**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-K**

**x**                               ANNUAL REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934

**For the fiscal year ended December 31, 2005**

**OR**

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

**For the transition periodfrom                           to                           **

**CommissionFile Number 000-50335**

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**DTS, Inc.**

(Exactname of Registrant as specified in its charter)

| **Delaware**                    |   | **77-0467655**         |
|---------------------------------|--------|------------------------|
| (State or Other Jurisdiction of |   | (I.R.S. Employer       |
| Incorporation or Organization)  |   | Identification Number) |

 

**5171 Clareton DriveAgoura Hills, California 91301**(Address, including zip code, of Registrant’sprincipal executive offices)

Registrant’s telephonenumber, including area code: **(818) 706-3525**

 

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Securities RegisteredPursuant to Section 12(g) of the Act:

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

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Indicateby check mark if the registrant is a well-known seasoned issuer, as defined by Rule 405of the Securities Act. Yes o    No x

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act. Yes o    No x

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes x    No o

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to thebest of registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. o

Indicateby check mark whether registrant is a large accelerated filer, acceleratedfiler or non-accelerated filer. See definition of “accelerated filer” and “largeaccelerated filer” in Rule 12b-2 of the Exchange Act.

Largeaccelerated filer  o                    Acceleratedfiler  x                    Non-acceleratedfiler  o

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Act). Yes o    No x

Theaggregate market value of the voting and non-voting common equity held bynon-affiliates of the registrant, as of June 30, 2005 was approximately$309,052,418 (based upon the closing price for shares of the registrant’sCommon Stock as reported by the Nasdaq National Market for that date). Sharesof Common Stock held by each officer and director of the outstanding CommonStock have been excluded in that such persons may be deemed affiliates.Exclusion of shares held by any person should not be construed to indicate thatsuch person possesses the power, direct or indirect, to direct or cause thedirection of management or policies of the registrant, or that such person iscontrolled by or under common control with the registrant.

Asof March 1, 2006, 17,508,108 shares of common stock were outstanding.

**DOCUMENTS INCORPORATED BY REFERENCE**

The information required by Part III of thisReport, to the extent not set forth herein, is incorporated herein by referenceto the registrant’s proxy statement relating to the annual meeting ofstockholders to be held on May 18, 2006.

 

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**DTS, INC.FORM 10-KFor the Fiscal Year Ended December 31, 2005INDEX**

|                   | ** ** | ** **                                                                                                          | **Page** |
|-------------------|------------|---------------------------------------------------------------------------------------------------------------------|----------|
|              |       | Restatement—Explanatory Note                                                                                   | 3        |
| **PART I**   | ** ** |
| Item 1.           |       | Business                                                                                                            | 4        |
| Item 1A.          |       | Risk Factors                                                                                                        | 22       |
| Item  1B.         |       | Unresolved Staff Comments                                                                                           | 36       |
| Item 2.           |       | Properties                                                                                                          | 36       |
| Item 3.           |       | Legal Proceedings                                                                                                   | 36       |
| Item  4.          |       | Submission of Matters to a  Vote of Security Holders                                                                | 36       |
| **PART II**  |       |
| Item  5.          |       | Market for Registrant’s  Common Equity, Related Stockholder Matters and Issuer Purchases of Equity  Securities | 37       |
| Item  6.          |       | Selected Financial Data                                                                                             | 38       |
| Item  7.          |       | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                         | 39       |
| Item  7A.         |       | Quantitative and Qualitative  Disclosures About Market Risk                                                         | 59       |
| Item  8.          |       | Financial Statements and  Supplementary Data                                                                        | 61       |
| Item  9.          |       | Changes in and Disagreements  with Accountants on Accounting and Financial Disclosure                               | 102      |
| Item 9A.          |       | Controls and  Procedures                                                                                            | 102      |
| Item 9B.          |       | Other Information                                                                                                   | 104      |
| **PART III** |       |
| Item  10.         |       | Directors and Executive  Officers of the Registrant                                                                 | 104      |
| Item  11.         |       | Executive Compensation                                                                                              | 104      |
| Item  12.         |       | Security Ownership of  Certain Beneficial Owners and Management and Related Stockholder Matters                     | 104      |
| Item  13.         |       | Certain Relationships and  Related Transactions                                                                     | 104      |
| Item  14.         |       | Principal Accounting Fees  and Services                                                                             | 104      |
| **PART IV**  |       |
| Item  15.         |       | Exhibits, Financial  Statement Schedules                                                                            | 105      |
| SIGNATURES        | 110        |

 

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**Restatement—Explanatory Note**

***Restatement of 2003 Financial Statements***

In connection with the preparation of the financialstatements for fiscal year 2005, an error was identified in the method used tocompute the weighting of common stock options and warrants included in thediluted shares outstanding calculation for the nine months ended September 30,2003 and the year ended December 31, 2003. This resulted in improperlyreporting the weighted average shares used to compute net income attributableto common stockholders per diluted common share and net income attributable tocommon stockholders per diluted common share.

As a result, the Company has restated its previouslyissued consolidated financial statements for the year ended December 31,2003. The consolidated financial statements contained herein for the year endedDecember 31, 2003 include the effects of this restatement.

Thefollowing table sets forth the effects of the restatement adjustments:

| ** **                                                                                                      | ** ** | **For the Nine Months Ended  September 30, 2003** | ** ** | **For the Year Ended  December 31, 2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                                      | ** ** | **Previously  Reported**                                                        | ** ** | **As  Restated**                                                   | ** ** | **Previously  Reported** | ** ** | **As  Restated** | ** ** |
| ** **                                                                                                      | ** ** | **(Unaudited)**                                                                 | ** ** | ** **                                                         | ** ** | ** ** | ** ** |
| Net income  attributable to common stockholders per diluted common share                                        | ** ** | $                                                                               | 0.59       | ** **                                                         | $          | 0.43 | ** ** | $ | 0.80 | ** ** | $ | 0.64 | ** ** |
| Weighted average shares  used to compute net income attributable to common stockholders per  common share: | ** ** | ** **                                                                      | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic                                                                                                           |       | 7,227,480                                                                       |       | 7,227,480                                                          |       | 9,166,389 |   | 9,166,389 |   |
| Effect of  dilutive securities:                                                                                 | ** ** | ** **                                                                      | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Common stock options                                                                                            |       | 1,682,055                                                                       |       | 1,546,000                                                          |       | 1,401,727 |   | 1,549,940 |   |
| Common stock warrants                                                                                           |       | 149,363                                                                         |       | 3,666,410                                                          |       | 196,751 |   | 2,885,000 |   |
| Diluted                                                                                                         |       | 9,058,898                                                                       |       | 12,439,890                                                         |       | 10,764,867 |   | 13,601,329 |   |
|                                                                                                                 |            |                                                                                 |            |                                                                    |            |  |  |  |  |  |  |  |  |

 

The incorrect calculation of diluted weighted averageshares outstanding did not affect net income for 2003 or any other period; nordid it affect earnings per share reported for any other period in 2003 or 2004or 2005.

We have not amended ourannual report on Form 10-K for the year ended December 31,2003, or our quarterly report on Form 10-Q for the third quarter of2003, which were the only periods impacted by the restatement. The informationthat has been previously filed or otherwise reported for these periods issuperseded by the information in this annual report.

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**FORWARD-LOOKINGSTATEMENTS**

*This Annual Report on Form 10-K and thedocuments incorporated herein by reference contain forward-looking statementsbased on our current expectations, estimates and projections about ourindustry, beliefs, and certain assumptions made by us. Words such as “believes,”“anticipates,” “estimates,” “expects,” “projections,” “may,” “potential,” “plan,”“continue” and words of similar import, constitute “forward-looking statements.”The forward-looking statements contained in this report involve known andunknown risks, uncertainties and other factors that may cause our actualresults to be materially different from those expressed or implied by thesestatements. These factors include those listed under the “Risk Factors” sectioncontained in Item 7 and elsewhere in this Form 10-K, and theother documents we file with the Securities and Exchange Commission, or SEC,including our most recent reports on Form 8-K and Form 10-Q.We cannot guarantee future results, levels of activity, performance or achievements.We do not undertake any obligation to revise these forward-looking statementsto reflect future events or circumstances.*

**PART I**

**Item 1.        *Business***

**Company Overview**

We are a leading provider of entertainment technology,products and services to the audio and image entertainment markets worldwide.Multi-channel audio, commonly referred to as surround sound, allows listenersto hear discrete sounds simultaneously through more than two speakers. Our DTSdigital multi-channel audio technology delivers compelling surround sound.

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 initial release, weestablished a technical and marketing platform for the development ofentertainment 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, distribute, andplay back digital multi-channel film soundtracks, pre-show entertainmentcontent, subtitles, captions and descriptive narration. We currently licenseour sound technology to all major film distributors in the United States. Mostmajor feature films currently released in the United States include a DTSsoundtrack. Our playback systems for DTS- formatted soundtracks have beeninstalled in over 27,000 movie screens worldwide. We also provide products andservices relating to cinema networking and content delivery as well as digitalcinema encoding services.

In 1996, we launched ourconsumer business, in which we license our technology to consumer electronicsproducts manufacturers for inclusion in products such as audio/video receivers,DVD players, personal computers, car audio products and home theater systems.The consumer products market has since grown to become the largest segment ofour business. To date, we have entered into licensing agreements with most ofthe major consumer audio electronics manufacturers in the world. We alsolicense our technology to many major semiconductor manufacturers. Ourtechnology, trademarks, and know-how have been incorporated in hundreds of millionsof consumer electronics products worldwide.

In January 2005, we expanded our business withthe acquisition of Lowry Digital Images, Inc. and changed its name to DTSDigital Images. Through this subsidiary, we provide high-quality digital imageprocessing, enhancement and restoration services for motion pictures, digitalcinema, and television content. These services enable current or archivedcontent to be restored, repaired or enhanced for high quality presentation inhigh definition optical media, broadcast or digital cinema applications.

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

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***Consumer Markets:***

·       Hometheater and consumer electronics entertainment devices such as audio/videoreceivers, DVD players, car audio products, and personal computers.

·       Emergingmarkets for digital multi-channel audio such as digital home networks, videogames and consoles, portable electronics devices, and digital satellite andcable 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 technology, products and services that enable the production anddistribution of soundtracks, subtitles, and pre-show or alternative content inour proprietary format.

·       Systemsfor playback and distribution of multi-channel audio soundtracks, pre-show, andalternative video content, subtitling, captioning, and descriptive narrationfor movie theaters and special venues.

·       Servicessupporting the operation, ingest, delivery and playback of digital content overdigital content networks.

·       Professional audio andvideo products and services for production of content for digital cinema thatcomplies with the technical specifications issued by the Digital CinemaInitiative, LLC, or DCI.

***Digital Imaging Markets:***

·       Digitalimage restoration and enhancement services for film and television content toenable high quality presentation in digital cinema, high definition opticalmedia or broadcast applications.

·       Digitalintermediate services for the motion picture industry.

·       Digitalimage services to repair and salvage damaged film and television content.

Regardless of the customeror entertainment application that incorporates our technology or services, wefacilitate the branded delivery and playback of high-quality digital content. Asthe transition from analog to digital entertainment technology continues, webelieve we are well-positioned to grow our licensing, product, and servicebusinesses worldwide. Our goal is to become essential to the ultimateentertainment experience by enabling the creation of compelling, high-qualitycontent and by incorporating our technology into every device that manages,controls or delivers high-quality digital entertainment.

**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, opticalstorage, and playback. These trends helped create a technical foundation forthe widespread adoption of digital multi-channel audio and high definitionvideo for many forms of entertainment.

***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. Stereoconsists of two channels and presents sound through discrete left and right 

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speakers. Stereo wasfollowed by matrix technology that allowed an inexpensive two-track system tobring surround sound to a large number of movie theaters. However, the audioquality and channel separation were limited.

In the early 1990s, thelistening experience of movie audiences was significantly enhanced through theintroduction of digital multi-channel surround sound technology. This format,commonly known as 5.1, combined high-quality audio with full separation in fivechannels: left, center, right, left surround, right surround, plus a channeldedicated to low frequency effects known as a subwoofer. Digital discretesurround sound enables movie directors and producers to create a moreenveloping and realistic entertainment environment. Many filmmakers recognizedthe ability of multi-channel audio to enhance the entertainment experience andpromoted its widespread 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 2005,over 165 major feature films were released in the United States with a DTSdigital multi-channel soundtrack with more than 1,300 films, including foreignfilms and dubbed language versions of films with DTS soundtracks being releasedworldwide.

Screen Digest Global MediaIntelligence, in its December 2005 Cinema Intelligence report estimatesthat in 2005 there were more than 141,000 movie theater screens worldwide, andthat in 2005 there were more than 40,000 screens in North America. ScreenDigest Global Media Intelligence estimates that in 2005, there wereapproximately 82,000 digital sound screens worldwide. As film studios haveincreasingly released films with digital multi-channel soundtracks, many movietheaters have purchased and installed digital multi-channel playback systemsand cinema processor equipment for both newly constructed and retrofitted movietheaters. A number of other venues also utilize digital multi-channel playbacksystems and cinema processor equipment to enhance the entertainment experience.These venues include large-screen format theaters, amusement parks, nationalparks, and museums.

***Proliferation ofHome 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;

·       thewidespread availability of DVDs released with digital multi-channelsoundtracks; and

·       thegrowth of high definition television displays.

According to the DVD Entertainment Group website atdvdinformation.com, annual sales of DVDs surpassed annual sales of prerecordedvideocassettes for the first time in 2001. The Digital Entertainment Group inthe first quarter of 2006, estimated that as of December 31, 2005, over73% of U.S. households own one or more DVD-Video players. They further estimatethat over 50% of DVD owners now have more than one player, and expect thisnumber to grow to nearly 90% by the end of 2009.

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.

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***Development ofRobust New Markets for Digital Multi-Channel Sound***

Digital multi-channelsound is extending into a growing number of consumer electronics environments,including homes, cars, personal computers, video games and consoles, portableelectronics devices, and digital satellite and cable broadcast products.Manufacturers of home audio products, music labels, and recording artists haverecognized that a substantial market opportunity exists for digital multi-channelhome audio systems and digital multi-channel music content. Currently, thereare multiple formats for CD- and DVD-based digital multi-channel audio content,many of which support our format. Nielsen SoundScan estimates that DVD musicvideo sales have grown in unit sales from over 5 million units in 2001 to 27million units in 2005, a 48% compounded annual growth rate. The DVD ReleaseReport for 2005 estimated that DVD music releases accounted for 12% of totalDVD releases with over 6,500 titles released.

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 digital multi-channelaudio to enhance the entertainment experience.

The digital satellite andcable broadcast markets may represent significant opportunities for digitalmulti-channel audio. ABI Research, in its first quarter 2006 quarterlymarketing briefing, estimates that digital satellite or digital cable wasinstalled in approximately 52% of U.S. households at the end of 2005, projectedto grow to 65% by the end of 2009, and in approximately 31% of Western Europeanhouseholds at the end of 2005, projected to grow to 47% by the end of 2009. Webelieve a significant market opportunity may exist in all sectors of thismarket including broadcast hardware, television set-top boxes, and televisions.

***Markets for Other Digital Technologies in the MotionPicture and Television Industries***

Motion picture exhibitors continue to seek new sourcesof revenue, independent of feature films. As a result, there is a growingdemand for products and services that facilitate the creation, distribution,control, and playback of digital pre-show advertising and alternative content.Pre-show and alternative content presentation can represent a sizable revenueopportunity for exhibitors who have historically been financially challenged bythe high cost of modern theater construction and the limited revenue sourcesavailable from theater operation. The Los Angeles Business Journal estimatesthat pre-show advertisements today account for over 80 percent of theateradvertising, which they indicate has shown double-digit growth for the past threeyears. Screen Digest estimates that revenues from pre-show advertising in NorthAmerica increased by 14% in 2005 to over $450 million.

In response to the growthin sales of high definition displays in homes and the move toward digitalcinema presentations, many film and television content owners are seeking toprepare their assets for presentation in high definition. Due to significantresolution differences between the standard and high definition formats,standard definition content often displays poorly when shown on a highdefinition device. To look compelling, content often must be prepared andenhanced to be appropriate for use in high definition optical media, broadcast,or digital cinema applications. Accordingly, we believe there is a growing marketfor digital image restoration and enhancement services in the motion picture,television, and home theater markets.

**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 

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encode the soundtracks oftheir films using our proprietary digital multi-channel sound format. Theaterowners purchase and use our products to play back DTS encoded soundtracks throughsix 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 optical media or hard discs rather thandirectly on film, we ensure reliable high-quality playback that is not subjectto film wear or subsequent audio degradation. Our system enables theateroperators to easily change audio tracks or languages without changing filmprints—a process that can take several hours. The use of DTS audio deliveredfrom discs also allows much more data capacity, and consequently higher audioquality, than data-on-film systems.

In addition, we provide products that enable thetransmission, scheduling and playback of video-based pre-show advertising andalternative content and systems for the projection and transmission ofsubtitles, captions, and descriptive narration. Our recently introduced DTSCinema Media NetworkTM is a product suite that will allow exhibitors to purchasea single integrated software and hardware solution for multiple in-theaterapplications, thereby combining incremental revenue opportunities with costefficient use of cinema hardware and personnel.

During 2005, DCI, a consortium of major HollywoodStudios, completed and issued its technical specifications for digital cinema. Thespecification outlines minimum requirements for distribution and playback ofdigital motion pictures encoded using JPEG2000 compression technology. Wesubsequently introduced the first DCI-compliant JPEG2000 Variable Bit Rateencoder to meet this need. Our DTS Digital Cinema EncoderTM provides highlyefficient, master quality encodes by optimizing bit-allocation according touser-defined parameters.

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, thatenables 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 backward compatibilitywith earlier implementations of the technology. The encoding process reducesthe storage space or transmission bandwidth required for the audio information,while maximizing the quality of the sound. The audio information can then bestored on a digital medium, such as a DVD, or transmitted over a broadbandconnection or broadcast signal. The encoded content can be played back ondigital audio electronics products equipped with a DTS Coherent Acousticsdecoder, 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.

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 facilitate the creation anddelivery of audio content in our proprietary digital multi-channel format. Wehave also entered the content-creation market directly through our DTSEntertainment label to further ensure the availability of high-quality digitalmulti-channel audio content.

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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 playback fromstereo content and has been incorporated into home theater, home audio, carelectronics, and our movie theater products. More recently, we introduced DTS-HDMaster Audio, which extends our technology offerings for next-generation bluelaser based optical media formats known as HD DVD and Blu-ray disc in two ways.First, the lossless extension delivers audio which is bit-for-bit identical tothe original master content. Secondly, DTS-HD includes a low bit rate mode thatextends into spaces where bandwidth and data size can be limiting, such asbroadcast and portable devices. Although DTS-HD will be first introduced inHD-DVD and Blu-ray Disc players and home theater systems, these newtechnologies have application in a wide variety of consumer electronic devices.

In 2005, we entered theimage enhancement, restoration and repair market through the acquisition ofLowry Digital Images, a leader in digital image processing. In this division,which is now known as DTS Digital Images, or DTS DI, we apply sophisticatedimage evaluation and processing algorithms in the digital domain to restore,enhance and repair motion picture and television content for the professionaland home entertainment markets. DTS DI processing is used by content owners torestore older content for release on DVD-Video and to repair content damaged inprocessing or problems encountered during production. Examples of the motionpictures that we have repaired or restored include a number of classic animatedfeatures, the original Star Wars trilogy, and the Indiana Jones series. Inaddition, we believe that DTS DI’s process is ideally suited to prepare contentof all types for distribution in the HD-DVD or Blu-ray Disc formats or highdefinition theatrical release. DTS DI processing technologies can also beapplied to correct or repair a multitude of photographic flaws that can resultfrom the production and processing of film and digital image content. Theseinclude the correction of out-of-focus sequences due to camera problems andremoving scratches or other flaws caused by incorrect processing.

**Products and Services**

We segment our businessinto consumer markets, cinema markets and digital images markets.

***Consumer Markets***

In our consumer business segment, we providetechnology that enables digital multi-channel surround sound for home theater,home audio, car audio, personal computer, and other emerging segments of theconsumer markets. Our Coherent Acoustics technology was designed for theconsumer electronics market. This proprietary technology enables delivery ofmultiple channels of discrete digital audio, but typically is used to providefrom two to eight channels. Coherent Acoustics enables consumers to experiencehigh-quality surround sound in or from their homes, cars, personal computers,or other listening environments.

We license our Coherent Acoustics technology toconsumer electronics product manufacturers primarily through two licensingchannels. First, we license our software developer kits to semiconductormanufacturers who embed our decoding software into their digital signalprocessor chips. In turn, these semiconductor manufacturers sell DTS-enabledchips only to hardware manufacturers who have entered into consumermanufacturer licenses with us. As part of the licensing terms for bothsemiconductor and hardware manufacturer licensees, we typically receive feesfor access to our developer kits and for our certification, prior to sale, ofthe quality and performance of their products. Our business model provides forus to receive a per-unit royalty for hardware products manufactured containingour technology.

Consumer electronics product 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 

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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, home-theater-in-a-boxsystems and some DVD players. Our technology is also embedded and supported innew and emerging consumer electronics products that use digital multi-channelaudio, including home audio systems, car audio systems, personal computers,video games and consoles, portable electronics devices, and digital satelliteand cable broadcast products. Importantly, Coherent Acoustics was selected as amandatory audio format in both next generation high definition optical mediaformats. As a result, DTS decoding technology will be featured in at leasttwo-channel form in any consumer product that is compatible with either theBlu-ray Disc or HD-DVD formats. Through December 31, 2005, our decodershave been embedded in more than 65 million audio/video devices.

As we enter new product categories, we fine-tune ourbusiness model to meet the specific needs of the relevant industry. In 2005, welaunched the DTS-Connect program for use in personal computer. DTS-Connectfeatures a real-time DTS encoder and a version of our Neo:6 matrix technologytuned especially for personal computers, which we call Neo:PC. In this businessmodel, integrated circuit  manufacturers payus fixed per unit royalties for each DTS-enabled chip shipped to a DTS licensedpersonal computer motherboard manufacturer. Each Licensed personal computermotherboard manufacturer reports to us the number of units purchased andmanufactured each quarter. 

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 products to professional audio equipment dealers. We license ourencoding technology to professional and professional/consumer 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 fromsuccessful industry artists and re-mixing and releasing digital multi-channelversions of these 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 or SACD discs.

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

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*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 aredesigned to play digital multi-channel music.

·       *Car Audio Systems.  *Currently, most major after-marketcar audio manufacturers sell products that include our digital multi-channelaudio technology. In addition, an increasing number of automobile manufacturershave introduced factory-installed digital multi-channel audio systems asstandard equipment or optional upgrades for a number of their new models. A DTSdigital multi-channel sound system is a standard feature on both the 2006 AcuraTL and RL models, and the Mercedes Benz 2006 S-Class model. In addition,Lexus, Land Rover, BMW, Infinity, Cadillac, Toyota, and Mazda of Japancurrently offer DTS-equipped digital multi-channel sound systems as afactory-installed option for certain vehicles. We anticipate growth in thismarket to continue as these and other manufacturers release vehicles thatincorporate our technology.

·       *Personal Computers.  *We have licensed our technologyfor incorporation 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 licensed ourdecoding technology to two of the leading software-based DVD player providers,Cyberlink Corporation and Intervideo Inc., who have incorporated ourtechnology into certain of their products. With the mandatory inclusion of ourtechnology in the Blu-ray and HD-DVD specifications, we expect an increasednumber of companies to introduce additional DTS-enabled software products inthe personal computer space. 

·       *Video Games and Consoles.  *We license our technologyfor inclusion into gaming hardware and software applications. We believe thatthe addition of interactive digital multi-channel audio to video games enablesa level of realism not provided by conventional audio systems and represents asignificant enhancement to the quality of the gaming experience. In the videogame hardware market, Sony Corporation’s PlayStation 2 supports our interactivedigital multi-channel sound technology when connected to a DTS-capableaudio/video receiver. We expect DTS technology to be an integral part of nextgeneration gaming devices especially as they utilize Blu-ray or HD-DVD drives.In the game software market, we have entered into licensing relationships withseveral major game publishers, including Activision, Inc., Atari, Inc.,and Electronic Arts, Inc., to incorporate our digital multi-channelencoding technology into their PlayStation 2 games.

·       *Portable Electronics Devices.  *Our technology isincorporated into some portable electronics devices, such as portable DVDplayers. We intend to aggressively pursue incorporation of our technology,including the new low bit rate technology, into other portable electronicsdevices such as camcorders, portable disc players, and music archival devicesfor stereo and simulated multi-channel playback via headphones.

·       *DigitalSatellite and Cable Broadcast Products.  *Our technology hasbeen adopted by the European Broadcasting Union’s Digital Video BroadcastProject as one of several formats for digital multi-channel audio delivery.This standards group sets digital cable, satellite, and terrestrial broadcaststandards for international markets including Europe. We are actively workingwith other relevant standards organizations for the inclusion of ourtechnology. Such inclusion would enable us to pursue the incorporation of ourtechnology into broadcast hardware, set-top-boxes, and televisions. To date, wehave licensed our trademarks and decoding technology for incorporation intotelevision set-top boxes.

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***NewTechnologies for Existing and Emerging Consumer Markets***

We continue to evolve and develop our technology forthe consumer market. Our Neo:6 matrix technology provides simulated multi-channelplay back from stereo, or two-channel, content. This technology increasingly isbeing incorporated into home theater systems, home audio systems, and car audiosystems. Our DTS-HD offering extends our Coherent Acoustics technology to fullbit-for-bit accurate lossless performance for applications where the highestquality is required, and adds DTS-HD low bit rate technology for applicationssuch as broadcast, portable and other devices where data size and bandwidth arelimiting factors. These additional technologies provide us with new revenueopportunities from existing and new customers.

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. 

*Professional AudioProducts and Services.**  *Wesell, license, and provide a variety of professional audio products andservices for content creators. The ultimate customers for these products arerecording artists, music labels, and post-production facilities. In 2005, wecontinued development and trials of a new set of professional audio products tosupport the launch of DTS-HD. Additionally, we worked with partners tointegrate DTS-HD encoding functionality into a broad array of next generationHD-DVD and Blu-Ray disc authoring systems. The following table lists theprofessional audio products and services that we currently provide:

| **Product or Service**           | ** ** | ** **                                                                                                                      | ** ** | **Description** |
|----------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| *DTS-HD Master Audio Suite*      |       | Mac & PC software suite for encoding,  monitoring and editing DTS-HD and standard definition digital audio.            |
| *DTS Surround Audio Suite*       |       | Mac & PC  software suite for encoding, monitoring and editing DTS Digital Surround  standard definition digital audio. |
| *DTS Software Licensing Objects* |       | DTS encode and decode  software for integration into third party professional software products.                                |
| *DTS  Encoding Service*          |       | Content providers create a digital multi-channel  master audio mix and provide it to us for encoding.                           |

 

*DTSEntertainment Label.**  *Were-mix and produce digital multi-channel music content to promote the use ofour technology and brand. We license this content and pay a royalty based onthe number of discs sold. We have released over 160 titles from artists indifferent genres of music including classical, jazz, country, pop, rock, andothers. These releases include works from classical composers such as Handeland Tchaikovsky, and titles by artists such as Diana Krall, The Crystal Method,Vince Gill, Lyle Lovett, 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 DVDplayers that are connected to a DTS-capable 5.1 playback system. Due to ourpatent coverage, we are the only company able to produce 5.1 Music Discs,although we have licensed, and may continue to license, the right to produce5.1 Music Discs in the future. We have released over 115 titles in this format.

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·       *DVD-Audio Discs.*   DVD-Audio is a format for musicpresentation. Our DVD-Audio discs are fully compatible with both DVD-Audioplayers and DVD-Video players. We have released 45 DVD-Audio discs. We havealso released three music title on the DVD-Video format.

·       *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 RecordLabels.*   We are pursuing relationships with majorrecord labels whereby we re-mix and produce titles from the label in ourmulti-channel format and the label distributes these titles. We announced ourfirst such relationship with EMI Music in August 2003. We producemulti-channel recordings from various EMI titles, these products carry the DTSlogo, and we receive a per-unit royalty for each unit sold. To date, we havereleased seven titles with EMI Music under the DTS Signature Series. Inaddition to its own branded content, DTS-Entertainment also provides servicesto other labels wishing to enter the surround music category.

***Cinema Markets***

In our cinema businesssegment we license technology and sell products and services to producers anddistributors of feature length films and digital content, and to movie theatersand special venues.

*Products andServices for Film Producers and Distributors*

For film producers and distributors, we licensetechnology to encode a movie’s audio master into our digital multi-channelformat and provide audio CD-ROMs for distribution with film prints tomovie theaters. To facilitate synchronization to the film print, we provide thestudios with equipment and a license to produce a timecode track which isprinted on the film. The discs and the film print have corresponding electronicserial numbers to ensure playback of the correct soundtrack.

