**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**

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

**Forthe fiscal year ended December 31, 2006**

**OR**

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

**For the transition periodfrom                           toCommission File Number 000-50335**

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**DTS, Inc.**(Exact name 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’s principal executive offices)

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

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**Securitiesregistered pursuant to Section 12(b) of the Act:**

| **Title of each class**         |   | **Name of each exchange on which registered** |
|---------------------------------|--------|-----------------------------------------------|
| Common Stock, $0.0001 par value |   | Nasdaq Global Select Market                   |

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Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes o    No x

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes o    No x

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past90 days. Yes x    No o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, andwill not be contained, to the best of registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III ofthis Form 10-K or any amendment to this Form 10-K. o

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

| Large accelerated filer o |   | Accelerated  filer x |   | Non-accelerated filer o |
|--------------------------------|--------|---------------------------|--------|------------------------------|

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).Yes o    No x

The aggregate market value of the voting and non-votingcommon equity held by non-affiliates of the registrant, as of June 30,2006 was approximately $342,166,375 (based upon the closing price for shares ofthe registrant’s Common Stock as reported by the Nasdaq National Market forthat date). Shares of Common Stock held by each officer and director have beenexcluded as such persons may be deemed affiliates. Exclusion of shares held byany person should not be construed to indicate that such person possesses thepower, direct or indirect, to direct or cause the direction of management orpolicies of the registrant, or that such person is controlled by or undercommon control with the registrant.

As of March 13, 2007, 18,124,305 shares of commonstock 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 17, 2007.

 

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**DTS, INC.FORM 10-KFor the Fiscal Year Ended December 31, 2006INDEX**

|            | ** ** | ** **                                                                                                                      | ** ** | **Page**   | ** ** |
|------------|------------|---------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|
|       | ** ** | **PART I**                                                                                                                 | ** ** | ** ** | ** ** |
| Item 1.    |       | Business                                                                                                                        |       | 3          |       |
| Item  1A.  |       | Risk  Factors                                                                                                                   |       | 24         |       |
| Item 1B.   |       | Unresolved Staff Comments                                                                                                       |       | 40         |       |
| Item 2.    |       | Properties                                                                                                                      |       | 40         |       |
| Item  3.   |       | Legal  Proceedings                                                                                                              |       | 40         |       |
| Item 4.    |       | Submission of Matters to a Vote of Security Holders                                                                             |       | 40         |       |
|       | ** ** | **PART II**                                                                                                                | ** ** | ** ** | ** ** |
| Item 5.    |       | Market for Registrant’s Common Equity, Related Stockholder  Matters and Issuer Purchases of Equity Securities              |       | 41         |       |
| Item  6.   |       | Selected  Financial Data                                                                                                        |       | 44         |       |
| Item 7.    |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations       |       | 45         |       |
| Item 7A.   |       | Quantitative and Qualitative Disclosures About Market  Risk                                                                     |       | 61         |       |
| Item 8.    |       | Financial Statements and Supplementary Data                                                                                     |       | 63         |       |
| Item 9.    |       | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure                  |       | 101        |       |
| Item 9A.   |       | Controls and Procedures                                                                                                         |       | 101        |       |
| Item  9B.  |       | Other  Information                                                                                                              |       | 102        |       |
|       | ** ** | **PART III**                                                                                                               | ** ** | ** ** | ** ** |
| Item 10.   |       | Directors, Executive Officers and Corporate Governance                                                                          |       | 102        |       |
| Item 11.   |       | Executive Compensation                                                                                                          |       | 103        |       |
| Item 12.   |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                  |       | 103        |       |
| Item 13.   |       | Certain Relationships and Related Transactions, and  Director Independence                                                      |       | 103        |       |
| Item 14.   |       | Principal Accounting Fees and Services                                                                                          |       | 103        |       |
|       | ** ** | **PART IV**                                                                                                                | ** ** | ** ** | ** ** |
| Item 15.   |       | Exhibits and Financial Statement Schedules                                                                                      |       | 104        |       |
| SIGNATURES |       | 109                                                                                                                             |       |

 

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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 1A 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 orachievements. We do not undertake any obligation to revise theseforward-looking statements to 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 enables the delivery of compellingsurround sound in theaters and in the home, and has been selected as a requiredtechnology in HD-DVD and Blu-ray Disc playback devices. Additionally, weprovide image processing services to film studios to prepare and enhance film,television and DVD content for high quality presentation.

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.

In 1996, we launched our consumer business, in whichwe license our technology to consumer electronics products manufacturers forinclusion in products such as audio/video receivers, DVD, HD-DVD and Blu-rayDisc players, personal computers, car audio products, video game consoles, andhome theater systems. The consumer products market has since grown to becomethe largest segment of our business. To date, we have entered into licensingagreements with most of the world’s major consumer audio electronicsmanufacturers. We also license our technology to many major semiconductormanufacturers. Our technology, trademarks, and know-how have been incorporatedin hundreds of millions of consumer electronics products worldwide.

We also 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 28,000 movie screens worldwide. Increasingly, we are focusingour efforts on providing products and services relating to digital contentdelivery, including digital cinema encoding and serving as a network integratorand operator to facilitate the delivery of pre-show advertising and motionpicture content to theaters. We believe the motion picture industry has begun a wide-scale motionpicture industry transition to digital content preparation, delivery andexhibition. In order to position ourselves to capitalize on this opportunity inJanuary 2007 and beyond, we have reorganized our film licensing, cinemahardware 

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anddigital images activities into a single business, DTS Digital Cinema, whichwill focus on providing end-to-end solutions for digital cinema. Tofurther this initiative, in November 2006, we entered into a worldwideexclusive license agreement with Avica Technology Corporation (“Avica”), toenable us to exploit its product line of software and hardware products fordigital cinema applications.

On February 20, 2007, we further announced thatour Board of Directors approved a plan to sell our DTS Digital Cinema businessto enable us to focus exclusively on licensing branded entertainment technologyto the large and evolving audio, game console, personal computer, portable andbroadcast markets. The sales process has begun and is expected to concludelater in 2007.

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

***Consumer Markets:***

·       Hometheater and consumer electronics entertainment devices such as audio/videoreceivers, home-theater-in-a-box, DVD, HD-DVD and Blu-ray Disc players, caraudio 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.

·       Professional audio productsand services for encoding and decoding digital multi-channel content in ourproprietary 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, digital cinema content.

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

·       Theaterhardware, software, and management systems that facilitate the booking,preparation and delivery of advertising and digital motion picture content.

***Digital Imaging Markets:***

·       Digitalimage enhancement and restoration 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, or tocorrect problems in the production process occurring as a result of errors oranomalies that may occur during filming or digital acquisition of content.

Regardless of the customeror entertainment application that incorporates our technology or services, wefacilitate the branded delivery and playback of high-quality digital content.As the transition from analog to digital entertainment technology continues, webelieve we are well-positioned to grow our 

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licensing,product, and service businesses worldwide. Our goal is to become essential tothe ultimate entertainment experience by enabling the creation of compelling,high-quality content and by incorporating our technology into every device thatmanages, controls or delivers high-quality digital entertainment.

**Industry Background**

Over the past 15 years,two trends have greatly impacted the entertainment industry: the transitionfrom analog to digital entertainment content, and technological advancements indigital coding, transmission, signal processing, optical storage, and playback.These trends helped create a technical foundation for the widespread adoptionof digital multi-channel audio and high definition video for many forms ofentertainment.

***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 rightspeakers. Stereo was followed by matrix technology that allowed an inexpensive two-tracksystem to bring surround sound to a large number of movie theaters. However,the audio quality and channel separation were limited.

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

Digital multi-channel audio is now an industrystandard audio format for feature films. Today, all of the major film studiosin the United States, and an increasing number of international film studios,release their feature films with digital multi-channel soundtracks. In 2006,182 major feature films were released in the United States with a DTS digitalmulti-channel soundtrack with 871 films, including foreign films and dubbedlanguage versions of films with DTS soundtracks being released worldwide.

Screen Digest Global MediaIntelligence, in its December 2006 Cinema Intelligence report, estimatesthat in 2006 there were more than 148,000 movie theater screens worldwide, andthat in 2006 there were approximately 43,000 screens in North America. ScreenDigest Global Media Intelligence estimates that in 2006, there wereapproximately 82,750 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 of Home Theater Systems***

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

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

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

·       thesuperior quality and feature sets of DVDs;

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

·       thegrowth of high definition television displays.

According to the Digital Entertainment Group, or DEG,website at dvdinformation.com, it is estimated that, as of December 31,2006, over 80% of U.S. households own one or more DVD-Video players. Theyfurther estimate that approximately 55% of DVD owners now have more than oneplayer.

Home theater systems generally consist of a display, aDVD-Video player, a digital multi-channel audio/video receiver, five speakers,and a subwoofer. Home-theater-in-a-box systems containing all of theseelements, but the display, are increasingly offered to consumers as anall-in-one home theater package for ease of use and installation.

High Definition Displays have been an important driverin the proliferation of home theater systems. Jupiter Research estimates that31% of U.S. households, or 35 million homes, had an HDTV as of the end of 2006.HDTV penetration is expected to reach over 70% of U.S. households by 2010.

Currently, CEA estimatesthat 36% of U.S. households (40 million households) own some configuration of ahome theater system. High quality sound is viewed by consumers as an importantfeature of a home theater system. According to a CEA Home Theater Opportunityresearch report, a significant percentage of online consumers rate sound (80%)and video quality (84%) as important or very important aspects of a hometheater system and 83% said that both are equally important factors.

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

Digital multi-channel sound is extending into agrowing number of consumer electronics environments, including homes, cars,personal computers, video games and consoles, portable electronics devices, anddigital satellite and cable broadcast products. Content providers in the film,music and video game markets have recognized that a substantial marketopportunity exists for digital multi-channel entertainment content. Forexample, Nielsen SoundScan estimates that DVD music video sales have grown inunit sales from over 10 million units in 2002 to 24 million units in 2006, a22% compounded annual growth rate. The DVD Release Report for 2006 estimatedthat DVD music releases accounted for 14% of total DVD releases with over 8,700titles 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 digitalmulti-channel audio to enhance the entertainment experience.

The digital satellite and cable broadcast markets mayrepresent significant opportunities for digital multi-channel audio. ABIResearch, in its Q4 2006 quarterly marketing briefing, estimates that digitalsatellite or digital cable was installed in approximately 59% of U.S.households at the end of 2006, projected to grow to 74% by the end of 2010, andin approximately 36% of Western European households at the end of 2006,projected to grow to 52% by the end of 2010. We believe a significant marketopportunity may exist in all sectors of this market including broadcasthardware, high definition set-top boxes, and televisions.

Looking forward, we expect that next generationformats will drive home entertainment growth in the form of high definition DVDplayers, game consoles and blue laser DVD-ROM Drives for personal computers. Webelieve that multi-channel audio will play a critical role in expanding thishigh definition experience.

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According to the DEG, andNPD Group, in the United States, over 750,000 set-top box and game consoleswere sold in 2006. The CEA estimates nearly 1 million high definition DVDset-top box units will be shipped in 2007. International Data Corporation, orIDC, estimates that through the end of 2006 over 5 million game consoles wereshipped in the United States, projected to grow to a total of 12 million by theend of 2010.

***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 growing demandfor products and services that facilitate the creation, distribution, control,and playback of digital pre-show advertising and alternative content. Pre-showand 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. Screen Digest estimates that pre-showadvertisements today account for over 80 percent of theater advertising, whichthey indicate has shown double-digit growth for the past three years. ScreenDigest estimates that revenues from pre-show advertising in North Americaincreased in 2006 to over $600 million.

In response to the growthin sales of high definition displays in homes and the move toward digitalcinema presentation, 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 growingmarket for digital image enhancement and restoration services in the motionpicture, 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 encode thesoundtracks of their films using our proprietary digital multi-channel soundformat. Theater owners purchase and use our products to playback DTS encodedsoundtracks through six or more discrete speakers.

Our competitors imprint their proprietary digitalmulti-channel audio data directly onto the film. This can result in audiodegradation or failure from repetitive use or handling. By contrast, we use adual-medium system whereby we store audio information on CD-ROM discs, whichare synchronized to the motion picture film by the use of our proprietarytimecode. The timecode is printed on the film, which enables the correlation ofsingle or multiple events, such as audio, light, or motion, to an individualframe of film. By placing audio data on optical media or hard discs rather thandirectly on film, we provide 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.

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During 2005, DCI, a consortium of major HollywoodStudios, completed and issued its technical specifications for digital cinema.The specification outlines minimum requirements for distribution and playback ofdigital motion pictures encoded using JPEG2000 compression technology. Wesubsequently introduced a DCI-compliant JPEG2000 Variable Bit Rate encoder tomeet this need. Our DTS Digital Cinema EncoderTM provides highly efficient,master quality encodes by optimizing bit-allocation according to user-definedparameters.

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 backwardcompatibility with earlier implementations of the technology. The encodingprocess reduces the storage space or transmission bandwidth required for theaudio information, while maximizing the quality of the sound. The audioinformation can then be stored on a digital medium, such as a DVD, ortransmitted over a broadband connection or broadcast signal. The encodedcontent can be played back on digital audio electronics products equipped witha DTS Coherent Acoustics decoder, such as a DVD-based home theater system.

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

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.

We strive to evolve and develop our technology on anongoing basis. For example, to offer an enhanced experience for existing andnew stereo content, we have developed our Neo:6 matrix technology. Thistechnology provides simulated multi-channel playback from stereo content andhas been incorporated into home theater, home audio, car electronics, and ourmovie theater products. More recently, we introduced DTS-HD Master Audio, whichextends our technology offerings for the next-generation optical media formatsknown as HD-DVD and Blu-ray Disc in two ways. First, our lossless codingextension delivers audio which is bit-for-bit identical to the original mastercontent. Secondly, DTS-HD Master Audio includes a low bit rate mode thatextends our technology for use in applications where bandwidth and datacapacity is much lower than in optical media, such as broadcast and portabledevices. Although DTS-HD will be first introduced in HD-DVD and Blu-ray Discplayers and home theater systems, these new technologies have application in awide variety of consumer electronic devices and applications.

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, the Bond series and the Indiana Jonesseries. In addition, our techniques are increasingly being used to preparecontent of all types for distribution in the HD-DVD or Blu-ray Disc formats orhigh definition theatrical release. DTS DI processing technologies can also beapplied to correct or repair a multitude of photographic flaws that can resultfrom the production and 

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processingof film and digital image content. These include the correction of out-of-focussequences due to camera problems and removing scratches or other flaws causedby incorrect processing.

**Products andServices**

We segment our businessinto consumer markets, cinema markets and digital images markets. Thecombination of our cinema and digital images markets creates our new DTSDigital Cinema business. Financial and geographic information for each of ourbusiness segments for each of the last three years is included in Footnote 20to the consolidated financial statements, “Operating Segment and GeographicInformation.”

***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 their homes, cars, and many other listeningenvironments.

We license our Coherent Acoustics technology toconsumer electronics product manufacturers primarily through a two stepprocess. First, we license our software developer kits to semiconductormanufacturers who typically embed our decoding software into their digitalsignal processor chips. In turn, these semiconductor manufacturers sellDTS-enabled chips 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. Additionally, our business modelprovides for us to receive a per-unit royalty for hardware productsmanufactured containing our decoding 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. Similar to our licensing program for decoding technology, ourDTS Digital Out trademark licensees typically pay us fees for access to ourdeveloper kits and for our certification of their products. Our business modelprovides that we receive per-unit royalties for products manufacturedcontaining our trademark.

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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 the HD-DVD and Blu-ray Disc optical mediaformats. As a result, DTS decoding technology will be utilized in at leasttwo-channel form in any consumer product that incorporates either a Blu-ray orHD-DVD disc drive. Our decoders have been embedded in nearly one hundred millionaudio/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 the use of our technology in personalcomputers. DTS-Connect features a real-time DTS encoder and a version ofour Neo:6 matrix technology tuned especially for personal computers, which wecall Neo:PC. This technology suite not only allows the personal computer userto take advantage of the playback capabilities of nearly one hundred millionDTS decoders by encoding audio resident on or streamed to the user’s computer,but also provides a multi-channel playback experience from stereo or monocontent. In this business model, integrated circuit manufacturers pay us fixedper unit royalties for each DTS-enabled chipset 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 primarily for promotional purposes.We sell professional audio encoding products to professional audio equipmentdealers. We license our encoding technology to professional andprofessional/consumer product manufacturers who in turn sell the products tocontent owners and post-production facilities, enabling them to produce andrelease audio and audio/video products containing DTS digital multi-channelsoundtracks. These content owners include home video producers anddistributors, individual music artists, and music labels.

*Home Theater*

We havehistorically derived the majority 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 pass-through DTS encoded audio content.In addition, some DVD players contain DTS decoding capability.

·       *HD-DVD and Blu-ray Disc Players*.   Embedded DTS decoderstypically enable these products to decode two channels of digital audio and topass a multi-channel bit stream through the player to an external device suchas an audio/video receiver.

·       *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.*    These are centralized home-basedentertainment systems and servers that deliver entertainment content to variousplayback devices throughout the home.

·       *Car Audio Systems.  * Currently, many 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 as eitherstandard or optional equipment for a number of their new models. A DTS digitalmulti-channel sound system is available on certain Acura, Lexus, Infiniti, Mercedes, Land Rover, BMW,Cadillac, Toyota, Nissan, Honda andMazda models. We anticipate growth in this market to continue as these andother manufacturers release vehicles that incorporate 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 licensedour decoding technology to most of the leading software-based DVD playerproviders, including Cyberlink Corporation and Intervideo Inc.Additionally, we expect that Nero AG, and ArcSoft, Inc. will incorporateour technology into certain of their products. With the mandatory inclusion ofour technology in the Blu-ray Disc and HD-DVD specifications, we expect anincreased number of companies to introduce additional DTS-enabled softwareproducts in the 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 in 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. In the game software market, we have entered intolicensing relationships with several major game publishers, includingActivision, Inc., Atari, Inc., and Electronic Arts, Inc., toincorporate our digital multi-channel encoding technology into theirPlayStation 2 games. Importantly, with the release of Sony’s PlayStation 3, DTSdecoding technology is now included in each hardware unit, allowing thecapability to decode 5.1 channels of digital audio within the player or thepass-through of a multi-channel stream to an external decoder. Similarly,Microsoft’s X-Box 360 now offers an external HD-DVD drive accessory whichsupports DTS 5.1 decoding capability.

·       *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 our new low bit rate technology, into other portable electronicsdevices such as flash memory players and portable disc players which enablestereo 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. 

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To date, we havelicensed our trademarks and decoding technology for incorporation intotelevision set-top boxes. Additionally, we continue to seek partnerships andstrategic alliances to move consumer entertainment forward. In 2005, we enteredinto a Memorandum of Understanding with Coding Technologies to develop abroadcast solution that provides Coding Technologies, through a CoherentAcoustics real-time DTS encoder, access to our installed base of home theaterdecoders. Coding Technologies is a leading provider of open standard codecs andis possibly best known for its spectral enhancement which forms the “plus” inaacPlus. In January 2007, Euro 1080, a European high definition mediacompany, entered into an agreement with us to become the first broadcaster todeploy the combined Coding Technologies and DTS solution.

*New Technologiesfor Existing and Emerging Consumer Markets*

We continue to evolve and develop our technology forthe consumer market. Our Neo:6 matrix technology provides simulatedmulti-channel play back from stereo, or two-channel, content. This technologyincreasingly is being incorporated into home theater systems, home audiosystems, and car audio systems. Our DTS-HD offering extends our CoherentAcoustics technology to full bit-for-bit accurate lossless performance forapplications where the highest quality is required, and adds DTS-HD low bitrate technology for applications such as broadcast, portable and other deviceswhere significant data size and bandwidth limitations exist. These additionaltechnologies provide us with new revenue opportunities from existing and newcustomers. With DTS-HD, we believe we are uniquely positioned for the futureevolution of high quality surround sound audio in the home. While DTS-HD isgenerally limited to 7.1 channels of audio in both the Blu-ray Disc and HD-DVDspecifications, the DTS-HD technology can support more than 2,000 channels at 32-bitdata. Current systems are typically limited to 24-bit data.

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. In addition, forpromotional purposes we also produce, market, and sell a limited number ofmusic titles in our digital multi-channel format.

*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. Over the pasttwo years, we have developed and launched a new set of professional audioproducts to support the launch of DTS-HD. Additionally, we worked with partnersto integrate DTS-HD encoding functionality into a broad array of nextgeneration HD-DVD and Blu-ray Disc authoring systems. The following table liststhe professional audio products and services that we currently provide:

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| **Product or Service**           | ** ** | ** **                                                                                                                    | ** ** | **Description** |
|----------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| *DTS-HD Master Audio Suite*      |       | Mac and PC software  suite for encoding, monitoring and editing DTS-HD and standard definition  digital audio.           |
| *DTS Surround Audio Suite*       |       | Mac and 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.                         |

 

***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 intermediate facilitiesengaged 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 or closedcaptioning, depending on the output device utilized. For open captions, theDTS-CSS system uses a separate video projector to render subtitles or captions;for closed captions, the system is utilized in conjunction with a rear-walldisplay device. This product is designed to address the increasing politicaland social pressure to provide access to the motion picture experience for thehearing and visually impaired.

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This same family ofproducts is also being used for electronic cinema applications includingalternative content presentations and pre-show advertising, incorporating bothhigh definition image and audio playback capabilities. These products enable atheater owner to extend its range of revenue opportunities, and help tomaximize the utility of equipment in theater projection rooms, saving expenseand space. In the pre-show advertising area, both the CSS system and the DTSXD10 Cinema Media Player can be used when coupled with a color projector. TheDTS XD10 has an extensive feature set, which includes networking capability tofacilitate its integration into a content distribution system. We also offerthe DTS Cinema Media NetworkTM product suite which incorporates the DTS XD10Cinema Media Player to manage the creation, transmission/delivery, scheduling,logging, remote system monitoring and playback of all types of digital contentincluding video, audio, subtitles, captions, and descriptive narration.

*Systems for Digital Video Preparation, Delivery andExhibition.  *Through ourexclusive licensing deal with Avica and initiatives to enhance our ability inthe digital cinema arena, we also offer our customers a range of technology,products and services for the preparation, delivery and exhibition of digitalcinema content. The Avica FilmStore Platform includes the FilmStore DigitalCinema Player, the FilmStore Central Multiplex Content Manager and theFilmStore Director Theater Management System. The FilmStore Digital CinemaPlayer supports both single screen and multiplex exhibition and provides simplestart, stop, play and status, sophisticated content protection and 4Kcapability. The FilmStore Central Multiplex Content Manager provides a link toan external network and provides secure movie storage, advanced rights managementand centralized show control. The FilmStore Director Theater Management Systemprovides a management system interface enabling local or remote access tocontrol a multiplex and security management for content and users. The AvicaStillStore captures and stores high quality, uncompressed still images withfunctionality that includes up- and down-conversions on-the-fly, networking,Internet export of stills, and machine control interface for industry standardcolor. The Avica MotionStore captures motion or still images as high definitiondigital data which can then be instantly recalled for playback or converted forexport to a wide variety of formats. 

Thechart below lists some products that we sell or plan to sell to movie theatersand special venues:

| **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. |

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| *DTS Digital Cinema EncoderTM*   |   | A DCI-compliant  variable bit rate JPEG2000 encoder used in the production of motion pictures  for digital cinema exhibition.                                                                                                                                                                                                                                                                                 |
|--------------------------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| *Avica FilmStoreTM Central*      |   | Hardware and  software used in digital cinema multiplex installations to provide  centralized, secure receipt, storage, management/scheduling and distribution  of digital cinema and other related digital content to individual screens  within a multiplex.                                                                                                                                                |
| *Avica FilmStoreTM Director*     |   | Software designed  for use by theater managers to control all of the digital cinema players and  a central management system within a theater complex.                                                                                                                                                                                                                                                        |
| *Digital Signage Products*           |   | As part of the  deployment of digital cinema and advertising systems within theater  complexes, we plan to also integrate digital playback devices to manage  playback of advertising and other promotional content in theater lobbies.                                                                                                                                                                       |
| *Digital Booking SystemTM (DBS)* |   | Digital Booking SystemTM,  or DBS, is a web-based application that enables the booking and scheduling of  digital content for theatrical exhibition. Our DBS service enables  distributors and exhibitors to communicate through the Internet to accelerate  the process of booking content, scheduling show times, programming trailers,  tracking attendance data and facilitating film rental payment. |

 

**Image Enhancement,Restoration and Repair Services**

In our Digital Imagesdivision, we provide enhancement, restoration and repair services for motionpictures captured in analog or digital form. Our services enable current orarchived film or television content to be enhanced, restored or repaired toenable high quality, high definition presentation in high definition opticalmedia, broadcast, or digital cinema applications. In addition, we believe thatDTS DI is uniquely suited for correcting or repairing a multitude ofphotographic challenges encountered in the production and processing of filmand digital image content. These issues range from the correction ofout-of-focus sequences due to camera problems to removing scratches or otherflaws caused by incorrect processing.

**DTS TechnologyPlatform**

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 andproducts that reduce the amount of data required to store and transmit an audiosignal and 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 

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strengths has been ourability to develop a system that enables the transparent reproduction of anoriginal audio signal, meaning that the reproduction sounds indistinguishablefrom 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 135 individual patents andmore than 82 patent applications throughout the world. We have more than 112trademarks and more than 42 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 do notbelieve that the expiration of any single patent is likely to significantly affectour intellectual property position or our ability to generate licensingrevenues.

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The following table lists our key patents and patentapplications and the inventions 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 our standardterms through 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 a license fee for each unit theyproduce that contains our technology or trademarks. We require that alllicensees have their integrated circuits or hardware devices certified by usprior to distribution. We reserve the right to audit their records and qualitystandards. Licensees are required to use the appropriate DTS trademark on theproducts they manufacture.

In our consumer business, we have 67 patents issuedand 72 patents pending worldwide spanning the entire spectrum of our technologyincluding the encoding and decoding process, the structure of the DTS audiostream, and media containing DTS encoded material. In addition, we have anumber of patents and applications covering extensions of our core technologyarchitecture as well as unique implementation approaches for various product applications.

In the cinema market, we have 47 patents issued and ninepatents pending worldwide covering our cinema system, the DTS time code, andour subtitling method. These patents cover the technology that is 

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utilized in our variouscinema products as well as our film license rights. We also have 21 patents andone patent application that span both the consumer products and cinema sectorsof our business. These rights primarily cover the process of producing mediacontaining DTS and digital multi-channel audio as well as the individualfinished 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 of over 30 individual wordmarks, logos, and slogans filed throughout the world. The marks cover ourvarious products, technology, improvements, and features as well as theservices that we provide. Our trademarks are an integral part of our licensingprogram and are required to be used on licensed products to identify theexistence of the technology and to provide greater consumer awareness. Ourtrademarks include the following:

We have a significantamount of copyright protected materials including software, textual materials,and master audio materials used to produce our DTS Entertainment (“DTSE”)products. A number of these products have been federally registered.

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**Customers**

***Consumer Markets***

*ConsumerElectronics Products Manufacturers*

We have licensed ourCoherent Acoustics technology or our trademarks to approximately 300 consumerelectronics products manufacturers for use in hundreds of consumer audioproducts. Collectively, these manufacturers have sold hundreds of millions ofDTS-licensed consumer electronic products worldwide. The following list setsforth some of the consumer electronics product manufacturers that have licensedour technology.

| Audio & Audio/Video  Receivers | ** ** | **DVD Players**                |
|-----------------------------------------|------------|--------------------------------|
| Koninklijke  Philips

Electronics N.V.  |       | Samsung  Electronics Co., Ltd. |   | Funai Electric Co., Ltd. |   | Samsung  Electronics Co., Ltd. |   |
| LG  Electronics, Inc.              |       | Sony Corporation               |   | LG Electronics, Inc. |   | Sony Corporation |   |
| Onkyo Corporation                       |       | Yamaha Corporation             |   | Pioneer Corporation |   | Thomson  Multimedia |   |
| Pioneer  Corporation                    |       |                           |   |   |   | Audio Hong Kong,  Ltd. |   |

 

| Car Audio Systems                                    |
|------------------------------------------------------|
| Alpine  Electronics, Inc. Fujitsu Ten Co., Ltd. |   | Harman International  Industries, Inc. |   | Kenwood  Corporation Matsushita Electric |   | Pioneer  Corporation Toshiba Alpine |
|                                                 |   | Hyundai Autonet Co., Ltd |   | Industrial Co., Ltd. |   |  Automotive Technology Corporation |

 

| Personal Computer           |
|-----------------------------|
| Asustek Computer, Inc. |   | Cyberlink Corporation |   | Intervideo, Inc. |   | Realtek  Semiconductor, Inc. |
| Creative Technology Ltd.    |   |   |   |   |   |   |

 

*SemiconductorManufacturers*

Wehave licensed to approximately 50 semiconductor manufacturers the right toincorporate our technology in their semiconductors and to sell semiconductorswith DTS technology to our hardware manufacturer licensees. Our majorsemiconductor-manufacturing customers include the following:
| Analog Devices  Broadcom Corporation                    | Fujitsu Limited  LSI Logic Recorder Corporation | MediaTek, Inc.  Sigma Designs, Inc.    |
|---------------------------------------------------------|-------------------------------------------------|--------------------------------------------------|
| Cirrus  Logic, Inc.  Freescale Semiconductor, Inc. | Matsushita Electrical  Industrial Co., Ltd.     | Texas Instruments, Inc.  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.

