| International            |       | 297                                   |       | 366 | ** ** | **2,219** | ** ** |
| Total long-lived  assets |       | $                                     | 3,541      |   | $ | 3,516 | ** ** | **$** | **5,318** | ** ** |

 

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note 19—NetIncome Attributable to Common Stockholders Per Share:**

Thefollowing table sets forth the computation of basic and diluted net incomeattributable to common stockholders per share:
| ** **                                                             | ** ** | **For the Years Ended  December 31,** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                             | ** ** | **2002**                                                  | ** ** | **2003** | ** ** | **2004** | ** ** |
| Basic net income  attributable to common stockholders per share:       |       |                                                      |       |   |   |   |   |
| Numerator:                                                             |       |                                                      |       |   |   |   |   |
| Net income                                                             |       | $                                                         | 6,250      |   | $ | 9,899 | ** ** | **$** | **9,976** | ** ** |
| Preferred stock dividends accrued                                      |       | (1,336                                                    | )          | (844 | ) | — |   |
| Accretion on preferred stock                                           |       | (512                                                      | )          | (390 | ) | — |   |
| Net income attributable to common stockholders                         |       | $                                                         | 4,402      |   | $ | 8,665 | ** ** | **$** | **9,976** | ** ** |
| Denominator:                                                           | ** ** | ** **                                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Weighted average common shares outstanding                             |       | 4,432,408                                                 |       | 9,166,389 | ** ** | **16,865,805** | ** ** |
| Shares subject to escrow                                               |       | —                                                    |       | — |   | — |   |
| Weighted average basic shares outstanding                              |       | 4,432,408                                                 |       | 9,166,389 | ** ** | **16,865,805** | ** ** |
| Basic net income attributable to common stockholders  per common share |       | $                                                         | 0.99       |   | $ | 0.95 | ** ** | **$** | **0.59** | ** ** |
| Diluted net  income attributable to common stockholders per share:     | ** ** | ** **                                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Numerator:                                                             |       |                                                      |       |   |   |   |   |
| Net income                                                             |       | $                                                         | 6,250      |   | $ | 9,899 | ** ** | **$** | **9,976** | ** ** |
| Preferred stock dividends accrued                                      |       | (1,336                                                    | )          | (844 | ) | — |   |
| Accretion on preferred stock                                           |       | (512                                                      | )          | (390 | ) | — |   |
| Net income attributable to common stockholders                         |       | $                                                         | 4,402      |   | $ | 8,665 | ** ** | **$** | **9,976** | ** ** |
| Denominator:                                                           |       |                                                      |       |   |   |   |   |
| Weighted average shares outstanding                                    |       | 4,432,408                                                 |       | 9,166,389 | ** ** | **16,865,805** | ** ** |
| Effect of  dilutive securities:                                        |       |                                                      |       |   |   |   |   |
| Common stock options                                                   |       | 156,196                                                   |       | 1,401,727 | ** ** | **1,002,857** | ** ** |
| Common stock warrants                                                  |       | 4,740,674                                                 |       | 196,751 | ** ** | **274,452** | ** ** |
| Diluted shares outstanding                                             |       | 9,329,278                                                 |       | 10,764,867 | ** ** | **18,143,114** | ** ** |
| Diluted net  income attributable to common stockholders per share      |       | $                                                         | 0.47       |   | $ | 0.80 | ** ** | **$** | **0.55** | ** ** |

 

Weighted average common shares outstanding, assumingdilution, include the incremental shares that would be issued upon the assumedexercise of stock options. For the year ended December 31, 2004, 597,750shares, with a weighted average exercise price of $23.33, of the Company’sstock options were excluded from the calculation of diluted earnings per sharebecause the exercise prices of the stock options were greater than or equal tothe average price of the common shares, and therefore their inclusion would havebeen anti-dilutive. These options could be dilutive in the future if theaverage share price increases and is equal to or greater than the exerciseprice of these options.

