**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

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| **(Mark One)**                                                                                                                                        |                                                                                               |
|-------------------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------|
| **ý**                                                                                                                                            | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**  |
|                                                                                                                                                  |                                                                                               |
| **For the quarterly period ended September 30, 2003**                                                                                                 |
|                                                                                                                                                  |                                                                                               |
| **OR**                                                                                                                                                |
|                                                                                                                                                  |                                                                                               |
| **o**                                                                                                                                                 | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                  |                                                                                               |
| **For the transition period from            to           ** |
|                                                                                                                                                  |                                                                                               |
| **Commission File Number 0-21123**                                                                                                                    |

 

 

**SRS LABS, INC.**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                                                                        |   | **33-0714264**                        |
|-------------------------------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization)                     |   | (I.R.S. Employer  Identification No.) |
|                                                                                |   |                                  |
| **2909 Daimler Street, Santa Ana, California 92705**                                |
| (Address of principal executive offices) (Zip Code)                                 |
|                                                                                |   |                                  |
| **(949) 442-1070**                                                             |
| (Registrant’s telephone number, including area code)                           |
|                                                                                |   |                                  |
| **Not Applicable**                                                                  |
| (Former name, former address and former fiscal year, if changed since  last report) |

 

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Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes ý No o

 

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

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date: as of October 31, 2003, 13,170,360 of the issuer’scommon stock, par value $.001 per share, were outstanding. In addition, as ofOctober 31, 2003, 225,300 shares of the issuer’s common stock were held astreasury shares.

 

 

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**SRS LABS, INC.**

 

**Form 10-Q**

**For the Period Ended September 30, 2003**

 

**Index**

 
| **PART I—FINANCIAL  INFORMATION** |
|----------------------------------------|
| Item 1.                                | Financial Statements. |
|                                   | Condensed  Consolidated Balance Sheets as of September 30, 2003 (Unaudited) and December  31, 2002 |
|                                   | Condensed  Consolidated Statements of Operations for the three months and nine months  ended September 30, 2003 and 2002 (Unaudited) |
|                                   | Condensed  Consolidated Statements of Stockholders’ Equity and Comprehensive Income  (Loss) for the nine months ended September 30, 2003 (Unaudited) |
|                                   | Condensed  Consolidated Statements of Cash Flows for the nine months ended September 30,  2003 and 2002 (Unaudited) |
|                                   | Notes to the Condensed  Interim 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  and Reports on Form 8-K. |
|                                   |   |
| SIGNATURES                             |

 

2

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**FORWARD-LOOKING INFORMATION**

 

This Quarterly Report onForm 10-Q contains forward-looking statements within the meaning ofSection 21E of the Securities Exchange Act of 1934, as amended, andSection 27A of the Securities Act of 1933, as amended, reflectingmanagement’s current expectations. Examples of such forward-looking statementsinclude the expectations of the Company with respect to its strategy. Althoughthe Company believes that its expectations are based upon reasonable assumptions,there can be no assurances that the Company’s financial goals will be realized.Such forward-looking statements involve known and unknown risks, uncertaintiesand other factors that may cause the actual results, performance orachievements of the Company, or industry results, to be materially differentfrom any future results, performance or achievements expressed or implied bysuch forward-looking statements. Numerous factors may affect the Company’sactual results and may cause results to differ materially from those expressedin forward-looking statements made by or on behalf of the Company. For thispurpose, any statements contained herein that are not statements of historicalfact may be deemed to be forward-looking statements. Without limiting the foregoing,the words, “believes,” “anticipates,” “plans,” “expects” and similarexpressions, are intended to identify forward-looking statements. The importantfactors discussed in Part I, Item 2, “Management’s Discussion and Analysisof Financial Condition and Results of Operations—Factors That May Affect FutureResults”, herein, among others, could cause actual results to differ materiallyfrom those indicated by forward-looking statements made herein and presentedelsewhere by management. Such forward-looking statements represent management’scurrent expectations and are inherently uncertain. Investors are warned thatactual results may differ from management’s expectations. The Company assumesno obligation to update the forward-looking information to reflect actualresults or changes in the factors affecting such forward-looking information.

 

3

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**PART I — FINANCIAL INFORMATION**

 

**Item 1.Financial Statements.**

 

**SRS LABS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 
|                                                                                                                                                                                                                         |   | **September  30, 2003** |       | **December 31, 2002** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|------------|----------------------------|--------|
|                                                                                                                                                                                                                         |   | **(unaudited)**         |       |                       |   |
| **ASSETS**                                                                                                                                                                                                                   |   |                    |       |                       |   |
| **Current Assets**                                                                                                                                                                                                           |   |                    |       |                       |   |
| Cash and cash equivalents                                                                                                                                                                                                    |   | $                       | 11,290,949 |                       | $      | 15,720,860 |   |
| Accounts receivable, net                                                                                                                                                                                                     |   | 1,155,884               |       | 1,074,421                  |   |
| Inventories, net                                                                                                                                                                                                             |   | 948,816                 |       | 807,382                    |   |
| Prepaid expenses and other current assets                                                                                                                                                                                    |   | 607,365                 |       | 462,442                    |   |
| Deferred income taxes                                                                                                                                                                                                        |   | 36,147                  |       | 36,147                     |   |
|                                                                                                                                                                                                                         |   |                    |       |                       |   |
| **Total Current Assets**                                                                                                                                                                                                     |   | 14,039,161              |       | 18,101,252                 |   |
|                                                                                                                                                                                                                         |   |                    |       |                       |   |
| Investments available for sale                                                                                                                                                                                               |   | 10,687,813              |       | 6,630,771                  |   |
| Furniture, fixtures & equipment, net                                                                                                                                                                                |   | 1,741,506               |       | 1,935,424                  |   |
| Goodwill, net                                                                                                                                                                                                                |   | 1,173,102               |       | 533,031                    |   |
| Intangible assets, net                                                                                                                                                                                                       |   | 1,889,577               |       | 1,957,359                  |   |
| Deferred income taxes                                                                                                                                                                                                        |   | 172,318                 |       | 149,498                    |   |
|                                                                                                                                                                                                                         |   |                    |       |                       |   |
| **Total Assets**                                                                                                                                                                                                             |   | $                       | 29,703,477 |                       | $      | 29,307,335 |   |
|                                                                                                                                                                                                                         |   |                    |       |                       |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                |   |                    |       |                       |   |
| **Current Liabilities**                                                                                                                                                                                                      |   |                    |       |                       |   |
| Accounts payable                                                                                                                                                                                                             |   | $                       | 1,164,736  |                       | $      | 1,011,032 |   |
| Accrued liabilities                                                                                                                                                                                                          |   | 1,204,232               |       | 2,347,702                  |   |
| Income taxes payable                                                                                                                                                                                                         |   | 591,806                 |       | 341,172                    |   |
|                                                                                                                                                                                                                         |   |                    |       |                       |   |
| **Total Current Liabilities**                                                                                                                                                                                                |   | 2,960,774               |       | 3,699,906                  |   |
| Minority interest                                                                                                                                                                                                            |   | —                  |       | 325,371                    |   |
| Commitments and contingencies                                                                                                                                                                                                |   |                    |       |                       |   |
|                                                                                                                                                                                                                         |   |                    |       |                       |   |
| **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; 13,364,198 and 12,876,314 shares issued; and 13,138,898 and  12,651,014 shares outstanding at September 30, 2003 and December 31,  2002, respectively |   | 13,365                  |       | 12,877                     |   |
| Additional paid in capital                                                                                                                                                                                                   |   | 57,366,350              |       | 55,966,589                 |   |
| Accumulated other comprehensive loss                                                                                                                                                                                         |   | (155,646                | )          | (88,564                    | )      |
| Accumulated deficit                                                                                                                                                                                                          |   | (29,762,765             | )          | (29,890,243                | )      |
| Treasury stock at cost, 225,300 shares at  September 30, 2003 and at December 31, 2002                                                                                                                                       |   | (718,601                | )          | (718,601                   | )      |
|                                                                                                                                                                                                                         |   |                    |       |                       |   |
| Total Stockholders’ Equity                                                                                                                                                                                              |   | 26,742,703              |       | 25,282,058                 |   |
|                                                                                                                                                                                                                         |   |                    |       |                       |   |
| Total Liabilities and Stockholders’ Equity                                                                                                                                                                              |   | $                       | 29,703,477 |                       | $      | 29,307,335 |   |

 

See accompanying notes to the condensed interim consolidated financialstatements

 

