**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-Q**
| **(Mark One)**                                                                                                                       |       |                                                                                                     |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|
| **x**                                                                                                                                | ** ** | **QUARTERLY REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934**  |
| ** **                                                                                                                           | ** ** | ** **                                                                                               | ** ** | ** ** |
| **For the  quarterly period ended September 30, 2006**                                                                          |
| ** **                                                                                                                           | ** ** | ** **                                                                                               |
| **OR**                                                                                                                               |
| ** **                                                                                                                           | ** ** | ** **                                                                                               |
| **o**                                                                                                                                | ** ** | **TRANSITION REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
| ** **                                                                                                                           |
| **For the  transition period          to          ** |
| ** **                                                                                                                           |
| **Commission  File Number 0-21123**                                                                                                  |

 

**SRS LABS, INC.**

(Exactname of registrant as specified in its charter)

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

 

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

(Address of principalexecutive offices) (Zip Code)

**(949) 442-1070**

(Registrant’s telephonenumber, including area code)

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

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

 

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

As of October 25, 2006,15,819,684 of the issuer’s common stock, par value $.001 per share, wereoutstanding; of this amount, 674,098 shares of the common stock were held as treasury shares.

 

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**SRS LABS, INC.**

**Form 10-QFor the Period Ended September 30, 2006Index**
| **PART I-FINANCIAL  INFORMATION** |
|----------------------------------------|
| Item  1.                               |   | Financial  Statements |
|                                   |   | Condensed Consolidated Balance Sheets as of  September 30, 2006 (Unaudited) and December 31, 2005 |
|                                   |   | Condensed Consolidated Statements of Operations for  the three and nine months ended September 30, 2006 and 2005 (Unaudited) |
|                                   |   | Condensed Consolidated Statements of Stockholders’  Equity and Comprehensive Income for the three and nine months ended  September 30, 2006 (Unaudited) |
|                                   |   | Condensed Consolidated Statements of Cash Flows for  the nine months ended September 30, 2006 and 2005 (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  1.A.                             |   | Risk  Factors |
| Item 2.                                |   | Unregistered  Sales of Equity Securities and Use of Proceeds |
| Item  6.                               |   | Exhibits |
|                                   |   |   |
| SIGNATURES                             |

 

2

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**FORWARD-LOOKING INFORMATION**

Asused herein, the “Company,” “SRS Labs,” “we,” “us,” or “our” means SRSLabs, Inc., its wholly-owned subsidiary SRSWOWcast, Inc.,  and for the applicable periods, its formerlyowned subsidiary ValenceTech Limited (including its direct and indirectwholly-owned subsidiaries, collectively “Valence”) and the former jointventure with Coming Home Studios LLC, CHS/SRS LLC.

Someof the statements in this Quarterly Report on Form 10-Q containforward-looking statements regarding our assumptions, projections,expectations, targets, intentions or beliefs about future events, which involverisks and uncertainties. All statements other than statements of historicalfacts included in this Quarterly Report relating to expectation of future financialperformance, continued growth, changes in economic conditions or capitalmarkets and changes in customer usage patterns and preferences, areforward-looking statements. In some cases, you can identify forward-lookingstatements by terms such as may, will, should, expect, plan, intend, forecast,anticipate, believe, estimate, predict, potential, continue or the negative ofthese terms or other comparable terminology. The forward-looking statementscontained in this Quarterly Report involve known and unknown risks,uncertainties and situations that may cause our or our industry’s actualresults, level of activity, performance or achievements to be materiallydifferent from any future results, levels of activity, performance orachievements expressed or implied by these statements. Factors that might causeactual events or results to differ materially from those indicated by theseforward-looking statements may include the matters listed under “RiskFactors” in Item 1A in our most recently filed Form 10-K and elsewhere inthis Form 10-Q, including, but not limited to, the acceptance of new SRSLabs products and technologies; the import of competitive products and pricing;the timely development and release of technologies by the Company; general businessand economic conditions, especially in Asia; product and customer concentrationin our business; our high dependence on the consumer electronics market, whichis characterized by short product life cycles, fluctuations in demand andseasonality; the risk of widespread illness; our dependence on growth inemerging markets; the length and unpredictable nature of our sales cycle; ourability to protect our products through patents and other intellectual propertyrights; our dependence on key personnel; the volatility of the price of ourcommon stock; provisions that could discourage transactions resulting in achange in control contained in our certificate of incorporation and bylaws aswell as Delaware law; competition we face from companies with greater brandrecognition and resources; pricing pressures on the consumer electronicsproduct manufacturers; adverse state, federal or foreign legislation orregulation or adverse determinations by regulators; and other factorsidentified from time to time in our filings with the Securities and ExchangeCommission.

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

3

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**PART I— FINANCIAL INFORMATION**

**Item 1.Financial Statements**

**SRS LABS, INC.CONDENSED CONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                                                                                                                                        | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                        | ** ** | **(unaudited)**              | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                                                        | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| **Current Assets**                                                                                                                                                                                                                |       |                         |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                                                                        |       | $                            | 26,126,915 |                        | $          | 8,752,339 |   |
| Accounts  receivable, net                                                                                                                                                                                                         |       | 2,289,830                    |       | 1,886,780                   |       |
| Inventories, net                                                                                                                                                                                                                  |       | 158,253                      |       | 80,421                      |       |
| Prepaid expenses  and other current assets                                                                                                                                                                                        |       | 910,902                      |       | 522,426                     |       |
| Investments  available for sale                                                                                                                                                                                                   |       | 1,993,279                    |       | —                      |       |
| Assets held for  sale                                                                                                                                                                                                             |       | —                       |       | 1,859,127                   |       |
|                                                                                                                                                                                                                              |       |                         |       |                        |       |
| **Total  Current Assets**                                                                                                                                                                                                         |       | 31,479,179                   |       | 13,101,093                  |       |
|                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Investments  available for sale                                                                                                                                                                                                   |       | 5,211,295                    |       | 17,077,170                  |       |
| Furniture,  fixtures and equipment, net                                                                                                                                                                                      |       | 441,453                      |       | 425,288                     |       |
| Intangible  assets, net                                                                                                                                                                                                           |       | 2,096,507                    |       | 2,015,605                   |       |
| Deferred income  taxes                                                                                                                                                                                                            |       | 386,412                      |       | 380,386                     |       |
| Long term assets  held for sale                                                                                                                                                                                                   |       | —                       |       | 2,065,123                   |       |
|                                                                                                                                                                                                                              |       |                         |       |                        |       |
| **Total  Assets**                                                                                                                                                                                                                 |       | $                            | 39,614,846 |                        | $          | 35,064,665 |   |
|                                                                                                                                                                                                                              |       |                         |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                    | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| **Current Liabilities**                                                                                                                                                                                                           |       |                         |       |                        |       |
| Accounts payable                                                                                                                                                                                                                  |       | $                            | 898,289    |                        | $          | 741,811 |   |
| Accrued  liabilities                                                                                                                                                                                                              |       | 1,113,929                    |       | 801,898                     |       |
| Deferred revenue                                                                                                                                                                                                                  |       | 440,861                      |       | 537,636                     |       |
| Liabilities  related to assets held for sale                                                                                                                                                                                      |       | —                       |       | 2,170,701                   |       |
|                                                                                                                                                                                                                              |       |                         |       |                        |       |
| **Total  Current Liabilities**                                                                                                                                                                                                    |       | 2,453,079                    |       | 4,252,046                   |       |
|                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Commitments and  contingencies (Note 7)                                                                                                                                                                                           |       |                         |       |                        |       |
|                                                                                                                                                                                                                              |       |                         |       |                        |       |
| **Stockholders’ Equity**                                                                                                                                                                                                     |       |                         |       |                        |       |
| Preferred stock—$.001  par value; 2,000,000 shares authorized; no shares issued or outstanding                                                                                                                               |       | —                       |       | —                      |       |
| Common stock—$.001 par  value; 56,000,000 shares authorized; 15,657,751 and 14,953,690 shares issued;  and 14,983,653 and 14,279,592 shares outstanding at September 30, 2006  and December 31, 2005, respectively |       | 15,659                       |       | 14,955                      |       |
| Additional  paid-in capital                                                                                                                                                                                                       |       | 66,239,460                   |       | 63,574,518                  |       |
| Accumulated  other comprehensive loss                                                                                                                                                                                             |       | (295,131                     | )          | (496,021                    | )          |
| Accumulated  deficit                                                                                                                                                                                                              |       | (25,794,776                  | )          | (29,277,388                 | )          |
| Treasury stock  at cost, 674,098 shares at September 30, 2006 and December 31, 2005                                                                                                                                     |       | (3,003,445                   | )          | (3,003,445                  | )          |
|                                                                                                                                                                                                                              |       |                         |       |                        |       |
| **Total  Stockholders’ Equity**                                                                                                                                                                                              |       | 37,161,767                   |       | 30,812,619                  |       |
|                                                                                                                                                                                                                              |       |                         |       |                        |       |
| **Total Liabilities and  Stockholders’ Equity**                                                                                                                                                                              |       | $                            | 39,614,846 |                        | $          | 35,064,665 |   |

