**UNITED STATESSECURITIES 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, 2005**                                                                                                     |
| ** **                                                                                                                                                      | ** ** |
| **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 itscharter)

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

 

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

(Address of principal executive offices) (ZipCode)

 

**(949) 442-1070**

(Registrant’s telephone number, includingarea code)

 

**NotApplicable**

(Former name, former address and formerfiscal year, if changed since last report)

 

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

 

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

 

Indicate by check mark whether the registrantis a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o   No ý

 

Indicate the number of shares outstanding of each ofthe issuer’s classes of common stock, as of the latest practicable date: as of October 31,2005, 14,901,124 of the issuer’s common stock, par value $.001 per share, wereoutstanding; of that amount, 674,098 shares were held as treasury shares.

 

 

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**SRSLABS, INC.**

 

**Form 10-Q**

**For thePeriod Ended September 30, 2005**

 

**Index**

 
| **PART I  - FINANCIAL INFORMATION** |
|------------------------------------------|
| Item 1.                                  | Financial Statements |
|                                     | Condensed  Consolidated Balance Sheets as of September 30, 2005 (Unaudited) and December 31,  2004 |
|                                     | Condensed  Consolidated Statements of Operations for the three months and nine months  ended September 30, 2005 and 2004 (Unaudited) |
|                                     | Condensed Consolidated  Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the  nine months ended September 30, 2005 (Unaudited) |
|                                     | Condensed  Consolidated Statements of Cash Flows for the nine months ended September 30,  2005 and 2004 (Unaudited) |
|                                     | Notes to the  Condensed Consolidated Financial Statements (Unaudited) |
| Item 2.                                  | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |
| Item 3.                                  | Quantitative and Qualitative Disclosures  About Market Risk |
| Item 4.                                  | Controls and Procedures |
| **PART II  - OTHER INFORMATION**    |
| Item 6.                                  | Exhibits |
|                                     |   |
| SIGNATURES                               |

 

2

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**FORWARD-LOOKINGINFORMATION**

 

This Quarterly Report on Form 10-Q containsforward-looking statements reflecting management’s current expectations.Examples of such forward-looking statements include the expectations of theCompany with respect to its strategy. Although the Company believes that itsexpectations are based upon reasonable assumptions, there can be no assurancesthat the Company’s financial goals will be realized. Such forward-lookingstatements involve known and unknown risks, uncertainties and other factorsthat may cause the actual results, performance or achievements of the Company,or industry results, to be materially different from any future results,performance or achievements expressed or implied by such forward-lookingstatements. Numerous factors may affect the Company’s actual results and maycause results to differ materially from those expressed in forward-lookingstatements made by or on behalf of the Company. For this purpose, anystatements contained herein that are not statements of historical fact may bedeemed to be forward-looking statements. Without limiting the foregoing, thewords, “believes,” “anticipates,” “plans,” “expects” and similar expressions,are intended to identify forward-looking statements. The important factorsdiscussed in Part I, Item 2, “Management’s Discussion and Analysis ofFinancial 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**

 

**SRSLABS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                       | ** ** | **September 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                                                                                                       | ** ** | **(unaudited)**             | ** ** | ** **                 | ** ** |
| **ASSETS**                                                                                                                                                                                                                       |       |                        |       |                       |       |
| **Current Assets**                                                                                                                                                                                                               |       |                        |       |                       |       |
| Cash and  cash equivalents                                                                                                                                                                                                       |       | $                           | 7,820,333  |                       | $          | 7,011,912 |   |
| Accounts  receivable, net                                                                                                                                                                                                        |       | 1,740,935                   |       | 1,318,665                  |       |
| Inventories,  net                                                                                                                                                                                                                |       | 624,440                     |       | 571,280                    |       |
| Prepaid  expenses and other current assets                                                                                                                                                                                       |       | 1,366,480                   |       | 1,337,506                  |       |
| Deferred  income taxes                                                                                                                                                                                                           |       | 23,406                      |       | 23,406                     |       |
|                                                                                                                                                                                                                             |       |                        |       |                       |       |
| **Total  Current Assets**                                                                                                                                                                                                        |       | 11,575,594                  |       | 10,262,769                 |       |
|                                                                                                                                                                                                                             |       |                        |       |                       |       |
| Investments  available for sale                                                                                                                                                                                                  |       | 17,068,070                  |       | 17,261,267                 |       |
| Investment  in LLC                                                                                                                                                                                                               |       | —                      |       | 2,596,090                  |       |
| Furniture,  fixtures and equipment, net                                                                                                                                                                                     |       | 1,592,861                   |       | 1,995,579                  |       |
| Capitalized  production costs, net                                                                                                                                                                                               |       | 3,023,775                   |       | —                     |       |
| Intangible  assets, net                                                                                                                                                                                                          |       | 2,546,886                   |       | 2,660,955                  |       |
| Goodwill                                                                                                                                                                                                                         |       | 533,031                     |       | 533,031                    |       |
| Deferred  income taxes                                                                                                                                                                                                           |       | 325,827                     |       | 192,750                    |       |
|                                                                                                                                                                                                                             |       |                        |       |                       |       |
| **Total  Assets**                                                                                                                                                                                                                |       | $                           | 36,666,044 |                       | $          | 35,502,441 |   |
|                                                                                                                                                                                                                             |       |                        |       |                       |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                   |       |                        |       |                       |       |
| **Current Liabilities**                                                                                                                                                                                                          |       |                        |       |                       |       |
| Accounts  payable                                                                                                                                                                                                                |       | $                           | 1,121,332  |                       | $          | 984,805 |   |
| Accrued  liabilities                                                                                                                                                                                                             |       | 1,813,976                   |       | 1,640,714                  |       |
| Deferred  revenue                                                                                                                                                                                                                |       | 350,072                     |       | 436,910                    |       |
| Income taxes  payable                                                                                                                                                                                                            |       | 27,043                      |       | 8,628                      |       |
|                                                                                                                                                                                                                             |       |                        |       |                       |       |
| **Total  Current Liabilities**                                                                                                                                                                                                   |       | 3,312,423                   |       | 3,071,057                  |       |
|                                                                                                                                                                                                                             |       |                        |       |                       |       |
| Commitments and contingencies (Note 8)                                                                                                                                                                                           |       |                        |       |                       |       |
|                                                                                                                                                                                                                             |       |                        |       |                       |       |
| **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;14,880,317 and 14,671,416 shares issued; and 14,206,219 and  14,229,541 shares outstanding at September 30, 2005 and December 31,  2004, respectively |       | 14,881                      |       | 14,672                     |       |
| Additional  paid-in capital                                                                                                                                                                                                      |       | 63,260,412                  |       | 62,523,292                 |       |
| Accumulated  other comprehensive loss                                                                                                                                                                                            |       | (504,612                    | )          | (309,722                   | )          |
| Accumulated  deficit                                                                                                                                                                                                             |       | (26,413,615                 | )          | (27,853,003                | )          |
| Treasury  stock at cost, 674,098 and 441,875 shares at September 30, 2005 and December 31,  2004, respectively                                                                                                         |       | (3,003,445                  | )          | (1,943,855                 | )          |
|                                                                                                                                                                                                                             |       |                        |       |                       |       |
| **Total  Stockholders’ Equity**                                                                                                                                                                                             |       | 33,353,621                  |       | 32,431,384                 |       |
|                                                                                                                                                                                                                             |       |                        |       |                       |       |
| **Total  Liabilities and Stockholders’ Equity**                                                                                                                                                                             |       | $                           | 36,666,044 |                       | $          | 35,502,441 |   |

 

See accompanying notes to the condensedconsolidated financial statements

 

4

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**SRSLABS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                                       | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                       | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                                                       | ** ** | **2005**               | ** ** | **2004**               | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                       | ** ** | ** **             | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues:                                                                        |       |                   |       |                   |       |   |   |   |   |
| Semiconductor                                                                    |       | $                      | 1,929,605  |                   | $          | 3,644,298 |   | $ | 6,435,342 |   | $ | 8,992,511 |   |
| Licensing                                                                        |       | 3,722,662              |       | 2,727,861              |       | 10,526,734 |   | 8,140,592 |   |
| Total revenues                                                                   |       | 5,652,267              |       | 6,372,159              |       | 16,962,076 |   | 17,133,103 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Cost of sales:                                                                   |       |                   |       |                   |       |   |   |   |   |
| Semiconductor                                                                    |       | 753,730                |       | 1,320,855              |       | 2,481,136 |   | 3,269,622 |   |
| Licensing                                                                        |       | 100,241                |       | 100,342                |       | 251,424 |   | 146,886 |   |
| Total cost of sales                                                              |       | 853,971                |       | 1,421,197              |       | 2,732,560 |   | 3,416,508 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Gross Margin                                                                     |       | 4,798,296              |       | 4,950,962              |       | 14,229,516 |   | 13,716,595 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Operating expenses:                                                              |       |                   |       |                   |       |   |   |   |   |
| Sales and  marketing                                                             |       | 1,521,788              |       | 1,305,349              |       | 4,892,666 |   | 4,260,784 |   |
| Research and  development                                                        |       | 1,220,889              |       | 1,266,606              |       | 3,610,829 |   | 3,620,219 |   |
| General and  administrative                                                      |       | 1,445,733              |       | 1,452,236              |       | 4,492,991 |   | 4,490,732 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Total  operating expenses                                                        |       | 4,188,410              |       | 4,024,191              |       | 12,996,486 |   | 12,371,735 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Income from operations                                                           |       | 609,886                |       | 926,771                |       | 1,233,030 |   | 1,344,860 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Equity in income of investee                                                     |       | —                 |       | —                 |       | 91,096 |   | — |   |
| Other income, net                                                                |       | 174,195                |       | 118,908                |       | 488,421 |   | 455,132 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Income before income tax expense                                                 |       | 784,081                |       | 1,045,679              |       | 1,812,547 |   | 1,799,992 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Income tax expense                                                               |       | 79,887                 |       | 241,721                |       | 373,159 |   | 790,863 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Net income                                                                       |       | $                      | 704,194    |                   | $          | 803,958 |   | $ | 1,439,388 |   | $ | 1,009,129 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Net income per common share:                                                     |       |                   |       |                   |       |   |   |   |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Basic                                                                            |       | $                      | 0.05       |                   | $          | 0.06 |   | $ | 0.10 |   | $ | 0.07 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Diluted                                                                          |       | $                      | 0.05       |                   | $          | 0.05 |   | $ | 0.10 |   | $ | 0.06 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Weighted  average shares used in the calculation of net income per common share: |       |                   |       |                   |       |   |   |   |   |
| Basic                                                                            |       | 14,094,690             |       | 14,278,589             |       | 14,076,833 |   | 14,045,162 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Diluted                                                                          |       | 15,300,803             |       | 15,395,792             |       | 15,070,362 |   | 15,991,331 |   |

