**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-Q**
| **(Mark One)**                                                                                                                      |                                                                                                |
|-------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------|
| **x**                                                                                                                               | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934**  |
| ** **                                                                                                                          | ** **                                                                                          |
| **For the  quarterly period ended March 31, 2007**                                                                             |
| ** **                                                                                                                          |
| **OR**                                                                                                                              |
| ** **                                                                                                                          |
| **o**                                                                                                                               | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
| ** **                                                                                                                          | ** **                                                                                          |
| **For the  transition period           to        ** |
| ** **                                                                                                                          | ** **                                                                                          |
| **Commission File Number 0-21123**                                                                                                  |

 

**SRS LABS, INC.**

(Exactname of registrant as specified in its charter)

| **Delaware**                                                     |   | **33-0714264**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |

 

**2909Daimler Street, Santa Ana, California 92705**

(Address of principalexecutive offices) (Zip Code)

**(949) 442-1070**

(Registrant’s telephonenumber, including area code)

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x No o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act. (Check one):
| Large accelerated  filer  o             Accelerated filer  o                   Non-accelerated filer  x |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

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

As of April 25, 2007,16,825,840 of the issuer’s common stock, par value $.001 per share, wereoutstanding; of this amount, 674,098 shares of the common stock were held astreasury shares.

 

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**SRS LABS, INC.**

**Form 10-Q**

**For theThree Months Ended March 31, 2007**

**Index**
| **PART I-FINANCIAL INFORMATION** |
|----------------------------------|
| Item 1.                          | Financial Statements |
|                             | Condensed  Consolidated Balance Sheets as of March 31, 2007 (Unaudited) and  December 31, 2006 |
|                             | Condensed  Consolidated Statements of Operations for the three months ended  March 31, 2007 and 2006 (Unaudited) |
|                             | Condensed  Consolidated Statements of Stockholders’ Equity and Comprehensive Income for  the three months ended March 31, 2007 (Unaudited) |
|                             | Condensed  Consolidated Statements of Cash Flows for the three months ended  March 31, 2007 and 2006 (Unaudited) |
|                             | Notes to the  Condensed Consolidated Financial Statements (Unaudited) |
| Item 2.                          | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
| Item 3.                          | Quantitative  and Qualitative Disclosures About Market Risk |
| Item 4.                          | Controls and  Procedures |
| **PART II-OTHER INFORMATION**    |
| Item  6.                         | Exhibits |
|                             |   |
| SIGNATURES                       |

 

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**FORWARD-LOOKINGINFORMATION**

As used herein, the “Company,” “SRS Labs,” “SRS,” “we,”“us,” or “our” means SRS Labs, Inc., its wholly-owned subsidiarySRSWOWcast.com, Inc. and, for the applicable periods, its formersubsidiary ValenceTech Limited (collectively with its direct and indirectwholly-owned subsidiaries, “Valence”) and the former joint venture with ComingHome Studios LLC, CHS/SRS LLC.

Someof the statements in this Quarterly Report on Form 10-Q containforward-looking statements regarding our assumptions, projections,expectations, targets, intentions or beliefs about future events, which involverisks and uncertainties. All statements other than statements of historicalfacts included in this Quarterly Report relating to expectation of futurefinancial performance, continued growth, changes in economic conditions orcapital markets and changes in customer usage patterns and preferences, areforward-looking statements. In some cases, you can identify forward-lookingstatements by terms such as may, will, should, expect, plan, intend, forecast,anticipate, believe, estimate, predict, potential, continue or the negative ofthese terms or other comparable terminology. The forward-looking statementscontained in this Quarterly Report involve known and unknown risks,uncertainties and situations that may cause our or our industry’s actualresults, level of activity, performance or achievements to be materiallydifferent from any future results, levels of activity, performance orachievements expressed or implied by these statements. Factors that might causeactual events or results to differ materially from those indicated by theseforward-looking statements may include the matters listed in our mostrecently filed Annual Report on Form 10-K and elsewhere in thisForm 10-Q, including, but not limited to, the loss of any one significantcustomer; the acceptance of new SRS Labs products and technologies; the importof competitive products and pricing; the timely development and release oftechnologies by the Company; general business and economic conditions,especially in Asia; product and customer concentration in our business; ourhigh dependence on the consumer electronics market, which is characterized byshort product life cycles, fluctuations in demand and seasonality; the risk ofwidespread illness; our dependence on growth in emerging markets; the lengthand unpredictable nature of our sales cycle; our ability to protect ourproducts through patents and other intellectual property rights; our dependenceon key personnel; the volatility of the price of our common stock; provisionsthat could discourage transactions resulting in a change in control containedin our certificate of incorporation and bylaws as well as Delaware law;competition we face from companies with greater brand recognition andresources; pricing pressures on the consumer electronics product manufacturers;adverse state, federal or foreign legislation or regulation or adversedeterminations by regulators; and other factors identified from time to time inour filings with the Securities and Exchange Commission.

Anyforward-looking statement speaks only as of the date on which such statement ismade, and, except as required by law, we undertake no obligation to update anyforward-looking statement to reflect events or circumstances after the date onwhich such statement is made or to reflect the occurrence of unanticipatedevents. New factors emerge from time to time, and it is not possible formanagement to predict all such factors.

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**PART I —FINANCIAL INFORMATION**

**Item 1.Financial Statements**

**SRS LABS, INC. AND SUBSIDIARY****CONDENSEDCONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                                                                                                                                    | ** ** | **March 31, 2007** | ** ** | **December 31, 2006** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                                                                                                                    | ** ** | **(unaudited)**              | ** ** | ** **                      | ** ** |
| **ASSETS**                                                                                                                                                                                                                    |       |                         |       |                            |       |
| **Current Assets**                                                                                                                                                                                                            |       |                         |       |                            |       |
| Cash and cash  equivalents                                                                                                                                                                                                    |       | $                            | 37,113,600 |                            | $          | 35,011,425 |   |
| Accounts  receivable, net                                                                                                                                                                                                     |       | 913,880                      |       | 1,180,879                       |       |
| Prepaid expenses  and other current assets                                                                                                                                                                                    |       | 625,384                      |       | 808,940                         |       |
|                                                                                                                                                                                                                          |       |                         |       |                            |       |
| **Total  Current Assets**                                                                                                                                                                                                     |       | 38,652,864                   |       | 37,001,244                      |       |
|                                                                                                                                                                                                                          |       |                         |       |                            |       |
| Investments  available for sale                                                                                                                                                                                               |       | 5,271,420                    |       | 5,226,705                       |       |
| Property and equipment,  net                                                                                                                                                                                                  |       | 367,643                      |       | 389,667                         |       |
| Intangible  assets, net                                                                                                                                                                                                       |       | 2,071,245                    |       | 2,045,139                       |       |
| Deferred income  taxes, net                                                                                                                                                                                                   |       | 699,472                      |       | 386,412                         |       |
|                                                                                                                                                                                                                          |       |                         |       |                            |       |
| **Total  Assets**                                                                                                                                                                                                             |       | $                            | 47,062,644 |                            | $          | 45,049,167 |   |
|                                                                                                                                                                                                                          |       |                         |       |                            |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                |       |                         |       |                            |       |
| **Current Liabilities**                                                                                                                                                                                                       |       |                         |       |                            |       |
| Accounts payable                                                                                                                                                                                                              |       | $                            | 232,285    |                            | $          | 609,899 |   |
| Accrued  liabilities                                                                                                                                                                                                          |       | 852,420                      |       | 1,295,236                       |       |
| Deferred revenue                                                                                                                                                                                                              |       | 245,000                      |       | 399,565                         |       |
|                                                                                                                                                                                                                          |       |                         |       |                            |       |
| **Total  Current Liabilities**                                                                                                                                                                                                |       | 1,329,705                    |       | 2,304,700                       |       |
|                                                                                                                                                                                                                          |       |                         |       |                            |       |
| Commitments and  contingencies (Note 7)                                                                                                                                                                                       |       |                         |       |                            |       |
|                                                                                                                                                                                                                          |       |                         |       |                            |       |
| **Stockholders’ Equity**                                                                                                                                                                                                 |       |                         |       |                            |       |
| Preferred stock—$.001  par value; 2,000,000 shares authorized; no shares issued or outstanding                                                                                                                           |       | —                       |       | —                          |       |
| Common stock—$.001 par  value; 56,000,000 shares authorized; 16,800,892 and 16,561,036 shares issued;  and 16,126,794 and 15,886,938 shares outstanding at March 31, 2007 and  December 31, 2006, respectively |       | 16,802                       |       | 16,562                          |       |
| Additional  paid-in capital                                                                                                                                                                                                   |       | 72,105,379                   |       | 70,574,176                      |       |
| Accumulated  other comprehensive loss                                                                                                                                                                                         |       | (228,580                     | )          | (273,295                        | )          |
| Accumulated  deficit                                                                                                                                                                                                          |       | (23,157,217                  | )          | (24,569,531                     | )          |
| Treasury stock  at cost, 674,098 shares at March 31, 2007 and December 31, 2006                                                                                                                                     |       | (3,003,445                   | )          | (3,003,445                      | )          |
|                                                                                                                                                                                                                          |       |                         |       |                            |       |
| **Total  Stockholders’ Equity**                                                                                                                                                                                          |       | 45,732,939                   |       | 42,744,467                      |       |
|                                                                                                                                                                                                                          |       |                         |       |                            |       |
| **Total Liabilities and  Stockholders’ Equity**                                                                                                                                                                          |       | $                            | 47,062,644 |                            | $          | 45,049,167 |   |