4

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**SRS LABS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
|                                                                             |   | **Three Months Ended  September 30,** |       | **Nine Months Ended  September 30,** |       |
|----------------------------------------------------------------------------------|--------|---------------------------------------|------------|--------------------------------------|------------|
|                                                                             |   | **2003**                              |       | **2002**                             |       | **2003** |   | **2002** |   |
|                                                                             |   |                                  | ** ** |                                 | ** ** |   | ** ** |   | ** ** |
| Revenues:                                                                        |   |                                  |       |                                 |       |   |   |   |   |
| Licensing                                                                        |   | $                                     | 1,854,707  |                                 | $          | 2,008,554 |   | $ | 6,441,297 |   | $ | 5,240,117 |   |
| Semiconductor                                                                    |   | 2,884,248                             |       | 2,945,687                            |       | 7,063,008 |   | 6,782,127 |   |
| Other                                                                            |   | 147,439                               |       | 457,372                              |       | 378,309 |   | 973,109 |   |
| Total revenues                                                                   |   | 4,886,394                             |       | 5,411,613                            |       | 13,882,614 |   | 12,995,353 |   |
|                                                                             |   |                                  |       |                                 |       |   |   |   |   |
| Cost of sales                                                                    |   | 1,242,436                             |       | 1,505,290                            |       | 2,812,569 |   | 3,413,450 |   |
|                                                                             |   |                                  |       |                                 |       |   |   |   |   |
| Gross margin                                                                     |   | 3,643,958                             |       | 3,906,323                            |       | 11,070,045 |   | 9,581,903 |   |
|                                                                             |   |                                  |       |                                 |       |   |   |   |   |
| Operating expenses:                                                              |   |                                  |       |                                 |       |   |   |   |   |
| Sales and marketing                                                              |   | 1,216,568                             |       | 995,759                              |       | 3,840,155 |   | 3,188,978 |   |
| Research and development                                                         |   | 1,032,100                             |       | 992,839                              |       | 3,083,438 |   | 2,895,436 |   |
| General and administrative                                                       |   | 1,143,930                             |       | 1,272,031                            |       | 3,668,573 |   | 3,385,737 |   |
|                                                                             |   |                                  |       |                                 |       |   |   |   |   |
| Total operating expenses                                                         |   | 3,392,598                             |       | 3,260,629                            |       | 10,592,166 |   | 9,470,151 |   |
|                                                                             |   |                                  |       |                                 |       |   |   |   |   |
| Income from operations                                                           |   | 251,360                               |       | 645,694                              |       | 477,879 |   | 111,752 |   |
|                                                                             |   |                                  |       |                                 |       |   |   |   |   |
| Other income, net                                                                |   | 131,925                               |       | 295,332                              |       | 414,655 |   | 611,882 |   |
| Minority interest                                                                |   | —                                |       | 19,178                               |       | 5,430 |   | 59,208 |   |
|                                                                             |   |                                  |       |                                 |       |   |   |   |   |
| Income before income tax expense                                                 |   | 383,285                               |       | 960,204                              |       | 897,964 |   | 782,842 |   |
|                                                                             |   |                                  |       |                                 |       |   |   |   |   |
| Income tax expense                                                               |   | 264,459                               |       | 364,430                              |       | 770,486 |   | 673,245 |   |
|                                                                             |   |                                  |       |                                 |       |   |   |   |   |
| Net income                                                                       |   | $                                     | 118,826    |                                 | $          | 595,774 |   | $ | 127,478 |   | $ | 109,597 |   |
|                                                                             |   |                                  |       |                                 |       |   |   |   |   |
| Net income per common share:                                                     |   |                                  |       |                                 |       |   |   |   |   |
|                                                                             |   |                                  |       |                                 |       |   |   |   |   |
| Basic                                                                            |   | $                                     | 0.01       |                                 | $          | 0.05 |   | $ | 0.01 |   | $ | 0.01 |   |
|                                                                             |   |                                  |       |                                 |       |   |   |   |   |
| Diluted                                                                          |   | $                                     | 0.01       |                                 | $          | 0.05 |   | $ | 0.01 |   | $ | 0.01 |   |
|                                                                             |   |                                  |       |                                 |       |   |   |   |   |
| Weighted average shares used in the calculation of  net income per common share: |   |                                  |       |                                 |       |   |   |   |   |
| Basic                                                                            |   | 13,076,315                            |       | 12,623,339                           |       | 12,956,971 |   | 12,659,347 |   |
|                                                                             |   |                                  |       |                                 |       |   |   |   |   |
| Diluted                                                                          |   | 14,730,290                            |       | 12,758,058                           |       | 13,729,676 |   | 12,903,526 |   |

 

 See accompanying notes to thecondensed interim consolidated financial statements

 

5

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**SRSLABS, INC.**

### **CONDENSED CONSOLIDATED STATEMENTS** OF STOCKHOLDERS’EQUITY ANDCOMPREHENSIVE INCOME (LOSS) (Unaudited)

 
|                                                           |   | **Common Stock** |   | **Additional  Paid-In********Capital** |   | **Accumulated  Other  Comprehensive********(Loss)** |   | **Accumulated****Deficit** |   | **Treasury********Stock** |     | **Total** |   | **Comprehensive  Income (Loss)  for the Periods********Ended** |   |
|----------------------------------------------------------------|--------|------------------|--------|----------------------------------------|--------|-----------------------------------------------------|--------|----------------------------|--------|---------------------------|----------|-----------|--------|----------------------------------------------------------------|--------|
|                                                           |   | **Shares**       |   | **Amount**                             |   |                                                |   |                       |   |                      |     |
|                                                           |   |             |   |                                   |   |                                                |   |                       |   |                      |     |      |   |                                                           |   |   |   |
| BALANCE, Dec. 31, 2002                                         |   | 12,651,014       |   | $                                      | 12,877 |                                                | $      | 55,966,589                 |   | $                         | (88,564  | )         | $      | (29,890,243                                                    | )      | $ | (718,601 | ) | $ | 25,282,058 |   |   |   |
| Proceeds from exercise of  stock options                       |   | 5,000            |   | 5                                      |   | 13,120                                              |   | —                     |   | —                    |     | —    |   | 13,125                                                         |   |   |   |
| Deferred stock option  compensation                            |   | —           |   | —                                 |   | 18,236                                              |   | —                     |   | —                    |     | —    |   | 18,236                                                         |   |   |   |
| Issuance of Common Stock                                       |   | 332,184          |   | 332                                    |   | 959,680                                             |   | —                     |   | —                    |     | —    |   | 960,012                                                        |   |   |   |
| Unrealized loss on  investments available for sale, net of tax |   | —           |   | —                                 |   | —                                              |   | (85,214                    | )      | —                    |     | —    |   | (85,214                                                        | )      | $ | (85,214 | ) |
| Net income                                                     |   | —           |   | —                                 |   | —                                              |   | —                     |   | 42,534                    |     | —    |   | 42,534                                                         |   | 42,534 |   |
|                                                           |   |             |   |                                   |   |                                                |   |                       |   |                      |     |      |   |                                                           |   |   |   |
| BALANCE, March 31, 2003                                        |   | 12,988,198       |   | $                                      | 13,214 |                                                | $      | 56,957,625                 |   | $                         | (173,778 | )         | $      | (29,847,709                                                    | )      | $ | (718,601 | ) | $ | 26,230,751 |   | $ | (42,680 | ) |
| Proceeds from exercise of  stock options                       |   | 24,332           |   | 24                                     |   | 38,997                                              |   | —                     |   | —                    |     | —    |   | 39,021                                                         |   |   |   |
| Deferred stock option  compensation                            |   | —           |   | —                                 |   | 18,236                                              |   | —                     |   | —                    |     | —    |   | 18,236                                                         |   |   |   |
| Unrealized loss on  investments available for sale, net of tax |   | —           |   | —                                 |   | —                                              |   | (7,604                     | )      | —                    |     | —    |   | (7,604                                                         | )      | (7,604 | ) |
| Net loss                                                       |   | —           |   | —                                 |   | —                                              |   | —                     |   | (33,882                   | )        | —    |   | (33,882                                                        | )      | (33,882 | ) |
|                                                           |   |             |   |                                   |   |                                                |   |                       |   |                      |     |      |   |                                                           |   |   |   |
| BALANCE, June 30, 2003                                         |   | 13,012,530       |   | $                                      | 13,238 |                                                | $      | 57,014,858                 |   | $                         | (181,382 | )         | $      | (29,881,591                                                    | )      | $ | (718,601 | ) | $ | 26,246,522 |   | $ | (84,166 | ) |
|                                                           |   |             |   |                                   |   |                                                |   |                       |   |                      |     |      |   |                                                           |   |   |   |
| Proceeds from exercise of  stock options                       |   | 126,368          |   | 127                                    |   | 333,256                                             |   | —                     |   | —                    |     | —    |   | 333,383                                                        |   |   |   |
| Deferred stock option  compensation                            |   | —           |   | —                                 |   | 18,236                                              |   | —                     |   | —                    |     | —    |   | 18,236                                                         |   |   |   |
| Unrealized loss on  investments available for sale, net of tax |   | —           |   | —                                 |   | —                                              |   | 25,736                     |   | —                    |     | —    |   | 25,736                                                         |   | 25,736 |   |
| Net income                                                     |   | —           |   | —                                 |   | —                                              |   | —                     |   | 118,826                   |     | —    |   | 118,826                                                        |   | 118,826 |   |
|                                                           |   |             |   |                                   |   |                                                |   |                       |   |                      |     |      |   |                                                           |   |   |   |
| BALANCE, Sept. 30, 2003                                        |   | 13,138,898       |   | $                                      | 13,365 |                                                | $      | 57,366,350                 |   | $                         | (155,646 | )         | $      | (29,762,765                                                    | )      | $ | (718,601 | ) | $ | 26,742,703 |   | $ | 60,396 |   |

 

See accompanying notes to thecondensed interim consolidated financial statements

 

6

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**SRS LABS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
|                                                                                         |   | **Nine Months Ended  September 30,** |       |
|----------------------------------------------------------------------------------------------|--------|--------------------------------------|------------|
|                                                                                         |   | **2003**                             |       | **2002** |   |
|                                                                                         |   |                                 |       |   |   |
| **Cash Flows From Operating  Activities:**                                                   |   |                                 |       |   |   |
| Net income                                                                                   |   | $                                    | 127,478    |   | $ | 109,597 |   |
| Adjustments to reconcile net income to net cash  provided by (used in) operating activities: |   |                                 |       |   |   |
| Depreciation and amortization                                                                |   | 833,508                              |       | 943,657 |   |
| Minority interest                                                                            |   | (5,430                               | )          | (59,208 | ) |
| Provision for doubtful accounts                                                              |   | (21,151                              | )          | 421 |   |
| Provision for obsolete inventory                                                             |   | (1,268                               | )          | (20,982 | ) |
| Deferred Taxes                                                                               |   | (22,820                              | )          | — |   |
| Increase in deferred stock option compensation                                               |   | 54,708                               |       | 70,260 |   |
| Changes in operating assets and liabilities:                                                 |   |                                 |       |   |   |
| Accounts receivable                                                                          |   | (60,313                              | )          | 135,701 |   |
| Inventories                                                                                  |   | (140,166                             | )          | 319,440 |   |
| Prepaid expenses and other current assets                                                    |   | (144,923                             | )          | 273,109 |   |
| Accounts payable                                                                             |   | 153,707                              |       | 33,253 |   |
| Accrued liabilities                                                                          |   | (1,143,468                           | )          | 472,253 |   |
| Income taxes payable                                                                         |   | 250,634                              |       | 314,161 |   |
|                                                                                         |   |                                 |       |   |   |
| Net cash provided by (used in) operating  activities                                         |   | (119,504                             | )          | 2,591,662 |   |
|                                                                                         |   |                                 |       |   |   |
| **Cash Flows From Investing  Activities:**                                                   |   |                                 |       |   |   |
| Purchase of furniture, fixtures & equipment                                              |   | (396,161                             | )          | (565,614 | ) |
| Purchase of investments available for sale                                                   |   | (5,232,533                           | )          | (7,289,978 | ) |
| Proceeds from sale of investments available for  sale                                        |   | 1,108,407                            |       | 582,556 |   |
| Expenditures related to patents and intangible  assets                                       |   | (175,649                             | )          | (177,051 | ) |
|                                                                                         |   |                                 |       |   |   |
| Net cash used in investing activities                                                        |   | (4,695,936                           | )          | (7,450,087 | ) |
|                                                                                         |   |                                 |       |   |   |
| **Cash Flows From Financing  Activities:**                                                   |   |                                 |       |   |   |
| Purchase of treasury stock                                                                   |   | —                               |       | (242,203 | ) |
| Proceeds from exercise of stock options                                                      |   | 385,529                              |       | 31,181 |   |
|                                                                                         |   |                                 |       |   |   |
| Net cash provided by (used in) financing  activities                                         |   | 385,529                              |       | (211,022 | ) |
|                                                                                         |   |                                 |       |   |   |
| **Net Decrease in Cash and Cash  Equivalents**                                               |   | (4,429,911                           | )          | (5,069,447 | ) |
| **Cash and Cash Equivalents,  Beginning of Period**                                          |   | 15,720,860                           |       | 19,011,167 |   |
|                                                                                         |   |                                 |       |   |   |
| **Cash and Cash Equivalents, End of  Period**                                                |   | $                                    | 11,290,949 |   | $ | 13,941,720 |   |
|                                                                                         |   |                                 |       |   |   |
| **Supplemental Disclosures of Cash  Flow Information:**                                      |   |                                 |       |   |   |
| Cash paid during the period for:                                                             |   |                                 |       |   |   |
| Income taxes                                                                                 |   | $                                    | 469,928    |   | $ | 359,084 |   |
| **Supplemental Disclosure of  Non-Cash Investing and Financing Activities:**                 |   |                                 |       |   |   |
| Unrealized gain (loss) on investments, net                                                   |   | $                                    | (67,082    | ) | $ | 7,831 |   |
| Issuance of Common stock for minority  interest                                              |   | $                                    | 960,012    |   | $ | — |   |