 

See accompanying notes to the condensedconsolidated financial statements

 

5

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**SRSLABS, INC.**

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

 
| ** **                                                     | ** ** | **Common Stock** | ** ** | **Additional  Paid-In** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Accumulated** | ** ** | **Treasury** | ** ** | ** ** | ** ** | **Comprehensive  Income (Loss)  for the Period** | ** ** |
|----------------------------------------------------------------|------------|------------------|------------|-------------------------|------------|---------------------------------------|------------|-----------------|------------|--------------|------------|------------|------------|--------------------------------------------------|------------|
| ** **                                                     | ** ** | **Shares**       | ** ** | **Amount**              | ** ** | **Capital**                           | ** ** | **Loss**        | ** ** | **Deficit**  | ** ** | **Stock**  | ** ** | **Total**                                        | ** ** | **Ended** | ** ** |
|                                                           |       |             |       |                    |       |                                  |       |            |       |         |       |       |       |                                             |       |   |   |
| BALANCE, Dec. 31, 2004                                    |       | 14,229,541       |       | $                       | 14,672     |                                  | $          | 62,523,292      |       | $            | (309,722   | )          | $          | (27,853,003                                      | )          | $ | (1,943,855 | ) | $ | 32,431,384 |   |   |   |
| Proceeds from exercise of stock options                        |       | 17,612           |       | 18                      |       | 66,269                                |       | —          |       | —       |       | —     |       | 66,287                                           |       |   |   |
| Deferred stock option compensation                             |       | —           |       | —                  |       | 14,831                                |       | —          |       | —       |       | —     |       | 14,831                                           |       |   |   |
| Unrealized loss on investments available for sale,  net of tax |       | —           |       | —                  |       | —                                |       | (259,460        | )          | —       |       | —     |       | (259,460                                         | )          | (259,460 | ) |
| Net income                                                     |       | —           |       | —                  |       | —                                |       | —          |       | 221,460      |       | —     |       | 221,460                                          |       | 221,460 |   |
|                                                           |       |             |       |                    |       |                                  |       |            |       |         |       |       |       |                                             |       |   |   |
| BALANCE, March 31, 2005                                   |       | 14,247,153       |       | $                       | 14,690     |                                  | $          | 62,604,392      |       | $            | (569,182   | )          | $          | (27,631,543                                      | )          | $ | (1,943,855 | ) | $ | 32,474,502 |   | $ | (38,000 | ) |
| Proceeds from exercise of stock options                        |       | 110,110          |       | 110                     |       | 355,742                               |       | —          |       | —       |       | —     |       | 355,852                                          |       |   |   |
| Deferred stock option compensation                             |       | —           |       | —                  |       | 9,739                                 |       | —          |       | —       |       | —     |       | 9,739                                            |       |   |   |
| Purchase of treasury stock                                     |       | (232,223         | )          | —                  |       | —                                |       | —          |       | —       |       | (1,059,590 | )          | (1,059,590                                       | )          |   |   |
|                                                           |       |             |       |                    |       |                                  |       |            |       |         |       |       |       |                                             |       |   |   |
| Unrealized gain on investments available for sale,  net of tax |       | —           |       | —                  |       | —                                |       | 218,348         |       | —       |       | —     |       | 218,348                                          |       | 218,348 |   |
|                                                           |       |             |       |                    |       |                                  |       |            |       |         |       |       |       |                                             |       |   |   |
| Net income                                                     |       | —           |       | —                  |       | —                                |       | —          |       | 513,734      |       | —     |       | 513,734                                          |       | 513,734 |   |
|                                                           |       |             |       |                    |       |                                  |       |            |       |         |       |       |       |                                             |       |   |   |
| BALANCE, June 30, 2005                                    |       | 14,125,040       |       | $                       | 14,800     |                                  | $          | 62,969,873      |       | $            | (350,834   | )          | $          | (27,117,809                                      | )          | $ | (3,003,445 | ) | $ | 32,512,585 |   | $ | 694,082 |   |
| Proceeds from exercise of stock options                        |       | 81,179           |       | 81                      |       | 282,490                               |       | —          |       | —       |       | —     |       | 282,571                                          |       |   |   |
| Deferred stock option compensation                             |       | —           |       | —                  |       | 8,049                                 |       | —          |       | —       |       | —     |       | 8,049                                            |       |   |   |
| Unrealized loss on investments available for sale,  net of tax |       | —           |       | —                  |       | —                                |       | (153,778        | )          | —       |       | —     |       | (153,778                                         | )          | (153,778 | ) |
| Net income                                                     |       | —           |       | —                  |       | —                                |       | —          |       | 704,194      |       | —     |       | 704,194                                          |       | 704,194 |   |
|                                                           |       |             |       |                    |       |                                  |       |            |       |         |       |       |       |                                             |       |   |   |
| BALANCE, Sept. 30, 2005                                   |       | 14,206,219       |       | $                       | 14,881     |                                  | $          | 63,260,412      |       | $            | (504,612   | )          | $          | (26,413,615                                      | )          | $ | (3,003,445 | ) | $ | 33,353,621 |   | $ | 1,244,498 |   |

 

See accompanying notes to the condensedconsolidated financial statements

 

6

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**SRSLABS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                         | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| ** **                                                                         | ** ** | ** **                                | ** ** | ** ** | ** ** |
| **Cash Flows From Operating Activities:**                                          |       |                                      |       |   |   |
| Net income                                                                         |       | $                                         | 1,439,388  |   | $ | 1,009,129 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                                      |       |   |   |
| Depreciation  and amortization                                                     |       | 1,020,639                                 |       | 966,692 |   |
| Provision  for doubtful accounts                                                   |       | 47,355                                    |       | 153,859 |   |
| Benefit for  obsolete inventory                                                    |       | (13,449                                   | )          | (44,600 | ) |
| Deferred  taxes                                                                    |       | (133,077                                  | )          | (20,513 | ) |
| (Accretion)  amortization of (discount) premium on investments available for sale  |       | (1,693                                    | )          | 5,981 |   |
| Deferred  stock option compensation                                                |       | 32,619                                    |       | 66,393 |   |
| Loss on  disposition of furniture, fixtures and equipment                          |       | 1,417                                     |       | 6,791 |   |
| Impairment  on intangible assets                                                   |       | —                                    |       | 12,163 |   |
| Equity in  income of investee                                                      |       | (91,096                                   | )          | — |   |
| Changes in  operating assets and liabilities, net of consolidation of CHS/SRS LLC: |       |                                      |       |   |   |
| Accounts  receivable                                                               |       | (360,554                                  | )          | (182,417 | ) |
| Inventories                                                                        |       | (25,188                                   | )          | 30,612 |   |
| Prepaid  expenses and other current assets                                         |       | 183,192                                   |       | 192,765 |   |
| Accounts  payable                                                                  |       | 132,885                                   |       | (22,402 | ) |
| Accrued  liabilities                                                               |       | 105,828                                   |       | 243,498 |   |
| Deferred  revenue                                                                  |       | (86,838                                   | )          | 369,125 |   |
| Income taxes  payable                                                              |       | 18,415                                    |       | 107,802 |   |
|                                                                               |       |                                      |       |   |   |
| Net cash  provided by operating activities                                         |       | 2,269,843                                 |       | 2,894,878 |   |
|                                                                               |       |                                      |       |   |   |
| **Cash Flows From Investing Activities:**                                          |       |                                      |       |   |   |
| Purchase of furniture, fixtures and  equipment                                     |       | (165,736                                  | )          | (874,737 | ) |
| Proceeds from sales of furniture and  equipment                                    |       | 2,300                                     |       | 550 |   |
| Proceeds from sale of investments available  for sale                              |       | —                                    |       | 241,876 |   |
| Investment in LLC                                                                  |       | —                                    |       | (2,025,626 | ) |
| Capitalized production costs.                                                      |       | (601,273                                  | )          | — |   |
| Expenditures related to patents and  intangible assets                             |       | (341,833                                  | )          | (417,742 | ) |
|                                                                               |       |                                      |       |   |   |
| Net cash  used in investing activities                                             |       | (1,106,542                                | )          | (3,075,679 | ) |
|                                                                               |       |                                      |       |   |   |
| **Cash Flows From Financing Activities:**                                          |       |                                      |       |   |   |
| Proceeds from exercise of stock options                                            |       | 704,710                                   |       | 3,569,927 |   |
| Purchase of Treasury Stock                                                         |       | (1,059,590                                | )          | (164,461 | ) |
|                                                                               |       |                                      |       |   |   |
| Net cash  (used in) provided by financing activities                               |       | (354,880                                  | )          | 3,405,466 |   |
|                                                                               |       |                                      |       |   |   |
| **Net Increase in Cash and Cash Equivalents**                                      |       | 808,421                                   |       | 3,224,665 |   |
| **Cash and Cash Equivalents, Beginning of  Period**                                |       | 7,011,912                                 |       | 12,795,620 |   |
|                                                                               |       |                                      |       |   |   |
| **Cash and Cash Equivalents, End of Period**                                       |       | $                                         | 7,820,333  |   | $ | 16,020,285 |   |
|                                                                               |       |                                      |       |   |   |
| **Supplemental Disclosure of Cash Flow  Information:**                             |       |                                      |       |   |   |
| Cash paid  during the period for:                                                  |       |                                      |       |   |   |
| Income taxes                                                                       |       | $                                         | 546,847    |   | $ | 456,600 |   |
| **Supplemental Disclosure of Non-Cash  Investing Activities:**                     |       |                                      |       |   |   |
| Unrealized (loss)  gain on investments, net                                        |       | $                                         | (194,890   | ) | $ | 38,823 |   |
| Fair market  value of assets consolidated, inclusive of cash of $10,733            |       | $                                         | 3,047,154  |   | $ | — |   |
| Fair market  value of liabilities assumed in the consolidation                     |       | $                                         | 71,076     |   | $ | — |   |

 

See accompanying notes to the condensedconsolidated financial statements

 

7

----

 

**SRS LABS,INC.**

**NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)**

 

**1.****                                     ****Basis of Presentation andSummary of Significant Accounting Policies and Estimates**

 

As used herein, the “Company,” “SRS Labs,” “we,” “us,”or “our” means SRS Labs, Inc. and its wholly-owned subsidiaries, ValenceTech Limited (including its wholly-owned subsidiaries) and SRSWOWcast.com, Inc.(“SRSWOWcast.com) and CHS/SRS, LLC, a joint venture between the Company andComing Home Studios LLC (“CHS”) to complete and distribute the concert DVDs(the “Joint Venture”).  The accompanyingunaudited condensed consolidated financial statements have been prepared by theCompany in conformity with accounting principles generally accepted in theUnited States of America (“generally accepted accounting principles”) forinterim financial information and the rules and regulations of the U.S.Securities and Exchange Commission (the “SEC”) for interim reporting. In theopinion of management, all adjustments (which include only normal recurringadjustments) considered necessary for a fair presentation of our financialposition and results of operations have been included. Certain amounts includedin the accompanying prior periods’ consolidated financial statements have beenreclassified to conform to the current period presentation.