We also offer products andservices for the encoding of movies in the DCI-specified JPEG2000 format. Wecurrently offer hardware and software and offer technical support to motionpicture studios, distribution service providers and digital intermediatefacilities engaged in preparation of content for digital cinema exhibition.

*Products for MovieTheaters and Special Venues*

*DigitalAudio 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.

*Systemsfor Subtitling, Captioning, and Descriptive Narration.**  *We also sell our DTS-CSS system to movie theaters.This system delivers feature-film subtitles, captions, and descriptivenarration for foreign language and hearing and visually impaired audiences. Webelieve this proprietary digital system is a cost-effective method to providesubtitles, captions, and descriptive narration for a film because it eliminatesthe need to permanently imprint, etch, or overlay the subtitles or captionsdirectly onto the film. The DTS-CSS system enables the delivery of open orclosed captioning, depending on the output device utilized. For open captions,the DTS-CSS system uses a separate video projector to render subtitles orcaptions; for closed captions, the system is utilized in conjunction with arear-wall display device. This product is 

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designed to address theincreasing political and social pressure to provide access to the motionpicture experience for the hearing and visually impaired.

This same family of products is also being used forelectronic cinema applications including alternative content presentations andpre-show advertising, incorporating both high definition image and audioplayback capabilities. These products enable a theater owner to extend itsrange of revenue opportunities, and help to maximize the utility of equipmentin theater projection rooms, saving expense and space. In the pre-showadvertising area, both the CSS system and the DTS XD10 Cinema Media Player can beused when coupled with a color projector. The DTS XD10 has an extensive featureset, which includes networking capability to facilitate its integration into acontent distribution system. We also offer the DTS Cinema Media NetworkTMproduct suite which incorporates the DTS XD10 Cinema Media Player to manage thecreation, transmission/delivery, scheduling, logging, remote system monitoringand playback of all types of digital content including video, audio, subtitles,captions, and descriptive narration. 

Thechart below lists the products that we sell to movie theaters and specialvenues:

| **Product or Service**              | ** ** | ** **                                                                                                                                                                                                                                                                              | ** ** | **Description** |
|-------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| *DTS XD10 Cinema Media Player*      |       | A DVD and  hard-drive-based multi-function playback device. Supports up to ten channels  of audio, and has digital video playback capability. Can be upgraded to  support DTS-CSS applications, pre-show advertising, and alternative content.                                          |
| *DTS XD10P Cinema Audio  Processor* |       | A stand alone  digital and analog cinema audio processor. Provides up to eight channels of  audio output and interfaces with the XD10 Cinema Media Player, other digital  sources and theater automation systems.                                                                       |
| *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-CSS System*                    |       | A digital  subtitling, captioning, and descriptive narration system consisting of a  processing unit, time code reader, and a digital projector.                                                                                                                                        |
| *DTS Cinema Media NetworkTM*    |       | A suite of  hardware and software products to manage network transmission, in-theater  scheduling, and digital content playout such as electronic cinema,  alternative content, digital preshow advertising, lobby advertising, audio,  captions, subtitles, and descriptive narration. |
| *DTS Digital Cinema EncoderTM*  |       | A DCI-compliant variable  bit rate JPEG2000 encoder used in the production of motion pictures for  digital cinema exhibition.                                                                                                                                                           |

 

**ImageRestoration, Enhancement, and Repair Services**

In our Digital Imagesdivision, we provide restoration, enhancement and repair services for motionpictures captured in analog or digital form. Our services enable current orarchived film or television content to be restored, enhanced or repaired toenable high quality, high definition presentation in high definition opticalmedia, broadcast, or digital cinema applications. In addition, we believethat  DTS DI is uniquely suited forcorrecting or repairing a multitude of photographic challenges encountered inthe production and processing of film and digital image content. These issuesrange from the correction of out-

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of-focussequences due to camera problems to removing scratches or other flaws caused byincorrect processing.

**DTS Technology Platform**

Our Coherent Acoustics audio technology platform isdesigned to capture, store, and reproduce audio signals. There are severaltechnical considerations involved in this process, including the frequency ofdata sampling, 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 and productsthat reduce the amount of data required to store and transmit an audio signaland to subsequently reproduce the audio.

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.

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 31individual patent families resulting in more than 125 individual patents andmore than 59 patent applications throughout the world. We have more than 87trademarks and more than 44 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 and other technical materials as well as numerous trade secrets. Wehave targeted our intellectual property coverage to provide protection in themajor manufacturing and commercial 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 having begun to expire in 2005 and others expiring through 2009. However,many of our more substantive patents are relatively young and have expirationdates ranging from 2015 to 2018. We have multiple patents covering uniqueaspects and improvements for many of our technologies. Accordingly, we 

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do not believe that theexpiration of any single patent is likely to significantly affect our intellectualproperty 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 our technology on standard termsthrough a two-tiered structure: first to integrated circuit semiconductormanufacturers and then to consumer electronics product manufacturers. Wegenerally license on a non-exclusive, worldwide basis. Our business modelprovides for hardware manufacturers to pay us for each unit they produce thatcontains our technology or trademarks. We require that all licensees have theirintegrated circuits or hardware devices certified by us prior to distribution.We reserve the right to audit their records and quality standards. Licenseesare required to use the appropriate DTS trademark on the products theymanufacture. 

In the consumer products market, we have 59 patentsissued and 47 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 43 patents issued and 10patents 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 23patents and two 

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patent applications thatspan both the consumer products and cinema sectors of our business. Theserights primarily cover the process of producing media containing DTS anddigital multi-channel audio as well as the individual finished product.

In our Digital Images business, we have historicallyrelied primarily on trade secrets to protect our intellectual property. In thefuture, we expect to seek patent protection for inventions relating to thisbusiness and we currently have several patent applications in development.

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 ofover 30 individual word marks, logos, and slogans filed throughout the world.The marks cover our various products, technology, improvements, and features aswell as the services that we provide. Our trademarks are an integral part ofour licensing program and are required to be used on licensed products toidentify the existence of the technology and to provide greater consumerawareness. Our trademarks include the following:

We have a significant amount of copyright protectedmaterials including software, textual materials, and master audio materialsused to produce our DTS Entertainment products. A number of these products havebeen federally registered.

**Customers**

***Consumer Markets***

*ConsumerElectronics Products Manufacturers*

Wehave licensed our Coherent Acoustics technology and trademarks to over 300consumer electronics products manufacturers for use in hundreds of consumeraudio products. Collectively, these manufacturers have sold over65 million products with DTS digital sound decoding technology. Thefollowing list sets forth some of the consumer electronics productmanufacturers that have licensed our technology.

| **Audio & Audio/Video  Receivers**                                           | ** ** | **DVD  Players**                                                     |
|---------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|
| Koninklijke  Philips Electronics N.V.

LG Electronics, Inc.

Pioneer Corporation |       | Samsung Electronics  Co., Ltd.

Sony Corporation

Yamaha Corporation |   | Funai Electric  Co.,   Ltd.

Pioneer Corporation  Toshiba Corporation |   | Samsung  Electronics Co., Ltd.

Sony Corporation

Thomson Multimedia  Audio Hong Kong Ltd. |
|                                                                                       |            |                                                                      |  |  |  |  |

 

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| Car Audio Systems                                                      |
|------------------------------------------------------------------------|
| Alpine Electronics, Inc. Clarion Co., Ltd.  Fujitsu Ten Co., Ltd. |   | Harman  International  Industries, Inc.

Hyundai Autonet Co., Ltd |   | Kenwood  Corporation

Matsushita  Electric  Industrial Co., Ltd. |   | Pioneer Corporation Sony Corporation |

 

| Personal  Computer        |
|---------------------------|
| Creative  Technology Ltd. |   | Cyberlink Corporation |   | Intervideo, Inc. |   | Logitech, Inc. |

 

*SemiconductorManufacturers*

Wehave licensed to over 60 semiconductor manufacturers the right to incorporateour technology in their semiconductors and to sell semiconductors with DTStechnology to our hardware manufacturer licensees. Our majorsemiconductor-manufacturing customers include the following:

| Analog Devices  Cirrus Logic, Inc.                        |   | Fujitsu Limited  LSI Logic Recorder Corporation    |   | MediaTek, Inc.  Texas Instruments, Inc. |
|----------------------------------------------------------------|--------|----------------------------------------------------|--------|---------------------------------------------------|
| ESS  Technology, Inc.  Freescale Semiconductor, Inc. |   | Matsushita  Electrical Industrial Co.,  Ltd.  |   | Yamaha Corporation                                |

 

*Content Providers*

We have also provided ourCoherent Acoustics technology to many of the leading home video and musiccontent providers including DreamWorks Home Entertainment, New Line HomeEntertainment, Inc., and Warner Bros. Records, Inc. To date,thousands of DVD titles have been produced with DTS digital multi-channel audiotracks.

*DTS Entertainment*

Major retail customers whosell DTS Entertainment labeled music content to consumers include Amazon.com,Best Buy, Musicland, and Tower Records.

***Cinema Markets***

Thesix major film studios in the United States are all customers of ours.According to Exhibitor Relations, these film studios accounted forapproximately 86% of admission revenues and 85 of the 100 highest grossingfilms in the United States in 2005. These studios, which released most of theirmajor feature films in the DTS format in 2005, are listed below.

| 20th Century Fox  Buena Vista Pictures |   |  Paramount Pictures  MGM Pictures/Sony/Columbia |   |  Universal Pictures  Warner Bros. Pictures |
|----------------------------------------|--------|------------------------------------------------------|--------|-------------------------------------------------|
| DreamWorks SKG                         |   | New Line Cinema Corp.                                |   |                                            |

 

In addition, we sell ourplayback equipment to movie theaters, including the following:

| Carmike Cinemas |   | Odeon Limited        |   | Regal Entertainment |
|-----------------|--------|----------------------|--------|---------------------|
| Cinemark        |   | Rave Motion Pictures |   |                |

 

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***Digital Images Markets***

Our Digital Imagesdivision’s customers primarily include major film and television distributors,including:

| Disney Worldwide Services |   | Paramount Pictures / CBS Television |   | 20th Century Fox       |
|---------------------------|--------|-------------------------------------|--------|------------------------|
| Earthship  Productions    |   | Sony / MGM Pictures                 |   | Warner Bros Television |
| LucasFilm                 |   |                                |   |                   |

 

**Sales, Marketing,and Support**

***Consumer Products***

We have a licensing teamthat markets our technology directly to large consumer electronic productsmanufacturers and semiconductor manufacturers. This team includes employeeslocated in the United States, China, England, Hong Kong, Japan, and NorthernIreland. We believe that by locating staff near the leading consumerelectronics and semiconductor manufacturers we can enhance our sales andbusiness 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 DTS encoders will result in more DTS content, which we believewill drive consumer demand for DTS-enabled electronics products.

***Film Producers andDistributors***

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.Cadiz Music Limited serves as our exclusive distributor of DTS Entertainmentlabel products in Europe and Disc Union serves as our exclusive distributor inJapan. We also sell this music directly to consumers through an online storeand other web-based retailers.

**Research and Development**

We have a group of 58 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 facilities in Bangor, Northern Ireland and Vancouver,Canada.

Our research anddevelopment expenses totaled approximately $5.0 million during 2003,$6.1 million during 2004, and $9.9 million during 2005. We expect that wewill continue to commit significant resources 

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toapplications engineering efforts, particularly in support of the new highdefinition disc standards, and to research and development in the future.

**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 not requiredto 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, DigitalLiving Network Alliance, High-Definition Multimedia Interface Standard, MediaOriented Systems Transport Bus, Audio Engineering Society and Society forMotion Picture and Television Engineers. We anticipate being involved in anumber of other standards organizations as appropriate to facilitate theimplementation of 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, and haveobtained mandatory status in both the HD DVD and Blu-ray Disc formats. ForDVD-Video, we have obtained optional status for our core Coherent Acoustics technology.Through our participation, we have expanded the supported specification of ourcodec, increasing the quality and number of channels. Our technology has beenaccepted as an optional format in the DVD-Audio Recordable specification and weare currently involved in the working groups for Interactive DVD and DVDrecording specifications for both audio and high 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 seven employeesand consultants focused on standards activities, including one in Europe, onein Japan, one in Korea, and four in the United States. We also employadditional resources as necessary to assist with specific standards-relatedtasks.

**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 almost 40 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.

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In addition to Dolby Laboratories, we also compete inspecific product markets with Coding Technologies, Fraunhofer InstitutIntegrierte Schaltungen, Koninklijke Philips Electronics N.V., Meridian AudioLimited, Microsoft Corporation, Smart Devices, Inc., Sony Corporation,Thomson, Ultra Stereo Labs, Inc., and various consumer electronicsproducts manufacturers. Many of these competitors have longer operatinghistories and significantly greater resources or greater name recognition thanwe do.

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

·       technology performance,flexibility, and range of application;

·       quality and reliability ofproducts and services;

·       brandrecognition and reputation;

·       inclusionin industry standards;

·       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 consumer,cinema, and digital images markets and building and maintaining significantmarket share. Most major feature-film releases in the United States are encodedin our format, many top selling and premier edition DVDs contain digitalmulti-channel soundtracks in our format, a substantial majority of consumerelectronics products with digital multi-channel capability incorporate ourtechnology, trademarks, or know-how, and many of the most valuable filmproperties in the world have been restored using our process. Our success hasbeen due in large part to our ability to position our brand as a premiumoffering that contains superior proprietary technology, the quality of ourcustomer service, our inclusion in industry standards, and our industryrelationships.

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. In the digital images market, we believe that we have a significantlead in automating the restoration and enhancement of television and motionpicture images through the use of sophisticated proprietary softwarealgorithms.

**Employees**

As of December 31,2005, we had 314 employees, which includes 58 employees in engineering,technical services, and research and development, 98 employees in productionand operations, 88 employees in sales, marketing, service, and support, 35employees in accounting and information technology, and 35 employees in seniormanagement and administration. Of the 314 total employees, 239 work in theUnited States and 75 work in our various international locations, including 54in the United Kingdom. None of our employees are 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 

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personnel.From time to time, we also employ independent contractors to support ourproduct development, sales, marketing, business development, and administrationorganizations.

**Website Access to SEC Filings**

We maintain an Internetwebsite at*www.dts.com.* We make available free ofcharge 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 we electronicallyfile such material with, or furnish it to, the SEC.

**Item 1A.   *Risk Factors***

**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 publicstatements we make. If any of the following risks actually occurs, ourbusiness, financial condition, or results of operations could suffer. In thatcase, the trading price of our common stock could decline, and you may lose allor part of your investment.*

**Risks Related to Our Business**

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

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

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

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

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

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

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

·       greatername recognition;

·       alonger operating history;

·       moredeveloped distribution channels and deeper relationships with our common customerbase;

·       amore extensive customer base;

·       digitaltechnologies that provide features that ours do not;

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·       broaderproduct and service offerings;

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

·       moretechnicians and engineers.

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

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

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

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

Technology standards are important in the audio andvideo industry as they help to assure compatibility across a system or seriesof products. Generally, standards adoption occurs on either a mandatory basis,requiring a particular technology to be available in a particular product or medium,or an optional basis, meaning that a particular technology may be, but is notrequired to be, utilized. For example, both our digital multi-channel audiotechnology and Dolby’s have optional status in Standard and High-Definition DVDand Blu-ray. In the emerging standards for high definition-DVD and Blu-ray,both DTS and Dolby technologies have been selected as mandatory standards fortwo-channel output. However, if either or both of these standards are re-examinedor a new standard is developed, we may not be included as mandatory in any suchnew or revised standard.

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

As new technologies andentertainment media emerge, new standards relating to these technologies or mediamay 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 ableto evolve our technology, products, and services or develop new technology,products, and services that are acceptable to our customers or the changingmarket.***

Themarket for our technology, products, and services is characterized by:

·       rapidtechnological change;

·       newand improved product introductions;

·       changingcustomer demands;

·       evolvingindustry standards; and

·       productobsolescence.

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

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

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

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

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

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

·       ourpatents may be challenged or invalidated by our competitors;

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

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

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

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

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

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

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

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

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

***Our operatingresults may be adversely affected as a result of required compliance with therecently adopted European Union Directives on Waste Electrical and ElectronicEquipment and the Restriction of the Use of Hazardous Substances in electricaland electronic equipment.***

In February 2003, the European Union enactedDirective 2002/96/EC on Waste Electrical and Electronic Equipment Directive, knownas the WEEE Directive. The WEEE Directive requires producers of certainelectrical and electronic equipment to be financially responsible for thefuture disposal costs of 

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this equipment. Our cinemaproducts may fall within the scope of this Directive and as such we may incursome financial responsibility for the collection, recycling, treatment anddisposal of both new products sold, and products already sold prior to the WEEEDirective’s enforcement date, to customers within the European Union. The Directivepotentially increases our financial liabilities by requiring producers to adoptnew approaches for improving sustainable product design and for encouragingrecycling or re-use at the end of the product’s life.

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

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

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

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

***If we are unable tomaintain and increase the amount of entertainment content released with DTSaudio soundtracks, demand for the technology, products, and services that weoffer to consumer electronics products manufacturers may significantly decline.***

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

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significantamount of content in movies, audio DVDs, computer software programs, videogames, or other entertainment mediums will be released with DTS audiosoundtracks. If the amount, variety, and popularity of entertainment contentreleased with DTS audio soundtracks do not increase, consumer electronicsproducts manufacturers that pay us per-unit licensing fees may discontinueoffering DTS playback capabilities in the consumer electronics products thatthey sell.

***If our independentregistered public accounting firm is unable to provide us with an unqualifiedreport as to the adequacy of our internal controls over financial reporting forfuture year-ends as required by Section 404 of the Sarbanes-OxleyAct of 2002, investors could lose confidence in the reliability of ourfinancial statements, which could result in a decrease in the value of ourshares.***

As directed by Section 404of the Sarbanes-Oxley Act of 2002, the SEC adopted rules requiringall public companies, including us, to include a report by management oninternal control over financial reporting in all annual reports on Form 10-Kthat contains an assessment by management of the effectiveness of internalcontrol over financial reporting. In addition, the independent registered publicaccounting firm auditing our financial statements must attest to and report onour management’s assessment of the effectiveness of internal control overfinancial reporting and the effectiveness of internal control over financialreporting. While we conduct rigorous reviews of our internal control overfinancial reporting in order to comply with the Section 404 requirements,our independent registered public accounting firm may interpret the Section 404requirements and the related rules and regulations differently from us, orour independent registered public accounting firm or management may not besatisfied with our internal control over financial reporting or with the levelat which these controls are documented, executed or reviewed. In addition, manyuncertainties remain regarding the requirements for auditor attestation, andguidance provided by the public accounting profession has changed frequentlyand materially to date and may continue to change such that we may not be ableto comply with these new requirements. Further, the demand for competent auditresources has grown dramatically as a result of the requirements of Section 404,and such demand may exceed available supply. In addition, in January 2005,we acquired Lowry Digital Images, Inc., or LDI, a privately held companywith limited financial resources that may not have implemented sufficientinternal control over financial reporting. We may in the future make additionalacquisitions which may be significant to our operations either individually orin the aggregate. We may face significant challenges in implementing therequired processes and procedures in the acquired operations of LDI or anyother businesses that we may acquire. As a result, our independent registeredpublic accounting firm may issue an adverse report or a disclaimer onmanagement’s assessment of internal control over financial reporting.Management may also identify material weaknesses which would cause managementto conclude internal control over financial reporting is not effective. Thiscould result in an adverse reaction in the financial markets due to a loss ofconfidence in the reliability of our financial statements, which could causethe market price of our shares to decline.

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

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

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

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

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

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

***Our revenues 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 or delay the number of films they release using DTStechnology or services.***

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

***If the movieindustry adopts new digital cinema technology in place of current filmtechnology, demand for our cinema products and services could decline.***

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

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

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

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

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

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

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

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

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

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

Although the first moviewith a DTS audio soundtrack was released in 1993, we did not enter the hometheater market until 1996, and our technology has only recently beenincorporated into other consumer electronics markets, such as car audio,personal computers, video games and consoles, portable electronics devices, anddigital satellite and cable broadcast products. In addition, while we havecompleted over 100 digital image processing, enhancement and restoration filmprojects, it is only recently that a large 

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numberof these projects have been completed. 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 andimage services is relatively new and rapidly evolving, we have limited insightinto trends that may emerge and affect our business. We may make errors inpredicting and reacting to relevant business trends, which could harm ourbusiness. Before investing in our common stock, you should consider the risks,uncertainties, and difficulties frequently encountered by companies in new andrapidly evolving markets such as ours. We may not be able to successfullyaddress any or all of these risks.

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

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

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

Although we havebeen in business since 1990, we have only achieved profits from our businessoperations since the third quarter of 2001. We expect our operating expenses toincrease as we, among other things:

·       expandour domestic and international sales and marketing activities;

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

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

·       hireadditional personnel, including engineers and other technical staff;

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

·       continueto assume the responsibilities of being a public company.

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

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

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

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

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

·       difficultiesin staffing and managing foreign operations;

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·       dependenceon foreign distributors and their sales channels;

·       longeraccounts receivable collection cycles and difficulties in collecting accountsreceivable;

·       lesseffective and less predictable protection of intellectual property;

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

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

·       potentiallyadverse tax consequences.

Such factors could cause our future internationalsales to decline.

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

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

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

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

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

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

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

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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 these distributorswere to go out of business, as one of our previous distributors did, orotherwise becomes incapable of continuing as our distributor, we couldexperience delays in distributing our DTS Entertainment products to the retailmarket, loss of inventory, and loss of revenue.

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

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

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

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

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

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

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

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

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

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

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

·       diversionof management’s attention from our core business;

·       adverseeffects on existing business relationships with suppliers and customers;

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

·       potentialloss of key employees of acquired organizations.

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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;

·       managemultiple concurrent development projects; and

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

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

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

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

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

***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 

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usingthe intrinsic value method, which results in no compensation expense, since wegrant employee options with exercise prices equal to the fair market value ofthe underlying stock at the time of grant. If, however, we had used the fairvalue method of accounting for stock options granted to employees using aBlack-Scholes option valuation formula, our net income for the fiscal yearended December 31, 2005, would have been reduced by $5.4 million, from$7.9 million to $2.5 million for the year. When we adopt SFAS No. 132R,“Share-Based Payment’’, in the first quarter of 2006, we will have on-goingaccounting charges significantly greater than those we would have recordedunder our current method of accounting for stock options, which will have amaterial adverse affect on our operating results.

**Risks Related to Our Common Stock**

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

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

·       actualor anticipated fluctuations in our results of operations;

·       announcementsof technological innovations or technology standards;

·       announcementsof significant contracts by us or our competitors;

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

·       developmentswith respect to intellectual property rights;

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

·       thecommencement of or our involvement in litigation;

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

·       conditionsand trends in technology industries;

·       changesin market valuation or earnings of our competitors;

·       thetrading volume of our common stock;

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

·       generaleconomic conditions.

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

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

As of December 31,2005, we had 17,472,543 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.

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

Our capitalrequirements will depend on many factors, including:

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

·       thecosts of developing new products or technology;

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

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

·       thecosts associated with our expansion, if any.

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

***Anti-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, tenderoffer, or proxy contest involving our company. Any delay or prevention of achange of control transaction or changes in our Board could cause the marketprice of our common stock to decline.

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**Item 1B.**               *Unresolved Staff Comments*

None.

**Item 2.**                        *Properties*

Our corporate headquartersand principal offices are located in Agoura Hills, California, where we leaseapproximately 48,000 square feet. This space is leased under three leases whichexpire in May 2007 and October 2007. We also lease smaller facilitiesin other locations including the United States, Canada, China, England, France,Italy, Northern Ireland, Hong Kong and Japan. 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.

**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.

We are not a party to anymaterial legal proceedings. We may, however, become subject to lawsuits fromtime to time in the course of our business.

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

We did not submit any matters to a vote of securityholders during the fourth quarter of the year ended December 31, 2005.

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**PART II**

**Item 5.**                        *Market for Registrant’s Common Equity, Related Stockholder Matters andIssuer Purchases of Equity Securities*

**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** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| **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 |   |
| **2005:**      |       |     |       |    |       |
| First Quarter  |       | $        | 22.00      |    | $          | 17.68 |   |
| Second Quarter |       | $        | 19.04      |    | $          | 14.76 |   |
| Third Quarter  |       | $        | 20.50      |    | $          | 16.30 |   |
| Fourth Quarter |       | $        | 17.20      |    | $          | 13.44 |   |

 

As of January 25, 2006 there were approximately3,500 stockholders of record of our common stock. We believe that the number ofbeneficial owners is substantially greater than the number of record holdersbecause a large portion of our common stock is held of record through brokeragefirms 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, wecompleted our initial public offering for the sale of 4,091,410 shares ofcommon stock at a price to the public of $17.00 per share, which resulted innet proceeds of approximately $63.0 million after payment of theunderwriters’ commissions and deductions of offering expenses. All of theshares of Common Stock sold in the offering were registered under the 1933 Acton a Registration Statement on Form S-1 (Reg. No. 333-104761)that was declared effective by the SEC on July 9, 2003 and a RegistrationStatement filed pursuant to Rule 462(b) under the Securities Act thatwas filed on July 10, 2003 (Reg. No. 333-106920). Subsequent tothe offering, we used approximately $22.5 million of our net proceeds toredeem all outstanding shares of redeemable preferred stock and to pay allaccrued but unpaid dividends on such shares through the date of redemption. Theremaining proceeds to us have conformed with our intended use outlined in theprospectus related to the offering. As of December 31, 2005, we haveapproximately $40.5 million remaining from the proceeds of the 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 DTS, Inc. The consolidated statement of operations data for the yearsended December 31, 2001 and 2002 and the consolidated balance sheetdata as of December 31, 2001, 2002, and 2003 are derived from our auditedconsolidated financial statements for such periods and dates, which are notincluded in this Form 10-K. The consolidated statement of operationsdata for the years ended December 31, 2003, 2004, and 2005 and theconsolidated balance sheet data as of December 31, 2004 and 2005 arederived from, and qualified by reference to, our audited consolidated financialstatements for such periods and dates, which appear elsewhere in this Form 10-K.It is important that you read the selected consolidated financial data setforth below in conjunction with our consolidated financial statements andrelated notes and “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” included elsewhere in this Form 10-K. Ourhistorical results are not necessarily indicative of the operating results thatmay be expected in the future. We have described various risks anduncertainties that could affect future operating results under the heading “RiskFactors” included elsewhere in this Form 10-K.

| ** **                                                                                                     | ** ** | **Years Ended December 31,**                                            | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|
| ** **                                                                                                     | ** ** | **2001**                                                                               | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005(2)** | ** ** |
| ** **                                                                                                     | ** ** | **(In thousands, except share and per share data)** | ** ** |
| **Consolidated Statement of Operations Data**                                                                  |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Revenues:                                                                                                      |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Technology and  film licensing                                                                                 |       | $                                                                                      | 19,615     |   | $ | 31,906 |   | $ | 42,229 |   | $ | 49,920 |   | $ | 56,947 |   |
| Product sales and  other  revenues                                                                             |       | 9,133                                                                                  |       | 9,150 |   | 9,473 |   | 11,511 |   | 18,305 |   |
| Total revenues                                                                                                 |       | 28,748                                                                                 |       | 41,056 |   | 51,702 |   | 61,431 |   | 75,252 |   |
| Cost of goods sold:                                                                                            |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Technology and  film licensing                                                                                 |       | 3,007                                                                                  |       | 3,687 |   | 4,281 |   | 4,451 |   | 4,715 |   |
| Product sales and  other  revenues                                                                             |       | 7,045                                                                                  |       | 6,949 |   | 6,751 |   | 11,711 |   | 14,898 |   |
| Total cost of  goods sold                                                                                      |       | 10,052                                                                                 |       | 10,636 |   | 11,032 |   | 16,162 |   | 19,613 |   |
| Gross profit                                                                                                   |       | 18,696                                                                                 |       | 30,420 |   | 40,670 |   | 45,269 |   | 55,639 |   |
| Operating expenses:                                                                                            |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Selling, general  and administrative                                                                           |       | 13,336                                                                                 |       | 16,379 |   | 20,473 |   | 27,644 |   | 33,960 |   |
| Research and  development                                                                                      |       | 3,603                                                                                  |       | 3,754 |   | 4,987 |   | 6,131 |   | 9,867 |   |
| In-process  research and development                                                                           |       | —                                                                                 |       | — |   | — |   | — |   | 2,300 |   |
| Total operating  expenses                                                                                      |       | 16,939                                                                                 |       | 20,133 |   | 25,460 |   | 33,775 |   | 46,127 |   |
| Income from  operations                                                                                        |       | 1,757                                                                                  |       | 10,287 |   | 15,210 |   | 11,494 |   | 9,512 |   |
| Interest income  (expense), net                                                                                |       | (278                                                                                   | )          | (94 | ) | 271 |   | 1,447 |   | 2,524 |   |
| Other expense, net                                                                                             |       | (302                                                                                   | )          | (255 | ) | (214 | ) | (31 | ) | 154 |   |
| Income from legal  settlement                                                                                  |       | —                                                                                 |       | — |   | — |   | 2,601 |   | — |   |
| Income before  provision (benefit) for income taxes                                                       |       | 1,177                                                                                  |       | 9,938 |   | 15,267 |   | 15,511 |   | 12,190 |   |
| Provision  (benefit) for income  taxes                                                                         |       | (2,731                                                                                 | )          | 3,688 |   | 5,368 |   | 5,535 |   | 4,282 |   |
| Net income                                                                                                     |       | 3,908                                                                                  |       | 6,250 |   | 9,899 |   | 9,976 |   | 7,908 |   |
| Accretion and  accrued dividends on preferred stock                                                       |       | (1,813                                                                                 | )          | (1,848 | ) | (1,234 | ) | — |   | — |   |
| Net income  attributable to common stockholders                                                                |       | $                                                                                      | 2,095      |   | $ | 4,402 |   | $ | 8,665 |   | $ | 9,976 |   | $ | 7,908 |   |
| Net income attributable to common stockholders per  common share:                                              |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Basic                                                                                                          |       | $                                                                                      | 0.49       |   | $ | 0.99 |   | $ | 0.95 |   | $ | 0.59 |   | $ | 0.46 |   |
| Diluted                                                                                                        |       | $                                                                                      | 0.23       |   | $ | 0.47 |   | $ | 0.64 | (1) | $ | 0.55 |   | $ | 0.43 |   |
| Weighted average shares used to compute net income  attributable to common stockholders per common share: |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Basic                                                                                                          |       | 4,295,419                                                                              |       | 4,432,408 |   | 9,166,389 |   | 16,865,805 |   | 17,321,148 |   |
| Diluted                                                                                                        |       | 9,054,843                                                                              |       | 9,329,278 |   | 13,601,329 | (1) | 18,143,114 |   | 18,310,372 |   |

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(1)             As restated. See Note 2 included in our auditedfinancial statements included elsewhere in this Form 10-K.