 

See accompanying notes to the condensed interim consolidated financialstatements

 

7

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**NOTES TO THE CONDENSED INTERIM****CONSOLIDATED FINANCIALSTATEMENTS (Unaudited****)**

**September 30, 2003**

 

**1.**                                      **General/Basis ofPresentation**

 

SRS Labs is a leading developer and provider of application specificintegrated circuits (“ASICs”), standard integrated circuits (“ICs”) and audioand voice technology solutions for the home theater, portable audio, wireless,computer, game, automotive, broadcast, Internet and telecommunications markets.The Company operates its business through three operating units: SRS Labs, theparent company; its wholly-owned subsidiary, ValenceTech Limited, andValenceTech Limited’s wholly-owned subsidiaries (collectively “Valence”) andSRS Labs’ wholly-owned subsidiary, SRSWOWcast.com, Inc., doing business asSRSWOWcast Technologies (“SRSWOWcast”). As used herein, the “Company,” “SRS Labs,” “we,” “us,” or “our” means SRS Labs,Inc. and its wholly-owned subsidiaries, including Valence and SRSWOWcast.

 

The Company operates in three business units in the following fivebusiness segments:

 

***SRS Labs***

 

*Licensing**:***  The Company’s licensing segment develops andlicenses audio and voice technologies to many of the world’s leading originalequipment manufacturers (“OEMs”), software providers and semiconductormanufacturers.

 

*Products**:***  The product segment develops and sellsconsumer products that incorporate proprietary audio and speaker technologies.

 

***Valence***

 

*Semiconductor:*  The semiconductor segment develops and sells technology solutionsin the form of analog and digital signal processor (“DSP”) ASIC semiconductorsor other imbedded custom semiconductor designs to OEMs around the world.

 

*Component Distribution:*  The component distribution segment is anauthorized, non-exclusive distributor of semiconductor components,subassemblies and finished goods for selected OEM customers. The Company is nolonger emphasizing this business due to its decision to focus on higher marginrevenue. Although the Company expects revenues for this segment to declinefurther in the current year, it will continue to operate in this segment.

 

***SRSWOWcast***

 

*Internet and Broadcast:** ***TheCompany’s Internet and broadcast segment develops and sells software andhardware audio enhancement technology solutions for the Internet and broadcastmarkets.

 

Theaccompanying condensed interim consolidated financial statements have beenprepared by the Company without audit in conformity with accounting principlesgenerally accepted in the United States of America (“generally acceptedaccounting principles”) for interim financial information and the rules andregulations of the U.S. Securities and Exchange Commission (“SEC”). In theopinion of management, all adjustments (which include only normal recurringadjustments) considered necessary for a fair presentation have been included.Certain accounts have been reclassified from that previously reported to conformto the current period presentation.

 

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 fiscal year ended December 31, 2002.Current and future financial statements may not be directly comparable to theCompany’s historical financial statements. The results of operations for theinterim periods are not necessarily indicative of the results to be expectedfor the full year.

 

**2.**                                      **Goodwill and IntangibleAssets**

 

OnJanuary 1, 2002, the Company adopted SFAS No. 142, “Goodwill andOther Intangible Assets”, which, among other things, establishes new standardsfor goodwill acquired in a business combination, eliminates the amortization ofgoodwill and requires the carrying value of goodwill and identifiableintangibles to be evaluated for impairment on at least an annual basis.Identifiable intangible assets with a determinable useful life are amortizedover that period.

 

8

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Inaccordance with SFAS No. 142, all of the Company’s intangible assets thathave definite lives are being amortized on a straight-line basis over theirestimated useful lives and goodwill is evaluated to determine if fair value ofthe asset has decreased below its carrying value. At December 31, 2002,the Company evaluated goodwill and determined that no adjustment to impairgoodwill was necessary.

 

Goodwill and intangible assets consist of the following:

 
|                                 |   | **September  30, 2003** |      | **December  31, 2002** |   |
|--------------------------------------|--------|-------------------------|-----------|------------------------|--------|
|                                 |   |                    |      |                   |   |
| Goodwill  & assembled workforce  |   | $                       | 1,173,102 |                   | $      | 533,031 |   |
| Patents                              |   | 1,510,660               |      | 1,398,565              |   |
| Accumulated  amortization            |   | (647,445                | )         | (590,365               | )      |
| Patents, net                         |   | 863,215                 |      | 808,200                |   |
| Other  intangibles                   |   | 5,088,008               |      | 5,030,400              |   |
| Accumulated  amortization            |   | (4,061,646              | )         | (3,881,241             | )      |
| Other  intangibles, net              |   | 1,026,362               |      | 1,149,159              |   |
| Goodwill and  intangible assets, net |   | $                       | 3,062,679 |                   | $      | 2,490,390 |   |

 

InFebruary 2003, SRS Labs completed an exchange offer with the minorityshareholders of SRSWOWcast, pursuant to which SRS Labs acquired all 3,000,000outstanding shares of Series A Convertible Preferred Stock in exchange forthe issuance of 332,184 shares of SRS Labs common stock. As a result of theexchange offer, goodwill in the amount of $640,071 was recorded.

 

Amortization periods range from three toeleven years depending on the estimated useful life of the asset. Amortizationexpense consists of the following:

 
|                                   |   | **Three  months ended  September 30,** |   | **Nine months  ended  September 30,** |   |
|----------------------------------------|--------|----------------------------------------|--------|---------------------------------------|--------|
|                                   |   | **2003**                               |   | **2002**                              |   | **2003** |   | **2002** |   |
|                                   |   |                                   |   |                                  |   |   |   |   |   |
| Patents                                |   | $                                      | 37,592 |                                  | $      | 34,324 |   | $ | 108,519 |   | $ | 98,988 |   |
| Other  intangibles                     |   | 57,477                                 |   | 85,831                                |   | 180,405 |   | 324,159 |   |
| Total  intangible amortization expense |   | $                                      | 95,069 |                                  | $      | 120,155 |   | $ | 288,924 |   | $ | 423,147 |   |

 

The Company’s weighted average amortization period for patents andother intangibles is approximately 10 years. The following table shows theestimated amortization expense for those assets for the current year and eachof the four succeeding fiscal years.

 

| **Year ending  December 31,** |   | **Estimated  expense** |    |
|-------------------------------|--------|------------------------|---------|
|                          |   |                   |    |
| 2003                          |   | $                      | 348,595 |   |
| 2004                          |   | $                      | 340,621 |   |
| 2005                          |   | $                      | 340,621 |   |
| 2006                          |   | $                      | 340,621 |   |
| 2007                          |   | $                      | 318,036 |   |

 

**3.**                                      **Investments Available forSale**

 

TheCompany has classified its investments as available-for-sale in accordance withSFAS No. 115, “Accounting for Certain Investments in Debt and EquitySecurities.” The following table summarizes the Company’s investmentsecurities available for sale:

 
|                                            |   | **September  30, 2003** |       | **December  31, 2002** |   |
|-------------------------------------------------|--------|-------------------------|------------|------------------------|--------|
|                                            |   |                    |       |                   |   |
| U.S.  Government securities available for sale: |   |                    |       |                   |   |
| Cost                                            |   | $                       | 10,762,157 |                   | $      | 6,638,033 |   |
| Unrealized  loss                                |   | (74,344                 | )          | (7,262                 | )      |
| Estimated  fair value                           |   | $                       | 10,687,813 |                   | $      | 6,630,771 |   |

 

9

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

 
|                                            |   | **September  30, 2003** |       | **December  31, 2002**    |   |
|-------------------------------------------------|--------|-------------------------|------------|---------------------------|--------|
|                                            |   | **Cost**                |       | **Estimated  Fair Value** |   | **Cost** |   | **Estimated  Fair Value** |   |
|                                            |   |                    |       |                      |   |   |   |   |   |
| U.S.  Government securities available for sale: |   |                    |       |                      |   |   |   |   |   |
| Due in one  to five years                       |   | $                       | 10,762,157 |                      | $      | 10,687,813 |   | $ | 6,638,033 |   | $ | 6,630,771 |   |
|                                                 |        |                         |            |                           |        |  |  |  |  |  |  |  |  |

 

**4.**                                      **Inventories**

 

Inventories, which consistof finished goods, are stated at the lower of cost or net realizable value.Cost is calculated using the weighted average method and is comprised ofmaterial costs and, where applicable, subcontracting and overhead costs thathave been incurred in bringing the inventories to their present location andcondition. Net realizable value represents the estimated selling price lesscosts to be incurred in selling and distribution.

 

**5.**                                      **Minority Interest**

 

Minorityinterest represents the minority stockholders’ proportionate share of theequity in the consolidated subsidiary SRSWOWcast. At December 31, 2002, theCompany owned approximately 87% of the outstanding capital stock of SRSWOWcast.In February 2003, SRS Labs completed an exchange offer with the minorityshareholders of SRSWOWcast, pursuant to which SRS Labs acquired all 3,000,000outstanding shares of Series A Convertible Preferred Stock in exchange forthe issuance of 332,184 shares of SRS Labs common stock. As a result of theexchange offer, SRSWOWcast became a wholly-owned subsidiary of SRS Labs.  The proforma effect of the transaction as ifit had occurred at the beginning of this quarter and the beginning of last yearwould have been immaterial.