 

See accompanying notes tothe condensed consolidated financial statements

4

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**SRSLABS, INC.****CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS(Unaudited)**
| ** **                                                                       | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                       | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                       | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                       | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                                         |       | $                                | 4,910,203  |                            | $          | 3,640,134 |   | $ | 13,505,710 |   | $ | 10,444,206 |   |
| Cost of sales                                                                    |       | 43,998                           |       | 39,804                          |       | 127,103 |   | 190,987 |   |
|                                                                             |       |                             |       |                            |       |   |   |   |   |
| Gross margin                                                                     |       | 4,866,205                        |       | 3,600,330                       |       | 13,378,607 |   | 10,253,219 |   |
|                                                                             |       |                             |       |                            |       |   |   |   |   |
| Operating  expenses:                                                             |       |                             |       |                            |       |   |   |   |   |
| Sales and marketing                                                              |       | 1,743,660                        |       | 1,087,025                       |       | 5,494,445 |   | 3,295,949 |   |
| Research and development                                                         |       | 628,227                          |       | 584,008                         |       | 1,914,255 |   | 1,708,000 |   |
| General and administrative                                                       |       | 1,277,601                        |       | 1,198,433                       |       | 4,272,598 |   | 3,898,785 |   |
|                                                                             |       |                             |       |                            |       |   |   |   |   |
| Total operating expenses                                                         |       | 3,649,488                        |       | 2,869,466                       |       | 11,681,298 |   | 8,902,734 |   |
|                                                                             |       |                             |       |                            |       |   |   |   |   |
| Income from  continuing operations                                               |       | 1,216,717                        |       | 730,864                         |       | 1,697,309 |   | 1,350,485 |   |
| Other income,  net                                                               |       | 291,236                          |       | 176,707                         |       | 694,954 |   | 486,318 |   |
| Income from continuing operations before income tax  expense                     |       | 1,507,953                        |       | 907,571                         |       | 2,392,263 |   | 1,836,803 |   |
| Income tax  expense                                                              |       | 231,620                          |       | 200,420                         |       | 558,788 |   | 487,950 |   |
| Income from  continuing operations                                               |       | 1,276,333                        |       | 707,151                         |       | 1,833,475 |   | 1,348,853 |   |
|                                                                             |       |                             |       |                            |       |   |   |   |   |
| Discontinued  operations (Note 9):                                               |       |                             |       |                            |       |   |   |   |   |
| Income (loss) from discontinued operations before  income tax expense (benefit)  |       | 859,843                          |       | (123,490                        | )          | 1,054,095 |   | (24,257 | ) |
| Gain on disposal                                                                 |       | 260,763                          |       | —                          |       | 632,058 |   | — |   |
| Income tax expense (benefit)                                                     |       | 6,320                            |       | (120,533                        | )          | 37,016 |   | (114,792 | ) |
| Income (loss)  from discontinued operations                                      |       | 1,114,286                        |       | (2,957                          | )          | 1,649,137 |   | 90,535 |   |
|                                                                             |       |                             |       |                            |       |   |   |   |   |
| Net income                                                                       |       | $                                | 2,390,619  |                            | $          | 704,194 |   | $ | 3,482,612 |   | $ | 1,439,388 |   |
|                                                                             |       |                             |       |                            |       |   |   |   |   |
| Income from  continuing operations per common share:                             |       |                             |       |                            |       |   |   |   |   |
| Basic                                                                            |       | $                                | 0.09       |                            | $          | 0.05 |   | $ | 0.13 |   | $ | 0.10 |   |
| Diluted                                                                          |       | $                                | 0.08       |                            | $          | 0.05 |   | $ | 0.11 |   | $ | 0.09 |   |
|                                                                             |       |                             |       |                            |       |   |   |   |   |
| Income from  discontinued operations per common share:                           |       |                             |       |                            |       |   |   |   |   |
| Basic                                                                            |       | $                                | 0.07       |                            | $          | 0.00 |   | $ | 0.11 |   | $ | 0.01 |   |
| Diluted                                                                          |       | $                                | 0.07       |                            | $          | 0.00 |   | $ | 0.10 |   | $ | 0.01 |   |
|                                                                             |       |                             |       |                            |       |   |   |   |   |
| Net income per  common share:                                                    |       |                             |       |                            |       |   |   |   |   |
| Basic                                                                            |       | $                                | 0.16       |                            | $          | 0.05 |   | $ | 0.24 |   | $ | 0.10 |   |
| Diluted                                                                          |       | $                                | 0.15       |                            | $          | 0.05 |   | $ | 0.21 |   | $ | 0.10 |   |
|                                                                             |       |                             |       |                            |       |   |   |   |   |
| Weighted average  shares used in the calculation of net income per common share: |       |                             |       |                            |       |   |   |   |   |
| Basic                                                                            |       | 14,939,806                       |       | 14,094,690                      |       | 14,663,767 |   | 14,076,833 |   |
| Diluted                                                                          |       | 16,479,112                       |       | 15,300,803                      |       | 16,428,894 |   | 15,070,362 |   |

 