(2)             Includes the results of operations for DTS DigitalImages, Inc. We acquired this business in January 2005.  In connection with this acquisition, weincurred a $2.3 million charge for in-process research and development.

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Seeour consolidated financial statements and related notes for a description ofthe calculation of the historical net income 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,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                          | ** ** | **2001**                              | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                          | ** ** | **(In thousands)**               | ** ** |
| **Consolidated  Balance Sheet Data**                |       |                                  |       |   |   |   |   |   |   |   |   |
| Cash, cash  equivalents, and short-term investments |       | $                                     | 6,858      |   | $ | 4,051 |   | $ | 99,389 |   | $ | 114,311 | ** ** | **$** | **111,417** | ** ** |
| Working capital                                     |       | 9,452                                 |       | 9,381 |   | 110,810 |   | 125,573 | ** ** | **122,763** | ** ** |
| Total assets                                        |       | 21,707                                |       | 25,779 |   | 127,495 |   | 144,689 | ** ** | **158,254** | ** ** |
| Long-term  obligations, less current  portion       |       | 6,303                                 |       | — |   | — |   | — |   | — |   |
| Mandatorily  redeemable preferred stock             |       | 19,454                                |       | 21,302 |   | — |   | — |   | — |   |
| Total stockholders’  equity (deficit)          |       | (10,855                               | )          | (6,315 | ) | 118,871 |   | 134,766 | ** ** | **144,090** | ** ** |
|                                                     |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Item 7.**                        *Management’s Discussion and Analysis of Financial Condition and Resultsof Operations*

This Annual Report on Form 10-K and thedocuments incorporated herein by reference contain forward-looking statementsbased on our current expectations, estimates and projections about ourindustry, beliefs, and certain assumptions made by us. Words such as “believes,”“anticipates,” “estimates,” “expects,” “projections,” “may,” “potential,” “plan,”“continue” and words of similar import, constitute “forward-looking statements.”The forward-looking statements contained in this report involve known andunknown risks, uncertainties and other factors that may cause our actualresults to be materially different from those expressed or implied by thesestatements. These factors include those listed under the “Risk Factors” sectioncontained 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 cannotguarantee future results, levels of activity, performance or achievements. Wedo not undertake any obligation to revise these forward-looking statements toreflect future events or circumstances.

You should read thefollowing discussion of our financial condition and results of operations inconjunction with the consolidated financial statements and the notes to thosestatements included elsewhere in this Form 10-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,products and services to the audio and image entertainment markets worldwide.Historically we have been focused on high quality digital multi-channel audio,commonly referred to as surround sound, which provides more than two-channelsof audio, allowing the listener to simultaneously hear discrete sounds frommultiple speakers. Our DTS digital multi-channel audio technology deliverscompelling surround sound for the motion picture and consumer electronicsmarkets. With our January 2005 acquisition of Lowry Digital Images, Inc.,now DTS Digital Images, Inc., or DTS DI, we have expanded our businessinto high quality digital image processing, enhancement and restoration for themotion pictures, digital cinema, and televisions content.

We manage our business through three reportablesegments—our consumer business, our cinema business, and our digital imagesbusiness.

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

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

In our digital images business, we derive revenuesfrom the processing, enhancement and restoration of cinema, home video andbroadcast television content. We provide these services to motion picture andtelevision studios and other content owners. We offer our services on either afixed fee or time and materials basis.

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

We actively engage in intellectual property complianceand enforcement activities focused on identifying third parties who have eitherincorporated our technology, trademarks, or know-how without a license or whohave under-reported to us the amount of royalties owed under license agreementswith us. We continue to invest in our compliance and enforcement infrastructureto support the value of our intellectual property to us and our licensees andto improve the long-term realization of revenue from our intellectual property.As a result of these activities, from time to time, we recognize royaltyrevenues that relate to consumer electronics manufacturing activities fromprior periods. These royalty recoveries may cause revenues to be higher thanexpected during a particular reporting period and may not occur in subsequentperiods. While we consider such revenues to be a regular part our normaloperations, we cannot predict the amount or timing of such revenues.

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

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Our selling, general, and administrative expensesconsist primarily of salaries, commissions, and related benefits for personnelengaged in sales, corporate administration, finance, human resources, informationsystems, legal, and operations, and costs associated with promotional and otherselling activities. Selling, general, and administrative expenses also includeprofessional fees, facility-related expenses, and other general corporateexpenses.

Our research and development costs consist primarilyof salaries and related benefits for research and development personnel,engineering consulting expenses associated with new product and technologydevelopment, and quality assurance and testing costs. Research and developmentcosts are expensed as incurred.

In our consumer business, we have a licensing teamthat markets our technology directly to large consumer electronics productsmanufacturers and semiconductor manufacturers. This team includes employeeslocated in the United States, China, England, Japan, Hong Kong and NorthernIreland. We sell music content released under our DTS Entertainment labelthrough exclusive distribution arrangements in the United States, Europe andJapan. We employ consultants to coordinate sales to independent retailers andwe sell this music directly to consumers through an online store and otherweb-based retailers.

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

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

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

**Consumer Segment**

Revenue from our consumer segment constitutes themajority of our total revenues, representing 68% of total revenues in thefiscal years ended December 31, 2003 and 2004, and 64% of total revenuesin the fiscal year ended December 31, 2005. Our consumer revenue isprimarily dependent upon the home theater and DVD player markets, which haveexperienced rapid growth over the past several years. However, we have recentlyexperienced softness in our DVD player trademark licensing program, and expectgrowth rates in this area to decline from recent levels. The success ofDVD-Video-based systems and products has fueled a demand for higher qualityentertainment in the home, and this demand is extending to the car audio andpersonal computer markets as well. We expect the recent acceleration of themarket for high definition televisions to drive demand for high definitionoptical disc players beginning in 2006. Because we have been selected as amandatory technology for next generation players, our consumer revenue growthshould more closely track the growth rate of these players over the nextseveral years. We expect that the market for high definition players will yieldnew growth that provides an offset to the expected decline in the overallgrowth in DVD player shipments. Further, we believe that expected mandatoryinclusion in next generation optical disc standards will help to improve theadoption rate of our technologies in other consumer products such as nextgeneration video game consoles, personal audio and video players, personalcomputers and in-car entertainment systems. If we are removed from mandatory 

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status in next generationhigh definition optical disc standards, it would cause revenue growth in ourconsumer business to be significantly lower than expected and would have amaterial adverse effect on our business.

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

**Cinema Segment**

Revenue from our cinema segment represented 32% oftotal revenues in the fiscal years ended December 31, 2003 and 2004, and29% of total revenues in the fiscal year ended December 31, 2005. In ourcinema business, 2005 was a solid year for sales of our playback hardware, withCinema products and other revenue up 23% over 2004. We expect growth in our cinema audio hardware to continue ata modest pace in 2006. We also believe that the cinema exhibition community hasrecognized that pre-show entertainment represents a significant revenue growthopportunity that will lead to investment in pre-show solutions over the nextseveral years. Because our XD10 Cinema Media Player can be configured to performaudio playback along with pre-show and subtitling presentation, we believe thatwe are well-positioned to participate in the anticipated growth in this market.

A trend that we believe will affect our cinemabusiness segment is the long-term trend toward digital distribution of content.We believe this trend will involve the near-term adoption of digital pre-showand/or electronic cinema solutions, followed by longer-term adoption of higherquality digital cinema. Digital distribution of content offers the motionpicture industry a means to achieve substantial cost savings, including theprinting and distribution of movies, help in combating piracy, and will enablemovies to be played repeatedly without degradation. It also provides additionalrevenue opportunities for cinema operators, as digital content such asadvertisements, concerts and sporting events could be shown in or broadcast todigitally equipped theaters. We believe the widespread adoption of digitalcinema will be longer-term because of the significant capital investment thatwill be required by cinema operators to purchase new equipment and solutions.We believe this represents an opportunity for us as we seek to provide productsand services in support of the transition from film-based content towardsdigital cinema. However, our current digital cinema offerings are limited andwe may not be successful in developing or selling competitive productofferings. We believe that the addition of our Cinema Media Network andvariable bit rate JPEG 2000 encoding tools, along with the services provided byour digital images business, and the pre-show and alternative contentcapabilities of our XD10 Cinema Media Player, will enhance our ability toparticipate in the industry transition to high definition sound and images fordigital cinema.

Sales of cinema productsand film licensing tend to fluctuate based on the underlying trends in themotion picture industry. For instance, in the late 1990s various cinemaoperators aggressively built megaplexes, which resulted in an oversupply ofscreens in some domestic and international markets. The resulting oversupply ofscreens led to significant declines in revenues per screen, and eventually,many theaters were closed. As a result of the closures, sales of our playbacksystems and cinema processors suffered. As the theater industry has regainedhealth in the last several years, sales of our DTS playback systems and cinemaprocessors have improved. Our film licensing revenues are also subject tofluctuations 

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based onindustry trends, most significantly, the number of films being made by studiosand independent filmmakers.

**Digital ImagesSegment**

Revenue from our digitalimages segment, acquired in January 2005, represented 7% of total revenuesfor the year ended December 31, 2005. We believe that the growing marketfor high resolution and high definition content in the cinema and the home willcreate a substantial demand for the type of services provided by DTS DI. Webelieve that we have a technological advantage over many of our competitorsbased on the sophistication of our processes and level of automation used toenhance the image quality of entertainment content. Revenues in this businesstotaled $5.3 million for the year ended December 31, 2005. To date, this businesshas restored and/or enhanced over 100 feature films, including such major DVDreleases as Star Wars and Indiana Jones. Major motion picture and televisionstudios possess libraries containing thousands of titles, which we believerepresent a sizable market opportunity for the services performed by DTS DI.

**CriticalAccounting Policies and Estimates**

Management’s Discussion and Analysis of FinancialCondition and Results of Operations are based upon our consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States. The preparation of our financialstatements requires us to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenues, and expenses, and related disclosureof contingent assets and liabilities. On an on-going basis, estimates areevaluated, including those related to revenue recognition, allowance fordoubtful accounts, inventories, goodwill and intangible assets, income taxes,impairment of long-lived assets, product warranty, and stock-based compensation.These estimates are based on historical experience and on various otherassumptions that we believe 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:

·       *RevenueRecognition.  *We recognize revenues in accordance with theguidelines of the SEC Staff Accounting Bulletin, or SAB, No. 101 asamended by SAB No. 104 “Revenue recognition in Financial Statements.” Revenues from multiple-element arrangements involving licensefees, up-front payments and milestone payments, which are received and/orbillable by us in connection with other rights and services that representcontinuing obligations of ours, are deferred until all of the elements havebeen delivered or until we have established objective and verifiable evidenceof the fair value of the undelivered elements.

Arrangements with multiple elements ordeliverables must be segmented into individual units of accounting based on theseparate deliverables only if there is objective and verifiable evidence offair value to allocate the consideration received to the deliverables. Accordingly,revenues from multiple-element arrangements involving license fees, up-front paymentsand milestone payments, which are received and/or billable in connection withother rights and services that represent continuing obligations of ours, aredeferred until all of the multiple elements have been delivered or untilobjective and verifiable evidence of the fair value of the undelivered elementshas been established. Upon establishing objective and verifiable evidence ofthe fair value of the elements in multiple-element arrangements, the fair valueis allocated to each element of the arrangement, such as products or additionaladd-ons, based on the relative fair values of the elements. We determine thefair value of each element in multiple-element arrangements based on objectiveand verifiable evidence of fair value, which is determined for each elementbased on the price charged when the same element is sold separately to a thirdparty. If objective 

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and verifiable evidence of fair value ofall undelivered elements exists but objective and verifiable evidence of fairvalue does not exist for one or more delivered elements, then revenue isrecognized using the residual method. Under the residual method, the revenuesfrom delivered elements are not recognized until the fair value of theundelivered element(s) have been determined. Significant contractinterpretation is sometimes required to determine the appropriate accounting,including whether the deliverables specified in a multiple element arrangementshould be treated as separate units of accounting for revenue recognitionpurposes, and if so, how the price should be allocated among the deliverableelements, when to recognize revenue for each element, and the period over whichrevenue should be recognized. Changes in the allocation of the sales pricebetween delivered to undelivered elements might impact the timing of revenuerecognition, but would not change the total revenue recognized on the contract.

We are responsible for the licensing andenforcement of our patented technologies and pursue third parties that areutilizing our intellectual property without a license or who haveunder-reported the amount of royalties owed under a license agreement with us. Asa result of these activities, from time to time, we may recognize royaltyrevenues that relate to infringements that occurred in prior periods. Theseroyalty recoveries may cause revenues to be higher than expected during aparticular reporting period and may not occur in subsequent periods. Differencesbetween amounts initially recognized and amounts subsequently audited orreported as an adjustment to those amounts due from licensees, will berecognized in the period such adjustment is determined or contracted, asappropriate, as a change in accounting estimate.

We make estimatesand judgments when determining whether the collectibility of license feesreceivable from licensees is reasonably assured. We assess the collectibilityof accrued license fees based on a number of factors, including pasttransaction history with licensees and the credit-worthiness of licensees. Ifit is determined that collection is not reasonably assured, the fee isrecognized when collectibility becomes reasonably assured, assuming all otherrevenue recognition criteria have been met, which is generally upon receipt ofcash. Management estimates regarding collectibility impact the actual revenuesrecognized each period and the timing of the recognition of revenues. Ourassumptions and judgments regarding future collectibility could differ fromactual events, thus materially impacting our financial position and results ofoperations. 

Revenues from the sale ofcinema hardware products are recorded upon shipment, assuming title and risk ofloss has transferred to the customer, we have no significant obligationsremaining, prices are fixed or determinable, and collection of the relatedreceivable is reasonably assured. The licensing, encoding and duplication ofmotion picture soundtracks for use in our playback systems is undertaken underarrangements with major film studios. Revenues arising from the licensing andduplication of soundtracks are recognized upon completion, assuming prices arefixed or determinable, we have no significant obligations remaining, andcollection of the related receivable is reasonably assured. 

Direct costs associatedwith deferred revenue are deferred and included in other assets. Included inthe balance sheet are $2.6 million and $1.7 million of deferred revenue andcosts, respectively, at December 31, 2005.

Revenues fromlicensing audio technology, trademarks, and know-how are generated fromlicensing agreements with consumer electronics products manufacturers thatgenerally pay a per-unit license fee for products manufactured under thoselicense agreements. Licensees generally report manufacturing information within30 to 60 days after the end of the quarter in which such activity takesplace. Consequently, we recognize revenue from these licensing agreements on athree-month lag basis, generally in the quarter following the quarter ofmanufacture, provided amounts are fixed or determinable and collection isreasonably assured. Use of this lag method allows for the receipt of licenseeroyalty reports prior to the recognition of revenue, since we cannot reliablyestimate the amount of revenue earned prior to our receipt of such reports.Revenues from the sale of digital 

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multi-channel audioand video content are recorded upon shipment to retail accounts or endcustomers, 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.

Revenues from digital image enhancement, restorationand repair are recognized when elements of a customer order or contract aredelivered and accepted by the customer and no significant obligations remain.Prices are established in advance of the work performed and are generally fixedin nature. Revenue related to time and materials contracts is recognized asservices are rendered at contract labor rates plus material and other directcosts incurred. If losses are anticipated on a contract, such losses arerecognized immediately.

·       *Allowance for Doubtful Accounts.  *An allowance fordoubtful accounts is maintained for estimated losses resulting from theinability of our customers to make required payments. If the financialcondition of our customers were to deteriorate, resulting in an impairment oftheir ability to make payments, additional allowances may be required. Indetermining the reserve, we evaluate the collectibility of our accountsreceivable based upon a variety of factors. In cases where we become aware ofcircumstances that may impair a specific customer’s ability to meet itsfinancial obligations, we record a specific allowance against amounts due. Forall other customers, we recognize allowances for doubtful accounts based on ourhistorical write-off experience in conjunction with the length of time thereceivables are past due, customer creditworthiness, geographic risk and thecurrent business environment. Our allowances for doubtful accounts at December 31,2004 and 2005 were not significant.

·       *Inventories.  *Inventory levels are based on projectionsof future demand and market conditions. Any sudden decline in demand and/orrapid product improvements and technological changes can result in excessand/or obsolete inventories. On an ongoing basis, inventories are reviewed andwritten down for estimated obsolescence or unmarketable inventories equal tothe difference between the costs of inventories and the estimated netrealizable value based upon forecasts for future demand and market conditions.If actual market conditions are less favorable than our forecasts, additionalinventory reserves may be required. Estimates could be influenced by suddendeclines in demand due to economic downturns, rapid product improvements, andtechnological changes. During 2004, we recorded a write-down of approximately$3.9 million related to our monochrome projector inventory as a result of ourrevised outlook based on declines in future demand and technologicalobsolescence.

·       *Goodwill and Intangible Assets.  *We account for goodwillin accordance 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 our companyas a whole. This value is determined by considering a number of factors,including our historical and projected financial results, valuation analyses,risks facing us and the liquidity of our common stock. If the carrying value ofthe assets 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 

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goodwill. Included in thebalance sheet at December 31, 2005 is $3.6 million of goodwill inconnection with our acquisition of DTS DI, which occurred in January 2005.

We account for intangible assets in accordance withSFAS 144. This standard requires that intangible assets with definite lives beamortized over their estimated useful lives and reviewed for impairmentwhenever events or changes in circumstances indicate an asset’s carrying valuemay not be recoverable. Recoverability of an asset is measured by comparison ofits carrying amount to the expected future undiscounted cash flows that theasset is expected to generate. If it is determined that an asset is notrecoverable, an impairment loss is recorded in the amount by which the carryingamount of the asset exceeds its fair value. Our intangible assets principallyconsist of acquired technology, which is being amortized overeleven years. No intangible or long-lived assets were impaired as of December 31,2005.

·       *Acquired In-Process Research and Development.  *Thevalue assigned to acquired in-process research and development is determined byidentifying acquired specific in-process research and development projects thatwould be continued and for which, upon consummation of a business combination, (1) technologicalfeasibility has not been established at the acquisition date, (2) there isno alternative future use, and (3) the fair value is estimable withreasonable reliability.

·       *Impairment of Long-Lived Assets.  *We periodicallyassess potential impairments of our long-lived assets in accordance with theprovisions of SFAS 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 existence of one ormore of the above indicators of impairment, we estimate the future undiscountedcash flows 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 warranty our productsagainst defects in materials and workmanship for either a one or three yearterm after sale and provide for estimated future warranty costs at the timerevenues are recognized. Our warranty obligation is affected by the length ofproduct warranties, product failure rates, material usage, and service deliverycosts incurred in correcting product failures. Should actual product failurerates, material usage, or service delivery costs differ from our estimates,revisions to the estimated warranty liability would be required. Our warrantyreserves at December 31, 2004 and 2005 were not significant.

·       *Stock-based Compensation.  *We account for employeestock option 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 Accounting StandardsBoard, 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 thefirst quarter of 2006, mentioned in Recently Issued Accounting Standardsincluded elsewhere in this document, we expect to incur significant charges tothe statement of operations.

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·       *Incometaxes.  *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, 2005, 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.

Income taxes receivable,net at December 31, 2004 and 2005, includes estimated tax contingencies of$1.8 million and $1.4 million, respectively, for both domestic and foreignissues. Inherent uncertainties exist in estimating tax contingencies due to theprogress of income tax audits and changes in tax law, both legislated andconcluded through the various jurisdictions’ tax court systems.

**Segment and Geographic Information**

Ourreportable segment and geographic information is as follows (in thousands):

| ** **               | ** ** | **Revenues by Segment**                         | ** ** |
|--------------------------|------------|-----------------------------------------------------------|------------|
| ** **               | ** ** | **For the Years Ended  December 31,** | ** ** |
| ** **               | ** ** | **2003**                                                  | ** ** | **2004** | ** ** | **2005** | ** ** |
| Cinema business          |       | $                                                         | 16,328     |   | $ | 19,545 | ** ** | **$** | **21,744** | ** ** |
| Consumer business        |       | 35,374                                                    |       | 41,886 | ** ** | **48,180** | ** ** |
| Digital Images  business |       | —                                                    |       | — | ** ** | **5,328** | ** ** |
| Total revenues           |       | $                                                         | 51,702     |   | $ | 61,431 | ** ** | **$** | **75,252** | ** ** |

 

| ** **               | ** ** | **Gross Profit by Segment**                | ** ** |
|--------------------------|------------|-----------------------------------------------------------|------------|
| ** **               | ** ** | **For the Years Ended  December 31,** | ** ** |
| ** **               | ** ** | **2003**                                                  | ** ** | **2004** | ** ** | **2005** | ** ** |
| Cinema business          |       | $                                                         | 7,190      |   | $ | 5,448 | ** ** | **$** | **10,618** | ** ** |
| Consumer business        |       | 33,480                                                    |       | 39,821 | ** ** | **45,970** | ** ** |
| Digital Images  business |       | —                                                    |       | — | ** ** | **(949** | **)** |
| Total gross  profit      |       | $                                                         | 40,670     |   | $ | 45,269 | ** ** | **$** | **55,639** | ** ** |

 

| ** **                    | ** ** | **Income (Loss) From Operations  by Segment** | ** ** |
|-------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                    | ** ** | **For the Years Ended  December 31,**         | ** ** |
| ** **                    | ** ** | **2003**                                                          | ** ** | **2004** | ** ** | **2005** | ** ** |
| Cinema business               |       | $                                                                 | (3,504     | ) | $ | (8,475 | ) | **$** | **(4,051** | **)** |
| Consumer business             |       | 18,714                                                            |       | 19,969 | ** ** | **21,139** | ** ** |
| Digital Images  business      |       | —                                                            |       | — | ** ** | **(7,576** | **)** |
| Total income from  operations |       | $                                                                 | 15,210     |   | $ | 11,494 | ** ** | **$** | **9,512** | ** ** |

 

 

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| ** **           | ** ** | **Revenues by Geographic Region**          | ** ** |
|----------------------|------------|-----------------------------------------------------------|------------|
| ** **           | ** ** | **For the Years Ended  December 31,** | ** ** |
| ** **           | ** ** | **2003**                                                  | ** ** | **2004** | ** ** | **2005** | ** ** |
| United States        |       | $                                                         | 15,837     |   | $ | 17,830 | ** ** | **$** | **27,157** | ** ** |
| Japan                |       | 11,886                                                    |       | 17,516 | ** ** | **18,870** | ** ** |
| South Korea          |       | 5,559                                                     |       | 7,772 | ** ** | **8,248** | ** ** |
| China                |       | 4,200                                                     |       | 6,936 | ** ** | **6,702** | ** ** |
| Other  international |       | 14,220                                                    |       | 11,377 | ** ** | **14,275** | ** ** |
| Total international  |       | 35,865                                                    |       | 43,601 | ** ** | **48,095** | ** ** |
| Total revenues       |       | $                                                         | 51,702     |   | $ | 61,431 | ** ** | **$** | **75,252** | ** ** |

 

The following table setsforth, for the periods indicated, long-lived assets by geographic region inwhich we hold assets (in thousands):

| ** **               | ** ** | **Long-Lived Assets**            | ** ** |
|--------------------------|------------|---------------------------------------|------------|
| ** **               | ** ** | **As of December 31,** | ** ** |
| ** **               | ** ** | **2003**                              | ** ** | **2004** | ** ** | **2005** | ** ** |
| United States            |       | $                                     | 3,150      |   | $ | 3,099 | ** ** | **$** | **5,859** | ** ** |
| International            |       | 366                                   |       | 2,219 | ** ** | **1,516** | ** ** |
| Total long-lived  assets |       | $                                     | 3,516      |   | $ | 5,318 | ** ** | **$** | **7,375** | ** ** |

 

**Results ofOperations**

Thefollowing table sets forth our results of operations expressed as a percentageof total revenues:

| ** **                                | ** ** | **For the Years Ended  December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                | ** ** | **2003**                                                  | ** ** | **2004** | ** ** | **2005** | ** ** |
| Revenues:                                 | ** ** | ** **                                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Technology and film licensing             |       | 81.7                                                      | %          | 81.3 | % | **75.7** | **%** |
| Product sales and other revenues          |       | 18.3                                                      |       | 18.7 | ** ** | **24.3** | ** ** |
| Total revenues                            |       | 100.0                                                     |       | 100.0 | ** ** | **100.0** | ** ** |
| Cost of goods  sold:                      | ** ** | ** **                                                |       |   | ** ** | ** ** | ** ** |
| Technology and film licensing             |       | 8.3                                                       |       | 7.2 | ** ** | **6.3** | ** ** |
| Product sales and other revenues          |       | 13.0                                                      |       | 19.1 | ** ** | **19.8** | ** ** |
| Total cost of goods sold                  |       | 21.3                                                      |       | 26.3 | ** ** | **26.1** | ** ** |
| Gross profit                              |       | 78.7                                                      |       | 73.7 | ** ** | **73.9** | ** ** |
| Operating  expenses:                      | ** ** | ** **                                                |       |   | ** ** | ** ** | ** ** |
| Selling, general and administrative       |       | 39.7                                                      |       | 45.0 | ** ** | **45.1** | ** ** |
| Research and development                  |       | 9.6                                                       |       | 10.0 | ** ** | **13.1** | ** ** |
| In-process research and development       |       | —                                                    |       | — | ** ** | **3.1** | ** ** |
| Total operating expenses                  |       | 49.3                                                      |       | 55.0 | ** ** | **61.3** | ** ** |
| Income from  operations                   |       | 29.4                                                      |       | 18.7 | ** ** | **12.6** | ** ** |
| Interest income,  net                     |       | 0.5                                                       |       | 2.4 | ** ** | **3.4** | ** ** |
| Other income  (expense), net              |       | (0.4                                                      | )          | (0.1 | ) | **0.2** | ** ** |
| Income from legal  settlement             |       | —                                                    |       | 4.2 |   | — |   |
| Income before  provision for income taxes |       | 29.5                                                      |       | 25.2 | ** ** | **16.2** | ** ** |
| Provision for  income taxes               |       | 10.4                                                      |       | 9.0 | ** ** | **5.7** | ** ** |
| Net income                                |       | 19.1                                                      | %          | 16.2 | % | **10.5** | **%** |

 

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**Comparisonof Years Ended December 31, 2005 and 2004**

***Revenues***

*Technologyand Film Licensing.**  *Technologyand film licensing revenues for the year ended December 31, 2005 increased14% to $56.9 million from $49.9 million for the year ended December 31,2004. The increase in revenues from technology and film licensing was primarilyattributable to an increase in royalty recoveries of $7.3 million fromintellectual property compliance and enforcement activities in the currentperiod relative to the prior year. These activities, which included audits ofshipments by certain of our licensees and legal actions taken against licenseesand parties who are not our licensees, resulted in recoveries of royaltypayments relating to prior periods. We are experiencing good growth in ourpersonal computer licensing and in car audio systems, which posted year overyear growth totals of 150% and 21%, respectively, in 2005. We remain cautiousin our outlook due to uncertainties surrounding the consumer electronicsmarket. Overall, we continue to expect technology licensing revenues to growmodestly for 2006, based primarily on the expected continuation of growth inour decoder licensing program and from our license enforcement activities. Ourfilm licensing revenues increased slightly in 2005 compared to the prior yeardue to additional releases in the DTS format and the timing of major featurefilm releases.