 

See accompanying notes to thecondensed consolidated financial statements

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**SRS LABS, INC. AND SUBSIDIARY****CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**
| ** **                                                  | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                  | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Revenues                                                    |       | $                                                | 5,072,403  |   | $ | 4,335,668 |   |
| Cost of sales                                               |       | 38,540                                           |       | 47,812 |   |
|                                                        |       |                                             |       |   |   |
| Gross margin                                                |       | 5,033,863                                        |       | 4,287,856 |   |
|                                                        |       |                                             |       |   |   |
| Operating  expenses:                                        |       |                                             |       |   |   |
| Sales and marketing                                         |       | 1,876,293                                        |       | 1,865,369 |   |
| Research and development                                    |       | 861,625                                          |       | 654,289 |   |
| General and administrative                                  |       | 1,377,427                                        |       | 1,637,208 |   |
|                                                        |       |                                             |       |   |   |
| Total operating expenses                                    |       | 4,115,345                                        |       | 4,156,866 |   |
|                                                        |       |                                             |       |   |   |
| Operating income                                            |       | 918,518                                          |       | 130,990 |   |
| Other income,  net                                          |       | 493,796                                          |       | 179,713 |   |
| Income from  continuing operations before income taxes      |       | 1,412,314                                        |       | 310,703 |   |
| Income taxes                                                |       | —                                           |       | 159,423 |   |
| Income from  continuing operations                          |       | 1,412,314                                        |       | 151,280 |   |
|                                                        |       |                                             |       |   |   |
| Discontinued  operations (Note 8):                          |       |                                             |       |   |   |
| Income from discontinued operations before income  taxes    |       | —                                           |       | 42,376 |   |
| Income taxes                                                |       | —                                           |       | 31,081 |   |
| Income from  discontinued operations                        |       | —                                           |       | 11,295 |   |
| Net income                                                  |       | $                                                | 1,412,314  |   | $ | 162,575 |   |
|                                                        |       |                                             |       |   |   |
| Income from  continuing operations per common share:        |       |                                             |       |   |   |
|                                                        |       |                                             |       |   |   |
| Basic                                                       |       | $                                                | 0.09       |   | $ | 0.01 |   |
| Diluted                                                     |       | $                                                | 0.08       |   | $ | 0.01 |   |
|                                                        |       |                                             |       |   |   |
| Income from  discontinued operations per common share:      |       |                                             |       |   |   |
| Basic                                                       |       | $                                                | 0.00       |   | $ | 0.00 |   |
| Diluted                                                     |       | $                                                | 0.00       |   | $ | 0.00 |   |
|                                                        |       |                                             |       |   |   |
| Net income per  common share:                               |       |                                             |       |   |   |
| Basic                                                       |       | $                                                | 0.09       |   | $ | 0.01 |   |
| Diluted                                                     |       | $                                                | 0.08       |   | $ | 0.01 |   |
|                                                        |       |                                             |       |   |   |
| Weighted average  shares used in the per share calculation: |       |                                             |       |   |   |
| Basic                                                       |       | 15,992,704                                       |       | 14,423,611 |   |
|                                                        |       |                                             |       |   |   |
| Diluted                                                     |       | 17,081,524                                       |       | 15,843,052 |   |

 

 See accompanying notes to the condensedconsolidated financial statements

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**SRSLABS, INC. AND SUBSIDIARYCONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY ANDCOMPREHENSIVE INCOME (Unaudited)**
| ** **                                                    | ** ** | **Common Stock** | ** ** | **Additional  Paid-In** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Accumulated** | ** ** | **Treasury** | ** ** | ** ** | ** ** | **Comprehensive  Income  for the Period** | ** ** |
|---------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|---------------------------------------|------------|-----------------|------------|--------------|------------|------------|------------|-----------------------------------------------------|------------|
| ** **                                                    | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Capital**                           | ** ** | **Loss**        | ** ** | **Deficit**  | ** ** | **Stock**  | ** ** | **Total**                                           | ** ** | **Ended** | ** ** |
| BALANCE,  December 31, 2006                              |       | 15,886,938            |       | $                       | 16,562     |                                  | $          | 70,574,176      |       | $            | (273,295   | )          | $          | (24,569,531                                         | )          | $ | (3,003,445 | ) | $ | 42,744,467 |   |   |   |
| Proceeds from exercise of stock options                       |       | 239,856               |       | 240                     |       | 1,104,361                             |       | —          |       | —       |       | —     |       | 1,104,601                                           |       |   |   |
| Stock based compensation                                      |       | —                |       | —                  |       | 426,842                               |       | —          |       | —       |       | —     |       | 426,842                                             |       |   |   |
| Unrealized gain on investments available for sale, net of tax |       | —                |       | —                  |       | —                                |       | 44,715          |       | —       |       | —     |       | 44,715                                              |       | 44,715 |   |
| Net income                                                    |       | —                |       | —                  |       | —                                |       | —          |       | 1,412,314    |       | —     |       | 1,412,314                                           |       | 1,412,314 |   |
|                                                          |       |                  |       |                    |       |                                  |       |            |       |         |       |       |       |                                                |       |   |   |
| BALANCE,    March 31, 2007                               |       | 16,126,794            |       | $                       | 16,802     |                                  | $          | 72,105,379      |       | $            | (228,580   | )          | $          | (23,157,217                                         | )          | $ | (3,003,445 | ) | $ | 45,732,939 |   | $ | 1,457,029 |   |
|                                                               |            |                       |            |                         |            |                                       |            |                 |            |              |            |            |            |                                                     |            |  |  |  |  |  |  |  |  |  |