See accompanying notes tothe condensed consolidated financial statements

5

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**SRSLABS, INC.CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY ANDCOMPREHENSIVE INCOME (Unaudited)**
| ** **                                                     | ** ** | **Common Stock** | ** ** | **Additional  Paid-In** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Accumulated**        | ** ** | **Treasury** | ** ** | ** ** | ** ** | **Comprehensive  Income  for the Period** | ** ** |
|----------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|---------------------------------------|------------|------------------------|------------|--------------|------------|------------|------------|-----------------------------------------------------|------------|
| ** **                                                     | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Capital**                           | ** ** | **(Loss) Income** | ** ** | **Deficit**  | ** ** | **Stock**  | ** ** | **Total**                                           | ** ** | **Ended** | ** ** |
| ** **                                                     | ** ** | ** **            | ** ** | ** **              | ** ** | ** **                            | ** ** | ** **             | ** ** | ** **   | ** ** | ** ** | ** ** | ** **                                          | ** ** | ** ** | ** ** |
| BALANCE, Dec. 31,  2005                                   |       | 14,279,592            |       | $                       | 14,955     |                                  | $          | 63,574,518             |       | $            | (496,021   | )          | $          | (29,277,388                                         | )          | $ | (3,003,445 | ) | $ | 30,812,619 |   |   |   |
| Proceeds from exercise  of stock options                       |       | 230,370               |       | 230                     |       | 1,014,988                             |       | —                 |       | —       |       | —     |       | 1,015,218                                           |       |   |   |
| Stock based compensation                                       |       | —                |       | —                  |       | 399,738                               |       | —                 |       | —       |       | —     |       | 399,738                                             |       |   |   |
| Unrealized loss on  investments available for sale, net of tax |       | —                |       | —                  |       | —                                |       | (58,282                | )          | —       |       | —     |       | (58,282                                             | )          | (58,282 | ) |
| Net income                                                     |       | —                |       | —                  |       | —                                |       | —                 |       | 162,575      |       | —     |       | 162,575                                             |       | 162,575 |   |
|                                                           |       |                  |       |                    |       |                                  |       |                   |       |         |       |       |       |                                                |       |   |   |
| BALANCE, March 31,  2006                                  |       | 14,509,962            |       | $                       | 15,185     |                                  | $          | 64,989,244             |       | $            | (554,303   | )          | $          | (29,114,813                                         | )          | $ | (3,003,445 | ) | $ | 32,331,868 |   | $ | 104,293 |   |
| Proceeds from exercise  of stock options                       |       | 400,759               |       | 401                     |       | 1,203,311                             |       | —                 |       | —       |       | —     |       | 1,203,712                                           |       |   |   |
| Stock based compensation                                       |       | —                |       | —                  |       | 388,805                               |       | —                 |       | —       |       | —     |       | 388,805                                             |       |   |   |
| Unrealized gain on  investments available for sale, net of tax |       | —                |       | —                  |       | —                                |       | 48,257                 |       | —       |       | —     |       | 48,257                                              |       | 48,257 |   |
| Net income                                                     |       | —                |       | —                  |       | —                                |       | —                 |       | 929,418      |       | —     |       | 929,418                                             |       | 929,418 |   |
|                                                           |       |                  |       |                    |       |                                  |       |                   |       |         |       |       |       |                                                |       |   |   |
| BALANCE, June 30,  2006                                   |       | 14,910,721            |       | $                       | 15,586     |                                  | $          | 66,581,360             |       | $            | (506,046   | )          | $          | (28,185,395                                         | )          | $ | (3,003,445 | ) | $ | 34,902,060 |   | $ | 1,081,968 |   |
| Proceeds from exercise  of stock options                       |       | 72,932                |       | 73                      |       | 237,747                               |       | —                 |       | —       |       | —     |       | 237,820                                             |       |   |   |
| Proceeds from exercise  of Valence mgmt stock options (Note 9) |       | 357,625               |       | 358                     |       | 1,151,177                             |       | —                 |       | —       |       | —     |       | 1,151,535                                           |       |   |   |
| Purchase of Treasury  stock                                    |       | —                |       | —                  |       | —                                |       | —                 |       | —       |       | (2,114,586 | )          | (2,114,586                                          | )          |   |   |
| Cancel Treasury stock                                          |       | (357,625              | )          | (358                    | )          | (2,114,228                            | )          | —                 |       | —       |       | 2,114,586  |       | —                                              |       |   |   |
| Stock based compensation                                       |       | —                |       | —                  |       | 383,404                               |       | —                 |       | —       |       | —     |       | 383,404                                             |       |   |   |
| Currency Translation  Adjustment                               |       | —                |       | —                  |       | —                                |       | 81,303                 |       | —       |       | —     |       | 81,303                                              |       | 81,303 |   |
| Unrealized gain on  investments available for sale, net of tax |       | —                |       | —                  |       | —                                |       | 129,612                |       | —       |       | —     |       | 129,612                                             |       | 129,612 |   |
| Net income                                                     |       | —                |       | —                  |       | —                                |       | —                 |       | 2,390,619    |       | —     |       | 2,390,619                                           |       | 2,390,619 |   |
|                                                           |       |                  |       |                    |       |                                  |       |                   |       |         |       |       |       |                                                |       |   |   |
| BALANCE, September 30, 2006                               |       | 14,983,653            |       | $                       | 15,659     |                                  | $          | 66,239,460             |       | $            | (295,131   | )          | $          | (25,794,776                                         | )          | $ | (3,003,445 | ) | $ | 37,161,767 |   | $ | 3,683,502 |   |

 

See accompanying notes to the condensed consolidatedfinancial statements

6

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**SRSLABS, INC.****CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)**
| ** **                                                                         | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| **Cash  Flows From Operating Activities:**                                         |       |                                                |       |   |   |
| Net income                                                                         |       | $                                                   | 3,482,612  |   | $ | 1,439,388 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                                |       |   |   |
| Depreciation and amortization                                                      |       | 549,259                                             |       | 628,175 |   |
| Provision for doubtful accounts                                                    |       | (1,588                                              | )          | 15,906 |   |
| Deferred taxes                                                                     |       | (6,026                                              | )          | — |   |
| Accretion of discount on investments available for  sale                           |       | (1,565                                              | )          | (1,693 | ) |
| Stock-based compensation expense                                                   |       | 1,070,804                                           |       | 32,619 |   |
| Loss on disposition of furniture, fixtures and  equipment                          |       | 1,582                                               |       | 1,417 |   |
| Equity in income of investee                                                       |       | —                                              |       | (91,096 | ) |
| Gain on sale of discontinued operations                                            |       | (632,058                                            | )          | — |   |
| Changes in operating assets and liabilities:                                       |       |                                                |       |   |   |
| Accounts receivable                                                                |       | (401,462                                            | )          | 315,621 |   |
| Inventories                                                                        |       | (77,832                                             | )          | (116,315 | ) |
| Prepaid expenses and other current assets                                          |       | (388,476                                            | )          | 152,680 |   |
| Accounts payable                                                                   |       | 156,478                                             |       | 88,615 |   |
| Accrued liabilities                                                                |       | 312,031                                             |       | 966,741 |   |
| Deferred revenue                                                                   |       | (96,775                                             | )          | (86,838 | ) |
| Income taxes payable                                                               |       | —                                              |       | 97,325 |   |
| Net cash used by operating activities of  discontinued operations                  |       | (1,922,668                                          | )          | (1,172,702 | ) |
| Net cash provided by operating activities                                          |       | 2,044,316                                           |       | 2,269,843 |   |
| **Cash  Flows From Investing Activities:**                                         |       |                                                |       |   |   |
| Purchase of  furniture, fixtures and equipment                                     |       | (204,790                                            | )          | (87,190 | ) |
| Proceeds from  sale of equipment                                                   |       | —                                              |       | 2,300 |   |
| Capitalized  production costs                                                      |       | —                                              |       | (601,273 | ) |
| Expenditures  related to patents and intangible assets                             |       | (443,118                                            | )          | (341,833 | ) |
| Proceeds from  sale of investments available for sale                              |       | 9,993,748                                           |       | — |   |
| Proceeds from  the sale of Valence                                                 |       | 4,300,000                                           |       | — |   |
| Proceeds from  the sale of equity interest in CHS/SRS LLC                          |       | 371,295                                             |       | — |   |
| Net cash used in  investing activities of discontinued operations                  |       | (180,216                                            | )          | (78,546 | ) |
| Net cash provided by (used in) investing activities                                |       | 13,836,919                                          |       | (1,106,542 | ) |
| **Cash  Flows From Financing Activities:**                                         |       |                                                |       |   |   |
| Purchase of  treasury stock                                                        |       | (2,114,586                                          | )          | (1,059,590 | ) |
| Proceeds from  exercise of stock options                                           |       | 3,607,927                                           |       | 704,710 |   |
| Net cash provided by (used in) financing activities                                |       | 1,493,341                                           |       | (354,880 | ) |
| ** **                                                                         |       |                                                |       |   |   |
| **Net  Increase in Cash and Cash Equivalents**                                     |       | 17,374,576                                          |       | 808,421 |   |
| **Cash  and Cash Equivalents, Beginning of Period**                                |       | 8,752,339                                           |       | 7,011,912 |   |
| **Cash  and Cash Equivalents, End of Period**                                      |       | $                                                   | 26,126,915 |   | $ | 7,820,333 |   |
|                                                                               |       |                                                |       |   |   |
| **Supplemental  Disclosure of Cash Flow Information:**                             |       |                                                |       |   |   |
| Cash paid for Income taxes                                                         |       | $                                                   | 506,010    |   | $ | 546,847 |   |
| **Supplemental  Disclosure of Non-Cash Investing Activities:**                     |       |                                                |       |   |   |
| Unrealized gain  (loss) on investments, net                                        |       | $                                                   | 33,247     |   | $ | (194,890 | ) |