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**DIGITAL THEATER SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Amounts in thousands, except share and per share data)**

**Note 20—Income From Legal Settlement:**

In May 2004, theCompany reached a settlement with Mintek Digital, Inc. (“Mintek”) for$3,500 for Trademark Infringement, False Designation of Origin, TrademarkDilution, and Unfair Competition relating to Mintek’s distribution of DVD playersbearing the Company’s registered trademarks without obtaining a license fromthe Company. The Company recognized $899 in revenue under the settlement forroyalties due on units that were identified as using the Company’s trademarkand accounted for the remaining $2,601 as other income. Selling, general andadministrative expenses for the year ended December 31, 2004 includedapproximately $300 in legal fees related to the Mintek case. Legal fees relatedto Mintek were approximately $200 for 2003.

**Note 21**—Selected QuarterlyData (Unaudited): 
| ** **                                      | ** ** | **For the Quarter Ended** | ** ** |
|-------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                      | ** ** | **Mar. 31,  2003**                  | ** ** | **June 30,  2003** | ** ** | **Sep. 30,  2003** | ** ** | **Dec. 31,  2003** | ** ** | **Mar. 31,  2004** | ** ** | **June 30,  2004** | ** ** | **Sep. 30,  2004** | ** ** | **Dec. 31,  2004** | ** ** |
| Revenues                                        |       | $                                        | 11,756     |   | $ | 11,701 |   | $ | 13,334 |   | $ | 14,911 |   | $ | 15,597 |   | $ | 13,252 |   | $ | 15,952 |   | $ | 16,630 |   |
| Gross profit                                    |       | $                                        | 9,343      |   | $ | 8,912 |   | $ | 10,444 |   | $ | 11,971 |   | $ | 12,705 |   | $ | 10,331 |   | $ | 12,842 |   | $ | 9,391 |   |
| Net income attributable  to common stockholders |       | $                                        | 1,561      |   | $ | 1,378 |   | $ | 2,393 |   | $ | 3,333 |   | $ | 3,440 |   | $ | 3,119 |   | $ | 3,225 |   | $ | 192 |   |
| Basic earnings per share                        |       | $                                        | 0.35       |   | $ | 0.31 |   | $ | 0.19 |   | $ | 0.22 |   | $ | 0.21 |   | $ | 0.19 |   | $ | 0.19 |   | $ | 0.01 |   |
| Diluted earnings per share                      |       | $                                        | 0.15       |   | $ | 0.13 |   | $ | 0.16 |   | $ | 0.20 |   | $ | 0.19 |   | $ | 0.17 |   | $ | 0.18 |   | $ | 0.01 |   |

 

During the fourth quarterof 2004, the Company incurred a write-down of approximately $3.9 millionrelated to its monochrome projector inventory.

**Note 22—Subsequent Event:**

In January 2005, the Company completed theacquisition of LDI for $9,600 in cash. Under the terms of the acquisition, theCompany has contingently agreed to issue up to 857,213 shares of DTS commonstock to the former owners of LDI if the LDI business achieves certain grossprofit targets in 2005 and 2006. In late 2004, the Company loaned LDI a totalof $1,250 to enable LDI to satisfy certain liabilities. Neither LDI nor itsstockholders were required to repay this loan prior to, or in connection with,the acquisition. The cash portion of the acquisition was funded by workingcapital.

The Merger Agreement also requires the Company toinvest approximately $3,500 in the business of LDI on or prior to June 30,2005 to enable LDI to make certain capital expenditures and, if and to theextent LDI meets specified gross profit milestones, to invest up to anadditional $1,500 through the end of 2006.

In connection with the acquisition, the Companyexpects to record between $5,000 and $6,000 in goodwill and intangibles ofapproximately $11,000 with expected lives ranging from one to eleven years. TheCompany also expects to record approximately $2,000 of IPR&D, which will beexpensed in the first quarter of 2005. The estimated purchase price allocationfor this acquisition is preliminary and subject to revision as more detailedanalysis is completed and additional information on the fair value of assetsand liabilities becomes available.