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***Cinema Markets***

Themajor film studios in the United States are all customers of ours. Thesestudios, which released most of their major feature films in the DTS format in2006, are listed below.
| 20th Century Fox      | Paramount Pictures         | Universal Pictures    |
|-----------------------|----------------------------|-----------------------|
| Buena Vista  Pictures | MGM Pictures/Sony/Columbia | Warner Bros. Pictures |
| DreamWorks SKG        | New Line Cinema Corp.      |                  |

 

Inaddition, we sell our playback equipment to movie theaters, including thefollowing:
| Carmike Cinemas | Odeon Limited        | Regal Entertainment |
|-----------------|----------------------|---------------------|
| Cinemark        | Rave Motion Pictures |                |

 

***Digital Images Markets***

OurDigital Images division’s customers primarily include major film and televisiondistributors, including:
| Disney Worldwide Services | Paramount Pictures / CBS Television | 20th Century Fox       |
|---------------------------|-------------------------------------|------------------------|
| LucasFilm                 | Sony / MGM Pictures                 | Warner Bros Television |

 

**Sales, Marketing,and Support**

***Consumer Products***

We have a licensing team that markets our technologydirectly to large consumer electronic products manufacturers and semiconductormanufacturers. This team includes employees located in the United States,China, England, Hong Kong, Japan, Northern Ireland, and Taiwan. We believe thatby locating staff near the leading consumer electronics and semiconductormanufacturers we can enhance our sales and business development efforts.

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

***Film Producers and Distributors***

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

***Movie Theaters***

We sell our cinemaplayback systems to movie theaters through a direct sales force and a networkof independent dealers. To date, most of our sales and marketing efforts havebeen focused in the United States, Western Europe, and in targeted markets inAsia and Latin America. We have also begun to focus our efforts on pursuingtheater companies that have a large concentration of movie theaters in selectedforeign countries such as India, China, and Eastern Europe.

**Research andDevelopment**

We have a group of 72 engineers and scientists,including seven PhDs, focused on research and development. This group overseesour product development efforts and is responsible for implementing 

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our technology into ourexisting and emerging products. We carry out research and developmentactivities at our corporate headquarters in Agoura Hills, California and at ourfacilities in Bangor, Northern Ireland; Vancouver, Canada; and Burbank,California.

Our research anddevelopment expenses totaled approximately $6.1 million during 2004, $9.9million during 2005, and $12.3 million during 2006. We expect that we willcontinue to commit significant resources to applications engineering efforts,particularly in support of the new high definition disc standards, and toresearch and development in the future.

**Governmental andIndustry Standards**

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

We actively participate in a variety of standardsorganizations worldwide, including the DVD Forum, Blu-ray Disc Association,Digital Video Broadcast Project, International Engineering Consortium, 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 Coherent Acousticstechnology. Through our participation in standards setting, we have expandedthe supported specification of our codec, increasing the audio quality andnumber of channels. Our technology has been accepted as an optional format inthe DVD-Audio Recordable specification and we are currently involved in theworking groups for Interactive DVD and DVD recording specifications for bothaudio 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 

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products and services.Except with respect to image enhancement and restoration, we compete with Dolbyin nearly all of our markets and product categories.

Dolby was founded over 40 years ago and for manyyears was the only significant provider of audio technologies. Dolby’slong-standing market position, brand, business relationships, and inclusion invarious industry standards provide it with a strong competitive position.

In addition to Dolby, we also compete in specificproduct markets with Coding Technologies, Fraunhofer Institut IntegrierteSchaltungen, Koninklijke Philips Electronics N.V., Meridian Audio Limited,Microsoft Corporation, Smart Devices, Inc., Sony Corporation, Thomson,Ultra Stereo Labs, Inc., and various consumer electronics productsmanufacturers. Many of these competitors have longer operating histories andsignificantly greater resources or greater name recognition than we do.

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

·       technologyperformance, flexibility, and range of application;

·       qualityand reliability of products and services;

·       brandrecognition and reputation;

·       inclusionin industry standards;

·       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 market share.Most major feature-film releases in the United States are encoded in ourformat, many top selling and premier edition DVDs contain digital multi-channelsoundtracks in our format, a substantial majority of consumer electronicsproducts with digital multi-channel capability incorporate our technology,trademarks, or know-how, and many of the most valuable film properties in theworld have been restored using our process. Our success has been due in largepart to our ability to position our brand as a premium offering that containssuperior proprietary technology, the quality of our customer service, ourinclusion in industry standards, and our industry relationships.

We believe there aresignificant barriers to entry in our key markets. In the film-based cinemamarket, there are three well-established formats—DTS, Dolby, and Sony—and webelieve it would be very difficult for a new entrant to penetrate the market.Key barriers to entry include physical limitations on the film, intellectualproperty coverage, and the reluctance of the film studios to pay additionallicense fees and theater operators to purchase additional playback equipment.In the consumer electronics products market, the standards relating toDVD-Video are well established and support a limited number of technologiesincluding DTS Coherent Acoustics. In the digital images market, we believe thatwe have a significant lead in automating the enhancement and restoration oftelevision and motion picture images through the use of sophisticated proprietarysoftware algorithms.

**Recent Developments**

On February 20, 2007, we announced that our Boardof Directors approved a plan to sell our DTS Digital Cinema business to enableus to focus exclusively on licensing branded entertainment technology to the largeand evolving audio, game console, personal computer, portable and broadcastmarkets. The sales 

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process has begun and isexpected to conclude later in 2007. The DTS Digital Cinema business will focuson the emerging and potentially large market for digital cinema products andservices. Beginning in the first quarter of 2007, we expect to report financialresults related to our DTS Digital Cinema business as “discontinued operations.”

On January 30, 2007we announced an agreement with Digital Cinema Ltd., or DCL, to install andmanage a trial deployment of 25 digital cinema systems in Ireland. We believethis was an important milestone for our DTS Digital Cinema business as itenabled us to showcase our many strengths—the breadth of our capabilities, thedepth of our knowledge of the cinema environment, and our ability to respond tocustomer needs.

**Employees**

As of December 31,2006, we had 325 employees, which includes 72 employees in engineering,technical services, and research and development, 62 employees in productionand operations, 99 employees in sales, marketing, service, and support, 40employees in accounting and information technology, and 52 employees in seniormanagement and administration. Of the 325 total employees, 239 work in theUnited States and 86 work in our various international locations, including 59in 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 satisfactory. Our future success dependson our ability to attract, motivate, and retain highly-qualified technical andmanagement personnel. From time to time, we also employ independent contractorsto support our product development, sales, marketing, business development,information technology and administration organizations.

**Website Access toSEC Filings**

We maintain an Internet website at*www.dts.com.* We make available free of charge through our Internetwebsite our annual report on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K, and amendments to those reports filedor furnished pursuant to Section 13(a) or 15(d) of theSecurities Exchange Act of 1934, as amended, as soon as reasonably practicableafter we electronically file such material with, or furnish it to, the SEC.

Materials we file with the SEC may be read and copiedat the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C.20549. Information on the operation of the Public Reference Room may beobtained by calling the SEC at 1-800-SEC-0330. The SEC alsomaintains an Internet website at www.sec.gov that contains reports, proxy andinformation statements, and other information regarding our Company that wefile electronically with the SEC.

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**Item1A.****               ***Risk********Factors*

**RISK FACTORS**

***Set forth below and elsewhere inthis report and in other documents we file with the SEC are risks anduncertainties that could cause our actual results to differ materially from theresults contemplated by the forward-looking statements contained in this reportand other public statements we make. If any of the following risks actuallyoccurs, our business, financial condition, and results of operations couldsuffer. In that case, the trading price of our common stock could decline, andyou may lose all or part of your investment.***

**Risks Related toOur Business**

***The sale of our DTSDigital Cinema business or any failure to successfully manage and complete anundertaken sales transaction could adversely affect our business and operatingresults.***

In order to better addressrapidly evolving markets, meet the needs of customers and increase stockholdervalue, we are proceeding with the sale of our DTS Digital Cinema business. Thesales process may be costly. The sale might not be accomplished by the end of2007 or at all. The sales process requires significant time and attention fromour management, finance, accounting and legal teams, which could disrupt ourday-to-day operations and shift the allocation of these resources away frommatters related to our core business. In addition, implementing any transactionwould involve a number of operational, legal and, possibly, regulatory steps.Implementation could be costly, cause further disruption to our day-to-dayoperations, and result in the loss of customers and/or sales revenue, whichcould cause our business and operating results to suffer. Furthermore,implementation of a sale is a complicated process and there is a risk that wemay not be successful in the execution of our sales strategy, which could causeour business to suffer and our stock price to decline.

***Our business andprospects depend on the strength of our brand, and if we do not maintain andstrengthen our brand, our business will be materially harmed.***

Establishing, maintainingand strengthening our “DTS” brand is critical to our success. Our brandidentity is key to maintaining and expanding our business and entering newmarkets. Our success depends in large part on our reputation for providing highquality products, services and technologies to the entertainment industry andthe consumer electronics products industry. If we fail to promote and maintainour brand successfully, our business and prospects may suffer. Moreover, webelieve that the likelihood that our technologies will be adopted in industrystandards depends, in part, upon the strength of our brand, becauseprofessional organizations and industry participants are more likely toincorporate technologies developed by a well-respected and well-known brand intostandards. Maintaining and strengthening our brand will depend heavily on ourability to develop innovative technologies for the entertainment industry, tocontinue to provide high quality products and services, and manage brandtransition in connection with the process of selling the DTS Digital Cinemabusiness, which we may not do successfully.

***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.***

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

·       rapidtechnological change;

·       newand improved product introductions;

·       changingcustomer demands;

·       evolvingindustry standards; and

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·       productobsolescence.

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

***If we fail toprotect our intellectual property rights, our ability to compete could beharmed.***

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 process;

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

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

·       effortsto identify and prosecute unauthorized uses of our technology are timeconsuming, expensive, and divert resources from the operation of our business;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 bythird parties for alleged infringement 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 

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

***We face intensecompetition. Many of our competitors have greater brand recognition andresources than we do.***

The digital audio,digital imaging, consumer electronics, cinema and entertainment markets areintensely competitive, subject to rapid change, and significantly affected bynew product introductions and other market activities of industry participants.Our principal competitor is Dolby Laboratories, Inc., who competes with usin most 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,Doremi Labs, Inc. 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.

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

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

·       greatername recognition;

·       alonger operating history;

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

·       amore extensive customer base;

·       digitaltechnologies that provide features that ours do not;

·       broaderproduct and service offerings;

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

·       moretechnicians and engineers; and

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·       greatertechnical support.

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 and 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 we have not, including DVD-Video and DVD-Audio Recordable, forits stereo technology and terrestrial digital television broadcasts in theUnited States. It also currently has more depth in digital cinema. As a resultof these factors, Dolby has a competitive advantage in selling its digitalmulti-channel audio technology to consumer electronics products manufacturersand in selling products and services designed for use in the digital cinemaspace.

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.

***We do not expectsales of traditional consumer DVD players to sustain their past growth rates.To the extent that sales of DVD players and home theater systems level off ordecline, or alternative technologies in which we do not participate replaceDVDs as a dominant medium for consumer video entertainment, our business willbe adversely affected.***

Growth in our businessover the past several years is due in large part to the rapid growth in salesof DVD players and home theater systems incorporating our technologies. As themarkets for DVD players mature, we do not expect sales of traditional consumerDVD players to sustain their past growth rates. To the extent that sales of DVDplayers and home theater systems level off or decline, our business will beadversely affected. Additionally, the release and consumer adoption ofnext-generation optical disc players has only just begun. There are currentlytwo potential, incompatible formats for high-definition optical disc format,and consumers may not react favorably to having to make a choice betweenformats. There is also the risk of consumer confusion and frustration over theinability of a given format player to play a disc in the competing format. Theslow uptake by consumers of these new formats, as well as the inability oftraditional DVD players to sustain their past growth rates, could adverselyaffect our business, as revenue and earnings derived from these new players andassociated home theater system sales may not fully replace the anticipateddecline in revenue and earnings associated with traditional DVD players andhome theater systems. Even assuming resolution of the competing disc formatconflict, the rate of consumer adoption and ultimate penetration ofnext-generation optical disc players is uncertain and may be slower than pastgrowth rates of traditional DVD players. In addition, if new technologies aredeveloped for use with DVDs or new technologies are developed thatsubstantially compete with or replace DVDs as a dominant medium for consumervideo entertainment, our business, operating results and prospects will beadversely affected.

***We have limitedcontrol over existing and potential customers’ and licensees’ decisions toinclude our technology in certain of 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 and builders and integrators ofdigital cinema networks—to incorporate our technology in their products,purchase our products and services, or release their content in our proprietaryDTS audio format. Although we have contracts and license agreements with manyof these 

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companiesother than builders and integrators of digital cinema networks, these agreementsdo not require any minimum purchase commitments, are on a non-exclusive basis,and do not require incorporation or use of our technology, trademarks orservices. Our customers, licensees and other manufacturers might not utilizeour technology or services in the future.

***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 significant amount of content in movies,audio DVDs, computer software programs, video games, or other entertainmentmediums will be released with DTS audio soundtracks. If the amount, variety,and popularity of entertainment content released with DTS audio soundtracks donot increase, consumer electronics products manufacturers that pay us per-unitlicensing fees may discontinue offering DTS playback capabilities in theconsumer electronics products that they sell.

***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 technology. As a result of pricing pressure, consumerelectronics products manufacturers who manufacture products in which our audiotechnology is not a mandatory standard could decide to exclude our DTS audiotechnology from their products altogether.

The market for consumervideo products is also intensely competitive and price sensitive. Retail pricesfor consumer video products have experienced price pressure and we expect thisprice pressure to continue for the foreseeable future. Declining retail pricesfor such video products could create downward pressure on the fees we chargeour customers for the image processing, enhancement and restoration services weprovide. If the motion picture studios, content owners, producers ordistributors were to believe that the existing image quality is satisfactory orthat the pricing for our services is too high, they could decide to not use ourservices altogether.

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***Our licensingrevenue depends in large part upon semiconductor manufacturers incorporatingour technologies into integrated circuits, or ICs, for sale to our consumerelectronics product licensees and if, for any reason, our technologies are notincorporated in these ICs or fewer ICs are sold that incorporate ourtechnologies, our operating results would be adversely affected.***

Our licensing revenue fromconsumer electronics product manufacturers depends in large part upon theavailability of ICs, that implement our technologies. IC manufacturersincorporate our technologies into these ICs, which are then incorporated inconsumer electronics products. We do not manufacture these ICs, but ratherdepend on IC manufacturers to develop, produce and then sell them to licensedconsumer electronics product manufacturers. We do not control the ICmanufacturers’ decisions whether or not to incorporate our technologies intotheir ICs, and we do not control their product development or commercializationefforts. If these IC manufacturers are unable or unwilling, for any reason, toimplement our technologies into their ICs, or if, for any reason, they sellfewer ICs incorporating our technologies, our operating results will be adverselyaffected.

***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, time consuming,difficult to manage effectively, dependent in large part on the cooperation ofour licensees and the quality of the records they keep, and could harm ourcustomer relationships. If any of our customer reports understate the number ofproducts they manufacture, we may not collect and recognize revenues to whichwe are entitled.

***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 annual profitability sincefiscal 2001. We expect our operating expenses to increase as we, among otherthings:

·       expandour domestic and international sales and marketing activities;

·       developand roll out our digital cinema products and services;

·       proceedwith the sale of our DTS Digital Cinema business;

·       restructureour international operations;

·       adopta more product-centric business model which is expected to entail additionalhiring;

·       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.

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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.

***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, including without limitation, digital cinema;

·       thenumber and timing of acquisitions and other strategic transactions;

·       theextent to which we deploy our digital cinema products to theaters;

·       thecosts associated with our expansion, if any; and

·       thesale of our DTS Digital Cinema business.

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.

***We have a limited operating history in our new andevolving markets.***

Although the first moviewith a DTS audio soundtrack was released in 1993, we did not enter the hometheater market until 1996, and our technology has only recently beenincorporated into other consumer electronics markets, such as car audio,personal computers, video games and consoles, portable electronics devices, anddigital satellite and cable broadcast products. In addition, while we havecompleted over 100 digital image processing, enhancement and restoration filmprojects, it is only recently that a large number of these projects have beencompleted. As a result, the demand for our technology, products, and servicesand the income potential of these businesses are unproven. In addition, becausethe market for digital audio technology and image services is relatively newand rapidly evolving, we have limited insight into trends that may emerge andaffect our business. We may make errors in predicting and reacting to relevantbusiness trends, which could harm our business. Before investing in our commonstock, you should consider the risks, uncertainties, and difficultiesfrequently encountered by companies in new and rapidly evolving markets such asours. We may not be able to successfully address any or all of these risks.

***Our technology andproducts are complex and may contain errors that could cause us to lose customers,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, as well as provide insurance coverage tosuch events, if these contract provisions are not enforced or are unenforceablefor any reason, if liabilities arise that are not 

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effectivelylimited, or if our insurance coverage is inadequate to satisfy the liability,we could incur substantial costs in defending and/or settling product liabilityclaims.

***Issues arising fromthe implementation of our new enterprise resource planning system could affectour operating results and ability to manage our business effectively.***

We recently began toimplement an enterprise resource planning, or ERP, system to enhance operatingefficiencies and provide more effective management of our business operations.Implementing a new ERP system is costly and involves risks inherent in theconversion to a new computer system, including disruption to our normalaccounting procedures and internal control over financial reporting andproblems achieving accuracy in the conversion of electronic data. Failure toproperly or adequately address these issues could result in increased costs,the diversion of management’s and employees’ attention and resources and couldmaterially adversely affect our operating results, internal control overfinancial reporting and ability to manage our business effectively. While theERP system is intended to improve and enhance our information systems, largescale implementation of new information systems exposes us to the risks ofstart up of the new system and integration of that system with our existingsystems and processes, including possible disruption of our financialreporting, which could lead to a failure to make required filings under thefederal securities laws on a timely basis. In addition, if we fail to implementthe ERP system or fail to implement the ERP system successfully, we willcontinue to rely on our current information systems.

***We cannot becertain of the future effectiveness of our internal controls over financialreporting or the impact thereof on our operations or the market price of ourcommon stock.***

Pursuant to Section 404of the Sarbanes-Oxley Act of 2002, we are required to include in our annualreports on Form 10-K our assessment of the effectiveness of ourinternal controls over financial reporting. We cannot assure you that oursystem of internal controls will be effective in the future as our operationsand control environment change. If we cannot adequately maintain theeffectiveness of our internal controls over financial reporting, our financialreporting may be inaccurate. If reporting errors actually occur, we could besubject to sanctions or investigation by regulatory authorities, such as theSEC. These results could adversely affect our financial results or the marketprice of our common stock. If our independent registered public accounting firmis unable to provide us with an unqualified report as to the adequacy of ourinternal controls over financial reporting as required by Section 404 ofthe Sarbanes Oxley Act of 2002, investors could lose confidence in thereliability of our financial statements, which could result in a decrease inthe value of our stock.

***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 more than ten countries worldwide. Many of our customersand licensees are located outside the United States. As a key component of ourbusiness strategy, we intend to expand our international sales. During fiscal2006, approximately 71% of our revenues were derived internationally. We facenumerous risks in doing business outside the United States, including:

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

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

·       difficultiesin staffing and managing foreign operations;

·       competitionfrom foreign companies;

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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. The main foreign currencies weencounter in our operations are the Yen, Euro, RMB and GBP. We do not currentlyengage in currency hedging activities to limit the risk of exchange ratefluctuations.

***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 military hostilities.This could severely harm our business by interrupting or delaying production orshipment of our products or products that incorporate our technology.

***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 and demand by film studios and movietheaters for our cinema products and services.

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***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, including withoutlimitation the potential acquisition of substantially all of the assets ofAvica. We have a limited history of acquiring and integrating businesses.Acquisitions and strategic investments involve numerous risks, including:

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

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

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

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

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

·       unanticipatedor unknown liabilities relating to the acquired businesses;

·       theneed to integrate accounting, management information, manufacturing, humanresources and other administrative systems to permit effective management; and

·       potentialloss of key employees of acquired organizations.

If we fail to properlyevaluate and execute acquisitions and strategic investments, our managementteam may be distracted from our day-to-day operations, our business may bedisrupted, and our operating results may suffer. In addition, if we financeacquisitions by issuing equity or convertible debt securities, our existingstockholders would be diluted. Foreign acquisitions involve unique risks inaddition to those mentioned above, including those related to integration ofoperations across different geographies, cultures and languages, currency risksand risks associated with the particular economic, political and regulatoryenvironment in specific countries. Also, the anticipated benefit of ouracquisitions may not materialize, whether because of failure to obtainstockholder approval or otherwise. Future acquisitions could result inpotentially dilutive issuances of our equity securities, the incurrence ofdebt, contingent liabilities or amortization expenses, or write-offs ofgoodwill, any of which could harm our operating results or financial condition.Future acquisitions may also require us to obtain additional equity or debt financing,which may not be available on favorable terms or at all.

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

As a result of acombination of internal growth and growth through acquisitions, 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;

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·       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 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 and amplify the seasonality described above. For example,the introduction of next generation optical disc players may result in anoverall near-term slowdown in our business as sales of standard definitionplayers slow in anticipation of purchasing next generation products, butpurchases of next generation products are in an early-adopter only phase.Similar issues may affect our cinema hardware business during the expectedtransition to digital cinema. Our revenues may continue to be subject tofluctuations, seasonal or otherwise, in the future. Unanticipated fluctuations,whether due to seasonality, product cycles, or otherwise, could cause us tomiss our earnings projections, or could lead to higher than normal variation inshort-term earnings, either of which could cause our stock price to decline.

In addition, we activelyengage in intellectual property compliance and enforcement activities focusedon identifying third parties who have either incorporated our technology,trademarks, or know-how without a license or who have underreported to us theamount of royalties owed under license agreements with us. As a result of theseactivities, from time to time, we may recognize royalty revenues that relate toconsumer electronics manufacturing activities from prior periods and we mayincur expenditures related to enforcement activity. These expenditures androyalty recoveries, as applicable, may cause revenues to be higher thanexpected, or net profit to be lower 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.

***Even if ourtechnologies are adopted as an industry standard for a particular market,market participants may not widely adopt our technologies.***

Even if astandards-setting body mandates our technologies for a particular market, ourtechnologies may not be the sole technologies adopted for that market as anindustry standard. Accordingly, our business may depend upon participants inthat market choosing to adopt our technologies instead of or in addition tocompetitive technologies that also may be acceptable under such standard.

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***Our licensing ofindustry standard technologies can be subject to limitations that couldadversely affect our business and prospects.***

When a standards-settingbody adopts our technologies as explicit industry standards, we generally mustagree to license such technologies on a fair, reasonable and non-discriminatorybasis, which could limit our control over the use of these technologies. Inthese situations, we may be required to limit the royalty rates we charge forthese technologies, which could adversely affect our business. Furthermore, wemay be unable to limit to whom we license such technologies, and may be unableto restrict many terms of the license. From time to time, we may be subject toclaims that our licenses of our industry standard technologies may not conformto the requirements of the standards-setting body. Claimants in such casescould seek to restrict or change our licensing practices or our ability tolicense our technologies in ways that could injure our reputation and otherwisematerially and adversely affect our business, operating results and prospects.

***Our ability todevelop proprietary technology in markets in which “open standards” are adoptedmay be limited, which could adversely affect our ability to generate revenue.***

Standards-setting bodies,such as those for digital cinema technologies, may require the use of so-called“open standards,” meaning that the technologies necessary to meet thosestandards are publicly available. The use of open standards may reduce ouropportunity to generate revenue, as open standards technologies are based uponnon-proprietary technology platforms in which no one company maintainsownership over the dominant technologies.

***We are dependent on our management team and technicaltalent.***

Our successdepends, in part, upon the continued availability and contributions of ourmanagement team and engineering and technical personnel because of thecomplexity of our products and services. Important factors that could cause theloss of key personnel include:

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

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

·       significantportions of the equity awards held by the members of our management team arevested; and

·       equityawards held by some of our executive officers provide for accelerated vestingin the event of a sale or change of control of our company.

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

***A loss of one ormore of our key customers or licensees in any of our markets could adverselyaffect our business.***

From time to time, one ora small number of our customers or licensees may represent a significantpercentage of our revenue. Although we have agreements with many of thesecustomers, these agreements typically do not require any material minimumpurchases or minimum royalty fees and do not prohibit customers from purchasingproducts and services from competitors. A decision by any of our majorcustomers or licensees not to use our technologies, or their failure orinability to pay amounts owed to us in a timely manner, or at all, could have asignificant adverse effect on our business.

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***We may have additional tax liabilities.***

We are subject to income taxes in both the UnitedStates and foreign jurisdictions. Significant judgment is required indetermining our worldwide provision for income taxes. In the ordinary course ofour business, there are many transactions and calculations where the ultimatetax determination is uncertain. We may come under audit by tax authorities.Although we believe our tax estimates are reasonable, the final determinationof tax audits and any related litigation could be materially different from ourhistorical income tax provisions and accruals. Based on the results of an auditor litigation, a material effect on our income tax provision, net income orcash flows in the period or periods for which that determination is made couldresult.

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

Technology standards are important in the audio andvideo industry as they help to assure compatibility across a system or seriesof products. Generally, standards adoption occurs on either a mandatory basis,requiring a particular technology to be available in a particular product ormedium, or an optional basis, meaning that a particular technology may be, butis not required to be, utilized. For example, both our digital multi-channelaudio technology and Dolby’s have optional status in Standard and HighDefinition-DVD and Blu-ray. In the standards for High Definition-DVD andBlu-ray, both DTS and Dolby technologies have been selected as mandatorystandards for two-channel output. However, if either or both of these standardsare re-examined or a new standard is developed, we may not be included asmandatory in any such new or revised standard which would cause revenue growthin our consumer business to be significantly lower than expected and could havea material adverse affect on our business.

Various national governments have adopted or are inthe process of adopting standards for all digital television broadcasts, includingcable, satellite, and terrestrial. In the United States, Dolby’s audiotechnology 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 ormedia may develop. New standards may also emerge in existing markets that arecurrently characterized by competing formats, such as the market for personalcomputers. We may not be successful in our efforts to include our technology inany such standards.

***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.

***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 the major U.S.film producers and distributors are customers of ours, we generally do not havecontractual arrangements that require them to use our DTS audio technology orour digital image services. Our cinema and digital images business depends onour having good relations with these film 

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studiosand other content owners. A deterioration in our relationship with any of thesecustomers could cause them to stop using our DTS audio technology or ourdigital image enhancement services. Any significant decline or delay in therelease of motion pictures with DTS audio soundtracks would decrease the demandfor and revenues from the playback products and services that we offer to movietheaters. In addition, other motion picture studios, content owners, producers,and distributors throughout the world generally adopt and use the processes andthe technologies used by the major U.S. film studios. Therefore, if the majorU.S. motion picture studios, content owners, producers or distributors stopusing our technology, we would not only lose the per-movie licensing fee wereceive from these customers, but may also lose per-movie licensing fees fromother film studios throughout the world. Furthermore, poor box-officeperformance caused by a weak film release calendar or declining consumerinterest in the films being released could have a negative impact on the demandfor the products and services we sell to the motion picture industry.

***The movie theaterindustry has suffered and may continue to suffer from an oversupply of screens,which has affected and may continue to affect demand for the products andservices we offer to movie theaters.***

Our cinema businessdepends in part on the construction of new screens and the renovation ofexisting theaters that install our DTS playback systems and cinema processors.Over the past decade, aggressive building of megaplexes by companies thatoperate movie theaters has generated significant competition and resulted in anoversupply of screens in some domestic and international markets. The resultingoversupply of screens led to significant declines in revenues per screen and,eventually, to an inability by many major film exhibitors to satisfy theirfinancial obligations. Several major movie theater operators have reorganizedthrough bankruptcy proceedings, and many movie theaters have closed. As aresult, our playback systems and cinema processors that we previously sold tomovie theaters that have reorganized and closed have been relocated to othertheaters or have been available for resale in the secondary market to movietheaters that might otherwise have purchased these products directly from us.More recently, the industry has experienced a decline in movie theaterattendance. If this decline were to continue, exhibitors could see a decline inrevenue per screen and, potentially, an inability to satisfy their financialobligations resulting in the closure of screens. If movie theater operatorsdecide to close a significant number of screens in the future or cut theircapital spending, demand for our playback systems and cinema processors willdecline. Additionally, the expected transition to digital cinema could harm ourlegacy cinema business because operators may decide to delay procurementdecisions as they wait to evaluate the widespread roll out of digital cinema,operators may decide to purchase digital cinema systems that do not require ourexisting products and services, and as existing screens are repurposed todigital cinema, the quantity of our existing products on the secondary marketmay increase significantly. These developments may harm our business andoperating results.

***The demand for ourcurrent or “legacy” cinema products and production services could decline ifthe film industry broadly adopts digital cinema.***

If the film industrybroadly adopts digital cinema, the demand for our current or “legacy” cinemaproducts and production services could decline. If, in such circumstances, weare unable to adapt our professional products and production services orreplace such business with new products for the market for digital cinemasuccessfully, our business could be materially adversely affected.

***We depend onseveral sole and limited source suppliers, manufacturers, and distributors forsome of our products, and the loss of any of these suppliers, manufacturers, ordistributors could harm our business.***

We purchase a small numberof parts from sole-source suppliers. In addition, our professional audio encodingdevices and movie theater playback systems are manufactured according to ourspecifications by single third-party manufacturers. Because we have no directcontrol over these third-party suppliers and 

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manufacturers,interruptions or delays in the products and services provided by these thirdparties may be difficult to remedy in a timely fashion. In addition, if suchsuppliers or manufacturers are incapable of or unwilling to deliver thenecessary parts or products, we may be unable to redesign our technology towork without such parts or find alternative suppliers or manufacturers. In suchevents, we could experience interruptions, delays, increased costs, or qualitycontrol problems.

***We are subject tovarious environmental laws and regulations that could impose substantial costsupon us and may adversely affect our business, operating results and financialcondition.***

Some of our operations use substances regulated undervarious federal, state, local and international laws governing the environment,including those governing the discharge of pollutants into the air and water,the management, disposal and labeling of hazardous substances and wastes andthe cleanup of contaminated sites. We could incur costs, fines and civil orcriminal sanctions, third-party property damage or personal injury claims, orcould be required to incur substantial investigation or remediation costs, ifwe were to violate or become liable under environmental laws. Liability underenvironmental laws can be joint and several and without regard to comparativefault. The ultimate costs under environmental laws and the timing of thesecosts are difficult to predict.