 

See accompanying notes tothe condensed consolidated financial statements

7

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**SRSLABS, INC.****NOTES TO THE CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS (Unaudited)**

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

As used herein, the “Company,” “SRS Labs,” “we,” “us,” or “our” meansSRS Labs, Inc. and its wholly-owned subsidiary SRSWOWcast, Inc (“SRSWOWcast”),and, for the applicable periods, its formerly owned subsidiary ValenceTechLimited (including its direct and indirect wholly-owned subsidiaries,collectively “Valence”) and the former joint venture with Coming Home StudiosLLC, CHS/SRS LLC. The accompanying unaudited condensed consolidated financialstatements have been prepared by the Company in conformity with accountingprinciples generally accepted in the United States of America (“generallyaccepted accounting principles”) for interim financial information and therules and regulations of the U.S. Securities and Exchange Commission (“SEC”)for interim reporting. In the opinion of management, all adjustments (whichinclude only normal recurring adjustments) considered necessary for a fairpresentation of our financial position and results of operations have beenincluded. Certain amounts included in the accompanying prior periods’consolidated financial statements have been reclassified to conform to thecurrent period presentation. All material inter-company accounts andtransactions have been eliminated.

Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with generally accepted accounting principles have beencondensed or omitted pursuant to SEC rules and regulations forpresentation of interim financial information. Therefore, the condensed interimconsolidated financial statements should be read in conjunction with theCompany’s Annual Report on Form 10-K for the fiscal year endedDecember 31, 2005. Current and future financial statements may not bedirectly comparable to the Company’s historical financial statements. Theresults of operations for the interim period are not necessarily indicative ofthe results to be expected for any other interim period or for the full year.

On February 23,2006, the Board of Directors of the Company (the “Board of Directors” or the “Board”)approved a plan to sell Valence in order to focus increased managementattention and financial resources on its licensing business. On July 14,2006, the Company entered into a definitive Sale and Purchase Agreement to sellValence to Noblehigh Enterprises Inc. (“Noblehigh”). On September 29, 2006, theCompany completed the sale of Valence to Noblehigh. See Note 9.

Additionally, onFebruary 23, 2006, the Board authorized management to take all reasonablesteps to divest the Company’s entire equity interest in the CHS/SRS LLC jointventure (the “Joint Venture”) to produce and distribute nine concert videosfeaturing our Circle Surround Technology. On June 30, 2006 the Company completedthe sale of its interest in the Joint Venture to Coming Home Studios, LLC (“CHS”)in exchange for $200,000, the rights to all cash assets of the Joint Venture,and a promissory note in the amount of $175,000. See Note 9.

As a result of ourdecisions to sell Valence and our entire equity interest in the joint venture,we have accounted for the semiconductor business segment and the joint ventureas discontinued operations in the accompanying condensed consolidated financialstatements. We have reclassified prior periods to conform to the currentperiod presentation.

**Estimates**

The preparation offinancial statements in accordance with generally accepted accountingprinciples requires management to make use of certain estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reported periods. Webase our estimates on historical experience and on various other assumptionsthat we believe are reasonable under the circumstances, the results of whichform the basis for making judgments about carrying values of assets andliabilities that are not readily apparent from other sources. Actual resultscould differ materially from those estimates. See the audited consolidatedfinancial statements and notes thereto included in our Annual Report onForm 10-K for the year ended December 31, 2005 for an additionaldiscussion of the significant accounting policies and estimates used in thepreparation of our financial statements.

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

In December 2004,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 123 (revised 2004), “Share-BasedPayment,” (“SFAS 123R”). This Statement requires companies to expense theestimated fair value of stock options and similar equity instruments issued toemployees over the requisite service period. SFAS 123R eliminates thealternative to use the intrinsic method of accounting provided for inAccounting Principles Board Opinion No. 25, Accounting for Stock Issued toEmployees (“APB 25”), which generally resulted in an immaterial amount ofcompensation expense recorded in the financial statements related to the grantof stock options to employees if certain conditions were met. The pro formaimpact from recognition of the estimated fair value of stock options granted toemployees has been previously disclosed in our footnotes as required underprevious accounting rules.

8

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Effective for the firstquarter of fiscal 2006, we adopted SFAS 123R using the modified prospectivemethod, which requires us to record compensation expense for all awards grantedafter the date of adoption, and for the unvested portion of previously grantedawards that remain outstanding at the date of adoption. Accordingly, priorperiod amounts presented herein have not been restated to reflect the adoptionof SFAS 123R.

The fair value conceptswere not changed significantly in SFAS 123R; however, in adopting SFAS 123R,companies must choose among alternative valuation models and amortizationassumptions. After assessing alternative valuation models and amortizationassumptions, we are continuing to use both the Black-Scholes-Merton (“BSM”)option-pricing formula and straight-line amortization of compensation expenseover the requisite service period of the grant. We will reconsider use of thismodel if additional information becomes available in the future that indicatesanother model would be more appropriate for us, or if grants issued in futureperiods have characteristics that cannot be reasonably estimated using thismodel. Under SFAS No. 123, “Accounting for Stock Based Compensation” (“SFAS123”), we were not required to estimate forfeitures in our expense calculationfor the stock compensation pro forma footnote disclosure; however, SFAS 123Rrequires an estimate of forfeitures and upon adoption we changed ourmethodology to include an estimate of forfeitures. The adoption of SFAS 123Rhad no effect on cash flows from financing activities.