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**DIGITAL THEATERSYSTEMS, INC.SCHEDULE II—VALUATION AND QUALIFYING ACCOUNTS(Amounts in thousands)**
| **For the Years Ended December 31,** | ** **                                   | ** ** | ** ** | **Balance at  Beginning  of Year** | ** ** | **Charged to  Costs and  Expenses** | ** ** | **Deductions  From  Reserves** | ** ** | **Balance at  End of Year** | ** ** |
|---------------------------------------------------------------|----------------------------------------------|------------|------------|----------------------------------------------|------------|-----------------------------------------------|------------|--------------------------------|------------|--------------------------------------------|------------|
| 2002                                                          | Allowance for  doubtful accounts             |       |       | $                                            | 550        |                                          |       |                           | $          | 10                                         |       |   |   | $ | 123 |   |   |   | $ | 437 |   |   |
|                                                          | Valuation  allowance for deferred tax assets |       |       | 120                                          |       |                                          |       | —                         |       |                                       |       | 120 |   |   |   | — |   |   |
| 2003                                                          | Allowance for  doubtful accounts             |       |       | 437                                          |       |                                          |       | 114                            |       |                                       |       | 122 |   |   |   | 429 |   |   |
|                                                          | Valuation  allowance for deferred tax assets |       |       | —                                       |       |                                          |       | —                         |       |                                       |       | — |   |   |   | — |   |   |
| 2004                                                          | Allowance for  doubtful accounts             |       |       | 429                                          |       |                                          |       | 61                             |       |                                       |       | 88 |   |   |   | 402 |   |   |
|                                                          | Valuation allowance for  deferred tax assets |       |       | —                                       |       |                                          |       | —                         |       |                                       |       | — |   |   |   | — |   |   |
|                                                               |                                              |            |            |                                              |            |                                               |            |                                |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**Item 9.** *Changes in andDisagreements With Accountants on Accounting and Financial Disclosure*

None.

**Item 9A. *Controls and Procedures***

**DisclosureControls and Procedures**

The Company’s management,with the participation of the Company’s Chief Executive Officer and ChiefFinancial Officer, has evaluated the effectiveness of the Company’s disclosurecontrols and procedures (as such term is defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (the“Exchange Act”)) as of the end of the period covered by this report. Based onsuch evaluation, the Company’s Chief Executive Officer and Chief FinancialOfficer have concluded that, as of the end of such period, the Company’sdisclosure controls and procedures are effective in recording, processing,summarizing and reporting, on a timely basis, information required to bedisclosed by the Company in the reports that it files or submits under theExchange Act.

**ManagementsReport on Internal Control Over Financial Reporting**

The Company’s managementis responsible for establishing and maintaining adequate internal control overfinancial reporting, as defined in Exchange Act Rules 13a-15(f) or15d-15(f). The Company’s internal control over financial reporting is designedto provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes, inaccordance with generally accepted accounting principles.

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

The Company’s managementassessed the effectiveness of the Company’s internal control over financialreporting as of December 31, 2004. In making this assessment, management usedthe criteria established by the Committee of Sponsoring Organizations of theTreadway Commission (“COSO”) in Internal Control-Integrated Framework.

Based on this assessment,management determined that the Company maintained effective internal control overfinancial reporting as of December 31, 2004.

Our management’sassessment of the effectiveness of the Company’s internal control overfinancial reporting as of December 31, 2004 has been audited byPricewaterhouseCoopers LLP, an independent registered public accounting firm,as stated in their report which appears herein in Item 8.

**Changesin Internal Control Over Financial Reporting**

There have not been anychanges in the Company’s internal control over financial reporting (as suchterm is defined in Rules 13a-15(f) and 15d-15(f) underthe Exchange Act) during the most recent fiscal quarter that have materiallyaffected, or are reasonably likely to materially affect, the Company’s internalcontrol over financial reporting.

**Item 9B. *Other Informatio*n**

The Company filed asexhibit 10.44 to this Form 10-K an employment agreement with Don Bird, SeniorVice President, Marketing, which was entered into in the fourth quarter of2004.

TheCompany filed as exhibit 10.45 to this Form 10-K a Secured Convertible Note inthe amount of $1.0 million by and between Lowry Digital Images, Inc. andDigital Theater Systems, Inc., which was entered into in the fourth quarter of2004.

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**PART III**

**Item 10. *Directors and ExecutiveOfficers of the Registrant***

Information concerning ourexecutive officers appears in our proxy statement under the caption “ExecutiveOfficers and Significant Employees” and information concerning our directorsappears in our Proxy Statement under the caption “Item 1—Election ofDirectors”. Such information is incorporated herein by reference.