 

**6.**                                      **Stock-Based Compensation**

 

TheCompany accounts for stock-based awards to employees under the recognition andmeasurement principles of APB No. 25, “Accounting for Stock Issued toEmployees,” and related interpretations. The Company provides additional pro forma disclosures as required underSFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) and SFASNo. 148, “Accounting for Stock-Based Compensation — Transition andDisclosure — an Amendment of SFAS No. 123.” Accordingly, no stock-based employee compensation cost is reflected innet income (loss), as all options granted under the plan had an exercise priceequal to the market value of the underlying common stock on the date of grant.Had compensation cost for the Company’s stock option plan been determined basedon the fair value at the grant date for awards for the three months and ninemonths ended September 30, 2003 and 2002, consistent with the provisions ofSFAS No. 123, the Company’s net income and earnings per share would havebeen decreased to the pro forma amounts indicated below:

 
|                                                                                       |   | **For the three months ended**September 30, |     | **For the nine months ended  September 30,** |   |
|--------------------------------------------------------------------------------------------|--------|---------------------------------------------|----------|----------------------------------------------|--------|
|                                                                                       |   | **2003**                                    |     | **2002**                                     |   | **2003** |   | **2002** |   |
|                                                                                       |   |                                        |     |                                         |   |   |   |   |   |
| Net income  as reported                                                                    |   | $                                           | 118,826  |                                         | $      | 595,774 |   | $ | 127,478 |   | $ | 109,597 |   |
| Add:  deferred compensation expense already recognized                                     |   | 18,236                                      |     | 42,854                                       |   | 54,708 |   | 70,260 |   |
| Less fair  value of stock-based employee compensation expense, net of related tax  effects |   | (563,564                                    | )        | (392,051                                     | )      | (1,671,514 | ) | (1,221,683 | ) |
|                                                                                       |   |                                        |     |                                         |   |   |   |   |   |
| Net income  (loss) pro forma                                                               |   | $                                           | (426,502 | )                                            | $      | 246,577 |   | $ | (1,489,328 | ) | $ | (1,041,826 | ) |
| Net income  per share (basic and diluted)—as reported                                 |   | $                                           | 0.01     |                                         | $      | 0.05 |   | $ | 0.01 |   | $ | 0.01 |   |
| Net income  (loss) per share (basic and diluted)—pro forma                            |   | $                                           | (0.03    | )                                            | $      | 0.02 |   | $ | (0.12 | ) | $ | (0.08 | ) |

 

Thefair value of each option grant was estimated on the date of grant using theBlack-Scholes option-pricing model with the following weighted averageassumptions used for grants during the quarter and nine months ended September30, 2003.

 

| Risk free  interest rate |   | 3.13    | %      |
|--------------------------|--------|---------|--------|
| Expected  life           |   | 5 years |   |
| Expected  volatility     |   | 69      | %      |

 

10

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BecauseFAS No. 123 has not been applied to options granted prior toJanuary 1, 1995, the resulting pro forma compensation cost may not berepresentative of that to be expected in future years.

 

**7.**                                      **Net Income Per Common Share**

 

TheCompany applies SFAS No. 128, “Earnings per Share,” which requires thedisclosure of basic and diluted net income or loss per share for all currentand prior periods. Basic net income or loss per common share is computed bydividing net income or loss available to common stockholders by the weightedaverage number of common shares outstanding during each year. Diluted netincome or loss per common share reflects the maximum dilution, based on theaverage price of the Company’s common stock 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 and nine months ended September 30, are as follows:

 
|                                                     |   | **For the  three months  ended September 30,** |    | **For the  nine months  ended September 30,** |   |
|----------------------------------------------------------|--------|------------------------------------------------|---------|-----------------------------------------------|--------|
|                                                     |   | **2003**                                       |    | **2002**                                      |   | **2003** |   | **2002** |   |
|                                                     |   |                                           |    |                                          |   |   |   |   |   |
| BASIC EPS                                                |   |                                           |    |                                          |   |   |   |   |   |
| Net income                                               |   | $                                              | 118,826 |                                          | $      | 595,774 |   | $ | 127,478 |   | $ | 109,597 |   |
| Denominator:  weighted average common shares outstanding |   | 13,076,315                                     |    | 12,623,339                                    |   | 12,956,971 |   | 12,659,347 |   |
| Net income  per share—basic                         |   | $                                              | 0.01    |                                          | $      | 0.05 |   | $ | 0.01 |   | $ | 0.01 |   |
|                                                     |   |                                           |    |                                          |   |   |   |   |   |
| DILUTED EPS                                              |   |                                           |    |                                          |   |   |   |   |   |
| Net income                                               |   | $                                              | 118,826 |                                          | $      | 595,774 |   | $ | 127,478 |   | $ | 109,597 |   |
| Denominator:  weighted average common shares outstanding |   | 13,076,315                                     |    | 12,623,339                                    |   | 12,956,971 |   | 12,659,347 |   |
| Common  equivalent shares outstanding:                   |   |                                           |    |                                          |   |   |   |   |   |
| Options                                                  |   | 1,653,975                                      |    | 134,719                                       |   | 772,705 |   | 244,179 |   |
| Total  diluted shares                                    |   | 14,730,290                                     |    | 12,758,058                                    |   | 13,729,676 |   | 12,903,526 |   |
| Net income  per share—diluted                       |   | $                                              | 0.01    |                                          | $      | 0.05 |   | $ | 0.01 |   | $ | 0.01 |   |

 

Therewere 1,109,881 and 4,085,067 potentially dilutive options outstanding for thequarters ending September 30, 2003 and 2002, respectively, and there were2,113,419 and 4,050,750 potentially dilutive options outstanding for the ninemonths ending September 30, 2003 and 2002, respectively, that were not includedin the table above because they would be anti-dilutive.

 

**8.**                                      **Commitments andContingencies**

 

TheCompany is subject to legal proceedings and claims that arise in the normalcourse of business. While the outcome of these proceedings and claims cannot bepredicted with certainty, management does not believe that the outcome of anyof these matters will have a material adverse effect on the Company’sconsolidated financial position or results of operations.

 

TheCompany has contractual obligations and commitments with regards to operatinglease arrangements. The following table quantifies the expected contractualobligations and commitments subsequent to December 31, 2002:

 
|                         |   | **Payments  due in fiscal** |    |
|------------------------------|--------|-----------------------------|---------|
|                         |   | **2003**                    |    | **2004** |   | **2005** |   |
|                         |   |                        |    |   |   |   |   |
| Operating  lease commitments |   | $                           | 421,894 |   | $ | 351,610 |   | $ | 126,083 |   |
|                              |        |                             |         |  |  |  |  |  |  |  |

 

11

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**9.**                                      **Stockholders’ Equity**

 

OnMay 9, 2002, the Company’s Board of Directors authorized the repurchase ofup to 500,000 of the outstanding shares of the Company’s common stock for aperiod from May 10, 2002 to November 10, 2002 (the “2002 RepurchaseProgram”). As of June 30, 2003, 225,300 shares had been repurchased at a costof $718,601 under the 2002 Repurchase Program. All repurchased shares arereflected as treasury stock in the accompanying consolidated balance sheets.

 

**10.**                               **Segment Information**

 

TheCompany operates its three operating units in the following five businesssegments: (a) SRS Labs:  (i) thelicensing of technologies developed by the Company to OEMs andsemiconductor manufacturers, and (ii) the sale of consumer productsincorporating SRS proprietary technologies; (b) Valence: (i) thedevelopment and marketing of technology either in the form of ASICs or otherimbedded custom semiconductor designs, and (ii) the component distributionbusiness; and (c) SRSWOWcast:  thesale of hardware and software solutions to the Internet and broadcast audiomarkets. The Company does not allocate corporate operating expenses or specificassets to these segments. Therefore, the segment information that followsincludes only net revenues, cost of sales and gross margins of the identifiedsegments:

 
|                                       |   | **Business Segments** |      |         |   |
|--------------------------------------------|--------|-----------------------|-----------|--------------|--------|
|                                       |   | **SRS Labs**          |      | **Valence**  |   | **SRS WOWcast** |   |   |   |
|                                       |   | **Licensing**         |      | **Products** |   | **ASIC** |   | **Components** |   | **Product and  Internet Sales** |   | **Total** |   |
|                                       |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| **Three Months Ended September 30,  2003** |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| Total revenues                             |   | $                     | 1,854,707 |         | $      | (1,951 | ) | $ | 2,884,248 |   | $ | 82,675 |   | $ | 66,715 |   | $ | 4,886,394 |   |
| Cost of sales                              |   | 11,525                |      | (1,278       | )      | 1,123,509 |   | 102,898 |   | 5,782 |   | 1,242,436 |   |
|                                       |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| Gross margin                               |   | $                     | 1,843,182 |         | $      | (673 | ) | $ | 1,760,739 |   | $ | (20,223 | ) | $ | 60,933 |   | $ | 3,643,958 |   |
|                                       |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| **Three Months Ended September 30,  2002** |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| Total revenues                             |   | $                     | 2,008,554 |         | $      | 8,510 |   | $ | 2,945,687 |   | $ | 433,100 |   | $ | 15,762 |   | $ | 5,411,613 |   |
| Cost of sales                              |   | 69,905                |      | 2,962        |   | 1,020,491 |   | 407,365 |   | 4,567 |   | 1,505,290 |   |
|                                       |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| Gross margin                               |   | $                     | 1,938,649 |         | $      | 5,548 |   | $ | 1,925,196 |   | $ | 25,735 |   | $ | 11,195 |   | $ | 3,906,323 |   |

 
|                                         |   | **Business Segments** |      |         |   |
|----------------------------------------------|--------|-----------------------|-----------|--------------|--------|
|                                         |   | **SRS Labs**          |      | **Valence**  |   | **SRSWOWcast** |   |   |   |
|                                         |   | **Licensing**         |      | **Products** |   | **ASIC** |   | **Components** |   | **Product and  Internet Sales** |   | **Total** |   |
|                                         |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| **Nine Months Ended****September 30,  2003** |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| Total revenues                               |   | $                     | 6,441,297 |         | $      | 3,696 |   | $ | 7,063,008 |   | $ | 181,315 |   | $ | 193,298 |   | $ | 13,882,614 |   |
| Cost of sales                                |   | 35,410                |      | 2,574        |   | 2,501,599 |   | 248,838 |   | 24,148 |   | 2,812,569 |   |
|                                         |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| Gross margin                                 |   | $                     | 6,405,887 |         | $      | 1,122 |   | $ | 4,561,409 |   | $ | (67,523 | ) | $ | 169,150 |   | $ | 11,070,045 |   |
|                                         |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| **Nine Months Ended****September 30,  2002** |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| Total revenues                               |   | $                     | 5,240,117 |         | $      | 53,979 |   | $ | 6,782,127 |   | $ | 875,297 |   | $ | 43,833 |   | $ | 12,995,353 |   |
| Cost of sales                                |   | 113,068               |      | 45,719       |   | 2,379,501 |   | 863,806 |   | 11,356 |   | 3,413,450 |   |
|                                         |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| Gross margin                                 |   | $                     | 5,127,049 |         | $      | 8,260 |   | $ | 4,402,626 |   | $ | 11,491 |   | $ | 32,477 |   | $ | 9,581,903 |   |

 

Thefollowing schedule presents the Company’s revenue by geographic area. Forproduct sales, revenue is allocated based on the country to which the productwas shipped. For licensing-related revenue, the allocation is based on thelocation of the licensee’s corporate headquarters. The Americas region includesNorth, Central and South America.