The following tableillustrates the effect on net income and net income per share as if the Companyhad applied the fair value recognition provisions of SFAS 123 as of January 1,2005 to options granted under the Company’s stock option plans. For purposes ofthis pro forma disclosure, the fair value of the options is estimated using aBSM option-pricing formula and amortized on a straight-line basis to expenseover the options’ vesting period:
| ** **                                                                                                                     | ** ** | **Three Months  Ended  September 30,  2005** | ** ** | **Nine Months  Ended  September 30,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
|                                                                                                                           |       |                                                   |       |                                                  |       |
| Net income - as  reported                                                                                                      |       | $                                                      | 704,194    |                                                  | $          | 1,439,388 |   |
| Add: Share-based  employee compensation expense included in net income, net of related  tax effects - as reported         |       | 4,829                                                  |       | 19,571                                                |       |
| Deduct:  Share-based employee compensation expense determined under fair value method,  net of related tax effects - pro forma |       | (273,860                                               | )          | (854,137                                              | )          |
| Net income - pro  forma                                                                                                        |       | $                                                      | 435,163    |                                                  | $          | 604,822 |   |
| Basic - as  reported                                                                                                           |       | $                                                      | 0.05       |                                                  | $          | 0.10 |   |
| Basic - pro  forma                                                                                                             |       | $                                                      | 0.03       |                                                  | $          | 0.04 |   |
| Diluted - as  reported                                                                                                         |       | $                                                      | 0.05       |                                                  | $          | 0.10 |   |
| Diluted - pro forma                                                                                                            |       | $                                                      | 0.03       |                                                  | $          | 0.04 |   |

 

**Share Option Plans**

The Company has in effectseveral share-based plans under which non-qualified and incentive stock optionshave been granted to employees, non-employees and board members. The followingequity compensation plans have also been approved by our stockholders: the SRSLabs, Inc. 2006 Stock Incentive Plan (the “2006 Plan”), the SRSLabs, Inc. Amended and Restated 1996 Long-Term Incentive Plan (the “1996Plan”), and the SRS Labs, Inc. Amended and Restated 1996 Non-employeeDirectors’ Stock Option Plan (the “Non-employee Directors Plan”). The Board ofDirectors determines eligibility, vesting schedules and exercise prices foroptions granted under the plans. We issue new shares to satisfy stock optionexercises under our share-based plans. No income tax benefit was realized fromactivity in our share-based plans during the three and nine months ended fiscal2006 and 2005.

A summary of the shares reserved for grant and optionsavailable for grant under each plan is as follows:

|                              | ** ** | **September 30, 2006** | ** ** |
|------------------------------|------------|----------------------------------|------------|
| ** **                   | ** ** | **Shares**                       | ** ** | **Shares** | ** ** |
| ** **                   | ** ** | **Reserved**                     | ** ** | **Available** | ** ** |
| ** **                   | ** ** | **for Grant**               | ** ** | **for Grant** | ** ** |
| 2006 Plan                    |       | 1,500,000                        |       | 1,380,000 |   |
| 1996 Plan                    |       | 8,500,000                        |       | 0 |   |
| Non-employee  Directors Plan |       | 500,000                          |       | 340,000 |   |
| Total                        |       | 10,500,000                       |       | 1,720,000 |   |

 

9

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

The fair value of eachshare-based award is estimated on the grant date using the BSM option-pricingformula. Expected volatilities are based on the historical volatility of theCompany’s stock price. The expected term of options granted subsequent to theadoption of SFAS 123R is derived using the simplified method as defined in theSEC’s Staff Accounting Bulletin 107, “Implementation of FASB 123R.” Therisk-free rate for periods within the contractual life of the option is basedon the U.S. Treasury interest rates in effect at the time of grant. The fairvalue of options granted was estimated using the following weighted-averageassumptions:
| ** **                | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                | ** ** | **2006 ***                  | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected term  (in years) |       | —                           |       | 6.25                            |       | 6.25 |   | 6.25 |   |
| Expected  volatility      |       | —                           |       | 55                              | %          | 57 | % | 60 | % |
| Risk-free  interest rate  |       | —                           |       | 4.2                             | %          | 4.9 | % | 4.0 | % |
| Dividend yield            |       | —                           |       | 0.00                            | %          | 0.00 | % | 0.00 | % |

 

----

*Note: there were no options granted in the three months ended September 30,2006.

Total compensation costrecognized in the three and nine months ending September 30, 2006 is asfollows:
| ** **                                                     | ** ** | **Three Months** | ** ** | **Nine Months** | ** ** |
|----------------------------------------------------------------|------------|-----------------------|------------|----------------------|------------|
| Continuing  Operations:                                        |       |                  |       |                 |       |
| Sales and Marketing                                            |       | $                     | 140,228    |                 | $          | 438,740 |   |
| Research and Development                                       |       | 67,383                |       | 269,544              |       |
| General and Administrative                                     |       | 175,793               |       | 362,520              |       |
| Total  compensation cost recognized in Continuing Operations   |       | $                     | 383,404    |                 | $          | 1,070,804 |   |
|                                                           |       |                  |       |                 |       |
| Total  compensation cost recognized in Discontinued Operations |       | $                     | —     |                 | $          | 101,143 |   |
| Total compensation cost  recognized                            |       | $                     | 383,404    |                 | $          | 1,171,947 |   |

 

A summary of option activity under the stock optionplans and changes during the three and nine months ended September 30,2006 is presented below:
| ** **                               | ** ** | ** ** | ** ** | **Weighted-Average** | ** ** | ** **      | ** ** |
|------------------------------------------|------------|------------|------------|----------------------|------------|-----------------|------------|
| ** **                               | ** ** | ** ** | ** ** | ** **           | ** ** | **Remaining**   | ** ** | **Aggregate** | ** ** |
| ** **                               | ** ** | ** ** | ** ** | **Exercise**         | ** ** | **Contractual** | ** ** | **Intrinsic** | ** ** |
| ** **                               | ** ** | **Shares** | ** ** | **Price**            | ** ** | **Term**        | ** ** | **Value** | ** ** |
|                                     |       |       |       |                 |       |            |       |   |   |
| Outstanding, January  1, 2006            |       | 4,444,254  |       | $                    | 4.41       |            |       |   |   |   |
| Granted                                  |       | 110,000    |       | 6.20                 |       |            |       |   |   |
| Cancelled/forfeited                      |       | (60,844    | )          | 3.37                 |       |            |       |   |   |
| Exercised                                |       | (230,370   | )          | 4.41                 |       |            |       |   |   |
| Outstanding,  March 31, 2006             |       | 4,263,040  |       | $                    | 4.47       |            | 5.1        |   | 7,171,095 |   |
| Granted                                  |       | 385,900    |       | 5.70                 |       |            |       |   |   |
| Cancelled/forfeited                      |       | (67,619    | )          | 6.28                 |       |            |       |   |   |
| Exercised                                |       | (400,759   | )          | 3.00                 |       |            |       |   |   |
| Outstanding,  June 30, 2006              |       | 4,180,562  |       | $                    | 4.69       |            | 5.4        |   | 3,272,877 |   |
| Granted                                  |       | —     |       | —               |       |            |       |   |   |
| Cancelled/Forfeited                      |       | (491,070   | )          | 5.36                 |       |            |       |   |   |
| Exercised                                |       | (430,557   | )          | 3.23                 |       |            |       |   |   |
| Outstanding,  September 30, 2006         |       | 3,258,935  |       | $                    | 4.79       |            | 5.0        |   | $ | 5,039,586 |   |
| Options exercisable,  September 30, 2006 |       | 2,387,453  |       | $                    | 4.45       |            | 4.6        |   | $ | 4,623,271 |   |

 

10

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A summary of thegrant-date fair value and intrinsic value information is as follows:
| ** **                                        | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                        | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                        | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Weighted-average  grant-date fair value per share |       | $                                | —     |                            | $          | 3.47 |   | $ | 3.46 |   | $ | 3.11 |   |
| Intrinsic value of  options exercised             |       | $                                | 1,138,340  |                            | $          | 223,288 |   | $ | 2,493,367 |   | $ | 426,131 |   |