 

In September 2004, the Company entered into astrategic alliance with CHS to produce and sell concert DVDs by Duran Duran,Boz Scaggs, Godsmack and All Access featuring our Circle Surroundtechnology.   In connection with thestrategic alliance, the Company and CHS established the Joint Venture.  In July 2005, the Company replaced CHSas the manager of the Joint Venture.  Asa result of becoming the manager of the Joint Venture, the Company has controlover the Joint Venture’s business strategy and decisions.  Accordingly, the Company is required underapplicable accounting rules to consolidate the financial statements of theJoint Venture into our financial statements commencing with the third quarterof fiscal 2005.  Previously, we accountedfor our interest (50% of the equity ownership) in the Joint Venture as aninvestment using the equity method.  Inthe consolidated financial statements, all inter-company accounts andtransactions between the Company and the Joint Venture have been eliminated.

 

Certain information and footnote disclosuresnormally included in financial statements prepared in accordance with generallyaccepted accounting principles have been condensed or omitted pursuant to SEC rules andregulations for presentation of interim financial information. Therefore, thecondensed interim consolidated financial statements should be read inconjunction with the Company’s Annual Report on Form 10-K for the fiscalyear ended December 31, 2004. Current and future financial statements maynot be directly comparable to the Company’s historical financial statements.The results of operations for the interim period is not necessarily indicativeof the results to be expected for any other interim period or for the fullyear.

 

**Estimates**

 

The preparation of financial statements inaccordance with generally accepted accounting principles requires management tomake use of certain estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements and the reported amounts of revenuesand expenses during the reported periods. We base our estimates on historicalexperience and on various other assumptions that we believe are reasonableunder the circumstances, the results of which form the basis for makingjudgments about carrying values of assets and liabilities that are not readilyapparent from other sources. Actual results could differ materially from thoseestimates. See the audited consolidated financial statements and notes theretoincluded in our Annual Report on Form 10-K for the year ended December 31,2004 for an additional discussion of the significant accounting policies andestimates used in the preparation of our financial statements.

 

**2.****                                     ****Stock-Based Compensation**

 

The Company accounts for stock-based awards toemployees under the recognition and measurement principles of AccountingPrinciples Board (“APB”) Opinion No. 25, “Accounting for Stock Issued toEmployees,” and related interpretations. The Company provides additional proforma disclosures as required under Statement of Financial Accounting Standards(“SFAS”) No. 123, “Accounting for Stock-Based Compensation” and SFAS No. 148,“Accounting for Stock-Based Compensation — Transition and Disclosure — anAmendment of SFAS No. 123.” Accordingly, no stock-based employeecompensation cost is reflected in net income, as all options granted under theplan had an exercise price equal to the market value of the underlying commonstock on the date of grant. Had compensation expense been recorded under the 

 

8

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provisionsof SFAS No. 123, the Company’s net income (loss) and earnings per sharewould have been the pro forma amounts indicated below:

 
| ** **                                                                                          | ** ** | **For the three months ended** | ** ** | **For the nine months ended** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                                                                          | ** ** | **September 30,**         | ** ** | **September 30,**        | ** ** |
| ** **                                                                                          | ** ** | **2005**                       | ** ** | **2004**                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                |       |                           |       |                          |       |   |   |   |   |
| Net income  (attributable to common shareholder) — as reported                                 |       | $                              | 704,194    |                          | $          | 803,958 |   | $ | 1,439,388 |   | $ | 1,009,129 |   |
| Add:  stock-based employee compensation expense included in reported net income,  net of tax effect |       | 4,829                          |       | 15,715                        |       | 19,571 |   | 39,590 |   |
| Less fair  value of stock-based employee compensation expense, net of tax effect                    |       | (273,860                       | )          | (380,894                      | )          | (854,137 | ) | (1,215,778 | ) |
| Net income  (loss) (attributable to common shareholder) — pro forma                            |       | $                              | 435,163    |                          | $          | 438,779 |   | $ | 604,822 |   | $ | (167,059 | ) |
| Net income  (loss) per share:                                                                       |       |                           |       |                          |       |   |   |   |   |
| Basic, as  reported                                                                                 |       | $                              | 0.05       |                          | $          | 0.06 |   | $ | 0.10 |   | $ | 0.07 |   |
| Basic, pro  forma                                                                                   |       | $                              | 0.03       |                          | $          | 0.03 |   | $ | 0.04 |   | $ | (0.01 | ) |
| Diluted, as  reported                                                                               |       | $                              | 0.05       |                          | $          | 0.05 |   | $ | 0.10 |   | $ | 0.06 |   |
| Diluted, pro  forma                                                                                 |       | $                              | 0.03       |                          | $          | 0.03 |   | $ | 0.04 |   | $ | (0.01 | ) |

 

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 three and nine months ended September 30,2005:

 
| ** **              | ** ** | **Three months ended  Sept 30, 2005** | ** ** | **Nine months ended  Sept. 30, 2005** | ** ** |
|-------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| Risk-free interest rate |       | 4.2                                   | %          | 4.0                                   | %          |
| Expected life           |       | 6.25 years                            |       | 6.25 years                            |       |
| Expected volatility     |       | 55                                    | %          | 60                                    | %          |

 

**3.****                                     ****Capitalized Production Costs**

 

Production costs consist of capitalized costs tofilm and produce concert DVDs for domestic and international distribution andinclude the costs of film and tape conversion to the optical disc format, menuand packaging design, authoring, compression and mastering.  The Companyamortizes the production costs as units are sold.  Capitalized production costs as of September 30,2005 is as follows:

 
| ** **                        | ** ** | **September 30,  2005** | ** ** |
|-----------------------------------|------------|------------------------------|------------|
| Capitalized production costs      |       | $                            | 3,046,196  |   |
| Accumulated amortization          |       | (22,421                      | )          |
| Capitalized production costs, net |       | $                            | 3,023,775  |   |

 

**4.****                                     ****Capitalization of SoftwareDevelopment Costs**

 

Costs incurred in the research, design anddevelopment of software for sale to others as a separate product or embedded ina product and sold as part of the product as a whole are charged to expenseuntil technological feasibility is established. Under SFAS No. 86, “Accountingfor the Costs of Computer Software to be Sold, Leased or Otherwise Marketed,”the Company capitalizes software purchased from third parties if the relatedsoftware product under development has reached technological feasibility or ifthere are alternative future uses for the purchased software, provided thatcapitalized amounts will be realized over a period not exceeding five years.Costs incurred prior to the establishment of technological feasibility arecharged to research and development expense.

 

9

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Capitalized software as of September 30, 2005and December 31, 2004 is as follows:

 
| ** **                | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Capitalized software      |       | $                            | 563,568    |                        | $          | 464,568 |   |
| Accumulated amortization  |       | (278,684                     | )          | (193,003                    | )          |
| Capitalized software, net |       | $                            | 284,884    |                        | $          | 271,565 |   |

 

As of September 30, 2005, the weighted averageuseful life of the Company’s capitalized software is approximately 2.0 years.The following table shows the estimated amortization expense for those assetsfor the remaining three months of the current fiscal year end and each of thefour succeeding fiscal years.

 

| **Year ending December 31,** | ** ** | **Estimated  Expense** | ** ** |
|-----------------------------------|------------|------------------------|------------|
| 2005                              |       | $                      | 32,914     |   |
| 2006                              |       | $                      | 130,964    |   |
| 2007                              |       | $                      | 78,690     |   |
| 2008                              |       | $                      | 38,158     |   |
| 2009                              |       | $                      | 4,158      |   |

 

**5.****                                     ****Goodwill and IntangibleAssets**

 

On January 1, 2002, the Company adopted SFAS No. 142“Goodwill and Other Intangible Assets,” which, among other things, establishesnew standards for goodwill acquired in a business combination, eliminates theamortization of goodwill and requires the carrying value of goodwill andidentifiable intangibles to be evaluated for impairment on an annual basis.

 

In accordance with SFAS No. 142, all of our intangibleassets that have definite lives are being amortized on a straight-line basisover their estimated useful lives and goodwill is evaluated at least annuallyto determine if fair value of the asset has decreased below its carrying value.We performed our annual assessment of goodwill as of December 31, 2004,and determined that no adjustment to impair goodwill was necessary.

 

Goodwill and intangible assets consist of thefollowing:

 
| ** **                                                                                                                                                                      | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Goodwill                                                                                                                                                                        |       | $                            | 533,031    |                        | $          | 533,031 |   |
|                                                                                                                                                                            |       |                         |       |                        |       |
| Patents                                                                                                                                                                         |       | $                            | 2,281,414  |                        | $          | 2,038,582 |   |
| Accumulated amortization                                                                                                                                                        |       | (1,046,394                   | )          | (891,178                    | )          |
| Patents, net                                                                                                                                                                    |       | 1,235,020                    |       | 1,147,404                   |       |
| Other Intangibles:                                                                                                                                                              |       |                         |       |                        |       |
| Assets  acquired in the purchase of our subsidiary Valence Technology in 1998: Covenant  not to compete, Developed Technology, ASP brand name, Cell Library, and  Customer List |       | 4,910,400                    |       | 4,910,400                   |       |
| License  agreements acquired in purchase of our subsidiary SRSWOWcast in February 2003                                                                                     |       | 640,071                      |       | 640,071                     |       |
| Poly Planar  purchased technology for speaker products                                                                                                                          |       | 120,000                      |       | 120,000                     |       |
| Capitalized  software and hardware for several technologies                                                                                                                     |       | 493,841                      |       | 394,840                     |       |
| Total of  Other Intangibles                                                                                                                                                     |       | 6,164,312                    |       | 6,065,311                   |       |
| Accumulated amortization, other intangibles                                                                                                                                     |       | (4,852,446                   | )          | (4,551,760                  | )          |
| Other intangibles, net                                                                                                                                                          |       | 1,311,866                    |       | 1,513,551                   |       |
| Intangible assets, net                                                                                                                                                          |       | $                            | 2,546,886  |                        | $          | 2,660,955 |   |

 