 

See accompanying notes to the condensed consolidatedfinancial statements

6

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**SRS LABS, INC. AND SUBSIDIARY****CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**
| ** **                                                                                                 | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                                 | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| **Cash  Flows from Operating Activities:**                                                                 |       |                                             |       |   |   |
| Net income                                                                                                 |       | $                                                | 1,412,314  |   | $ | 162,575 |   |
| Adjustments to  reconcile income from continuing operations to net cash provided by operating  activities: |       |                                             |       |   |   |
| Depreciation and amortization                                                                              |       | 184,049                                          |       | 171,548 |   |
| Provision for doubtful accounts                                                                            |       | 20,927                                           |       | — |   |
| Deferred taxes                                                                                             |       | (313,060                                         | )          | (6,026 | ) |
| Accretion of discount on investments available for  sale                                                   |       | —                                           |       | (507 | ) |
| Stock-based compensation expense                                                                           |       | 426,842                                          |       | 343,380 |   |
| Loss on disposition of property and equipment                                                              |       | —                                           |       | 1,166 |   |
| Changes in operating assets and liabilities:                                                               |       |                                             |       |   |   |
| Accounts receivable                                                                                        |       | 246,072                                          |       | 736,677 |   |
| Prepaid expenses and other current assets                                                                  |       | 183,556                                          |       | 24,108 |   |
| Accounts payable                                                                                           |       | (377,614                                         | )          | 114,231 |   |
| Accrued liabilities                                                                                        |       | (442,816                                         | )          | 58,918 |   |
| Deferred revenue                                                                                           |       | (154,565                                         | )          | (128,982 | ) |
| Net cash used in operating activities of  discontinued operations                                          |       | —                                           |       | (257,624 | ) |
|                                                                                                       |       |                                             |       |   |   |
| Net cash provided by operating activities                                                                  |       | 1,185,705                                        |       | 1,219,464 |   |
|                                                                                                       |       |                                             |       |   |   |
| **Cash  Flows from Investing Activities:**                                                                 |       |                                             |       |   |   |
| Purchase of  property and equipment                                                                        |       | (31,410                                          | )          | (118,753 | ) |
| Expenditures  related to intangible assets                                                                 |       | (156,721                                         | )          | (197,049 | ) |
| Net cash used in  investing activities of discontinued operations                                          |       | —                                           |       | (43,810 | ) |
| Net cash used in investing activities                                                                      |       | (188,131                                         | )          | (359,612 | ) |
|                                                                                                       |       |                                             |       |   |   |
| **Cash  Flows from Financing Activities:**                                                                 |       |                                             |       |   |   |
| Proceeds from  exercise of stock options                                                                   |       | 1,104,601                                        |       | 914,830 |   |
| Net cash  provided by financing activities of discontinued operations                                      |       | —                                           |       | 100,388 |   |
| Net cash provided by financing activities                                                                  |       | 1,104,601                                        |       | 1,015,218 |   |
|                                                                                                       |       |                                             |       |   |   |
| **Net  Increase in cash and cash equivalents**                                                             |       | 2,102,175                                        |       | 1,875,070 |   |
| **Cash  and cash equivalents, Beginning of Period**                                                        |       | 35,011,425                                       |       | 8,752,339 |   |
|                                                                                                       |       |                                             |       |   |   |
| **Cash  and cash equivalents, End of Period**                                                              |       | $                                                | 37,113,600 |   | $ | 10,627,409 |   |
|                                                                                                       |       |                                             |       |   |   |
| **Supplemental  Disclosure of Cash Flow Information:**                                                     |       |                                             |       |   |   |
| Cash paid during the period for:                                                                           |       |                                             |       |   |   |
| Income taxes                                                                                               |       | $                                                | 277,041    |   | $ | 153,836 |   |
| **Supplemental  Disclosure of Non-Cash Investing Activities:**                                             |       |                                             |       |   |   |
| Unrealized gain  (loss) on investments, net                                                                |       | $                                                | 44,715     |   | $ | (58,282 | ) |

 

See accompanying notes tothe condensed consolidated financial statements

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**SRSLABS, INC. AND SUBSIDIARY****NOTES TO THE CONDENSED CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

**1.             Basis ofPresentation and Summary of Significant Accounting Policies and Estimates**

Asused herein, the “Company,” “SRS Labs,” “SRS,” “we,” “us,” or “our” means SRSLabs, Inc., its wholly-owned subsidiary SRSWOWcast.com, Inc. and, forthe applicable periods, its former subsidiary ValenceTech Limited (collectivelywith its direct and indirect wholly-owned subsidiaries, “Valence”) and theformer joint venture with Coming Home Studios LLC, CHS/SRS LLC.  The accompanying unaudited condensedconsolidated financial statements have been prepared by the Company inconformity with accounting principles generally accepted in the United Statesof America (“generally accepted accounting principles”) for interim financialinformation and the rules and regulations of the U.S. Securities and ExchangeCommission (“SEC”) for interim reporting. In the opinion of management, alladjustments (which include only normal recurring adjustments) considerednecessary for a fair presentation of our financial position and results ofoperations have been included. Certain amounts included in the accompanyingprior periods’ consolidated financial statements have been reclassified toconform to the current period presentation. All inter-company accounts andtransactions have been eliminated.

Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with generally accepted accounting principles have beencondensed or omitted pursuant to SEC rules and regulations for presentation ofinterim financial information. Therefore, the condensed interim consolidatedfinancial statements should be read in conjunction with the Company’s AnnualReport on Form 10-K for the year ended December 31, 2006. Current andfuture financial statements may not be directly comparable to the Company’shistorical financial statements. The results of operations for the interimperiod are not necessarily indicative of the results to be expected for anyother interim period or for the full year.

OnFebruary 23, 2006, the Board of Directors of the Company (the “Board ofDirectors” or the “Board”) approved a plan to sell Valence in order to focusincreased management attention and financial resources on its licensingbusiness.  Additionally, onFebruary 23, 2006, the Board authorized management to take all reasonablesteps to divest the Company’s entire equity interest in the CHS/SRS LLC jointventure (the “Joint Venture”), to produce and distribute six concert videosfeaturing our Circle Surround Technology. As a result of the Company’s decisions to sell Valence and its entireequity interest in CHS/SRS LLC, the Company has accounted for the semiconductorbusiness segment and CHS/SRS LLC as discontinued operations in the accompanyingcondensed consolidated financial statements beginning in the first fiscalquarter of 2006.  The Company soldValence in September 2006 and its entire equity interest in CHS/SRS LLC in June2006.   See Note 8.

**Estimates**

Thepreparation of financial statements in accordance with generally acceptedaccounting principles requires management to make use of certain estimates andassumptions that affect the reported amounts of assets and liabilities and disclosureof contingent assets and liabilities at the date of the financial statementsand the reported amounts of revenues and expenses during the reported periods.We base our estimates on historical experience and on various other assumptionsthat we believe are reasonable under the circumstances, the results of whichform the basis for making judgments about carrying values of assets andliabilities that are not readily apparent from other sources. Actual resultscould differ materially from those estimates. See the audited consolidatedfinancial statements and notes thereto included in our Annual Report on Form10-K for the year ended December 31, 2006 for an additional discussion ofthe significant accounting policies and estimates used in the preparation ofour financial statements.