*ProductSales and Other.**  *Productsales and other revenues increased 59% to $18.3 million for the year endedDecember 31, 2005 from $11.5 million for the year ended December 31,2004. This increase was primarily attributable to revenues generated by DTS DI,which we acquired in January 2005, along with an increase in Cinemahardware sales of $2.1 million. Stronger demand for our XD10 Cinema MediaPlayer and XD10P Cinema Audio Processor were primary drivers of sales. Productsales and other revenue is expected to grow at a modest rate in 2006, as wecontinue to expect market interest in multi-function playback devices todevelop at a measured pace.

*Segment Sales.**  *Revenues from our consumer business totaled$48.2 million for the year ended December 31, 2005, an increase of15% from $41.9 million for the year ended December 31, 2004. Theincrease in revenues was driven primarily by an increase in royalty recoveries mentionedabove as well as the overall growth in our personal computer and car audiomarkets. Cinema revenues were $21.7 million for the year ended December 31,2005, an increase of 11% from $19.5 million for the year ended December 31,2004. The increase in revenues was driven primarily by an increase in cinemahardware revenues. Revenues from our digital images business were $5.3 millionfor the year ended December 31, 2005, the first year these revenues havebeen included in our results of operations.

***Gross Profit***

Consolidated gross profit remained consistent betweenyears at 74%, and we expect this trend to continue into 2006. An increase incinema gross profit, primarily due to an increase in sales of our higher marginXD10 Cinema Media Player, offset the decrease in consolidated gross profit dueto the inclusion of DTS DI in our 2005 revenues.

*Technologyand Film Licensing.**  *Grossprofit associated with technology and film licensing revenues increasedslightly to 92% for the year ended December 31, 2005, from 91% of relatedrevenues for the year ended December 31, 2004, respectively and we expectthis rate to increase slightly during 2006 due to a higher mix of technologylicensing relative to film licensing.

*ProductSales and Other.**  *Grossprofit associated with product sales and other revenues increased to 19% ofrelated revenues for the year ended December 31, 2005 from (2)% in theprior year period due to the inventory write-down in 2004. The current periodmargin is the result of a loss in our digital images business due to high fixedoverhead costs and amortization of acquired intangibles.

*Segment GrossProfit*.*  *Grossprofit for our consumer business remained consistent between years at 95% andwe expect this trend to continue into 2006. Our cinema business gross profitincreased to 49% of 

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related revenues for the year ended December 31, 2005 from 28% inthe prior year period primarily due to higher margin hardware sales. Ourdigital images business experienced low gross margins due to lower thananticipated revenues and the amortization of acquired intangibles included incost of goods sold of $977,000. We expect margins in the digital imagesbusiness to improve in 2006 as we re-focus on more profitable projects andcomplete a large project. Gross margins for this project will be unusually highupon completion because all revenue was deferred during 2005, but a significantportion of the restoration costs did not qualify for deferral.

***Selling, General and Administrative***

Selling, general and administrative expenses increased23% to $34.0 million for the year ended December 31, 2005, comparedto $27.7 million in the prior year period. The increase is primarily dueto increases in salaries and related costs of $3.5 million as we increasedheadcount to support our growth. Other expenses related to growth of ouroperations, such as depreciation, travel and entertainment, increasedapproximately $828,000. Also contributing to the increase was $1.6 millionrelating to the inclusion of DTS DI in our results of operations.

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

***Research and Development***

For the year ended December 31, 2005, researchand development expenses were $9.9 million, compared to $6.1 million forthe year ended December 31, 2004. The increase is primarily due toincreased labor costs associated with new product initiatives, the optimizationof our Coherent Acoustics technology, and the development of tools associatedwith next generation optical disc standards. Also contributing to the increasewas $1.1 million relating to the inclusion of DTS DI research and developmentactivities in our results of operations.

We expect to continue toincrease our investment in applications engineering and research anddevelopment activities overall in future periods, primarily in support of newproduct initiatives, the roll out of next generation optical disc standards andthe continued optimization of our Coherent Acoustics technology.

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

In-process research anddevelopment of $2.3 million for the year ended December 31, 2005, relatesto development projects that had not reached technological feasibility, were ofno future alternative use and which were expensed upon consummation of theacquisition of DTS DI. Developed technology and in-process research anddevelopment were identified and valued through extensive interviews, analysisof data provided by DTS DI concerning development projects, their stage ofdevelopment, the time and resources needed to complete them, if applicable, andtheir expected income generating ability and associated risks. Wheredevelopment projects had reached technological feasibility, they wereclassified as developed technology and the value assigned to developedtechnology was capitalized. The income approach, which includes an analysis of thecash flows and risks associated with achieving such cash flows, was the primarytechnique utilized in valuing acquired in-process research and development. Keyassumptions for in-process research and development included a discountrate of 30% and estimates of revenue growth, cost of sales, operating expensesand taxes.

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

Interest income, net, forthe year ended December 31, 2005 increased significantly over the sameperiod of the prior year due to the generally improved interest rateenvironment.

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***Income From Legal Settlement***

In May 2004, wereached a settlement with Mintek for $3.5 million for trademark infringement,false designation of origin, trademark dilution, and unfair competitionrelating to Mintek’s distribution of DVD players bearing our registeredtrademarks 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.

***Income Taxes***

For the year ended December 31,2005, we recorded an income tax provision of $4.3 million on pre-tax income of$12.2 million. This resulted in an annualized effective tax rate of 35%. Forthe year ended December 31, 2004, we recorded an income tax provision of$5.5 million on pre-tax income of $15.5 million. This resulted in anannualized effective tax rate of 36%. 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 2006 will be in the range of 37% to 38%.

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

***Revenues***

*Technologyand 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 endedDecember 31, 2003. The increase in revenues from technology and film licensingwas primarily attributable to continued growth in consumer electronicslicensing, driven by an increase in the number of DVD-based home entertainmentsystems that incorporate DTS technology, such as audio/video receivers, DVDplayers, and home-theater-in-a-box systems. The increase also related torevenues recognized as a result of intellectual property compliance andenforcement activities. In addition, our film licensing revenues increasedmoderately in 2004 due to revenues generated from increases in the number ofU.S. films released, foreign language dubbed versions of major films, andforeign original-version films released with a DTS soundtrack.

*ProductSales 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 endedDecember 31, 2003. This increase was primarily attributable to increasedpurchases by theater operators of our cinema processors and playback equipmentby theater operators as a result of the film exhibition industry’s return togrowth as well as solid interest in our XD10 Cinema Media Player.

*Segment Sales.**  *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 electronics technologylicensing as mentioned above. Cinema revenues were $19.5 million for theyear ended December 31, 2004, up 20% from the same period in the prioryear due primarily to growth in the sales of our cinema audio products, drivenby the film exhibition industry return to growth, as mentioned above.

***Gross Profit***

Consolidated gross profit decreased to 74% of revenuesfor the year ended December 31, 2004, from 79% for the year endedDecember 31, 2003. The decrease was primarily due to the write-down of ourmonochrome projector inventory of approximately $3.9 million in 2004 that was aresult of our revised outlook based on declines in future demand andtechnological obsolescence.

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*Technologyand Film Licensing.**  *Grossprofit associated with technology and film licensing revenues increasedslightly to 91% for the year ended December 31, 2004, from 90% of relatedrevenues for the year ended December 31, 2003.

*ProductSales 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 inventory write-down discussed above.

*Segment Gross Profit.**  *Gross profit for our consumer business remainedconsistent between years at 95%. Our cinema business gross profit decreased to28% of related revenues for the year ended December 31, 2004 from 44% inthe prior year period primarily due to the write-down of the monochromeprojector inventory discussed above. The impact of this write-down on gross profitwas partially offset by the increase in revenue for our cinema businessyear-over-year relative to fixed costs.

***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 was 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 was anincrease of $2.2 million in salaries and related costs as we increasedheadcount to support our growth. The increase also includes increases inadvertising and promotion costs related to new product introductions, andinsurance costs. Salaries and related costs include stock-basedcompensation, which decreased to $273,000 for the year ended December 31,2004 from $497,000 in the prior year period. Stock-based compensation for theprior period primarily consisted of a charge related to the issuance of awarrant. Included in professional services for the year ended December 31,2004 was approximately $300,000 in legal costs related to our settlement withMintek that was reached in May 2004.

Costs of compliance withthe Sarbanes-Oxley Act were approximately $899,000 for the year endedDecember 31, 2004.

***Research and Development***

For the year endedDecember 31, 2004, research and development expenses were $6.1 million,compared to $5.0 million for the year ended December 31, 2003. Theincrease was primarily due to increased labor costs associated with new productinitiatives and the optimization of our Coherent Acoustics technology for newconsumer electronics applications and development of tools associated with nextgeneration optical disc standards.

***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 our settlement with Mintek for $3.5 million. In the year endedDecember 31, 2004, we recognized $899,000 in revenue under the settlementagreement for royalties due on known units that could be identified as usingour trademark and accounted for the remaining $2.6 million as otherincome. Selling, general and administrative expenses for the year endedDecember 31, 2004 included 

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approximately$300,000 in legal fees related to the Mintek case. Legal fees related to Mintekwere approximately $200,000 for 2003.

***Income Taxes***

For the year endedDecember 31, 2004, we recorded an income tax provision of $5.5 million onpre-tax income of $15.6 million. This resulted in an annualized effective taxrate of 36%. For the year ended December 31, 2003, we recorded an incometax provision of $5.4 million on pre-tax income of $15.3 million. Thisresulted in an annualized effective tax rate of 35%. These rates differed fromthe statutory rates primarily due to state income taxes offset by benefitsassociated with the foreign rate differentials and research and developmentcredits.

**Liquidity and Capital Resources**

At December 31, 2005, we had cash, cashequivalents, and short-term investments of $111.4 million, compared to$114.3 million at December 31, 2004. In addition, we had long-terminvestments of $2.7 at December 31, 2004.

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, 2005, we had nooutstanding borrowings under our bank facility, which expires on June 30,2006 and is renewable annually . The bank facility provides for working capitalfinancing and is unsecured. The bank agreement requires us to comply withcertain covenants including a tangible effective net worth of $60.0 millionincreasing by 50% of net income on an annual basis. The covenants also requireus to keep $2.0 million in cash or securities at the bank. Availability underthis facility was $10.0 million at December 31, 2005. 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, 2005, 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$9.2 million, $17.6 million and $9.6 million for the years endedDecember 31, 2003, 2004 and 2005, respectively. Accounts receivableincreased $2.5 million for the year ended December 31, 2005 due to royaltyrecoveries and other accrued license fees. Our tax benefit from the exercise ofoptions decreased $4.1 million for the year ended December 31, 2005,compared to the prior year. Our income tax receivable increased $2.6 million asa result of overpayments in the later portion of 2005. Included in 2004 was anunusually high volume of option exercises during the year subsequent to ourinitial public offering lockup release in early 2004. Additionally, loweraverage market prices for shares of our common stock in 2005 relative to thesame period in 2004 resulted in lower option exercise activity during 2005. Aspart of the acquisition of DTS DI, we assumed $1.8 million in liabilities and asignificant portion of these liabilities were paid during 2005. Upon theadoption of SFAS 123R, the tax benefits for employee benefit plans will be includedas a financing 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 

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used in investingactivities totaled $62.0 million and $36.8 million in the years endedDecember 31, 2003 and 2004, respectively. Cash provided by investingactivities totaled $1.4 million in the year ended December 31, 2005. Theincrease in cash provided by investing activities is primarily the result ofinvestment sales and maturities, net of purchases, of $17.5 million in the yearended December 31, 2005, compared to cash used for investment purchases,net of sales and maturities,  of $61.0million and $32.6 million in the years ended December 31, 2003 and2004, respectively. In December 2004, in advance of our acquisition of DTSDI in January 2005, we provided bridge financing of approximately $1.3million to DTS DI and also acquired QDesign for net cash of $1.4 million during2004. The principal and interest outstanding under the bridge loan reduced theamount we paid to acquire DTS DI by the aggregate amount due. InJanuary 2005, we used $11.0 million for our purchase of DTS DI. Wecontinue to invest in property and equipment, including office equipment andfixtures, engineering and manufacturing test equipment, and computer hardwareand software.

Net cash flows used in financing activities totaled$90.1 million for the year ended December 31, 2003. For the years endedDecember 31, 2004 and 2005, cash provided by financing activities were$1.3 million and $1.1 million, respectively. For the year endedDecember 31, 2003, cash provided by financing activities was$90.1 million representing net proceeds of $63.0 million from ourinitial public offering and proceeds of $48.9 million from our follow-onpublic offering. These cash inflows were partially offset by cash dividendspaid to our preferred stockholders totaling $6.8 million as well aspayments of $15.8 million to redeem the principal value of our mandatorilyredeemable preferred stock. For the year ended December 31, 2004, cashprovided by financing activities primarily consisted of proceeds from theissuance of common stock under our option and employee stock purchase plans.For the year ended December 31, 2005, cash provided by financingactivities primarily consists of the exercise of stock options and purchases ofstock under our employee stock purchase plan.

We entered into an agreement for the purchase andimplementation of a new enterprise resource planning system, or ERP, forapproximately $747,000. We expect that we will incur additional costs in therange of $2 to $4 million over the next several years in connection with ourERP implementation.

We believe that our cash,cash equivalents, short-term investments, funds available under our existingbank line of credit facility, and cash flows from operations will be sufficientto satisfy our working capital and capital expenditure requirements for atleast the next twelve months. Beyond the next twelve months, additional financingmay be required to fund working capital and capital expenditures. Changes inour operating plans, lower than anticipated revenues, increased expenses,acquisition of companies, products or technologies or other events, includingthose described in “Risk Factors” included herein and in any other filings maycause us to seek additional debt or equity financing on an accelerated basis.Financing may not be available on acceptable terms, or at all, and our failureto raise capital when needed could negatively impact our growth plans and ourfinancial condition and results of operations. Additional equity financing maybe dilutive to the holders of our common stock and debt financing, ifavailable, may involve significant cash payment obligations and financial oroperational covenants that restrict our ability to operate our business.

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**Contractual Obligations and Commitments**

Futurepayments due under non-cancelable lease obligations and commitments at ofDecember 31, 2005 are described below (in thousands):

| ** **                           | ** ** | **2006**         | ** ** | **2007**         | ** ** | **2008**   | ** ** | **2009**   | ** ** | **2010**   | ** ** | **2011 and  thereafter** | ** ** | **Total** | ** ** |
|--------------------------------------|------------|------------------|------------|------------------|------------|------------|------------|------------|------------|------------|------------|-------------------------------|------------|-----------|------------|
| Operating leases                     |       | $  942 |       | $  730 |       | $ 373 |       | $ 318 |       | $ 249 |       |                          | $ 632 |      |       | $ 3,244 |   |
| Acquisition  consideration           |       | 150              |       | 150              |       | —     |       | —     |       | —     |       |                          | —     |      |       | 300 |   |
| Enterprise resource  planning system |       | 374              |       | 373              |       | —     |       | —     |       | —     |       |                          | —     |      |       | 747 |   |
| Total                                |       | $ 1,466     |       | $ 1,253     |       | $ 373 |       | $ 318 |       | $ 249 |       |                          | $ 632 |      |       | $ 4,291 |   |

 

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, 2005, we would have to make payments ofapproximately $1.9 million.

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. Beyond the next twelve months, additionalfinancing may be required to fund working capital and capital expenditures.Changes in our operating plans, lower than anticipated revenues, increasedexpenses, acquisitions of companies, products or technologies or other events,including those described in “Risk Factors,” may cause us to seek additionaldebt or equity financing on an accelerated basis. Financing may not beavailable on acceptable terms, or at all, and our failure to raise capital whenneeded could negatively impact our growth plans and our financial condition andresults of operations. Additional equity financing may be dilutive to theholders of our common stock and debt financing, if available, may involvesignificant cash payment obligations and covenants and/or financial ratios thatrestrict our ability to operate our business.

**QuarterlyResults of Operations**

The following table sets forth the unaudited quarterlyresults of operations for each of the eight quarters ended December 31,2005, 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 thisForm 10-K. In the opinion of management, all necessary adjustments,consisting only of normal recurring adjustments, have been included to presentfairly the unaudited quarterly results. The results of historical periods arenot necessarily indicative of results for any future period.

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 terms ofmanufacturing 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 

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growing markets can have a material effect onquarterly revenues and profits, and can distort the moderate seasonalitydescribed above.

| ** **                               | ** ** | **For the Three Months Ended** | ** **    |
|------------------------------------------|------------|----------------------------------------------------|---------------|
| ** **                               | ** ** | **Mar. 31,   2004**                      | ** **    | **Jun. 30,    2004** | ** ** | **Sep. 30,  2004** | ** ** | **Dec. 31,  2004** | ** ** | **Mar. 31,   2005** | ** ** | **Jun. 30,  2005** | ** ** | **Sep. 30,  2005** | ** ** | **Dec. 31,  2005** | ** ** |
| ** **                               | ** ** | **(Unaudited, in thousands)**                      | ** **    |
| Revenues:                                |       |                                               |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Technology and film licensing            |       |                                               | $ 12,497 |   |   |   | $ 10,720 |   |   |   | $ 13,058 |   |   |   | $ 13,645 |   |   |   | $ 18,464 |   |   |   | $ 12,835 |   |   |   | $ 12,611 |   |   |   | $ 13,037 |   |   |
| Product sales and other revenues    |       |                                               | 3,100         |   |   |   | 2,532 |   |   |   | 2,894 |   |   |   | 2,985 |   |   |   | 3,593 |   |   |   | 4,893 |   |   |   | 4,942 |   |   |   | 4,877 |   |   |
| Total revenues                           |       |                                               | 15,597        |   |   |   | 13,252 |   |   |   | 15,952 |   |   |   | 16,630 |   |   |   | 22,057 |   |   |   | 17,728 |   |   |   | 17,553 |   |   |   | 17,914 |   |   |
| Cost of goods sold:                      |       |                                               |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Technology and film licensing            |       |                                               | 980           |   |   |   | 1,166 |   |   |   | 1,199 |   |   |   | 1,106 |   |   |   | 1,282 |   |   |   | 1,035 |   |   |   | 1,194 |   |   |   | 1,204 |   |   |
| Product sales and other revenues    |       |                                               | 1,912         |   |   |   | 1,755 |   |   |   | 1,911 |   |   |   | 6,133 |   |   |   | 3,181 |   |   |   | 3,995 |   |   |   | 3,450 |   |   |   | 4,272 |   |   |
| Total cost of goods sold                 |       |                                               | 2,892         |   |   |   | 2,921 |   |   |   | 3,110 |   |   |   | 7,239 |   |   |   | 4,463 |   |   |   | 5,030 |   |   |   | 4,644 |   |   |   | 5,476 |   |   |
| Gross profit                             |       |                                               | 12,705        |   |   |   | 10,331 |   |   |   | 12,842 |   |   |   | 9,391 |   |   |   | 17,594 |   |   |   | 12,698 |   |   |   | 12,909 |   |   |   | 12,438 |   |   |
| Operating expenses:                      |       |                                               |          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and  administrative     |       |                                               | 6,440         |   |   |   | 6,798 |   |   |   | 6,746 |   |   |   | 7,660 |   |   |   | 8,044 |   |   |   | 8,080 |   |   |   | 8,971 |   |   |   | 8,865 |   |   |
| Research and development                 |       |                                               | 1,332         |   |   |   | 1,568 |   |   |   | 1,501 |   |   |   | 1,730 |   |   |   | 2,094 |   |   |   | 2,532 |   |   |   | 2,612 |   |   |   | 2,629 |   |   |
| In-process research and development      |       |                                               | —        |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 2,300 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Total operating expenses                 |       |                                               | 7,772         |   |   |   | 8,366 |   |   |   | 8,247 |   |   |   | 9,390 |   |   |   | 12,438 |   |   |   | 10,612 |   |   |   | 11,583 |   |   |   | 11,494 |   |   |
| Income from operations                   |       |                                               | 4,933         |   |   |   | 1,965 |   |   |   | 4,595 |   |   |   | 1 |   |   |   | 5,156 |   |   |   | 2,086 |   |   |   | 1,326 |   |   |   | 944 |   |   |
| Interest income, net                     |       |                                               | 439           |   |   |   | 310 |   |   |   | 373 |   |   |   | 325 |   |   |   | 354 |   |   |   | 835 |   |   |   | 635 |   |   |   | 700 |   |   |
| Other income (expense), net              |       |                                               | (14           | ) |   |   | (17 | ) |   |   | 31 |   |   |   | (31 | ) |   |   | (12 | ) |   |   | (11 | ) |   |   | 123 |   |   |   | 54 |   |   |
| Income from legal settlement             |       |                                               | —        |   |   |   | 2,601 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Income before provision for income taxes |       |                                               | 5,358         |   |   |   | 4,859 |   |   |   | 4,999 |   |   |   | 295 |   |   |   | 5,498 |   |   |   | 2,910 |   |   |   | 2,084 |   |   |   | 1,698 |   |   |
| Provision for income taxes               |       |                                               | 1,918         |   |   |   | 1,740 |   |   |   | 1,774 |   |   |   | 103 |   |   |   | 1,942 |   |   |   | 1,094 |   |   |   | 890 |   |   |   | 356 |   |   |
| Net income                               |       |                                               | $ 3,440  |   |   |   | $ 3,119 |   |   |   | $ 3,225 |   |   |   | $   192 |   |   |   | $ 3,556 |   |   |   | $ 1,816 |   |   |   | $ 1,194 |   |   |   | $ 1,342 |   |   |

 

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| ** **                               | ** ** | **For the Three Months Ended** | ** ** |                          |
|------------------------------------------|------------|----------------------------------------------------|------------|-------------------------------|
| ** **                               | ** ** | **Mar. 31,   2004**                      | ** ** | **Jun. 30,   2004** | ** ** | **Sep. 30,  2004** | ** ** | **Dec. 31,  2004** | ** ** | **Mar. 31,   2005** | ** ** | **Jun. 30,  2005** | ** ** | **Sep. 30,  2005** | ** ** | **Dec. 31,  2005** | ** ** |   |
| ** **                               | ** ** | **(Unaudited)**                                    | ** ** |                          |
| Revenues:                                |       |                                               |       |                          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Technology and film licensing            |       |                                               | 80.1       | %                             |   |   | 80.9 | % |   |   | 81.9 | % |   |   | 82.1 | % |   |   | 83.7 | % |   |   | 72.4 | % |   |   | 71.8 | % |   |   | 72.8 | % |   |
| Product sales and other  revenues        |       |                                               | 19.9       |                          |   |   | 19.1 |   |   |   | 18.1 |   |   |   | 17.9 |   |   |   | 16.3 |   |   |   | 27.6 |   |   |   | 28.2 |   |   |   | 27.2 |   |   |
| 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            |       |                                               | 6.3        |                          |   |   | 8.8 |   |   |   | 7.5 |   |   |   | 6.7 |   |   |   | 5.8 |   |   |   | 5.8 |   |   |   | 6.8 |   |   |   | 6.7 |   |   |
| Product sales and other  revenues        |       |                                               | 12.3       |                          |   |   | 13.2 |   |   |   | 12.0 |   |   |   | 36.9 |   |   |   | 14.4 |   |   |   | 22.5 |   |   |   | 19.7 |   |   |   | 23.8 |   |   |
| Total cost of goods sold                 |       |                                               | 18.6       |                          |   |   | 22.0 |   |   |   | 19.5 |   |   |   | 43.6 |   |   |   | 20.2 |   |   |   | 28.4 |   |   |   | 26.5 |   |   |   | 30.6 |   |   |
| Gross profit                             |       |                                               | 81.4       |                          |   |   | 78.0 |   |   |   | 80.5 |   |   |   | 56.4 |   |   |   | 79.8 |   |   |   | 71.6 |   |   |   | 73.5 |   |   |   | 69.4 |   |   |
| Operating  expenses:                     |       |                                               |       |                          |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and  administrative     |       |                                               | 41.3       |                          |   |   | 51.3 |   |   |   | 42.3 |   |   |   | 46.1 |   |   |   | 36.5 |   |   |   | 45.6 |   |   |   | 51.1 |   |   |   | 49.5 |   |   |
| Research and development                 |       |                                               | 8.5        |                          |   |   | 11.8 |   |   |   | 9.4 |   |   |   | 10.4 |   |   |   | 9.5 |   |   |   | 14.3 |   |   |   | 14.9 |   |   |   | 14.7 |   |   |
| In-process research and development      |       |                                               | —     |                          |   |   | — |   |   |   | — |   |   |   | — |   |   |   | 10.4 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Total operating expenses                 |       |                                               | 49.8       |                          |   |   | 63.1 |   |   |   | 51.7 |   |   |   | 56.5 |   |   |   | 56.4 |   |   |   | 59.9 |   |   |   | 66.0 |   |   |   | 64.2 |   |   |
| Income from operations                   |       |                                               | 31.6       |                          |   |   | 14.9 |   |   |   | 28.8 |   |   |   | (0.1 | ) |   |   | 23.4 |   |   |   | 11.8 |   |   |   | 7.6 |   |   |   | 5.3 |   |   |
| Interest income, net                     |       |                                               | 2.8        |                          |   |   | 2.3 |   |   |   | 2.3 |   |   |   | 2.0 |   |   |   | 1.6 |   |   |   | 4.7 |   |   |   | 3.6 |   |   |   | 3.9 |   |   |
| Other income (expense), net              |       |                                               | (0.1       | )                             |   |   | (0.1 | ) |   |   | 0.2 |   |   |   | (0.2 | ) |   |   | (0.1 | ) |   |   | (0.1 | ) |   |   | 0.7 |   |   |   | 0.3 |   |   |
| Income from legal settlement             |       |                                               | —     |                          |   |   | 19.6 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Income before provision for income taxes |       |                                               | 34.3       |                          |   |   | 36.7 |   |   |   | 31.3 |   |   |   | 1.7 |   |   |   | 24.9 |   |   |   | 16.4 |   |   |   | 11.9 |   |   |   | 9.5 |   |   |
| Provision for income taxes               |       |                                               | 12.3       |                          |   |   | 13.1 |   |   |   | 11.1 |   |   |   | 0.6 |   |   |   | 8.8 |   |   |   | 6.2 |   |   |   | 5.1 |   |   |   | 2.0 |   |   |
| Net income                               |       |                                               | 22.0       | %                             |   |   | 23.6 | % |   |   | 20.2 | % |   |   | 1.1 | % |   |   | 16.1 | % |   |   | 10.2 | % |   |   | 6.8 | % |   |   | 7.5 | % |   |
|                                          |            |                                                    |            |                               |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Revenues for the quarters presented above wereimpacted by the seasonality factors noted above and generally increased quarterto quarter in 2004. Revenue from licensing activities started to experience aslow down in the third and fourth quarters of 2005.

Revenues for the first and second quarter of 2005 wereimpacted by higher than normal royalty recoveries.

Selling, general and administrative expenses for thefourth quarter of 2004 were impacted by costs related to Sarbanes-Oxley, ourfirst year of complying with rules.

In-process research and development relates to ouracquisition of DTS DI in the first quarter of 2005.

The decrease in gross profit and net income for thequarter ended December 31, 2004 is primarily due to the write-down of ourmonochrome projector inventory of approximately $3.9 million that was a resultof our revised outlook based on declines in future demand and technologicalobsolescence.

Interest income, net, for the quarter ended June 30,2005 increased due to the generally improved interest rate environment and atemporary shift away from tax-exempt auction rate securities to taxableinvestments, which generate higher nominal yields. Offsetting our return to thetax-exempt auction rate securities market in the third quarter of 2005 wasimproved interest rate environment during the third and fourth quarters of2005.

Income from legal settlement for the quarter ended June 30,2004, consisted of our 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.