10

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Amortization periods range from three to elevenyears depending on the estimated useful life of the asset. Amortization expenseconsists of the following:

 
| ** **                                                                                      | ** ** | **Three months ended  September 30,** | ** ** | **Nine Months ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Patents                                                                                         |       | $                                          | 53,834     |                                      | $          | 46,331 |   | $ | 155,216 |   | $ | 113,307 |   |
| Other intangibles:                                                                              |       |                                       |       |                                      |       |   |   |   |   |
| Covenant not  to compete, Developed Technology, ASP brand name, Cell Library and Customer  List |       | 51,477                                     |       | 51,477                                    |       | 154,432 |   | 154,431 |   |
| License  agreements acquired in purchase of our subsidiary SRSWOWcast in February 2003     |       | 16,002                                     |       | 16,002                                    |       | 48,005 |   | 48,005 |   |
| Poly Planar  purchased technology                                                               |       | —                                     |       | 6,000                                     |       | 4,000 |   | 18,000 |   |
| Capitalized  software and hardware                                                              |       | 32,746                                     |       | 29,713                                    |       | 94,249 |   | 60,358 |   |
| Total  intangible amortization expense                                                          |       | $                                          | 154,059    |                                      | $          | 149,523 |   | $ | 455,902 |   | $ | 394,101 |   |

 

As of September 30, 2005, the weighted averageuseful life of the Company’s patents and intangible assets is approximately3.0 years. The following table shows the estimated amortization expensefor those assets for the remaining three months of the current fiscal year andeach of the four succeeding fiscal years:

 
| **Year ending  December 31,** | ** ** | **Estimated  expense** | ** ** |
|------------------------------------|------------|------------------------|------------|
| 2005                               |       | $                      | 161,618    |   |
| 2006                               |       | $                      | 643,112    |   |
| 2007                               |       | $                      | 560,148    |   |
| 2008                               |       | $                      | 340,215    |   |
| 2009                               |       | $                      | 184,882    |   |
| Thereafter                         |       | $                      | 656,911    |   |

 

**6.****                                     ****Investments Available forSale**

 

The Company has classified its investments asavailable for sale in accordance with SFAS No. 115, “Accounting forCertain Investments in Debt and Equity Securities.” The following tablesummarizes the Company’s investment securities available for sale:

 
| ** **            | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------------|------------|------------------------------|------------|-----------------------------|------------|
| Cost                  |       | $                            | 17,489,688 |                        | $          | 17,489,688 |   |
| Accretion of discount |       | 1,693                        |       | —                      |       |
| Unrealized loss       |       | (423,311                     | )          | (228,421                    | )          |
| Estimated fair value  |       | $                            | 17,068,070 |                        | $          | 17,261,267 |   |

 

The contractual maturities of investments are shownbelow. Actual maturities may differ from contractual maturities.

 
| ** **                                      | ** ** | **September 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                                      | ** ** | **Cost**                    | ** ** | **Estimated  Fair Value**  | ** ** | **Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| U.S. Government securities available for  sale: |       |                        |       |                       |       |   |   |   |   |
| Due in one to five years                        |       | $                           | 17,489,688 |                       | $          | 17,068,070 |   | $ | 17,489,688 |   | $ | 17,261,267 |   |
|                                                 |            |                             |            |                            |            |  |  |  |  |  |  |  |  |

 

11

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The following table summarizes sales of availablefor sale securities for three months and nine months ended September 30,2005 and 2004. Specific identification was used to determine costs in computingrealized gains or losses.

 
| ** **         | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|--------------------|------------|------------------------|------------|------------------------|------------|
| ** **         | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **         | ** ** | **2005**               | ** ** | **2004**               | ** ** | **2005** | ** ** | **2004** | ** ** |
| Proceeds from sale |       | $                      | —     |                   | $          | — |   | $ | — |   | $ | 5,235,626 |   |
| Realized gains     |       | —                 |       | —                 |       | — |   | 139,375 |   |
|                    |            |                        |            |                        |            |  |  |  |  |  |  |  |  |

 

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

 

The Company applies SFAS No. 128, “Earnings perShare,” which requires the disclosure of basic and diluted net income or lossper share for all current and prior periods. Basic net income or loss percommon share is computed by dividing net income or loss available to commonstockholders by the weighted average number of common shares outstanding duringeach year. Diluted net income or loss per common share reflects the maximumdilution, based on the average price of the Company’s common stock each period,and is computed similar to basic income or loss per share except that thedenominator is increased to include the number of additional shares that wouldhave been outstanding if potentially dilutive stock options and warrants hadbeen exercised.

 

Basic and diluted net income per share computed inaccordance with SFAS 128 for the three months and nine months ended September 30,are as follows:

 
| ** **                                               | ** ** | **For the three months**     | ** ** | **For the nine months**      | ** ** |
|----------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                               | ** ** | **ended September 30,** | ** ** | **ended September 30,** | ** ** |
| ** **                                               | ** ** | **2005**                     | ** ** | **2004**                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| BASIC EPS                                                |       |                         |       |                         |       |   |   |   |   |
| Net income                                               |       | $                            | 704,194    |                         | $          | 803,958 |   | $ | 1,439,388 |   | $ | 1,009,129 |   |
| Denominator:  weighted average common shares outstanding |       | 14,094,690                   |       | 14,278,589                   |       | 14,076,833 |   | 14,045,162 |   |
| Net income  per share—basic                         |       | $                            | 0.05       |                         | $          | 0.06 |   | $ | 0.10 |   | $ | 0.07 |   |
| DILUTED EPS                                              |       |                         |       |                         |       |   |   |   |   |
| Net income                                               |       | $                            | 704,194    |                         | $          | 803,958 |   | $ | 1,439,388 |   | $ | 1,009,129 |   |
| Denominator:  weighted average common shares outstanding |       | 14,094,690                   |       | 14,278,589                   |       | 14,076,833 |   | 14,045,162 |   |
| Common  equivalent shares outstanding:                   |       |                         |       |                         |       |   |   |   |   |
|                                                     |       |                         |       |                         |       |   |   |   |   |
| Options                                                  |       | 1,206,113                    |       | 1,117,203                    |       | 993,529 |   | 1,946,169 |   |
| Total  diluted shares                                    |       | 15,300,803                   |       | 15,395,792                   |       | 15,070,362 |   | 15,991,331 |   |
| Net income  per share—diluted                       |       | $                            | 0.05       |                         | $          | 0.05 |   | $ | 0.10 |   | $ | 0.06 |   |

 

There were 898,811 and 1,308,500 potentiallydilutive options outstanding for the quarters ending September 30, 2005and 2004, respectively and there were 1,349,811 and 164,000 potentiallydilutive options outstanding for the nine months ending September 30, 2005and 2004, respectively, that were not included in the table above because theywould be anti-dilutive.

 

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

 

The Company is subject to legal proceedings andclaims that arise in the normal course of business. While the outcome of theseproceedings and claims cannot be predicted with certainty, management does notbelieve that the outcome of any of these matters will have a material adverseeffect on the Company’s consolidated financial position or results ofoperations.

 

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

 

On June 30, 2004, the Company’s Board ofDirectors authorized the repurchase of up to $3,000,000 of its outstandingcommon stock for a period from July 1, 2004 to December 31, 2004 (the“2004 Repurchase Program”).  The Companyrepurchased 216,575 shares at a cost of $1,225,254 under the 2004 RepurchaseProgram.

 

On March 24, 2005, the Company’s Board ofDirectors authorized the repurchase of up to $3,000,000 of the outstandingshares of the Company’s common stock for a period from January 1, 2005 to December 31,2005 (the “2005 Repurchase Program”). As of September 30, 2005, 232,223shares had been repurchased under the 2005 Repurchase Program. Purchases may bemade from time to time in the open market, block purchases or privatelynegotiated transactions,

 

12

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dependingon market conditions, share price and other factors.  All repurchased shares are reflected astreasury stock in the accompanying consolidated balance sheets. The followingtable shows activity under the 2005 Repurchase Program for the nine monthsending September 30, 2005:

 
| ** **                      | ** ** | **September 30,** | ** ** |
|---------------------------------|------------|------------------------|------------|
| ** **                      | ** ** | **2005**               | ** ** |
| Shares repurchased              |       | 232,223                |       |
| Average price per share         |       | $                      | 4.56       |   |
| Total repurchase authorized     |       | $                      | 3,000,000  |   |
| Repurchases under the plan      |       | $                      | (1,059,590 | ) |
| Authorized repurchase remaining |       | $                      | 1,940,410  |   |

 

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

 

The Company operates two business segments —semiconductors and licensing.  TheCompany does not allocate corporate operating expenses or specific assets tothese segments. Therefore, the segment information that follows includes onlynet revenues, cost of sales and gross margins of the identified segments:

 
| ** **                                     | ** ** | **Valence  Semiconductor** | ** ** | **SRS Labs  Licensing** | ** ** | **Total** | ** ** |
|------------------------------------------------|------------|----------------------------|------------|-------------------------|------------|-----------|------------|
| **Three Months Ended September 30, 2005** |       |                       |       |                    |       |      |       |
| Total revenues                                 |       | $                          | 1,929,605  |                    | $          | 3,722,662 |       | $ | 5,652,267 |   |
| Cost of sales                                  |       | 753,730                    |       | 100,241                 |       | 853,971   |       |
|                                           |       |                       |       |                    |       |      |       |
| Gross margin                                   |       | $                          | 1,175,875  |                    | $          | 3,622,421 |       | $ | 4,798,296 |   |
|                                           |       |                       |       |                    |       |      |       |
| **Three Months Ended September 30, 2004** |       |                       |       |                    |       |      |       |
| Total revenues                                 |       | $                          | 3,644,298  |                    | $          | 2,727,861 |       | $ | 6,372,159 |   |
| Cost of sales                                  |       | 1,320,855                  |       | 100,342                 |       | 1,421,197 |       |
|                                           |       |                       |       |                    |       |      |       |
| Gross margin                                   |       | $                          | 2,323,443  |                    | $          | 2,627,519 |       | $ | 4,950,962 |   |

 
| ** **                                    | ** ** | **Valence  Semiconductor** | ** ** | **SRS Labs  Licensing** | ** ** | **Total**  | ** ** |
|-----------------------------------------------|------------|----------------------------|------------|-------------------------|------------|------------|------------|
| **Nine Months Ended September 30, 2005** |       |                       |       |                    |       |       |       |
| Total revenues                                |       | $                          | 6,435,342  |                    | $          | 10,526,734 |       | $ | 16,962,076 |   |
| Cost of sales                                 |       | 2,481,136                  |       | 251,424                 |       | 2,732,560  |       |
|                                          |       |                       |       |                    |       |       |       |
| Gross margin                                  |       | $                          | 3,954,206  |                    | $          | 10,275,310 |       | $ | 14,229,516 |   |
|                                          |       |                       |       |                    |       |       |       |
| **Nine Months Ended September 30, 2004** |       |                       |       |                    |       |       |       |
| Total revenues                                |       | $                          | 8,992,511  |                    | $          | 8,140,592  |       | $ | 17,133,103 |   |
| Cost of sales                                 |       | 3,269,622                  |       | 146,886                 |       | 3,416,508  |       |
|                                          |       |                       |       |                    |       |       |       |
| Gross margin                                  |       | $                          | 5,722,889  |                    | $          | 7,993,706  |       | $ | 13,716,595 |   |

 

For the three months ending September 30, 2005,one customer accounted for approximately 10% of consolidated revenues, or$568,149, in the semiconductor segment. For the same period in the prior year,one customer accounted for approximately 12% of consolidated revenues, or$757,886, in the semiconductor segment. There was no significant customer inthe licensing segment for the three months ending September 30, 2005 and September 30,2004.