 

12

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|                         |   | **Three Months Ended  September 30,** |      | **Nine  Months Ended  September 30,** |   |
|------------------------------|--------|---------------------------------------|-----------|---------------------------------------|--------|
|                         |   | **2003**                              |      | **2002**                              |   | **2003** |   | **2002** |   |
| **Geographic Area Revenue:** |   |                                  |      |                                  |   |   |   |   |   |
|                         |   |                                  |      |                                  |   |   |   |   |   |
| Asia Pacific                 |   | $                                     | 4,405,427 |                                  | $      | 5,313,454 |   | $ | 12,654,677 |   | $ | 12,102,767 |   |
| Americas                     |   | 179,521                               |      | 66,572                                |   | 736,567 |   | 545,162 |   |
| Europe                       |   | 301,446                               |      | 31,587                                |   | 491,370 |   | 347,424 |   |
|                         |   |                                  |      |                                  |   |   |   |   |   |
| Total                        |   | $                                     | 4,886,394 |                                  | $      | 5,411,613 |   | $ | 13,882,614 |   | $ | 12,995,353 |   |

 

**11.**                               **Recent AccountingPronouncements**

 

InJuly 2002, the Financial Accounting Standards Board (“FASB”) issuedSFAS 146, “Accounting for Costs Associated with Exit or DisposalActivities,” which addressed financial accounting and reporting for costsassociated with exit or disposal activities and supercedes Emerging Issues TaskForce (EITF) Issue 94-3, “Liability Recognition for Certain EmployeeTermination Benefits and Other Costs to Exit an Activity (Including CertainCosts Incurred in a Restructuring).” SFAS 146 requires that a liabilityfor a cost associated with an exit or disposal activity be recognized at thedate of an entity’s commitment to an exit plan. SFAS 146 also establishesthat the liability should initially be measured and recorded at fair value. TheCompany has adopted the provisions of SFAS 146 for exit or disposalactivities effective January 1, 2003. The adoption of SFAS No. 146 did nothave a material impact on the Company’s consolidated results of operations,financial position or cash flows.

 

InDecember 2002, the FASB issued SFAS No. 148, “Accounting forStock-Based Compensation—Transition and Disclosure—an Amendment to SFASNo. 123.” SFAS No. 148 provides alternative methods of transition fora voluntary change to the fair value based method on accounting for stock-basedemployee compensation. SFAS148 also requires that disclosures of the pro forma effect of using the fairvalue method of accounting for stock-based employee compensation be displayedmore prominently and in a tabular format. Additionally, SFAS 148 requiresdisclosures of the pro forma effect in interim financial statements. The Company has not currently adopted SFASNo. 123 and accordingly the implementation of SFAS No. 148 has not had amaterial effect on the Company’s consolidated financial position or results ofoperations. The Company hasadopted the disclosure provision of SFAS 148.

 

InNovember 2002, the FASB issued interpretation No. 45, “Guarantor’sAccounting and Disclosure Requirements for Guarantees. Including indirectGuarantees of Indebtedness of Others,” which disclosures are effective forfinancial statements for periods ending after December 15, 2002. While theCompany has various guarantees included in contracts in the normal course ofbusiness, primarily in the form of indemnities, these guarantees would onlyresult in immaterial increases in future costs, but do not representsignificant commitments or contingent liabilities of the indebtedness ofothers.

 

InJanuary 2003, the FASB issued interpretation No. 46, “Consolidationof Variable Interest Entities” (FIN 46), which requires the consolidationof variable interest entities, as defined. FIN 46 is applicable to financialstatements to be issued by the Company after 2002; however, disclosures arerequired currently if the Company expects to consolidate any variable interestentities. No material entities were consolidated as a result of FIN 46.

 

InApril 2003, the FSAB issued SFAS No. 149, “Amendment of Statement 133 onDerivative Instruments and Hedging Activities.”  This statement amends and clarifies financial accounting andreporting for derivative instruments, including certain derivative instrumentsembedded in other contracts (collectively referred to as derivatives) and forhedging activities under SFAS No. 133, “Accounting for Derivative Instrumentsand Hedging Activities.”  This statementis effective for contracts entered into or modified after June 30, 2003.  Adoption of this statement is not expectedto have a significant effect on the Company’s financial position or results ofoperations.

 

InMay 2003, the FASB issued SFAS No. 150, “Accounting for Certain FinancialInstruments with Characteristics of Both Liabilities and Equity.” Thisstatement establishes standards for how an issuer classifies and measures certainfinancial instruments with characteristics of both liabilities and equity.  This statement is effective for financialinstruments entered into or modified after May 31, 2003, and otherwise iseffective for the first interim period beginning after June 15, 2003.  The adoption of SFAS No. 150 is not expectedto have a significant effect on the Company’s financial position, results ofoperations, or cash flows.

 

13

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**Item2.  Management’s Discussion****and Analysis of FinancialCondition and Results of Operations**

 

Thisinformation should be read in conjunction with the audited consolidatedfinancial statements and notes thereto and Management’s Discussion and Analysisof Financial Condition and Results of Operations contained in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2002 (the“Form 10-K”), the audited consolidated financial statements and the notesthereto included in the Form 10-K and the unaudited condensed interim consolidatedfinancial statements and notes thereto included in this Quarterly Report.

 

**Overview**

 

SRS Labs is a leading developer and provider of application specificintegrated circuits (“ASICs”), standard integrated circuits (“ICs”) and audioand voice technology solutions for the home theater, portable audio, wireless,computer, game, automotive, broadcast, Internet and telecommunications markets.The Company operates its business through three operating units: SRS Labs, theparent company; its wholly-owned subsidiary, ValenceTech Limited, andValenceTech Limited’s wholly-owned subsidiaries (collectively “Valence”) andSRS Labs’ wholly-owned subsidiary, SRSWOWcast.com, Inc., doing business asSRSWOWcast Technologies (“SRSWOWcast”). As used herein, the “Company,” “SRS Labs,” “we,” “us,” or “our” means SRS Labs,Inc. and its wholly-owned subsidiaries, including Valence and SRSWOWcast.

 

The Company operates in three business units in the following fivebusiness segments:

 

***SRS**** **Labs***

*Licensing:* The Company’s licensingsegment develops and licenses audio and voice technologies to many of theworld’s leading original equipment manufacturers (“OEMs”), software providersand semiconductor manufacturers.

 

*Products:* The product segment develops and sells consumer products that incorporateproprietary audio and speaker technologies.

 

***Valence***

*Semiconductor**:***  The semiconductor segment develops and sellstechnology solutions in the form of analog and digital signal processor (“DSP”)ASIC semiconductors or other imbedded custom semiconductor designs toOEMs around the world.

 

*Component Distribution:*  The component distribution segment is anauthorized, non-exclusive distributor of semiconductor components,subassemblies and finished goods for selected OEM customers. The Company is nolonger emphasizing this business due to its decision to focus on higher marginrevenue. Although the Company expects revenues for this segment to declinefurther in the current year, it will continue to operate in this segment.

 

***SRSWOWcast***

*Internet and Broadcast:* The Company’s Internet and broadcast segmentdevelops and sells software and hardware audio enhancement technology solutionsfor the Internet and broadcast markets.

 

**Critical Accounting Policies**

 

The Company has prepared the accompanying condensed interimconsolidated financial statements without audit in conformity with accountingprinciples generally accepted in the United States for interim financialinformation.

 

The preparation of these financial statements requires us to makeestimates 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, estimatesare subject to an inherent degree of uncertainty. Actual results may differfrom our estimates.

 

The following represents a summary of our critical accounting policies,defined as those policies that we believe are: (a) the most important tothe portrayal of our financial condition and results of operations, and(b) that require management’s most difficult, subjective or complexjudgments, often as a result of the need to make estimates about the mattersthat are inherently uncertain.

 

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*Allowance for Doubtful Accounts*

 

We maintain allowances for doubtful accounts for estimated lossesresulting from the inability of our customers to make required payments. Weevaluate the ability to collect upon our accounts receivable based on specificcustomer circumstances, current economic trends, historical experience and theage of past due receivables. Unanticipated changes in the liquidity orfinancial position of our customers may require additional provisions fordoubtful accounts.

 

*Inventory Obsolescence Reserves*

 

Our inventories are stated at the lower of cost or net realizablevalue. We make provisions for estimated excess and obsolete inventory based onour regular reviews of inventory quantities on hand and the latest forecasts ofproduct demand and production requirements from our customers. If actual marketconditions or our customer’s product demands are less favorable than thoseprojected, additional provisions may be required.

 

*Valuation of Intangible Assets*

 

In accordance with Statement of Financial Accounting Standards (“SFAS”)No. 142, “Goodwill and Other Intangible Assets”, we assess potentialimpairments to intangible assets when there is evidence that events or changesin circumstances indicate that the carrying amount of an asset may not berecovered. Our judgments regarding the existence of impairment indicators andfuture cash flows related to intangible assets are based on operationalperformance of our acquired businesses, market conditions and other factors. Ifthe carrying value of a reporting unit exceeds its fair value, goodwill isconsidered impaired and a second test is performed to measure the amount ofimpairment loss, if any. For fiscal 2002, an independent valuation of goodwill andother intangibles was performed. To date, we have not recognized any impairmentof our goodwill and other intangible assets in connection with our adoption ofSFAS 142. However, no assurances can be given that future evaluation ofgoodwill will not result in charges as a result of future impairment.