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**RecentlyIssued Accounting Standards**

In December 2004,the FASB issued SFAS No. 123R, “Share-Based Payment”, or SFAS 123R, an amendmentto SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS 123Rrequires compensation expense related to stock-based awards to be recognized inthe financial statements. The amount of compensation expense will be measuredbased upon the fair value of the stock-based awards at the date of grant. SFAS123R also requires an enterprise to assess the most appropriate model tocalculate the value of the options. We currently use the Black-Scholes optionpricing model to value options, and are currently assessing which model we mayuse in the future under SFAS 123R and may deem an alternative model to be themost appropriate. The use of a different model to value options may result in adifferent fair value than the use of the Black-Scholes option pricing model. Inaddition, there are a number of other requirements under the new standard thatwill result in differing accounting treatment than currently required. Thesedifferences include, but are not limited to, the accounting for the tax benefiton employee stock options. In addition to the appropriate fair value model tobe used for valuing share-based payments, we will also be required to determinethe transition method to be used at the date of adoption. The allowedtransition methods include prospective and retroactive adoption methods. Underthe retroactive method, prior periods may be restated either as of thebeginning of the year of adoption or for all periods presented. The prospectivemethod requires that compensation expense be recorded for all unvested stockoptions and restricted stock at the beginning of the first quarter of adoptionof SFAS 123R while the retroactive method would record compensation expense forall unvested stock options and restricted stock beginning with the first periodrestated. This statement was to have become effective for public companies asof the first interim or annual reporting period beginning after June 15,2005. In April 2005, the SEC amended the compliance date for implementingSFAS 123R extending the compliance date to the first fiscal year that beginsafter June 15, 2005. We plan to adopt SFAS 123R beginning in thefirst quarter of fiscal 2006. If we had adopted SFAS 123R as of December 31,2005, using the Black-Scholes method, the effects of the adoption of SFAS 123Ron our financial results for the next five years, based on stock-based awardsgranted as of December 31, 2005, would be as follows:

| ** **                                                                           | ** ** | **Expenses by Fiscal Year** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                           | ** ** | **2006**                                   | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** |
| ** **                                                                           | ** ** | **(unaudited)**                            | ** ** |
| ** **                                                                           | ** ** | **(in thousands)**                    | ** ** |
| Additional stock-based  compensation expense under SFAS 123R before tax benefit |       | $ 1,495                               |       | $ 1,346 |   | $ 1,173 |   | $640 |   |   | — |   |   |
|                                                                                      |            |                                            |            |  |  |  |  |  |  |  |  |  |  |

 

SFAS 123R also affects the presentation of taxbenefits for option exercises in the statement of cash flows. Prior to adoptionSFAS 123R, the benefit is classified in cash provided by operating activities.Upon adoption, the tax benefit will be classified in cash provided by financingactivities. We are in the process of determining the impact the adoption willhave on our consolidated statement of cash flows.

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

In June 2005, the FASB issued Statement No. 154,“Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20,Accounting Changes, and Statement No. 3, Reporting Accounting Changes inInterim Financial Statements”, or SFAS 154. SFAS 154 changes therequirements for the accounting for, and reporting of, a change in accountingprinciple. Previously, most voluntary changes in accounting principles wererequired to be recognized by way of a cumulative effect adjustment within netincome during the period of the change. SFAS 154 requires retrospectiveapplication to prior periods’ 

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financial statements,unless it is impracticable to determine either the period-specific effects orthe cumulative effect of the change. SFAS 154 is effective for accountingchanges made in fiscal years beginning after December 15, 2005; however,the Statement does not change the transition provisions of any existingaccounting pronouncements. We do not believe adoption of SFAS 154 willhave a material effect on our consolidated financial position, results of operationsor cash flows.

In June 2005 FASBStaff Position, or FSP, No. 143-1, “Accounting for ElectronicEquipment Waste Obligations” was issued. FSP 143-1 addresses theaccounting for obligations associated with Directive 2002/96/EC on WasteElectrical and Electronic Equipment, or the Directive, of the European Union,or EU, which is subject to transformation into the respective national laws.Under the Directive, the waste management obligation remains with thecommercial user until the historical waste equipment (put on the market before August 13,2005) is replaced. At that time, the waste management obligation for theequipment may be transferred to the producer of the replacement equipmentdepending on the transformation of the Directive into national law by theEU-member country. If the commercial user does not replace the equipment, theobligation remains with that user until the equipment is disposed. FSP 143-1requires the commercial user to apply the provisions of SFAS 143, “Accountingfor Asset Retirement Obligations” to the obligation associated with historicalwaste. FSP 143-1 will have to be applied in the first reporting periodending after the date the law is adopted by the applicable EU-member countries.The adoption of FSP 143-1 did not have a material impact on ourconsolidated financial statements.

**Item 7A.**                *Quantitative and Qualitative Disclosure About Market Risk*

Market risk represents the risk of loss arising fromadverse changes in market rates and foreign exchange rates. At December 31,2005, we did not have any balances outstanding under our bank line of creditarrangement; however, the amount of outstanding debt at any time may fluctuateand we may from time to time be subject to refinancing risk.

Our interest income is sensitive to changes in thegeneral level of U.S. interest rates, particularly since a significant portionof our investments are and will be in short-term marketable securities, U.S.government securities and corporate bonds. Due to the nature and maturity ofour short-term investments, we have concluded that there is no material marketrisk exposure to our principal. The average maturity of our investmentportfolio is less than one month. As of December 31, 2005, a 1% change ininterest rates throughout a one-year period would have an annual effect ofapproximately $1.1 million on our income.

We derive in the range of half to two-thirds of ourrevenues from sales outside the United States, and maintain research, sales,marketing, or business development offices in six countries. Therefore, ourresults could be negatively affected by such factors as changes in foreigncurrency exchange rates, trade protection measures, longer accounts receivablecollection patterns, and changes in regional or worldwide economic or politicalconditions. The risks of our international operations are mitigated in part bythe extent to which our revenues are denominated in U.S. dollars and,accordingly, we are not exposed to significant foreign currency risk on theseitems. We do have limited foreign currency risk on certain revenues andoperating expenses such as salaries and overhead costs of our foreignoperations and a small amount of cash maintained by these operations. Revenuesdenominated in foreign currencies accounted for approximately 8% of totalrevenues during 2005. Operating expenses, including cost of sales, for ourforeign subsidiaries were approximately $8.4 million in 2005. Based upon theexpenses for 2005, a 1% change in foreign currency rates throughout a one-yearperiod would have an annual effect of approximately $84,000.

Our international business is subject to risks,including, but not limited to, differing economic conditions, changes inpolitical climate, differing tax structures, other regulations andrestrictions, and 

59

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foreign exchange ratevolatility when compared to the United States dollar. Accordingly, our futureresults could be materially impacted by changes in these 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 or positivelyimpact overall profitability. During 2005, the positive impact of foreignexchange rate fluctuations related to translation of our foreign subsidiaries’financial statements was $295,000.

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

**DTS, INC.INDEX TO CONSOLIDATED FINANCIAL STATEMENTS**

| **Consolidated Financial Statements:**                                                                                               | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
| Report of Independent Registered  Public Accounting Firm                                                                             |       | 62         |
| Consolidated Balance Sheets as of  December 31, 2004 and 2005                                                                   |       | 64         |
| Consolidated Statements of  Operations for the years ended December 31, 2003, 2004  and 2005                          |       | 65         |
| Consolidated Statements of  Stockholders’ Equity (Deficit) for the years ended December 31, 2003, 2004  and 2005 |       | 66         |
| Consolidated Statements of  Cash Flows for the years ended December 31, 2003, 2004  and 2005                          |       | 67         |
| Notes  to Consolidated Financial Statements                                                                                          |       | 68         |
| **Financial Statement Schedule:**                                                                                                    | ** ** | ** ** |
| Schedule  II—Valuation and Qualifying Accounts for the years ended December 31,  2003, 2004 and 2005             |       | 102        |

 

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**Report of Independent Registered Public AccountingFirm**

To the Board of Directors and Shareholders of DTS, Inc.:

We have completedintegrated audits of DTS, Inc.’s 2005 and 2004 consolidated financialstatements and of its internal control over financial reporting as of December 31,2005, and an audit of its 2003 consolidated financial statements in accordancewith the standards of the Public Company Accounting Oversight Board (UnitedStates). Our opinions, based on our audits, are presented below.

*Consolidated financial statements and financialstatement schedule*

In our opinion, the consolidated financial statementslisted in the accompanying index present fairly, in all material respects, thefinancial position of DTS, Inc. and its subsidiaries at December 31,2005 and 2004, and the results of their operations and their cash flows foreach of the three years in the period ended December 31, 2005 inconformity with accounting principles generally accepted in the United Statesof America. In addition, in our opinion, the financial statement schedulelisted in the accompanying index presents fairly, in all material respects, theinformation set forth therein when read in conjunction with the relatedconsolidated financial statements. These financial statements and financialstatement schedule are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements andfinancial statement schedule based on our audits. We conducted our audits ofthese statements in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. An audit of financialstatements includes examining, on a test basis, evidence supporting the amountsand disclosures in the financial statements, assessing the accountingprinciples used and significant estimates made by management, and evaluatingthe overall financial statement presentation. We believe that our auditsprovide a reasonable basis for our opinion.

As discussed in Note 2 ofthe consolidated financial statements, the Company has restated itsconsolidated financial statements for the year ended December 31, 2003.

*Internal control over financial reporting*

Also, in our opinion, management’s assessment,included in Management’s Report on Internal Control Over Financial Reportingappearing in Item 9A. *Controls and Procedures*,that the Company maintained effective internal control over financial reportingas of December 31, 2005 based on criteria established in *Internal Control—Integrated Framework*issued by theCommittee of Sponsoring Organizations of the Treadway Commission (“COSO”), isfairly stated, in all material respects, based on those criteria. Furthermore,in our opinion, the Company maintained, in all material respects, effectiveinternal control over financial reporting as of December 31, 2005, basedon criteria established in *Internal Control—IntegratedFramework*issued by the COSO. The Company’s management isresponsible for maintaining effective internal control over financial reportingand for its assessment of the effectiveness of internal control over financialreporting. Our responsibility is to express opinions on management’s assessmentand on the effectiveness of the Company’s internal control over financialreporting based on our audit. We conducted our audit of internal control overfinancial reporting in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan 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.

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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 externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (i) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (ii) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (iii) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluations of effectiveness to future periods are subjectto the risk that controls may become inadequate because of changes inconditions, or that the degree of compliance with the policies or proceduresmay deteriorate.

Asdescribed in Management’s Report on Internal Control Over Financial Reporting,management has excluded DTS Digital Images, Inc. (“DTS DI”) from its assessmentof internal control over financial reporting as of December 31, 2005because it was acquired by the Company in a purchase business combinationduring 2005. We have also excluded DTS DI from our audit of internal controlover financial reporting. DTS DI is a wholly-owned subsidiary whose totalassets and total revenues represent approximately 14% and 7%, respectively, ofthe related consolidated financial statement amounts as of and for the yearended December 31, 2005. 
| /s/ PRICEWATERHOUSECOOPERS  LLP |   |
|---------------------------------|--------|
| Los Angeles, CA                 |   |
| March 16,  2006            |   |

 

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**DTS, INC.CONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                                                                                                       | ** ** | **As of December 31,**                                                          | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                                       | ** ** | **2004**                                                                                       | ** ** | **2005** | ** ** |
| ** **                                                                                                                                                                                                       | ** ** | **(Amounts in thousands,  except share and per  share amounts)** | ** ** |
| **ASSETS**                                                                                                                                                                                                       | ** ** | ** **                                                                                     | ** ** | ** ** | ** ** |
| Current assets:                                                                                                                                                                                                  |       |                                                                                           |       |   |   |
| Cash and cash equivalents                                                                                                                                                                                        |       | $                                                                                              | 21,271     | ** ** | **$** | **33,254** | ** ** |
| Short-term investments                                                                                                                                                                                           |       | 93,040                                                                                         | ** ** | **78,163** | ** ** |
| Accounts receivable, net of allowance for doubtful  accounts of $402 and $370 at December 31, 2004 and 2005,  respectively                                                                             |       | 4,649                                                                                          | ** ** | **7,311** | ** ** |
| Inventories                                                                                                                                                                                                      |       | 3,669                                                                                          | ** ** | **3,261** | ** ** |
| Deferred income taxes                                                                                                                                                                                            |       | 9,144                                                                                          | ** ** | **7,255** | ** ** |
| Prepaid expenses and other current assets                                                                                                                                                                        |       | 3,651                                                                                          | ** ** | **3,112** | ** ** |
| Income taxes receivable, net                                                                                                                                                                                     |       | 72                                                                                             | ** ** | **2,654** | ** ** |
| Total current assets                                                                                                                                                                                             |       | 135,496                                                                                        | ** ** | **135,010** | ** ** |
| Long-term  investments                                                                                                                                                                                           |       | 2,657                                                                                          |       | — |   |
| Property and  equipment, net                                                                                                                                                                                     |       | 3,539                                                                                          | ** ** | **7,375** | ** ** |
| Intangible  assets, net                                                                                                                                                                                          |       | 1,779                                                                                          | ** ** | **11,612** | ** ** |
| Goodwill                                                                                                                                                                                                         |       | —                                                                                         | ** ** | **3,585** | ** ** |
| Deferred income  taxes                                                                                                                                                                                           |       | 500                                                                                            |       | **303** | ** ** |
| Other assets                                                                                                                                                                                                     |       | 718                                                                                            | ** ** | **369** | ** ** |
| Total assets                                                                                                                                                                                                     |       | $                                                                                              | 144,689    | ** ** | **$** | **158,254** | ** ** |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                   | ** ** | ** **                                                                                     | ** ** | ** ** | ** ** |
| Current  liabilities:                                                                                                                                                                                            | ** ** | ** **                                                                                     | ** ** | ** ** | ** ** |
| Accounts payable                                                                                                                                                                                                 |       | $                                                                                              | 3,716      | ** ** | **$** | **2,634** | ** ** |
| Accrued expenses                                                                                                                                                                                                 |       | 5,688                                                                                          | ** ** | **6,983** | ** ** |
| Deferred revenue                                                                                                                                                                                                 |       | 519                                                                                            | ** ** | **2,630** | ** ** |
| Total current liabilities                                                                                                                                                                                        |       | 9,923                                                                                          | ** ** | **12,247** | ** ** |
| Deferred income  taxes                                                                                                                                                                                           |       | —                                                                                         | ** ** | **1,917** | ** ** |
| Commitments and  contingencies (Note 11)                                                                                                                                                                    |       |                                                                                           |       |   |   |
| Stockholders’ equity:                                                                                                                                                                                       |       |                                                                                           |       |   |   |
| Preferred stock—$0.0001 par value, 5,000,000 shares  authorized at December 31, 2005; no shares issued and outstanding                                                                                 |       | —                                                                                         | ** ** | **—** | ** ** |
| Common stock—$0.0001 par value, 70,000,000 shares  authorized at December 31, 2004 and 2005; 17,067,573 and 17,472,543 shares  issued and outstanding at December 31, 2004 and 2005, respectively |       | 2                                                                                              | ** ** | **2** | ** ** |
| Additional paid-in capital                                                                                                                                                                                       |       | 121,431                                                                                        | ** ** | **122,847** | ** ** |
| Retained earnings                                                                                                                                                                                                |       | 13,333                                                                                         | ** ** | **21,241** | ** ** |
| Total stockholders’ equity                                                                                                                                                                                  |       | 134,766                                                                                        | ** ** | **144,090** | ** ** |
| Total liabilities  and stockholders’ equity                                                                                                                                                                 |       | $                                                                                              | 144,689    | ** ** | **$** | **158,254** | ** ** |

 

See accompanying notes to consolidated financial statements.

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**DTS, INC.CONSOLIDATED STATEMENTSOF OPERATIONS**

| ** **                                                                                                 | ** ** | **For the Years Ended December 31,**                                      | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                 | ** ** | **2003**                                                                                           | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                                                                                 | ** ** | **(Amounts in thousands, except share and per  share amounts)** | ** ** |
| Revenues:                                                                                                  | ** ** | ** **                                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Technology and film licensing                                                                              |       | $                                                                                                  | 42,229     |   | $ | 49,920 | ** ** | **$** | **56,947** | ** ** |
| Product sales and other revenues                                                                           |       | 9,473                                                                                              |       | 11,511 | ** ** | **18,305** | ** ** |
| Total revenues                                                                                             |       | 51,702                                                                                             |       | 61,431 | ** ** | **75,252** | ** ** |
| Cost of goods  sold:                                                                                       | ** ** | ** **                                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Technology and film licensing                                                                              |       | 4,281                                                                                              |       | 4,451 | ** ** | **4,715** | ** ** |
| Product sales and other revenues                                                                           |       | 6,751                                                                                              |       | 11,711 | ** ** | **14,898** | ** ** |
| Total cost of goods sold                                                                                   |       | 11,032                                                                                             |       | 16,162 | ** ** | **19,613** | ** ** |
| Gross profit                                                                                               |       | 40,670                                                                                             |       | 45,269 | ** ** | **55,639** | ** ** |
| Operating expenses:                                                                                        | ** ** | ** **                                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Selling, general and administrative                                                                        |       | 20,473                                                                                             |       | 27,644 | ** ** | **33,960** | ** ** |
| Research and development                                                                                   |       | 4,987                                                                                              |       | 6,131 | ** ** | **9,867** | ** ** |
| In-process research and development                                                                        |       | —                                                                                             |       | — | ** ** | **2,300** | ** ** |
| Total operating expenses                                                                                   |       | 25,460                                                                                             |       | 33,775 | ** ** | **46,127** | ** ** |
| Income from  operations                                                                                    |       | 15,210                                                                                             |       | 11,494 | ** ** | **9,512** | ** ** |
| Interest income,  net                                                                                      |       | 271                                                                                                |       | 1,447 | ** ** | **2,524** | ** ** |
| Other income  (expense), net                                                                               |       | (214                                                                                               | )          | (31 | ) | **154** | ** ** |
| Income from legal  settlement (Note 21)                                                                    |       | —                                                                                             |       | 2,601 |   | — | ** ** |
| Income before  provision for income taxes                                                                  |       | 15,267                                                                                             |       | 15,511 | ** ** | **12,190** | ** ** |
| Provision for  income taxes                                                                                |       | 5,368                                                                                              |       | 5,535 | ** ** | **4,282** | ** ** |
| Net income                                                                                                 |       | 9,899                                                                                              |       | 9,976 | ** ** | **7,908** | ** ** |
| Accretion and accrued dividends on preferred stock                                                         |       | (1,234                                                                                             | )          | — |   | — | ** ** |
| Net income  attributable to common stockholders                                                            |       | $                                                                                                  | 8,665      |   | $ | 9,976 | ** ** | **$** | **7,908** | ** ** |
| Net income  attributable to common stockholders per common share:                                          | ** ** | ** **                                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic                                                                                                      |       | $                                                                                                  | 0.95       |   | $ | 0.59 | ** ** | **$** | **0.46** | ** ** |
| Diluted                                                                                                    |       | $                                                                                                  | 0.64       | (1) | $ | 0.55 |   | **$** | **0.43** | ** ** |
| Weighted average  shares used to compute net income attributable to common stockholders per  common share: | ** ** | ** **                                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic                                                                                                      |       | 9,166,389                                                                                          |       | 16,865,805 | ** ** | **17,321,148** | ** ** |
| Diluted                                                                                                    |       | 13,601,329                                                                                         | (1)        | 18,143,114 |   | **18,310,372** | ** ** |

 

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(1)    Asrestated (Note 2)

See accompanying notes to consolidated financial statements.

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**DTS, INC.CONSOLIDATED STATEMENTSOF STOCKHOLDERS’ EQUITY (DEFICIT)**

| ** **                                                                            | ** ** | **Common Stock**                                                     | ** ** | **Additional  Paid-in** | ** ** | **Retained  Earnings  (Accumulated** | ** ** | **Total  Stockholders’** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|-------------------------|------------|--------------------------------------|------------|-------------------------------|------------|
| ** **                                                                            | ** ** | **Shares**                                                                | ** ** | **Amount**              | ** ** | **Capital**                          | ** ** | **Deficit)**                  | ** ** | **Equity (Deficit)** | ** ** |
| ** **                                                                            | ** ** | **(Amounts in thousands, except share amounts)** | ** ** |
| 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 |   |   |
| Exercise of warrants                                                                  |       | 211,583                                                                   |       |                    | —     |                                 |       | —                        |       |   | — |   |   |   | — |   |   |
| Exercise of options and  related tax benefit of $283                             |       | 130,073                                                                   |       |                    | —     |                                 |       | 516                           |       |   | — |   |   |   | 516 |   |   |
| Issuance of common stock  under employee stock purchase plan                          |       | 63,314                                                                    |       |                    | —     |                                 |       | 825                           |       |   | — |   |   |   | 825 |   |   |
| Stock-based compensation  charge for options issued to non-employees                  |       | —                                                                    |       |                    | —     |                                 |       | 75                            |       |   | — |   |   |   | 75 |   |   |
| Net income                                                                            |       |                                                                      |       |                    |       |                                 |       |                          |       |   | 7,908 |   |   |   | 7,908 |   |   |
| Balance at December 31, 2005                                                     |       | 17,472,543                                                                |       |                    | $          | 2                                    |       |                          | $          | 122,847 |   |   | $ | 21,241 |   |   |   | $ | 144,090 |   |   |

 

See accompanying notes to consolidated financial statements.

66

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**DTS, INC.CONSOLIDATED STATEMENTSOF CASH FLOWS**

| ** **                                                                                                                    | ** ** | **For the Years Ended  December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                                                                    | ** ** | **2003**                                                  | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                                                                                                    | ** ** | **(Amounts in thousands)**                      | ** ** |
| Cash flows from operating activities:                                                                                         |       |                                                      |       |   |   |   |   |
| Net income                                                                                                                    |       | $                                                         | 9,899      |   | $ | 9,976 | ** ** | **$** | **7,908** | ** ** |
| Adjustments to reconcile  net income to net cash provided by operating activities:                                            |       |                                                      |       |   |   |   |   |
| Depreciation and  amortization                                                                                                |       | 910                                                       |       | 1,298 | ** ** | **3,793** | ** ** |
| Stock-based  compensation charges                                                                                             |       | 497                                                       |       | 273 | ** ** | **75** | ** ** |
| Allowance for  doubtful accounts                                                                                              |       | 114                                                       |       | 61 | ** ** | **30** | ** ** |
| Loss on disposal  of property and equipment                                                                                   |       | 93                                                        |       | — | ** ** | **5** | ** ** |
| Deferred income  taxes                                                                                                        |       | (374                                                      | )          | (2,092 | ) | **1,003** | ** ** |
| In-process  research and development                                                                                          |       | —                                                    |       | — | ** ** | **2,300** | ** ** |
| Tax benefit from  employee stock plans                                                                                        |       | 3,384                                                     |       | 4,348 | ** ** | **283** | ** ** |
| Write-down of  projector inventory                                                                                            |       | —                                                    |       | 3,871 |   | — |   |
| Changes in operating  assets and liabilities, net of the effect of acquisitions:                                              |       |                                                      |       |   |   |   |   |
| Accounts  receivable                                                                                                          |       | 1,542                                                     |       | (748 | ) | **(2,489** | **)** |
| Inventories                                                                                                                   |       | (2,906                                                    | )          | 12 | ** ** | **409** | ** ** |
| Prepaid expenses  and other assets                                                                                            |       | (1,121                                                    | )          | (1,245 | ) | **(228** | **)** |
| Accounts payable  and accrued expenses                                                                                        |       | 359                                                       |       | 713 | ** ** | **(2,139** | **)** |
| Deferred revenue                                                                                                              |       | —                                                    |       | 519 | ** ** | **1,184** | ** ** |
| Income taxes                                                                                                                  |       | (3,187                                                    | )          | 588 | ** ** | **(2,582** | **)** |
| Net cash provided  by operating activities                                                                                    |       | 9,210                                                     |       | 17,574 | ** ** | **9,552** | ** ** |
| Cash flows from investing activities:                                                                                         |       |                                                      |       |   |   |   |   |
| Purchases of  investments                                                                                                     |       | (115,285                                                  | )          | (114,429 | ) | **(103,563** | **)** |
| Maturities of  investments                                                                                                    |       | 2,160                                                     |       | 12,413 | ** ** | **63,591** | ** ** |
| Sales of  investments                                                                                                         |       | 52,125                                                    |       | 69,462 | ** ** | **57,506** | ** ** |
| Purchase of  property and equipment                                                                                           |       | (892                                                      | )          | (1,567 | ) | **(4,976** | **)** |
| Bridge loan for  acquisition                                                                                                  |       | —                                                    |       | (1,250 | ) | — |   |
| Cash paid for  acquisitions, net of cash acquired                                                                             |       | —                                                    |       | (1,383 | ) | **(11,000** | **)** |
| Payment for  patents and trademarks in process                                                                                |       | (86                                                       | )          | (90 | ) | **(185** | **)** |
| Net cash provided  by (used in) investing activities                                                                          |       | (61,978                                                   | )          | (36,844 | ) | **1,373** | ** ** |
| 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 | ** ** | **233** | ** ** |
| 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 | ** ** | **825** | ** ** |
| Net cash provided  by financing activities                                                                                    |       | 90,104                                                    |       | 1,298 | ** ** | **1,058** | ** ** |
| Net increase  (decrease) in cash and cash equivalents                                                                         |       | 37,336                                                    |       | (17,972 | ) | **11,983** | ** ** |
| Cash and cash  equivalents, beginning of period                                                                               |       | 1,907                                                     |       | 39,243 | ** ** | **21,271** | ** ** |
| Cash and cash  equivalents, end of period                                                                                     |       | $                                                         | 39,243     |   | $ | 21,271 | ** ** | **$** | **33,254** | ** ** |
| Supplemental  disclosure of cash flow information:                                                                            |       |                                                      |       |   |   |   |   |
| Cash paid for  interest                                                                                                       |       | $                                                         | 2          |   | $ | — | ** ** | **$** | **19** | ** ** |
| Cash paid for  income taxes                                                                                                   |       | $                                                         | 2,774      |   | $ | 482 | ** ** | **$** | **3,178** | ** ** |
| Non-cash investing  and financing activities:                                                                                 |       |                                                      |       |   |   |   |   |
| Non-cash  cumulative preferred dividends accrued and accretion of preferred stock  redemption value                           |       | $                                                         | 1,234      |   | $ | — | ** ** | **$** | **—** | ** ** |

 

See accompanying notes to consolidated financial statements.

67

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

**Note 1—TheCompany**

DTS, Inc. (the “Company”) provides digitalentertainment technologies, products and services to the motion picture,consumer electronics, professional audio and related industries. The Company’sCinema business provides digital playback systems and cinema processorequipment to movie theaters, and licenses and provides services to filmproducers and distributors. The Company’s Consumer business licenses audiotechnology to consumer electronics, personal computer, broadcast andprofessional audio companies, and sells DVD-based entertainment content. TheCompany’s Digital Images business, which was acquired in January 2005,provides image restoration and enhancement services for film producers anddistributors for home or professional playback of high quality, high definitionpresentations in digital cinema, high definition optical media or broadcastapplications.

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. In May 2005, the Company changed itsname from Digital Theater Systems, Inc. to DTS, Inc.

**Note 2—Restatement of 2003 Financial Statements**

***Restatement of 2003 Financial Statements***

In connection with the preparation of the financialstatements for fiscal year 2005, an error was identified in the method used tocompute the weighting of common stock options and warrants included in thediluted shares outstanding calculation for the year ended December 31,2003. This resulted in improperly reporting the weighted average shares used tocompute net income attributable to common stockholders per diluted common shareand net income attributable to common stockholders per diluted common share.

As a result, the Company has restated its previouslyissued consolidated financial statements for the year ended December 31,2003. The consolidated financial statements contained herein for the year endedDecember 31, 2003 include the effects of this restatement.

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

**Note 2—Restatementof 2003 Financial Statements (Continued)**

The following table setsforth the effects of the restatement adjustments:

| ** **                                                                                                 | ** ** | **For the Year Ended  December 31, 2003** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                                 | ** ** | **Previously  Reported**                                           | ** ** | **As  Restated** | ** ** |
| Net income  attributable to common stockholders per diluted common share                                   |       | $                                                                  | 0.80       |   | $ | 0.64 |   |
| Weighted average shares  used to compute net income attributable to common stockholders per common  share: | ** ** | ** **                                                         | ** ** | ** ** | ** ** |
| Basic                                                                                                      |       | 9,166,389                                                          |       | 9,166,389 |   |
| Effect of  dilutive securities:                                                                            | ** ** | ** **                                                         | ** ** | ** ** | ** ** |
| Common stock options                                                                                       |       | 1,401,727                                                          |       | 1,549,940 |   |
| Common stock warrants                                                                                      |       | 196,751                                                            |       | 2,885,000 |   |
| Diluted                                                                                                    |       | 10,764,867                                                         |       | 13,601,329 |   |
|                                                                                                            |            |                                                                    |            |  |  |  |  |

 

The incorrect calculation of diluted weighted averageshares outstanding did not affect net income for 2003 or any other period.