 

For the nine months ending September 30, 2005,one customer accounted for approximately 11% of consolidated revenues, or$1,799,659, in the semiconductor segment. For the same period in the prior yearno single customer accounted for more than 10% of revenues in the eithersegment.

 

13

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The following schedule presents the Company’srevenue by geographic area. For product sales, revenue is allocated based onthe country to which the product was shipped. For licensing-related revenue,the allocation is based on the location of the licensee’s corporateheadquarters. The Americas region includes North, Central and South America.

 
| ** **                   | ** ** | **Three Months Ended  September 30,** | ** ** | ** ** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------|------------|--------------------------------------------|------------|------------|------------|-------------------------------------------|------------|
| ** **                   | ** ** | **2005**                                   | ** ** | **%**      | ** ** | **2004**                                  | ** ** | **%** | ** ** | **2005** | ** ** | **%** | ** ** | **2004** | ** ** | **%** | ** ** |
| **Geographic Area Revenue:** |       |                                       |       |       |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
|                         |       |                                       |       |       |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Hong Kong                    |       | $                                          | 1,809,186  |       | 32         |                                      | $          | 3,283,202 |   | 52 |   | $ | 5,864,536 |   | 35 |   | $ | 8,264,269 |   | 54 |   |
| Japan                        |       | 1,253,986                                  |       | 22         |       | 1,098,643                                 |       | 17 |   | 4,221,028 |   | 25 |   | 3,756,473 |   | 19 |   |
| Other Asia Pacific           |       | 1,256,014                                  |       | 22         |       | 502,769                                   |       | 7 |   | 3,268,729 |   | 19 |   | 1,103,930 |   | 9 |   |
| Americas                     |       | 590,251                                    |       | 11         |       | 512,699                                   |       | 8 |   | 1,770,102 |   | 10 |   | 1,824,668 |   | 3 |   |
| China                        |       | 662,681                                    |       | 12         |       | 797,074                                   |       | 13 |   | 1,625,284 |   | 10 |   | 1,590,754 |   | 9 |   |
| Europe                       |       | 80,149                                     |       | 1          |       | 177,772                                   |       | 3 |   | 212,397 |   | 1 |   | 593,009 |   | 6 |   |
| Total                        |       | $                                          | 5,652,267  |       | 100        |                                      | $          | 6,372,159 |   | 100 |   | $ | 16,962,076 |   | 100 |   | $ | 17,133,103 |   | 100 |   |

 

**11.****                              ****Recent Accounting Pronouncements**

 

 In December 2004, the FinancialAccounting Standards Board (“FASB”) issued a revised Statement 123, which asamended is effective for the Company’s first quarter of 2006. Statement 123(R)requires companies to expense in their consolidated statement of operations theestimated fair value of employee stock options and similar awards. SFAS 123(R)will be effective for quarterly periods beginning after December 31,2005.  The Company will adopt theprovisions of Statement 123(R) using a modified prospective application. Underthe modified prospective application, Statement 123(R), which provides certainchanges to the method for valuing stock-based compensation among other changes,will apply to new awards and to awards that are outstanding on the effectivedate and are subsequently modified or cancelled. Compensation expense foroutstanding awards for which the requisite service had not been rendered as ofthe effective date will be recognized over the remaining period using thecompensation cost calculated for pro forma disclosure purposes under Statement123. Depending on the model used to calculate stock-based compensation expensein the future, the implementation of certain other requirements of Statement123(R) and additional option grants expected to be made in the future, the proforma disclosure may not be indicative of the stock-based compensation expensethat will be recognized in the Company’s future financial statements. TheCompany is in the process of determining how the new method of valuingstock-based compensation as prescribed in Statement 123(R) will be applied tovaluing stock-based awards granted after the effective date and the impact therecognition of compensation expense related to such awards will have on itsfinancial statements.

 

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**Item2.  Management’s Discussion and Analysisof Financial Condition and Results of Operations**

 

This information should be read in conjunction withthe audited consolidated financial statements and notes thereto and Management’sDiscussion and Analysis of Financial Condition and Results of Operationscontained in the Company’s Annual Report on Form 10-K for the year ended December 31,2004 (the “Form 10-K”), the audited consolidated financial statements andthe notes thereto included in the Form 10-K and the unaudited condensedinterim consolidated financial statements and notes thereto included in thisQuarterly Report.

 

**Overview**

 

SRS Labs is a leading developer and provider ofapplication-specific integrated circuits, or (“ASIC”), standard integratedcircuits, or ICs, and audio and voice technology solutions for the homeentertainment, portable media device, personal telecommunications, personalcomputer, automotive and broadcast markets. We operate in the following twobusiness segments:

 

*Semiconductors:*Through SRS Labs, Inc.’s wholly-ownedsubsidiary, Valence Tech Limited, and ValenceTech Limited’s wholly-ownedsubsidiaries (collectively “Valence”), we operate a fabless semiconductorbusiness which develops, designs and markets standard and custom analog ICs,digital signal processors, or DSPs, and mixed signal integrated circuitsprimarily to original equipment manufacturers, or OEMs, and original designmanufacturers, or ODMs, in the Asia Pacific region.

 

*Licensing:*Through SRSLabs, the parent company, and its wholly-owned subsidiary, SRSWOWcast.com, Inc.,doing business as SRSWOWcast Technologies (“SRSWOWcast”), the licensing segmentdevelops and licenses audio, voice and surround sound technology solutions tomany of the world’s leading OEMs/ODMs, software providers and semiconductorcompanies, and licenses and markets hardware and software products for theInternet and professional audio markets.

 

As used herein, the “Company,” “SRS Labs,” “we,” “us,”or “our” means SRS Labs, Inc. and its wholly owned subsidiaries andCHS/SRS, LLC, a joint venture (the “Joint Venture”) that we entered into withComing Home Studios LLC (“CHS”).

 

In September 2004, we entered into a strategicalliance with CHS to produce and sell concert DVDs by Duran Duran, Boz Scaggs,Godsmack and All Access featuring our Circle Surround technology.   In connection with the strategic alliance,the Company and CHS established the Joint Venture to complete and distributethe concert DVDs.  In July 2005, wereplaced CHS as the manager of the Joint Venture.  As a result of becoming the manager of theJoint Venture, we have control over the Joint Venture’s business strategy anddecisions; accordingly, we are required under applicable accounting rules toconsolidate the financial statements of the Joint Venture into our financialstatements commencing with the third quarter of fiscal 2005.  Previously, we accounted for our interest (50%of the equity ownership) in the Joint Venture as an investment using the equitymethod.  In the consolidated financialstatements, all inter-company accounts and transactions between the Company andthe Joint Venture have been eliminated.

 

**Results of Operations**

 

**Three Months Ended September 30, 2005 Compared toThree Months Ended September 30, 2004**

 

*Revenues*

 

Semiconductor revenues consists of (a) designfees relating to, and sales of, ASIC for third parties by Valence to originalequipment manufacturers (“OEMs”); and  (b) salesof general purpose integrated circuits (“ICs”) designed by Valence under thebrand name ASP.  Licensing revenuesconsist primarily of royalties generated from the license of SRS Labs’ audioand voice technologies.  License androyalty agreements generally provide for the license of technologies for a feebased on the number of units distributed by the licensee.  However, we have in the past and may again inthe future, enter into a license agreement for a one-time fee. Also included inlicensing revenue are revenues generated from the sale of hardware and softwareapplications into the broadcast audio markets and the sale of concert DVDs.

 

Total revenues for the three months ended September 30, 2005 were$5,652,267 compared to $6,372,159 for the three months ended September 30,2004, a decrease of $719,892 or 11.3%. Semiconductor revenues were $1,929,605for the three months ended September 30, 2005 compared to $3,644,298 forthe three months ended September 30, 2004, a decrease of $1,714,693 or47.1%. Within semiconductor revenue, ASIC accounted for $1,086,207 or 56.3% forthe three months

 

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ended September 30, 2005 compared to $2,526,417 or 69.3% for thesame period last year, a decrease of $1,440,210 or 57.0%. ASP chips accountedfor $843,398 or 43.7% for the three months ended September 30, 2005compared to $1,117,881 or 30.7% for the same period last year, a decrease of$274,483 or 24.6%. Within ASP revenues, SRS chips accounted for 37.3% for thethree months ended September 30, 2005 compared to 49.5% for the sameperiod last year. The decrease in semiconductor sales can be attributed to thechange in backlog movement, which built up in Q2 2004 and shipped in Q3 2004resulting in a non-recurring spike in revenue in Q3 2004.  The decrease is also due to competitivepressure in the market and a decline in certain customer sales due to a shiftin market trends from CD combo and Boombox to MP3.

 

Licensing revenues were $3,722,662 for the three months ended September 30,2005, compared to $2,727,861 for the three months ended September 30,2004, an increase of $994,801 or 36.5%. The sales growth in licensing wasattributable to our continued diversification strategy, which yielded newaccounts as well as the expanded use of our technologies in existing accountsin portable devices, PC, mobile phone and automotive markets.  The following table presents the Company’slicensing revenues mix by market segment:

 
| ** **                                                | ** ** | **Three Months Ended   September 30,** | ** ** |
|-----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                | ** ** | **2005**                                    | ** ** | **2004** | ** ** |
| Home Entertainment (TV, Set Top Box, A/V  Receiver, DVD)  |       | 48                                          | %          | 69 | % |
| Portable  Media Devices (Digital Media Player, Headphone) |       | 29                                          | %          | 13 | % |
| PC (Software, Hardware)                                   |       | 9                                           | %          | 8 | % |
| Personal Telecommunications (Mobile Phone,  PDA)          |       | 11                                          | %          | 7 | % |
| Automotive                                                |       | 3                                           | %          | 3 | % |

 

*Gross Margin*

 

Cost of sales consists primarily of fabricationcosts, assembly and test costs, and the cost of materials and overhead fromoperations. Gross margins are dependent on the mix of products sold, servicesprovided and royalties earned. The decline in semiconductor gross margins canbe attributable to the amortization of masking charges, competitive pressure inthe ASIC market and an aggressive pricing strategy on ASP chipsto increase market penetration. The following table presents the Company’sgross margin percentages for the three months ended September 30:

 
| ** **                                                    | ** ** | **Three Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                    | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| **Semiconductor**                                             |       |                                       |       |   |   |
| ASIC revenue as a percentage of total  semiconductor revenue  |       | 56.3                                       | %          | 69.3 | % |
| ASIC gross margin                                             |       | 64.8                                       | %          | 63.0 | % |
|                                                          |       |                                       |       |   |   |
| ASP revenue as a percentage of total  semiconductor revenue   |       | 43.7                                       | %          | 30.7 | % |
| ASP gross margin                                              |       | 55.9                                       | %          | 65.5 | % |
|                                                          |       |                                       |       |   |   |
| Total semiconductor revenue as a percentage  of total revenue |       | 34.1                                       | %          | 57.2 | % |
| Total semiconductor gross margin                              |       | 60.9                                       | %          | 63.8 | % |
|                                                          |       |                                       |       |   |   |
| **Licensing**                                                 |       |                                       |       |   |   |
| Licensing revenue as a percentage of total  revenue           |       | 65.9                                       | %          | 42.8 | % |
| Licensing gross margin                                        |       | 97.3                                       | %          | 96.3 | % |
|                                                          |       |                                       |       |   |   |
| **Total Gross Margin**                                        |       | 84.9                                       | %          | 77.7 | % |

 

*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 $1,521,788 for the threemonths ended September 30, 2005 compared to $1,305,349 for the same prioryear period, an increase of $216,439 or 16.6%. The increase is attributable to an increase in sales and marketingheadcount in our semiconductor and licensing segments. As a percentage of totalrevenues, sales and marketing expenses increased from 20.5% for the quarterended September 30, 2004 to 26.9% for the same period this year.