 

A summary of the activity of the Company’s non-vestedshares during the nine months ended September 30, 2006 is presented below:
| ** **                                    | ** ** | ** ** | ** ** | **Weighted-Average** | ** ** | **Remaining**    | ** ** |
|-----------------------------------------------|------------|------------|------------|----------------------|------------|------------------|------------|
| ** **                                    | ** ** | ** ** | ** ** | ** **           | ** ** | **Remaining**    | ** ** | **Unrecognized** | ** ** |
| ** **                                    | ** ** | ** ** | ** ** | **Grant-Date**       | ** ** | **Years**        | ** ** | **Compensation** | ** ** |
| ** **                                    | ** ** | **Shares** | ** ** | **Fair Value**  | ** ** | **To Vest** | ** ** | **Cost** | ** ** |
| Nonvested  outstanding at beginning of period |       | 1,195,964  |       | $                    | 3.21       |             |       |   |   |   |
| Granted                                       |       | 495,900    |       | 3.46                 |       |             |       |   |   |
| Vested                                        |       | (577,868   | )          | 3.34                 |       |             |       |   |   |
| Forfeited                                     |       | (337,019   | )          | 3.54                 |       |             |       |   |   |
| Nonvested outstanding  at end of period       |       | 776,977    |       | $                    | 3.46       |             | 3.11       |   | $ | 2,347,772 |   |
|                                               |            |            |            |                      |            |                  |            |  |  |  |  |

 

**3.             Capitalizationof Software Development Costs**

Costs incurred in theresearch, design and development of software for sale to others as a separateproduct or embedded in a product and sold as part of the product as awhole are charged to expense until technological feasibility is established. UnderSFAS No. 86, “Accounting for the Costs of Computer Software to be Sold,Leased or Otherwise Marketed,” the Company capitalizes software purchased fromthird parties if the related software product under development has reachedtechnological feasibility or if there are alternative future uses for thepurchased software, provided that capitalized amounts will be realized over aperiod not exceeding five years. Costs incurred prior to the establishment oftechnological feasibility are charged to research and development expense.

Capitalized software as of September 30, 2006 andDecember 31, 2005 is as follows:
|                            | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Capitalized  software      |       | $                            | 710,914    |                        | $          | 595,568 |   |
| Accumulated  amortization  |       | (430,899                     | )          | (309,990                    | )          |
| Capitalized software,  net |       | $                            | 280,015    |                        | $          | 285,578 |   |

 

Asof September 30, 2006, the weighted average useful life of the Company’scapitalized software is approximately 1.6 years. The following table shows theestimated amortization expense for those assets for the remaining three monthsof the current fiscal year end and each of the four succeeding fiscal years.

| Year ending December 31, | ** ** | **Estimated  Expense** | ** ** |
|-----------------------------------------|------------|------------------------|------------|
| 2006                                    |       | $                      | 44,518     |   |
| 2007                                    |       | 127,816                |       |
| 2008                                    |       | 88,868                 |       |
| 2009                                    |       | 18,813                 |       |
| 2010                                    |       | —                 |       |
|                                         |            |                        |            |  |

 

**4.             IntangibleAssets**

On January 1, 2002, the Company adopted SFASNo. 142 “Goodwill and Other Intangible Assets,” which, among other things,establishes new standards for goodwill acquired in a business combination,eliminates the amortization of goodwill and requires the carrying value ofgoodwill and identifiable intangibles to be evaluated for impairment on anannual basis.

In accordance with SFAS No. 142, all of ourintangible assets that have definite lives are being amortized on astraight-line basis over their estimated useful lives and are evaluated atleast annually to determine if fair value of the asset has decreased below itscarrying value. At December 31, 2005, we performed our annual assessmentand determined that no impairment existed.

11

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Intangible assets consist of the following:

|                                                                              | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                   | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Patents                                                                      |       | $                            | 2,667,314  |                        | $          | 2,339,543 |   |
| Accumulated  amortization                                                    |       | (1,274,102                   | )          | (1,093,368                  | )          |
| Patents, net                                                                 |       | 1,393,212                    |       | 1,246,175                   |       |
| Other Intangibles:                                                           |       |                         |       |                        |       |
| License agreements acquired in purchase of  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                  |       | 641,187                      |       | 525,840                     |       |
| Total of Other Intangibles                                                   |       | 1,401,258                    |       | 1,285,911                   |       |
| Accumulated  amortization, other intangibles                                 |       | (697,963                     | )          | (516,481                    | )          |
| Other  intangibles, net                                                      |       | 703,295                      |       | 769,430                     |       |
| Intangible assets, net                                                       |       | $                            | 2,096,507  |                        | $          | 2,015,605 |   |

 

Amortizationperiods range from three to ten years depending on the estimated useful life ofthe asset. Amortization expense consists of the following:
| ** **                                                                                  | ** ** | **Three months ended  September 30,** | ** ** | **Nine Months ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                  | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Patents                                                                                     |       | $                                                    | 62,655     |                                                | $          | 53,834 |   | $ | 180,734 |   | $ | 155,216 |   |
| Other  intangibles:                                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| License agreements acquired in purchase of our  subsidiary SRSWOWcast in February 2003 |       | 16,002                                               |       | 16,002                                              |       | 48,005 |   | 48,005 |   |
| Poly Planar purchased technology                                                            |       | —                                               |       | —                                              |       | — |   | 4,000 |   |
| Capitalized software and hardware                                                           |       | 48,269                                               |       | 32,746                                              |       | 133,477 |   | 94,249 |   |
| Total intangible  amortization expense                                                      |       | $                                                    | 126,926    |                                                | $          | 102,582 |   | $ | 362,216 |   | $ | 301,470 |   |

 

As ofSeptember 30, 2006, the weighted average useful life of the Company’spatents and intangible assets is approximately 2.5 years. The followingtable shows the estimated amortization expense for those assets for theremaining three months of the current fiscal year and each of the foursucceeding fiscal years and thereafter:

| Year ending  December 31, | ** ** | **Estimated expense** | ** ** |
|-------------------------------------|------------|----------------------------|------------|
| 2006                                |       | $                          | 131,392    |   |
| 2007                                |       | $                          | 397,442    |   |
| 2008                                |       | $                          | 403,411    |   |
| 2009                                |       | $                          | 252,478    |   |
| 2010                                |       | $                          | 217,953    |   |
| Thereafter                          |       | $                          | 693,831    |   |

 

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

The Company has classified its investments as available for sale inaccordance with SFAS No. 115, “Accounting for Certain Investments in Debtand Equity Securities.” The following table summarizes the Company’sinvestment securities available for sale:

|                       | ** ** | **September 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|-----------------------|------------|----------------------------------|------------|---------------------------------|------------|
| Cost                  |       | $                                | 7,495,938  |                            | $          | 17,489,688 |   |
| Accretion of discount |       | 3,767                            |       | 2,202                           |       |
| Unrealized loss       |       | (295,131                         | )          | (414,720                        | )          |
| Estimated fair value  |       | $                                | 7,204,574  |                            | $          | 17,077,170 |   |

 

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

|                                                 | ** ** | **September 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                      | ** ** | **Cost**                         | ** ** | **Estimated  Fair Value**  | ** ** | **Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| U.S. Government  securities available for sale: |       |                             |       |                            |       |   |   |   |   |
| Due in one year or less  (a)                    |       | 1,999,705                        |       | 1,993,279                       |       | — |   | — |   |
| Due in one to five  years                       |       | 5,500,000                        |       | 5,211,295                       |       | 17,491,890 |   | 17,077,170 |   |
|                                            |       | $                                | 7,499,705  |                            | $          | 7,204,574 |   | $ | 17,491,890 |   | $ | 17,077,170 |   |
|                                                 |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |

----

(a)    Availablefor sale securities due in one year or less are classified as short-term in thecondensed consolidated balance sheets, as the original contractual maturitiesare greater than 90 days.