 

*Income Taxes*

 

In preparing our consolidated financial statements, we go through aprocess to estimate our income taxes in each of the countries in which weoperate. The process includes an assessment of the current tax expense, theresults from tax examinations and the effects of temporary differencesresulting from the different treatment of transactions for tax and financialaccounting purposes. These differences result in deferred tax assets andliabilities, which are included in the Consolidated Balance Sheet. Therealization of deferred tax assets as a result of future taxable income must beassessed and to the extent that the realization is doubtful, we establish avaluation allowance. Our income tax provision is based on calculations andassumptions that will be subject to examination by the taxing authorities inthe jurisdictions in which we operate. Should the actual results differ fromour estimates, we would have to adjust the income tax provision in the periodin which the facts and circumstances that give rise to the revision becomeknown. Tax law and rate changes are reflected in the income tax provision inthe period in which such changes are enacted.

 

**Results of Operations**

 

**Three Months Ended September 30, 2003 Compared to ThreeMonths Ended September 30, 2002**

 

*Revenues*

 

Semiconductorrevenues consists of (a) design fees relating to, and sales of, ASICs forthird parties by Valence to OEMs; and (b) sales of general purposeintegrated circuits (“ICs”) designed by Valence under the brand name ASP.Licensing revenues are royalties generated primarily from the license of SRSLabs’ audio and voice technologies. License and royalty agreements generallyprovide for the license of technologies for a specified period of time foreither a single fee or a fee based on the number of units distributed by thelicensee. Component distribution revenue consists of the distribution ofsemiconductor products, manufacturing components and sub-assemblies toOEMs for the Hong Kong and People’s Republic of China (“PRC”) markets.Product sales represent sales of consumer products incorporating one or more ofSRS Labs’ proprietary technologies. Internet and broadcast revenues consist ofthe sale of hardware and software applications involving the Internet andbroadcast audio markets.

 

Totalrevenues for the three months ended September 30, 2003 were $4,886,394 comparedto $5,411,613 for the three months ended September 30, 2002, a decrease of$525,219 or 9.7%. Licensing revenues were $1,854,707 for the three months endedSeptember 30, 2003 compared to $2,008,554 for the three months ended September30, 2002, a decrease of $153,847 or 7.7%. The companyattributes this decrease to reduction of revenue received from a customer whoaccounted for a significant portion of the company’s revenue from the DVDplayer segment of the home theater market. A majority of the decrease was offset by revenues related to new productcategories such as portable audio devices and our increased penetration of SRSLabs technologies within the home theater market.  In addition, the lingering effects of the outbreak and spread ofSevere Acute Respiratory Syndrome (“SARS”) condition, continued to adverselyaffect the company’s licensing business, which is reported one quarter inarrears.

 

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Semiconductor revenues were $2,884,248 for the three months endedSeptember 30, 2003 compared to $2,945,687 for the three months ended September30, 2002, a decrease of $61,439 or 2.1%. Revenue was slightly down fromprevious year’s comparable quarter, due to lingering negative effects fromSARS, as business travel and sales calls returned to a more normal level duringthe quarter.

 

Otherrevenues were $147,439 for the three months ended September 30, 2003 comparedto $457,372 for the three months ended September 30, 2002, a decrease of$309,933 or 67.8%.  Other revenues arecomprised of the following components for the quarters ended September 30, 2003and 2002, respectively:  componentdistribution — 56% and 95%; product revenues — (1)% and 2%; internet andbroadcast business — 45% and 3%. Component distribution revenues were $82,675 for the three months endedSeptember 30, 2003 compared to $433,100 for the three months ended September30, 2002, a decrease of $350,425 or 80.9%. This decrease was due to theCompany’s decision to focus on higher margin semiconductor and licensingrevenues and de-emphasize certain lower margin distribution activities. Productrevenues were $(1,951) for the three months ended September 30, 2003 comparedto $8,510 for the comparable period in 2002, a decrease of $10,461 or 122.9%.This decrease was due to the decrease of on-line merchandising and returns.* *Revenuesgenerated by the Company’s Internet and broadcast based business were $66,715for the three months ended September 30, 2003 compared to $15,762 for the threemonths ended September 30, 2002, an increase of $50,953 or 323.3%.  This increase was attributable to the salesof professional hardware equipment to the broadcast market.

 

*Gross Margin*

 

Costof sales consists primarily of fabrication costs, assembly and test costs, andthe cost of materials and overhead from operations. The gross margin percentagefor the three months ended September 30, 2003 increased to 74.6% as apercentage of total revenue as compared to 72.2% for the three months endedSeptember 30, 2002. The increase is attributable to continued efforts by theCompany to focus the revenue base towards higher margin semiconductor andlicensing revenues and away from lower margin component distribution. Grossmargins for the licensing business for the quarters ended September 30, 2003and 2002 were 99% and 97% respectively. Licensing revenues accounted for 38% oftotal revenues as compared to 37% for the three months ended September 30, 2003and 2002, respectively. Gross margins for the semiconductor business for thequarters ended September 30, 2003 and 2002 were 61% and 65%, respectively. Thisdecrease in gross margin can be attributed to competitive pricing in the ASICbusiness. Semiconductor revenues accounted for 59% of total revenues ascompared to 54% for the three months ended September 30, 2003 and 2002,respectively. Gross margins for other revenues for the quarters ended September30, 2003 and 2002 were 27% and 9%, respectively.  Other revenues accounted for 3% of total revenues as compared to9% for the three months ended September 30, 2003 and 2002, respectively. Grossmargins may fluctuate in future quarters depending on the mix of products soldand services provided, royalties earned, competitive pricing, new productintroduction costs and other factors.

 

*Sales and Marketing*

 

Salesand marketing expenses consist primarily of employee salaries, salesconsultants’ fees and related expenses, sales commissions and product promotioncosts. Sales and marketing expenses were $1,216,568 for the three months endedSeptember 30, 2003 compared to $995,759 for the same prior year period, anincrease of $220,809 or 22.2%. The net increase in sales and marketing expensesfor the three months ended September 30, 2003 is primarily attributable toincreased investments in branding and promotion of our technologies in newmarkets designed to increase future revenues. As a percentage of totalrevenues, sales and marketing expenses increased from 18.4% for the quarterended September 30, 2002, to 24.9% for the same period in 2003.

 

*Research and Development*

 

Researchand development expenses consist of salaries and related costs of employeesengaged in ongoing research, design and development activities and costs forengineering materials and supplies. Research and development expenses were$1,032,100 for the three months ended September 30, 2003 compared to $992,839for the same prior year period, an increase of $39,261, or 4.0%. The increasein research and development costs is primarily due to the addition of researchand development personnel.  As apercentage of total revenues, research and development expenses increased from18.3% for the quarter ended September 30, 2002, to 21.1% for the same period in2003.

 

*General and Administrative*

 

Generaland administrative (“G&A”) expenses consist primarily of employee-relatedexpenses, legal costs associated with the administration of intellectualproperty and other professional fees. G&A expenses were $1,143,930 for thethree months ended September 30, 2003 compared to $1,272,031 for the same prioryear period, a decrease of $128,101 or 10.1%. The decrease was primarilyattributable to decreased**professionalfees*. *As a percentage of total revenues, G&A expenses decreasedfrom 23.5% for the quarter ended September 30, 2002, to 23.4% for the sameperiod in 2003.

 

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*Income (Loss) From Operations*

 

Incomefrom operations decreased by $394,334 to $251,360 for the quarter endedSeptember 30, 2003 as compared to income from operations of $645,694 for thequarter ended September 30, 2002.  Thedecrease in income from operations is due to a decrease in revenue and increasein operating expenses.

 

*Other Income, Net*

 

Otherincome, net, consists primarily of interest income, gain or (loss) on sale ofsecurities and foreign currency transaction gains and losses. Other income,net, was $131,925 for the three months ended September 30, 2003 compared to$295,332 for the same prior year period, a decrease of $163,407 or 55.3%. Otherincome net was substantially higher in the three months ended September 30,2002 due to a recognized gain on the sale of investments in the amount of$130,000 and higher interest income earned on investment balances.

 

*Minority Interest*

 

Minorityinterest represents the minority shareholders’ proportionate share of losses inSRSWOWcast. Minority interest was $0 for the three months ended September 30,2003 compared to $19,178 for the three months ended September 30, 2002. InFebruary 2003, SRS Labs completed an exchange offer with the minorityshareholders of SRSWOWcast, pursuant to which SRS Labs acquired all of theoutstanding shares of Series A Convertible Preferred Stock in exchange forthe issuance of shares of SRS Labs common stock. As a result of the exchangeoffer, SRSWOWcast became a wholly-owned subsidiary of SRS Labs.

 

*Provision for Income Taxes*

 

Theincome tax expense for the three months ended September 30, 2003 was $264,459compared to tax expense of $364,430 for the same prior year period, a decreaseof $99,971 or 27.4%. The decrease results from the decrease in pre-tax incomeof $576,919.

 

**Nine Months Ended September 30, 2003 Compared to Nine MonthsEnded September 30, 2002**

 

*Revenues*

 

Totalrevenues for the nine months ended September 30, 2003 were $13,882,614 comparedto $12,995,353 for the nine months ended September 30, 2002, an increase of$887,261 or 6.8%. Licensing revenues were $6,441,297 for the nine months endedSeptember 30, 2003 compared to $5,240,117 for the nine months ended September30, 2002, an increase of $1,201,180 or 22.9%. This increase was attributable torevenues generated from new product categories such as portable audio devices, andexpanding our penetration of SRS Labs technologies within our key home theatermarket. These revenues from new product categories and our increasedpenetration of the home theater market reflect upon the Company’s strategy todiversify its customer base. Theincrease in licensing revenue provided much higher gross margins which resultedin higher operating income for the nine months ended September 30, 2003 ascompared to the same period in 2002.

 

Semiconductorrevenues were $7,063,008 for the nine months ended September 30, 2003 comparedto $6,782,127 for the nine months ended September 30, 2002, an increase of$280,881 or 4.1%. This increase was attributable to expansion of Valence’scustomer base, increased design wins and new chip offerings.