 

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*Researchand Development*

 

Researchand development expenses consist of salaries and related costs of employeesengaged in ongoing research, design and development activities. Research anddevelopment expenses were $1,220,889 for the three months ended September 30,2005 compared to $1,266,606 for the same prior year period, a decrease of$45,717 or 3.6 %.  As a percentage oftotal revenues, research and development expenses increased from 19.9% for thequarter ended September 30, 2004 to 21.6% for the same period this year.

 

*Generaland Administrative*

 

General and administrative (“G&A”) expensesconsist primarily of employee-related expenses, legal costs associated with theadministration of intellectual property and other professional fees. G&Aexpenses were $1,445,733 for the three months ended September 30, 2005compared to $1,452,236 for the same prior year period, a decrease of $6,503. Asa percentage of total revenues, G&A expenses increased from 22.8% for thequarter ended September 30, 2004, to 25.6% for the same period this year.

 

*OtherIncome, Net*

 

Otherincome, net, consists primarily of interest income, gain on sale of securitiesand foreign currency transaction gains and losses. Other income, net, was$174,195 for the three months ended September 30, 2005, compared to$118,908 for the same prior year period, an increase of $55,287 or 46.5%. Theincrease is primarily attributable to improved interest rates on investments.

 

*Provisionfor Income Taxes*

 

Theincome tax expense for the three months ended September 30, 2005 was$79,887, compared to tax expense of $241,721 for the same prior year period, adecrease of $161,834 or 67.0%. The provision consists primarily of taxes paidon licensing revenues sourced from countries requiring foreign tax withholdingsand taxes paid on profits in Hong Kong at the rate of 17.5%.  The lower tax expense for the three monthsended September 30, 2005 resulted from decreased taxable income in ourforeign subsidiary.

 

**Nine Months Ended September 30, 2005 Compared toNine Months Ended September 30, 2004**

 

Total revenues for the nine months ended September 30, 2005 were$16,962,076 compared to $17,133,103 for the period ended September 30,2004, a decrease of $171,027 or 1.0%. Semiconductor revenues were $6,435,342for the nine months ended September 30, 2005 compared to$8,992,511 for the period ended September 30, 2004, a decrease of$2,557,169 or 28.4%. Within semiconductor revenue, ASIC accounted for$4,300,283 or 66.8% for the nine months ended September 30, 2005 comparedto $6,188,486 or 68.8% for the same period last year, a decrease of $1,888,203or 30.5%. ASP chips accounted for $2,135,059 or 33.2% for the nine months endedSeptember 30, 2005 compared to $2,804,025 or 31.2% for the same periodlast year, a decrease of $668,966 or 23.9%. Within ASP revenues, SRS chipsaccounted for 40.2% for the nine months ended September 30, 2005 comparedto 40.6% for the same period last year. The decrease in semiconductor sales can be attributed to competitivepressure and the decline in certain customer sales due to a shift in markettrends from CD Combo and Boombox products to MP3.

 

Licensing revenues were $10,526,734 for the ninemonths ended September 30, 2005, compared to $8,140,592 for the ninemonths ended September 30, 2004, an increase of $2,386,142 or 29.3%. Thesales growth in licensing was attributable to our continued diversificationstrategy, which yielded new customers and expanded the use of our technologiesin portable devices, PC, mobile phone and automotive markets. The followingtable presents the Company’s licensing revenues mix by market segment:

 

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| ** **                                                | ** ** | **Nine Months Ended   September 30,** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| Home Entertainment (TV, Set Top Box, A/V  Receiver, DVD)  |       | 51                                         | %          | 68 | % |
| Portable  Media Devices (Digital Media Player, Headphone) |       | 23                                         | %          | 10 | % |
| PC (Software, Hardware)                                   |       | 11                                         | %          | 11 | % |
| Personal Telecommunications (Mobile Phone,  PDA)          |       | 12                                         | %          | 10 | % |
| Automotive                                                |       | 3                                          | %          | 1 | % |

 

*Gross Margin*

 

Cost of sales consists primarily of fabricationcosts, assembly and test costs, and the cost of materials and overhead fromoperations. Gross margins are dependent on the mix of products sold, servicesprovided and royalties earned. The decline in semiconductor gross margins canbe attributable to the amortization of masking charges and an aggressivepricing strategy on ASP chips to increase market penetration. Thefollowing table presents the Company’s gross margin percentages for the ninemonths ended September 30:

 
| ** **                                                    | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                    | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| **Semiconductor**                                             |       |                                      |       |   |   |
| ASIC revenue  as a percentage of total semiconductor revenue  |       | 66.8                                      | %          | 68.8 | % |
| ASIC gross  margin                                            |       | 64.8                                      | %          | 65.4 | % |
|                                                          |       |                                      |       |   |   |
| ASP revenue  as a percentage of total semiconductor revenue   |       | 33.2                                      | %          | 31.2 | % |
| ASP gross  margin                                             |       | 54.6                                      | %          | 59.8 | % |
|                                                          |       |                                      |       |   |   |
| Total  semiconductor revenue as a percentage of total revenue |       | 37.9                                      | %          | 52.5 | % |
| Total  semiconductor gross margin                             |       | 61.4                                      | %          | 63.6 | % |
|                                                          |       |                                      |       |   |   |
| **Licensing**                                                 |       |                                      |       |   |   |
| Licensing revenue  as a percentage of total revenue           |       | 62.1                                      | %          | 47.5 | % |
| Licensing  gross margin                                       |       | 97.6                                      | %          | 98.2 | % |
|                                                          |       |                                      |       |   |   |
| **Total Gross Margin**                                        |       | 83.9                                      | %          | 80.1 | % |

 

*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 $4,892,666 for the ninemonths ended September 30, 2005 compared to $4,260,784 for the same prioryear period, an increase of $631,882 or 14.8%. The increase is primarilyattributable to headcount and recruiting expenses related to increased salesand marketing personnel in our semiconductor and licensing segments.  As a percentage of total revenues, sales andmarketing expenses increased from 24.9% for the nine months ended September 30,2004 to 28.8% for the same period this year.

 

*Researchand Development*

 

Researchand development expenses consist of salaries and related costs of employeesengaged in ongoing research, design and development activities. Research anddevelopment expenses were $3,610,829 for the nine months ended September 30,2005 compared to $3,620,219 for the same prior year period, a decrease of$9,390.  As a percentage of totalrevenues, research and development expenses were 21.1% for the nine monthsended September 30, 2004, and 21.3% for the same period this year.

 

*Generaland Administrative*

 

General and administrative (“G&A”) expenses consist primarily ofemployee-related expenses, legal costs associated with the administration ofintellectual property and other professional fees. G&A expenses were$4,492,991 for the nine months ended September 30, 2005 compared to$4,490,732 for the same prior year period, an increase of $2,259. As apercentage of total revenues, G&A expenses were 26.2% for the nine-monthsended September 30, 2004 and 26.5% for the same period this year.

 

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*Equity in Income of Investee*

 

Equityin income of investee of $91,096 for the nine months ended September 30,2005 represents the Company’s proportionate share of profit from the JointVenture prior to the consolidation of the Joint Venture’s financial statementwith our condensed consolidated financial statements.

 

*OtherIncome, Net*

 

Otherincome, net, consists primarily of interest income, gain on sale of securitiesand foreign currency transaction gains and losses. Other income, net, was$488,421 for the nine months ended September 30, 2005, compared to$455,132 for the same prior year period, an increase of $33,289 or 7.3%. Theincrease is primarily attributable to improved interest rates on investments.

 

*Provisionfor Income Taxes*

 

Theincome tax expense for the nine months ended September 30, 2005 was$373,159, compared to tax expense of $790,863 for the same prior year period, adecrease of $417,704 or 52.8%. The provision consists primarily of taxes paidon licensing revenues sourced from countries requiring foreign tax withholdingsand taxes paid on profits in Hong Kong at the rate of 17.5%.  The lower tax expense in fiscal 2005 resultedfrom decreased taxable income in our foreign subsidiary.  In addition, we benefited from the U.S. Japantax treaty, which eliminated source-country withholdings on royalties. Thattreaty became effective on July 1, 2004.

 

**Liquidityand Capital Resources**

 

TheCompany’s principal source of liquidity to fund ongoing operations at September 30,2005 consisted of cash, cash equivalents and long-term investments of$24,888,403.  At September 30, 2005,the Company had cash and cash equivalents of $7,820,333 and long-terminvestments of $17,068,070. Cash and cash equivalents generally consist ofcash, money market funds and other money market instruments with originalmaturities of three months or less. Investments consist of U.S. governmentsecurities rated AAA.

 

Wegenerated $2,269,843 of cash and cash equivalents in our operating activitiesduring the first nine months of fiscal year 2005, primarily due to net income,further adjusted for depreciation and amortization and a decrease in prepaidexpenses, increases in accounts payable and accrued liabilities offset by anincrease in accounts receivable.  In thecomparable period of fiscal year 2004, we generated $2,894,878 of cash and cashequivalents in our operating activities primarily due to net income, furtheradjusted for depreciation and amortization and a decrease in prepaid expenses,increases in accrued liabilities and deferred revenue offset by an increase inaccounts receivable.

 

Duringthe first nine months of fiscal year 2005, we used $1,106,542 in investingactivities primarily related to the investment in production costs associatedwith our strategic alliance with Coming Home Studios LLC, referenced aboveunder the caption “Overview” and expenditures relating to capital equipment,patents and intangibles.  In thecomparable period of fiscal year 2004, we used $3,075,679 in investingactivities primarily related to the investment in the strategic alliance withComing Home Studios LLC and expenditures relating to capital equipment, patentsand intangibles.