We have not amended ourannual report on Form 10-K for the year ended December 31,2003. The information that has been previously filed or otherwise reported issuperseded by the information in this annual report.

**Note 3—Significant Accounting Policies**

***Principles of Consolidation***

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

***Use of Estimates***

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.

***Cash and Cash Equivalents***

The Company considers allshort-term highly liquid investments with an original maturity of three monthsor less, when acquired, to be cash equivalents. Cash and cash equivalentsconsist of funds held in general checking accounts, money market accounts, andbank certificates of deposit. Cash and cash equivalents are stated at cost plusaccrued interest, which approximates fair value.

69

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

**Note 3—SignificantAccounting Policies (Continued)**

***Short-Term Investments***

Short-term investmentsconsist of bank certificates of deposit and certain marketable debt securities,which are classified as available-for-sale. The Company considers all debtsecurities to be short-term investments. Marketable debt securities consistprimarily of auction rate and variable rate obligation securities and arerecorded at market value. Despite the long-term nature of the contractualmaturities underlying our auction rate and variable rate obligation securities,we have the ability to quickly liquidate those investments. We had no materialgross realized or unrealized holding gains or losses from our investments inauction rate and variable rate obligation securities for the years ended December 31,2003, 2004 and 2005. All income generated from those investments was recordedas interest income.

***Long-Term Investments***

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 of Business and Credit Risk***

The Company markets its products and services to majormotion picture producers and distributors, movie theaters, and consumerelectronics product manufacturers in the United States and internationally.Although the Company is generally subject to the financial well being of themotion picture industry and the consumer electronics business, management doesnot believe that the Company is subject to significant credit risk with respectto trade accounts receivable. Additionally, the Company performs ongoing creditevaluations of its customers and maintains allowances for potential creditlosses which, when realized, have generally been within the range of management’sexpectations.

One customer accounted for 11% of revenues for theyear ended December 31, 2003. There were no customers that accounted formore than 10% of revenues for the years ended December 31, 2004 or 2005.One customer accounted for 24% of accounts receivable at December 31,2004. Another customer accounted for 17% of accounts receivable at December 31,2005.

The Company purchases its professional audio encodingdevices and movie theater playback systems from several third-partymanufacturers 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 significant losses on  its investments.

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

**Note 3—SignificantAccounting Policies (Continued)**

***Allowance For Doubtful 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 experience inconjunction 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.

***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 and Equipment***

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 

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

**Note 3—SignificantAccounting Policies (Continued)**

theasset, the Company recognizes an impairment loss. An impairment loss isreflected as the amount by which the carrying amount of the asset exceeds thefair market value of the asset, based on the fair market value if available, ordiscounted cash flows if not. To date, there has been no impairment oflong-lived assets.

***Goodwill and Intangible Assets***

The Company accounts for goodwill in accordance withSFAS No. 142, “Goodwill and Other Intangible Assets,” (“SFAS 142”), which,among other things, establishes standards for goodwill acquired in a businesscombination, eliminates the amortization of goodwill and requires the carryingvalue of goodwill and certain non-amortizing intangibles to be evaluated forimpairment on an annual basis. As required by SFAS 142, the Company performs animpairment test on recorded goodwill by comparing the estimated fair value ofeach of the Company’s reporting units to the carrying value of the assets andliabilities of each unit, including goodwill. The Company determines fair valueof the reporting units principally based upon management’s determination of thevalue of the Company as a whole. This value is determined by considering anumber of factors, including the Company’s historical and projected financialresults, valuation analyses, risks facing the Company and the liquidity of itscommon stock. If the carrying value of the assets and liabilities of thereporting units, including goodwill, were to exceed the Company’s estimation ofthe fair value of the reporting units, the Company would record an impairment chargein an amount equal to the excess of the carrying value of goodwill over theimplied fair value of the goodwill for each reporting unit. The Companyperforms an evaluation of goodwill as of October 31 of each year, absentany indicators of earlier impairment The Company’s first impairment testconducted in 2005, concluded that there was no impairment.

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 developed patents and trademarks, which are beingamortized over their respective lives. To date, there has been no impairment ofintangible assets.

***Revenue Recognition***

The Company recognizes revenue when it has persuasiveevidence of an arrangement, the price is fixed and determinable, collection isreasonably assured and delivery has occurred.

Revenues from multiple-element arrangements involvinglicense fees, up-front payments and milestone payments, which are receivedand/or billable by us in connection with other rights and services thatrepresent continuing obligations of ours, are deferred until all of the elementshave been delivered or until we have established objective and verifiableevidence of the fair value of the undelivered elements. Deferred revenues arisefrom payments received in advance of the culmination of the earnings process. 

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

**Note 3—SignificantAccounting Policies (Continued)**

Deferred revenues expectedto be recognized within the next twelve months are classified within currentliabilities. Deferred revenues will be recognized as revenue in future periodswhen the applicable revenue recognition criteria, as described above, are met.

Revenue from the sale of cinema hardware products isrecorded upon delivery assuming all other revenue recognition criteria are met.The licensing, encoding and duplication of motion picture soundtracks for usein the audio playback systems manufactured by the Company is undertaken underarrangements with major film producers and distributors. Revenue arising fromthe licensing and duplication of soundtracks is recognized upon deliveryassuming all other revenue recognition criteria are met.

Direct costs associated with deferred revenue aredeferred and included in other assets. Included in the balance sheet are $2,630and $1,734 of deferred revenue and costs, respectively, at December 31,2005.

Revenue from licensing audio technology, trademarksand know-how is generated from licensing agreements with consumer electronicsproduct manufacturers that pay a per-unit license fee for products manufacturedunder those license agreements. Licensees generally report manufacturinginformation within 30 to 60 days after the end of the quarter in whichsuch activity takes place. Consequently, the Company recognizes revenue fromthese licensing agreements on a three-month lag basis, generally in the quarterfollowing the quarter of manufacture, provided amounts are fixed ordeterminable and collection is reasonably assured, since the Company cannotreliably estimate the amount of revenue earned prior to the receipt of such reports.Use of this lag method allows for the receipt of licensee royalty reports priorto the recognition of revenue.

Revenue from the sale of multi-channel audio contentis recorded upon delivery to retail accounts or end customers, assuming: titleand risk of loss has transferred to the customer; prices are fixed ordeterminable; no significant Company obligations remain; and collection of therelated receivable is reasonably assured. The Company’s shipping terms arecustomarily FOB shipping point with title transfer and risk of losstransferring to the customer upon shipment.

Management provides for returns on product sales basedon historical experience and adjusts such reserves as considered necessary.

Revenues from digitalimage enhancement, restoration and repair are recognized when titles subject toa customer order or contract are delivered and accepted by the customer and nosignificant obligations remain assuming all other revenue recognition criteriaare met. Prices are established in advance of the work performed and aregenerally fixed in nature. Revenue related to time and materials contracts isrecognized as services are rendered at contract labor rates plus material andother direct costs incurred. If losses are anticipated on a contract, such lossesare recognized immediately.

***Shipping and Handling Costs***

Costs related to thedelivery of products to customers are included in cost of goods sold, andpayment for those costs are included in revenue.

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

**Note 3—SignificantAccounting Policies (Continued)**

***Patents and Trademarks***

Costs incurred in securingpatents and trademarks protecting the Company’s proprietary technology andbrand name are capitalized. Patent and trademark costs are amortized over theirestimated useful lives, typically five years and ten years, respectively. Theamortization period commences when the patent or trademark is issued.Amortization of patent and trademark costs amounted to $103, $74 and $52 forthe years ended December 31, 2003, 2004 and 2005, respectively.Accumulated amortization at December 31, 2004 and 2005 amounted to $575and $627, respectively.

***Research and Development Costs***

Research and developmentcosts are expensed as incurred.

***Acquired In-process Research and Development***

The value assigned toacquired in-process research and development is determined by identifyingspecific acquired in-process research and development projects that would becontinued and for which, upon consummation of a business combination,(1) technological feasibility has not been established at the acquisitiondate, (2) there is no alternative future use, and (3) the fair valueis estimable with reasonable reliability.

***Provision for Warranty Claims***

The Company offers a limited warranty for productsales that generally provides customers with a one or three year warrantyperiod against defects. Provisions for warranty claims are recorded at the timeproducts are sold and are reviewed and adjusted by management periodically toreflect actual and anticipated experience.

Ananalysis of changes in the liability for product warranty claims is as follows:

| *** ***                    | ** ** | **For the Years Ended  December 31,** | ** ** |
|---------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                      | ** ** | **2003**                                                  | ** ** | **2004** | ** ** | **2005** | ** ** |
| Balance at  beginning of period |       | $                                                         | 52         |   | $ | 81 | ** ** | **$** | **162** | ** ** |
| Current year  provision         |       | 57                                                        |       | 135 | ** ** | **315** | ** ** |
| Expenditures                    |       | (28                                                       | )          | (54 | ) | **(112** | **)** |
| Balance at end of period        |       | $                                                         | 81         |   | $ | 162 | ** ** | **$** | **365** | ** ** |

 

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

**Note 3—SignificantAccounting Policies (Continued)**

***Foreign Currency Translation***

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. To date, the gains and losses have not been significant.

***Advertising Expenses***

Advertising andpromotional costs are expensed as incurred and amounted to $2,376, $2,508 and$2,373 for the years ended December 31, 2003, 2004 and 2005, respectively.

***Comprehensive Income***

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 result ofchanges in the deferred tax assets and liabilities.

***Stock-Based Compensation***

Since 1997, the Company has maintained stock-basedemployee compensation plans, which are described more fully in Note 14.During 2003, the Company adopted the 2003 Employee Stock Purchase Plan. TheCompany accounts for its employee stock incentive 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 employee stock options is recorded, if on the date of the grant, thefair value of the underlying stock exceeds the exercise price.

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

**Note 3—SignificantAccounting Policies (Continued)**

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,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                                                          | ** ** | **2003**                                                  | ** ** | **2004** | ** ** | **2005** | ** ** |
| Net income  attributable to common stockholders:                                                                    |       |                                                      |       |   |   |   |   |
| As reported                                                                                                         |       | $                                                         | 8,665      |   | $ | 9,976 | ** ** | **$** | **7,908** | ** ** |
| Additional stock-based compensation expense  determined under the fair value method, net of tax                     |       | (780                                                      | )          | (1,786 | ) | **(5,392** | **)** |
| Pro forma                                                                                                           |       | $                                                         | 7,885      |   | $ | 8,190 | ** ** | **$** | **2,516** | ** ** |
| Net income  attributable to common stockholders per common share—basic:                                        | ** ** | ** **                                                |       |   | ** ** | ** ** | ** ** |
| As reported                                                                                                         |       | $                                                         | 0.95       |   | $ | 0.59 | ** ** | **$** | **0.46** | ** ** |
| Per share effect of additional stock-based  compensation expense determined under the fair value method, net of tax |       | (0.09                                                     | )          | (0.11 | ) | **(0.31** | **)** |
| Pro forma                                                                                                           |       | $                                                         | 0.86       |   | $ | 0.48 | ** ** | **$** | **0.15** | ** ** |
| Net income  attributable to common stockholders per common share—diluted:                                      | ** ** | ** **                                                |       |   | ** ** | ** ** | ** ** |
| As reported                                                                                                         |       | $                                                         | 0.64       | (1) | $ | 0.55 |   | **$** | **0.43** | ** ** |
| Per share effect of additional stock-based  compensation expense determined under the fair value method, net of tax |       | (0.06                                                     | )(1)       | (0.10 | ) | **(0.29** | **)** |
| Pro forma                                                                                                           |       | $                                                         | 0.58       | (1) | $ | 0.45 |   | **$** | **0.14** | ** ** |

----

(1)           As restated (Note 2)

The key assumptions usedfor the determination of the fair value of stock and employee stock purchaseplans are further described in Note 14.

For the years ended December 31, 2003 and 2004,the pro forma net income has been adjusted for additional stock-basedcompensation expense by approximately $176 and $321, respectively, to excludethe tax effect on incentive stock options.

The Companyaccounts for stock, stock options and warrants issued to non-employees inaccordance with the provisions of SFAS No. 123 and Emerging Issues TaskForce (“EITF”) Issue No. 96-18 “Accounting for Equity InstrumentsThat Are Issued to Other Than Employees for Acquiring, or in Conjunction withSelling, Goods and Services.” Under SFAS No. 123 and EITF Issue No. 96-18,stock option awards issued to non-employees are accounted for at fair valueusing the Black-Scholes option pricing model. Management believes that the fairvalue of the stock options is more reliably measured than 

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

**Note 3—Significant Accounting Policies(Continued)**

the fair value of theservices received. The fair value of each non-employee equity award isremeasured each period until a commitment date is reached, which is generallythe vesting date. For non-employee equity awards, deferred stock-basedcompensation is not reflected in stockholders’ deficit until a commitment dateis reached. For the years ended December 31, 2003, 2004 and 2005, theCompany recorded stock-based compensation expense of $497, $273 and $75,respectively, related to non-employee equity awards.

The Company hashistorically recognized compensation cost over the nominal vesting period,whereby if an employee retired before the end of the vesting period, the Companywould recognize any remaining unrecognized compensation cost at the date ofretirement. The FASB clarified in SFAS No. 123R that the fair value ofsuch stock options should be expensed based on recognition under anon-substantive vesting period approach, requiring compensation expenserecognition when an employee is eligible to retire. DTS employees are eligibleto retire after age 60. For those employees that retire and are eligible, theiroptions continue to vest upon the original vesting schedules. The SEC recentlyclarified that companies should continue the vesting method they have beenusing until adoption of FAS 123R, then apply the acceleratednon-substantive vesting approach to all subsequent grants to those employeeswhose options continue to vest after the date of retirement eligibility. Hadthe Company been accounting for such stock options using the non-substantivevesting approach for retirement-eligible employees, the Company wouldhave recognized additional stock-based compensation expense resulting in thefollowing adjusted pro forma diluted earnings per share.

| ** **                                                                                    | ** ** | **For the Years Ended December 31,**  | ** ** |
|-----------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                                                                    | ** ** | **    2003     ** | ** ** | **    2004    ** | ** ** | **    2005     ** | ** ** |
| Diluted pro forma  earnings per share (from above table)                                      |       |                                                           | $          | 0.58 | (1) |   |   | $ | 0.45 |   |   |   | $ | 0.14 |   |   |
| Impact of  retirement-eligible                                                                |       |                                                           | —     |   |   |   | 0.01 |   |   |   | — |   |   |
| Diluted pro forma  earnings per share (adjusted to reflect non-substantive vesting  approach) |       |                                                           | $          | 0.58 |   |   |   | $ | 0.44 |   |   |   | $ | 0.14 |   |   |

----

(1)    Asrestated (Note 2)

On November 17, 2005, the Compensation Committee(the “Committee”) of the Board of Directors of the Company approved theacceleration of the unvested portion of certain stock options held byemployees, officers and directors of the Company. The options that wereaccelerated have exercise prices greater than $21.00 per share, which is higherthan the $14.76 closing price of the Company’s common stock as quoted on theNasdaq National Market on November 17, 2005. These options would havevested and become exercisable from time to time over the next 32 months. As aresult of the acceleration, all of these options became fully vested andimmediately exercisable. All other terms and conditions applicable tooutstanding stock option grants remain in effect. Shares received upon theexercise of accelerated options held by members of the Company’s Board ofDirectors and by the Company’s President and Chief Executive Officer and itsExecutive Vice Presidents may not be sold or otherwise transferred prior to theearlier of the original vesting date of such options or their termination ofemployment or service.

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

**Note 3—SignificantAccounting Policies (Continued)**

The Committee’s decision to accelerate the vesting ofthe affected stock options was based upon the issuance by the FinancialAccounting Standards Board Statement of Financial Accounting Standard No. 123(revised 2004), “Share-Based Payment” (“FAS 123R”), which requires the Company,effective as of the beginning of the first fiscal quarter of 2006, to recordcompensation cost as expense for the portion of outstanding unvested awards,based on the fair value of those awards on the date of grant. As a resultof the acceleration, the Company expects to reduce the stock option expense itotherwise would have been required to recognize in its consolidated statementsof income pursuant to FAS 123R by approximately $1,300 in 2006 and an aggregateof approximately $1,600 in subsequent years.

See Recent AccountingDevelopments below for further discussion regarding the impact of adopting SFAS123R in the first quarter of 2006.

***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. Diluted net income pershare is calculated by dividing the net income attributable to commonstockholders for the period by the weighted average common shares outstanding,adjusted for all dilutive potential common share equivalents including sharesissuable upon the exercise of stock options, and common stock warrantsdetermined using the treasury stock method. Common share equivalents areexcluded from the calculation if their effect is anti-dilutive. As the Company’smandatorily redeemable preferred stock was not convertible into shares ofcommon stock, the mandatorily redeemable preferred stock was not considered acommon 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 was outstanding. In addition, accrued but unpaiddividends were recorded to increase the carrying value of the mandatorilyredeemable preferred 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 the chief operating decisionmaker, the Chief Executive Officer, for making operating decisions andassessing performance as the source for determining the Company’s reportablesegments.

***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.

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

**Note 3—SignificantAccounting Policies (Continued)**

***Recent Accounting Pronouncements***

In December 2004, the FASB issued SFAS No. 123R,“Share-Based Payment” (“SFAS 123R”), an amendment to SFAS No. 123, “Accountingfor Stock-Based Compensation.” SFAS 123R requires compensation expenserelated to stock-based awards to be recognized in the financial statements. Theamount of compensation expense will be measured based upon the fair value ofthe stock-based awards at the date of grant. SFAS 123R also requires anenterprise to assess the most appropriate model to calculate the value of theoptions. The Company currently uses the Black-Scholes option pricing model tovalue options, and is currently assessing which model it may use in the futureunder SFAS 123R and may deem an alternative model to be the most appropriate.The use of a different model to value options may result in a different fairvalue than the use of the Black-Scholes option pricing model. In addition,there are a number of other requirements under the new standard that willresult in differing accounting treatment than currently required. Thesedifferences include, but are not limited to, the accounting for the tax benefiton employee stock options. In addition to the appropriate fair value model tobe used for valuing share-based payments, the Company will also be required todetermine the transition method to be used at the date of adoption. The allowedtransition methods include prospective and retroactive adoption methods. Underthe retroactive method, prior periods may be restated either as of thebeginning of the year of adoption or for all periods presented. The prospectivemethod requires that compensation expense be recorded for all unvested stockoptions and restricted stock at the beginning of the first quarter of adoptionof SFAS 123R while the retroactive method would record compensation expense forall unvested stock options and restricted stock beginning with the first periodrestated. This statement was to have become effective for public companies asof the first interim or annual reporting period beginning after June 15,2005. In April 2005, the SEC amended the compliance date for implementingSFAS 123R extending the compliance date to the first fiscal year that beginsafter June 15, 2005. The Company plans to adopt SFAS 123R beginningin the first quarter of fiscal 2006. If we had adopted SFAS 123R as of December 31,2005, using the Black-Scholes method, the effects of the adoption of SFAS 123Ron the Company’s financial results for the next five years, based onstock-based awards granted as of December 31, 2005, would be as follows:

| ** **                                                                           | ** ** | **Expenses by Fiscal Year** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                           | ** ** | **2006**                                   | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** |
| ** **                                                                           | ** ** | **(in thousands)**                    | ** ** |
| Additional stock-based  compensation expense under SFAS 123R before tax benefit |       | $                                          | 1,495      |   | $ | 1,346 |   | $ | 1,173 |   | $ | 640 |   |   | — | ** ** |   |
|                                                                                      |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

In March 2005, the SEC issued Staff AccountingBulletin (“SAB”) No. 107 to provide guidance on SFAS 123R. SAB 107 wasissued to assist registrants by simplifying some of the implementationchallenges of SFAS 123R while enhancing the information that investors receive.SAB 107 provides guidance 

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

**Note 3—SignificantAccounting Policies (Continued)**

regarding valuationmodels, expected volatility and expected term. The Company will apply theguidance of SAB 107 in conjunction with its adoption of SFAS 123R.

In June 2005, the FASB issued Statement No. 154,“Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20,Accounting Changes, and Statement No. 3, Reporting Accounting Changes in InterimFinancial Statements” (“SFAS 154”). SFAS 154 changes the requirementsfor the accounting for, and reporting of, a change in accounting principle.Previously, most voluntary changes in accounting principles were required to berecognized by way of a cumulative effect adjustment within net income duringthe period of the change. SFAS 154 requires retrospective application toprior periods’ financial statements, unless it is impracticable to determineeither the period-specific effects or the cumulative effect of the change.SFAS 154 is effective for accounting changes made in fiscal yearsbeginning after December 15, 2005; however, the Statement does not changethe transition provisions of any existing accounting pronouncements. TheCompany does not believe adoption of SFAS 154 will have a material effecton the Company’s consolidated financial position, results of operations or cashflows.

In June 2005 FASBStaff Position (“FSP”) 143-1, “Accounting for Electronic Equipment WasteObligations” was issued. FSP 143-1 addresses the accounting forobligations associated with Directive 2002/96/EC on Waste Electrical andElectronic Equipment (the “Directive”) of the European Union (“EU”) which issubject to transformation into the respective national laws. Under theDirective, the waste management obligation remains with the commercial useruntil the historical waste equipment (put on the market before August 13,2005) is replaced. At that time, the waste management obligation for theequipment may be transferred to the producer of the replacement equipmentdepending on the transformation of the Directive into national law by theEU-member country. If the commercial user does not replace the equipment, theobligation remains with that user until the equipment is disposed. FSP 143-1requires the commercial user to apply the provisions of SFAS 143, “Accountingfor Asset Retirement Obligations” to the obligation associated with historicalwaste. FSP 143-1 will have to be applied in the first reporting periodending after the date the law is adopted by the applicable EU-member countries.The adoption of FSP 143-1 did not have a material impact on the Company’sconsolidated financial statements.

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

**Note 4—Cash, Short-term and Long-term Investments**

Cash,short-term and long-term investments consist of the following:

| ** **                                     | ** ** | **As of December 31,** | ** ** |
|------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                     | ** ** | **2004**                              | ** ** | **2005** | ** ** |
| Cash and cash  equivalents:                    |       |                                  |       |   |   |
| Cash                                           |       | $                                     | 15,116     | ** ** | **$** | **12,040** | ** ** |
| Money market accounts                          |       | 6,155                                 | ** ** | **21,214** | ** ** |
| Total cash and cash equivalents                |       | $                                     | 21,271     | ** ** | **$** | **33,254** | ** ** |
| Short-term  investments:                       |       |                                  | ** ** | ** ** | ** ** |
| Certificates of deposit                        |       | $                                     | 11,787     | ** ** | **$** | **8,121** | ** ** |
| Corporate bonds                                |       | —                                | ** ** | **3,570** | ** ** |
| Commercial paper                               |       | —                                | ** ** | **6,993** | ** ** |
| United States government and agency securities |       | 12,086                                |       | — |   |
| Municipal securities                           |       | 69,167                                | ** ** | **59,479** | ** ** |
| Total short-term investments                   |       | $                                     | 93,040     | ** ** | **$** | **78,163** | ** ** |
| Long-term  investments:                        |       |                                  | ** ** | ** ** | ** ** |
| Municipal securities                           |       | $                                     | 2,657      |   | $ | — |   |
| Total long-term  investments                   |       | $                                     | 2,657      | ** ** | **$** | **—** | ** ** |

 

The contractual maturitiesof short-term investments at December 31, 2005 are as follows:

| Due within one  year                    |   | $      | 40,383 |   |
|-----------------------------------------|--------|--------|--------|--------|
| Due after one  year through five years  |   | 1,002  |   |
| Due after five  years through ten years |   | 1,002  |   |
| Due after ten  years                    |   | 35,776 |   |
| Total short investments                 |   | $      | 78,163 |   |

 

**Note 5—Inventories**

Inventoriesconsist of the following:

| ** **        | ** ** | **As of   December 31,** | ** ** |
|-------------------|------------|-----------------------------------------|------------|
| ** **        | ** ** | **2004**                                | ** ** | **2005** | ** ** |
| Raw materials     |       | $                                       | 1,313      | ** ** | **$** | **1,062** | ** ** |
| Finished goods    |       | 2,356                                   | ** ** | **2,199** | ** ** |
| Total inventories |       | $                                       | 3,669      | ** ** | **$** | **3,261** | ** ** |

 

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

**Note 6—Property andEquipment**

Propertyand equipment consist of the following:

| ** **                      | ** ** | **As of December 31,** | ** ** |
|---------------------------------|------------|---------------------------------------|------------|
| ** **                      | ** ** | **2004**                              | ** ** | **2005** | ** ** |
| Machinery and  equipment        |       | $                                     | 3,036      | ** ** | **$** | **7,437** | ** ** |
| Office furniture  and fixtures  |       | 2,693                                 | ** ** | **3,588** | ** ** |
| Leasehold  improvements         |       | 2,926                                 | ** ** | **3,697** | ** ** |
|                            |       | 8,655                                 | ** ** | **14,722** | ** ** |
| Less: Accumulated  depreciation |       | (5,116                                | )          | **(7,347** | **)** |
| Property and  equipment, net    |       | $                                     | 3,539      | ** ** | **$** | **7,375** | ** ** |

 

Depreciation expense was$807, $1,135 and $2,231 for the years ended December 31, 2003, 2004 and2005, respectively.

**Note 7—Goodwill and Intangibles**

In the year ended December 31, 2005, we added$3,585 to goodwill in connection with our acquisition of Lowry Digital Images, Inc.,which is included in the Digital Images business segment. Subsequent to theacquisition, the business was renamed to DTS Digital Images (“DTS DI”). TheCompany did not have goodwill prior to this acquisition.

Included in cost of salesis $977 of amortization relating to existing technologies, backlog and customerrelationships for the year ended December 31, 2005. Included in operatingexpenses is $594 of amortization relating to non-compete and tradename for theyear ended December 31, 2005. The following table summarizes the weightedaverage lives and the carrying values of our acquired intangible assets bycategory:

| ** **              | ** ** | ** **                               | ** ** | **As of December 31, 2005** | ** ** | **As of December 31, 2004** | ** ** |
|-------------------------|------------|------------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **              | ** ** | **Weighted  Average Life  (Years)** | ** ** | **Gross  Amount**                               | ** ** | **Accumulated  Amortization**                   | ** ** | **Net  Carrying  Amount** | ** ** | **Gross  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** |
| Existing  technology    |       |                                     | 10.6       |                                            |       | $                                               | 11,627     |   |   | $ | (1,195 | ) |   | $ | 10,432 |   |   | $ | 1,426 |   |   |   | $ | (89 | ) |   |   | $ | 1,337 |   |   |
| Customer  relationships |       |                                     | 4          |                                            |       | 331                                             |       |   | (21 | ) |   | 310 |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Non-compete             |       |                                     | 3          |                                            |       | 400                                             |       |   | (133 | ) |   | 267 |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Backlog                 |       |                                     | 2          |                                            |       | 100                                             |       |   | (50 | ) |   | 50 |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Tradename               |       |                                     | 1          |                                            |       | 200                                             |       |   | (200 | ) |   | — |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Total                   |       |                                     |       |                                            |       | $                                               | 12,658     |   |   | $ | (1,599 | ) |   | $ | 11,059 |   |   | $ | 1,426 |   |   |   | $ | (89 | ) |   |   | $ | 1,337 |   |   |

 

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

**Note 7—Goodwilland Intangibles (Continued)**

The following tablesummarizes the weighted average lives and the carrying values of our otherintangible assets:

| ** ** | ** ** | ** **                               | ** ** | **As of December 31, 2005** | ** ** | **As of December 31, 2004** | ** ** |
|------------|------------|------------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| ** ** | ** ** | **Weighted  Average Life  (Years)** | ** ** | **Gross  Amount**                               | ** ** | **Accumulated  Amortization**                   | ** ** | **Net  Carrying  Amount** | ** ** | **Gross  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** |
| Patents    |       |                                     | 1.8        |                                            |       |                                            | $          | 965 |   |   |   | $ | (528 | ) |   |   | $ | 437 |   |   |   | $ | 829 |   |   |   | $ | (491 | ) |   |   | $ | 338 |   |   |
| Trademarks |       |                                     | 7.6        |                                            |       |                                            | 215        |   |   |   | (99 | ) |   |   | 116 |   |   |   | 188 |   |   |   | (84 | ) |   |   | 104 |   |   |
| Total      |       |                                     |       |                                            |       |                                            | $          | 1,180 |   |   |   | $(627 | ) |   |   | $ | 553 |   |   |   | $ | 1,017 |   |   |   | $ | (575 | ) |   |   | $ | 442 |   |   |

 

As of December 31,2005, we expect the amortization of intangible assets for future periods to beas follows:

| ** ** | ** ** | **Estimated  Amortization  Expense** | ** ** |
|------------|------------|--------------------------------------|------------|
| 2006       |       |                                 | $          | 1,819 |   |   |
| 2007       |       |                                 | 1,366      |   |   |
| 2008       |       |                                 | 1,224      |   |   |
| 2009       |       |                                 | 1,200      |   |   |
| 2010       |       |                                 | 1,114      |   |   |
| Thereafter |       |                                 | 4,889      |   |   |
| Total      |       |                                 | $          | 11,612 |   |   |

 

**Note 8—Accrued Expenses**

Accruedexpenses consist of the following:

| ** **                            | ** ** | **As of December 31,** | ** ** |
|---------------------------------------|------------|---------------------------------------|------------|
| ** **                            | ** ** | **2004**                              | ** ** | **2005** | ** ** |
| Accrued payroll  and related benefits |       | $                                     | 2,409      | ** ** | **$** | **3,898** | ** ** |
| Production  advance                   |       | 1,248                                 | ** ** | **1,022** | ** ** |
| Accrued royalties                     |       | 507                                   | ** ** | **309** | ** ** |
| Other                                 |       | 1,524                                 | ** ** | **1,754** | ** ** |
| Total accrued  expenses               |       | $                                     | 5,688      | ** ** | **$** | **6,983** | ** ** |

 

**Note 9—Bank Line of Credit**

We have in place a $10,000 facility that expires on June 30,2006 and is renewable annually. The bank agreement provides for working capitalfinancing and is unsecured. The bank agreement requires the Company to complywith certain covenants including a tangible effective net worth of $60,000,increasing by 50% of net income on an annual basis. The covenants also requirethe Company to keep $2,000 in cash or securities at the bank. At December 31,2005, the Company was compliant with all covenants under the bank agreement.