**2.**             **Stock-BasedCompensation**

Weaccount for stock-based compensation under the provisions of Statement ofFinancial Accounting Standards (“SFAS”) No. 123(R), *Share-BasedPayment* (“SFAS 123R”). SFAS 123R requires measurement of allemployee stock-based awards using a fair-value method and recording of relatedcompensation expense in the consolidated financial statements over therequisite service period. Further, as required under SFAS 123R, we estimateforfeitures for share based awards that are not expected to vest. In the firstquarter of fiscal 2007, we recorded stock-based compensation expense of$426,842 under the fair-value provisions of SFAS 123R, compared to $399,738 inthe first quarter of fiscal 2006.

Optionawards are granted with an exercise price equal to the market price of theCompany’s stock at the date of grant. Option awards generally have a term of 10years and vest and become exercisable over a four-year service period.

Thefair value of each share-based award is estimated on the grant date using theBlack-Scholes-Merton (“BSM”) option-pricing formula and straight-lineamortization of compensation expense over the requisite service period of thegrant. Expected volatilities are based on the historical volatility of theCompany’s stock price. The expected term of options granted 

8

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is derived usingthe simplified method as defined in the SEC’s Staff Accounting Bulletin 107, *Implementation of FASB 123R*. The risk-free rate for periodswithin the contractual life of the option is based on the U.S. Treasuryinterest rates in effect at the time of grant. The fair value of optionsgranted was estimated using the following weighted-average assumptions:

|                           | ** ** | **Three Months Ended** | ** ** |
|---------------------------|------------|----------------------------------|------------|
| ** **                | ** ** | **March 31,**               | ** ** |
| ** **                | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| Expected term  (in years) |       | 6.25                             |       | 6.25 |   |
| Expected  volatility      |       | 56                               | %          | 60 | % |
| Risk-free  interest rate  |       | 4.8                              | %          | 4.4 | % |
| Dividend yield            |       | 0.00                             | %          | 0.00 | % |

 

Totalcompensation cost recognized in the quarters ended March 31, 2007 and 2006 isas follows:

|                                                                | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                     | ** ** | **March 31,**               | ** ** |
| ** **                                                     | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| Continuing  Operations:                                        |       |                             |       |   |   |
| Sales and marketing                                            |       | $                                | 141,800    |   | $ | 162,053 |   |
| Research and development                                       |       | 101,725                          |       | 126,987 |   |
| General and administrative                                     |       | 183,317                          |       | 54,340 |   |
| Total  compensation cost recognized in continuing operations   |       | $                                | 426,842    |   | $ | 343,380 |   |
|                                                           |       |                             |       |   |   |
| Total  compensation cost recognized in discontinued operations |       | $                                | —     |   | $ | 56,358 |   |
| Total compensation cost  recognized                            |       | $                                | 426,842    |   | $ | 399,738 |   |

 

**3.             Capitalizationof Software Development Costs**

Costs incurred in the research, design and developmentof software for sale to others as a separate product or embedded in a productand sold as part of the product as a whole are charged to expense untiltechnological feasibility is established. Under SFAS No. 86, *Accounting for the Costs of Computer Software to be Sold, Leased orOtherwise Marketed*, the Company capitalizes software purchased fromthird parties if the related software product under development has reachedtechnological feasibility or if there are alternative future uses for thepurchased software, provided that capitalized amounts will be realized over aperiod not exceeding five years. Costs incurred prior to the establishment oftechnological feasibility are charged to research and development expense.

Capitalized software as of March 31,2007 and December 31, 2006 is as follows:
| ** **                 | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|----------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Capitalized  software      |       | $                        | 767,496    |                        | $          | 728,670 |   |
| Accumulated  amortization  |       | (518,546                 | )          | (475,034                    | )          |
| Capitalized software,  net |       | $                        | 248,950    |                        | $          | 253,636 |   |

 

As of March 31, 2007, the weightedaverage useful life of the Company’s capitalized software is approximately 1.7years. The following table shows the estimated amortization expense for thoseassets for the remaining nine months of the current fiscal year end and each ofthe remaining three succeeding fiscal years.

| Years Ending December 31, | ** ** | **Estimated  Expense** | ** ** |
|------------------------------------------|------------|------------------------|------------|
| 2007                                     |       | $                      | 131,591    |   |
| 2008                                     |       | 91,997                 |       |
| 2009                                     |       | 24,725                 |       |
| 2010                                     |       | 637                    |       |
| Total                                    |       | 248,950                |       |
|                                          |            |                        |            |  |

 

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**4.             IntangibleAssets**

Intangibleassets consist of the following:
| ** **                                                  | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|-------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Patents                                                     |       | $                        | 2,833,144  |                        | $          | 2,715,250 |   |
| Accumulated  amortization                                   |       | (1,393,747               | )          | (1,326,836                  | )          |
| Patents, net                                                |       | 1,439,397                |       | 1,388,414                   |       |
| Other  intangibles:                                         |       |                     |       |                        |       |
| License agreements acquired in purchase of  SRSWOWcast      |       | 640,071                  |       | 640,071                     |       |
| Poly Planar purchased technology for speaker  products      |       | 120,000                  |       | 120,000                     |       |
| Capitalized software and hardware for several  technologies |       | 697,768                  |       | 658,942                     |       |
| Total of other intangibles                                  |       | 1,457,839                |       | 1,419,013                   |       |
| Accumulated  amortization, other intangibles                |       | (825,991                 | )          | (762,288                    | )          |
| Other  intangibles, net                                     |       | 631,848                  |       | 656,725                     |       |
| Intangible assets, net                                      |       | $                        | 2,071,245  |                        | $          | 2,045,139 |   |

 

Amortizationperiods range from three to ten years depending on the estimated useful life ofthe asset. Amortization expense consists of the following:

|                                                             | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                  | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Patents                                                     |       | $                                                | 66,911     |   | $ | 57,668 |   |
| Other  intangibles:                                         |       |                                             |       |   |   |
| License agreements acquired in purchase of  SRSWOWcast      |       | 16,002                                           |       | 16,001 |   |
| Capitalized software and hardware for several  technologies |       | 47,701                                           |       | 40,690 |   |
| Total intangible  amortization expense                      |       | $                                                | 130,614    |   | $ | 114,359 |   |

 

As of March 31, 2007, the weighted average usefullife of the Company’s patents and intangible assets is approximately6.5 years. The following table shows the estimated amortization expensefor those assets for the remaining nine months of the current fiscal year andeach of the four succeeding fiscal years and thereafter:

| Years Ending December 31, | ** ** | **Estimated Expense** | ** ** |
|------------------------------------------|------------|----------------------------|------------|
| 2007                                     |       | $                          | 476,471    |   |
| 2008                                     |       | $                          | 349,939    |   |
| 2009                                     |       | $                          | 259,851    |   |
| 2010                                     |       | $                          | 235,173    |   |
| 2011                                     |       | $                          | 228,605    |   |
| Thereafter                               |       | $                          | 521,206    |   |
| Total                                    |       | $                          | 2,071,245  |   |

 

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**5.**             **InvestmentsAvailable for Sale**

The Company has classifiedits investments as available for sale in accordance with SFAS No. 115, *Accounting for Certain Investments in Debt and Equity Securities*.The following table summarizes the Company’s investment securitiesavailable for sale:
| ** **           | ** ** | **March 31, 2007** | ** ** | **December 31, 2006** | ** ** |
|----------------------|------------|------------------------------|------------|---------------------------------|------------|
| Cost                 |       | $                            | 5,500,000  |                            | $          | 5,500,000 |   |
| Unrealized loss      |       | (228,580                     | )          | (273,295                        | )          |
| Estimated fair value |       | $                            | 5,271,420  |                            | $          | 5,226,705 |   |