 

 Duringthe nine months ended September 30, 2005, we used $354,880 in financingactivities due to the purchase of treasury stock offset by proceeds receivedfrom the issuance of common stock in connection with option exercises.  In the comparable period of fiscal year 2004,we generated $3,405,466 from financing activities primarily due to the issuanceof common stock in connection with option exercises.

 

OnSeptember 23, 2004, we entered into a strategic alliance with Coming HomeStudios LLC (“CHS”) to produce and sell concert DVDs which incorporate ourCircle Surround technology. In connection with that strategic alliance, weentered into a joint venture, CHS/SRS, LLC, formed to complete and distributeconcert videos featuring Duran Duran, Boz Scaggs, Godsmack and All Access.

 

Asnoted above, in September 2004 we entered into a strategic alliance withCHS to produce and sell concert DVDs using our Circle Surround technology.  In connection with this strategic alliance,we formed the Joint Venture with CHS to complete and distribute the concertDVDs.  Profits from the distribution ofthe concert DVDs and related assets pursuant to the Joint Venture will beallocated and distributed in the following manner and order: (a) 100% tothe Company until such

 

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time as we have received130% of the cumulative additional advances that we provided to the JointVenture; (b) equally until we and CHS have each received 1.75 times ourrespective original defined capital contributions; and thereafter (c) 90%to CHS and 10% to the Company.  As of September 30,2005, our aggregate capital contribution was $3.2 million, consisting of $1.8million in original capital contributions, $1.1 million in additional advancesand $.3 million in capitalized costs associated with the formation of the jointventure.  As of September 30, 2005,CHS’ capital contribution was valued at $1.8 million and consisted of theartist agreements with Duran Duran, Boz Scaggs, Godsmack and All Accesspursuant to which the concert videos are filmed, produced and distributed, andis recorded at $0 in the accompanying financial statements.

 

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.

 

**FactorsThat May Affect Future Results**

 

*The concert DVDs for our joint venture with ComingHome Studios may not be completed.*

 

Wehave invested a total of $3.2 million in CHS/SRS, LLC, our joint venture withCHS to produce a total of six concert DVDs by *DuranDuran, Godsmack, Boz Scaggs*and *AllAccess* featuring our Circle Surround technology.  Although three of the concert DVDs have beencompleted and are in distribution, the remaining three concert DVDs have beendelayed past the originally scheduled completion date.  We depend on the services of other partiesbeyond our control to produce, complete and distribute the concert DVDs,including, without limitation, the services of CHS pursuant to a productionservices agreement between CHS and the Joint Venture.  In the event additional funds are required tocomplete the purpose of the Joint Venture, we may need to make additional cashcontributions to the Joint Venture.

 

Theproduction, completion and distribution of the concert DVDs is subject to anumber of uncertainties, including delays and increased expenditures due tocreative problems, technical difficulties, talent availability, accidents,natural disasters and other events beyond our control.  Because of these uncertainties, the projectedcost of the concert DVDs may increase, the completion dates may besubstantially delayed or the projects may be abandoned due to the exigencies ofproduction.  Delays in production mayalso result in concert DVDs not being ready for release at the intended timeand being postponed to a less favorable time, which could result in lowerrevenues.  In extreme cases, a concertDVD may be abandoned.  We cannot predictthe success of any of the concert DVDs even if they are completed because theireconomic success will depend on their acceptance by the public, which cannot beaccurately predicted.  The economicsuccess of a concert DVD may also depend on the public’s acceptance ofcompeting shows, the availability of alternative forms of entertainment andleisure time activities, general economic conditions, and other tangible andintangible factors, all of which can change and cannot be predicted withcertainty.  There can be no assurancethat the concert DVDs can be completed, or if completed and distributed, thatthe concert DVDs will achieve economic success. If the concert DVDs are further delayed, not completed or generateinsufficient returns once completed, there is a risk that our investment inCHS/SRS, LLC will be impaired or lost.

 

*We are exposed to risks in our licensing businessrelated to product and customer concentration*

 

Currently,our licensing revenue is concentrated in the home theater market with themajority of revenue generated from the inclusion of SRS technology insidetelevisions, DVD players and set-top boxes. We expect that the consumer homeentertainment market will continue to account for a significant portion of ourlicensing revenues for the foreseeable future. While consumer spending ingeneral on consumer electronic products has increased, retail prices forcertain consumer electronics products that include our audio technology, suchas DVD players, have decreased significantly. Indications are that this trendwill continue for the foreseeable future. From time to time, certain of ouroriginal equipment manufacturer and semiconductor manufacturer customers mayaccount for a significant portion of revenue from a particular productapplication, 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 our financial condition and results of operations.

 

*Our business is highly dependent on the consumerelectronics market, which is characterized by short product life cycles,fluctuations in demand and seasonality, and subject to risks related to producttransitions and supply of other components*

 

Theconsumer electronics market is characterized by intense competition, rapidlyevolving technology, and ever-changing consumer preferences. These factorsresult in the frequent introduction of new products, short product life cyclesand significant price competition. The dynamic nature of this market limitsour, as well as our customers’, ability to

 

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accurately forecastquarterly and annual sales. If we, or our customers, are unable to manageproduct transitions, our business and results of operations could be negativelyaffected.

 

*Pricing pressures on the consumer electronics productmanufacturers who incorporate our technologies into their products could limitthe licensing fees we charge for our technologies, which could adversely affectour revenues*

 

Themarkets for the consumer electronics products in which our technologies areincorporated are intensely competitive and price sensitive. Retail prices forconsumer electronics products that include our technologies, such as DVDplayers and home theater systems, have decreased significantly, and we expectprices to continue to decrease for the foreseeable future. In response, manufacturershave sought to reduce their product costs, which can result in downwardpressure on the licensing fees we charge our customers who incorporate ourtechnologies. A decline in the licensing fees we charge could materially andadversely affect our operating results.

 

*Our business and prospects depend on the strength ofour brand, and if we do not maintain and strengthen our brand, our businesswill be materially harmed*

 

Maintainingand strengthening the “SRS” brand is critical to maintaining and expanding bothour products and services business and our technology licensing business, aswell as to our ability to enter new markets for our audio and othertechnologies. Our continued success is due, in part, to our reputation forproviding high quality products, services and technologies across multipleconsumer electronics product segments. If we fail to effectively promote andmaintain the SRS brand, our business and prospects will suffer.

 

*Our quarterly results may fluctuate*

 

Ouroperating results may fluctuate from those in prior quarters and will continueto be subject to quarterly and other fluctuations due to a variety of factors,including the extent to which our licensees incorporate our technologies intotheir products; the timing of orders from, and the shipments to, majorcustomers; the timing of new product introductions; the gain or loss ofsignificant 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 are subject to the highly cyclical nature of thesemiconductor industry*

 

Thesemiconductor industry is highly cyclical. The industry has experiencedsignificant downturns, often in connection with, or in anticipation of,maturing product cycles (of both semiconductor companies’ and their customers’products) and declines in general economic conditions. These downturns havebeen characterized by production overcapacity, high inventory levels andaccelerated erosion of average selling prices. Any future downturns couldsignificantly harm our sales or reduce our profitability for a prolonged periodof time. From time to time, the semiconductor industry also has experiencedperiods of increased demand and production capacity constraints. We mayexperience substantial changes in future operating results due to generalsemiconductor industry conditions, general economic conditions and otherfactors.

 

*We rely on revenue contribution from our ASIC andstandard IC business*

 

Wederive a significant amount of our revenue from Valence’s ASIC business. Valence’sengineering team focuses on the design of custom ASICs to meet specificcustomers’ requirements and out sources the production of the design to maskhouses, foundries and packaging houses located primarily in Asia. Theoperations of Valence could be affected by a variety of factors, including thetiming of customer orders, the timing of development revenue, changes in themix of products distributed and the mix of distribution channels employed, theemergence of a new industry standard, product obsolescence and changes inpricing policies by us, our competitors or our suppliers.

 

Businessrevenue from ASICs is concentrated in a limited number of customers in theareas of consumer electronics, communications products, computers and computerperipherals. The business generated from any one customer may be for a fixedlength or quantity. As such, it is customary in our ASIC business to have acertain amount of customer turnover as new ASIC projects are obtained fordifferent customers. However, it is possible that the loss of any particularcustomer or any bad debt arising from such customer may have a materiallyadverse impact on our financial condition and results of operation.

 

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Valenceadds significant diversity to our overall business structure and opportunities.We recognize that in the presence of such corporate diversity, and inparticular with regard to the semiconductor industry, there will always exist apotential for conflict among sales channels between us and our technologylicensees. Although the operations of our licensing business and those ofValence are generally complementary, there can be no assurances that saleschannel conflicts will not arise. If such potential conflicts do materialize,we may or may not be able to mitigate the effect of such perceived conflicts,which, if not resolved, may impact the results of operations.

 

*Potential channel conflict with existingsemiconductor partners could cause us to lose future business*

 

Aswe bring out more and more Valence semiconductors with SRS audio technologiesembedded in them, our current semiconductor partners may perceive those newdevices as threats to their own products. The semiconductor partners mayrespond by reducing or eliminating the volumes of business they presently dowith us, which would have an adverse effect on our licensing revenue.

 

*We are exposed to risks in our Valence businessrelated to product fabrication outsourcing to third parties*

 

Valenceis a “fabless” semiconductor company meaning that Valence designs, develops andmarkets our selection of custom and standard integrated circuits but we rely onthird-party contractors to manufacture, assemble and test our products. Fromtime to time there can be foundry capacity issues due to global demands thataffect the semiconductor industry. Although we believe our relationships aregenerally good, we do not have long-term supply agreements with our third-party

 

vendors and they are notobligated to perform services or supply products to us for any particularperiod or in any particular quantities, except as provided in each separatepurchase order accepted by them. The increased demand for our products coupledwith the demand for foundry services, is, and will continue to be for theforeseeable future, a challenge for us. In times of high demand, there aresignificant risks associated with our reliance on third-party vendorsincluding: reallocation of capacity to other foundry customers, potential priceincreases, delays and interruptions in order deliveries, reduced control overproduct quality and increased risk of misappropriation of intellectualproperty.

 

*We conduct operations in a number of countries andare subject to risks of international operations, particularly in the People’sRepublic of China (“PRC”) and other parts of Asia*

 

Wehave significant operations in the PRC and other parts of Asia that requirerefinement to adapt to the changing market conditions in those regions. Ouroperations in Asia, and international operations in general, are subject torisks of unexpected changes in, or impositions of, legislative or regulatoryrequirements.

 

Ourcustomers geographically located in the Asia Pacific markets accounted forapproximately 86%, 93% and 90% of total Company sales in 2004, 2003 and 2002,respectively and are expected to continue to account for a substantialpercentage of sales in the future.