We also face increasing complexity in our productdesign as we adjust to new and future requirements relating to the materialscomposition of our products, including the restrictions on lead and otherhazardous substances that apply to specified electronic products put on themarket in the European Union, or EU, as of July 1, 2006 (Restriction onthe Use of Hazardous Substances Directive 2002/95/EC, also known as the “RoHSDirective”) and similar legislation proposed for China.

For some products, substituting particular componentscontaining regulated hazardous substances can be difficult or costly, andredesign efforts could result in production delays. Selected products that wemaintain in inventory may be rendered obsolete if not in compliance with theRoHS Directive, which could negatively impact our ability to generate revenuefrom those products. We could also face significant costs and liabilities inconnection with product take-back legislation. The European Union Directive2002/96/EC as amended by 2003/108/EC (Waste Electrical and Electronic EquipmentDirective also known as the “WEEE Directive”) requires producers of particularelectrical and electronic equipment, including broadcast equipment, to befinancially responsible for specified collection, recycling, treatment anddisposal of past and future covered products. As of December 2006, not allmember states within the EU have enacted enabling legislation under the WEEEDirective, and in the absence of such legislation, it is difficult to determinethe costs to comply with the WEEE Directive.

Other countries, such asChina and the United States, may enact similar product-content and take-backlegislation, the cumulative impact of which could significantly increase ouroperating costs and adversely affect our operating results. We also expect thatour operations, whether manufacturing or licensing, will be affected by othernew environmental laws and regulations on an ongoing basis. Although we cannotpredict the ultimate impact of any such new laws and regulations, they willlikely result in additional costs or decreased revenue, and could require thatwe redesign or change how we manufacture our products, any of which could havea material adverse effect on our business.

**Risks Related toOur Common Stock**

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

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

·       actualor anticipated fluctuations in our results of operations;

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·       marketperception of our progress toward announced objectives, including withoutlimitation, the sale of our DTS Digital Cinema business;

·       announcementsof technological innovations by us or our competitors 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;

·       announcementsof potential acquisitions;

·       theadoption rate of new products incorporating our or our competitors’technologies, including next generation optical disc players;

·       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 Global Select Market and the market fortechnology companies in particular, has experienced extreme price and volumefluctuations that have often been unrelated or disproportionate to theoperating performance of those companies. Further, the market prices ofsecurities of technology companies have been particularly volatile. These broadmarket and industry factors may materially harm the market price of our commonstock, regardless of our operating performance. In the past, following periodsof volatility in the market price of a company’s securities, securitiesclass-action litigation has often been instituted against that company. Suchlitigation, if instituted against us, could result in substantial costs and adiversion of management’s attention and resources.

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

As a result of ourrelatively small public float, our common stock may be less liquid than thecommon stock 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.

***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;

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

·       requireadvance written notice of stockholder proposals and director nominations.

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

**Item 1B.**               UnresolvedStaff Comments

None.

**Item 2.**                        Properties

Our corporate headquartersand principal offices are located in Agoura Hills, California, where we leaseapproximately 54,000 square feet. This space is leased under four differentleases, one of which expires in October 2007 and the other three of whichexpire in November 2008. We also lease smaller facilities in otherlocations including the United States, Canada, China, England, France, Italy,Northern Ireland, Hong Kong and Japan. We believe that our existing space isadequate for our current operations. We believe that suitable replacement andadditional space will be available in the future on commercially reasonableterms.

**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 anymatters to a vote of security holders during the fourth quarter of the yearended December 31, 2006.

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**PART II**

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

**PRICE RANGE OFCOMMON STOCK**

Ourcommon stock is traded on the Nasdaq Global Select Market under the symbol “DTSI.”Prior to July 1, 2006 our common stock was listed on the Nasdaq NationalMarket since our initial public offering on July 9, 2003. The followingtable sets forth, for the periods indicated, the high and low sales prices forour common stock as reported by the Nasdaq National Market for periods prior toJuly 1, 2006, and Nasdaq Global Select Market from July 1, 2006through December 31, 2006:

| ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| **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 |   |
| **2006:**      |       |     |       |    |       |
| First Quarter  |       | $        | 19.87      |    | $          | 14.59 |   |
| Second Quarter |       | $        | 22.22      |    | $          | 17.04 |   |
| Third Quarter  |       | $        | 22.09      |    | $          | 15.57 |   |
| Fourth Quarter |       | $        | 26.99      |    | $          | 19.36 |   |

 

As of February 20,2007 there were approximately 3,400 stockholders of record of our common stock.We believe that the number of beneficial owners is substantially greater thanthe number of record holders because a large portion of our common stock isheld of record through brokerage firms in “street name.”

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**STOCK PERFORMANCEGRAPH**

Thefollowing graph compares the cumulative total stockholder return on our commonstock to that of the NASDAQ Market Index and the Russell 2000® Index from July 9,2003 (the date our common stock began to trade publicly) through December 31,2006, the date of our fiscal year end. The graph assumes that a $100 investmentwas made at the close of trading on July 9, 2003 in our common ctock andin each index, and that dividends, if any, were reinvested. The stock priceperformance shown on the graph below should not be considered indicative offuture price performance.

****

| ** **          | ** ** | **July 10,  2003** | ** ** | **December 31,  2003** | ** ** | **December 31,  2004** | ** ** | **December 30,  2005** | ** ** | **December 29,  2006** | ** ** |
|---------------------|------------|-------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| DTS, Inc.      |       | $                       | 100.00     |                        |       | $                           | 99.08      |                        |       |                        | $          | 80.78 |   |   |   | $ | 59.39 |   |   |   | $ | 97.07 |   |   |
| Russell 2000  Index |       | 100.00                  |       |                        | 124.21     |                        |       |                        | 145.94     |                        |       |   | 150.79 |   |   |   | 176.53 |   |   |
| NASDAQ Market Index |       | 100.00                  |       |                        | 123.75     |                        |       |                        | 134.15     |                        |       |   | 137.10 |   |   |   | 151.17 |   |   |
|                     |            |                         |            |                             |            |                             |            |                             |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**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 9, 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 theSecurities Act of 1933, as amended, (the “Securities Act”) on a RegistrationStatement on Form S-1 (Reg. No. 333-104761) that wasdeclared effective by the SEC on July 9, 2003 and a Registration Statementfiled pursuant to Rule 462(b) under the Securities Act that was filedon July 9, 2003 (Reg. No. 333-106920). Subsequent to theoffering, we used approximately $22.5 million of our net proceeds toredeem all outstanding shares of redeemable preferred stock and to pay allaccrued but unpaid dividends on such shares through the date of redemption. Theremaining proceeds to us have conformed with our intended use outlined in theprospectus related to the offering.

**ISSUER PURCHASES OFEQUITY SECURITIES**

On August 1, 2006, our Board of Directorsauthorized, subject to certain business and market conditions, the purchase ofup to one million shares of our common stock in the open market or in privatelynegotiated transactions. Through March 16, 2007, there were no sharespurchased under this authorization. Any shares repurchased would be consideredtreasury stock.

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

**SELECTEDCONSOLIDATED FINANCIAL DATA**

In thetable below, we provide you with historical selected consolidated financialdata of DTS, Inc. We derived the following historical data from ouraudited consolidated financial statements. It is important that you read theselected consolidated financial data set forth below in conjunction with ourconsolidated financial statements and related notes and “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”included elsewhere in this Form 10-K. Our historical results are notnecessarily indicative of the operating results that may be expected in thefuture. We have described various risks and uncertainties that could affectfuture operating results under the heading “Risk Factors” included elsewhere inthis Form 10-K.

| ** **                                                                                                      | ** ** | **Years Ended December 31,**                        | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                                      | ** ** | **2002**                                                           | ** ** | **2003** | ** ** | **2004** | ** ** | **2005(1)** | ** ** | **2006(2)** | ** ** |
| ** **                                                                                                      | ** ** | **(In thousands, except per share data)** | ** ** |
| **Consolidated  Statement of Operations Data**                                                                  | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Revenues:                                                                                                       |       |                                                               |       |   |   |   |   |   |   | ** ** |   |   | ** ** | ** ** |   |
| Technology and film  licensing                                                                                  |       | $                                                                  | 31,906     |   | $ | 42,229 |   | $ | 49,920 |   |   | $ | 56,947 | ** ** |   |   | **$** | **59,053** | ** ** |   |
| Product sales and other  revenues                                                                               |       | 9,150                                                              |       | 9,473 |   | 11,511 |   |   | 18,305 | ** ** |   |   | **19,261** | ** ** |   |
| Total revenues                                                                                                  |       | 41,056                                                             |       | 51,702 |   | 61,431 |   |   | 75,252 | ** ** |   |   | **78,314** | ** ** |   |
| Cost  of goods sold:                                                                                            |       |                                                               |       |   |   |   |   |   |   | ** ** |   |   | ** ** | ** ** |   |
| Technology and film  licensing                                                                                  |       | 3,687                                                              |       | 4,281 |   | 4,451 |   |   | 4,715 | ** ** |   |   | **4,769** | ** ** |   |
| Product sales and other  revenues                                                                               |       | 6,949                                                              |       | 6,751 |   | 11,711 |   |   | 14,898 | ** ** |   |   | **15,635** | ** ** |   |
| Total cost of goods sold                                                                                        |       | 10,636                                                             |       | 11,032 |   | 16,162 |   |   | 19,613 | ** ** |   |   | **20,404** | ** ** |   |
| Gross profit                                                                                                    |       | 30,420                                                             |       | 40,670 |   | 45,269 |   |   | 55,639 | ** ** |   |   | **57,910** | ** ** |   |
| Operating  expenses:                                                                                            |       |                                                               |       |   |   |   |   |   |   | ** ** |   |   | ** ** | ** ** |   |
| Selling, general and  administrative                                                                            |       | 16,379                                                             |       | 20,473 |   | 27,644 |   |   | 33,960 | ** ** |   |   | **41,754** | ** ** |   |
| Research and development                                                                                        |       | 3,754                                                              |       | 4,987 |   | 6,131 |   |   | 9,867 | ** ** |   |   | **12,334** | ** ** |   |
| In-process research and  development                                                                            |       | —                                                             |       | — |   | — |   |   | 2,300 | ** ** |   |   | **—** | ** ** |   |
| Separation and  restructuring costs                                                                             |       | —                                                             |       | — |   | — |   |   | — | ** ** |   |   | **4,903** | **(3)** |   |
| Total operating expenses                                                                                        |       | 20,133                                                             |       | 25,460 |   | 33,775 |   |   | 46,127 | ** ** |   |   | **58,991** | ** ** |   |
| Income (loss) from  operations                                                                                  |       | 10,287                                                             |       | 15,210 |   | 11,494 |   |   | 9,512 | ** ** |   |   | **(1,081** | **)** |   |
| Interest income (expense),  net                                                                                 |       | (94                                                                | )          | 271 |   | 1,447 |   |   | 2,524 | ** ** |   |   | **4,923** | ** ** |   |
| Other income (expense), net                                                                                     |       | (255                                                               | )          | (214 | ) | (31 | ) |   | 154 | ** ** |   |   | **—** | ** ** |   |
| Income from legal  settlement                                                                                   |       | —                                                             |       | — |   | 2,601 |   |   | — | ** ** |   |   | **—** | ** ** |   |
| Income before income taxes                                                                                      |       | 9,938                                                              |       | 15,267 |   | 15,511 |   |   | 12,190 | ** ** |   |   | **3,842** | ** ** |   |
| Provision for income taxes                                                                                      |       | 3,688                                                              |       | 5,368 |   | 5,535 |   |   | 4,282 | ** ** |   |   | **818** | ** ** |   |
| Net income                                                                                                      |       | 6,250                                                              |       | 9,899 |   | 9,976 |   |   | 7,908 | ** ** |   |   | **3,024** | ** ** |   |
| Accretion and accrued  dividends on preferred stock                                                             |       | (1,848                                                             | )          | (1,234 | ) | — |   |   | — | ** ** |   |   | **—** | ** ** |   |
| Net income attributable to  common stockholders                                                                 |       | $                                                                  | 4,402      |   | $ | 8,665 |   | $ | 9,976 |   |   | $ | 7,908 | ** ** |   |   | **$** | **3,024** | ** ** |   |
| Net  income attributable to common stockholders per common share:                                               |       |                                                               |       |   |   |   |   |   |   | ** ** |   |   | ** ** | ** ** |   |
| Basic                                                                                                           |       | $                                                                  | 0.99       |   | $ | 0.95 |   | $ | 0.59 |   |   | $ | 0.46 | ** ** |   |   | **$** | **0.17** | ** ** |   |
| Diluted                                                                                                         |       | $                                                                  | 0.47       |   | $ | 0.64 |   | $ | 0.55 |   |   | $ | 0.43 | ** ** |   |   | **$** | **0.16** | ** ** |   |
| Weighted  average shares used to compute net income attributable to common  stockholders per common share: |       |                                                               |       |   |   |   |   |   |   | ** ** |   |   | ** ** | ** ** |   |
| Basic                                                                                                           |       | 4,432                                                              |       | 9,166 |   | 16,866 |   |   | 17,321 | ** ** |   |   | **17,623** | ** ** |   |
| Diluted                                                                                                         |       | 9,329                                                              |       | 13,601 |   | 18,143 |   |   | 18,310 | ** ** |   |   | **18,401** | ** ** |   |

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(1)             Includes theresults of operations for DTS Digital Images, Inc. We acquired thisbusiness in January 2005. In connection with this acquisition, we incurreda $2,300 charge for in-process research and development.

(2)             Includes $134,$2,989 and $463 in cost of goods sold, selling, general and administrative andresearch and development, respectively, due to the adoption of Statement ofFinancial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment”on January 1, 2006. For additional information regarding SFAS 123(R),refer to Footnote 16 of our consolidated financial statements, “Stock-BasedCompensation.” Also includes the impact of consolidating Avica, as discussed inFootnote 3 of our consolidated financial statements, “Consolidation of Avica asa Variable Interest Entity.”

(3)             Includes $1,145,$3,000 and $758 for the separation of our business, the early termination of abusiness agreement and the write-down of DTSE inventory and other assets,respectively.

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| ** **                                          | ** ** | **As of December 31,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                          | ** ** | **2002**                              | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006(1)** | ** ** |
| ** **                                          | ** ** | **(In thousands)**               | ** ** |
| **Consolidated  Balance Sheet Data**                | ** ** | ** **                            |       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash, cash equivalents, and  short-term investments |       | $                                     | 4,051      |   | $ | 99,389 |   | $ | 114,311 |   | $ | 111,417 | ** ** | **$** | **111,465** | ** ** |
| Working capital                                     |       | 9,381                                 |       | 110,810 |   | 125,573 |   | 122,763 | ** ** | **120,510** | ** ** |
| Total assets                                        |       | 25,779                                |       | 127,495 |   | 144,689 |   | 158,254 | ** ** | **168,200** | ** ** |
| Total long-term liabilities                         |       | —                                |       | — |   | — |   | 1,917 | ** ** | **1,466** | ** ** |
| Mandatorily redeemable  preferred stock             |       | 21,302                                |       | — |   | — |   | — | ** ** | **—** | ** ** |
| Total stockholders’ equity (deficit)           |       | (6,315                                | )          | 118,871 |   | 134,766 |   | 144,090 | ** ** | **153,816** | ** ** |
|                                                     |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)             Includes theimpact of consolidating Avica, as discussed in Footnote 3 of our consolidatedfinancial statements, “Consolidation of Avica as a Variable Interest Entity.”

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

This Annual Report on Form 10-Kand the documents incorporated herein by reference contain forward-lookingstatements based on our current expectations, estimates and projections aboutour industry, beliefs, and certain assumptions made by us. Words such as “believes,”“anticipates,” “estimates,” “expects,” “projections,” “may,” “potential,” “plan,”“continue” and words of similar import, constitute “forward-looking statements.”The forward-looking statements contained in 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 1A 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 orachievements. We do not undertake any obligation to revise theseforward-looking statements to reflect 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 providerof entertainment technology, products and services to the audio and imageentertainment markets worldwide. Historically we have been focused on highquality digital multi-channel audio, commonly referred to as surround sound,which provides more than two-channels of audio, allowing the listener tosimultaneously hear discrete sounds from multiple speakers. Our DTS digitalmulti-channel audio technology delivers compelling surround sound for theconsumer electronics and motion picture markets. We also provide high qualitydigital image processing, enhancement and restoration services for motionpictures, digital cinema, and television content.

We manage our businessthrough three reportable segments—our consumer business, our cinema business,and our digital images business.

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

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In our cinema business, wederive revenues from sales of our playback equipment and cinema processors tomovie theaters and special venues. In addition, we license technology and sellencoding and duplication services to film producers and distributors for thecreation of digital multi-channel motion picture soundtracks. We also deriverevenues from the sale of systems and encoding services for digital cinema,pre-show advertising, alternative content, subtitling, captioning, anddescriptive narration.

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

In January 2007, wecombined our Cinema and Digital Images businesses into a single business knownas DTS Digital Cinema. In February 2007, our Board of Directors approved aplan to sell our DTS Digital Cinema business to enable us to focus exclusively onlicensing branded entertainment technology to the large and evolving audio,game console, personal computer, portable and broadcast markets. The salesprocess has begun and is expected to conclude later in 2007. The DTS DigitalCinema business will focus on the potentially large and emerging market fordigital cinema products and services.

We present revenues in ourconsolidated financial statements and in this “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” as derived from (i) technologyand film licensing and (ii) product sales and other revenues. Ourtechnology and film licensing revenues are derived from each of our consumerand cinema business segments. Revenues from technology licensing in connectionwith our consumer business segment include revenues derived from licensing ouraudio technology, 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 our professional audio products andservices and sales of music titles that we produce in our digital multi-channelformat. Revenues from product sales and other revenues in connection with ourcinema business segment include revenues derived from sales of our digitalplayback systems, cinema processor equipment, and systems for subtitling,captioning, and descriptive narration to movie theaters and special venues.Revenues from product sales and other revenues in connection with our digitalimages business segment include fees for processing, enhancing and restoringcinema, home video and broadcast television content.

We actively engage inintellectual property compliance and enforcement activities focused onidentifying third parties who have either incorporated our technology,trademarks, or know-how without a license or who have under-reported the amountof royalties owed under license agreements with us. We continue to invest inour compliance and enforcement infrastructure to support the value of ourintellectual property to us and our licensees and to improve the long-termrealization of revenue from our intellectual property. As a result of theseactivities, from time to time, we recognize royalty revenues that relate to consumerelectronics manufacturing activities from prior periods. These royaltyrecoveries may cause revenues to be higher than expected during a particularreporting period and may not occur in subsequent periods. While we considersuch revenues to be a regular part our normal operations, we cannot predict theamount or timing of such revenues.

Our cost of goods soldconsists primarily of amounts paid for products and materials, salaries andrelated benefits for production personnel, stock-based compensation,depreciation of production equipment, amortization of acquired intangibles andpayments to third parties for licensing technology and copyrighted material.

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

Our research anddevelopment costs consist primarily of salaries and related benefits forresearch and development personnel, stock-based compensation, engineeringconsulting expenses associated with new product and technology development, andquality assurance and testing costs. Research and development costs areexpensed as incurred.

In our consumer business,we have a licensing team that markets our technology directly to large consumerelectronics products manufacturers and semiconductor manufacturers. This teamincludes employees located in the United States, China, England, Japan, HongKong, Northern Ireland, and Taiwan. We sell music content released under ourDTS Entertainment label through exclusive distribution arrangements in theUnited States, Canada, Europe and Japan. We employ consultants to coordinatesales to independent retailers and we sell this music directly to consumersthrough an online store and other web-based retailers.

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

**Management Discussion Regarding Trends, Opportunities,and Challenges**

***New StrategicInitiatives***

In January 2007, Euro1080, a European high definition media company, entered into an agreement withus to become the first broadcaster to deploy the combined Coding Technologiesand DTS solution.

On February 20, 2007,we announced that our Board of Directors approved a plan to sell our DTSDigital Cinema business to enable us to focus exclusively on licensing brandedentertainment technology to the large and evolving audio, game console,personal computer, portable and broadcast markets. The sales process has begunand is expected to conclude later in 2007. The DTS Digital Cinema business willfocus on the emerging and potentially large market for digital cinema productsand services. Beginning in the first quarter of 2007, we expect to reportfinancial results related to our DTS Digital Cinema business as “discontinuedoperations.”

The trend in the motionpicture industry and movie exhibition market toward digital delivery ofentertainment content continues to gain momentum and we believe it presents along-term opportunity for the expansion of our cinema business. As part of ourstrategy to pursue opportunities in the digital cinema market, we signed anexclusive license agreement and an option agreement with Avica, a provider ofproducts and services for the digital cinema market. We believe Avica’s suiteof digital cinema technologies, products and services will complement ourexisting cinema product offerings and will accelerate our entry into thedigital cinema market.

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***Trends,Opportunities, and Challenges by Business Segment***

**Consumer Segment**

Revenue from our consumersegment constitutes the majority of our total revenues, representing 68%, 64%and 64% of total revenues for the years ended December 31, 2004, 2005 and2006, respectively. Our consumer revenue is primarily dependent upon the hometheater and DVD player markets, which have experienced rapid growth over the pastseveral years. However, we have recently experienced softness in our DVD playertrademark licensing program, and expect declines from recent levels in thisarea. The success of DVD-Video-based systems and products has fueled a demandfor higher quality entertainment in the home, and this demand is extending tothe car audio and personal computer markets as well. In addition, we expect therecent acceleration of the market for high definition televisions to drivedemand for high definition optical disc players. Because we have been selectedas a mandatory technology for HD-DVD and Blu-ray players, our consumer revenuegrowth should more closely track the growth rate for sales of these playersover the next several years. We expect that the market for high definitionplayers will yield new growth that provides an offset to the expected declinein the overall growth in standard definition DVD player shipments. Further, webelieve that expected mandatory inclusion in HD-DVD and Blu-ray optical discstandards will help to improve the adoption rate of our technologies in otherconsumer products such as next generation video game consoles, personal audioand video players, personal computers, broadcast applications and in-carentertainment systems.

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 cinemasegment represented 32%, 29% and 26% of total revenues for the years ended December 31,2004, 2005 and 2006, respectively. Sales of cinema products and film licensingtend to fluctuate based on the underlying trends in the motion picture industry.We believe that the cinema exhibition community has begun to defer purchases ofdigital multi-channel audio equipment as they evaluate the pace of progress inthe emerging digital cinema market as discussed below. Accordingly, we expectour cinema hardware business to continue to decline as exhibitors evaluatetheir digital cinema alternatives. We also believe that the cinema exhibitioncommunity has recognized that pre-show entertainment represents a significantrevenue growth opportunity that will lead to investment in pre-show solutionsover the next several years. Because our XD10 Cinema Media Player can beconfigured to perform audio playback along with pre-show and subtitlingpresentation, we believe that we are well-positioned to participate in theanticipated growth in this market.

A trend that we believewill affect our cinema business segment is the long-term trend toward digitaldistribution of content. We believe this trend will involve the near-termadoption of digital pre-show and/or electronic cinema solutions, andincreasingly the adoption of higher quality digital cinema. Digitaldistribution of content offers the motion picture industry a means to achievesubstantial cost savings, including with respect to the printing anddistribution of movies, help in combating piracy, and will enable movies to beplayed repeatedly without degradation. It also provides additional revenueopportunities for cinema operators, as digital content such as advertisements,concerts and sporting events could be shown in or broadcast to digitallyequipped theaters. In recent months, there has been increasing momentum in 

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thedigital cinema industry, as product and service vendors attempt to find aviable business model. We believe that these activities represent an importantand significant step in the transition. We believe this represents anopportunity for us as we seek to provide products and services in support ofthe transition from film-based content towards digital cinema. However, ourcurrent digital cinema offerings are limited and we may not be successful indeveloping or selling competitive product offerings. We believe that theaddition of our Cinema Media Network and variable bit rate JPEG 2000 encodingtools, along with the services provided by our digital images business, and thepre-show and alternative content capabilities of our XD10 Cinema Media Player,combined with the addition of the products, technologies and know-how obtainedunder our exclusive license agreement with Avica, will enhance our ability toparticipate in the industry transition to high definition sound and images fordigital cinema. Already in 2007, we have installed a trial deployment of 25digital cinema systems in Ireland, which allows the exhibition of digitalcinema content. The content was digitally enhanced, encoded, packaged anddelivered by our digital images and content services group in a fully DCIcompliant form.

**Digital Images Segment**

Revenue from our digitalimages segment, which we acquired in January 2005, represented 7% and 10%of total revenues for the years ended December 31, 2005 and 2006,respectively. We believe that the growing market for high resolution and highdefinition content in the cinema and the home will create a substantial demandfor the type of services provided by DTS DI. A relatively new application forour process is the correction of problems encountered with the use of digitalcameras, enabling our involvement at the earliest stages of digital contentdevelopment. We believe that we provide leading digital lab capabilities,including digital enhancement, restoration and other pre-compression servicesand that we have a technological advantage over many of our competitors basedon the sophistication of our processes and level of automation used to enhancethe image quality of entertainment content. During 2006, as a result of theenhancement of the technology platform, we were able to complete more thanthree times the number of projects than in 2005, improve gross margins and gainaccess to newer and faster growing markets including pre-compression processingand digital cinema content preparation. To date, this business has enhancedand/or restored over 100 feature films, including such major DVD releases asStar Wars, James Bond 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.

**Critical Accounting Policies and Estimates**

Management’s Discussionand Analysis of Financial Condition and Results of Operations are based uponour consolidated financial statements, which have been prepared in accordancewith accounting principles generally accepted in the United States. Thepreparation of our financial statements requires us to make estimates andjudgments that affect the reported amounts of assets, liabilities, revenues,and expenses, and related disclosure of contingent assets and liabilities. Onan on-going basis, estimates and judgments are evaluated, including thoserelated to revenue recognition, allowance for doubtful accounts, inventories,goodwill and intangible assets, income taxes, impairment of long-lived assets,product warranty, and stock-based compensation. These estimates and judgmentsare based on historical experience and on various other assumptions that webelieve to be reasonable under the circumstances, which form the basis for ourjudgments about the carrying values of assets and liabilities not readilyapparent from other sources. By their nature, estimates are subject to aninherent degree of uncertainty. Actual results may differ from these estimates.

Webelieve the following critical accounting policies, among others, affect ourmore significant judgments and estimates used in the preparation of ourconsolidated financial statements.

·       *Revenue Recognition.  *We recognize revenues inaccordance with the guidelines of the SEC Staff Accounting Bulletin, or SAB,No. 101 as amended by SAB No. 104 “Revenue Recognition in 

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Financial Statements.”Revenues frommultiple-element arrangements involving license fees, up-front payments andmilestone payments, which are received and/or billable by us in connection withother rights and services that represent continuing obligations of ours, aredeferred until all of the elements have been delivered or until we haveestablished objective and verifiable evidence of the fair value of theundelivered elements.

Arrangements withmultiple elements or deliverables must be segmented into individual units ofaccounting based on the separate deliverables only if there is objective andverifiable evidence of fair value to allocate the consideration received to thedeliverables. Accordingly, revenues from multiple-element arrangementsinvolving license fees, up-front payments and milestone payments, which arereceived and/or billable in connection with other rights and services thatrepresent continuing obligations of ours, are deferred until all of themultiple elements have been delivered or until objective and verifiableevidence of the fair value of the undelivered elements has been established.Upon establishing objective and verifiable evidence of the fair value of theelements in multiple-element arrangements, the fair value is allocated to eachelement of the arrangement, such as products or additional add-ons, based onthe relative fair values of the elements. We determine the fair value of eachelement in multiple-element arrangements based on objective and verifiableevidence of fair value, which is determined for each element based on the pricecharged when the same element is sold separately to a third party. If objectiveand verifiable evidence of fair value of all undelivered elements exists butobjective and verifiable evidence of fair value does not exist for one or moredelivered elements, then revenue is recognized using the residual method. Underthe residual method, the revenues from delivered elements are not recognizeduntil the fair value of the undelivered element(s) have been determined.Significant contract interpretation is sometimes required to determine theappropriate accounting, including whether the deliverables specified in amultiple element arrangement should be treated as separate units of accountingfor revenue recognition purposes, and if so, how the price should be allocatedamong the deliverable elements, when to recognize revenue for each element, andthe period over which revenue should be recognized. Changes in the allocationof the sales price between delivered to undelivered elements might impact thetiming of revenue recognition, but would not change the total revenuerecognized on the contract.

We are responsiblefor the licensing and enforcement of our patented technologies and pursue thirdparties that are utilizing our intellectual property without a license or whohave under-reported the amount of royalties owed under a license agreement withus. As a result of these activities, from time to time, we may recognizeroyalty revenues that relate to infringements that occurred in prior periods.These royalty recoveries may cause revenues to be higher than expected during aparticular reporting period and may not occur in subsequent periods.Differences between amounts initially recognized and amounts subsequently auditedor reported 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 

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are fixed or determinable,and collection of the related receivable is reasonably assured. The licensing,encoding and duplication of motion picture soundtracks for use in our playbacksystems is undertaken under arrangements with major film studios. Revenuesarising from the licensing and duplication of soundtracks are recognized uponcompletion, assuming prices are fixed or determinable, we have no significantobligations remaining, and collection of the related receivable is reasonablyassured. 