 

Thecontractual maturities of investments are shown below. Actual maturities maydiffer from contractual maturities.

|                                                 | ** ** | **March 31, 2007** | ** ** | **December 31, 2006** | ** ** |
|-------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                                      | ** ** | **Cost**                     | ** ** | **Estimated  Fair Value**  | ** ** | **Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| U.S. Government  securities available for sale: |       |                         |       |                            |       |   |   |   |   |
| Due in one year or less                         |       | $                            | —     |                            | $          | — |   | $ | — |   | $ | — |   |
| Due in one to five years                        |       | 5,500,000                    |       | 5,271,420                       |       | 5,500,000 |   | 5,226,705 |   |
|                                            |       | $                            | 5,500,000  |                            | $          | 5,271,420 |   | $ | 5,500,000 |   | $ | 5,226,705 |   |

 

**6.**             **NetIncome Per Common Share**

The Company applies SFASNo. 128, *Earnings per Share* (“SFAS 128”),which requires the disclosure of basic and diluted net income or loss per sharefor all current and prior periods. Basic net income or loss per common share iscomputed by dividing net income or loss available to common stockholders by theweighted average number of common shares outstanding during each year. Dilutednet income or loss per common share reflects the maximum dilution, based on theaverage price of the Company’s common stock during each period, and is computedsimilar to basic income or loss per share except that the denominator isincreased to include the number of additional shares that would have beenoutstanding if potentially dilutive stock options and warrants had beenexercised.

Basicand diluted net income per share computed in accordance with SFAS 128 forthe three months ended March 31, are as follows:

|                                                          | ** ** | **For the Three Months  Ended March 31,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                               | ** ** | **2007**                                                           | ** ** | **2006** | ** ** |
| BASIC EPS                                                | ** ** | ** **                                                         | ** ** | ** ** | ** ** |
| Income from continuing operations                        |       | $                                                                  | 1,412,314  |   | $ | 151,280 |   |
| Income from discontinued operations                      |       | —                                                             |       | 11,295 |   |
| Net income                                               |       | $                                                                  | 1,412,314  |   | $ | 162,575 |   |
| Denominator: weighted average common shares outstanding  |       | 15,992,704                                                         |       | 14,423,611 |   |
| Income from  continuing operations per share             |       | $                                                                  | 0.09       |   | $ | 0.01 |   |
| Income from  discontinued operations per share           |       | $                                                                  | 0.00       |   | $ | 0.00 |   |
| Net income per  share                                    |       | $                                                                  | 0.09       |   | $ | 0.01 |   |
|                                                     |       |                                                               |       |   |   |
| DILUTED EPS                                              |       |                                                               |       |   |   |
| Income from continuing operations                        |       | $                                                                  | 1,412,314  |   | $ | 151,280 |   |
| Income from discontinued operations                      |       | —                                                             |       | 11,295 |   |
| Net income                                               |       | $                                                                  | 1,412,314  |   | $ | 162,575 |   |
| Denominator: weighted average common shares  outstanding |       | 15,992,704                                                         |       | 14,423,611 |   |
| Common equivalent shares outstanding:                    |       |                                                               |       |   |   |
| Options                                                  |       | 1,088,820                                                          |       | 1,419,441 |   |
| Total diluted shares                                     |       | 17,081,524                                                         |       | 15,843,052 |   |
| Income from  continuing operations per share             |       | $                                                                  | 0.08       |   | $ | 0.01 |   |
| Income from  discontinued operations per share           |       | $                                                                  | 0.00       |   | $ | 0.00 |   |
| Net income per share                                     |       | $                                                                  | 0.08       |   | $ | 0.01 |   |

 

11

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There were outstandingoptions to purchase an aggregate of 392,420 and 715,750  shares of the Company’s common stock for thequarters ended March 31, 2007 and 2006, respectively, that were notincluded in the table above because they would be anti-dilutive.

**7.**             **Commitmentsand Contingencies**

The Company is subject tolegal proceedings and claims that arise in the normal course of business. Whilethe outcome of these proceedings and claims cannot be predicted with certainty,management does not believe that the outcome of any of these matters will havea material adverse effect on the Company’s consolidated financial position orresults of operations.

**8.**             **DiscontinuedOperations**

On February 23, 2006, the Board approved a planto sell Valence in order to focus increased management attention and financialresources on its licensing business.  OnJuly 14, 2006, we entered into a definitive Sale and Purchase Agreement tosell Valence to Noblehigh Enterprises Inc. (“Noblehigh”). Noblehigh is owned byWillas Array Electronics (Holding) Limited as well as certain members ofmanagement of Valence.  The saletransaction was completed on September 29, 2006.

The sale to Noblehigh was effected through twosimultaneous transactions: (1) the repurchase by Valence of approximately74% of the outstanding shares of Valence from SRS using its existing cash and(2) the purchase by Noblehigh of the remaining outstanding shares ofValence from SRS for $4.3 million. The sale resulted in a gain on the disposalof discontinued operations of $237,625.

Additionally, on February 23, 2006, the Boardauthorized management to take all reasonable steps to divest the Company’sentire equity interest in the Joint Venture. On June 30, 2006, we completed the sale of our interest in theJoint Venture to Coming Home Studios LLC in exchange for $200,000, the rightsto all cash assets of the Joint Venture, and a promissory note in the amount of$175,000.  The sale of our interest inthe Joint Venture resulted in a gain on the sale of $387,021. As of March 31,2007, the outstanding principal balance due on the note was $161,159 plusaccrued interest.   Any amounts relatedto the promissory note and accrued interest thereon will be recorded at thetime the cash is received by us.

As a result of our decision to sell Valence and ourentire equity interest in the Joint Venture in February 2006, we accounted forthe semiconductor business segment and the Joint Venture as discontinuedoperations beginning in the first fiscal quarter of 2006.

Income from discontinuedoperations for the three months ended March 31, 2006 consisted of directrevenues and direct expenses of Valence and CHS/SRS LLC. General corporateoverhead costs have not been allocated to discontinued operations.  A summary of the operating results of Valenceand the Joint Venture included in discontinued operations in the accompanyingcondensed consolidated statements of operation is as follows:
| ** **                                                 | ** ** | **For the three  months ended** | ** ** |
|------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                 | ** ** | **March 31, 2006**                   | ** ** |
| **Valence:**                                               | ** ** | ** **                                     | ** ** |
| Revenues                                                   |       | $                                              | 2,141,708  |   |
| Cost of sales                                              |       | 1,068,484                                      |       |
| Gross margin                                               |       | 1,073,224                                      |       |
| Total operating expenses                                   |       | 1,129,148                                      |       |
| Loss from  operations                                      |       | (55,924                                        | )          |
| Other income,  net                                         |       | 4,185                                          |       |
| Loss before  income tax expense                            |       | (51,739                                        | )          |
| Income tax  expense                                        |       | 31,081                                         |       |
| **Net  loss from Valence**                                 |       | (82,820                                        | )          |
| **Net  income from the Joint Venture**                     |       | 94,115                                         |       |
| **Net income from discontinued  operations, net of taxes** |       | $                                              | 11,295     |   |

 

**9.             SegmentInformation**

The Company previouslyoperated in two business segments — semiconductors and licensing.  However, as a result of the Board’s decisionon February 23, 2006 to sell the semiconductor business, the Company nowhas continuing operations in only one business segment, licensing.  Our revenue from continuing operations issolely derived from licensing related revenue.