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

**Note 9—BankLine of Credit (Continued)**

At December 31, 2005,there were no balances outstanding under this agreement and there was $10,000of available borrowings under this credit facility. Future borrowings will bearinterest based on either of the two options the Company selects at the time ofadvances 1) a rate equal to 2% above the Bank’s LIBOR, or 2) a rateequal to the Base Rate as quoted from the bank less one-half percent. Theannual commitment fee for this line of credit is not significant.

**Note 10—Business Combinations**

In January 2005, the Company completed theacquisition of DTS DI for $9,642 in cash. DTS DI provides image restoration andenhancement services for film producers and distributors for home orprofessional playback of high quality, high definition presentations in digitalcinema, high definition optical media or broadcast applications. In late 2004,the Company loaned DTS DI a total of $1,250 to enable DTS DI to satisfy certainliabilities. Neither DTS DI nor its stockholders were required to repay thisloan prior to, or in connection with, the acquisition. The cash portion of theacquisition was funded by working capital.

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

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

 

The DTS DI acquisition wasaccounted for as a purchase business combination. The results of operations ofDTS DI are included in our Consolidated Statement of Operations from January 3,2005. 

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

**Note 10—BusinessCombinations (Continued)**

The final purchase price is dependent on sharesissued, if any, as further discussed below. Under the purchase method ofaccounting, the total estimated purchase price is allocated to DTS DI’s nettangible and intangible assets based on their estimated fair value as of thedate of completion of the acquisition. Based on the estimated purchase priceand the valuation, the purchase price allocation is as follows:

| Accounts  receivable                                                         |   | $      | 190    |   |
|------------------------------------------------------------------------------|--------|--------|--------|--------|
| Tangible assets                                                              |   | 1,094  |   |
| Other assets                                                                 |   | 57     |   |
| Deferred tax  assets                                                         |   | 1,356  |   |
| Amortizable intangible  assets:                                              |   |   |   |
| Existing technology                                                          |   | 10,200 |   |
| Non-compete                                                                  |   | 400    |   |
| Backlog                                                                      |   | 100    |   |
| Tradename                                                                    |   | 200    |   |
| IPR&D                                                                    |   | 2,300  |   |
| Goodwill                                                                     |   | 3,585  |   |
| Total assets  acquired                                                       |   | 19,482 |   |
| Liabilities assumed:                                                         |   |   |   |
| Accounts payable                                                             |   | (942   | )      |
| Accrued  liabilities                                                         |   | (819   | )      |
| Notes payable                                                                |   | (368   | )      |
| Deferred revenues                                                            |   | (928   | )      |
| Total liabilities  assumed                                                   |   | (3,057 | )      |
| Net deferred tax  liability for acquired intangibles and purchase accounting |   | (4,176 | )      |
| Total purchase price                                                         |   | $      | 12,249 |   |

 

The Company allocated $10,900 to amortizableintangible assets consisting of existing technology, non-compete, backlog, andtradenames.

The Company allocated $3,585 to goodwill. Goodwillrepresents the excess of the purchase price over the fair market value of thenet tangible and amortizable intangible assets acquired. Goodwill will not beamortized and will be tested for impairment at least annually.

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

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

 

85

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

**Note 10—BusinessCombinations (Continued)**

Developed technology and IPR&D were identified andvalued through extensive interviews, analysis of data provided by DTS DIconcerning development projects, their stage of development, the time andresources needed to complete them, if applicable, and their expected incomegenerating ability and associated risks. Where development projects had reachedtechnological feasibility, they were classified as developed technology and thevalue assigned to developed technology was capitalized. The income approach,which includes an analysis of the cash flows and risks associated withachieving such cash flows, was the primary technique utilized in valuingacquired IPR&D. Key assumptions for IPR&D included a discount rate of30% and estimates of revenue growth, cost of sales, operating expenses andtaxes.

The former shareholders of DTS DI are entitled toreceive shares of DTS common stock if certain gross profit targets in 2006 aremet. In the event that the targets are met in full, an aggregate of up toapproximately 653,000 shares of DTS common stock will be issued. The value ofthese shares will be accounted for as an addition to goodwill.

Theresults of operations of DTS DI are included in our Consolidated Statements ofOperations from January 3, 2005, the date of acquisition. For the purposesof presenting the unaudited pro forma financial information, the Company used theincome statements of DTS DI for the year ended December 31, 2004. If theCompany had acquired DTS DI at the beginning of fiscal year 2004, the Company’sunaudited pro forma net revenues, net income and net income per share for theyear ended December 31, 2004 would have been as follows:

| ** **                         | ** ** | **Year**                    | ** ** |
|------------------------------------|------------|-----------------------------|------------|
| ** **                         | ** ** | **Ended**                   | ** ** |
| ** **                         | ** ** | **December 31,  2004** | ** ** |
| Revenue                            |       |                        | $          | 66,456 |   |   |
| Net income                         |       |                        | $          | 8,039 |   |   |
| Net income per  share—Basic   |       |                        | $          | 0.48 |   |   |
| Net income per  share—Diluted |       |                        | $          | 0.44 |   |   |

 

In July 2004, the Company completed the acquisitionof QDesign Corporation for $1,500 in cash. Under the terms of the acquisition,the Company also contingently agreed to pay an additional amount up to amaximum of $450 in cash, which is held by the Company in a restricted account.The Company classifies the restricted cash in other current and non-currentassets. The contingent payment is being accounted for as compensation expenseratably over the three-year period ending July 2007, and will be paid outif certain criteria are met. The first payment of $150 was paid in 2005.

86

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

**Note 10—Business Combinations (Continued)**

Theallocation of the purchase price to the assets acquired and liabilities assumedbased on the estimated 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 operations of this acquisition havebeen included in the Company’s condensed consolidated statements of operationssince the completion of the acquisition in July 2004. Results ofoperations for the acquisition for periods prior to the acquisition were notmaterial to the Company and, accordingly, pro forma results of operations havenot been presented.

**Note 11—Commitments and Contingencies**

Warehouse,office facilities and certain office equipment are leased under operatingleases expiring in various years through 2015. Some leases contain renewal optionsand escalation clauses including increases in annual rents based upon increasesin the consumer price index. Minimum future rental payments undernon-cancelable operating leases, net of sublease income are as follows:

| **Years Ending December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|------------|------------|
| 2006                                         |       | $          | 942        |       |
| 2007                                         |       | 730        |       |
| 2008                                         |       | 373        |       |
| 2009                                         |       | 318        |       |
| 2010                                         |       | 249        |       |
| 2011 and  thereafter                         |       | 632        |       |
|                                         |       | $          | 3,244      |       |

 

Rent expense, net of sublease income amounted to $485,$883 and $1,379 for the years ended December 31, 2003, 2004 and 2005,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 

87

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

**Note 11—Commitmentsand Contingencies (Continued)**

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 the normal course ofbusiness, the Company is subject to certain claims and litigation, includingunasserted claims. The Company is of the opinion that, based on informationpresently available, any such legal matters will not have a material adverseeffect on the financial position, results of operations or cash flows of theCompany.

**Note 12—Related Party Transactions**

One of the Company’s 5% or greater stockholders wasboth a customer of and a supplier to the Company. Sales to this stockholdertotaled $615 and $648 for the years ended December 31, 2003 and 2004,respectively. Purchases from the stockholder totaled $0 and $39 for the yearsended December 31, 2003 and 2004, respectively. Accounts receivable at December 31,2004 include $176 due from this stockholder. This entity was not considered arelated party in 2005.

Sales to another 5% or greater stockholder totaled$369 for the year ended December 31, 2003. Accounts receivable at December 31,2003 include $129 due from this stockholder. This entity was not considered arelated party in 2004 or 2005.

The Company had sales of $90 and $219 for the yearsended December 31, 2003 and 2004, respectively, to a customer which was an18.8% owned affiliate up until the end of the third quarter of 2005. TheCompany had sales of $41 for the nine months ended September 30, 2005. Accountsreceivable at December 31, 2004 included $132 due from this previousaffiliate. This entity was not considered a related party as of the fourthquarter of 2005.

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 $12 for such services during the year ended December 31,2003. This entity was not considered a related party in 2004 or 2005.

88

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

**Note 13—Income Taxes**

The provision for income taxes consists of thefollowing:

| ** **                        | ** ** | **Years Ended  December 31,** | ** ** |
|-----------------------------------|------------|-----------------------------------------|------------|
| ** **                        | ** ** | **2003**                                | ** ** | **2004** | ** ** | **2005** | ** ** |
| Current:                          |       |                                    |       |   |   |   |   |
| Federal                           |       | $                                       | 1,462      |   | $ | 5,307 | ** ** | **$** | **2,375** | ** ** |
| State                             |       | 1,106                                   |       | 1,358 | ** ** | **253** | ** ** |
| Foreign                           |       | 3,174                                   |       | 960 | ** ** | **184** | ** ** |
| Total current                     |       | 5,742                                   |       | 7,625 | ** ** | **2,812** | ** ** |
| Deferred:                         | ** ** | ** **                              |       |   | ** ** | ** ** | ** ** |
| Federal                           |       | (242                                    | )          | (1,774 | ) | **1,010** | ** ** |
| State                             |       | (132                                    | )          | (316 | ) | **460** | ** ** |
| Total deferred                    |       | (374                                    | )          | (2,090 | ) | **1,470** | ** ** |
| Total provision for  income taxes |       | $                                       | 5,368      |   | $ | 5,535 | ** ** | **$** | **4,282** | ** ** |

 

Thecomponents of temporary differences that gave rise to deferred income tax areas follows:

| ** **                                          | ** ** | **As of  December 31,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                          | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| Deferred tax assets:                                |       |                                        |       |   |   |
| Accrued revenues                                    |       | $                                           | 4,650      | ** ** | **$** | **4,667** | ** ** |
| Loss carryforwards                                  |       | —                                      | ** ** | **561** | ** ** |
| Inventory                                           |       | 1,877                                       | ** ** | **1,145** | ** ** |
| Credit carryforwards                                |       | 1,340                                       |       | — |   |
| Deferred Revenue                                    |       | —                                      | ** ** | **1,458** | ** ** |
| Depreciation and amortization                       |       | 500                                         | ** ** | **436** | ** ** |
| Accrued expenses                                    |       | 992                                         | ** ** | **895** | ** ** |
| Other assets                                        |       | 285                                         |       | **152** |   |
| Total deferred tax assets                           |       | 9,644                                       | ** ** | **9,314** | ** ** |
| Deferred tax  liabilities:                          |       |                                        | ** ** | ** ** | ** ** |
| Acquired intangibles                                |       | —                                      | ** ** | **3,673** | ** ** |
| Total deferred tax liabilities                      |       | —                                      | ** ** | **3,673** | ** ** |
| Deferred tax assets, net                            |       | 9,644                                       | ** ** | **5,641** | ** ** |
| Deferred tax assets                                 |       | 9,144                                       | ** ** | **7,558** | ** ** |
| Non-current  deferred tax assets (liabilities), net |       | $                                           | 500        | ** ** | **$** | **(1,917** | **)** |

 

There is no valuation allowance for deferred taxassets at December 31, 2005, based on management’s assessment of theCompany’s ability to utilize these deferred tax assets. Realization of the netdeferred tax assets of $5,641 is dependent on the Company generating sufficienttaxable income in the future. Although realization is not assured, the Companybelieves it is more likely than not that the deferred tax assets will berealized. The amount of the deferred tax assets considered realizable, however,could be reduced in the future if estimates of future taxable income arereduced. The Company has $697 in tax loss carryforwards 

89

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

**Note 13—IncomeTaxes (Continued)**

as of December 31, 2005which consists primarily of a pre-acquisition federal net operating loss of asubsidiary which begins to expire in 2024. Additionally, the Company has taxloss carryforwards of approximately $1,008 in the United Kingdom. These taxloss carryforwards can be utilized indefinitely. It is the Company’s assessmentthat it is more likely than not that these loss carryforwards will be fullyutilized.

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 and a corresponding decrease in the income taxespayable in the accompanying balance sheets.

Theprovision for income taxes differs from the amount obtained by applying thefederal statutory income tax rate to income before provision for income taxesas follows:

| ** **                           | ** ** | **Years Ended  December 31,** | ** ** |
|--------------------------------------|------------|-----------------------------------------|------------|
| ** **                           | ** ** | **2003**                                | ** ** | **2004** | ** ** | **2005** | ** ** |
| Statutory federal  rate              |       | 34.0                                    | %          | 35.0 | % | **35.0** | **%** |
| State income  taxes, net             |       | 4.2                                     |       | 4.5 | ** ** | **5.9** | ** ** |
| In-process  research and development |       | —                                  |       | — | ** ** | **6.6** | ** ** |
| Effect of varying  foreign rates     |       | —                                  |       | (6.9 | ) | **4.9** | ** ** |
| Extraterritorial  income exclusion   |       | —                                  |       | — |   | **(9.3** | **)** |
| Tax exempt  interest                 |       | —                                  |       | — |   | **(4.1** | **)** |
| Other                                |       | (3.0                                    | )          | 3.1 | ** ** | **(3.9** | **)** |
| Effective tax rate                   |       | 35.2                                    | %          | 35.7 | % | **35.1** | **%** |

 

The Company has not provided for U.S. income taxes orforeign withholding taxes on approximately $2,827 of undistributed earnings ofits non-U.S. subsidiaries as of December 31, 2005. The Company intends toreinvest these earnings indefinitely in operations outside of the United States.

During the years ended December 31, 2003 and2004, the Company received a tax holiday from the Chinese taxing authorities. Forthe tax year ended December 31, 2005, the Company was awarded a reduced taxrate of 18% on income in China based on achieving “high-tech” status, which theCompany expects to renew on an annual basis. The tax holiday and reduced rateresulted in reductions to income taxes of $940 and $323 for the years endedDecember 31, 2004 and 2005, respectively, with earnings per diluted commonshare benefits for these same periods of $0.05 and $0.02, respectively. Therewas no significant impact on 2003.

Income tax receivable, netat December 31, 2004 and 2005, includes estimated tax contingencies of $1,785and $1,410, respectively, for both domestic and foreign issues. The netdecrease of $400 was due mainly to settlement of the Internal Revenue Service(“IRS”) regular audit of the Company’s 2002 tax return in March 2005. The IRSis currently conductiing a regular audit of our federal income tax return for2003. The Company believes that its accruals for tax liabilities are adequatefor all open years, based on the assessment of many factors including pastexperience and interpretations of tax law applied to the facts of each matter. Inherentuncertainties exist in estimating tax contingencies due to the progress ofincome tax 

90

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

**Note 13—IncomeTaxes (Continued)**

auditsand changes in tax law, both legislated and concluded through the variousjurisdictions’ tax court systems.

**Note 14—Stock Plans**

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 optionsintended to satisfy the requirements of Section 422 of the InternalRevenue Code of 1986, as amended, and the regulations thereunder, ornon-qualified options. Options generally become exercisable over a four-yearperiod and expire in ten years. The total number of shares of common stock thatmay be issued under both plans amounted to a maximum of 2,071,051. Optionsgranted prior to 2002 were granted at exercise prices equal to the preferredstock financing prices, which were in excess of the estimated fair value of theunderlying common stock.

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) anumber of shares set by the Board of Directors.

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 

91

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

**Note 14—StockPlans (Continued)**

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 $152, $273 and $75 for the years ended December 31,2003, 2004 and 2005, respectively.

The following tablesummarizes information about stock option activity: 

| ** **                                                     | ** ** | **Options  Outstanding** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|----------------------------------------------------------------|------------|--------------------------|------------|------------------------------------------------|------------|
| 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 |   |   |
| Granted                                                        |       |                     | 684,900    |                                           |       |   | 17.63 |   |   |
| Exercised                                                      |       |                     | (130,073   | )                                              |       |   | 1.77 |   |   |
| Expired or cancelled                                           |       |                     | (37,346    | )                                              |       |   | 16.81 |   |   |
| Options  outstanding at December 31, 2005                 |       |                     | 2,321,552  |                                           |       |   | $ | 12.73 |   |   |
| Options available  for future grant at December 31,  2005 |       |                     | 401,928    |                                           |       |   |   |   |   |

                                                                                                                                                                                                

| ** **                                                        | ** ** | ** ** | ** ** | **Options Outstanding**                             | ** ** | **Options Exercisable**                            | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| **Range of Exercise Prices**                       | ** ** | ** ** | ** ** | **Number  Outstanding at  December 31,  2005** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Number  Exercisable at   December 31,   2005** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| $  1.02  – $  3.07                       |       |       | 852,147    |                                                     |       |                                                    | 6.72       |   |   |   | $ | 1.02 |   |   |   | 823,198 |   |   |   | $ | 1.02 |   |   |
|     3.08  –     6.16 |       |       | 9,580      |                                                     |       |                                                    | 2.75       |   |   |   | 4.12 |   |   |   | 8,704 |   |   |   | 4.05 |   |   |
|     6.17  –     9.23 |       |       | 10,250     |                                                     |       |                                                    | 7.20       |   |   |   | 8.02 |   |   |   | 5,125 |   |   |   | 8.02 |   |   |
|     9.24  –   12.31            |       |       | 2,750      |                                                     |       |                                                    | 7.29       |   |   |   | 10.59 |   |   |   | 2,625 |   |   |   | 10.55 |   |   |
|   12.32  –   15.40                       |       |       | 77,750     |                                                     |       |                                                    | 8.57       |   |   |   | 14.20 |   |   |   | 19,125 |   |   |   | 13.84 |   |   |
|   15.41  –   18.47                       |       |       | 536,000    |                                                     |       |                                                    | 8.93       |   |   |   | 16.48 |   |   |   | 93,957 |   |   |   | 16.35 |   |   |
|   18.48  –   21.55                       |       |       | 245,325    |                                                     |       |                                                    | 9.06       |   |   |   | 19.90 |   |   |   | 21,873 |   |   |   | 19.75 |   |   |
|   21.56  –   24.63                       |       |       | 550,500    |                                                     |       |                                                    | 8.13       |   |   |   | 23.10 |   |   |   | 538,000 |   |   |   | 23.11 |   |   |
|   24.64  –   27.71                       |       |       | 29,750     |                                                     |       |                                                    | 7.92       |   |   |   | 25.94 |   |   |   | 29,562 |   |   |   | 25.94 |   |   |
|   27.72  –   30.79                       |       |       | 7,500      |                                                     |       |                                                    | 7.77       |   |   |   | 30.79 |   |   |   | 7,500 |   |   |   | 30.79 |   |   |
| $  1.02 – $30.79                                   |       |       | 2,321,552  |                                                     |       |                                                    | 7.88       |   |   |   | $ | 12.73 |   |   |   | 1,549,669 |   |   |   | $ | 10.72 |   |   |
|                                                                   |            |            |            |                                                          |            |                                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

**Note 14—StockPlans (Continued)**

Options exercisable at December 31, 2003 and 2004were 1,431,652 and 643,464, respectively, at weighted average exercise pricesof $1.64 and $3.39 per share, respectively.

As further described inNote 3, 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,** | ** ** |
|--------------------------|------------|-----------------------------------------|------------|
| ** **               | ** ** | **2003**                                | ** ** | **2004** | ** ** | **2005** | ** ** |
| Risk free  interest rate |       |                                    | 3.9        | % |   |   | 3.4 | % |   |   | **3.8** | **%** |   |
| 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, 2003, 2004 and 2005 was $7.69,$9.40, and $7.62, respectively.

In accordance with the evergreen provision in the 2003Plan and as approved by the Board of Directors, effective January 1, 2006,the number of shares reserved under the 2003 Plan was increased by 698,901shares.

On April 17, 2003,the Company’s board adopted the 2003 Employee Stock Purchase Plan and the 2003Foreign Subsidiary Employee Stock Purchase Plan (“ESPP”), under which, subjectto certain limitations, the initial aggregate number of shares of stock thatmay be issued is 500,000, cumulatively increased on January 1, 2004 andeach January 1 thereafter until and including January 1, 2013 by thelesser of: 1) 500,000 shares, 2) one percent of the number of sharesof all classes of common stock of the Company outstanding on that date, or3) a lesser amount determined by the Board of Directors. Under 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, 2004 and 2005:

| ** **               | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|
| Risk free  interest rate |       |     | 1.2        | %        |       |     | 1.4        | % |   |   | **2.6** | **%** |   |
| Expected lives  (years)  |       |     | 1.2        |     |       |     | 1.3        |   |   |   | **1.3** | ** ** |   |
| Dividend yield           |       |     | 0          | %        |       |     | 0          | % |   |   | **0** | **%** |   |
| Expected volatility      |       |     | 50         | %        |       |     | 50         | % |   |   | **50** | **%** |   |

 

In accordance with the evergreen provision in theESPP, the Board of Directors approved an increase in the number of sharesreserved under the ESPP by 100,000 shares, effective January 1, 2006.

**Note 15—Defined Contribution Plan**

The Company has savingsand investment plans, including a savings plan that qualifies as a definedcontribution plan under Section 401(k) of the Internal Revenue Code,that allow eligible employees to allocate up to 15% of salary through payrolldeductions. Substantially all full-time employees on the 

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

**Note 15—DefinedContribution Plan (Continued)**

payrollof the Company are eligible to participate in the plans. Prior to 2004, theCompany matched up to 50% of the employee’s contributions up to 6%. Effectivefor 2004, the Company matches 50% of the first 4% of salary contributed to theplan and up to 6% if certain financial targets are met. For the years endedDecember 31, 2003, 2004 and 2005, the costs of these matches were $156,$194 and $223, respectively.

**Note 16—Mandatorily Redeemable Preferred Stock**

In 1997, the Company issued 5,943,536 shares ofSeries A preferred stock, $0.0001 par value per share, for net proceeds ofapproximately $11,000 as a result of a completed private placement. Theseshares contained mandatory redemption provisions and were redeemable at a priceof $2.02 each plus accrued and unpaid dividends, 50% of the shares atOctober 24, 2002, and the remaining 50% at October 24, 2003. Asfurther described below, on October 22, 2002, the redemption date was extendedto May 24, 2004. Along with the issuance of the Series A preferredstock, the Company issued 2,971,768 common stock warrants, each of whichentitles the holder to purchase one share of the Company’s common stock for$0.02 per share. These warrants are further described in Note 17.

Additionally, in connection with the privateplacement, the Company issued warrants to the placement agent to purchase29,717 shares of common stock at a price of $4.04 per share, expiring onDecember 31, 2007. The estimated fair value of these warrants asdetermined using the Black-Scholes option pricing model was insignificant.

In January 2000, the Company completed theissuance of 1,857,355 shares of Series B redeemable preferred stock(“Series B preferred stock”) for net proceeds of approximately $3,689.These shares contained mandatory redemption provisions and were redeemable at aprice of $2.02 each, 50% of the shares on January 27, 2005, and theremaining 50% on January 27, 2006. As further described below, onOctober 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 17.

On October 22, 2002, the terms of theSeries A preferred stock were amended to provide for the extension of theredemption from the equal installments due on October 24, 2002 andOctober 24, 2003 to one installment due on May 24, 2004. At the sametime, the redemption of the Series B preferred stock was accelerated tocoincide with the Series A redemption on May 24, 2004. In addition,the dividend rate was increased from 8% to 10% per annum for accrual of alldividends after October 24, 2002 through maturity on May 24, 2004.

In conjunction with its initial public offering, theCompany redeemed its preferred stock and paid accrued dividends. As ofDecember 31, 2004 and 2005, no balances were outstanding.

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

**Note 16—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 theamount of the total dividend due on the Series A and Series Bpreferred stock, respectively (the “Dividend Amount”). If the Dividend Amountwas less than the amount of all accrued dividends, any dividends not paid wouldcontinue to 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 and preferred stock voted together as a single class.The holders of a majority of the shares of Series A and Series Bpreferred stock outstanding, voting separately as one class, had the specialand exclusive right to 

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

**Note 16—MandatorilyRedeemable Preferred Stock (Continued)**

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, including cumulativeaccrued but unpaid dividends with a corresponding charge to accumulateddeficit. The Series A and Series B preferred stock were redeemedduring 2003.

**Note 17—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 14, the Company issued2,971,768 warrants to the holders of Series A preferred stock thatentitled the holders to purchase one share each of common stock at a price of$0.02 per share. At issuance, the warrants were cancelable if the Company wasable to consummate a Qualified Public Offering or Qualified Sales Transaction,as defined, 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 14.

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 proceeds was based on the relative fair valuesbetween the common stock warrants and the Series A preferred stock. Thefair value of the common stock warrant was determined using the Black-Scholes 

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

**Note 17—CommonStock Warrants (Continued)**

optionpricing model using the following assumptions: risk-free interest rate of 6.4%;contractual life of 7 years; dividend yield of 0%; and expected volatilityof 50%.

In connection with the Series B financingdiscussed in Note 14, the Company issued 1,857,355 warrants to the holdersof Series B preferred stock that entitle the holders to purchase one shareeach of common stock of the Company at a price of $0.02 per share. The warrantsare exercisable at any time through December 31, 2007. The proceedsattributable to these common stock warrants was estimated to be $514 and wasrecorded as a charge to additional paid-in capital. The allocation of proceedswas based on the relative fair values between the common stock warrants and theSeries B preferred stock. The fair value of the common stock warrants 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%.

Through 2002, warrants related to the Series Aand Series B financings, representing 12,500 shares of common stock, wereexercised. Concurrent with the initial public offering in 2003, the outstandingwarrants related to the Series A and Series B preferred stockfinancings were automatically converted into common stock through cashlessexercise, resulting in the issuance of 4,690,390 shares of common stock.

In March 2003, the Company issued warrants to aholder of Series A preferred stock to purchase 32,864 shares of theCompany’s common stock at an exercise price of $0.02 per share. The warrantsare immediately exercisable, non-forfeitable and expire in 10 years. Thefair value ascribed to these warrants amounted to $345 and was determined usingthe Black-Scholes option pricing model using the following assumptions:risk-free interest rate of 4%; contractual life of ten years; dividend yield of0%, expected volatility of 50%; and a fair value of $10.50 per share of commonstock. The charge for these warrants was recorded in selling, general andadministrative expenses for the year ended December 31, 2003. In April 2003,all of these warrants were exercised for proceeds totaling $1.

As of December 31,2005, there were 18,928 and 19,491 warrants exercisable to purchase commonstock outstanding with exercise prices of $12.114 and $4.038 per share,respectively.

**Note 18—Capital Structure and Sale of CommonStock**

In April 2003, the Company’s Board approved anincrease in the number of authorized shares of common stock to 70,000,000shares and authorized 5,000,000 shares of undesignated preferred stock at a$0.0001 par value.

On July 15, 2003, the Company completed its initialpublic offering of 3,840,000 shares of its common stock at $17.00 per share,before underwriting discounts and commissions. In addition, the Company sold anadditional 251,410 shares of common stock and certain of the Company’sstockholders sold an aggregate of 324,590 shares of common stock pursuant tothe underwriter’s exercise of their option to purchase additional shares ofcommon stock to cover over-allotments. The Company raised a total of $69,600 ingross proceeds from the offering. After deducting the underwriting fee ofapproximately $4,900 and approximately $1,671 of other offering expenses, netproceeds were approximately $63,029. Concurrent with the initial publicoffering, certain warrants 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.