**Item 11. *Executive Compensation***

Information concerningexecutive compensation appears in our proxy statement, under the caption “ExecutiveCompensation” and is incorporated herein by reference.

**Item 12. *Security Ownership ofCertain Beneficial Owners and Management and Related Stockholder Matters***

Information concerning thesecurity ownership of certain beneficial owners and management appears in ourproxy statement under the caption “Security Ownership of Certain BeneficialOwners and Management” and is incorporated herein by reference.

**Item 13. *Certain Relationships andRelated Transactions***

Information concerningcertain relationships and related transactions appears in our proxy statementunder the captions “Certain Relationships and Related Transactions” and isincorporated herein by reference.

**Item 14. *Principal Accountant Feesand Services***

Information concerningprincipal accountant fees and services appears in our proxy statement under thecaption “Item 2—Ratification of Independent Auditors” and is incorporatedherein by reference.

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**PART IV**

**Item 15.*Exhibits and Financial Statement Schedules***

**(a)(1) and(2) Financial Statements and Schedules**

Theinformation required by this Item is included in Item 8 of Part II of thisreport.

**(a)(3) Exhibits**

SeeItem 15 (b) below.

**(b) Exhibits:**
| Exhibit   Number                         | ** ** | ** **                                                                                                                           | ** ** | **Description** |
|------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
|        3.3 |       | Restated Certificate of  Incorporation(3)                                                                                            |
|        3.5 |       | Restated Bylaws(3)                                                                                                                   |
|        3.6 |       | Audit Committee  Charter(1)                                                                                                          |
|        3.7 |       | Compensation Committee  Charter(1)                                                                                                   |
|        3.8 |       | Nominating/Corporate  Governance Committee Charter(1)                                                                                |
|        4.1 |       | Specimen Common Stock  Certificate(2)                                                                                                |
|      10.1            |       | Registration Rights  Agreement, dated October 24, 1997(1)                                                                       |
|      10.2            |       | Amended and Restated  Registration Rights Agreement, dated January 27, 2000(1)                                                  |
|      10.3            |       | [reserved]                                                                                                                           |
|      10.4            |       | [reserved]                                                                                                                           |
|      10.5            |       | [reserved]                                                                                                                           |
|      10.6            |       | [reserved]                                                                                                                           |
|      10.7            |       | 1997 Stock Option  Plan(1)                                                                                                           |
|      10.8            |       | Form of Incentive  Stock Option Agreement for grants under the 1997 Stock Option Plan(1)                                        |
|      10.9            |       | Form of  Nonqualified Stock Option Agreement for grants under the 1997 Stock Option  Plan(1)                                    |
|      10.10           |       | 2002 Stock Option  Plan(1)                                                                                                           |
|      10.11           |       | Form of Incentive  Stock Option Agreement for grants under the 2002 Stock Option Plan(1)                                        |
|      10.12           |       | Form of  Non-qualified Stock Option Agreement for grants under the 2002 Stock Option  Plan(1)                                   |
|     10.13                 |       | 2003 Equity Incentive  Plan(2)                                                                                                       |
|     10.14                 |       | Form of Grant of  Stock Option under 2003 Equity Incentive Plan(2)                                                              |
|     10.15                 |       | Form of Option  Exercise and Stock Purchase Agreement under 2003 Equity Incentive Plan(2)                                       |
|     10.16                 |       | Form of Restricted  Stock Grant Notice under 2003 Equity Incentive Plan(2)                                                      |
|     10.17                 |       | 2003 Employee Stock  Purchase Plan(2)                                                                                                |
|     10.18                 |       | 2003 Foreign Subsidiary  Employee Stock Purchase Plan(2)                                                                             |
|     10.19                 |       | Replacement Warrant to  Purchase Common Stock between the Registrant and Comerica Incorporated, dated  February 27, 2004(4)     |
|     10.20                 |       | Replacement Warrant to  purchase Common Stock between the Registrant and J.P. Morgan Securities Inc.,  dated January 9, 2004(4) |