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For the three months endedMarch 31, 2007, two customers, Samsung and Sony, accounted forapproximately 23% and 12%, respectively, of the licensing revenue.  For the same period in the prior year, twocustomers, Samsung and Sony, accounted for approximately 17% and 13%,respectively, of the licensing revenue. During April 2007, we were informed bySony it has begun to sell televisions with their own internally created audioenhancement technology.  While the impactof this on our revenues is not yet known, it is anticipated that this maynegatively impact our revenues in the future. The followingschedule presents the Company’s revenue from continuing operations bygeographic area. Licensing-related revenue is allocated based on the locationof the licensee’s corporate headquarters. The Americas region includes North,Central and South Americas.

|                               | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------|------------|--------------------------------------------------|------------|
| ** **                    | ** ** | **2007**                                         | ** ** | **%** | ** ** | **2006** | ** ** | **%** | ** ** |
| **Geographic  Area Revenue:** |       |                                             |       |   |   |   |   |   |   |
| Japan                         |       | $                                                | 2,364,509  |   | 46 | % | $ | 2,027,781 |   | 47 | % |
| Korea                         |       | 1,787,920                                        |       | 35 | % | 1,176,501 |   | 27 | % |
| Americas                      |       | 501,885                                          |       | 10 | % | 470,439 |   | 11 | % |
| China                         |       | 407,444                                          |       | 8 | % | 604,142 |   | 14 | % |
| Europe                        |       | 10,645                                           |       | 1 | % | 56,805 |   | 1 | % |
|                          |       |                                             |       |   |   |   |   |   |   |
| Total                         |       | $                                                | 5,072,403  |   | 100 | % | $ | 4,335,668 |   | 100 | % |

 

**10.**          **RecentAccounting Pronouncements**

In July 2006, the Financial Accounting StandardsBoard (“FASB”) issued FASB Interpretation No. 48 (“FIN 48”), *Accounting for Uncertainty in Income Taxes*. FIN 48 is aninterpretation of FASB Statement No. 109, *Accountingfor Income Taxes*, and it seeks to reduce the diversity in practiceassociated with certain aspects of measurement and recognition in accountingfor income taxes. FIN 48 prescribes a recognition threshold and measurementattribute for the financial statement recognition and measurement of a taxposition that an entity takes or expects to take in a tax return. Additionally,FIN 48 provides guidance on de-recognition, classification, interest andpenalties, accounting in interim periods, disclosure, and transition.  Under FIN 48, an entity may only recognize orcontinue to recognize tax positions that meet a “more likely than not”threshold. We adopted FIN 48 on January 1, 2007.  As a result of adoption of FIN 48, werecognized no liability for unrecognized income tax benefits. Additionally, werecognized no interest and penalties related to uncertain tax positions and asof March 31, 2007, we have no accrued interest related to uncertain taxpositions. The tax years 2003-2006 remain open to examination by the majortaxing jurisdictions.

In February 2007, the FASB issued Statement No. 159, *The Fair Value Option for Financial Assets and Financial Liabilities*(“SFAS159”).  SFAS 159 permits entities tochoose to measure financial assets and liabilities (except for those that arespecifically scoped out of the Statement) at fair value. The election tomeasure a financial asset or liability at fair value can be made on an instrument-by-instrumentbasis and is irrevocable. The difference between carrying value and fair valueat the election date is recorded as a transition adjustment to opening retainedearnings. Subsequent changes in fair value are recognized in earnings. Theeffective date for this Stateme nt is as of the beginning of an entity’s firstfiscal year that begins after November 15, 2007. The Company will adopt SFAS159, effective January 1, 2008. The Company does not expect the adoption ofSFAS 159 to have a material impact on our consolidated financial position orconsolidated results of operations.

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**Item 2. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

This information should beread in conjunction with the audited consolidated financial statements andnotes thereto and Management’s Discussion and Analysis of Financial Conditionand Results of Operations contained in the Company’s Annual Report onForm 10-K for the year ended December 31, 2006, and the unauditedcondensed interim consolidated financial statements and notes thereto includedin this Quarterly Report.

**Overview**

SRS Labs is a leading developer and provider of audioand voice technology solutions for the home entertainment, portable mediadevice, personal telecommunications, personal computer, automotive, andbroadcast markets. Prior to September 29, 2006, the Company was also adeveloper and provider of application specific integrated circuits and standardintegrated circuits through its formerly wholly-owned subsidiary, Valence TechLimited.

***Licensing:******  ***Ouroperations are conducted through SRS Labs, Inc., the parent company, andits wholly-owned subsidiary, SRSWOWcast.com, Inc. Our business is focusedon developing and licensing audio, voice and surround sound technologysolutions to many of the world’s leading original equipment manufacturers, orOEMs, software providers and semiconductor companies, and licensing andmarketing hardware and software products for the Internet and professionalaudio markets.

***DiscontinuedOperations:***

*Valence:*   Through SRS Labs, Inc.’s formerlywholly-owned subsidiary, ValenceTech Limited, we operated a fablesssemiconductor business which developed, designed and marketed standard andcustom analog integrated circuits, digital signal processors, and mixed signalintegrated circuits primarily to OEMs and original design manufacturers, in theAsia Pacific region.

On February 23, 2006, our Board approved a planto sell Valence in order to focus management’s attention and financialresources on our licensing business. On July 14, 2006, we entered into adefinitive Sale and Purchase Agreement to sell Valence to Noblehigh EnterprisesInc. Noblehigh is owned by Willas Array Electronics (Holding) Limited as wellas certain members of management of Valence. The sale transaction was completed on September 29, 2006 andaccordingly the results of the operations of Valence are included asdiscontinued operations in the accompanying condensed consolidated statement ofoperations for the three months ended March 31, 2006.

*CHS/SRS LLC:**  *InSeptember 2004, we entered into a strategic alliance with Coming HomeStudios LLC, or CHS,  to use and promoteSRS Labs’ technologies, to promote CHS productions and to promote each company’srespective brands. In connection with the strategic alliance, SRS and CHSestablished a Joint Venture, CHS/SRS LLC, to produce and distribute nineconcert videos featuring our Circle Surround technology. On February 23,2006, our Board authorized management to take all reasonable steps to divestour entire equity interest in the Joint Venture. On June 30, 2006, wecompleted the sale of our interest in the Joint Venture to CHS.   Accordingly the results of operations ofCHS/SRS LLC are included as discontinued operations in the accompanyingcondensed consolidated statement of operations for the three months endedMarch 31, 2006.

#### **Critical Accounting Policies**

Our discussion and analysis of our results of operations andliquidity and capital resources are based on our consolidated financialstatements which have been prepared in accordance with accounting principlesgenerally accepted in the United States of America.

The preparation of these financial statements requiresus to make estimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and disclosure of contingent assets andliabilities. We base our estimates on historical and anticipated results andtrends and on various other assumptions that we believe are reasonable underthe circumstances, including assumptions as to future events. These estimatesform the basis for making judgments about the carrying value of assets andliabilities that are not readily apparent from other sources. By their nature,estimates are subject to an inherent degree of uncertainty. Actual results maymaterially differ from our estimates.