Revenues from licensing audiotechnology, trademarks, and know-how are generated from licensing agreementswith consumer electronics products manufacturers that generally pay a per-unitlicense fee for products manufactured under those license agreements. Licenseesgenerally report manufacturing information within 30 to 60 days after theend of the quarter in which such activity takes place. Consequently, werecognize revenue from these licensing agreements on a three-month lag basis,generally in the quarter following the quarter of manufacture, provided amountsare fixed or determinable and collection is reasonably assured. Use of this lagmethod allows for the receipt of licensee royalty reports prior to therecognition of revenue, since we cannot reliably estimate the amount of revenueearned prior to our receipt of such reports. Revenues from the sale of digitalmulti-channel audio and video content are recorded upon shipment to retailaccounts or end customers, assuming title and risk of loss has transferred,prices are fixed or determinable, we have no significant obligations remaining,and collection of the related receivable is reasonably assured. We provide forreturns on product sales based on historical experience and adjust suchreserves as considered necessary. To date, there have been no significant salesreturns.

Revenues from digitalimage enhancement, restoration and repair are recognized when elements of acustomer order or contract are delivered and accepted by the customer and nosignificant obligations remain. Prices are established in advance of the workperformed and are generally fixed in nature. Revenue related to time andmaterials contracts is recognized as services are rendered at contract laborrates plus material and other direct costs incurred. If losses are anticipatedon a contract, such losses are recognized immediately.

We believe these to becritical accounting policies because if actual results vary from our estimatesand assumptions, it could have a material impact on our reported sales andresults of operations.

·       *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.Estimates could be influenced by sudden declines in demand due to economicdownturns, rapid product improvements, and technological changes. We believethis to be a critical accounting policy because if actual market conditions areless favorable than our forecasts, additional inventory reserves may berequired which could have a material impact on our results of operations.

·       *Goodwill.  *We currently evaluate goodwill, inaccordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” forimpairment whenever events or changes in circumstances indicate the carryingvalue of an asset may not be recoverable. We also evaluate goodwill forimpairment on an annual basis during the fourth quarter of each year. Inassessing the recoverability of goodwill, we must make assumptions regardingestimated future cash flows and other factors, including the discount rateused, to calculate the fair value of the respective assets. Assumptions aboutestimated future cash flows require significant judgments around futurerevenues, future expenses, working capital investments, capital expendituresbased on industry norms, and the current state of the economy. In calculatingthe estimated fair value of our reporting units, we have used a discounted 

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cash flow model. Webelieve this to be a critical accounting policy because if those estimates orrelated assumptions change in the future, we may be required to recordimpairment charges for these assets which could have a material impact on ourresults of operations. While we believe the likelihood of an impairment of ourCinema and Digital Images reporting units is remote, there can be no assurancethat our decision to sell these assets subsequent to year end will not resultin an impairment.

·       *Impairment of Long-Lived Assets and Intangibles.  *Weperiodically assess potential impairments of our long-lived assets and intangiblesin accordance with the provisions of SFAS 144, “Accounting for the Impairmentor Disposal of Long-lived Assets.” An impairment review is performed wheneverevents or changes 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. We believe this to be a criticalaccounting policy because if those estimates or related assumptions change inthe future, we may be required to record impairment charges for these assetswhich could have a material impact on our results of operations. While webelieve the likelihood of an impairment of our Cinema and Digital Imagesreporting units is remote, there can be no assurance that our decision to sellthese assets subsequent to year end will not result in an impairment.

·       *Stock-based Compensation.  *Upon adoption of SFAS 123(R) inJanuary of 2006, we began incurring significant charges to the statementof operations for stock-based compensation. These charges are based upon thefair value of each employee option on the date of grant using the Black-Scholesoption pricing model. This model requires that we estimate a risk free interestrate, expected lives, dividend yield, and the expected volatility of our stock.In March 2005, the SEC issued Staff Accounting Bulletin (“SAB”) No. 107relating to SFAS 123(R). We have applied the provisions of SAB 107 in ouradoption of SFAS 123(R). We believe this to be a critical accounting policybecause if any of the estimates above require significant changes, thesechanges could result in expenses that could have a material impact on ourresults of operations.

·       *Income taxes.  *We must make certain estimates andjudgments in determining income tax expense for financial statement purposes.These estimates and judgments occur in the calculation of certain tax assetsand liabilities, 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, 2006, we believe that all ofthe deferred tax assets recorded on our balance sheet would ultimately berecovered. We believe this to be a critical accounting policy because shouldthere be a change in our ability to recover our deferred tax assets, our taxprovision would increase in the period in which we determine that the recoveryis not probable, which could have a material impact on our results ofoperations.

Income taxes receivable,net, at December 31, 2005 and 2006, includes estimated tax contingenciesof $1.4 million and $0.7 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.

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**Segment andGeographic Information**

During the first quarter of 2007, we announced thatour Board of Directors approved a plan to sell our DTS Digital Cinema business,which is comprised of our Cinema business segment and Digital Images businesssegment. Therefore, we have included a subtotal representing the DTS DigitalCinema business.

Our reportable segment andgeographic information is as follows (in thousands):

| ** **                  | ** ** | **Revenues by Segment**                         | ** ** |
|-----------------------------|------------|-----------------------------------------------------------|------------|
| ** **                  | ** ** | **For the Years Ended  December 31,** | ** ** |
| ** **                  | ** ** | **2004**                                                  | ** ** | **2005** | ** ** | **2006** | ** ** |
| Consumer business           |       | $                                                         | 41,886     |   | $ | 48,180 | ** ** | **$** | **50,039** | ** ** |
| Cinema business             |       | 19,545                                                    |       | 21,744 | ** ** | **20,260** | ** ** |
| Digital Images  business    |       | —                                                    |       | 5,328 | ** ** | **8,015** | ** ** |
| DTS Digital Cinema business |       | 19,545                                                    |       | 27,072 | ** ** | **28,275** | ** ** |
| Total revenues              |       | $                                                         | 61,431     |   | $ | 75,252 | ** ** | **$** | **78,314** | ** ** |

 

| ** **                  | ** ** | **Gross Profit by Segment**                | ** ** |
|-----------------------------|------------|-----------------------------------------------------------|------------|
| ** **                  | ** ** | **For the Years Ended  December 31,** | ** ** |
| ** **                  | ** ** | **2004**                                                  | ** ** | **2005** | ** ** | **2006** | ** ** |
| Consumer business           |       | $                                                         | 39,821     |   | $ | 45,970 | ** ** | **$** | **48,345** | ** ** |
| Cinema business             |       | 5,448                                                     |       | 10,618 | ** ** | **9,793** | ** ** |
| Digital Images  business    |       | —                                                    |       | (949 | ) | **(228** | **)** |
| DTS Digital Cinema business |       | 5,448                                                     |       | 9,669 | ** ** | **9,565** | ** ** |
| Total gross  profit         |       | $                                                         | 45,269     |   | $ | 55,639 | ** ** | **$** | **57,910** | ** ** |

 

| ** **                           | ** ** | **Income (Loss) From Operations  by Segment** | ** ** |
|--------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                           | ** ** | **For the Years Ended  December 31,**         | ** ** |
| ** **                           | ** ** | **2004**                                                          | ** ** | **2005** | ** ** | **2006** | ** ** |
| Consumer business                    |       | $                                                                 | 19,969     |   | $ | 21,139 | ** ** | **$** | **15,130** | ** ** |
| Cinema business                      |       | (8,475                                                            | )          | (4,051 | ) | **(10,025** | **)** |
| Digital Images  business             |       | —                                                            |       | (7,576 | ) | **(6,186** | **)** |
| DTS Digital Cinema business          |       | (8,475                                                            | )          | (11,627 | ) | **(16,211** | **)** |
| Total income  (loss) from operations |       | $                                                                 | 11,494     |   | $ | 9,512 | ** ** | **$** | **(1,081** | **)** |

 

| ** **           | ** ** | **Revenues by Geographic Region**          | ** ** |
|----------------------|------------|-----------------------------------------------------------|------------|
| ** **           | ** ** | **For the Years Ended  December 31,** | ** ** |
| ** **           | ** ** | **2004**                                                  | ** ** | **2005** | ** ** | **2006** | ** ** |
| United States        |       | $                                                         | 17,830     |   | $ | 27,157 | ** ** | **$** | **23,168** | ** ** |
| Japan                |       | 17,516                                                    |       | 18,870 | ** ** | **18,316** | ** ** |
| Taiwan               |       | 279                                                       |       | 3,251 | ** ** | **10,309** | ** ** |
| South Korea          |       | 7,772                                                     |       | 8,248 | ** ** | **7,847** | ** ** |
| China                |       | 6,936                                                     |       | 6,702 | ** ** | **3,365** | ** ** |
| Other  international |       | 11,098                                                    |       | 11,024 | ** ** | **15,309** | ** ** |
| Total international  |       | 43,601                                                    |       | 48,095 | ** ** | **55,146** | ** ** |
| Total revenues       |       | $                                                         | 61,431     |   | $ | 75,252 | ** ** | **$** | **78,314** | ** ** |

 

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The following table sets forth, for the periodsindicated, long-lived assets by geographic region:

| ** **               | ** ** | **Long-Lived Assets**            | ** ** |
|--------------------------|------------|---------------------------------------|------------|
| ** **               | ** ** | **As of December 31,** | ** ** |
| ** **               | ** ** | **2004**                              | ** ** | **2005** | ** ** | **2006** | ** ** |
| United States            |       | $                                     | 3,099      |   | $ | 5,859 | ** ** | **$** | **9,694** | ** ** |
| International            |       | 2,219                                 |       | 1,516 | ** ** | **1,644** | ** ** |
| Total long-lived  assets |       | $                                     | 5,318      |   | $ | 7,375 | ** ** | **$** | **11,338** | ** ** |

 

**Results ofOperations**

***Revenues***

| ** **                        | ** ** | ** **                     | ** ** | ** ** | ** ** | ** **   | ** ** | ** ** | ** ** | ** **   | ** ** | ** ** | ** ** | **Twelve Months Ended  December 31,** | ** ** |
|-----------------------------------|------------|--------------------------------|------------|------------|------------|--------------|------------|------------|------------|--------------|------------|------------|------------|------------------------------------------------------|------------|
| ** **                        | ** ** | ** **                     | ** ** | ** ** | ** ** | ** **   | ** ** | ** ** | ** ** | ** **   | ** ** | ** ** | ** ** | **2006 vs. 2005**                          | ** ** | **2005 vs. 2004** | ** ** |
| ** **                        | ** ** | **2006**                       | ** ** | **2005**   | ** ** | **2004**     | ** ** | **Change** | ** ** | **Change**   | ** ** |
| ** **                        | ** ** | **Revenues**                   | ** ** | **%**      | ** ** | **Revenues** | ** ** | **%**      | ** ** | **Revenues** | ** ** | **%**      | ** ** | **$**                                                | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                        | ** ** | **($ in thousands)** | ** ** |       |
| Technology and film  licensing    |       |                           | $          | 59,053     |       |         | 75%        |       |       | $            | 56,947     |       |       | 76%                                                  |       |   | $ | 49,920 |   |   | 81% |   | $ | 2,106 |   | 4% |   | $ | 7,027 |   | 14% |   |
| Product sales and other  revenues |       |                           | 19,261     |       |       | 25%          |       |       | 18,305     |         |       | 24%        |       |                                                 | 11,511     |   |   | 19% |   | 956 |   | 5% |   | 6,794 |   | 59% |   |
| Total                             |       |                           | $          | 78,314     |       |         | 100%       |       |       | $            | 75,252     |       |       | 100%                                                 |       |   | $ | 61,431 |   |   | 100% |   | $ | 3,062 |   | 4% |   | $ | 13,821 |   | 22% |   |
|                                   |            |                                |            |            |            |              |            |            |            |              |            |            |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Technology and FilmLicensing*

Technology and film licensing revenues for the yearended December 31, 2006 increased compared to the year ended December 31,2005 primarily due to strong growth in the car audio systems and personalcomputer markets, which posted year over year growth totals of 81% and 20%,respectively. However, we remain cautious in our revenue outlook due touncertainties surrounding the expected transition to high definition opticaldisc formats. Overall, we continue to expect technology licensing revenues togrow modestly for 2007, based primarily on the expected continuation of growthin our decoder licensing program and our mandatory inclusion in both the HD-DVDand Blu-ray disc formats. Our film licensing revenues increased slightly in2006 compared to the prior year due to additional releases in the DTS formatand the timing of major feature film releases. Film licensing revenue isexpected to remain relatively flat in 2007.

Technology and filmlicensing revenues for the year ended December 31, 2005 increased comparedto the year ended December 31, 2004 primarily driven due to an increase inroyalty recoveries of $7.3 million from intellectual property compliance andenforcement activities in 2005 relative to the prior year. These activities,which included audits of shipments by certain of our licensees and legalactions taken against licensees and parties who are not our licensees, resultedin recoveries of royalties due from prior periods. We experienced good growthin our personal computer licensing and in car audio systems, which posted yearover year growth totals of 150% and 21%, respectively, in 2005. Our filmlicensing revenues increased slightly in 2005 compared to the prior year due toadditional releases in the DTS format and the timing of major feature filmreleases.

*Product Sales andOther*

Product sales and other revenues increased for theyear ended December 31, 2006 compared to the year ended December 31,2005 primarily due to a 50% increase in revenues generated by DTS DI as aresult of the completion of certain significant projects, and ongoingimprovements in our digital enhancement and restoration processes. Partiallyoffsetting the growth in DTS DI revenues is a decrease in U.S. hardware salesfor 2006 resulting from the exhibition community’s hesitation to purchasecinema hardware during the early stages of the industry’s transition to digitalcinema.

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Product sales and otherrevenues increased for the year ended December 31, 2005 compared to theyear ended December 31, 2004 primarily due to the revenues generated byDTS 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.

*Segment Revenues*

| ** **                  | ** ** | ** **                     | ** ** | ** ** | ** ** | ** **   | ** ** | ** ** | ** ** | ** **   | ** ** | ** ** | ** ** | **Twelve Months Ended  December 31,** | ** ** |
|-----------------------------|------------|--------------------------------|------------|------------|------------|--------------|------------|------------|------------|--------------|------------|------------|------------|------------------------------------------------------|------------|
| ** **                  | ** ** | ** **                     | ** ** | ** ** | ** ** | ** **   | ** ** | ** ** | ** ** | ** **   | ** ** | ** ** | ** ** | **2006 vs. 2005**                          | ** ** | **2005 vs. 2004** | ** ** |
| ** **                  | ** ** | **2006**                       | ** ** | **2005**   | ** ** | **2004**     | ** ** | **Change** | ** ** | **Change**   | ** ** |
| ** **                  | ** ** | **Revenues**                   | ** ** | **%**      | ** ** | **Revenues** | ** ** | **%**      | ** ** | **Revenues** | ** ** | **%**      | ** ** | **$**                                                | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                  | ** ** | **($ in thousands)** | ** ** |
| Consumer business           |       |                           | $          | 50,039     |       |         | 64%        |       |       | $            | 48,180     |       |       | 64%                                                  |       |   | $ | 41,886 |   |   | 68% |   | $ | 1,859 |   | 4% |   | $ | 6,294 |   | 15% |   |
| Cinema business             |       |                           | 20,260     |       |       | 26%          |       |       | 21,744     |         |       | 29%        |       |                                                 | 19,545     |   |   | 32% |   | (1,484 | ) | (7% | ) | 2,199 |   | 11% |   |
| Digital Images business     |       |                           | 8,015      |       |       | 10%          |       |       | 5,328      |         |       | 7%         |       |                                                 | —     |   |   | 0% |   | 2,687 |   | 50% |   | 5,328 |   | 100% |   |
| DTS Digital Cinema business |       |                           | 28,275     |       |       | 36%          |       |       | 27,072     |         |       | 36%        |       |                                                 | 19,545     |   |   | 32% |   | 1,203 |   | 4% |   | 7,527 |   | 39% |   |
| Total                       |       |                           | $          | 78,314     |       |         | 100%       |       |       | $            | 75,252     |       |       | 100%                                                 |       |   | $ | 61,431 |   |   | 100% |   | $ | 3,062 |   | 4% |   | $ | 13,821 |   | 22% |   |

 

The increase in revenues from our consumer businessfor the year ended December 31, 2006 compared to the year endedDecember 31, 2005 was driven primarily by an increase in the car audio andpersonal computer markets as mentioned above. The decrease in revenues from ourcinema business for the year ended December 31, 2006 compared to the yearended December 31, 2005 was primarily driven by a slowdown in cinema hardwaresales during 2006 as mentioned above. The increase in revenues from our digitalimages business for the year ended December 31, 2006 compared to the yearended December 31, 2005 was primarily driven by the completion of certainsignificant projects, and ongoing improvements in our digital enhancement andrestoration processes.

The increase in revenues from our consumer businessfor the year ended December 31, 2005 compared to the year endedDecember 31, 2004 was driven primarily by an increase in royalty recoveriesas mentioned above as well as overall growth in our personal computer and caraudio markets. The increase in revenues from our cinema business for the yearended December 31, 2006 compared to the year ended December 31, 2005was primarily driven by an increase in cinema hardware revenues. Revenues fromour digital images business were included in our operations for the first timeduring the year ended December 31, 2005.

***Gross Profit***

| ** **                        | ** ** | ** **                     | ** ** | ** **   | ** ** | ** ** | ** ** | ** **                                | ** ** | ** ** | ** ** | ** **   | ** ** | **Percentage point change**     | ** ** |
|-----------------------------------|------------|--------------------------------|------------|--------------|------------|------------|------------|-------------------------------------------|------------|------------|------------|--------------|------------|-------------------------------------------|------------|
| ** **                        | ** ** | **2006**                       | ** ** | **2005**     | ** ** | **2004**   | ** ** | **in gross profit margin** | ** ** |
| ** **                        | ** ** | **Gross**                      | ** ** | **Relative** | ** ** | **Gross**  | ** ** | **Relative**                              | ** ** | **Gross**  | ** ** | **Relative** | ** ** | **relative to prior year** | ** ** |
| ** **                        | ** ** | **Profit**                     | ** ** | **%**        | ** ** | **Profit** | ** ** | **%**                                     | ** ** | **Profit** | ** ** | **%**        | ** ** | **2006 vs. 2005**               | ** ** | **2005 vs. 2004** | ** ** |
| ** **                        | ** ** | **($ in thousands)** | ** ** |
| Technology and film  licensing    |       | $                         | 54,284     |         |       | 92         | %          |                                      | $     | 52,232     |       |         | 92         | %                                         |       | $  | 45,469 |   |   | 91 | % |   |   | 0 | % |   |   | 1 | % |   |
| Product sales and other  revenues |       | 3,626                          |       |         | 19         | %          |       | 3,407                                     |       |       | 19         | %            |       | (200                                      | )          |   | (2 | )% |   |   | 0 | % |   |   | 21 | % |   |
| Total                             |       | $                              | 57,910     |         |       | 74         | %          |                                      | $          | 55,639     |       |         | 74         | %                                         |       | $ | 45,269 |   |   | 74 | % |   |   |   |   |   |   |   |   |   |

 

Consolidated gross profitpercentage for the years ended December 31, 2006, 2005 and 2004 remainedconsistent. We expect consolidated gross margins in the 70% to 75% range for2007. However, because we expect to report our DTS Digital Cinema business as adiscontinued operations in 2007, we expect gross margins from our ongoingconsumer business in the 97% to 98% range for 2007.

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*Technology and FilmLicensing*

Gross profit percentageassociated with technology and film licensing revenues was consistent for theyears ended December 31, 2006 and 2005. We expect this rate to increaseslightly during 2007 due to a higher mix of technology licensing relative tofilm licensing. However, because we expect to report our DTS Digital Cinemabusiness as a discontinued operations in 2007, we expect gross margin fromtechnology licensing to exceed 98% in 2007.

*Product Sales andOther*

Gross profit percentageassociated with product sales and other revenues was consistent for the yearsended December 31, 2006 and 2005. The gross profit percentage increase forthe year ended December 31, 2005 is due to the write-off of subtitlingprojector inventories in 2004.

*Segment Gross Profit*

| ** **                  | ** ** | ** **                     | ** ** | ** **   | ** ** | ** ** | ** ** | ** **                                | ** ** | ** ** | ** ** | ** **   | ** ** | **Percentage point change**     | ** ** |
|-----------------------------|------------|--------------------------------|------------|--------------|------------|------------|------------|-------------------------------------------|------------|------------|------------|--------------|------------|-------------------------------------------|------------|
| ** **                  | ** ** | **2006**                       | ** ** | **2005**     | ** ** | **2004**   | ** ** | **in gross profit margin** | ** ** |
| ** **                  | ** ** | **Gross**                      | ** ** | **Relative** | ** ** | **Gross**  | ** ** | **Relative**                              | ** ** | **Gross**  | ** ** | **Relative** | ** ** | **relative to prior year** | ** ** |
| ** **                  | ** ** | **Profit**                     | ** ** | **%**        | ** ** | **Profit** | ** ** | **%**                                     | ** ** | **Profit** | ** ** | **%**        | ** ** | **2006 vs. 2005**               | ** ** | **2005 vs. 2004** | ** ** |
| ** **                  | ** ** | **($ in thousands)** | ** ** |
| Consumer business           |       | $                              | 48,345     |         |       | 97         | %          |                                      | $          | 45,970     |       |         | 95         | %                                         |       | $ | 39,821 |   |   | 95 | % |   |   | 2 | % |   |   | 0 | % |   |
| Cinema business             |       | 9,793                          |       |         | 48         | %          |       | 10,618                                    |       |       | 49         | %            |       | 5,448                                     |       |   | 28 | % |   |   | (1 | )% |   |   | 21 | % |   |
| Digital Images business     |       | (228                           | )          |         | (3         | )%         |       | (949                                      | )          |       | (18        | )%           |       | —                                    |       |   | 0 | % |   |   | 15 | % |   |   | (18 | )% |   |
| DTS Digital Cinema business |       | 9,565                          |       |         | 34         | %          |       | 9,669                                     |       |       | 36         | %            |       | 5,448                                     |       |   | 28 | % |   |   | (2 | )% |   |   | 8 | % |   |
| Total                       |       | $                              | 57,910     |         |       | 74         | %          |                                      | $          | 55,639     |       |         | 74         | %                                         |       | $ | 45,269 |   |   | 74 | % |   |   |   |   |   |   |   |   |   |

 

Gross profit percentageassociated with our consumer business for the year ended December 31, 2006increased compared to the year ended December 31, 2005 due to the increasein licensing revenues, as mentioned above. Gross profit percentage associatedwith our cinema business decreased slightly for the year ended December 31,2006 compared to the year ended December 31, 2005 due to the decline incinema hardware sales as mentioned above. The increase in gross profitpercentage for the cinema business for the year ended December 31, 2005 ascompared to the year ended December 31, 2004 is primarily due to theprojector inventory write-off in 2004.

***Selling, Generaland Administrative (“SG&A”)***

| ** ** | ** ** | **SG&A**                   | ** ** | **Percent of** | ** ** | **Change  relative to  prior year** | ** ** |
|------------|------------|--------------------------------|------------|---------------------|------------|-----------------------------------------------|------------|
| ** ** | ** ** | **Expenses**                   | ** ** | **Revenues**        | ** ** | **$**                                         | ** ** | **%** | ** ** |
| ** ** | ** ** | **($ in thousands)** | ** ** |
| 2006       |       | $                              | 41,754     |                |       | 53                                            | %          |   | $ | 7,794 |   | 23 | % |
| 2005       |       | $                              | 33,960     |                |       | 45                                            | %          |   | $ | 6,316 |   | 23 | % |
| 2004       |       | $                              | 27,644     |                |       | 45                                            | %          |   |   |   |   |   |

 

SG&A expenses increased for the year ended December 31,2006, compared to the prior year period as salaries and related costs increased$3.6 million due to increased headcount to support our growth. With theadoption of SFAS No. 123(R) during 2006, SG&A expenses alsoinclude additional stock-based compensation charges totaling $3.0 million. Theconsolidation of Avica into our operations increased SG&A expenses by $0.2million for 2006, compared to 2005.

SG&A expensesincreased for the year ended December 31, 2005, compared to the prior yearperiod primarily due to increased salaries and related costs of $3.5 million aswe increased headcount to support our growth. Other expenses related to growthof our operations, such as depreciation, travel and 

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entertainment,increased approximately $0.8 million. Also contributing to the increase was$1.6 million relating to the inclusion of DTS DI in our results of operations.

***Research andDevelopment (“R&D”)***

| ** ** | ** ** | **R&D**                    | ** ** | **Percent of** | ** ** | **Change  relative to  prior year** | ** ** |
|------------|------------|--------------------------------|------------|---------------------|------------|-----------------------------------------------|------------|
| ** ** | ** ** | **Expenses**                   | ** ** | **Revenues**        | ** ** | **$**                                         | ** ** | **%** | ** ** |
| ** ** | ** ** | **($ in thousands)** | ** ** |
| 2006       |       | $                              | 12,334     |                |       | 16                                            | %          |   | $ | 2,467 |   | 25 | % |
| 2005       |       | $                              | 9,867      |                |       | 13                                            | %          |   | $ | 3,736 |   | 61 | % |
| 2004       |       | $                              | 6,131      |                |       | 10                                            | %          |   |   |   |   |   |

 

R&D expenses increased for the year ended December 31,2006, compared to the prior year period primarily due to increased salaries andrelated costs of $2.0 million as we increased headcount to support our growthand new product initiatives. With the adoption of SFAS No. 123(R) during2006, R&D expenses also include additional stock based compensation chargesof $0.5 million.

R&D expenses increasedfor the year ended December 31, 2005, compared to the prior year periodprimarily due to increased salaries and related costs as we increased headcountto support new product initiatives, the optimization of our Coherent Acousticstechnology and the development of tools associated with next generation opticaldisc standards. Also contributing to the increase was $1.1 million relating tothe inclusion of DTS DI R&D activities in our results of operations.

***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 and wereof no future alternative use and expensed upon consummation of the acquisitionof DTS DI. Developed technology and in-process research and development wereidentified and valued through extensive interviews, analysis of data providedby DTS DI concerning development projects, their stage of development, the timeand resources 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 in-process research and development. Key assumptions for in-processresearch and development included a discount rate of 30% and estimates ofrevenue growth, cost of sales, operating expenses and taxes.

***Separation and Restructuring Costs***

Separation and restructuring costs for the year ended December 31,2006, were $4.9 million. These costs relate to three components: (i) theseparation of our business, (ii) to buy out a commission agreement forlicensing intellectual property in the China market and (iii) thewrite-down of DTSE inventory and other assets.

In August 2006, we announced that we werestudying the potential separation of our business and in November 2006, weannounced our intent to proceed with the separation of our Cinema and DigitalImages businesses from our Consumer licensing business. These separation costs,which totaled $1.1 million, consist primarily of legal and accounting expensesrelating to the proposed separation of our business. In February 2007, ourBoard of Directors approved a plan to sell our DTS Digital Cinema business,which we expect to conclude later in 2007. We expect to continue to incur costsrelating to the 

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sale of the DTS DigitalCinema business but cannot currently estimate the amount of any future costsrelating to such sale.

When we started our Consumer operations in China in2003, we engaged a company with a strong presence in China to assist us withcertain aspects of these operations. The agreement called for annual paymentsto the Chinese company based on the profitability of our China subsidiary andcertain other factors. Management decided to take complete control over ourfuture in China. Therefore, we negotiated an early termination of thisagreement, which required us to make a one-time termination payment of $3.0million, which was paid in the fourth quarter of 2006.

During the fourth quarterof 2006, we wrote-down $0.8 million of DTSE inventory and other assets as partof our restructuring effort to redirect the focus of our DTS Entertainmentgroup away from the production and sale of DVD-audio discs toward supportingcontent providers in their adoption of DTS technologies.

***Interest Income, Net***

Interest income, net, forthe year ended December 31, 2006 increased due to the increase in interestrates in 2006 relative to 2005 and higher average investment balances. Interestincome, net, for the year ended December 31, 2005 increased significantlyover the prior year due to the generally improved interest rate environment.

***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 $0.9 million 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***

Our income tax expense was $5.5 million, $4.3 million,and $0.8 million for the years ended December 31, 2004, 2005, and 2006,respectively. The abnormally low 2006 tax expense in relation to our incomebefore tax is due to large amounts of favorable discrete items recorded in thetax provision for 2006. These discrete items include, among other things, thefavorable resolution with the Internal Revenue Service relating toextraterritorial income exclusion, large amounts of tax exempt interest, andFAS 123(R) deductions. These favorable items were partially offset by ournon-deductible separation-related costs and our foreign tax rate differential.

Our rates havehistorically differed from statutory rates due to the benefits of lower foreigntax rates, tax exempt interest, and research and development credits. We expectthe effective tax rate for 2007 to be more closely aligned with the statutoryrates.

**Liquidity andCapital Resources**

At December 31, 2006, we had cash, cashequivalents, and short-term investments of $111.5 million, compared to$111.4 million at December 31, 2005.

At December 31, 2006, we had no balanceoutstanding and $10.0 million of available borrowings under our bank line ofcredit facility, which expires on June 30, 2007 and is renewable annually.The bank facility provides for working capital financing and is unsecured. Thebank agreement requires us to comply with certain covenants including atangible effective net worth of $60.0 million increasing by 50% of net 

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income on an annual basis.The covenants also require us to keep $2.0 million in cash or securities at theissuing bank. Future borrowings will bear interest based on either of the twooptions we select at the time of advances: 1) a rate equal to 2% above theLIBOR, or 2) a rate equal to the Base Rate as quoted from the bank lessone-half percent.

Net cash provided by operating activities was$17.6 million, $9.6 million and $5.4 million for the years endedDecember 31, 2004, 2005 and 2006, respectively. The primary source ofoperating cash flow for 2006 was net income of $3.0 million, adjusted fornon-cash items including depreciation and amortization expense and stock-basedcompensation charges.

We use cash in investing activities primarily topurchase office equipment, fixtures, computer hardware and software,engineering and manufacturing test and certification equipment, for businessand technology acquisitions, for securing patent and trademark protection forour proprietary technology and brand name, and to purchase short-terminvestments such as bank certificates of deposit, municipal bonds and auctionrate securities. Cash used in investing activities totaled $36.8 millionand $24.5 million in the years ended December 31, 2004 and 2006,respectively. Cash provided by investing activities totaled $1.4 millionin the year ended December 31, 2005. Cash used in investing activities forthe year ended December 31, 2006 primarily consists of net purchases ofinvestments of $16.2 million and capital expenditures of $7.1 million.