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

**Note 18—CapitalStructure and Sale of Common Stock (Continued)**

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 19—OperatingSegment and Geographic Information**

The Company operates itsbusiness in three reportable segments: the Cinema business segment, theConsumer business segment and the Digital Images 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’sDigital Images business segment provides restoration, enhancement and repairservices for moving pictures captured on film or in digital form, televisioncontent, and other forms of image content.

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

The Company’s reportablesegments and geographical information are as follows:

| ** **              | ** ** | **Revenues**                                              | ** ** |
|-------------------------|------------|-----------------------------------------------------------|------------|
| ** **              | ** ** | **For the Years Ended  December 31,** | ** ** |
| ** **              | ** ** | **2003**                                                  | ** ** | **2004** | ** ** | **2005** | ** ** |
| Cinema business         |       | $                                                         | 16,328     |   | $ | 19,545 | ** ** | **$** | **21,744** | ** ** |
| Consumer business       |       | 35,374                                                    |       | 41,886 | ** ** | **48,180** | ** ** |
| Digital Images business |       | —                                                    |       | — | ** ** | **5,328** | ** ** |
| Total revenues          |       | $                                                         | 51,702     |   | $ | 61,431 | ** ** | **$** | **75,252** | ** ** |

 

For 2003, sales to a customer accounted for 11% ofconsolidated revenues. This same customer accounted for 4% and 14% of the 2003revenues for the Cinema and Consumer business segments, respectively. Nocustomers accounted for more than 10% of revenues for any business segment in2004 or 2005.

| ** **              | ** ** | **Gross Profit**                                     | ** ** |
|-------------------------|------------|-----------------------------------------------------------|------------|
| ** **              | ** ** | **For the Years Ended  December 31,** | ** ** |
| ** **              | ** ** | **2003**                                                  | ** ** | **2004** | ** ** | **2005** | ** ** |
| Cinema business         |       | $                                                         | 7,190      |   | $ | 5,448 | ** ** | **$** | **10,618** | ** ** |
| Consumer business       |       | 33,480                                                    |       | 39,821 | ** ** | **45,970** | ** ** |
| Digital Images business |       | —                                                    |       | — | ** ** | **(949** | **)** |
| Total gross profit      |       | $                                                         | 40,670     |   | $ | 45,269 | ** ** | **$** | **55,639** | ** ** |

 

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

**Note 19—OperatingSegment and Geographic Information (Continued)**

| ** **                    | ** ** | **Income (loss) From Operations**          | ** ** |
|-------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                    | ** ** | **For the Years Ended  December 31,** | ** ** |
| ** **                    | ** ** | **2003**                                                  | ** ** | **2004** | ** ** | **2005** | ** ** |
| Cinema business               |       | $                                                         | (3,504     | ) | $ | (8,475 | ) | **$** | **(4,051** | **)** |
| Consumer business             |       | 18,714                                                    |       | 19,969 | ** ** | **21,139** | ** ** |
| Digital Images  business      |       | —                                                    |       | — | ** ** | **(7,576** | **)** |
| Total income from  operations |       | $                                                         | 15,210     |   | $ | 11,494 | ** ** | **$** | **9,512** | ** ** |

 

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

The Cinema business lossfrom operations includes depreciation and amortization expense of $326, $545and $588 for the years ended December 31, 2003, 2004 and 2005,respectively. The Consumer business income from operations includesdepreciation and amortization expense of $584, $753 and $1,170 for the yearsended December 31, 2003, 2004 and 2005, respectively. The Digital Imagesbusiness income from operations includes depreciation and amortization expenseof $2,035 for the year ended December 31, 2005, the first yearincorporated into our results of operations. The Digital Images business incomefrom operations also includes a charge of $2,300 for in-process research anddevelopment for 2005.

| ** **           | ** ** | **Revenues by Geographic Region**          | ** ** |
|----------------------|------------|-----------------------------------------------------------|------------|
| ** **           | ** ** | **For the Years Ended  December 31,** | ** ** |
| ** **           | ** ** | **2003**                                                  | ** ** | **2004** | ** ** | **2005** | ** ** |
| United States        |       | $                                                         | 15,837     |   | $ | 17,830 | ** ** | **$** | **27,157** | ** ** |
| Japan                |       | 11,886                                                    |       | 17,516 | ** ** | **18,870** | ** ** |
| South Korea          |       | 5,559                                                     |       | 7,772 | ** ** | **8,248** | ** ** |
| China                |       | 4,200                                                     |       | 6,936 | ** ** | **6,702** | ** ** |
| Other  international |       | 14,220                                                    |       | 11,377 | ** ** | **14,275** | ** ** |
| Total international  |       | 35,865                                                    |       | 43,601 | ** ** | **48,095** | ** ** |
| Total revenues       |       | $                                                         | 51,702     |   | $ | 61,431 | ** ** | **$** | **75,252** | ** ** |

 

The following tablesets forth, for the periods indicated, long-lived assets by geographic region:

| ** **               | ** ** | **Long-Lived Assets**            | ** ** |
|--------------------------|------------|---------------------------------------|------------|
| ** **               | ** ** | **As of December 31,** | ** ** |
| ** **               | ** ** | **2003**                              | ** ** | **2004** | ** ** | **2005** | ** ** |
| United States            |       | $                                     | 3,150      |   | $ | 3,099 | ** ** | **$** | **5,859** | ** ** |
| International            |       | 366                                   |       | 2,219 | ** ** | **1,516** | ** ** |
| Total long-lived  assets |       | $                                     | 3,516      |   | $ | 5,318 | ** ** | **$** | **7,375** | ** ** |

 

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

**Note 20—Net IncomeAttributable 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,** | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                  | ** ** | **2003**                                                  | ** ** | **2004** | ** ** | **2005** | ** ** |
| Basic net income  attributable to common stockholders per share:       |       |                                                      |       |   |   |   |   |
| Numerator:                                                                  |       |                                                      |       |   |   |   |   |
| Net income                                                                  |       | $                                                         | 9,899      |   | $ | 9,976 | ** ** | **$** | **7,908** | ** ** |
| Preferred stock dividends accrued                                           |       | (844                                                      | )          | — |   | — |   |
| Accretion on preferred stock                                                |       | (390                                                      | )          | — |   | — |   |
| Net income attributable to common stockholders                              |       | $                                                         | 8,665      |   | $ | 9,976 | ** ** | **$** | **7,908** | ** ** |
| Denominator:                                                                | ** ** | ** **                                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Weighted average basic shares outstanding                                   |       | 9,166,389                                                 |       | 16,865,805 | ** ** | **17,321,148** | ** ** |
| Basic net income attributable to common stockholders  per common share |       | $                                                         | 0.95       |   | $ | 0.59 | ** ** | **$** | **0.46** | ** ** |
| Diluted net income  attributable to common stockholders per share:     | ** ** | ** **                                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Numerator:                                                                  |       |                                                      |       |   |   |   |   |
| Net income                                                                  |       | $                                                         | 9,899      |   | $ | 9,976 | ** ** | **$** | **7,908** | ** ** |
| Preferred stock dividends accrued                                           |       | (844                                                      | )          | — |   | — |   |
| Accretion on preferred stock                                                |       | (390                                                      | )          | — |   | — |   |
| Net income attributable to common stockholders                              |       | $                                                         | 8,665      |   | $ | 9,976 | ** ** | **$** | **7,908** | ** ** |
| Denominator:                                                                |       |                                                      |       |   |   |   |   |
| Weighted average shares outstanding                                         |       | 9,166,389                                                 |       | 16,865,805 | ** ** | **17,321,148** | ** ** |
| Effect of  dilutive securities:                                             |       |                                                      |       |   |   |   |   |
| Common stock options                                                        |       | 1,549,940                                                 | (1)        | 1,002,857 | ** ** | **930,222** | ** ** |
| Common stock warrants                                                       |       | 2,885,000                                                 | (1)        | 274,452 | ** ** | **59,002** | ** ** |
| Diluted shares outstanding                                                  |       | 13,601,329                                                | (1)        | 18,143,114 | ** ** | **18,310,372** | ** ** |
| Diluted net income  attributable to common stockholders per share      |       | $                                                         | 0.64       | (1) | $ | 0.55 | ** ** | **$** | **0.43** | ** ** |

----

(1)    Asrestated (Note 2)

Weighted average commonshares outstanding, assuming dilution, includes the incremental shares thatwould be issued upon the assumed exercise of stock options. For the years endedDecember 31, 2003, 2004 and 2005, 92,500, 597,750 and 795,007 shares,respectively, with a weighted average exercise price of $23.33, $23.33 and$22.47, respectively, of the Company’s stock options were excluded from thecalculation of diluted earnings per share because the exercise prices of thestock options were greater than or equal to the average price of the commonshares, and therefore their inclusion would have been anti-dilutive. These 

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

**Note 20—NetIncome Attributable to Common Stockholders Per Share (Continued)**

optionscould be dilutive in the future if the average share price increases and isequal to or greater than the exercise price of these options.

**Note 21—Income FromLegal 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 DVDplayers bearing the Company’s registered trademarks without obtaining a licensefrom the Company. The Company recognized $899 in revenue under the settlementfor royalties due on units that were identified as using the Company’strademark and accounted for the remaining $2,601 as other income. Selling,general and administrative expenses for the year ended December 31, 2004included approximately $300 in legal fees related to the Mintek case. Legalfees related to Mintek were approximately $200 for 2003.

**Note 22—SelectedQuarterly Data (Unaudited)**

| ** **                                     | ** ** | **For the Quarter Ended** | ** ** |
|------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                     | ** ** | **Mar. 31,  2004**                  | ** ** | **June 30,  2004** | ** ** | **Sep. 30,  2004** | ** ** | **Dec. 31,  2004** | ** ** | **Mar. 31,  2005** | ** ** | **June 30,  2005** | ** ** | **Sep. 30,  2005** | ** ** | **Dec. 31,  2005** | ** ** |
| Revenues                                       |       |                                     | $          | 15,597 |   |   |   | $ | 13,252 |   |   |   | $ | 15,952 |   |   |   | $ | 16,630 |   |   |   | $ | 22,057 |   |   |   | $ | 17,728 |   |   |   | $ | 17,553 |   |   |   | $ | 17,914 |   |   |
| Gross profit                                   |       |                                     | $          | 12,705 |   |   |   | $ | 10,331 |   |   |   | $ | 12,842 |   |   |   | $ | 9,391 |   |   |   | $ | 17,594 |   |   |   | $ | 12,698 |   |   |   | $ | 12,909 |   |   |   | $ | 12,438 |   |   |
| Net income attributable to common stockholders |       |                                     | $          | 3,440 |   |   |   | $ | 3,119 |   |   |   | $ | 3,225 |   |   |   | $ | 192 |   |   |   | $ | 3,556 |   |   |   | $ | 1,816 |   |   |   | $ | 1,194 |   |   |   | $ | 1,342 |   |   |
| Basic earnings per share                       |       |                                     | $          | 0.21 |   |   |   | $ | 0.19 |   |   |   | $ | 0.19 |   |   |   | $ | 0.01 |   |   |   | $ | 0.21 |   |   |   | $ | 0.10 |   |   |   | $ | 0.07 |   |   |   | $ | 0.08 |   |   |
| Diluted earnings  per share                    |       |                                     | $          | 0.19 |   |   |   | $ | 0.17 |   |   |   | $ | 0.18 |   |   |   | $ | 0.01 |   |   |   | $ | 0.19 |   |   |   | $ | 0.10 |   |   |   | $ | 0.07 |   |   |   | $ | 0.07 |   |   |

 

During the fourth quarter of 2004, the Companyincurred a write-down of approximately $3.9 million related to its monochromeprojector inventory.

The Company determined there was an error in themethod used to compute the weighting of warrants and options included in thediluted shares calculation for the year ended December 31, 2003 (Note 2)and for the nine months ended September 30, 2003. This results in a changein diluted earnings per share for those periods. For the nine months ended September 30,2003, diluted weighted average shares outstanding should have been 12,439,890shares rather than 9,058,898 diluted shares, resulting in a change in reportedearnings per share attributable to common stockholders to $0.43 from $0.59.

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**DTS, INC.SCHEDULE II—VALUATIONAND 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** | ** ** |
|---------------------------------------------------------------|----------------------------------|------------|------------|----------------------------------------------|------------|-----------------------------------------------|------------|--------------------------------|------------|--------------------------------------------|------------|
| 2003                                                          | Allowance for  doubtful accounts |       |       | $                                            | 437        |                                          |       |                           | $          | 114                                        |       |   |   | $ | 122 |   |   |   | $ | 429 |   |   |
| 2004                                                          | Allowance for  doubtful accounts |       |       | 429                                          |       |                                          |       | 61                             |       |                                       |       | 88 |   |   |   | 402 |   |   |
| 2005                                                          | Allowance for  doubtful accounts |       |       | 402                                          |       |                                          |       | 30                             |       |                                       |       | 62 |   |   |   | 370 |   |   |
|                                                               |                                  |            |            |                                              |            |                                               |            |                                |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Item 9.**                        *Changes in and Disagreements With Accountants on Accounting andFinancial Disclosure*

None.

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

**Disclosure Controls and Procedures**

**TheCompany’s management, with the participation of the Company’s Chief ExecutiveOfficer and Chief Financial Officer, has evaluated the effectiveness of theCompany’s disclosure controls and procedures (as such term is defined in Rules13a-15(e) and 15d-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. Basedon such evaluation, the Company’s Chief Executive Officer and Chief FinancialOfficer have concluded that, as of December 31, 2005, the Company’s disclosurecontrols and procedures are effective in recording, processing, summarizing andreporting, on a timely basis, information required to be disclosed by theCompany in the reports that it files or submits under the Exchange Act and areeffective in ensuring that information required to be disclosed by the Companyin the reports that it files or submits under the Exchange Act is accumulatedand communicated to the Company’s management including the Company’s ChiefExecutive Officer and Chief Financial Offer as appropriate to allow timelydecisions regarding required disclosure.**

**Restatement**

**In connection with the preparationof the financial statements for fiscal year 2005, an error was identified inthe method used to compute the weighting of common stock options and warrantsincluded in the diluted shares outstanding calculation for the year endedDecember 31, 2003. This resulted in improperly reporting the weighted averageshares used to compute net income attributable to common stockholders perdiluted common share and net income attributable to common stockholders perdiluted common share.  As a result, theCompany has restated its previously issued consolidated financial statementsfor the year ended December 31, 2003. **

**Incoming to the conclusion that our disclosure controls and procedures and ourinternal control over financial reporting were effective as of December 31,2004 and 2005, our management considered, among other things, the controldeficiency related to the accounting for earnings per share, which resulted inthe need to restate our previously issued financial statements as disclosed inNote 2 of Notes to Consolidated Financial Statements included in Item 8 of thisAnnual Report on Form 10-K.  Managementhas concluded that the control deficiency that resulted in the restatement ofthe 2003 financial statements did not constitute a material weakness as of December31, 2004 or 2005 because management determined that the likelihood of dilutedearnings per share being materially misstated is not more than remote.**

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**Management’sReport on Internal Control Over Financial Reporting**

**The Company’s management is responsiblefor establishing and maintaining adequate internal control over financialreporting, as defined in Exchange Act Rules 13a-15(f) or 15d-15(f). TheCompany’s internal control over financial reporting is designed to providereasonable assurance regarding the reliability of financial reporting and thepreparation of financial statements for external purposes, in accordance withgenerally accepted accounting principles.**

**The Company’s internal control overfinancial reporting includes policies and procedures that pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect transactions and dispositions of assets of the Company; providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures are being made onlyin accordance with authorization of management and directors of the Company;and provide reasonable assurance regarding prevention or timely detection ofunauthorized acquisition, use or disposition of the Company’s assets that couldhave a material effect on the Company’s financial statements.**

**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 the policiesor procedures may deteriorate.**

**The Company’s management assessedthe effectiveness of the Company’s internal control over financial reporting asof December 31, 2005. In making this assessment, management used the criteriaestablished by the Committee of Sponsoring Organizations of the TreadwayCommission (“COSO”) in Internal Control-Integrated Framework.**

**In reliance on interpretiveguidance issued by the staff of the SEC’s Office of the Chief Accountant andthe Division of Corporate Finance, the Company’s management excluded DTSDigital Images, Inc. (“DTS DI”), which the Company acquired in a purchasebusiness combination in January 2005, from the scope of its assessment ofinternal control over financial reporting as of December 31, 2005.  DTS DI is a wholly owned subsidiary whosetotal assets and total revenues represent approximately 14% and 7%,respectively, of the Company’s related consolidated financial statement amountsas of and for the year ended December 31, 2005.   **

**Based on this assessment, managementdetermined that the Company maintained effective internal control overfinancial reporting as of December 31, 2005.**

**Ourmanagement’s assessment of the effectiveness of the Company’s internal controlover financial reporting as of December 31, 2005 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) under the Exchange Act) duringthe most recent fiscal quarter that have materially affected, or are reasonablylikely to materially affect, the Company’s internal control over financialreporting.

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**Item 9B.**               *Other Information*

On December 19, 2005,the Compensation Committee of the Board of Directors approved an increase inthe salary for Jon Kirchner, the Company’s President and Chief ExecutiveOfficer. His salary was increased from $335,000 to $360,000, effective January 1,2006. On December 19, 2005, the Compensation Committee also approved anincrease to Mr. Kirchner’s target bonus for 2005 from 80% of his salary to100% of his salary.

**PART III**

**Item 10.**                 *Directors and Executive Officers of the Registrant*

The information concerning our executive officers tobe included under the caption “Executive Officers and Significant Employees” inour proxy statement relating to our 2006 annual meeting of stockholders to befiled by us with the Securities and Exchange Commission no later than120 days after the close of our fiscal year ended December 31, 2005(the “Proxy Statement”) is incorporated herein by reference.

The information concerning our directors to be includedin our Proxy Statement under the caption “Item 1—Election of Directors” isincorporated herein by reference.

The information to be included in the Proxy Statementunder the caption “Section 16(a) Beneficial Ownership ReportingCompliance” is incorporated herein by reference.

The information concerningour code of ethics and code of conduct to be included in the Proxy Statementunder the caption “Governance of the Company” is incorporated herein byreference.

**Item 11.      *Executive Compensation***

The information to beincluded in the Proxy Statement under the captions “Executive Compensation,”“Compensation of Directors,” “Stock Performance Graph” and “Report ofCompensation Committee on Executive Compensation” is incorporated herein byreference.

**Item 12.      *Security Ownership of Certain Beneficial Owners and Management andRelated Stockholder Matters***

The information to beincluded in the Proxy Statement under the captions “Equity Compensation PlanInformation” and “Security Ownership of Certain Beneficial Owners andManagement” is incorporated herein by reference.

**Item 13.      *Certain Relationships and Related Transactions***

Information concerningcertain relationships and related transactions will be included in the ProxyStatement under the captions “Certain Relationships and Related Transactions”and is incorporated herein by reference.

**Item 14.      *Principal Accounting Fees and Services***

Information concerningprincipal accounting fees and services will be included in the Proxy Statementunder the caption “Item 2—Ratification of Independent Auditors” and isincorporated herein by reference.

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**PART IV**

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

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

The information required by this Item is included inItem 8 of Part II of this report.

**(a)(3) Exhibits**

See Item 15 (b) below.

**(b) Exhibits:**

| Exhibit   Number | ** ** | ** **                                                                                                                                                                                                                            | ** ** | **Description** |
|------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 2.1              |       | Agreement and Plan of  Merger, dated as of January 3, 2005 by and among the Registrant, LIVE Acquisition  Corp., Lowry Digital Images, Inc., John Lowry, as Stockholder Representative,  and the Stockholders listed therein(10) |
| 3.3              |       | [reserved]                                                                                                                                                                                                                            |
| 3.5              |       | Restated Bylaws(3)                                                                                                                                                                                                                    |
| 3.6              |       | Audit Committee Charter                                                                                                                                                                                                               |
| 3.7              |       | Compensation Committee  Charter                                                                                                                                                                                                       |
| 3.8              |       | Nominating/Corporate  Governance Committee Charter                                                                                                                                                                                    |
| 3.9              |       | Restated Certificate of Incorporation,  as amended by Amendment dated May 20, 2005(9)                                                                                                                                            |
| 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)*                                                                                                                                                                             |

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| 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)                                                                             |
| 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   |   | [reserved]                                                                                                                                                                                                       |
| 10.34   |   | [reserved]                                                                                                                                                                                                       |
| 10.35   |   | [reserved]                                                                                                                                                                                                       |
| 10.36   |   | [reserved]                                                                                                                                                                                                       |
| 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)                                                                                           |
| 10.42.1 |   | Loan Extension  Agreement and Modification to Loan Documents between the Registrant and  Comerica Bank, effective July 7, 2005                                                                              |

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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(8)*                                                                                                                  |
| 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 DTS, Inc.(8) |
| 10.46 |   | Employment  Agreement by and between the Registrant and Melvin Flanigan, effective as of  May 20, 2005(9)*                                                                                                            |
| 10.47 |   | Employment  Agreement by and between the Registrant and Blake Welcher, effective as of  May 20, 2005(9)*                                                                                                              |
| 10.48 |   | Employment  Agreement by and between the Registrant and Andrea Nee, effective as of May  20, 2005(9)*                                                                                                                 |
| 10.49 |   | Employment  Agreement by and between the Registrant and Jan Wissmuller, effective as of  May 20, 2005(9)*                                                                                                             |
| 10.50 |   | Second Amendment  to Service Agreement between the Registrant and Mr. William Paul Smith, dated  June 3, 2005(9)*                                                                                                     |
| 10.51 |   | Employment  Agreement by and between the Registrant and Don Bird, effective as of May 20,  2005(9)*                                                                                                                   |
| 10.52 |   | Employment  Agreement by and between the Registrant and Brian Towne, effective as of May  20, 2005(9)*                                                                                                                |
| 10.53 |   | Employment Agreement by  and between the Registrant and Patrick Watson, effective as of May 20,  2005(9)*                                                                                                             |
| 10.54 |   | Employment Agreement by  and between the Registrant and William Neighbors, effective as of May 18,  2005(9)*                                                                                                          |

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| 10.55 |   | Registration Rights Agreement, dated as of January  3, 2005 by and among the Registrant and John Lowry, as Stockholder  Representative(10)                               |
|-------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.56 |   | Employment Agreement, dated as of January 3, 2005 by  and between DTS Digital Images, Inc., the Registrant and John Lowry(10)*                                           |
| 10.57 |   | Employment Agreement, dated as of January 3, 2005 by  and between DTS Digital Images, Inc., the Registrant and Michael  Inchalik(10)*                                    |
| 10.58 |   | Employment Agreement, dated as of January 3, 2005 by  and between DTS Canada ULC, the Registrant and Ian Cavén(10)*                                                 |
| 10.59 |   | Employment Agreement, dated as of January 3, 2005 by  and between DTS Digital Images, Inc., the Registrant and Ian Godin(10)*                                            |
| 10.60 |   | Employment Agreement, effective as of January 3,  2005, between the Registrant and Daniel E. Slusser(11)*                                                                |
| 10.61 |   | Summary of 2004 bonus payments for the Chief  Executive Officer and other Named Executive Officers(12)*                                                                  |
| 10.62 |   | Summary of Director compensation arrangement and related  amendments to 2003 Equity Incentive Plan(13)*                                                                  |
| 10.63 |   | Summary of option grants to and 2005 salaries for  the Chief Executive Officer and other Named Executive Officers(14)*                                                   |
| 10.64 |   | 2005 Performance Incentive Plan(14)*                                                                                                                                     |
| 10.65 |   | Summary of performance objectives and bonus targets  with respect to incentive bonuses for 2005 for the Chief Executive Officer  and other Named Executive Officers(15)* |
| 10.66 |   | Description of acceleration of vesting of certain  unvested stock options(16)*                                                                                           |
| 21.1  |   | List of all subsidiaries of the Registrant                                                                                                                               |
| 23.1  |   | Consent of PricewaterhouseCoopers LLP, independent  registered public accounting firm                                                                                    |
| 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       |

 

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*       Indicates management contract, arrangement or compensatoryplan.

(1)          Incorporatedby reference to the identically numbered exhibit filed with the Registrant’sForm S-1 Registration Statement (File No. 333-104761) onApril 25, 2003.

(2)          Incorporatedby reference to the identically numbered exhibit filed with the Registrant’sAmendment No. 1 to Form S-1 Registration Statement (FileNo. 333-104761) on June 5, 2003.

(3)          Incorporatedby reference to the identically numbered exhibit filed with the Registrant’sForm S-1 Registration Statement (File No. 333-110120) onOctober 31, 2003.

(4)          Incorporatedby reference to the identically numbered exhibit filed with the Registrant’sAnnual Report on Form 10-K for the year ended December 31,2003.

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(5)          Incorporatedby reference to the identically numbered exhibit filed with the Registrant’sQuarterly Report on Form 10-Q for the quarter ended March 31,2004.

(6)          Incorporatedby reference to the identically numbered exhibit filed with the Registrant’sQuarterly Report on Form 10-Q for the quarter ended June 30,2004.

(7)          Incorporatedby reference to Exhibit 10.41 to the Registrant’s Quarterly Report onForm 10-Q for the quarter ended June 30, 2004.

(8)   Incorporatedby reference to the identically numbered exhibit filed with the Registrant’sAnnual Report on Form 10-K for the year ended December 31, 2004.

(9)   Incorporatedby reference to the identically numbered exhibit filed with the Registrant’sQuarterly Report on Form 10-Q for the quarter ended June 30, 2005.

(10) Incorporatedby reference to the Registrant’s Report on Form 8-K filed with the Securitiesand Exchange Commission on January 6, 2005.

(11) Incorporatedby reference to the Registrant’s Report on Form 8-K filed with the Securitiesand Exchange Commission on March 1, 2005.

(12) Incorporatedby reference to the Registrant’s Report on Form 8-K filed with the Securitiesand Exchange Commission on March 25, 2005.

(13) Incorporatedby reference to the Registrant’s Report on Form 8-K filed with the Securitiesand Exchange Commission on May 11, 2005.

(14) Incorporatedby reference to the Registrant’s Report on Form 8-K filed with the Securitiesand Exchange Commission on May 24, 2005.

(15) Incorporatedby reference to the Registrant’s Report on Form 8-K filed with the Securitiesand Exchange Commission on July 29, 2005.

(16) Incorporatedby reference to the Registrant’s Report on Form 8-K filed with the Securitiesand Exchange Commission on November 23, 2005.

†                    Certainconfidential portions of this Exhibit were omitted by means of redacting aportion of the text (the “Mark”). This Exhibit has been filed separatelywith the Secretary of the Commission without the Mark pursuant to theRegistrant’s Application Requesting Confidential Treatment under Rule 406under the Securities Act.

109

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized, on this 16th day ofMarch, 2006.
|        | DTS, INC. |                                     |
|--------|-----------|------------------------------------------|
|   | By:       | /s/  JON E. KIRCHNER           |
|   |      | Jon E. Kirchner                          |
|   | * *  | *President  and Chief Executive Officer* |
|        |           |                                          |  |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.
|                                    | **Signature** | ** **                                    | ** ** |                     | **Title(s)** | ** ** | ** ** |  | **Date** | ** ** |
|------------------------------------|---------------|-----------------------------------------------|------------|---------------------|--------------|------------|------------|--|----------|------------|
| /s/  JON  E. KIRCHNER    |          | President, Chief Executive Officer, and       |       | March 16, 2006 |
| Jon  E. Kirchner                   |          | Director                                      |       |                |
|                               |          | (principal  executive officer)                |       |                |
| /s/  MELVIN  L. FLANIGAN |          | Executive Vice President, Finance and         |       | March 16, 2006 |
| Melvin  L. Flanigan                |          | Chief  Financial Officer                      |       |                |
|                               |          | (principal  financial and accounting officer) |       |                |
| /s/  DANIEL  E. SLUSSER  |          | Chairman of the Board                         |       | March 16, 2006 |
| Daniel  E. Slusser                 |          |                                          |       |                |
| /s/  JOERG  D. AGIN      |          | Director                                      |       | March 16, 2006 |
| Joerg  D. Agin                     |          |                                          |       |                |
| /s/  C. ANN  BUSBY       |          | Director                                      |       | March 16, 2006 |
| C.  Ann Busby                      |          |                                          |       |                |
| /s/  JOSEPH  A. FISCHER  |          | Director                                      |       | March 16, 2006 |
| Joseph  A. Fischer                 |          |                                          |       |                |
| /s/  JAMES  B. MCELWEE   |          | Director                                      |       | March 16, 2006 |
| James  B. McElwee                  |          |                                          |       |                |
| /s/  RONALD  N. STONE    |          | Director                                      |       | March 16, 2006 |
| Ronald N. Stone                    |          |                                          |       |                |

 

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