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

TheCompany applies SFAS No. 128, “Earnings per Share,” which requires thedisclosure of basic and diluted net income or loss per share for all currentand prior periods. Basic net income or loss per common share is computed bydividing net income or loss available to common stockholders by the weightedaverage number of common shares outstanding during each year. Diluted netincome or loss per common share reflects the maximum dilution, based on theaverage price of the Company’s common stock each period, and is computedsimilar to basic income or loss per share except that the denominator isincreased to include the number of additional shares that would have beenoutstanding if potentially dilutive stock options and warrants had beenexercised.

13

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Basic and diluted net incomeper share computed in accordance with SFAS 128 for the three and ninemonths ended September 30, are as follows:
| ** **                                               | ** ** | **For the three months** | ** ** | **For the nine months** | ** ** |
|----------------------------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                                               | ** ** | **Ended September 30,**       | ** ** | **Ended September 30,**      | ** ** |
| ** **                                               | ** ** | **2006**                                | ** ** | **2005**                               | ** ** | **2006** | ** ** | **2005** | ** ** |
| BASIC EPS                                                |       |                                    |       |                                   |       |   |   |   |   |
| Income from  continuing operations                       |       | $                                       | 1,276,333  |                                   | $          | 707,151 |   | $ | 1,833,475 |   | $ | 1,348,853 |   |
| Income (loss)  from discontinued operations              |       | 1,114,286                               |       | (2,957                                 | )          | 1,649,137 |   | 90,535 |   |
| Net income                                               |       | $                                       | 2,390,619  |                                   | $          | 704,194 |   | $ | 3,482,612 |   | $ | 1,439,388 |   |
| Denominator:  weighted average common shares outstanding |       | 14,939,806                              |       | 14,094,690                             |       | 14,663,767 |   | 14,076,833 |   |
| Income from continuing  operations—basic            |       | $                                       | 0.09       |                                   | $          | 0.05 |   | $ | 0.13 |   | $ | 0.10 |   |
| Income from  discontinued operations—basic          |       | $                                       | 0.07       |                                   | $          | 0.00 |   | $ | 0.11 |   | $ | 0.01 |   |
| Net income per  share—basic                         |       | $                                       | 0.16       |                                   | $          | 0.05 |   | $ | 0.24 |   | $ | 0.10 |   |
|                                                     |       |                                    |       |                                   |       |   |   |   |   |
| DILUTED EPS                                              |       |                                    |       |                                   |       |   |   |   |   |
| Income from  continuing operations                       |       | $                                       | 1,276,333  |                                   | $          | 707,151 |   | $ | 1,833,475 |   | $ | 1,348,853 |   |
| Income (loss)  from discontinued operations              |       | 1,114,286                               |       | (2,957                                 | )          | 1,649,137 |   | 90,535 |   |
| Net income                                               |       | $                                       | 2,390,619  |                                   | $          | 704,194 |   | $ | 3,482,612 |   | $ | 1,439,388 |   |
| Denominator:  weighted average common shares outstanding |       | 14,939,806                              |       | 14,094,690                             |       | 14,663,767 |   | 14,076,833 |   |
| Common  equivalent shares outstanding:                   |       |                                    |       |                                   |       |   |   |   |   |
| Options                                                  |       | 1,539,306                               |       | 1,206,113                              |       | 1,765,127 |   | 993,529 |   |
| Total diluted  shares                                    |       | 16,479,112                              |       | 15,300,803                             |       | 16,428,894 |   | 15,070,362 |   |
| Income from continuing  operations—diluted          |       | $                                       | 0.08       |                                   | $          | 0.05 |   | $ | 0.11 |   | $ | 0.09 |   |
| Income from  discontinued operations—diluted        |       | $                                       | 0.07       |                                   | $          | 0.00 |   | $ | 0.10 |   | $ | 0.01 |   |
| Net income per share—diluted                        |       | $                                       | 0.15       |                                   | $          | 0.05 |   | $ | 0.21 |   | $ | 0.10 |   |

 

Therewere 1,051,859 and 898,811 potentially dilutive options outstanding for thethree months ending September 30, 2006 and 2005, respectively, and therewere 677,336 and 1,349,811 potentially dilutive options outstanding for thenine months ending September 30, 2006 and 2005, respectively, that werenot included in the table above because they would be anti-dilutive.

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

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

**8.**             **Stockholders’Equity**

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 March 25, 2005 toMarch 24, 2006 (the “2005 Repurchase Program”). The Company repurchased232,223 shares under this plan. There was no activity under the 2005 RepurchaseProgram during the first fiscal quarter of 2006, and the program expired onMarch 24, 2006.

On June 22, 2006,the Company’s Board of Directors adopted and the Company’s stockholdersapproved the 2006 Stock Incentive Plan (the “2006 Plan”), a plan for which1,500,000 shares of the Company’s common stock may be issued pursuant toAwards under the Plan provided that the Company shall not make additionalawards under the 1996 Plan. Either the Board of Directors or a committeeappointed by the Board will administer the 2006 Plan. Under the 2006 Plan, theCommittee may grant options that are intended to qualify as incentivestock options (“ISOs”). Additionally, the Committee may also grant shareappreciation rights, restricted shares, restricted share units, unrestrictedshares, deferred share units, and performance awards. The vesting period isdependent on the type of Award granted.

14

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**9.**             **DiscontinuedOperations**

*Valence*

On February 23,2006, the Board approved a plan to sell Valence in order to focus increasedmanagement attention and financial resources on its licensing business. OnJuly 14, 2006, the Company entered into a definitive Sale and PurchaseAgreement (“Purchase Agreement”) to sell Valence to Noblehigh Enterprises Inc.(“Noblehigh”). Noblehigh is owned by Willas Array Electronics (Holding) Limited(“Willas-Array”) as well as certain members of management of Valence(collectively referred to herein as the “Management Buyers”). The saletransaction was completed on September 29, 2006 and accordingly the results ofthe operations of Valence through the date of sale are included in theaccompanying condensed consolidated statements of operations and condensedconsolidates statements of cash flows for the three and nine month periodsended September 30, 2006.

The sale to Noblehigh waseffected through two simultaneous transactions: (1) the repurchase byValence of approximately 74% of the outstanding shares of Valence from SRSusing its existing cash and (2) the purchase by Noblehigh of the remainingoutstanding shares of Valence from SRS for $4.3 million. The sale resulted in again on the disposal of discontinued operations of $260,763 in the accompanyingcondensed consolidated statement of operations for the three month period endedSeptember 30, 2006. 

Additionally, the Companyrepurchased from the Management Buyers 357,625 shares of SRS common stock,which were obtained through the exercise of vested employee stock options. Suchshares were immediately canceled and are therefore not outstanding as ofSeptember 30, 2006. The repurchase price paid for such shares was equal to theaverage closing price of SRS common stock for the 7 trading days ending threedays prior to the closing date of the sale of Valence. 