For the years ended December 31, 2004, 2005 and2006, cash provided by financing activities was $1.3 million, $1.1 millionand $2.9 million, respectively, and consists of the exercise of stock optionsand related tax benefits and sales of stock under our employee stock purchaseplan. Prior to adoption of SFAS No. 123(R), excess tax benefits fromexercise of stock options were shown as an operating cash inflow.

In 2005, we entered into an agreement for the purchaseand implementation of a new enterprise resource planning system, or ERP, forapproximately $0.7 million. We expect that we will incur additional costs inthe range of $1 to $2 million over the next several years in connection withour ERP implementation. Through December 31, 2006, we incurredapproximately $3.8 million, of which $3.2 million has been capitalized tosoftware.

On August 1, 2006, our Board of Directorsauthorized, subject to certain business and market conditions, the purchase ofup to one million shares of our common stock in the open market or in privatelynegotiated transactions. Through March 16, 2007, there were no sharespurchased under this authorization. Any shares repurchased would be consideredtreasury stock.

In August 2006, we announced that we werestudying the potential separation of our business and in November 2006, weannounced our intent to proceed with the separation of our Cinema and DigitalImages businesses from our Consumer licensing business. Through December 31,2006, we incurred approximately $1.1 million in separation costs, consistingprimarily of legal and accounting expenses relating to the separation of ourbusiness. In February 2007, we announced that our Board of Directors hadapproved a plan to sell our DTS Digital Cinema business, which was createdthrough the combination and restructuring of our Cinema and Digital Imagesbusinesses, to enable us to focus exclusively on licensing brandedentertainment technology to the large and evolving audio, game console,personal computer, portable and broadcast markets. The sales process has begunand is expected to conclude later in 2007.

We believe that our cash,cash equivalents, short-term investments, funds available under our existingbank line of credit facility, and cash flows from operations will be sufficientto satisfy our working capital and capital expenditure requirements for atleast the next twelve months. Beyond the next twelve months, additionalfinancing may be required to fund working capital and capital expenditures.Changes in our operating plans including lower than anticipated revenues,increased expenses, acquisition of companies, products or technologies or otherevents, including those described in “Risk Factors” included elsewhere 

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hereinand in other filings may cause us to seek additional debt or equity financingon an accelerated basis. Financing may not be available on acceptable terms, orat all, and our failure to raise capital when needed could negatively impactour growth plans and our financial condition and results of operations.Additional equity financing may be dilutive to the holders of our common stockand debt financing, if available, may involve significant cash paymentobligations and financial or operational covenants that restrict our ability tooperate our business.

**ContractualObligations and Commitments**

Future payments due undernon-cancelable lease obligations and commitments at December 31, 2006 aredescribed below (in thousands):

| ** **                           | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **2012 and  thereafter** | ** ** | **Total** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|-------------------------------|------------|-----------|------------|
| Operating leases                     |       | $        | 1,092      |     | $          | 921      |       | $        | 367        |     | $          | 284                           |       | $         | 240        |   |   | $ | 565 |   |   | $ | 3,469 |   |
| Acquisition  consideration           |       | 150      |       | —   |       | —   |       | —   |       | —   |       |                          | —     |      |       | 150 |   |
| Enterprise  resource planning system |       | 373      |       | —   |       | —   |       | —   |       | —   |       |                          | —     |      |       | 373 |   |
| Total                                |       | $        | 1,615      |     | $          | 921      |       | $        | 367        |     | $          | 284                           |       | $         | 240        |   |   | $ | 565 |   |   | $ | 3,992 |   |

 

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.

Under the terms of the acquisition of QDesignCorporation, we have contingently committed to pay a maximum of $150 during2007 as compensation expense if certain criteria are met. For additionalinformation regarding this commitment, see Footnote 12 of our consolidatedfinancial statements, “Business Combinations.”

In 2005, we entered into an agreement for the purchaseand implementation of a new enterprise resource planning system, or ERP, forapproximately $747, which was due in two equal installments over two years. Wehave a commitment to pay the second installment of $373 during 2007.

We also enter into contracts with manufacturers toprovide certain manufacturing services. If we were to have terminated thesecontracts at December 31, 2006, we would have been required to makepayments of approximately $2.6 million.

**Recently IssuedAccounting Standards**

In September 2006, the FASB issued SFAS No. 157,“Fair Value Measurements.” SFAS No. 157 defines fair value, establishes aframework for measuring fair value, and expands disclosures about fair valuemeasurements. This statement is effective for financial statements issued forfiscal years beginning after November 15, 2007. We plan to adopt SFAS No. 157effective January 1, 2008. We are in the process of determining theeffect, if any, the adoption of SFAS No. 157 will have on our financialstatements.

In June 2006, the FASB issued FIN No. 48, “Accountingfor Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109”(“FIN No. 48”), which clarifies the accounting for uncertainty inincome tax positions. This Interpretation requires that we recognize in ourfinancial statements the impact of a tax position if that position is morelikely than not of being sustained on audit, based on the technical merits ofthe position. The accounting provisions of FIN No. 48 are effective forfiscal years beginning after December 15, 2006. We plan to adopt FIN No. 48effective January 1, 2007, with the cumulative effect of the change inaccounting principle, if any, recorded as an adjustment to opening 

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retained earnings. We arecurrently evaluating the impact of adopting FIN No. 48 and its impacton our financial position, cash flows, and results of operations.

In June 2006, the FASB Emerging Issues Task Force(“EITF”) issued EITF Issue No. 06-3, “How Sales Taxes Collected fromCustomers and Remitted to Governmental Authorities Should Be Presented in theIncome Statement (That Is, Gross Versus Net Presentation),” which states that acompany should disclose its accounting policy (i.e., gross or net presentation)regarding presentation of taxes within the scope of this Issue. If taxesincluded in gross revenues are significant, a company should disclose theamount of such taxes for each period for which an income statement ispresented. The consensus would be effective for the first annual or interimreporting period beginning after December 15, 2006. The disclosures arerequired for annual and interim financial statements for each period for whichan income statement is presented. We plan to adopt EITF Issue No. 06-3effective January 1, 2007. Based on our current evaluation, we do notexpect the adoption of EITF Issue No. 06-3 to have a significantimpact on our consolidated results of operations or financial position.

In December 2004, the FASB finalized SFAS No. 123(R),which requires companies to measure and recognize compensation costs for allshare-based payments (including stock options) at fair value, effective forinterim or annual periods beginning after June 15, 2005. On April 15,2005, the SEC announced a deferral of the effective date of SFAS No. 123(R) untilthe first interim or annual reporting period of the first fiscal year beginningon or after June 15, 2005. Effective January 1, 2006, we adopted theprovisions of SFAS No. 123(R) as discussed in Footnote 16 of ourconsolidated financial statements, “Stock-Based Compensation.”

Prior to adoption of SFAS No. 123(R), wepresented all tax benefits of deductions resulting from the exercise of stockoptions as operating cash flows in the Consolidated Statements of Cash Flows.SFAS No. 123(R) requires the cash flows resulting from the tax benefitsresulting from tax deductions in excess of the compensation cost recognized forthose options (excess tax benefits) to be classified as financing cash flows.

In September 2006,the SEC staff issued SAB No. 108, “Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements.” SAB No. 108 provides guidance on how prior year misstatementsshould be taken into consideration when quantifying misstatements in currentyear financial statements for purposes of determining whether the current year’sfinancial statements are materially misstated. SAB No. 108 is effectivefor fiscal years ending after November 15, 2006. The adoption of SAB No. 108did not have a material effect on our consolidated financial position, results ofoperations or cash flows.

**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 31,2006, 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, 2006, a 1% change ininterest rates throughout a one-year period would have an annual effect ofapproximately $1.1 million on our income before income taxes.

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We derive in the range of 70% of our revenues fromsales outside the United States, and maintain research, sales, marketing, orbusiness development offices in nine countries. Therefore, our results could benegatively affected by such factors as changes in foreign currency exchangerates, trade protection measures, longer accounts receivable collectionpatterns, and changes in regional or worldwide economic or politicalconditions. The risks of our international operations are mitigated in part bythe extent to which our revenues are denominated in U.S. dollars and,accordingly, we are not exposed to significant foreign currency risk on theseitems. We do have limited foreign currency risk on certain revenues andoperating expenses such as salaries and overhead costs of our foreignoperations and a small amount of cash maintained by these operations. Revenuesdenominated in foreign currencies accounted for approximately 6% of totalrevenues during 2006. Operating expenses, including cost of sales, for our foreignsubsidiaries were approximately $15.7 million in 2006. Based upon the expensesfor 2006, a 1% change in foreign currency rates throughout a one-year periodwould have an annual effect of approximately $0.2 million on our operatingincome.

Our international business is subject to risks,including, but not limited to, differing economic conditions, changes inpolitical climate, differing tax structures, other regulations andrestrictions, and foreign exchange rate volatility when compared to the United Statesdollar. Accordingly, our future results could be materially impacted by changesin 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 2006, the positive impact of foreignexchange rate fluctuations related to translation of our foreign subsidiaries’financial statements was $0.1 million on retained earnings.

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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                                                                                                           |       | 64         |       |
| Consolidated  Balance Sheets as of December 31, 2005 and 2006                                                                                                 |       | 66         |       |
| Consolidated  Statements of Operations for the years ended December 31, 2004, 2005  and 2006                                                        |       | 67         |       |
| Consolidated  Statements of Stockholders’ Equity for the years ended December 31,  2004, 2005 and 2006                                         |       | 68         |       |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2004,  2005 and 2006                                                        |       | 69         |       |
| Notes to  Consolidated Financial Statements                                                                                                                        |       | 70         |       |
| **Financial  Statement Schedule:**                                                                                                                                 | ** ** | ** ** | ** ** |
| Schedule  II—Valuation and Qualifying Accounts for the years ended December 31,  2004, 2005 and 2006        |       | 101        |       |

 

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**Report ofIndependent Registered Public Accounting Firm**

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

We have completedintegrated audits of DTS, Inc.’s consolidated financial statements and ofits internal control over financial reporting as of December 31, 2006, inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Our opinions, based on our audits, are presented below.

*Consolidated financial statements and financial statementschedule*

In our opinion, theconsolidated financial statements listed in the accompanying index present fairly, in all material respects, thefinancial position of DTS, Inc. and its subsidiaries at December 31,2006 and 2005, and the results of their operations and their cash flows foreach of the three years in the period ended December 31, 2006 inconformity with accounting principles generally accepted in the United Statesof America. In addition, in our opinion,the financial statement schedule listed in the accompanying indexpresents fairly, in all material respects, theinformation set forth therein when read in conjunction with the relatedconsolidated financial statements. These financial statements andfinancial statement schedules are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements and financial statement schedules based on our audits. We conductedour audits of these statements in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement. An audit offinancial statements includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements, assessing theaccounting principles used and significant estimates made by management, andevaluating the overall financial statement presentation. We believe that our auditsprovide a reasonable basis for our opinion.

As discussed in Note 16 tothe consolidated financial statements, the Company changed the manner in whichit accounts for stock-based compensation in 2006.

*Internal controlover 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, 2006 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, 2006, basedon criteria established in *Internal Control—IntegratedFramework* issued by the COSO. The Company’s management is responsiblefor maintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reporting.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.

Becauseof its inherent limitations, internal control over financial reporting may notprevent or detect misstatements. Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

| /s/ PRICEWATERHOUSECOOPERS LLP |   |
|--------------------------------|--------|
| Los Angeles, California        |   |
| March 16, 2007            |   |

 

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**DTS, INC.CONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                                                                                           | ** ** | **As of December 31,**                                      | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                           | ** ** | **2005**                                                                   | ** ** | **2006** | ** ** |
| ** **                                                                                                                                                                                           | ** ** | **(Amounts in thousands,  except per share  amounts)** | ** ** |
| **ASSETS**                                                                                                                                                                                           | ** ** | ** **                                                                 | ** ** | ** ** | ** ** |
| Current assets:                                                                                                                                                                                      |       |                                                                       |       |   |   |
| Cash and cash equivalents                                                                                                                                                                            |       | $                                                                          | 33,254     | ** ** | **$** | **17,097** | ** ** |
| Short-term investments                                                                                                                                                                               |       | 78,163                                                                     | ** ** | **94,368** | ** ** |
| Accounts receivable, net of allowance for doubtful  accounts of $370 and $256 at December 31, 2005 and 2006, respectively                                                                       |       | 7,311                                                                      | ** ** | **7,472** | ** ** |
| Inventories, net                                                                                                                                                                                     |       | 3,261                                                                      | ** ** | **3,156** | ** ** |
| Deferred income taxes                                                                                                                                                                                |       | 7,255                                                                      | ** ** | **7,059** | ** ** |
| Prepaid expenses and other current assets                                                                                                                                                            |       | 3,112                                                                      | ** ** | **2,032** | ** ** |
| Income taxes receivable, net                                                                                                                                                                         |       | 2,654                                                                      | ** ** | **2,244** | ** ** |
| Total current assets                                                                                                                                                                                 |       | 135,010                                                                    | ** ** | **133,428** | ** ** |
| Property and  equipment, net                                                                                                                                                                         |       | 7,375                                                                      | ** ** | **11,338** | ** ** |
| Intangible  assets, net                                                                                                                                                                              |       | 11,612                                                                     | ** ** | **18,424** | ** ** |
| Goodwill                                                                                                                                                                                             |       | 3,585                                                                      | ** ** | **3,585** | ** ** |
| Deferred income  taxes                                                                                                                                                                               |       | 303                                                                        | ** ** | **305** | ** ** |
| Other assets                                                                                                                                                                                         |       | 369                                                                        | ** ** | **1,120** | ** ** |
| Total assets                                                                                                                                                                                         |       | $                                                                          | 158,254    | ** ** | **$** | **168,200** | ** ** |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                       | ** ** | ** **                                                                 | ** ** | ** ** | ** ** |
| Current liabilities:                                                                                                                                                                                 | ** ** | ** **                                                                 | ** ** | ** ** | ** ** |
| Accounts payable                                                                                                                                                                                     |       | $                                                                          | 2,634      | ** ** | **$** | **5,971** | ** ** |
| Accrued expenses                                                                                                                                                                                     |       | 6,983                                                                      | ** ** | **6,853** | ** ** |
| Deferred revenue                                                                                                                                                                                     |       | 2,630                                                                      | ** ** | **94** | ** ** |
| Total current liabilities                                                                                                                                                                            |       | 12,247                                                                     | ** ** | **12,918** | ** ** |
| Deferred income  taxes                                                                                                                                                                               |       | 1,917                                                                      |       | — |   |
| Other long-term  liabilities                                                                                                                                                                         |       | —                                                                     | ** ** | **1,466** | ** ** |
| Commitments and  contingencies (Note 13)                                                                                                                                                             |       |                                                                       |       |   |   |
| Stockholders’ equity:                                                                                                                                                                           |       |                                                                       |       |   |   |
| Preferred stock—$0.0001 par value, 5,000 shares  authorized at December 31, 2005 and 2006; no shares issued and  outstanding                                                               |       | —                                                                     | ** ** | **—** | ** ** |
| Common stock—$0.0001 par value, 70,000 shares  authorized at December 31, 2005 and 2006; 17,473 and 18,024 shares  issued and outstanding at December 31, 2005 and 2006, respectively |       | 2                                                                          | ** ** | **2** | ** ** |
| Additional paid-in capital                                                                                                                                                                           |       | 122,847                                                                    | ** ** | **129,549** | ** ** |
| Retained earnings                                                                                                                                                                                    |       | 21,241                                                                     | ** ** | **24,265** | ** ** |
| Total stockholders’ equity                                                                                                                                                                      |       | 144,090                                                                    | ** ** | **153,816** | ** ** |
| Total liabilities  and stockholders’ equity                                                                                                                                                     |       | $                                                                          | 158,254    | ** ** | **$** | **168,200** | ** ** |

 

See accompanying notes to consolidated financial statements.

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**DTS, INC.CONSOLIDATED STATEMENTS OF OPERATIONS**

| ** **                                                            | ** ** | **For the Years Ended December 31,**                  | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|
| ** **                                                            | ** ** | **2004**                                                                       | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                                            | ** ** | **(Amounts in thousands,  except per share amounts)** | ** ** |
| Revenues:                                                             | ** ** | ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Technology and film licensing                                         |       | $                                                                              | 49,920     |   | $ | 56,947 | ** ** | **$** | **59,053** | ** ** |
| Product sales and other revenues                                      |       | 11,511                                                                         |       | 18,305 | ** ** | **19,261** | ** ** |
| Total revenues                                                        |       | 61,431                                                                         |       | 75,252 | ** ** | **78,314** | ** ** |
| Cost of goods sold:                                                   | ** ** | ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Technology and film licensing                                         |       | 4,451                                                                          |       | 4,715 | ** ** | **4,769** | ** ** |
| Product sales and other revenues                                      |       | 11,711                                                                         |       | 14,898 | ** ** | **15,635** | ** ** |
| Total cost of goods sold                                              |       | 16,162                                                                         |       | 19,613 | ** ** | **20,404** | ** ** |
| Gross profit                                                          |       | 45,269                                                                         |       | 55,639 | ** ** | **57,910** | ** ** |
| Operating expenses:                                                   | ** ** | ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Selling, general and administrative                                   |       | 27,644                                                                         |       | 33,960 | ** ** | **41,754** | ** ** |
| Research and development                                              |       | 6,131                                                                          |       | 9,867 | ** ** | **12,334** | ** ** |
| In-process research and development                                   |       | —                                                                         |       | 2,300 |   | — |   |
| Separation and restructuring costs                                    |       | —                                                                         |       | — | ** ** | **4,903** | ** ** |
| Total operating expenses                                              |       | 33,775                                                                         |       | 46,127 | ** ** | **58,991** | ** ** |
| Income (loss)  from operations                                        |       | 11,494                                                                         |       | 9,512 | ** ** | **(1,081** | **)** |
| Interest income,  net                                                 |       | 1,447                                                                          |       | 2,524 | ** ** | **4,923** | ** ** |
| Other income  (expense), net                                          |       | (31                                                                            | )          | 154 |   | — |   |
| Income from legal  settlement (Note 22)                               |       | 2,601                                                                          |       | — |   | — |   |
| Income before  income taxes                                           |       | 15,511                                                                         |       | 12,190 | ** ** | **3,842** | ** ** |
| Provision for  income taxes                                           |       | 5,535                                                                          |       | 4,282 | ** ** | **818** | ** ** |
| Net income                                                            |       | $                                                                              | 9,976      |   | $ | 7,908 | ** ** | **$** | **3,024** | ** ** |
| Net income per common  share:                                         | ** ** | ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic                                                                 |       | $                                                                              | 0.59       |   | $ | 0.46 | ** ** | **$** | **0.17** | ** ** |
| Diluted                                                               |       | $                                                                              | 0.55       |   | $ | 0.43 | ** ** | **$** | **0.16** | ** ** |
| Weighted average shares  used to compute net income per common share: | ** ** | ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic                                                                 |       | 16,866                                                                         |       | 17,321 | ** ** | **17,623** | ** ** |
| Diluted                                                               |       | 18,143                                                                         |       | 18,310 | ** ** | **18,401** | ** ** |

 

See accompanying notes to consolidated financial statements.

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**DTS, INC.CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY**

| ** **                                                           | ** ** | ** **                           | ** ** | ** **  | ** ** | **Additional** | ** ** | ** **             | ** ** | **Total**  | ** ** |
|----------------------------------------------------------------------|------------|--------------------------------------|------------|-------------|------------|----------------|------------|------------------------|------------|------------|------------|
| ** **                                                           | ** ** | **Common Stock**                | ** ** | **Paid-in** | ** ** | **Retained**   | ** ** | **Stockholders’** | ** ** |
| ** **                                                           | ** ** | **Shares**                           | ** ** | **Amount**  | ** ** | **Capital**    | ** ** | **Earnings**           | ** ** | **Equity** | ** ** |
| ** **                                                           | ** ** | **(Amounts in thousands)** | ** ** |
| Balance at  December 31, 2003                                   |       | 16,513                               |       |        | $          | 2              |       |                   | $          | 115,512    |       | $ | 3,357 |   |   | $ | 118,871 |   |   |
| Exercise of warrants                                                 |       | 49                                   |       |        | —     |           |       | —                 |       | —     |       |   | — |   |   |
| Exercise of options and related tax benefit  of $4,348     |       | 449                                  |       |        | —     |           |       | 4,855                  |       | —     |       |   | 4,855 |   |   |
| Issuance of common stock under employee stock  purchase plan         |       | 57                                   |       |        | —     |           |       | 821                    |       | —     |       |   | 821 |   |   |
| Issuance costs for follow-up 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                                   |       | 17,068                               |       |        | 2          |           |       | 121,431                |       | 13,333     |       |   | 134,766 |   |   |
| Exercise of warrants                                                 |       | 212                                  |       |        | —     |           |       | —                 |       | —     |       |   | — |   |   |
| Exercise of options and related tax benefit of  $283            |       | 130                                  |       |        | —     |           |       | 516                    |       | —     |       |   | 516 |   |   |
| Issuance of common stock under employee stock  purchase plan         |       | 63                                   |       |        | —     |           |       | 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                                   |       | 17,473                               |       |        | 2          |           |       | 122,847                |       | 21,241     |       |   | 144,090 |   |   |
| Exercise of warrants                                                 |       | 21                                   |       |        | —     |           |       | —                 |       | —     |       |   | — |   |   |
| Exercise of options and related tax benefit of  $458            |       | 357                                  |       |        | —     |           |       | 2,065                  |       | —     |       |   | 2,065 |   |   |
| Issuance of common stock under employee stock  purchase plan         |       | 70                                   |       |        | —     |           |       | 900                    |       | —     |       |   | 900 |   |   |
| Restricted stock award grants                                        |       | 103                                  |       |        | —     |           |       | —                 |       | —     |       |   | — |   |   |
| Stock-based compensation charge                                      |       | —                               |       |        | —     |           |       | 3,737                  |       | —     |       |   | 3,737 |   |   |
| Net income                                                           |       | —                               |       |        | —     |           |       | —                 |       | 3,024      |       |   | 3,024 |   |   |
| Balance at  December 31, 2006                                   |       | 18,024                               |       |        | $          | 2              |       |                   | $          | 129,549    |       | $ | 24,265 |   |   | $ | 153,816 |   |   |

 

See accompanying notes to consolidated financial statements.

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**DTS, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS**

| ** **                                                                                                                   | ** ** | **For the Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                                                   | ** ** | **2004**                                                      | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                                                                                                   | ** ** | **(Amounts in thousands)**                          | ** ** |
| Cash flows from operating  activities:                                                                                       |       |                                                          |       |   |   |   |   |
| Net income                                                                                                                   |       | $                                                             | 9,976      |   | $ | 7,908 | ** ** | **$** | **3,024** | ** ** |
| Adjustments  to reconcile net income to net cash provided by operating activities:                                           |       |                                                          |       |   |   |   |   |
| Depreciation and amortization                                                                                                |       | 1,298                                                         |       | 3,793 | ** ** | **4,770** | ** ** |
| Stock-based compensation charges                                                                                             |       | 273                                                           |       | 75 | ** ** | **3,737** | ** ** |
| Allowance for doubtful accounts                                                                                              |       | 61                                                            |       | 30 | ** ** | **10** | ** ** |
| Loss on disposal of property and equipment                                                                                   |       | —                                                        |       | 5 | ** ** | **114** | ** ** |
| Deferred income taxes                                                                                                        |       | (2,092                                                        | )          | 1,003 | ** ** | **(2,324** | **)** |
| In-process research and development                                                                                          |       | —                                                        |       | 2,300 |   | — |   |
| Tax benefits from stock-based awards                                                                                         |       | 4,348                                                         |       | 283 | ** ** | **458** | ** ** |
| Excess tax benefits from stock-based awards                                                                                  |       | —                                                        |       | — | ** ** | **(411** | **)** |
| Write-down of inventory and other assets                                                                                     |       | 3,871                                                         |       | — | ** ** | **902** | ** ** |
| Changes  in operating assets and liabilities, net of the effect of acquisitions:                                             |       |                                                          |       |   |   |   |   |
| Accounts receivable                                                                                                          |       | (748                                                          | )          | (2,489 | ) | **(159** | **)** |
| Inventories                                                                                                                  |       | 12                                                            |       | 409 | ** ** | **(470** | **)** |
| Prepaid expenses and other assets                                                                                            |       | (1,245                                                        | )          | (228 | ) | **263** | ** ** |
| Accounts payable and accrued expenses                                                                                        |       | 713                                                           |       | (2,139 | ) | **(2,343** | **)** |
| Deferred revenue                                                                                                             |       | 519                                                           |       | 1,184 | ** ** | **(2,537** | **)** |
| Income taxes receivable                                                                                                      |       | 588                                                           |       | (2,582 | ) | **410** | ** ** |
| Net cash provided by operating activities                                                                                    |       | 17,574                                                        |       | 9,552 | ** ** | **5,444** | ** ** |
| Cash flows from investing  activities:                                                                                       |       |                                                          |       |   |   |   |   |
| Purchases of investments                                                                                                     |       | (114,429                                                      | )          | (103,563 | ) | **(163,822** | **)** |
| Maturities of investments                                                                                                    |       | 12,413                                                        |       | 63,591 | ** ** | **73,512** | ** ** |
| Sales of investments                                                                                                         |       | 69,462                                                        |       | 57,506 | ** ** | **74,105** | ** ** |
| Purchase of property and equipment                                                                                           |       | (1,567                                                        | )          | (4,976 | ) | **(7,119** | **)** |
| Bridge loan for acquisition                                                                                                  |       | (1,250                                                        | )          | — |   | — |   |
| Cash paid for business and technology acquisitions,  net of cash acquired                                                    |       | (1,383                                                        | )          | (11,000 | ) | **(950** | **)** |
| Payment for patents and trademarks in process                                                                                |       | (90                                                           | )          | (185 | ) | **(245** | **)** |
| Net cash provided by (used in) investing activities                                                                          |       | (36,844                                                       | )          | 1,373 | ** ** | **(24,519** | **)** |
| Cash flows from financing  activities:                                                                                       |       |                                                          |       |   |   |   |   |
| Proceeds from the sale of common stock in connection  with the initial and follow-on public offerings, net of issuance costs |       | (30                                                           | )          | — |   | — |   |
| Proceeds from the issuance of common stock upon  exercise of employee stock options                                     |       | 507                                                           |       | 233 | ** ** | **1,607** | ** ** |
| Proceeds from the issuance of common stock under  employee stock purchase plan                                               |       | 821                                                           |       | 825 | ** ** | **900** | ** ** |
| Excess tax benefits from stock-based awards                                                                                  |       | —                                                        |       | — | ** ** | **411** | ** ** |
| Net cash provided by financing activities                                                                                    |       | 1,298                                                         |       | 1,058 | ** ** | **2,918** | ** ** |
| Net increase  (decrease) in cash and cash equivalents                                                                        |       | (17,972                                                       | )          | 11,983 | ** ** | **(16,157** | **)** |
| Cash and cash  equivalents, beginning of period                                                                              |       | 39,243                                                        |       | 21,271 | ** ** | **33,254** | ** ** |
| Cash and cash  equivalents, end of period                                                                                    |       | $                                                             | 21,271     |   | $ | 33,254 | ** ** | **$** | **17,097** | ** ** |
| Supplemental disclosure  of cash flow information:                                                                           |       |                                                          |       |   |   |   |   |
| Cash paid for interest                                                                                                       |       | $                                                             | —     |   | $ | 19 | ** ** | **$** | **—** | ** ** |
| Cash paid for  income taxes                                                                                                  |       | $                                                             | 482        |   | $ | 3,178 | ** ** | **$** | **545** | ** ** |

 

See accompanying notes to consolidated financial statements.

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

**Note 1—The Company**

DTS, Inc. (the “Company”)provides digital entertainment technologies, products and services to themotion picture, consumer electronics, professional audio and relatedindustries. The Company’s Consumer business licenses audio technology,trademarks and know-how to consumer electronics, personal computer, broadcastand professional audio companies, and sells multi-channel audio content andproducts to consumers. The Company’s Cinema business licenses technology andsells products and services to producers and distributors of feature lengthfilms and digital content, and to movie theaters and special venues. TheCompany’s Digital Images business provides image enhancement, restoration andrepair services for moving pictures captured on film or in digital form,television content, and other forms of image content.

The Company commencedoperations in 1990 as Digital Theater Systems Corporation (“DTS Corp”). In1993, DTS Corp became the general partner of Digital Theater Systems, L.P., aDelaware limited partnership (“the Partnership”). In 1994, the Partnershipformed DTS Technology, LLC (“DTS Technology”) to develop audio technologies forthe consumer electronics and other markets. On October 24, 1997 theCompany completed a reorganization and tax-free exchange with the predecessorentities and was incorporated in Delaware. The reorganization and formation ofthe Company was accounted for as a transaction by entities under common controland was effected by each of the former stockholders and owners of DTS Corp, thePartnership and DTS Technology receiving an ownership interest in the Company,represented by shares of common stock and warrants to acquire shares of commonstock, substantially equivalent to their previous interests in DTS Corp, thePartnership and DTS Technology. On July 9, 2003, the Companycompleted its initial public offering for the sale of 4,091 shares of commonstock at a price to the public of $17.00 per share. All of the shares of commonstock sold in the offering were registered under the Securities Act of 1933, asamended (the “Securities Act”) on a Registration Statement on Form S-1(Reg. No. 333-104761) that was declared effective by the Securitiesand Exchange Commission (the “SEC”) on July 9, 2003 and a Registration Statementfiled pursuant to Rule 426(b) under the Securities Act that was filedon July 9, 2003 (Reg. No. 333-106920). In May 2005, theCompany changed its name from Digital Theater Systems, Inc. to DTS, Inc.