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|     10.21 |   | Form of Warrant to Purchase Common Stock  between the Registrant and each of the entities listed on the Schedule of  Warrant Holders attached thereto, dated October 24, 1997(1)                       |
|--------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|     10.22 |   | Amendment to Warrants  issued October 24, 1997(1)                                                                                                                                                           |
|     10.23 |   | Form of Existing  Shareholder Warrant to Purchase Common Stock between the Registrant and each  of the entities listed on the Schedule of Warrant Holders attached thereto,  dated October 24, 1997(1) |
|     10.24 |   | Replacement  Warrant to Purchase Common Stock between the Registrant and W. Paul  Smith, dated January 20, 2004(4)                                                                                     |
|     10.25 |   | Form of Warrant to  Purchase Common Stock between the Registrant and each of the entities listed  on the Schedule of Warrant Holders attached thereto, dated January 27,  2000(1)                      |
|     10.26 |   | Form of Warrant to Purchase Common Stock  between the Registrant and each of the entities listed on the Schedule of  Warrant Holders attached thereto, dated September 30, 2000(1)                     |
|     10.27 |   | Amendment to Warrants  issued January 27, 2000 and September 30, 2000(1)                                                                                                                               |
|     10.28 |   | Lease Agreement between  the Registrant and the Butler Family Trust, dated September 8, 1997(1)                                                                                                             |
|     10.29 |   | Amendment to Lease  Agreement between the Registrant and the Butler Family Trust, dated  November 18, 2002(1)                                                                                               |
|     10.30 |   | Lease Agreement between  the Registrant and Gewerbegrund Bauträger GMBH & Co. Immobillien KG,  dated April 21, 2002(1)                                                                        |
|     10.31 |   | [reserved]                                                                                                                                                                                                       |
|     10.32 |   | Employment Agreement by  and between the Registrant and Jon Kirchner, dated September 30, 2002(1)                                                                                                      |
|     10.33 |   | Employment Agreement by  and between the Registrant and Daniel E. Slusser, dated January 8, 2003(1)                                                                                                    |
|     10.34 |   | Employment Agreement by  and between the Registrant and Melvin Flanigan, dated March 6, 2000(1)                                                                                                             |
|     10.35 |   | Amendment to Employment  Agreement Between the Registrant and Melvin Flanigan, dated  September 30, 2002(1)                                                                                                 |
|     10.36 |   | Employment Agreement by  and between the Registrant and Patrick Watson, dated January 1, 2001(1)                                                                                                       |
|     10.37 |   | Employment Agreement by  and between the Registrant and William Paul Smith, dated November 1, 2002(1)                                                                                                  |
|     10.38 |   | Purchase-Sales Agreement  dated as of March 13, 2002, between the Registrant and InFocus Corporation(1)†                                                                                               |
|     10.39 |   | Form of  Indemnification Agreement between the Registrant and its directors(1)                                                                                                                              |
|     10.40 |   | Form of  Indemnification Agreement between the Registrant and its officers(1)                                                                                                                               |
|     10.41 |   | Letter Agreement dated  March 9, 2004, by and between the Registrant and InFocus Corporation  amending the Purchase-Sales Agreement between such parties dated as of  March 13, 2002(5)†          |
|     10.42 |   | Revolving Credit  Agreement between the Registrant and Comerica Bank—California, effective  June 30, 2004(6)                                                                                           |

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|     10.43 |   | Employment Agreement by  and between the Registrant and Daniel E. Slusser, dated June 9, 2004(7)                                                                                                                                  |
|--------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|     10.44 |   | Employment Agreement by  and between the Registrant and Don Bird, executed October 1, 2004                                                                                                                                        |
|     10.45 |   | Secured Convertible Note  Purchase Agreement dated December 17, 2004 and Secured Convertible  Promissory Note dated December 17, 2004 by and between Lowry Digital  Images, Inc. and Digital Theater Systems, Inc. |
|     21.1  |   | List of all subsidiaries  of the Registrant                                                                                                                                                                                            |
|     23.1  |   | Consent of  PricewaterhouseCoopers LLP, independent accountants                                                                                                                                                                        |
|     31.1  |   | Certification of Chief  Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the  Securities Exchange Act of 1934, as amended                                                                                           |
|     31.2  |   | Certification of Chief  Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the  Securities Exchange Act of 1934, as amended                                                                                           |
|     32.1  |   | Certification of the  Chief Executive Officer pursuant to Rule 13a-14(b) of the  Securities Exchange Act of 1934, as amended, and 18 U.S.C. section 1350                                                                     |
|     32.2  |   | Certification of the  Chief Financial Officer pursuant to Rule 13a-14(b) of the  Securities Exchange Act of 1934, as amended, and 18 U.S.C. section 1350                                                                     |