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**Results of Continuing Operations**

**Three Months Ended March 31,2007 Compared to Three Months Ended March 31, 2006**

*Revenues*

Licensing revenues consistprimarily of royalties generated from the license of SRS Labs’ audio and voicetechnologies.  License and royaltyagreements generally provide for the license of technologies for a fee based onthe number of units distributed by the licensee.  However, we have in the past and may again inthe future, enter into a license agreement for a one-time fee. Also included inlicensing revenue are revenues generated from the sale of hardware and softwareapplications into the PC and broadcast audio markets.

Licensing revenues were$5,072,403 for the three months ended March 31, 2007, compared to$4,335,668 for the three months ended March 31, 2006, an increase of$736,735 or 17%.  The increase inlicensing revenues was primarily attributable to our strong sales in flat paneltelevisions and monitors in our Home Entertainment market during the holidayseason, which grew by $1,112,481 or 62%. As noted earlier in this report, wehave been informed by Sony, one of our largest licensees, that it has begun todistribute televisions that include internally developed audio technology, ratherthan technology licensed from us. While the impact of this on our revenues isnot yet known, it is anticipated that this may negatively impact our revenuesin the future.  Additionally, weexperienced an increase in royalties in the automotive market of $157,341 or70% and an increase in revenue from our PC market segment of $168,696 or 42%due to increases in software downloads. During April 2007, we were informed that one of our licensees haselected to eliminate our technology from its personal computers during2007.  We do not believe that this willimpact our revenues for the three months ending June 2007, however, we expectsuch revenues to decrease in the three months ending September 30, 2007 andDecember 31, 2007.  Such customeraccounted for $284,239 of revenues during the three months ended March 31,2007.  The following tablepresents our licensing revenues mix by market:

|                                                           | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                | ** ** | **2007**                                             | ** ** | **2006** | ** ** |
| Home  Entertainment (TV, Set Top Box, A/V Receiver, DVD)  |       | 66                                                   | %          | 55 | % |
| Portable Media  Devices (Digital Media Player, Headphone) |       | 8                                                    | %          | 20 | % |
| Personal  Telecommunications (Mobile phone, PDA)          |       | 8                                                    | %          | 11 | % |
| PC (Software,  Hardware)                                  |       | 11                                                   | %          | 9 | % |
| Automotive                                                |       | 7                                                    | %          | 5 | % |

 

*Sales andMarketing*

Sales and marketing expenses consist primarily ofemployee salaries, sales consultants’ fees and related expenses, salescommissions and product promotion costs. Sales and marketing expenses were$1,876,293 for the three months ended March 31, 2007, compared to$1,865,369 for the same prior year period, an increase of $10,924.  This increase is primarily attributable to anincrease in sales consultants in Europe and Taiwan, increases in commissionsdue to achievement of higher revenue, and increases in quarterly bonuses due toachievement of higher net income, offset by decreased marketing head count andrelated expenses.   Included in sales andmarketing expenses is stock based compensation expense of $141,800 and $162,053for the three months ended March 31, 2007 and 2006, respectively.  As a percentage of total revenues, sales andmarketing expenses decreased from 43% for the quarter ended March 31, 2006to 37% for the same period thisyear.

*Research and Development*

Research and development expenses consist of salariesand related costs of employees engaged in ongoing research, design anddevelopment activities and costs for engineering materials and supplies.Research and development expenses were $861,625 for the three months endedMarch 31, 2007, compared to $654,289 for the same prior year period, anincrease of $207,336 or 32%.  Thisincrease is attributable to an increase in head count and payroll related costsand an increase in quarterly bonuses due to the achievement of higher netincome. Included in research and development expenses is stock basedcompensation expense of $101,725 and $126,987 for the three months ended March31, 2007 and 2006, respectively.  As apercentage of total revenues, research and development expenses increased from 15% for the quarter endedMarch 31, 2006 to 17% for the same period this year.

*General and Administrative*

General and administrative (“G&A”) expensesconsist primarily of employee-related expenses, legal costs associated with theadministration of intellectual property and other professional fees. G&Aexpenses were $1,377,427 for the three months ended March 31, 2007,compared to $1,637,208 for the same prior year period, a decrease of $259,781or 16%. The decrease isprimarily attributable to decreased accounting and legal fees and a decrease incosts associated with the 

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Company’sseparation from its former Chief Financial Officer in the first quarter of2006, partially offset by an increase in stock based compensation expense of$128,977.  Included in general andadministrative expenses is stock based compensation expense of $183,317 and$54,340 for the three months ended March 31, 2007 and 2006, respectively.  As a percentage of total revenues, G&Aexpenses decreased from 38% forthe quarter ended March 31, 2006, to 27% for the same period this year.

*Other Income, Net*

Other income, net consists primarily of interestincome and foreign currency transaction gains and losses. Other income, net was$493,796 for the three months ended March 31, 2007, compared to $179,713for the same prior year period, an increase of $314,083 or 175%. This increaseis primarily attributable to higher interest rates earned on larger cashbalances invested.

*Provision for Income Taxes*

The income tax expense forthe three months ended March 31, 2007 was $0, compared to a tax expense of $159,423 forthe same prior year period.  Theprovision consists primarily of taxes paid on licensing revenues sourced fromcountries requiring foreign tax withholdings, principally Korea.  We reduced our current quarter tax provisionand our valuation allowance on its deferred tax assets by $313,060 based on ourassessment of the future relizability of certain deferred tax assets.

*Discontinued Operations*

As aresult of our February 2006 decisions to sell Valence and our entire equityinterest in CHS/SRS LLC, we have accounted for the semiconductor businesssegment and CHS/SRS LLC as discontinued operations in the accompanyingcondensed consolidated financial statements beginning in the first fiscalquarter of 2006.  The Company sold Valencein September 2006 and its entire equity interest in CHS/SRS LLC in June 2006.

Income from discontinuedoperations consists of direct revenues and direct expenses of Valence andCHS/SRS LLC. General corporate overhead costs have not been allocated to discontinuedoperations.  A summary of the operatingresults of Valence and the Joint Venture included in discontinued operations inthe accompanying condensed consolidated statements of operation for the threemonths ended March 31, 2006 is as follows:
| ** **                                     | ** ** | **For the three months  ended March 31,** | ** ** |
|------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                     | ** ** | **2006**                                                           | ** ** |
| **Semiconductors:**                            | ** ** | ** **                                                         | ** ** |
| Revenues                                       |       | $                                                                  | 2,141,708  |   |
| Cost of sales                                  |       | 1,068,484                                                          |       |
| Gross margin                                   |       | 1,073,224                                                          |       |
| Total operating expenses                       |       | 1,129,148                                                          |       |
| Loss from  operations                          |       | (55,924                                                            | )          |
| Other income  (expense), net                   |       | 4,185                                                              |       |
| Loss before  income tax expense                |       | (51,739                                                            | )          |
| Income tax  expense                            |       | 31,081                                                             |       |
| **Net  loss from semiconductors**              |       | (82,820                                                            | )          |
| **Net  income from CHS/SRS LLC**               |       | 94,115                                                             |       |
| **Total income from discontinued  operations** |       | $                                                                  | 11,295     |   |

 

**Liquidity and Capital Resources**

Our principal source of liquidity to fundongoing operations at March 31, 2006 consisted of cash, cash equivalentsand long-term investments of $42,385,020. At March 31, 2006, we had cashand cash equivalents of $37,113,600 and long-term investments of $5,271,420.Cash and cash equivalents generally consist of cash, money market funds andother money market instruments with original maturities of three months orless. Investments consist of U.S. government securities rated AAA.