 

Other revenues were $378,309 for the nine months ended September 30,2003 compared to $973,109 for the nine months ended September 30, 2002, adecrease of $594,800 or 61.1%.  Otherrevenues are comprised of the following components for the nine month periodsended September 30, 2003 and 2002, respectively:  component distribution — 48% and 90%; product revenues — 1% and6% ; Internet and broadcast business — 51% and 5%.  Component distribution revenues were $181,315 for the nine monthsended September 30, 2003 compared to $875,297 for the nine months endedSeptember 30, 2002, a decrease of $693,982 or 79.3%. This decrease was due tothe Company’s decision to focus on higher margin ASIC and licensing revenuesand de-emphasize certain lower margin distribution activities. Product revenueswere $3,696 for the nine months ended September 30, 2003 compared to $53,979for the comparable period in 2002, a decrease of $50,283 or 93.2 %. Thisdecrease was due to the decrease of the on-line merchandising of SRSproducts.  Revenues generated by theCompany’s Internet and broadcast based business were $193,298 for the ninemonths ended September 30, 2003 compared to $43,833 for the nine months endedSeptember 30, 2002, an increase of $149,465 or 341%.  This increase was attributable to the sales of professionalhardware equipment to the broadcast market.

 

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###### *Gross Margin*

 

Cost of sales consists primarily of fabrication costs, assembly andtest costs, and the cost of materials and overhead from operations. The grossmargin percentage for the nine months ended September 30, 2003 increased to 80%as a percentage of total revenue as compared to 74% for the nine months endedSeptember 30, 2002. Gross margins for the licensing business for the ninemonths ended September 30, 2003 and 2002 were 100% and 98%, respectively.Licensing revenues accounted for 46% of total revenues as compared to 40% forthe nine months ended September 30, 2003 and 2002, respectively. Gross marginsfor the semiconductor business for the periods ended September 30, 2003 and2002 were 65% and 65%, respectively. Semiconductor revenues accounted for 51% of total revenues as comparedto 52% for the nine months ended September 30, 2003 and 2002, respectively.Gross margins for other revenues for the nine months ended September 30, 2003and 2002 were 27% and 0%, respectively. Other revenues accounted for 3% oftotal revenues as compared to 7% for the nine months ended September 30, 2003and 2002, respectively. The increase is attributable to continued efforts bythe Company to focus the revenue base towards higher margin semiconductor andlicensing revenues and away from lower margin component distribution. Grossmargins may fluctuate in future quarters depending on the mix of products soldand services provided, royalties earned, competitive pricing, new productintroduction costs and other factors.

 

*Sales and Marketing*

 

Sales and marketing expenses consist primarily of employee salaries,sales consultants’ fees and related expenses, sales commissions and productpromotion costs. Sales and marketing expenses were $3,840,155 for the ninemonths ended September 30, 2003 compared to $3,188,978 for the same prior yearperiod, an increase of $651,177 or 20.4%. The net increase in sales andmarketing expenses for the nine months ended September 30, 2003 is primarilyattributable to investments in branding and promotion of our technologies innew markets designed to increase future revenues. As a percentage of totalrevenues, sales and marketing expenses increased from 24.5% for the nine monthsended September 30, 2002, to 27.7% for the same period in 2003.

 

*Research and Development*

 

Researchand development expenses consist of salaries and related costs of employeesengaged in ongoing research, design and development activities and costs forengineering materials and supplies. Research and development expenses were$3,083,438 for the nine months ended September 30, 2003 compared to $2,895,436for the same prior year period, an increase of $188,002, or 6.5%. The increasein research and development costs is primarily due to the addition of researchand development personnel and increased costs associated with the increasedsemiconductor business activity.  As apercentage of total revenues, research and development expenses decreased from22.3% for the nine months ended September 30, 2002, to 22.2% for the sameperiod in 2003.

 

*General and Administrative*

 

G&A expenses consist primarily of employee-related expenses, legalcosts associated with the administration of intellectual property and otherprofessional fees. G&A expenses were $3,668,573 for the nine months endedSeptember 30, 2003 compared to $3,385,737 for the same prior year period, anincrease of $282,836 or 8.4%. The increase was primarily attributable toadditions to infrastructure and personnel for management of our foreignoperations, increased professional fees and public company expenses. As apercentage of total revenues, G&A expenses increased from 26.1% for thenine months ended September 30, 2002, to 26.4% for the same period in 2003.

 

*Income From Operations*

 

Incomefrom operations increased by $366,127 to $477,879 for the nine months endedSeptember 30, 2003, as compared to income from operations of $111,752 for thesame period ended September 30, 2002. The increase in income from operations is due to an increase in grossprofit, partially offset by an increase in operating expenses.

 

*Other Income, Net*

 

Otherincome, net, consists primarily of interest income, gain or loss on sale ofsecurities and foreign currency transaction gains and losses. Other income,net, was $414,655 for the nine months ended September 30, 2003 compared to$611,882 for the same prior year period, a decrease of $197,227 or 32.2%. Otherincome, net was higher for the nine months ended September 30, 2002 due torealized gains on sales of investments and higher interest income earned oninvestment balances.

 

###### *Minority Interest*

 

Minorityinterest represents the minority shareholders’ proportionate share of losses inSRSWOWcast. Minority interest was $5,430 for the nine months ended September30, 2003 compared to $59,208 for the nine months ended September 30, 2002, adecrease of $53,778 or 90.8%. In February 2003, SRS Labs completed anexchange offer with the minority shareholders of SRSWOWcast, pursuant to whichSRS Labs acquired all of the outstanding shares of Series A ConvertiblePreferred Stock in exchange for the issuance of shares of SRS Labs commonstock. As a result of the exchange offer, SRSWOWcast became a wholly-ownedsubsidiary of SRS Labs.

 

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*Provision for Income Taxes*

 

Theincome tax expense for the nine months ended September 30, 2003 was $770,486compared to tax expense of $673,245 for the same prior year period, an increaseof $97,241 or 14.4%. The increase results from the increase in the Hong Kongtax rate from 16.5% to 17.5%, effective January 1, 2003, the higher levels offoreign tax on higher licensing revenues sourced from countries requiringforeign tax withholdings, and higher pretax income of $897,964.

 

**Liquidity and Capital Resources**

 

TheCompany’s principal source of liquidity to fund ongoing operations at September30, 2003 consisted of cash, cash equivalents and long-term investmentsaggregating $21,978,762. At September 30, 2003, the Company had cash and cashequivalents of $11,290,949 and long-term investments of $10,687,813. Cash andcash equivalents generally consist of cash, money market funds and other moneymarket instruments with original maturities of three months or less.Investments consist of U.S. government securities rated AAA.

 

Cashused by operating activities for the nine months ended September 30, 2003 was$119,504.  Net cash used by operationsresulted from a net increase in accounts receivable, inventory and prepaidexpenses and other current assets and a decrease in accrued liabilitiesassociated with commissions, bonus, product promotion costs as well asprofessional fees.  These decreases werepartially offset by increases in accounts payable and income taxes payable, aswell as certain adjustments to reconcile net income to cash used in operatingactivities including depreciation and amortization.  Net cash used by investing activities for the nine months endedSeptember 30, 2003 was $4,695,936, resulting primarily from the purchase ofU.S. government securities and purchases of furniture, fixtures and equipmentand expenditures related to intangible assets. Net cash provided by financingactivities for the nine months ended September 30, 2003 was $385,529,reflecting the proceeds from sale of common stock pursuant to exercise ofemployee stock options.

 

Basedon current plans and business conditions, the Company expects that its cash,cash equivalents and investments together with any amounts generated fromoperations will be sufficient to meet the Company’s cash requirements for theforeseeable future. However, there can be no assurance that the Company willnot be required to seek other financing sooner or that such financing, ifrequired, will be available on terms satisfactory to the Company.

 

**Factors That May Affect Future Results**

 

*Our quarterly results may fluctuate*

 

Our operating results may fluctuate from those in prior quarters andwill continue to be subject to quarterly and other fluctuations due to avariety of factors, including the extent to which our licensees incorporate ourtechnologies into their products; the timing of orders from, and the shipmentsto, major customers; the timing of new product introductions; the gain or lossof significant customers; competitive pressures on selling prices; the marketacceptance of new or enhanced versions of our technologies; the rate that oursemiconductor licensees manufacture and distribute chips to productmanufacturers; and fluctuations in general economic conditions, particularlythose affecting the consumer electronics market. Due to our dependence on theconsumer electronics market, the substantial seasonality of sales in the marketcould impact our revenues and net income. In particular, we believe that thereis seasonality relating to the Christmas season generally and the Chinese NewYear within the Asia region, which fall into the fourth and first quartersrespectively. As a result, we believe that period-to-period comparisons of ourresults of operations are not necessarily meaningful and should not be reliedon as indications of future performance.

 

*We rely on revenue contribution from our ASICand standard IC business*

 

We derive a significant amount of our revenue from Valence’s ASICbusiness. Valence’s engineering team focuses on the design of custom ASICs tomeet specific customers’ requirements and out sources the production of thedesign to mask houses, foundries and packaging houses located primarily inAsia. The operations of Valence could be affected by a variety of factors,including the timing of customer orders, the timing of development revenue,changes in the mix of products distributed and the mix of distribution channelsemployed, the emergence of a new industry standard, product obsolescence andchanges in pricing policies by the Company, its competitors or its suppliers.

 

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Business revenue from ASICs is concentrated in a limited number ofcustomers in the areas of consumer electronics, communications products,computers and computer peripherals. The business generated from any onecustomer may be for a fixed length or quantity. As such, it is customary in ourASIC business to have a certain amount of customer turnover as new ASICprojects are obtained for different customers. However, it is possible that theloss of any particular customer or any bad debt arising from such customer mayhave a material adverse impact on our financial condition and results ofoperation.

 

Valence adds significant diversity to our overall business structureand opportunities. We recognize that in the presence of such corporatediversity, and in particular with regard to the semiconductor industry, therewill always exist a potential for a conflict among sales channels between theCompany and our technology licensees. Although the operations of our licensingbusiness and those of Valence are generally complementary, there can be noassurances that sales channel conflicts will not arise. If such potentialconflicts do materialize, we may or may not be able to mitigate the effect ofsuch perceived conflicts, which, if not resolved, may impact the results ofoperations.