In January 2007, theCompany combined its Cinema and Digital Images businesses into a singlebusiness known as “DTS Digital Cinema.” In February 2007, the Company’sBoard of Directors approved a plan to sell its DTS Digital Cinema business toenable the Company to focus exclusively on licensing branded entertainmenttechnology to the large and evolving audio, game console, personal computer,portable, broadcast, and other markets. The sales process has begun and isexpected to conclude later in 2007. For additional information, refer toFootnote 24 of the consolidated financial statements, “Subsequent Events.”

**Note 2—Significant Accounting Policies**

***Principles ofConsolidation***

The consolidated financialstatements include the accounts of the Company, its wholly-owned subsidiaries,and Avica Technology Corporation (“Avica”), a variable interest entity (“VIE”).VIEs are defined by the Financial Accounting Standards Board (“FASB”) in FASBInterpretation No. (“FIN”) 46 (Revised 2003), “Consolidation ofVariable Interest Entities—an Interpretation of Accounting Research Bulletin No. 51”(“FIN 46(R)”). For additional information regarding Avica, refer to Footnote 3of the 

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

consolidatedfinancial statements, “Consolidation of Avica as a Variable Interest Entity.”All material intercompany 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. On an on-going basis, the Company evaluates its estimates andassumptions, including those related to revenue recognition, inventories,adequacy of allowances for doubtful accounts, valuation of long-lived assetsand goodwill, income taxes, and warranties. The Company bases its estimates onhistorical and anticipated results, trends and on various other assumptionsthat it believes are reasonable under the circumstances, including assumptionsas to future events. These estimates form the basis for making assumptionsabout the carrying values of assets and liabilities that are not readilyapparent from other sources. By their nature, estimates are subject to aninherent degree of uncertainty. Actual results could differ from thoseestimates.

***Cash and CashEquivalents***

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, bankcertificates of deposit and municipal securities. Cash and cash equivalents arestated at cost plus accrued interest, which approximates fair value.

***Short-TermInvestments***

In accordance withStatement of Financial Accounting Standards (“SFAS”) No. 115, “Accountingfor Certain Investments in Debt and Equity Securities” and FASB Emerging IssuesTask Force (“EITF”) No. 03-1 “The Meaning of Other-Than-TemporaryImpairment and Its Application to Certain Investments,” the Company considers,at the time that they are purchased, investments with maturities greater thanthree months, but less than one year, to be short-term investments. Short-terminvestments consist primarily of auction rate and variable rate obligationsecurities, which are classified as available-for-sale. Auction rate andvariable rate obligation securities have interest rate resets through amodified Dutch auction at predetermined short-term intervals, typically every7, 28, or 35 days. Interest paid during a given period is based upon theinterest rate determined during the prior auction. Although the securities areissued and rated as long-term bonds, they are priced and traded as short-terminstruments because of the liquidity provided through the interest rate reset.We had no material gross realized or unrealized holding gains or losses fromour investments in auction rate and variable rate obligation securities for theyears ended December 31, 2004, 2005 and 2006. Other short-term investmentsare classified as held-to-maturity. All income generated from those investmentswas recorded as interest income.

***Concentration ofBusiness and Credit Risk***

The Company markets itsproducts and services to major motion picture producers and distributors, movietheaters, and consumer electronics product manufacturers in the United Statesand internationally. Although the Company is generally subject to the financialwell being of the motion picture industry and 

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

theconsumer electronics business, management does not believe that the Company issubject to significant credit risk with respect to trade accounts receivable.Additionally, the Company performs ongoing credit evaluations of its customersand maintains allowances for potential credit losses which, when realized, havegenerally been within the range of management’s expectations.

There were no customersthat accounted for more than 10% of revenues for the years ended December 31,2004 and 2005. One customer accounted for 13% of revenues for the year ended December 31,2006. One customer accounted for 17% of accounts receivable at December 31,2005. One customer accounted for 19% and another for 12% of accounts receivableat December 31, 2006.

The Company purchases itsprofessional audio encoding devices and movie theater playback systems fromseveral third-party manufacturers who manufacture these units according to theCompany’s specifications. Although the Company believes it could findalternative suppliers if necessary, a lack of key components could causesignificant delays, increased costs, or quality control problems, which couldhave a material adverse effect on the Company’s business and results ofoperations.

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

***Allowance ForDoubtful Accounts***

The Company continuallymonitors customer payments and maintains a reserve for estimated lossesresulting from its customers’ inability to make required payments. Indetermining the reserve, the Company evaluates the collectibility of itsaccounts receivable based upon a variety of factors. In cases where the Companybecomes aware of circumstances that may impair a specific customer’s ability tomeet its financial obligations, the Company records a specific allowanceagainst amounts due. For all other customers, the Company recognizes allowancesfor doubtful accounts based on its historical write-off 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. The Company recorded inventorywrite-downs of $624 during the year ended December 31, 2006, primarilyrelated to its DTS Entertainment (“DTSE”) inventory. Because the Company redirectedthe focus of its DTSE business away from the sale and marketing of discs andthus will no longer fully fund those activities, it was determined that DTSE 

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

inventorieshave a lower estimated fair market value than the original cost of thoseinventories and were therefore written down to their estimated fair marketvalue.

***Property andEquipment***

Property and equipment arerecorded at cost, less accumulated depreciation. Depreciation is calculated usingthe straight-line method over the related assets’ estimated useful lives, whichis generally two to five years for machinery and equipment and three to sevenyears for office furniture and equipment. Leasehold improvements are amortizedover their estimated useful lives, or the lease term, whichever is shorter.Expenditures that materially increase asset life are capitalized, whileordinary maintenance and repairs are expensed as incurred.

***CapitalizedSoftware Costs***

The Company capitalizesthe costs of computer software developed or obtained for internal use inaccordance with Statement of Position 98-1, “Accounting for the Costs ofComputer Software Developed or Obtained for Internal Use.” Capitalized computersoftware costs consist of purchased software licenses, implementation costs,consulting costs and payroll-related costs for certain projects that qualifyfor capitalization. The Company expenses costs related to preliminary projectassessment, training and application maintenance as incurred, and amortizes thecapitalized computer software costs on a straight-line basis over the estimateduseful life of the software upon being placed in service.

***Long-Lived Assets***

The Company periodicallyassesses potential impairments to its long-lived assets in accordance with theprovisions of SFAS No. 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets.” SFAS No. 144 requires, among other things, that anentity perform an impairment review whenever events or changes in circumstancesindicate that the carrying value may not be fully recoverable. Factorsconsidered by the Company include, but are not limited to: significantunderperformance relative to expected historical or projected future operatingresults; significant changes in the manner of use of the acquired assets or thestrategy for the Company’s overall business; and significant negative industryor economic trends. When the Company determines that the carrying value of along-lived asset may not be recoverable based upon the existence of one or moreof the above indicators of impairment, the Company estimates the futureundiscounted cash flows expected to result from the use of the asset and itseventual disposition. If the sum of the expected future undiscounted cash flowsand eventual disposition is less than the carrying amount of the asset, theCompany recognizes an impairment loss. An impairment loss is reflected as theamount by which the carrying amount of the asset exceeds the fair market valueof the asset, based on the fair market value if available, or discounted cashflows. To date, there has been no impairment of long-lived assets.

***Goodwill andIntangible Assets***

The Company accounts forgoodwill in accordance with SFAS No. 142, “Goodwill and Other IntangibleAssets,” which, among other things, establishes standards for goodwill acquiredin a business combination, eliminates the amortization of goodwill and requiresthe carrying value of goodwill and certain non-amortizing intangibles to beevaluated for impairment on an annual basis. As required by SFAS No. 142,the Company performs an impairment test on recorded goodwill by comparing the 

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

estimatedfair value of each of the Company’s three reporting units, which are the sameas the Company’s three operating segments, to the carrying value of the assetsand liabilities of each unit, including goodwill. The Company determines fairvalue of the reporting units principally based upon management’s determinationof the value of the Company as a whole. This value is determined by consideringa number of factors, including the Company’s historical and projected financialresults, valuation analysis, 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 impairmentcharge in an amount equal to the excess of the carrying value of goodwill overthe implied 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, to ensure that impairment charges, ifapplicable, are reflected in our financial results before December 31 ofeach year. To date, there has been no impairment of goodwill.

The Company accounts forintangible assets in accordance with SFAS No. 144. This standard requiresthat intangible assets with definite lives be amortized over their estimateduseful lives and reviewed for impairment whenever events or changes incircumstances 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 of acquiredtechnology and developed patents and trademarks, which are being amortized overtheir respective lives. To date, there has been no impairment of intangibleassets.

***Variable InterestEntities***

VIEs as defined byFIN 46(R), are entities in which equity investors generally do not havethe characteristics of a “controlling financial interest,” or for which thereis not sufficient equity at risk for the entity to finance its activitieswithout additional subordinated financial support. FIN 46(R) requires thatif an entity is the primary beneficiary of a VIE, the assets, liabilities, andresults of operations of the VIE should be included in the consolidatedfinancial statements of the entity. For variable interest entities, the Companyassesses the terms of its interest in each entity to determine if it is theprimary beneficiary as prescribed by FIN 46(R). The primary beneficiary of avariable interest entity is the party that absorbs a majority of the entity’sexpected losses, receives a majority of its expected residual returns, or both,as a result of holding variable interests, which are the ownership,contractual, or other pecuniary interests in an entity that change with changesin the fair value of the entity’s net assets excluding variable interests.

***Revenue Recognition***

The Company recognizesrevenue when persuasive evidence of a sales arrangement exists, delivery hasoccurred or services have been rendered, the buyer’s price is fixed ordeterminable and collection is reasonably assured.

Revenues frommultiple-element arrangements involving license fees, up-front payments andmilestone payments, which are received and/or billable by the Company inconnection with other rights and services that represent continuing obligationsof the Company, are deferred until all of the elements have been delivered oruntil the Company has established objective and verifiable evidence of the fair

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

value ofthe undelivered elements. Deferred revenues arise from payments received inadvance of the culmination of the earnings process. 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 ofcinema hardware products is recorded upon delivery, assuming all other revenuerecognition criteria are met. The licensing, encoding and duplication of motionpicture soundtracks for use in the audio playback systems manufactured by theCompany is undertaken under arrangements with major film producers anddistributors. Revenue arising from the licensing and duplication of soundtracksis recognized upon delivery, assuming all other revenue recognition criteria aremet.

Direct costs associatedwith deferred revenue are deferred and included in other assets. Included inthe balance sheet are $2,630 and $1,734 of deferred revenue and costs,respectively, at December 31, 2005. Included in the balance sheet are $94and $44 of deferred revenue and costs, respectively, at December 31, 2006.

Revenue from licensingaudio technology, trademarks and know-how is generated from licensingagreements with consumer electronics product manufacturers that pay a per-unitlicense fee for products manufactured under those license agreements. Licenseesgenerally report manufacturing information within 30 to 60 days after theend of the quarter in which such activity takes place. Consequently, theCompany recognizes revenue from these licensing agreements on a three-month lagbasis, generally in the quarter following the quarter of manufacture, providedamounts are fixed or determinable and collection is reasonably assured, sincethe Company cannot reliably estimate the amount of revenue earned prior to thereceipt of such reports. Use of this lag method allows for the receipt oflicensee royalty reports prior to the recognition of revenue.

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

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

Service revenues of $0,$5,328 and $8,015 and cost of sales of $0, $6,277 and $8,243 for the yearsended December 31, 2004, 2005 and 2006, respectively, from digital imageenhancement, restoration and repair were recognized when completed titles orfilm reels subject to a customer order or contract were delivered and acceptedby the customer and no significant obligations remained assuming all otherrevenue recognition criteria were met. Prices are established in advance of thework performed and are generally fixed in nature. Revenue related to time andmaterials contracts is recognized as services are rendered at contract laborrates plus material and other direct costs incurred. If losses are anticipatedon a contract, such losses are recognized immediately.

***Shipping andHandling 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 per share data)**

***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 ten years and five years, respectively. Theamortization period commences when the patent or trademark is issued.

***Research and Development Costs (“R&D”)***

The Company conducts its R&D internally andexpenses are comprised of the following types of costs incurred in performingresearch and development activities: salaries and benefits, allocated overhead,contract services, consultants and other outside costs. In accordance with SFASNo. 2, “Accounting for Research and Development Costs,” all R&D costsare expensed as incurred.

***Acquired In-process Research and Development (“IPR&D”)***

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 the fair value is estimable with reasonablereliability. Upon consummation of a business combination, acquired in-processresearch and development is expensed where (i) technological feasibilityhas not been established at the acquisition date and (ii) there is noalternative future use.

***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,** | ** ** |
|---------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                      | ** ** | **2004**                                                  | ** ** | **2005** | ** ** | **2006** | ** ** |
| Balance at  beginning of period |       | $                                                         | 81         |   | $ | 162 | ** ** | **$** | **365** | ** ** |
| Current year  provision         |       | 135                                                       |       | 315 | ** ** | **84** | ** ** |
| Expenditures                    |       | (54                                                       | )          | (112 | ) | **(174** | **)** |
| Balance at end of period        |       | $                                                         | 162        |   | $ | 365 | ** ** | **$** | **275** | ** ** |

 

***Foreign Currency Translation***

The functional currency ofthe Company’s wholly-owned subsidiaries is the United States dollar andaccordingly, gains and losses resulting from the translation of accountsdenominated in currencies other than the functional currency are reflected inthe determination of net income. To date, annual gains and losses have not beensignificant.

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

***Advertising Expenses***

Advertising andpromotional costs are expensed as incurred and amounted to $2,508, $2,373 and$2,109 for the years ended December 31, 2004, 2005 and 2006, 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 utilizing SFAS No. 109 “Accounting for Income Taxes,” asamended. Under SFAS No. 109, the deferred tax assets and liabilities aremeasured each year based on the difference between the financial statement andtax bases of assets and liabilities at the applicable enacted tax rates.Additionally, a valuation allowance is recorded for that portion of deferredtax assets for which it is more likely than not that the assets will not berealized. The deferred tax provision is the result of changes in the deferredtax assets and liabilities.

***Segment Information***

The Company uses the “managementapproach” in accordance with SFAS No. 131, “Disclosures about Segments ofan Enterprise and Related Information.” The management approach designates theinternal organization used by the chief operating decision maker, the ChiefExecutive Officer, for making operating decisions and assessing performance asthe source for determining the Company’s reportable segments.

***Fair Value of Financial Instruments***

The carrying amount ofcash, cash equivalents, short-term investments, accounts receivable, accountspayable and accrued liabilities approximates fair value due to the short-termnature of these instruments.

***Recent Accounting Pronouncements***

In September 2006, the FASB issued SFAS No. 157,“Fair Value Measurements.” SFAS No. 157 defines fair value, establishes aframework for measuring fair value, and expands disclosures about fair valuemeasurements. This statement is effective for financial statements issued forfiscal years beginning after November 15, 2007. The Company plans to adoptSFAS No. 157 effective January 1, 2008. The Company is in the processof determining the effect, if any, the adoption of SFAS No. 157 will haveon its financial statements.

In June 2006, the FASB issued FIN No. 48, “Accountingfor Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109”(“FIN No. 48”), which clarifies the accounting for uncertainty inincome tax positions. This Interpretation requires that the Company recognizein its financial statements the impact of a tax position if that position ismore likely than not of being sustained on audit, based on the 

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

technical merits of theposition. The accounting provisions of FIN No. 48 are effective for fiscalyears beginning after December 15, 2006. The Company plans to adopt FIN No. 48effective January 1, 2007, with the cumulative effect of the change inaccounting principle, if any, recorded as an adjustment to opening retainedearnings. The Company is currently evaluating the impact of adopting FIN No. 48and its impact on the Company’s financial position, cash flows, and results ofoperations.

In June 2006, the FASB EITF issued EITF Issue No. 06-3,“How Sales Taxes Collected from Customers and Remitted to GovernmentalAuthorities Should Be Presented in the Income Statement (That Is, Gross VersusNet Presentation),” which states that a company should disclose its accountingpolicy (i.e., gross or net presentation) regarding presentation of taxes withinthe scope of this issue. If taxes included in gross revenues are significant, acompany should disclose the amount of such taxes for each period for which anincome statement is presented. The consensus would be effective for the firstannual or interim reporting period beginning after December 15, 2006. Thedisclosures are required for annual and interim financial statements for eachperiod for which an income statement is presented. The Company plans to adoptthis issue effective January 1, 2007. Based on the Company’s currentevaluation of this issue, the Company does not expect the adoption of EITFIssue No. 06-3 to have a significant impact on its consolidatedfinancial position or results of operations.

In December 2004, the FASB finalized SFAS No. 123(R),“Share-Based Payment,” which requires companies to measure and recognizecompensation costs for all share-based payments (including stock options) atfair value, effective for interim or annual periods beginning after June 15,2005. On April 15, 2005, the SEC announced a deferral of the effectivedate of SFAS No. 123(R) until the first interim or annual reportingperiod of the first fiscal year beginning on or after June 15, 2005.Effective January 1, 2006, the Company adopted the provisions ofSFAS No. 123(R) as discussed in Footnote 16 of the consolidatedfinancial statements, “Stock-Based Compensation.” In March 2005, the SECstaff issued Staff Accounting Bulletin (“SAB”) No. 107 relating to SFAS123(R). The Company has applied the provisions of SAB 107 in its adoption ofSFAS 123(R).

In September 2006,the SEC staff issued SAB No. 108, “Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements.” SAB No. 108 provides guidance on how prior year misstatementsshould be taken into consideration when quantifying misstatements in currentyear financial statements for purposes of determining whether the current year’sfinancial statements are materially misstated. SAB No. 108 is effectivefor fiscal years ending after November 15, 2006. The adoption of SAB No. 108had no effect on the Company’s consolidated financial position, results ofoperations or cash flows.

**Note 3—Consolidationof Avica as a Variable Interest Entity**

In November 2006, the Company closed a worldwideexclusive license agreement with Avica, a provider of a suite of technologies,products and services that handle content delivery and presentation fordistribution networks. Under the worldwide exclusive license agreement, theCompany acquired for $5,000 a worldwide exclusive license for substantially allof Avica’s intellectual property in all fields of use other than militaryapplications. The Company may also be required to pay Avica up to $2,500 uponthe Company meeting certain unit sales targets of licensed Avica product. Underan option agreement entered into between the Company and Avica, the Company mayelect, in its sole discretion, to purchase substantially all of the assets ofAvica for a purchase price not to exceed $1,500. If Avica meets certain 

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

obligations to the Companyand the Company does not exercise its option before expiration of the term ofthe agreements or if the Company voluntarily terminates the agreements, theCompany may be required to pay up to $500. During the term of the agreementsAvica is restricted from entering into material contracts, initiatingbankruptcy, commencing any legal actions and paying bonuses, among other items,without first obtaining written consent from the Company.

The Company, Avica and a significant majority of Avica’sshareholders have also entered into a voting agreement, pursuant to which eachsuch Avica shareholder has covenanted (i) to vote in favor of, and notagainst, the above-noted transactions with the Company and (ii) not tosell or transfer Avica shares without obtaining a written agreement from thetransferee to abide by the terms and conditions of the voting agreement.

Although the Company currently has no ownershipinterest in Avica, it is considered to be a VIE of the Company in accordancewith FIN 46(R), and the Company is considered to be the primarybeneficiary of Avica. Therefore, the Company has included the assets,liabilities, and results of operations of Avica in its consolidated financialstatements from the date of the close of the license agreement. The Companyexpects the consolidation of Avica will continue to have an impact on itsfinancial results in future periods, because it will continue to recognize theoperating losses generated by Avica since the shareholders’ equity of Avica isin a net deficit position.

While the Company has consolidated the liabilities ofAvica in accordance with FIN 46(R), it has no obligation to pay anyamounts to any of Avica’s creditors. As such, creditors of Avica lack anyrecourse to the assets of the Company.

The total changes to the Company’s total assets andtotal liabilities related to the consolidation of  Avica included in the Company’s ConsolidatedBalance Sheets as of December 31, 2006 were $3,616 and $3,878,respectively.

The total revenues, grossloss, loss from operations and net loss of Avica from the close of the licenseagreement on November 11, 2006 through December 31, 2006, which isincluded in the Company’s Consolidated Statement of Operations were $0, $82,$266, and $262, respectively. These amounts are also included in the Company’sCinema operating segment.

**Note 4—Separationand Restructuring Costs**

Separation and restructuring costs for the year ended December 31,2006 were $4.9 million. These costs relate to three components: (i) theseparation of the Company’s DTS Digital Cinema business, (ii) the buy-outof a commission agreement related to licensing intellectual property in theChina market, and (iii) the write-down of DTSE inventory and other assets.

In August 2006, the Company announced that it wasstudying the potential separation of its business and in November 2006,the Company announced its intent to proceed with the separation of its Cinemaand Digital Images businesses from its Consumer licensing business. The separationcosts, which totaled $1.1 million, consist primarily of legal andaccounting expenses relating to the proposed separation of its business. TheCompany expects to continue to incur costs relating to the sale of the DTSDigital Cinema business but cannot currently estimate the amount of any futurecosts relating to the sale.

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

When the Company started its Consumer operations inChina in 2003, it engaged a company with a strong presence in China to assistit with certain aspects of these operations. The agreement called for annualpayments to the Chinese company based on the profitability of the Company’sChina subsidiary and certain other factors. The Company decided to takecomplete control over its future in China. Therefore, the Company negotiated anearly termination of this agreement, which required the Company to make aone-time termination payment of $3.0 million, which was paid in the fourthquarter of 2006.

During the fourth quarterof 2006, the Company wrote-down $0.8 million of DTSE inventory and other assetsas part of its restructuring effort to refocus DTSE’s efforts back to more of alicensing and content support role.

**Note 5—Cashand Short-term Investments**

Cashand short-term investments consist of the following:

| ** **                      | ** ** | **As of December 31,** | ** ** |
|---------------------------------|------------|---------------------------------------|------------|
| ** **                      | ** ** | **2005**                              | ** ** | **2006** | ** ** |
| Cash and cash  equivalents:     |       |                                  |       |   |   |
| Cash                            |       | $                                     | 12,040     |   | **$** | **10,038** | ** ** |
| Money market accounts           |       | 21,214                                |       | **6,033** | ** ** |
| Municipal securities            |       | —                                |       | **1,026** | ** ** |
| Total cash and cash equivalents |       | $                                     | 33,254     |   | **$** | **17,097** | ** ** |
| Short-term investments:         |       |                                  |       | ** ** | ** ** |
| Available-for-sale securities:  |       |                                  |       | ** ** | ** ** |
| Certificates of deposit         |       | $                                     | 8,121      |   | $ | — |   |
| Corporate bonds                 |       | 3,570                                 |       | — |   |
| Commercial paper                |       | 6,993                                 |       | — |   |
| Municipal securities            |       | 59,479                                |       | **64,652** | ** ** |
|                            |       | 78,163                                |       | **64,652** | ** ** |
| Held-to-maturity  securities:   |       |                                  |       | ** ** | ** ** |
| Certificates of deposit         |       | —                                |       | **522** | ** ** |
| Corporate bonds                 |       | —                                |       | **5,434** | ** ** |
| Commercial paper                |       | —                                |       | **9,316** | ** ** |
| Municipal securities            |       | —                                |       | **14,444** | ** ** |
|                            |       | —                                |       | **29,716** | ** ** |
| Total short-term  investments   |       | $                                     | 78,163     |   | **$** | **94,368** | ** ** |

 

As of December 31, 2005 and 2006, the Company didnot have material unrealized gains or losses on its available-for-sale orheld-to-maturity securities.

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

Thecontractual maturities of short-term investments at December 31, 2006 areas follows:

| Available-for-sale  securities:        |   |   |   |
|----------------------------------------|--------|--------|--------|
| Due within one year                    |   | $      | 11,109 |   |
| Due after one year through five years  |   | 1,104  |   |
| Due after five years through ten years |   | 1,003  |   |
| Due after ten years                    |   | 51,436 |   |
|                                   |   | 64,652 |   |
| Held-to-maturity securities:           |   |   |   |
| Due within one year                    |   | 29,716 |   |
|                                   |   |   |   |
| Total short-term  investments          |   | $      | 94,368 |   |

 

**Note 6—Inventories**

Inventoriesconsist of the following:

| ** **              | ** ** | **As of   December 31,** | ** ** |
|-------------------------|------------|-----------------------------------------|------------|
| ** **              | ** ** | **2005**                                | ** ** | **2006** | ** ** |
| Raw materials,  net     |       | $                                       | 1,062      | ** ** | **$** | **1,170** | ** ** |
| Finished goods,  net    |       | 2,199                                   | ** ** | **1,986** | ** ** |
| Total  inventories, net |       | $                                       | 3,261      | ** ** | **$** | **3,156** | ** ** |

 

**Note 7—Propertyand Equipment**

Propertyand equipment consist of the following:

| ** **                      | ** ** | **As of December 31,** | ** ** |
|---------------------------------|------------|---------------------------------------|------------|
| ** **                      | ** ** | **2005**                              | ** ** | **2006** | ** ** |
| Machinery and  equipment        |       | $                                     | 6,847      | ** ** | **$** | **8,533** | ** ** |
| Office furniture  and fixtures  |       | 3,588                                 | ** ** | **3,989** | ** ** |
| Leasehold  improvements         |       | 3,697                                 | ** ** | **3,915** | ** ** |
| Software                        |       | 590                                   | ** ** | **3,776** | ** ** |
|                            |       | 14,722                                | ** ** | **20,213** | ** ** |
| Less: Accumulated  depreciation |       | (7,347                                | )          | **(8,875** | **)** |
| Property and  equipment, net    |       | $                                     | 7,375      | ** ** | **$** | **11,338** | ** ** |

 

 

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

Depreciation expense was$1,135, $2,231 and $3,056 for the years ended December 31, 2004, 2005 and2006, respectively.

**Note 8—AcquiredTechnology**

On April 17, 2006,the Company acquired for $1,000 the Digital Booking Systems technology (“DBS”)from FilmStew International, Inc. DBS is an application that enablescinema exhibitors and distributors to manage entertainment content via theinternet. DBS allows exhibitors and distributors to conduct business online,thereby accelerating the process of booking playdates, scheduling showtimes,programming trailers, tracking data and facilitating film rental payments.Intangible assets, net, includes $929 for the purchase of this asset, whichrepresents the net present value of the total acquisition cost. As of December 31,2006, the Company has paid $500 of the total purchase price and the balance isdue in two future installments through 2008.

**Note 9—Goodwilland Intangibles**

In the year ended December 31, 2005, the Companyadded $3,585 to goodwill in connection with the acquisition of Lowry DigitalImages, Inc., which is included in the Digital Images business segment.Subsequent to the acquisition, the business was renamed to DTS Digital Images (“DTSDI”). The Company did not have goodwill prior to this acquisition.

Includedin cost of sales is $0, $977 and $1,335 of amortization relating to existingtechnologies, backlog and customer relationships for the year ended December 31,2004, 2005 and 2006, respectively. Included in operating expenses is $89, $594and $379 of amortization relating to non-compete and tradename for the yearended December 31, 2004, 2005 and 2006, respectively. The following tablesummarizes the weighted average lives and the carrying values of the Company’sacquired intangible and other intangible assets by category:

| ** **                  | ** ** | **Weighted**               | ** ** | **As of December 31, 2006** | ** ** | **As of December 31, 2005** | ** ** |
|-----------------------------|------------|----------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                  | ** ** | **Average  Life  (Years)** | ** ** | **Gross  Amount**                               | ** ** | **Accumulated  Amortization**                   | ** ** | **Net  Carrying  Amount** | ** ** | **Gross  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** |
| Acquired intangible assets: |       |                       |       |                                            |       |                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Existing technology         |       |                       | 10         |                                            |       | $                                               | 19,905     |   |   | $ | (2,564 | ) |   | $ | 17,341 |   | $ | 11,627 |   |   | $ | (1,195 | ) |   | $ | 10,432 |   |
| Customer relationships      |       |                       | 4          |                                            |       | 331                                             |       |   | (115 | ) |   | 216 |   | 331 |   |   | (21 | ) |   | 310 |   |
| Non-compete                 |       |                       | 3          |                                            |       | 400                                             |       |   | (267 | ) |   | 133 |   | 400 |   |   | (133 | ) |   | 267 |   |
| Backlog                     |       |                       | 2          |                                            |       | 100                                             |       |   | (100 | ) |   | — |   | 100 |   |   | (50 | ) |   | 50 |   |
| Tradename                   |       |                       | 1          |                                            |       | 200                                             |       |   | (200 | ) |   | — |   | 200 |   |   | (200 | ) |   | — |   |
|                        |       |                       |       |                                            |       | 20,936                                          |       |   | (3,246 | ) |   | 17,690 |   | 12,658 |   |   | (1,599 | ) |   | 11,059 |   |
| Other intangible assets:    |       |                       |       |                                            |       |                                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Patents                     |       |                       | 10         |                                            |       | 1,188                                           |       |   | (583 | ) |   | 605 |   | 965 |   |   | (528 | ) |   | 437 |   |
| Trademarks                  |       |                       | 5          |                                            |       | 240                                             |       |   | (111 | ) |   | 129 |   | 215 |   |   | (99 | ) |   | 116 |   |
|                        |       |                       |       |                                            |       | 1,428                                           |       |   | (694 | ) |   | 734 |   | 1,180 |   |   | (627 | ) |   | 553 |   |
| Total intangible assets     |       |                       |       |                                            |       | $                                               | 22,364     |   |   | $ | (3,940 | ) |   | $ | 18,424 |   | $ | 13,838 |   |   | $ | (2,226 | ) |   | $ | 11,612 |   |

 

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

As of December 31,2006, the Company expects the amortization of intangible assets for futureperiods to be as follows:

| ** ** | ** ** | **Estimated  Amortization  Expense** | ** ** | ** ** |
|------------|------------|--------------------------------------|------------|------------|
| 2007       |       |                                 | $          | 2,459      |   |   |   |
| 2008       |       |                                 | 2,320      |       |   |   |
| 2009       |       |                                 | 2,233      |       |   |   |
| 2010       |       |                                 | 2,121      |       |   |   |
| 2011       |       |                                 | 1,976      |       |   |   |
| Thereafter |       |                                 | 7,315      |       |   |   |
| Total      |       |                                 | $          | 18,424     |   |   |   |

 

**Note 10—AccruedExpenses**

Accruedexpenses consist of the following:

| ** **                            | ** ** | **As of December 31,** | ** ** |
|---------------------------------------|------------|---------------------------------------|------------|
| ** **                            | ** ** | **2005**                              | ** ** | **2006** | ** ** |
| Accrued payroll  and related benefits |       | $                                     | 3,898      | ** ** | **$** | **3,328** | ** ** |
| Production  advance                   |       | 1,022                                 | ** ** | **822** | ** ** |
| Other                                 |       | 2,063                                 | ** ** | **2,703** | ** ** |
| Total accrued  expenses               |       | $                                     | 6,983      | ** ** | **$** | **6,853** | ** ** |

 

**Note 11—BankLine of Credit**

The Company has in place a $10,000 credit facilitythat expires on June 30, 2007 and is renewable annually. The bankagreement provides for working capital financing and is unsecured. The bankagreement requires the Company to comply with certain covenants including atangible effective net worth of $60,000, increasing by 50% of net income on anannual basis. The covenants also require the Company to keep $2,000 in cash orsecurities at the bank. At December 31, 2006, the Company was compliantwith all covenants under the bank agreement.