----

 
| (1)    | Incorporated by reference to the identically  numbered exhibit filed with the Registrant’s Form S-1 Registration  Statement (File No. 333-104761) on April 25, 2003.                                                                                                                                                                                 |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2)    | Incorporated by  reference to the identically numbered exhibit filed with the Registrant’s  Amendment No. 1 to Form S-1 Registration Statement (File  No. 333-104761) on June 5, 2003.                                                                                                                                                          |
| (3)    | Incorporated by  reference to the identically numbered exhibit filed with the Registrant’s  Form S-1 Registration Statement (File No. 333-110120)  on October 31, 2003.                                                                                                                                                                              |
| (4)    | Incorporated by  reference to the identically numbered exhibit filed with the Registrant’s  Annual Report on Form 10-K for the year ended December 31,  2003.                                                                                                                                                                                             |
| (5)    | Incorporated by  reference to the identically numbered exhibit filed with the Registrant’s  Quarterly Report on Form 10-Q for the quarter ended March 31,  2004.                                                                                                                                                                                          |
| (6)    | Incorporated by  reference to the identically numbered exhibit filed with the Registrant’s  Quarterly Report on Form 10-Q for the quarter ended June 30,  2004.                                                                                                                                                                                           |
| (7)    | Incorporated by  reference to Exhibit 10.41 to the Registrant’s Quarterly Report on  Form 10-Q for the quarter ended June 30, 2004.                                                                                                                                                                                                                  |
| † | Certain confidential  portions of this Exhibit were omitted by means of redacting a portion of  the text (the “Mark”). This Exhibit has been filed separately with the  Secretary of the Commission without the Mark pursuant to the Registrant’s  Application Requesting Confidential Treatment under Rule 406 under the  Securities Act. |

 

95

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**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized, on this 15th day of March, 2005.
|        | DIGITAL THEATER SYSTEMS, INC.            |
|--------|------------------------------------------|
|   | By:                                      | /s/  JON E. KIRCHNER |
|   | Jon E. Kirchner                          |
|   | *President  and Chief Executive Officer* |

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.
| Signature                         | ** ** | **Title(s)**                                  | ** ** | **Date**       |
|-----------------------------------|------------|-----------------------------------------------|------------|----------------|
| /s/  JON E. KIRCHNER    |       | President,  Chief Executive Officer, and      |       | March 15, 2005 |
| Jon E. Kirchner                   |       | Director                                      |       |           |
|                              |       | (principal  executive officer)                |       |           |
| /s/  MELVIN L. FLANIGAN |       | Executive  Vice President, Finance and        |       | March 15, 2005 |
| Melvin L.  Flanigan               |       | Chief Financial  Officer                      |       |           |
|                              |       | (principal  financial and accounting officer) |       |           |
| /s/  DAN E. SLUSSER     |       | Chairman  of the Board                        |       | March 15, 2005 |
| Dan E. Slusser                    |       |                                          |       |           |
| /s/  JOERG D. AGIN      |       | Director                                      |       | March 15, 2005 |
| Joerg D. Agin                     |       |                                          |       |           |
| /s/  JOSEPH A. FISCHER  |       | Director                                      |       | March 15, 2005 |
| Joseph A. Fischer                 |       |                                          |       |           |
| /s/  STEVEN M. FRIEDMAN |       | Director                                      |       | March 15, 2005 |
| Steven M.  Friedman               |       |                                          |       |           |
| /s/  JAMES B. MCELWEE   |       | Director                                      |       | March 15, 2005 |
| James B. McElwee                  |       |                                          |       |           |
| /s/  RONALD N. STONE    |       | Director                                      |       | March 15, 2005 |
| Ronald N. Stone                   |       |                                          |       |           |

 

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