 

*We conduct operations in a number ofcountries and are subject to risks of international operations, particularly inAsia and the PRC*

 

We have significant operations in Hong Kong, the PRC and other parts ofAsia that require refinement to adapt to the changing market conditions in thatregion. Our customers geographically located in the Asia Pacific marketsaccounted for approximately 90% and 98% of total Company sales in the quartersended September 30, 2003 and 2002, respectively; and 91% and 93% of total Companysales in the nine months ended September 30, 2003 and 2002, respectively; andare expected to continue to account for a substantial percentage of sales inthe future. Because we rely on sales to customers in Asia for a substantialportion of our revenue, our business is very likely to be adversely impacted byeconomic downturns and instability in that region. In addition, internationalsales are subject to risks, including, but not limited to:

 

•                                          fluctuationsin foreign exchange rates;

•                                          changesin legal and regulatory requirements;

•                                          politicaland economic instability and acts of terrorism;

•                                          anypublic health crisis such as SARS;

•                                          difficultiesin staffing and managing international operations;

•                                          foreigntrade disputes; and

•                                          potentiallyadverse tax consequences.

 

The PRC economy has experienced significant growth in the past decade;but such growth has been uneven across geographic and economic sectors. Therecan be no assurance that such growth will continue or that any potentialcurrency devaluation in the region will not have a negative effect on ourbusiness, including Valence.

 

Hong Kong is a Special Administrative Region of the PRC with its owngovernment and legislature. Hong Kong enjoys a high degree of autonomy from thePRC under the principle of “one country, two systems.” We can give no assurancethat Hong Kong will continue to enjoy autonomy from the PRC.

 

The Hong Kong dollar has remained relatively constant due to the U.S.dollar peg and currency board system that has been in effect in Hong Kong since1983. Since mid-1997, interest rates in Hong Kong have fluctuated significantlyand real estate and retail sales have declined. We can give no assurance thatthe Hong Kong economy will not worsen or that the historical currency peg ofthe Hong Kong dollar to the U.S. dollar will be maintained. Continued decliningconsumer spending in Hong Kong, deflation or the discontinuation of thecurrency peg could adversely affect our business.

 

Hong Kong, and other regions of Asia, have been particularly affectedby the outbreak and spread of SARS which, in turn, has impacted the economiclandscape of these regions and companies that conduct business in the sameregions.  While it is difficult toconclusively quantify the impact of SARS on our business, based on discussionswe have had with our customers we believe and it appears that the growth of ourlicensing revenue and expansion of our semiconductor business have beennegatively impacted.  Although employeesof our Hong Kong operations were subject to temporary travel restrictions inthe second quarter of 2003 that are now lifted, it is impossible to predict theprecise economic impact of SARS and whether such impact will have a continuingor significant long-term effect on the Company.  Accordingly, the Company remains potentially at risk from theeffects of SARS, or similar health emergencies, which restrict travel and mayotherwise negatively impact the ability to routinely conduct and expandbusiness in those areas affected by SARS.

 

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*We are exposed to risks in our licensingbusiness related to product and customer concentration*

 

Currently, our licensing revenue is concentrated in the home theatermarket with the majority of revenue generated from the inclusion of SRStechnology inside televisions, DVD players and set-top boxes. We expect thatthe consumer home entertainment market will continue to account for asignificant portion of our licensing revenues for the foreseeable future. Whileconsumer spending in general on consumer electronic products has increased,retail prices for certain consumer electronics products that include our audiotechnology, such as DVD players have decreased significantly and indicationsare that this trend will continue for the foreseeable future. In addition, from time to time, certain of our original equipment manufacturer andsemiconductor manufacturer customersmay account for a significantportion of revenue from a particular product application, such as DVD players,set-top boxes or televisions.  Consumerelectronics products manufacturers could decide to exclude our audioenhancement technology from their home theater products altogether in an effortto reduce cost.  The loss of any such customer could have a material adverseaffect on the company’s financial condition and results of operations.

 

Declining prices of consumer electronic products could put pressure onour licensing fees that are charged to the manufacturers.  Also, given thecurrent economic environment, consumer spending on DVD players and other homeelectronic products may not increase as expected.  Such declines in consumer spending, should they occur, andcontinued decreases in consumer product pricing for electronic goods may have asignificant negative impact on our financial results. The company's strategy isto diversify its customer base in an effort to decrease the impact from theloss of a particular customer, product segment or change in market trend.

 

*We are exposed to certain risks in producingprofessional and consumer products*

 

We have developed high-end audio enhancement products, includingprofessional and consumer hardware and software products. We have alsodeveloped a line of speakers that incorporate proprietary flat panel designs,which have been marketed to OEMs and industry retail buyers. There can beno assurance that our products will be accepted in the market or that we willbe able to develop an effective distribution channel and build acceptable brandrecognition as a product manufacturer. As the business increases, it isanticipated that significant capital will be required to finance productinventory and accounts receivable. As a result, we are subject to risks ofproduct obsolescence, bad debt and insufficient finance to grow the business.

 

We also recognize that as we develop and market new consumer audioproducts, there will always exist a potential for conflict and competitionbetween SRS Labs and our technology licensees. Although our intended productsand those of our licensees do not generally overlap, there can be no assurancesthat our products will not compete with those of our licensees. If suchconflicts do materialize, it is uncertain whether we will be able to mitigatethe effect of such conflicts, which, if not resolved, may adversely impact ourbusiness and results of operations.

 

*Our results of operations may be adverselyaffected by a slowdown in the global economy*

 

Over the past year, the global economy experienced a slowdown due tomany factors, including decreased consumer confidence, unemployment, theongoing threat and cost of terrorism and reduced corporate profits and capitalspending. Recent political events, including the U.S. military action in theMiddle East, have put further pressure on economic conditions. The potentialturmoil that may result from such events contribute to the uncertainty of theeconomic climate, further reducing predictability and our ability to developand implement long-term strategic plans. Although the U.S. and other major economieshave recently showed signs of growth, the future remains uncertain and theimpact of political, military, terrorism and similar events may have a materialadverse impact on our operating results and financial position.

 

*We are subject to competitive pressures*

 

Our existing and potential competitors include both large and emergingdomestic and international companies that have substantially greater financial,manufacturing, technical, marketing, distribution and other resources. Presentor future competitors may be able to develop products and technologiescomparable or superior to ours, and to adapt more quickly than us to newtechnologies or evolving market needs. We believe that the competitive factorsaffecting the market for our products and technologies include productperformance, price and quality; product functionality and features; the ease ofintegration; and implementation of the products and technologies with otherhardware and software components in the OEM’s products. In addition, the marketsin which we compete are intensely competitive and are characterized by rapidtechnological changes, declining average sales prices and rapid productobsolescence. Accordingly, there can be no assurance that we will be able tocontinue to compete effectively in all of our existing markets, thatcompetition will not intensify or that future competition will not have amaterial adverse effect on our business, operating results, cash flows andfinancial condition.

 

*We strongly rely on our intellectual property*

 

Our ability to compete may be affected by our ability to protect ourproprietary information. We have filed numerous U.S. and foreign patentapplications and, to date, have a number of issued U.S. and foreign patentscovering various aspects of our technologies. There can be no assurance that the steps taken by SRS Labs to protectour intellectual property will be adequate to prevent misappropriation of ourtechnology or that our competitors will not independently develop technologiesthat are substantially equivalent or superior to our technology. In addition,the laws of certain foreign countries may not protect our intellectual propertyrights to the same extent, as do the laws of the U.S. The semiconductorindustry is characterized by frequent claims and litigation regarding patentand other property rights. We are not currently a party to any claims of thisnature. There can be no assurances that third parties will not assert claims orinitiate litigation against the Company or our customers with respect toexisting or future products. In addition, we may initiate claims or litigationagainst third parties for infringement of our proprietary rights or todetermine the scope and validity of our proprietary rights.

 

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*We depend on our executive officers and otherkey personnel*

 

Our future success depends to a large extent upon the continued serviceof our executives, as well as key engineering, sales, and marketing staff,including highly skilled semiconductor design personnel. We anticipate that anyfuture growth will require us to recruit and hire a number of new personnel inengineering, sales and marketing, operations and finance. Competition for suchpersonnel is intense, and there can be no assurance that we can recruit andretain necessary personnel to operate its business and support future growth.

 

*The market price of our common stock isvolatile*

 

The trading price of our Common Stock has been, and will likelycontinue to be, subject to wide fluctuations in response to quarterlyvariations in our operating results, announcements of new products ortechnological innovations by the Company or our competitors, strategicalliances between SRS Labs and third parties, general market fluctuations andother events and factors. Changes in earnings estimates made by brokerage firmsand industry analysts relating to the markets in which we do business, orrelating to the Company specifically, have in the past resulted in, and couldin the future result in, an immediate and adverse effect on the market price ofthe Common Stock. Even though our stock is quoted on the Nasdaq Stock Market,our stock has had, and may continue to have, low trading volume and highvolatility. The historically low trading volume of our stock makes it morelikely that a severe fluctuation in volume, either up or down, willsignificantly impact the stock price. Since our shares are thinly traded, ourshareholders may have difficulty selling our common stock.

 

**Item3.  Quantitative and Qualitative****Disclosures about MarketRisk**

 

There have been no material changes to information called for by thisItem 3 from the disclosures set forth in Part II, Item 7A in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2002.

 

**Item4.  Controls and Procedures**

 

Basedon an evaluation of the effectiveness of our disclosure controls and procedures(as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Act of 1934,as amended), our Chief Executive Officer and Chief Financial Officer haveconcluded that such controls and procedures were effective as of the periodcovered by this report. In connection with such evaluation, no change in ourinternal control over financial reporting occurred during the period covered bythis report that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

 

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**PART II—OTHER INFORMATION**

 

**Item6.  Exhibits and****Reports on Form 8-K.**

 

(a)                                  *Exhibits*.

 

Theexhibit listed below is hereby filed with the Commission as part of thisReport.

 
| **Exhibit  Number** |   | **Description**                                                                                                         |
|---------------------|--------|-------------------------------------------------------------------------------------------------------------------------|
|                |   |                                                                                                                    |
| 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. |

 

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

 

On August 12, 2003, SRS Labs, Inc. (the “Company”) issued a pressrelease announcing its operating results for the three and six months endedJune 30, 2003.

 

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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:  November 14, 2003 | By:                                           | /s/ THOMAS C.K. YUEN |
|                     |                                          | **Thomas C.K. Yuen** |
|                     |                                          | **Chairman of the Board and Chief Executive  Officer** |
|                     |                                          | **(Principal Executive Officer)** |
|                     |                                          |   |
|                     |                                          |   |
| Date:  November 14, 2003 | By:                                           | /s/ JANET M. BISKI |
|                     |                                          | **Janet M. Biski** |
|                     |                                          | **Chief Financial Officer** |
|                     |                                          | **(Principal Financial and Accounting  Officer)** |

 

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