At December 31, 2006,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 (i) a rate equal to 2% above the LIBOR, or (ii) a rate equalto the Base Rate as quoted from the bank less one-half percent. The annualcommitment fee for this line of credit is not significant.

**Note 12—BusinessCombinations**

In January 2005, the Company completed theacquisition of DTS DI for $9,642 in cash. DTS DI provides image enhancement andrestoration 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 

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

prior to, or in connectionwith, the acquisition. The cash portion of the acquisition was funded byworking capital.

Thetotal purchase price for the acquisition of all of the outstanding shares ofDTS DI is as follows:

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

 

TheDTS DI acquisition was accounted for as a purchase business combination. Theresults of operations of DTS DI are included in our Consolidated Statement ofOperations from January 3, 2005. Under the purchase method of accounting,the total purchase price is allocated to DTS DI’s net tangible and intangibleassets based on their estimated fair value as of the date of completion of theacquisition. Based on the purchase price and the valuation, the purchase priceallocation 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.

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

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 over the following estimated economic useful lives:

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

 

Developed technology and IPR&D were identified andvalued through extensive interviews, analysis of data provided by 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 were entitled toreceive shares of DTS common stock if certain gross profit targets in 2006 weremet. In the event that the targets were met in full, an aggregate of up toapproximately 653,000 shares of DTS common stock would be issued. The grossprofit targets were not met in 2006; therefore, no additional compensation isowed to the former shareholders of DTS DI.

Theresults of operations of DTS DI are included in the Company’s ConsolidatedStatements of Operations from January 3, 2005, the date of acquisition.For the purposes of presenting the unaudited pro forma financial information,the Company used the income statements of DTS DI for the year ended December 31,2004. If the Company had acquired DTS DI at the beginning of fiscal year 2004,the Company’s unaudited pro forma net revenues, net income and net income pershare for the year 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 theacquisition of QDesign Corporation for $1,500 in cash. Under the terms of theacquisition, the Company also contingently agreed to pay an additional amountup to a maximum of $450 in cash, which is held by the Company in a restrictedaccount. The Company classifies the restricted cash in other current andnon-current assets. The contingent payment is being accounted for ascompensation expense ratably over the three-year period ending July 2007,and will be 

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

paid out if certaincriteria are met. Two payments of $150 each have been made related to theaforementioned contingent amount, one in 2005 and the other in 2006.

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 operationsof this acquisition have been included in the Company’s Consolidated Statementsof Operations since the completion of the acquisition in July 2004.

**Note 13—Commitmentsand Contingencies**

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

| **Years Ending December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|------------|------------|
| 2007                                         |       | $          | 1,092      |       |
| 2008                                         |       | 921        |       |
| 2009                                         |       | 367        |       |
| 2010                                         |       | 284        |       |
| 2011                                         |       | 240        |       |
| 2012 and  thereafter                         |       | 565        |       |
|                                         |       | $          | 3,469      |       |

 

Rent expense, net of sublease income, amounted to$883, $1,379 and $1,718 for the years ended December 31, 2004, 2005 and2006, respectively.

Under the terms of the acquisition of QDesign Corporation,the Company has contingently committed to pay a maximum of $150 during 2007 ascompensation expense if certain criteria are met. For additional informationregarding this commitment, see Footnote 12 of the consolidated financialstatements, “Business Combinations.”

In 2005, the Company entered into an agreement for thepurchase and implementation of a new enterprise resource planning system, orERP, for approximately $747, which was due in two equal 

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

installments over twoyears. The Company has a commitment to pay the second installment of $373during 2007.

The Company also enters into contracts withmanufacturers to provide certain manufacturing services. If the Company were tohave terminated these contracts at December 31, 2006, it would have to makepayments of approximately $2,576.

During its normal course of business, the Company hasmade certain indemnities, commitments and guarantees under which it may berequired to make payments in relation to certain transactions. Thoseindemnities include intellectual property indemnities to the Company’scustomers in connection with the sale of its products and the licensing of itstechnology, indemnities for liabilities associated with the infringement ofother parties’ technology based upon the Company’s products and technology, andindemnities to directors and officers of the Company to the maximum extentpermitted under the laws of the State of Delaware. The duration of theseindemnities, commitments and guarantees varies, and in certain cases, is indefinite.The majority of these indemnities, commitments and guarantees do not providefor any limitation of the maximum potential future payments that the Companycould be obligated to make. To date, the Company has not been required to makeany payments and has not recorded any liability for these indemnities,commitments and guarantees in the accompanying balance sheets. The Companydoes, however, accrue for losses for any known contingent liability, includingthose that may arise from indemnification provisions, when future payment isprobable.

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 14—RelatedParty Transactions**

One of the Company’s 5% or greater stockholders wasboth a customer of and a supplier to the Company. Sales to this stockholdertotaled $648 for the year ended December 31, 2004. Purchases from thestockholder totaled $39 for the year ended December 31, 2004. This entitywas not considered a related party in 2005 or 2006.

The Company had sales of$219 for the year ended December 31, 2004, to a customer which was an18.8% owned affiliate up until the end of the third quarter of 2005. TheCompany had sales of $41 to this customer for the nine months ended September 30,2005. This entity was not considered a related party as of the fourth quarterof 2005 or for the full year of 2006.

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

**Note 15—Income Taxes**

United States and foreignincome (loss) before taxes and details of the provision for income taxes are asfollows:

| ** **                  | ** ** | **Years Ended  December 31,** | ** ** |
|-----------------------------|------------|-----------------------------------------|------------|
| ** **                  | ** ** | **2004**                                | ** ** | **2005** | ** ** | **2006** | ** ** |
| United States               |       | $                                       | 12,237     |   | $ | 13,746 | ** ** | **$** | **9,343** | ** ** |
| Foreign                     |       | 3,274                                   |       | (1,556 | ) | **(5,501** | **)** |
| Income before  income taxes |       | $                                       | 15,511     |   | $ | 12,190 | ** ** | **$** | **3,842** | ** ** |
| Current:                    |       |                                    |       |   | ** ** | ** ** | ** ** |
| Federal                     |       | $                                       | 5,307      |   | $ | 2,375 | ** ** | **$** | **(1,287** | **)** |
| State                       |       | 1,358                                   |       | 253 | ** ** | **456** | ** ** |
| Foreign                     |       | 960                                     |       | 184 | ** ** | **4,271** | ** ** |
| Total current               |       | 7,625                                   |       | 2,812 | ** ** | **3,440** | ** ** |
| Deferred:                   | ** ** | ** **                              |       |   | ** ** | ** ** | ** ** |
| Federal                     |       | (1,774                                  | )          | 1,010 | ** ** | **(2,326** | **)** |
| State                       |       | (316                                    | )          | 460 | ** ** | **(296** | **)** |
| Total deferred              |       | (2,090                                  | )          | 1,470 | ** ** | **(2,622** | **)** |
| Provision for income taxes  |       | $                                       | 5,535      |   | $ | 4,282 | ** ** | **$** | **818** | ** ** |

 

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

| ** **                                         | ** ** | **As of  December 31,** | ** ** |
|----------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                         | ** ** | **2005**                                    | ** ** | **2006** | ** ** |
| Deferred tax assets:                               |       |                                        |       |   |   |
| Accrued revenues                                   |       | $                                           | 4,667      | ** ** | **$** | **5,146** | ** ** |
| Loss carryforwards                                 |       | 561                                         | ** ** | **338** | ** ** |
| Inventory                                          |       | 1,145                                       | ** ** | **1,282** | ** ** |
| Credit carryforwards                               |       | —                                      | ** ** | **2,685** | ** ** |
| Accounting method change                           |       | 1,063                                       | ** ** | **835** | ** ** |
| Deferred Revenue                                   |       | 395                                         | ** ** | **36** | ** ** |
| Depreciation and amortization                      |       | 436                                         |       | — |   |
| Compensation expense under SFAS No. 123(R)    |       | —                                      | ** ** | **922** | ** ** |
| Accrued expenses                                   |       | 895                                         | ** ** | **570** | ** ** |
| Other assets                                       |       | 152                                         |       | — |   |
| Total deferred tax assets                          |       | 9,314                                       | ** ** | **11,814** | ** ** |
| Deferred tax  liabilities:                         |       |                                        | ** ** | ** ** | ** ** |
| Depreciation and amortization                      |       | —                                      | ** ** | **654** | ** ** |
| Acquired intangibles                               |       | 3,673                                       | ** ** | **3,796** | ** ** |
| Total deferred tax liabilities                     |       | 3,673                                       | ** ** | **4,450** | ** ** |
| Deferred tax assets, net                           |       | 5,641                                       | ** ** | **7,364** | ** ** |
| Current deferred tax assets                        |       | 7,255                                       | ** ** | **7,059** | ** ** |
| Non-current deferred tax assets (liabilities), net |       | $                                           | (1,614     | ) | **$** | **305** | ** ** |
| Deferred tax  assets, net                          |       | 5,641                                       | ** ** | **7,364** | ** ** |

 

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

 

There is no valuation allowance for deferred taxassets of $7,364 at December 31, 2006, based on management’s assessment ofthe Company’s ability to utilize these deferred tax assets. Realization of thenet deferred tax assets 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 are reduced.

At December 31, 2006, the Company had approximately$11,019 in tax loss carryforwards.  Thesetax loss carryforwards consist of federal and state net operating losses of$5,229 and $5,790, respectively, and begin to expire in 2024 and 2014,respectively. Included in these tax loss carryforwards are stock-basedcompensation deductions that, when fully utilized, reduce cash income taxes andwill result in a financial statement income tax benefit of $1,688. The futureincome tax benefit, if realized, will be recorded to additional paid-incapital.

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 or for which the income tax deduction exceeded the expense recordedfor accounting purposes.

The provisionfor income taxes differs from the amount obtained by applying the federalstatutory income tax rate to income before provision for income taxes asfollows:

| ** **                                | ** ** | **Years Ended  December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                | ** ** | **2004**                                | ** ** | **2005** | ** ** | **2006** | ** ** |
| Statutory federal rate                    |       | 35.0                                    | %          | 35.0 | % | **35.0** | **%** |
| State income taxes, net                   |       | 4.5                                     |       | 5.9 | ** ** | **5.1** | ** ** |
| In-process research and  development      |       | —                                  |       | 6.6 |   | — |   |
| Effect of varying  foreign rates          |       | (6.9                                    | )          | 4.9 | ** ** | **62.2** | ** ** |
| Extraterritorial income  exclusion        |       | —                                  |       | (9.3 | ) | **(69.6** | **)** |
| Tax exempt  interest                      |       | —                                  |       | (4.1 | ) | **(35.8** | **)** |
| Separation and  restructuring costs       |       | —                                  |       | — | ** ** | **10.4** | ** ** |
| Equity based  compensation expense        |       |                                    |       |   | ** ** | **8.6** | ** ** |
| Impact of Avica  consolidation            |       | —                                  |       | — | ** ** | **2.4** | ** ** |
| Research and development  credits         |       | —                                  |       | — | ** ** | **5.4** | ** ** |
| Domestic  Production Activities Deduction |       |                                    |       |   | ** ** | **(3.8** | **)** |
| Other                                     |       | 3.1                                     |       | (3.9 | ) | **1.4** | ** ** |
| Effective tax rate                        |       | 35.7                                    | %          | 35.1 | % | **21.3** | **%** |

 

The Company had not provided for United States incometaxes or foreign withholding taxes in its effective tax rate on approximately$1,857 of undistributed earnings from its foreign subsidiaries as of December31, 2006. The Company intends to reinvest these earnings indefinitely inoperations outside of the United States.

The significant rate increase due to the effect onvarying foreign income tax rates was largely due to unbenefited losses incertain foreign jurisdictions resulting from cost sharing and service agreement

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

termination payments. However,this was offset by additional benefit from the extraterritorial incomeexclusion that resulted from a favorable resolution of the Internal RevenueService (the “IRS”) audit mentioned below.

During the years ended December 31, 2004, theCompany received a tax holiday from the Chinese taxing authorities. For the taxyear ended December 31, 2005 and 2006, the Company was awarded a reducedtax rate of 18% on income in China based on achieving “high-tech” status, whichthe Company expects to renew on an annual basis. The tax holiday and reducedrate resulted in reductions to income taxes of $323 and $215 for the yearsended December 31, 2005 and 2006, respectively, with earnings per dilutedcommon share benefits for these same periods of $0.02 and $0.01, respectively.

Income tax receivable, netat December 31, 2005 and 2006, includes estimated tax contingencies of$1,410 and $726, respectively, for both domestic and foreign issues. The netdecrease of $684 was due mainly to the conclusion of the IRS regular audit ofthe Company’s 2003 tax returns in June 2006. The Company believes that itsaccruals for tax liabilities are adequate for all open years, based on theassessment of many factors including past experience and interpretations of taxlaw applied to the facts of each matter. Inherent uncertainties exist inestimating tax contingencies due to the progress of income tax audits andchanges in tax law, both legislated and concluded through the variousjurisdictions’ tax court systems.

**Note 16—Stock-BasedCompensation**

**Adoption of SFAS No. 123(R)**

Effective January 1, 2006, the Company adoptedthe provisions of SFAS No. 123(R), which requires compensation costrelating to share-based payment awards made to employees and directors berecognized in the financial statements. The Company elected to use themodified-prospective-transition method. Under the transition method,compensation expense recognized beginning January 1, 2006 includes: (i) compensationcost for all share-based payments granted prior to, but not yet vested as of January 1,2006, based on the grant date fair value estimated in accordance with theoriginal provisions of SFAS No. 123, and (ii) compensation costfor all share-based payments granted on or after January 1, 2006, based onthe grant date fair value estimated in accordance with the provisions of SFAS No. 123(R).The Company did not restate its results for prior periods.

Prior to January 1, 2006, the Company accountedfor its employee stock option and stock purchase plans in accordance with theprovisions of Accounting Principles Board Opinion (“APB”) No. 25, “Accountingfor Stock Issued to Employees” and the related FIN No. 44, “Accounting forCertain Transactions Involving Stock Compensation,” and complied with thedisclosure provisions of SFAS No. 123, “Accounting for Stock-BasedCompensation.” Under the provisions of these pronouncements, all optionsgranted under those plans had an exercise price equal to or greater than themarket value of the underlying common stock on the date of grant, whichresulted in no recognition of stock-based compensation expense. For the yearsended December 31, 2005 and 2004, the company recognized no stock-basedemployee compensation cost from stock options.

As a result of adopting SFAS No. 123(R) on January 1,2006, the Company’s income before taxes and net income for the year ended December 31,2006, were approximately $3,586 and $2,125 lower, respectively, than if it hadcontinued to account for share-based compensation under APB No. 25. Basic 

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

and diluted earnings pershare for the year ended December 31, 2006 would have been $0.29 and$0.28, respectively, if it had not adopted SFAS No. 123(R), compared toreported basic and diluted earnings per share of $0.17 and $0.16, respectively.The total stock-based compensation cost that has been recognized in theConsolidated Statements of Operations was $273, $75 and $3,737 for the yearsended December 31, 2004, 2005 and 2006, respectively, was recorded to costof goods sold, and selling, general and administrative expenses, and researchand development expenses. Stock-based compensation cost recorded to cost ofgoods sold for the years ended December 31, 2004, 2005 and 2006 was $0, $0and $134, respectively. Stock-based compensation cost recorded to selling,general and administrative expenses for the years ended December 31, 2004,2005 and 2006 was $273, $75 and $3,140, respectively. Stock-based compensationcost recorded to research and development expenses for the years ended December 31,2004, 2005 and 2006 was $0, $0 and $463, respectively. The total income taxbenefit recognized was $97, $26 and $1,523 for the years ended December 31,2004, 2005 and 2006, respectively.

Prior to adoption of SFAS No. 123(R), the Companypresented all tax benefits of deductions resulting from the exercise of stockoptions as operating cash flows in the Consolidated Statements of Cash Flows.SFAS No. 123(R) requires the cash flows resulting from the taxbenefits resulting from tax deductions in excess of the compensation costrecognized for those options (excess tax benefits) to be classified as financingcash flows. The $411 excess tax benefit classified as a financing cash inflowwould have been classified as an operating cash inflow if the Company had notadopted SFAS No. 123(R). During the year ended December 31, 2006, theCompany received $1,607 in cash from stock option exercises.

In November 2005, the FASB issued FASB StaffPosition No. FAS 123(R)-3, “Transition Election Related toAccounting for Tax Effects of Share-Based Payment Awards,” (“FSP 123(R)-3”).The Company has elected to adopt the alternative transition method provided inFSP 123(R)-3 for calculating the tax effects of stock-based compensationpursuant to SFAS No. 123(R). The alternative transition method includes asimplified method to establish the beginning balance of the additional paid-incapital (“APIC pool”) related to the tax effects of employee and directorstock-based compensation, and to determine the subsequent impact on the APICpool and the consolidated statements of cash flows of the tax effects ofemployee and director stock-based awards that are outstanding upon adoption ofSFAS No. 123(R).

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

If theCompany had elected for the years ended December 31, 2004 and 2005 torecognize compensation cost for stock options based on their fair value at thegrant dates, consistent with the method prescribed by SFAS No. 123, netincome and net income per share would have been as follows:

| ** **                                                                                                               | ** ** | **For the Years Ended  December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                                                               | ** ** | **2004**                                                  | ** ** | **2005** | ** ** |
| Net income:                                                                                                              |       |                                                      |       |   |   |
| As reported                                                                                                              |       | $                                                         | 9,976      |   | $ | 7,908 |   |
| Additional stock-based compensation expense determined  under the   fair value method, net of tax                        |       | (1,786                                                    | )          | (5,392 | ) |
| Pro forma                                                                                                                |       | $                                                         | 8,190      |   | $ | 2,516 |   |
| Net income per common share—basic:                                                                                  |       |                                                      |       |   |   |
| As reported                                                                                                              |       | $                                                         | 0.59       |   | $ | 0.46 |   |
| Per share effect of additional stock-based  compensation expense determined under the fair value method, net of tax |       | (0.11                                                     | )          | (0.31 | ) |
| Pro forma                                                                                                                |       | $                                                         | 0.48       |   | $ | 0.15 |   |
| Net income per common share—diluted:                                                                                |       |                                                      |       |   |   |
| As reported                                                                                                              |       | $                                                         | 0.55       |   | $ | 0.43 |   |
| Per share effect of additional stock-based  compensation expense determined under the fair value method, net of tax |       | (0.10                                                     | )          | (0.29 | ) |
| Pro forma                                                                                                                |       | $                                                         | 0.45       |   | $ | 0.14 |   |

 

The Company hashistorically recognized compensation cost over the nominal vesting period,whereby if an employee retired before the end of the vesting period, theCompany would recognize any remaining unrecognized compensation cost at thedate of retirement. The FASB clarified in SFAS No. 123(R) that thefair value of such stock options should be expensed based on recognition undera non-substantive vesting period approach, requiring compensation expenserecognition when an employee is eligible to retire. Company employees areeligible to retire after age 60. For those employees that retire and areeligible, their options may continue to vest upon the original vestingschedules. The SEC recently clarified that companies should continue thevesting method they have been using until adoption of SFAS 123(R), thenapply the accelerated non-substantive vesting approach to all subsequent grantsto those employees whose options continue to vest after the date of retirementeligibility. For the year ended December 31, 2005, had the Company beenaccounting for such stock options using the non-substantive vesting approachfor retirement-eligible employees, the Company would have not recognizedadditional stock-based compensation expense.

**Various 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 

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

expire in ten years. Thetotal number of shares of common stock that may be issued under both plansamounted to a maximum of 2,071. Options granted prior to 2002 were granted atexercise prices equal to the preferred stock financing prices, which were inexcess of the estimated fair value of the underlying 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 having an exerciseprice equal to the stock’s then-current fair value. Options to purchase a totalof 930 shares were cancelled under the stock option replacement program. On September 30,2002, six months and 15 days after the cancellation of options exchangedunder the option replacement program, the Company granted options to purchase atotal of 929 shares of common stock as replacement awards at an exercise priceof $1.02, which represented the fair value of the Company’s common stock onthat date.

In April 2003, the Company’s Board adopted the2003 Equity Incentive Plan (the “2003 Plan”) under which an additional 929shares were authorized for future issuances of common stock. Additionally, theshares available for issuances of common stock options under the 1997 and 2002Plans were transferred to the 2003 Plan for future issuances of common stockoptions. The 2003 Plan contains a provision (the “Evergreen Provision”) for anautomatic increase 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: (i) fourpercent of the number of shares issued and outstanding on the immediatelypreceding December 31, (ii) 1,500 shares, or (iii) a number ofshares set by the Board of Directors.

Thefair value of each employee option grant is estimated on the date of the grantusing the Black-Scholes option pricing model with the following weightedaverage key assumptions: 

| ** **               | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------|------------|----------------------------------------|------------|
| ** **               | ** ** | **2004**                               | ** ** | **2005** | ** ** | **2006** | ** ** |
| Risk free  interest rate |       |                                   | 3.4        | % |   |   | 3.8 | % |   |   | 4.4 | % |   |
| Expected lives  (years)  |       |                                   | 4          |   |   |   | 4 |   |   |   | 5.8 |   |   |
| Dividend yield           |       |                                   | 0          | % |   |   | 0 | % |   |   | 0 | % |   |
| Expected volatility      |       |                                   | 50         | % |   |   | 50 | % |   |   | 58 | % |   |

 

The dividend yieldwas not calculated because the Company does not currently expect to pay adividend. The expected life of the options granted was derived from thehistorical activity of the Company’s options and represented the period of timethat options granted were expected to be outstanding. Expected volatility wasbased on a blend of the historical volatility of the Company’s common stock andpublicly traded peer companies. The risk-free interest rate was the averageinterest rates of U.S. government bonds of comparable term to the options onthe dates of the option grants.

There were 571, 685 and 374 options granted during theyear ended December 31, 2004, 2005 and 2006, respectively. The weightedaverage fair value of options granted during the year ended December 31,2004, 2005 and 2006 was $9.40, $7.62 and $10.56, respectively. Stock-basedcompensation expense for stock options for the year ended December 31,2006, was calculated based on their fair value at the grant dates, consistentwith the method prescribed by SFAS No. 123(R) adjusted by estimatedforfeitures as prescribed 

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

by SFAS 123(R).Compensation expense for stock options, under SFAS 123(R), was $2,631 for theyear ended December 31, 2006.

Thefollowing table summarizes information about stock option activity during theyear ended December 31, 2006: 

| ** **                                     | ** ** | **Options  Outstanding** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Life (Years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|------------------------------------------------|------------|--------------------------|------------|-----------------------------------------|------------|-------------------------------------------------------------------|------------|---------------------------------|------------|
| Options  outstanding at December 31, 2005 |       |                     | 2,322      |                                    |       |                                                              | $          | 12.73                           |       |   |   |   |   |   |   |   |   |   |
| Granted                                        |       |                     | 374        |                                    |       |                                                              | 19.04      |                            |       |   |   |   |   |   |   |   |   |
| Exercised                                      |       |                     | (357       | )                                       |       |                                                              | 4.50       |                            |       |   |   |   |   |   |   |   |   |
| Expired or cancelled                           |       |                     | (51        | )                                       |       |                                                              | 19.48      |                            |       |   |   |   |   |   |   |   |   |
| Options  outstanding at December 31, 2006 |       |                     | 2,288      |                                    |       |                                                              | $          | 14.90                           |       |   |   | 7.40 |   |   |   | $ | 21,252 |   |   |
| Options exercisable at  December 31, 2006 |       |                     | 1,486      |                                    |       |                                                              | $          | 13.19                           |       |   |   | 6.71 |   |   |   | $ | 16,347 |   |   |

 

| ** **                                                            | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                             | ** ** |
|-----------------------------------------------------------------------|------------|------------------------------|------------|----------------------------------------------------------|------------|
| **Range of Exercise Prices**                           | ** ** | ** **                   | ** ** | **Number  Outstanding at  December 31,  2006** | ** ** | **Weighted-  Average  Remaining  Contractual  Life (Years)** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Number  Exercisable at   December 31,   2006** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| $  1.02 - $  3.07                       |       |                         | 573        |                                                     |       |   | 5.66 |   |   |   | $ | 1.02 |   |   |   | 573 |   |   |   | $ | 1.02 |   |   |
|     3.08 -     6.16 |       |                         | 8          |                                                     |       |   | 2.31 |   |   |   | 4.15 |   |   |   | 7 |   |   |   | 4.10 |   |   |
|     6.17 -     9.23 |       |                         | 10         |                                                     |       |   | 6.20 |   |   |   | 8.02 |   |   |   | 7 |   |   |   | 8.02 |   |   |
|     9.24 -   12.31            |       |                         | 3          |                                                     |       |   | 6.29 |   |   |   | 10.59 |   |   |   | 3 |   |   |   | 10.57 |   |   |
|   12.32 -   15.40                       |       |                         | 59         |                                                     |       |   | 7.70 |   |   |   | 14.16 |   |   |   | 24 |   |   |   | 13.87 |   |   |
|   15.41 -   18.47                       |       |                         | 735        |                                                     |       |   | 8.46 |   |   |   | 17.11 |   |   |   | 221 |   |   |   | 16.52 |   |   |
|   18.48 -   21.55                       |       |                         | 308        |                                                     |       |   | 8.61 |   |   |   | 19.75 |   |   |   | 81 |   |   |   | 19.74 |   |   |
|   21.56 -   24.63                       |       |                         | 557        |                                                     |       |   | 7.23 |   |   |   | 23.18 |   |   |   | 535 |   |   |   | 23.12 |   |   |
|   24.64 -   27.71                       |       |                         | 28         |                                                     |       |   | 6.92 |   |   |   | 25.94 |   |   |   | 28 |   |   |   | 25.94 |   |   |
|   27.72 -   30.79                       |       |                         | 7          |                                                     |       |   | 6.77 |   |   |   | 30.79 |   |   |   | 7 |   |   |   | 30.79 |   |   |
| $  1.02 - $30.79                                  |       |                         | 2,288      |                                                     |       |   | 7.40 |   |   |   | $ | 14.90 |   |   |   | 1,486 |   |   |   | $ | 13.19 |   |   |
|                                                                       |            |                              |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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. The 

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

Committee’s decision toaccelerate the vesting of the affected stock options was based upon therequired adoption of SFAS No. 123(R).

The aggregate intrinsic value of options exercisedduring the year ended December 31, 2004, 2005 and 2006 was $10,338, $2,173and $6,121, respectively. As of December 31, 2006, total remainingunearned compensation related to unvested stock options was approximately$5,253, which will be amortized over the weighted-average remaining serviceperiod of two years.

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 the2003 Foreign Subsidiary Employee Stock Purchase Plan (“ESPP”), under which,subject to certain limitations, the initial aggregate number of shares of stockthat may be issued is 500, with a provision (the “Evergreen Provision”) thatprovides for an automatic increase in the number of shares available forissuance on January 1, 2004 and each January 1 thereafter until andincluding January 1, 2013 by the lesser of: (i) 500 shares, (ii) onepercent of the number of shares of all classes of common stock of the Companyoutstanding on that date, or (iii) a lesser amount determined by the Boardof Directors. Under the ESPP, shares are only issued during the second andfourth quarter of each year. The values were estimated at the date of grantusing the Black-Scholes option pricing model with the following weightedaverage key assumptions:

| ** **               | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|
| Risk free  interest rate |       |     | 1.4        | %        |       |     | 2.6        | % |   |   | 4.5 | % |   |
| Expected lives  (years)  |       |     | 1.3        |     |       |     | 1.3        |   |   |   | 0.8 |   |   |
| Dividend yield           |       |     | 0          | %        |       |     | 0          | % |   |   | 0 | % |   |
| Expected volatility      |       |     | 50         | %        |       |     | 50         | % |   |   | 63 | % |   |

 

The dividend yield was not calculated because theCompany does not currently expect to pay a dividend. The expected liferepresented the service period. Expected volatility was based on a blend of thehistorical volatility of the Company’s common stock and publicly traded peercompanies. The risk-free interest rate was the average interest rates of U.S.government bonds of comparable term to the service period.

In accordance with the Evergreen Provision in theESPP, and as approved by the Board of Directors, effective January 1, 2006,the number of shares reserved under the ESPP was increased by 100 shares.Compensation expense under the ESPP was $405 for the year ended December 31, 2006.