Net cash provided by operating activities was$1,185,705 and $1,219,464 during the three months ended March 31, 2007 andMarch 31, 2006, respectively. The decrease in our operating cash flows isprimarily the result of a decrease in our accounts receivable of $246,072 and$736,677 during the three months ended March 31, 2007 and 2006, respectively,due to timing of billing and cash receipts. Accounts payable and accrued liabilities decreased $377,614 and$442,816, respectively, 

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during thethree months ended March 31, 2007. In contrast, accounts payable and accrued liabilities increased $114,231and $58,918, respectively, during the three months ended March 31, 2006.  The changes in liability accounts generallyrelate to the decrease in 2007 professional fees and the timing of payments tovendors and employees. Offsetting the decreases, we did not have any cashoutflow related to discontinued operations during the three months ended March31, 2007, as the discontinued operations were sold in the second and thirdfiscal quarters of 2006.

Our net cash used in investing activities from continuing operations was $188,131and $359,612 during the three months ended March 31, 2007 and March 31, 2006, respectively. The decrease in net cash used by investing activities was attributable primarily to a $40,328 decrease in cash used in expenditures related to patents and intangible assets and an $87,343 decrease in purchases of furniture, fixtures and equipment.

Our net cash provided by financing activities from continuing operations was $1,104,601 and $1,015,218 during the three months ended March 31, 2007 and March 31, 2006, respectively. The increase in net cash provided by financing activities was attributable to an increase in stock option exercises.

We expect expendituresrelated to patents and intangible assets to increase in the future consistentwith the growth in our licensing business, as we continue to invest in thedevelopment of new technologies.

Based on current plans and business conditions, weexpect that our cash, cash equivalents and investments together with anyamounts generated from operations will be sufficient to meet our cashrequirements for the next twelve months. However, there can be no assurancethat we will not be required to seek other financing sooner or that suchfinancing, if required, will be available on terms satisfactory to us.

Our operations and financial results are subject tovarious risks and uncertainties that could adversely affect our business,financial condition, results of operations and trading price of our commonstock. Please refer to Item 1A, “Risk Factors” in our annual report on Form10-K for fiscal year 2006 for information concerning these and otheruncertainties that could negatively impact us.

**Item3.  Quantitative and QualitativeDisclosures about Market Risk**

There have been no material changes to the informationcalled for by this Item 3 from the disclosures set forth in Part II, Item 7A inthe Company’s Annual Report on Form 10-K for the year ended December 31,2006.

**Item4.  Controls and Procedures**

*Evaluation of DisclosureControls and Procedures.**  *Our Chief Executive Officer and President and ourChief Financial Officer have evaluated the effectiveness of our disclosurecontrols and procedures (as defined in Rules 13a-15 (e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the endof the period covered by this Quarterly Report on Form 10-Q and,based on this evaluation, have concluded that our disclosure controls andprocedures are effective.

*Changes in InternalControls.**  *Therehave been no changes in our internal controls over financial reporting thatoccurred during our first quarter ended March 31, 2007 that havematerially affected, or are reasonably likely to materially affect, ourinternal controls over financial reporting.

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**PART II: OTHER INFORMATION**

**Item 6. Exhibits**

The exhibits listed below are hereby filed with theU.S. Securities and Exchange Commission (the “SEC”) as part of this Report.
| Exhibit  Number | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                       |
|-----------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1             |       | Certificate of Incorporation of the Company,  previously filed with the SEC as Exhibit 3.1 to the Company’s Registration  Statement on Form SB-2, specifically included in Amendment No. 1 to such  Registration Statement filed with the SEC on July 3, 1996 (File No.  333-4974-LA), which is incorporated herein by reference.                                                                                |
| 3.2             |       | Bylaws of the Company, previously filed with the SEC  as Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q for the period  ended September 30, 1999, filed with the SEC on November 12, 1999, which is  incorporated herein by reference.                                                                                                                                                               |
| 10.1            |       | Salary adjustment for Alan Kraemer, Executive Vice  President, Chief Technology Officer, Sarah Yang, Vice President, Software  Engineering and Michael Franzi, Vice President, Sales Licensing, as approved  on February 8, 2007, previously filed with the SEC on the Company’s  Current Report on Form 8-K filed with the SEC on February 13,  2007, which is incorporated herein by reference. |
| 31.1            |       | Certification of Chief Executive Officer of SRS  Labs, Inc., pursuant to Rule 13a-14 of the Securities Exchange Act.                                                                                                                                                                                                                                                                                                  |
| 31.2            |       | Certification of Chief Financial Officer of SRS  Labs, Inc., pursuant to Rule 13a-14 of the Securities Exchange Act.                                                                                                                                                                                                                                                                                                  |
| 32.1            |       | Certification of Chief Executive Officer of SRS  Labs, Inc., pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                          |
| 32.2            |       | Certification of Chief Financial Officer of SRS  Labs, Inc., pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                          |

 

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**SIGNATURES**

Pursuant to the requirementsof the Securities Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.

 
|                                   | SRS LABS, INC., a Delaware corporation       |
|-----------------------------------|---------------------------------------------------|
|                              |                                              |   |
| Date:  May 3, 2007      | By:                                               | /S/ THOMAS C.K.  YUEN |
|                              | Thomas C.K. Yuen                                  |
|                              | Chairman of the Board and Chief Executive Officer |
|                              | (Principal Executive Officer)                     |
| ** **                        | ** **                                        | ** ** |
| ** **                        | ** **                                        | ** ** |
| Date:  May 3, 2007 | By:                                               | /S/ ULRICH  GOTTSCHLING |
|                              | Ulrich Gottschling                                |
|                              | Chief Financial Officer                           |
|                              | (Principal Financial and Accounting Officer)      |

 

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**EXHIBIT INDEX**

Theexhibits listed below are hereby filed with the SEC as part of this Report.
| Exhibit  Number | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                       |
|-----------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1             |       | Certificate of Incorporation of the Company,  previously filed with the SEC as Exhibit 3.1 to the Company’s Registration  Statement on Form SB-2, specifically included in Amendment No. 1 to such  Registration Statement filed with the SEC on July 3, 1996 (File No.  333-4974-LA), which is incorporated herein by reference.                                                                                |
| 3.2             |       | Bylaws of the Company, previously filed with the SEC  as Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q for the period  ended September 30, 1999, filed with the SEC on November 12, 1999, which is  incorporated herein by reference.                                                                                                                                                               |
| 10.1            |       | Salary adjustment for Alan Kraemer, Executive Vice  President, Chief Technology Officer, Sarah Yang, Vice President, Software  Engineering and Michael Franzi, Vice President, Sales Licensing, as approved  on February 8, 2007, previously filed with the SEC on the Company’s  Current Report on Form 8-K filed with the SEC on February 13,  2007, which is incorporated herein by reference. |
| 31.1            |       | Certification of Chief Executive Officer of SRS  Labs, Inc., pursuant to Rule 13a-14 of the Securities Exchange Act.                                                                                                                                                                                                                                                                                                  |
| 31.2            |       | Certification of Chief Financial Officer of SRS  Labs, Inc., pursuant to Rule 13a-14 of the Securities Exchange Act.                                                                                                                                                                                                                                                                                                  |
| 32.1            |       | Certification of Chief Executive Officer of SRS  Labs, Inc., pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                          |
| 32.2            |       | Certification of Chief Financial Officer of SRS  Labs, Inc., pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                          |

 

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