 

ThePRC economy has experienced significant growth in the past decade; but suchgrowth has been uneven across geographic and economic sectors. There can be noassurance that such growth will continue or that any potential currencydevaluation in the region will not have a negative effect on our business,including Valence. The PRC economy has also experienced deflation in the past,which may continue in the future. The current economic situation may adverselyaffect our profitability over time as expenditures for consumer electronicsproducts and information technology may decrease due to the results of slowingdomestic demand and deflation.

 

HongKong is a Special Administrative Region of the PRC with its own government andlegislature. Hong Kong enjoys a high degree of autonomy from the PRC under theprinciple of “one country, two systems.” We can give no assurance that HongKong will continue to enjoy autonomy from the PRC.

 

TheHong Kong dollar has remained relatively constant due to the U.S. dollar pegand currency board system that has been in effect in Hong Kong since 1983.Since mid-1997, interest rates in Hong Kong have fluctuated significantly andreal estate and retail sales have declined. We can give no assurance that theHong Kong economy will not worsen or that the historical currency peg of theHong 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.

 

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*We are exposed to currency fluctuations andinstability in the Asian markets*

 

Weexpect that international sales will continue to represent a significantportion of our total revenues. To date, all of our licensing revenues have beendenominated in U.S. dollars and most costs have been incurred in U.S. dollars.It is our expectation that licensing revenues will continue to be denominatedin U.S. dollars for the foreseeable future. Because Valence’s business isprimarily focused in Asia and because of our anticipated expansion of businessin the PRC and other parts of Asia, our consolidated results of operations andfinancial position could be significantly affected by risks associated withinternational activities, including economic and labor conditions, politicalinstability, tax laws (including U.S. taxes on foreign subsidiaries) andchanges in the value of the U.S. dollar versus the local currency in which theproducts are sold. In addition, our valuation of assets recorded as a result ofthe Valence acquisition may also be adversely impacted by the currencyfluctuations relative to the U.S. dollar. We intend to actively monitor our****foreign exchange exposure and to implementstrategies to reduce our foreign exchange risk at such time that we determinethe benefits of such strategies outweigh the associated costs. However, there isno guarantee that we will take steps to insure against such risks, and shouldsuch risks occur, there is no guarantee that we will not be significantlyimpacted.

 

*If the sale of consumer electronics productsincorporating our technologies does not grow in emerging markets, our abilityto increase our licensing revenue may be limited*

 

Wealso expect that growth in our licensing revenue will depend, in part, upon thegrowth of sales of consumer electronics products incorporating our technologiesin other countries, including China and India, as consumers in these marketshave more disposable income and are increasingly purchasing entertainmentproducts with surround sound capabilities. However, if our licensing revenuefrom the use of our technologies in these new markets or geographic areas doesnot expand, our prospects could be adversely affected.

 

*We are subject to competitive pressures*

 

Ourexisting and potential competitors include both large and emerging domestic andinternational 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 new technologiesor evolving market needs. We believe that the competitive factors affecting themarket for our products and technologies include product performance, price andquality; product functionality and features; the ease of integration; andimplementation of the products and technologies with other hardware andsoftware components in the OEM’s products. In addition, the markets in which wecompete are intensely competitive and are characterized by rapid technologicalchanges, declining average sales prices and rapid product obsolescence.Accordingly, there can be no assurance that we will be able to continue tocompete effectively in its respective markets, that competition will notintensify or that future competition will not have a material adverse effect onour business, operating results, cash flows and financial condition.

 

*We have a long and unpredictable sales cycle, whichcan result in uncertainty and delays in generating additional revenues*

 

Historically,because of the complexity of our technologies, it can take a significant amountof time and effort to explain the benefits and to negotiate a sale. Forexample, it typically takes six to nine months after our first contact with aprospective customer before we start licensing our technology to that customer.In addition, purchase of our products is usually made in connection with newdesign starts, the timing of which is outside of our control. Accordingly, wemay be unable to predict accurately the timing of any significant future salesof our products. We may also spend substantial time and management attention onpotential license agreements that are not consummated, thereby foregoing otheropportunities.

 

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*We strongly rely on our intellectual property*

 

Ourability to compete may be affected by our ability to protect our proprietaryinformation. We have filed numerous U.S. and foreign patent applications and todate have a number of issued U.S. and foreign patents covering various aspectsof our technologies. There can be no assurance that the steps taken by us toprotect our intellectual property will be adequate to prevent misappropriationof our technology or that our competitors will not independently developtechnologies that are substantially equivalent or superior to our technology.In addition, the laws of certain foreign countries may not protect ourintellectual property rights to the same extent, as do the laws of the U.S. Thesemiconductor industry is characterized by frequent claims and litigationregarding patent and other property rights. We are not currently a party to anyclaims of this nature. There can be no assurances that third parties will notassert claims or initiate litigation against us or our customers with respectto existing or future products. In addition, we may initiate claims orlitigation against third parties for infringement of our proprietary rights orto determine the scope and validity of our proprietary rights.

 

*We depend on our key personnel*

 

Ourfuture success depends to a large extent upon the continued service of keypersonnel, including engineering, sales and marketing staff, and highly skilledsemiconductor design staff. We anticipate that any future growth will requireus to recruit and hire a number of new personnel in engineering, operations,finance, sales and marketing. Competition for such personnel can be intense,and there can be no assurance that we can recruit and retain necessarypersonnel to operate our business and support future growth.

 

*The market price of our common stock is volatile*

 

Thetrading price of our common stock has been, and will likely continue to be,subject to wide fluctuations in response to quarterly variations in ouroperating results, announcements of new products or technological innovationsby us or our competitors, strategic alliances between us and third parties,general market fluctuations and other events and factors. Changes in earningsestimates made by brokerage firms and industry analysts relating to the marketsin which we do business, or relating to us specifically, have in the pastresulted in, and could in the future result in, an immediate and adverse effecton the market price of the common stock. Even though our stock is quoted on theNasdaq Stock Market, our stock has had and may continue to have low tradingvolume and high volatility. The historically low trading volume of our stockmakes it more likely that a severe fluctuation in volume, either up or down,will significantly impact the stock price. Since our shares are thinly traded,our shareholders may have difficulty selling our common stock.

 

*Our certificate of incorporation, bylaws, change incontrol agreements with officers and key employees,  as well as Delaware law contain provisionsthat could discourage transactions resulting in a change in control, which maynegatively affect the market price of our common stock*

 

Ourcertificate of incorporation, bylaws, change in control agreements withofficers and key employees and Delaware law contain provisions that mightenable our management to discourage, delay or prevent change in control. Inaddition, these provisions could limit the price that investors would bewilling to pay in the future for shares of our common stock.

 

**Item 3. Quantitative and Qualitative Disclosures about Market Risk**

 

Therehave been no material changes to the information called for by this Item 3 fromthe disclosures set forth in Part II, Item 7A in the Company’s AnnualReport on Form 10-K for the year ended December 31, 2004.

 

**Item 4. Controls and Procedures**

 

*Evaluationof Disclosure Controls and Procedures*

 

Weconducted an evaluation of the effectiveness of the design and operation of ourdisclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)) as of the end of the period covered by this Quarterly Report. Thecontrols evaluation was done under the supervision and with the participationof management, including our Chief Executive Officer and Chief FinancialOfficer. Based on their evaluation as of the end of the period covered by thisQuarterly Report, our Chief Executive Officer and Chief Financial Officer haveconcluded that our disclosure controls and procedures are effective.

 

*Changes inInternal Controls*

 

Therehave been no changes in the Company’s internal controls over financialreporting (as defined in Rules 13a-15(f) and 15d-15(f) under theExchange Act) occurred during the third quarter ended September 30, 2005,that has materially affected, or is reasonably likely to materially affect, theCompany’s internal control over financial reporting.

 

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**PART II — OTHER INFORMATION**

 

**Item6.  Exhibits**

 

The exhibits listed beloware hereby filed with the U.S. Securities and Exchange Commission as part ofthis Report.

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |       | Certificate  of Incorporation of the Company, previously filed with the Commission as Exhibit 3.1  to the Company’s Registration Statement on Form SB-2, specifically  included in Amendment No. 1 to such Registration Statement filed with  the Commission on July 3, 1996 (File No. 333-4974-LA), which is  incorporated herein by reference. |
|                |       |                                                                                                                                                                                                                                                                                                                                                                           |
| 3.2                 |       | Bylaws  of the Company, previously filed with the Commission as Exhibit 3.1 to  the Company’s Quarterly Report on Form 10-Q for the period ended September 30,  1999, filed with the Commission on November 12, 1999, which is  incorporated herein by reference.                                                                                     |
|                |       |                                                                                                                                                                                                                                                                                                                                                                           |
| 10.1                |       | Employment  Letter Agreement dated June 24, 2005, between the Company and Michael  Franzi, previously filed with the Commission as Exhibit 10.1 to the Form 8-K,  filed with the Commission on August 16, 2005, which is incorporated  herein by reference.                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                           |
| 10.2                |       | Separation  Agreement dated September 30, 2005, between the Company and Philip Wong,  previously filed with the Commission as Exhibit 10.1 to the Form 8-K, filed  with the Commission on September 30, 2005, which is incorporated herein by  reference.                                                                                                                      |
|                |       |                                                                                                                                                                                                                                                                                                                                                                           |
| 31.1                |       | Certification  of Chief Executive Officer of SRS Labs, Inc., pursuant to Rule 13a-14  of the Securities Exchange Act.                                                                                                                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                           |
| 31.2                |       | Certification  of Chief Financial Officer of SRS Labs, Inc., pursuant to Rule 13a-14  of the Securities Exchange Act.                                                                                                                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                           |
| 32.1                |       | Certification  of Chief Executive Officer of SRS Labs, Inc., pursuant to Section 906  of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                             |
|                |       |                                                                                                                                                                                                                                                                                                                                                                           |
| 32.2                |       | Certification  of Chief Financial Officer of SRS Labs, Inc., pursuant to Section 906  of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                             |

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                                     | SRS LABS, INC., a  Delaware corporation |
|------------------------------------------|----------------------------------------------|
|                                     |                                         |   |
| Date:  November 10,  2005 | By:                                          | /s/ THOMAS C.K. YUEN |   |
|                                     |                                         | Thomas C.K. Yuen |
|                                     |                                         | Chairman of the Board and  Chief Executive Officer |
|                                     |                                         | (Principal Executive  Officer) |
| ** **                               | ** **                                   | ** ** |
| ** **                               | ** **                                   | ** ** |
| Date:  November 10,  2005 | By:                                          | /s/ JANET M. BISKI |   |
|                                     |                                         | Janet M. Biski |
|                                     |                                         | Chief Financial Officer |
|                                     |                                         | (Principal Financial and  Accounting Officer) |

 

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