During 2006, the Compensation Committee of the Boardof Directors approved a grant of 93 shares of restricted stock to executiveofficers and employees pursuant to the 2003 Plan. The shares of restrictedstock granted to executive officers and employees generally vest in equal annualinstallments on each of the four year anniversaries following the date ofgrant. Also during 2006, in accordance with the 2003 Plan, 12 shares ofrestricted stock were automatically issued to the outside directors. The sharesof restricted stock granted to outside directors generally vest on the one yearanniversary following the date of grant. Compensation expense on these shareswas $550 for the year ended December 31, 2006.

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

Thefollowing table summarizes information about restricted stock activity duringthe year ended December 31, 2006: 

| ** **                                | ** ** | **Number of  Shares** | ** ** | **Weighted-  Average  Grant-Date  Fair Value** | ** ** |
|-------------------------------------------|------------|----------------------------|------------|-----------------------------------------------------|------------|
| Granted                                   |       |                       | 105        |                                                |       |   | $ | 18.92 |   |   |
| Vested                                    |       |                       | (5         | )                                                   |       |   | 18.32 |   |   |
| Forfeited                                 |       |                       | —     |                                                |       |   | — |   |   |
| Unvested stock at  December 31, 2006 |       |                       | 100        |                                                |       |   | $ | 18.95 |   |   |

 

As of December 31,2006, total remaining unearned compensation related to restricted stock was$1,297, which will be amortized over the weighted-average remaining serviceperiod of two years.

**Non-Employee Equity Awards**

The Company grants optionsto purchase shares of common stock to non-employee consultants. Additionallythe terms of the plan allow employees who are terminated, but have continuingservice obligations to the Company to continue vesting in their options. Assuch the Company recorded stock-based compensation expense in selling, generaland administrative expense of $273, $75 and $151 for the years ended December 31,2004, 2005 and 2006, respectively.

**Note 17—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 payroll of the Companyare eligible to participate in the plans. Prior to 2004, the Company matched upto 50% of the employee’s contributions up to 6% of salary. Effective beginningin 2004, the Company matches 50% of the first 4% of salary contributed to theplan and up to 6% of salary if certain financial targets are met. For the yearsended December 31, 2004, 2005 and 2006, the costs of these matchingpayments were $194, $223 and $199, respectively.

**Note 18—Common Stock Warrants**

In connection with thereorganization as described in Footnote 1 of the consolidated financialstatements, “The Company”, each of the former stockholders and the Partnershipmembers of the predecessor entities were also granted warrants to acquire apro-rata number of 2,127 shares of the Company’s common stock at an exerciseprice of $12.14 per share at any time through December 31, 2007. As thereorganization was accounted for as a common control transaction, no additionalvalue was ascribed to these warrants.

As of December 31,2006, there were warrants outstanding to acquire 7 shares of common stock withan exercise price of $12.14 per share.

**Note 19—Stock Repurchase Plan**

In August 2006, theCompany’s Board of Directors authorized, subject to certain business and marketconditions, the purchase of up to one million shares of the Company’s commonstock in the open market or in privately negotiated transactions. At December 31,2006, there were no shares purchased under this authorization. Any sharesrepurchased would be considered treasury stock.

96

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

**Note 20—Operating Segment and GeographicInformation**

The Company operates itsbusiness in three reportable segments: the Consumer business segment, theCinema business segment and the Digital Images business segment. The Company’sConsumer business segment licenses audio technology, trademarks and know-how toconsumer electronics, personal computer, broadcast and professional audiocompanies, and sells multi-channel audio content and products to consumers. TheCinema business segment licenses technology and sells products and services toproducers and distributors of feature length films and digital content, and tomovie theaters and special venues. The Company’s Digital Images business segmentprovides enhancement, restoration and repair services for moving picturescaptured on film or in digital form, television content, and other forms ofimage content.

During the first quarterof 2007, the Company announced that its Board of Directors approved a plan tosell its DTS Digital Cinema business, which is comprised of its Cinema businesssegment and Digital Images business segment. Therefore, the Company hasincluded a subtotal representing the DTS Digital Cinema business.

The Company does not separatelyidentify and manage capital expenditures or long-lived assets related to thesethree business segments.

TheCompany’s reportable segments and geographical information are as follows:

| ** **                  | ** ** | **Revenues by Segment**                         | ** ** |
|-----------------------------|------------|-----------------------------------------------------------|------------|
| ** **                  | ** ** | **For the Years Ended  December 31,** | ** ** |
| ** **                  | ** ** | **2004**                                                  | ** ** | **2005** | ** ** | **2006** | ** ** |
| Consumer business           |       | $                                                         | 41,886     |   | $ | 48,180 | ** ** | **$** | **50,039** | ** ** |
| Cinema business             |       | 19,545                                                    |       | 21,744 | ** ** | **20,260** | ** ** |
| Digital Images  business    |       | —                                                    |       | 5,328 | ** ** | **8,015** | ** ** |
| DTS Digital Cinema business |       | 19,545                                                    |       | 27,072 | ** ** | **28,275** | ** ** |
| Total revenues              |       | $                                                         | 61,431     |   | $ | 75,252 | ** ** | **$** | **78,314** | ** ** |

 

Nocustomers accounted for more than 10% of revenues for any business segment in2004 or 2005. One Consumer customer accounted for 13% of total revenues in2006.

| ** **                  | ** ** | **Gross Profit by Segment**                | ** ** |
|-----------------------------|------------|-----------------------------------------------------------|------------|
| ** **                  | ** ** | **For the Years Ended  December 31,** | ** ** |
| ** **                  | ** ** | **2004**                                                  | ** ** | **2005** | ** ** | **2006** | ** ** |
| Consumer business           |       | $                                                         | 39,821     |   | $ | 45,970 | ** ** | **$** | **48,345** | ** ** |
| Cinema business             |       | 5,448                                                     |       | 10,618 | ** ** | **9,793** | ** ** |
| Digital Images  business    |       | —                                                    |       | (949 | ) | **(228** | **)** |
| DTS Digital Cinema business |       | 5,448                                                     |       | 9,669 | ** ** | **9,565** | ** ** |
| Total gross  profit         |       | $                                                         | 45,269     |   | $ | 55,639 | ** ** | **$** | **57,910** | ** ** |

 

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

 

| ** **                           | ** ** | **Income (Loss) From Operations  by Segment** | ** ** |
|--------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                           | ** ** | **For the Years Ended  December 31,**         | ** ** |
| ** **                           | ** ** | **2004**                                                          | ** ** | **2005** | ** ** | **2006** | ** ** |
| Consumer business                    |       | $                                                                 | 19,969     |   | $ | 21,139 | ** ** | **$** | **15,130** | ** ** |
| Cinema business                      |       | (8,475                                                            | )          | (4,051 | ) | **(10,025** | **)** |
| Digital Images  business             |       | —                                                            |       | (7,576 | ) | **(6,186** | **)** |
| DTS Digital Cinema business          |       | (8,475                                                            | )          | (11,627 | ) | **(16,211** | **)** |
| Total income  (loss) from operations |       | $                                                                 | 11,494     |   | $ | 9,512 | ** ** | **$** | **(1,081** | **)** |

 

Included in the Consumer business segment’s loss forthe year ended December 31, 2006 is the $3.8 million of restructuringcosts relating to the early termination of a business agreement related to theCompany’s licensing of intellectual property in China and the write-down ofDTSE inventory and other related assets. Included in the Cinema businesssegment’s loss for the year ended December 31, 2006 is the $1.1 million ofseparation costs relating to the separation of the Company’s DTS Digital Cinemabusiness. Included in gross profit and loss from operations for the Cinemabusiness for the year ended December 31, 2004 is a $3,871 write-down ofthe monochrome projector inventory.

TheConsumer business income from operations includes depreciation and amortizationexpense of $753, $1,170 and $1,380 for the years ended December 31, 2004,2005 and 2006, respectively. The Cinema business loss from operations includesdepreciation and amortization expense of $545, $588 and $1,063 for the yearsended December 31, 2004, 2005 and 2006, respectively. The Digital Imagesbusiness loss from operations includes depreciation and amortization expense of$2,035 and $2,327 for the years ended December 31, 2005 and 2006,respectively. The Digital Images business loss from operations also includes acharge of $2,300 for in-process research and development for 2005.

| ** **           | ** ** | **Revenues by Geographic Region**          | ** ** |
|----------------------|------------|-----------------------------------------------------------|------------|
| ** **           | ** ** | **For the Years Ended  December 31,** | ** ** |
| ** **           | ** ** | **2004**                                                  | ** ** | **2005** | ** ** | **2006** | ** ** |
| United States        |       | $                                                         | 17,830     |   | $ | 27,157 | ** ** | **$** | **23,168** | ** ** |
| Japan                |       | 17,516                                                    |       | 18,870 | ** ** | **18,316** | ** ** |
| Taiwan               |       | 279                                                       |       | 3,251 | ** ** | **10,309** | ** ** |
| South Korea          |       | 7,772                                                     |       | 8,248 | ** ** | **7,847** | ** ** |
| China                |       | 6,936                                                     |       | 6,702 | ** ** | **3,365** | ** ** |
| Other  international |       | 11,098                                                    |       | 11,024 | ** ** | **15,309** | ** ** |
| Total international  |       | 43,601                                                    |       | 48,095 | ** ** | **55,146** | ** ** |
| Total revenues       |       | $                                                         | 61,431     |   | $ | 75,252 | ** ** | **$** | **78,314** | ** ** |

 

Thefollowing table sets forth, for the periods indicated, long-lived assets bygeographic region:

| ** **              | ** ** | **Long-Lived Assets**            | ** ** |
|-------------------------|------------|---------------------------------------|------------|
| ** **              | ** ** | **As of December 31,** | ** ** |
| ** **              | ** ** | **2004**                              | ** ** | **2005** | ** ** | **2006** | ** ** |
| United States           |       | $                                     | 3,099      |   | $ | 5,859 | ** ** | **$** | **9,694** | ** ** |
| International           |       | 2,219                                 |       | 1,516 | ** ** | **1,644** | ** ** |
| Total long-lived assets |       | $                                     | 5,318      |   | $ | 7,375 | ** ** | **$** | **11,338** | ** ** |

 

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

**Note 21—Net Income Per Share**

Basic net incomeper common share is calculated by dividing net income by the weighted averagenumber of common shares outstanding during the period. Diluted net income percommon share is calculated by dividing net income by the sum of the weightedaverage number of common shares outstanding plus the dilutive effect ofunvested restricted stock, outstanding stock options, common stock warrants,and the ESPP using the “treasury stock” method.

Thefollowing table sets forth the computation of basic and diluted net income pershare:

| ** **                                | ** ** | **For the Years Ended December 31,**                   | ** ** |
|-------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                | ** ** | **2004**                                                                        | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                | ** ** | **(Amounts in thousands,   except per share amounts)** | ** ** |
| Basic net income per share:          |       |                                                                            |       |   |   |   |   |
| Numerator:                                |       |                                                                            |       |   |   |   |   |
| Net income                                |       | $                                                                               | 9,976      |   | $ | 7,908 | ** ** | **$** | **3,024** | ** ** |
| Denominator:                              |       |                                                                            |       |   |   |   |   |
| Weighted average basic shares outstanding |       | 16,866                                                                          |       | 17,321 | ** ** | **17,623** | ** ** |
| Basic net income per common share    |       | $                                                                               | 0.59       |   | $ | 0.46 | ** ** | **$** | **0.17** | ** ** |
| Diluted net income per share:        |       |                                                                            |       |   |   |   |   |
| Numerator:                                |       |                                                                            |       |   |   |   |   |
| Net income                                |       | $                                                                               | 9,976      |   | $ | 7,908 | ** ** | **$** | **3,024** | ** ** |
| Denominator:                              |       |                                                                            |       |   |   |   |   |
| Weighted average shares outstanding       |       | 16,866                                                                          |       | 17,321 | ** ** | **17,623** | ** ** |
| Effect of dilutive securities:            |       |                                                                            |       |   |   |   |   |
| Common stock options                      |       | 1,003                                                                           |       | 930 | ** ** | **745** | ** ** |
| Common stock warrants                     |       | 274                                                                             |       | 59 | ** ** | **14** | ** ** |
| Restricted stock                          |       | —                                                                          |       | — | ** ** | **13** | ** ** |
| ESPP                                      |       | —                                                                          |       | — | ** ** | **6** | ** ** |
| Diluted shares outstanding                |       | 18,143                                                                          |       | 18,310 | ** ** | **18,401** | ** ** |
| Diluted net income per common share  |       | $                                                                               | 0.55       |   | $ | 0.43 | ** ** | **$** | **0.16** | ** ** |

 

For the years ended December 31,2004, 2005 and 2006, 598, 795 and 1,176 shares, respectively, of the Company’sstock options and restricted stock were excluded from the calculation ofdiluted earnings per share because their inclusion would have been anti-dilutive.

**Note 22—Income From Legal Settlement**

The Company is involved invarious legal actions arising in the ordinary course of business, which mayinvolve commercial transactions, product liability, and health and safetymatters. These claims have not had, and are not expected to have, a materialadverse effect on the Company’s financial condition or results of operations.

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.

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

**Note 23—Selected Quarterly Data (Unaudited)**

| ** **                         | ** ** | **For the Quarter Ended** | ** ** |
|------------------------------------|------------|------------------------------------------|------------|
| ** **                         | ** ** | **Mar. 31,**                        | ** ** | **June 30,** | ** ** | **Sep. 30,** | ** ** | **Dec. 31,** | ** ** |
| **2006**                           | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                           |       | $                                        | 28,701     |   | $ | 16,897 |   | $ | 15,253 |   | $ | 17,463 |   |
| Gross profit                       |       | $                                        | 22,559     |   | $ | 11,863 |   | $ | 10,931 |   | $ | 12,557 |   |
| Net income (loss)                  |       | $                                        | 7,007      |   | $ | 1,883 |   | $ | (898 | )(1) | $ | (4,968 | )(2) |
| Basic earnings (loss)  per share   |       | $                                        | 0.40       |   | $ | 0.11 |   | $ | (0.05 | ) | $ | (0.28 | ) |
| Diluted earnings (loss)  per share |       | $                                        | 0.38       |   | $ | 0.10 |   | $ | (0.05 | ) | $ | (0.28 | ) |
| **2005**                           | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                           |       | $                                        | 22,057     |   | $ | 17,728 |   | $ | 17,553 |   | $ | 17,914 |   |
| Gross profit                       |       | $                                        | 17,594     |   | $ | 12,698 |   | $ | 12,909 |   | $ | 12,438 |   |
| Net income                         |       | $                                        | 3,556      |   | $ | 1,816 |   | $ | 1,194 |   | $ | 1,342 |   |
| Basic earnings per share           |       | $                                        | 0.21       |   | $ | 0.10 |   | $ | 0.07 |   | $ | 0.08 |   |
| Diluted earnings per share         |       | $                                        | 0.19       |   | $ | 0.10 |   | $ | 0.07 |   | $ | 0.07 |   |

----

(1)          Includes $396 of expensefor the separation of our business. For additional information, refer toFootnote 4 of the consolidated financial statements, “Separation andRestructuring Costs.”

(2)          Includes$749, $3,000 and $449 of expenses for the separation of our business, the earlytermination of a business agreement and write-down of DTSE inventory and otherassets, respectively. For additional information, refer to Footnote 4 of theconsolidated financial statements, “Separation and Restructuring Costs.” Alsoincludes $262 for the impact of consolidating Avica, as discussed in Footnote 3of the consolidated financial statements, “Consolidation of Avica as a VariableInterest Entity.”

**Note 24—Subsequent Events**

In February 2007, the Company announced that itsBoard of Directors had approved a plan to sell its DTS Digital Cinema businessto enable the Company to focus exclusively on licensing branded entertainmenttechnology to the large and evolving audio, game console, personal computer,portable and broadcast markets. The sales process has begun and is expected toconclude later in 2007.

The following tablepresents total current assets, total assets, total current liabilities andtotal liabilities for DTS Digital Cinema included in the Company’s ConsolidatedBalance Sheets as of December 31, 2005 and 2006. 

| ** **                | ** ** | **As of December 31,** | ** ** |
|---------------------------|------------|---------------------------------------|------------|
| ** **                | ** ** | **2005**                              | ** ** | **2006** | ** ** |
| Total current assets      |       | $                                     | 13,723     |   | $ | 11,572 |   |
| Total assets              |       | $                                     | 32,248     |   | $ | 37,952 |   |
| Total current liabilities |       | $                                     | 7,228      |   | $ | 7,167 |   |
| Total liabilities         |       | $                                     | 7,228      |   | $ | 8,633 |   |

 

Additionally, thefollowing table presents total revenues, gross profit and loss from operationsfor DTS Digital Cinema included in the Company’s Consolidated Statements ofOperations for the years ended December 31, 2004, 2005 and 2006.

| ** **           | ** ** | **For the Years Ended December 31,** | ** ** |
|----------------------|------------|---------------------------------------------------------------|------------|
| ** **           | ** ** | **2004**                                                      | ** ** | **2005** | ** ** | **2006** | ** ** |
| Total revenues       |       | $                                                             | 19,545     |   | $ | 27,072 |   | $ | 28,275 |   |
| Gross profit         |       | $                                                             | 5,448      |   | $ | 9,669 |   | $ | 9,565 |   |
| Loss from operations |       | $                                                             | 8,475      |   | $ | 11,627 |   | $ | 16,211 |   |

 

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**DTS, INC.SCHEDULE II—VALUATION AND QUALIFYING ACCOUNTS(Amounts in thousands)**

| **For the Years Ended December 31,** | ** ** | ** ** | ** ** | **Balance at  Beginning  of Year** | ** ** | **Charged to  Costs and  Expenses** | ** ** | **Deductions  From  Reserves** | ** ** | **Balance at  End of Year** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|----------------------------------------------|------------|-----------------------------------------------|------------|--------------------------------|------------|--------------------------------------------|------------|
| Allowance for doubtful  accounts: (1)                         |       |       |       |                                         |       |                                          |       |                           |       |                                       |       |   |   |   |   |   |   |
| 2004                                                          |       |       | $          | 429                                          |       |                                          |       | $                              | 61         |                                       |       |   | $ | 88 |   |   |   | $ | 402 |   |   |
| 2005                                                          |       |       | 402        |                                         |       |                                          | 30         |                           |       |                                       | 62         |   |   |   | 370 |   |   |
| 2006                                                          |       |       | 370        |                                         |       |                                          | 10         |                           |       |                                       | 124        |   |   |   | 256 |   |   |
| Allowance for  obsolescence: (2)                              |       |       |       |                                         |       |                                          |       |                           |       |                                       |       |   |   |   |   |   |   |
| 2004                                                          |       |       | 393        |                                         |       |                                          | 4,312      |                           |       |                                       | 99         |   |   |   | 4,606 |   |   |
| 2005                                                          |       |       | 4,606      |                                         |       |                                          | —     |                           |       |                                       | 1,715      |   |   |   | 2,891 |   |   |
| 2006                                                          |       |       | 2,891      |                                         |       |                                          | 624        |                           |       |                                       | 214        |   |   |   | 3,301 |   |   |
|                                                               |            |            |            |                                              |            |                                               |            |                                |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          The additions to theallowance for doubtful accounts represent the estimates of our bad debt expensebased upon the factors for which we evaluate the collectability of our accountsreceivable. Deductions are the actual write-offs of the receivables.

(2)          Theadditions to the allowance for obsolescence represent the estimated amounts ofinventoried product, which we estimate will not be consumed or sold in a timelymanner, and also includes amounts estimated for lower of cost or marketadjustments. Deductions represent the write-off or sale of that inventory.

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

None.

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

**Disclosure Controls and Procedures**

The Company’s management,with the participation of the Company’s Chief Executive Officer and ChiefFinancial Officer, has evaluated the effectiveness of the Company’s disclosurecontrols and procedures (as such term is defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (the“Exchange Act”)) as of the end of the period covered by this report. Based onsuch evaluation, the Company’s Chief Executive Officer and Chief FinancialOfficer have concluded that, as of December 31, 2006, the Company’sdisclosure controls and procedures are effective in recording, processing,summarizing and reporting, on a timely basis, information required to bedisclosed by the Company in the reports that it files or submits under theExchange Act and are effective in ensuring that information required to bedisclosed by the Company in the reports that it files or submits under theExchange Act is accumulated and communicated to the Company’s managementincluding the Company’s Chief Executive Officer and Chief Financial Offer asappropriate to allow timely decisions regarding required disclosure.

**Management’s Report on Internal Control Over FinancialReporting**

The Company’s management is responsible forestablishing and maintaining adequate internal control over financialreporting, as defined in Exchange Act Rules 13a-15(f) or 15d-15(f).The Company’s internal control over financial reporting is designed to providereasonable assurance regarding the reliability of 

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financial reporting andthe preparation of financial statements for external purposes, in accordancewith generally accepted accounting principles.

The Company’s internal control over financialreporting includes policies and procedures that pertain to the maintenance ofrecords that, in reasonable detail, accurately and fairly reflect transactionsand dispositions of assets of the Company; provide reasonable assurance thattransactions are recorded as necessary to permit preparation of financialstatements in accordance with generally accepted accounting principles, andthat receipts and expenditures are being made only in accordance withauthorization of management and directors of the Company; and providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use or disposition of the Company’s assets that could have amaterial effect on the Company’s financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures may deteriorate.

The Company’s management assessed the effectiveness ofthe Company’s internal control over financial reporting as of December 31,2006. In making this assessment, management used the criteria established bythe Committee of Sponsoring Organizations of the Treadway Commission (“COSO”)in Internal Control-Integrated Framework.

Based on this assessment, management determined thatthe Company maintained effective internal control over financial reporting asof December 31, 2006.

Our management’sassessment of the effectiveness of the Company’s internal control overfinancial reporting as of December 31, 2006 has been audited byPricewaterhouseCoopers LLP, an independent registered public accounting firm,as stated in their report which appears herein in Item 8.

**Changes in InternalControl Over Financial Reporting**

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

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

The Company has enteredinto an employment agreement, effective as of June 28, 2006, with SharonFaltemier. The Company has filed this agreement as exhibit 10.72 included withthis Report.

**PART III**

**Item 10.**                 *Directors, Executive Officers and Corporate Governance*

The information concerning our executive officers tobe included under the caption “Executive Officers and Significant Employees” inour proxy statement relating to our 2007 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, 2006(the “Proxy Statement”) is incorporated herein by reference.

The information concerning our directors to beincluded in our Proxy Statement under the caption “Item 1—Election ofDirectors” is incorporated herein by reference.

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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,” “CompensationDiscussion and Analysis,”  “Compensationof Directors” and “Report of Compensation Committee on Executive Compensation”is incorporated herein by reference.

**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, and DirectorIndependence*

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 concerning principal accounting fees andservices will be included in the Proxy Statement under the caption “Item 2—Ratificationof Independent Auditors” and is incorporated herein by reference.

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**PART IV**

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

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

The information requiredby this Item is included in Item 8 of Part II of this report.

**(a)(3) Exhibits**

SeeItem 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(18)                                                                                                                                                                                                               |
| 3.7              |       | Compensation Committee  Charter                                                                                                                                                                                                            |
| 3.8              |       | Nominating/Corporate  Governance Committee Charter(18)                                                                                                                                                                                     |
| 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)*                                                                                                                                                           |
| 10.16.1          |       | Form of Restricted  Stock Grant Notice and Restricted Stock Agreement under 2003 Equity Incentive  Plan (for annual non-employee director grants)(20)*                                                                                |

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| 10.16.2 |   | Form of Restricted  Stock Grant Notice and Restricted Stock Agreement under 2003 Equity Incentive  Plan (for employee and consultant grants)(20)*                                                           |
|---------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.17   |   | 2003 Employee Stock  Purchase Plan(2)*                                                                                                                                                                           |
| 10.18   |   | 2003 Foreign Subsidiary  Employee Stock Purchase Plan(2)*                                                                                                                                                        |
| 10.19   |   | Replacement Warrant to  Purchase Common Stock between the Registrant and Comerica Incorporated, dated  February 27, 2004(4)                                                                                 |
| 10.20   |   | Replacement Warrant to  purchase Common Stock between the Registrant and J.P. Morgan Securities Inc.,  dated January 9, 2004(4)                                                                             |
| 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)                                                                                                                               |

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| 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(18)                                                                               |
| 10.42.2 |   | Loan Extension  Agreement and Modification to Loan Documents between the Registrant and Comerica  Bank, effective June 12, 2006                                                                                       |
| 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)*                                                                                                     |
| 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)*                                                                                        |

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| 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)*                                                                                           |
| 10.67 |   | Employment Agreement by  and between the Registrant and Daniel E. Slusser, effective as of  January 2, 2006(19)*                                                    |
| 10.68 |   | Amendment to Employment  Agreement, dated as of October 1, 2006, between the Registrant and  Daniel E. Slusser(20)*                                                 |
| 10.69 |   | Exclusive License  Agreement between the Company and Avica Technology Corporation, dated as of  August 8, 2006(21) †                                           |
| 10.70 |   | Option Agreement between  the Company and Avica Technology Corporation, dated as of August 8,  2006(21) †                                                      |
| 10.71 |   | Summary of 2005 bonus  payments for the Chief Executive Officer and other Named Executive  Officers(17)*                                                                 |
| 10.72 |   | Employment Agreement by  and between the Registrant and Sharon Faltemier, dated as of June 28,  2006                                                                |
| 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       |

----

*                  Indicates management contract, arrangement orcompensatory plan.

       (1) Incorporated by reference to the identicallynumbered exhibit filed with the Registrant’s Form S-1 RegistrationStatement (File No. 333-104761) on April 25, 2003.

       (2) Incorporated by reference to the identicallynumbered exhibit filed with the Registrant’s Amendment No. 1 to Form S-1Registration Statement (File No. 333-104761) on June 5, 2003.

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       (3) Incorporated by reference to the identicallynumbered exhibit filed with the Registrant’s Form S-1 RegistrationStatement (File No. 333-110120) on October 31, 2003.

       (4) Incorporated by reference to the identicallynumbered exhibit filed with the Registrant’s Annual Report on Form 10-Kfor the year ended December 31, 2003.

       (5) Incorporated by reference to the identicallynumbered exhibit filed with the Registrant’s Quarterly Report on Form 10-Qfor the quarter ended March 31, 2004.

       (6) Incorporated by reference to the identicallynumbered exhibit filed with the Registrant’s Quarterly Report on Form 10-Qfor the quarter ended June 30, 2004.

       (7) Incorporated by reference to Exhibit 10.41to the Registrant’s Quarterly Report on Form 10-Q for the quarterended June 30, 2004.

       (8) Incorporated by reference to the identicallynumbered exhibit filed with the Registrant’s Annual Report on Form 10-Kfor the year ended December 31, 2004.

       (9) Incorporated by reference to the identicallynumbered exhibit filed with the Registrant’s Quarterly Report on Form 10-Qfor the quarter ended June 30, 2005.

(10) Incorporated by reference to the Registrant’sReport on Form 8-K filed with the Securities and Exchange Commissionon January 6, 2005.

(11) Incorporated by reference to the Registrant’sReport on Form 8-K filed with the Securities and Exchange Commissionon March 1, 2005.

(12) Incorporated by reference to the Registrant’sReport on Form 8-K filed with the Securities and Exchange Commissionon March 25, 2005.

(13) Incorporated by reference to the Registrant’sReport on Form 8-K filed with the Securities and Exchange Commissionon May 11, 2005.

(14) Incorporated by reference to the Registrant’sReport on Form 8-K filed with the Securities and Exchange Commissionon May 24, 2005.

(15) Incorporated by reference to the Registrant’sReport on Form 8-K filed with the Securities and Exchange Commissionon July 29, 2005.

(16) Incorporated by reference to the Registrant’sReport on Form 8-K filed with the Securities and Exchange Commissionon November 23, 2005.

(17) Incorporated by reference to the Registrant’sReport on Form 8-K filed with the Securities and Exchange Commissionon March 1, 2006.

(18) Incorporated by reference to the identicallynumbered exhibit filed with the Registrant’s Annual Report on Form 10-K for theyear ended December 31, 2005.

(19) Incorporated by reference to the Registrant’sReport on Form 10-Q filed with the Securities and ExchangeCommission on May 10, 2006.

(20) Incorporated by reference to the Registrant’sReport on Form 10-Q filed with the Securities and ExchangeCommission on August 9, 2006.

(20) Incorporated by reference to the Registrant’sReport on Form 8-K filed with the Securities and Exchange Commissionon October 5, 2006.

(21) Incorporated by reference to the Registrant’sReport on Form 10-Q filed with the Securities and Exchange Commissionon November 9, 2006.

†                    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.

108

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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, 2007.
|        | 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       |       | March 16, 2007 |
| Jon E. Kirchner                   |          | Officer, and Director  (principal |       |                |
|                              |          | executive officer)                |       |                |
| /s/  MELVIN L. FLANIGAN |          | Executive Vice  President,        |       | March 16, 2007 |
| Melvin L. Flanigan                |          | Finance and Chief  Financial      |       |                |
|                              |          | Officer (principal  financial and |       |                |
|                              |          | accounting officer)               |       |                |
| /s/  DANIEL E. SLUSSER  |          | Chairman of the  Board            |       | March 16, 2007 |
| Daniel E. Slusser                 |          |                              |       |                |
| /s/  JOERG D. AGIN      |          | Director                          |       | March 16, 2007 |
| Joerg D. Agin                     |          |                              |       |                |
| /s/  C. ANN BUSBY       |          | Director                          |       | March 16, 2007 |
| C. Ann Busby                      |          |                              |       |                |
| /s/  JOSEPH A. FISCHER  |          | Director                          |       | March 16, 2007 |
| Joseph A. Fischer                 |          |                              |       |                |
| /s/  JAMES B. MCELWEE   |          | Director                          |       | March 16, 2007 |
| James B. McElwee                  |          |                              |       |                |
| /s/  RONALD N. STONE    |          | Director                          |       | March 16, 2007 |
| Ronald N. Stone                   |          |                              |       |                |

 

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