*CHS/SRS LLC*

On February 23, 2006, the Board authorizedmanagement to take all reasonable steps to divest the Company’s entire equityinterest in the Joint Venture. On June 30, 2006, the Company completed the saleof its interest in the Joint Venture to Coming Home Studios, LLC (“CHS”) inexchange for $200,000, the rights to all cash assets of the joint venture, anda promissory note in the amount of $175,000. As of the close of business on June30, 2006, SRS had received $150,000 from CHS and had transferred the cashassets of the joint venture to SRS. The remaining $50,000 was received from CHSon July 5, 2006. The Company recorded a gain on disposal of its interestin the LLC of $371,295 in the Company’s second fiscal quarter of 2006. The gainon the sale is included in the accompanying condensed consolidated statement ofoperations for the nine month period ended September 30, 2006. Any amountsrelated to the promissory note will be recorded at the time the cash isreceived by SRS.

Incomefrom discontinued operations consists of direct revenues and direct expenses ofValence and CHS/SRS LLC. General corporate overhead costs have not beenallocated to discontinued operations. A summary of the operating results ofValence and the Joint Venture included in discontinued operations in theaccompanying condensed consolidated statements of operation is as follows:

|                                                      | ** ** | **For the three months  ended September 30,** | ** ** | **For the nine months  ended September 30,** | ** ** |
|------------------------------------------------------|------------|------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                                               | ** ** | **2005**                                                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Semiconductors:**                                  | ** ** | ** **                                                             | ** ** | ** **                                                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                             | ** ** | $                                                                      | 3,312,397  |                                                                  | $          | 1,929,605 |   | $ | 7,682,931 |   | $ | 6,435,342 | ** ** |
| Cost of sales                                        |       | 1,493,004                                                              |       | 753,730                                                               |       | 3,562,750 |   | 2,481,136 |   |
| Gross margin                                         |       | 1,819,393                                                              |       | 1,175,875                                                             |       | 4,120,181 |   | 3,954,206 |   |
| Total operating  expenses                            |       | 983,356                                                                |       | 1,318,696                                                             |       | 3,193,519 |   | 4,093,504 |   |
| Income (loss) from  operations                       |       | 836,037                                                                |       | (142,821                                                              | )          | 926,662 |   | (139,298 | ) |
| Other income (loss),  net                            |       | 23,806                                                                 |       | (2,512                                                                | )          | 31,669 |   | 2,102 |   |
| Income (loss) before  income tax expense             |       | 859,843                                                                |       | (145,333                                                              | )          | 958,331 |   | (137,196 | ) |
| Income tax expense  (benefit)                        |       | 2,936                                                                  |       | (120,533                                                              | )          | 33,632 |   | (114,792 | ) |
| **Net income (loss) from  semiconductors**           |       | 856,907                                                                |       | (24,800                                                               | )          | 924,699 |   | (22,404 | ) |
| **Net (loss) income from CHS/SRS  LLC**              |       | (3,384                                                                 | )          | 21,843                                                                |       | 92,380 |   | 112,939 |   |
| **Subtotal**                                         |       | 853,523                                                                |       | (2,957                                                                | )          | 1,017,079 |   | 90,535 |   |
| **Gain on Sale of Valence**                          |       | 260,763                                                                |       | —                                                                |       | 260,763 |   | — |   |
| **Gain on Sale of CHS/SRS LLC**                      |       | —                                                                 |       | —                                                                |       | 371,295 |   | — |   |
| **Total income (loss) from discontinued operations** |       | $                                                                      | 1,114,286  |                                                                  | $          | (2,957 | ) | $ | 1,649,137 |   | $ | 90,535 |   |

 

15

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Asummary of the assets and liabilities related to the discontinued operations ofValence and the Joint Venture classified as held for sale in the accompanyingcondensed consolidated balance sheet is as follows:

|                                                   | ** ** | **December 31, 2005** | ** ** |
|---------------------------------------------------|------------|---------------------------------|------------|
| ** **                                        | ** ** | ** **                      | ** ** |
| **Current  assets held for sale:**                |       |                            |       |
| Accounts receivable, net                          |       | $                               | 902,771    |   |
| Inventories, net                                  |       | 534,226                         |       |
| Prepaid expenses and other current assets         |       | 422,130                         |       |
| Total                                             |       | 1,859,127                       |       |
|                                              |       |                            |       |
| **Long  term assets held for sale:**              |       |                            |       |
| Furniture, fixtures and equipment, net       |       | 1,060,631                       |       |
| Goodwill                                          |       | 533,031                         |       |
| Intangibles, net                                  |       | 471,461                         |       |
| Total                                             |       | 2,065,123                       |       |
|                                              |       |                            |       |
| **Liabilities  related to assets held for sale:** |       |                            |       |
| Accounts payable                                  |       | 855,559                         |       |
| Accrued liabilities                               |       | 1,315,142                       |       |
| Total                                             |       | 2,170,701                       |       |
|                                                   |            |                                 |            |  |

 

**10.          SegmentInformation**

The Company previously operated in two businesssegments — semiconductors and licensing. However, as a result of selling thesemiconductor business, the Company now has continuing operations in only onebusiness segment, licensing. Our revenue from continuing operations is solelyderived from licensing related revenue.

Forthe three and nine months ending September 30, 2006, there was onecustomer that accounted for approximately 10% of revenues. In the prior year,there was no significant customer for the three months ended September 30, 2005and there was one customer that accounted for approximately 10% of licensingrevenues for the nine months ended September 30, 2005. The followingschedule presents the Company’s revenue from continuing operations bygeographic area. Licensing-related revenue is allocated based on the locationof the licensee’s corporate headquarters. The Americas region includes North,Central and South America.
| ** **                   | ** ** | **Three Months Ended  September 30,** | ** ** | ** ** | ** ** | **Nine Months Ended  September 30,** | ** ** | ** ** | ** ** |
|------------------------------|------------|------------------------------------------------------|------------|------------|------------|-----------------------------------------------------|------------|------------|------------|
| ** **                   | ** ** | **2006**                                             | ** ** | **%**      | ** ** | **2005**                                            | ** ** | **%**      | ** ** | **2006** | ** ** | **%** | ** ** | **2005** | ** ** | **%** | ** ** |
| **Geographic Area Revenue:** |       |                                                 |       |       |       |                                                |       |       |       |   |   |   |   |   |   |   |   |
|                         |       |                                                 |       |       |       |                                                |       |       |       |   |   |   |   |   |   |   |   |
| Japan                        |       | $                                                    | 1,824,612  |       | 37         |                                                | $          | 1,253,986  |       | 34 |   | $ | 5,735,707 |   | 45 |   | $ | 4,221,028 |   | 40 |   |
| Korea                        |       | 1,613,933                                            |       | 33         |       | 1,160,442                                           |       | 32         |       | 3,998,542 |   | 28 |   | 2,815,263 |   | 27 |   |
| Americas                     |       | 528,165                                              |       | 11         |       | 500,636                                             |       | 14         |       | 1,334,685 |   | 9 |   | 1,599,675 |   | 15 |   |
| China                        |       | 922,229                                              |       | 19         |       | 644,921                                             |       | 18         |       | 2,348,057 |   | 17 |   | 1,595,844 |   | 15 |   |
| Europe                       |       | 21,264                                               |       | 0          |       | 80,149                                              |       | 2          |       | 88,719 |   | 1 |   | 212,396 |   | 3 |   |
| Total                        |       | $                                                    | 4,910,203  |       | 100        |                                                | $          | 3,640,134  |       | 100 |   | $ | 13,505,710 |   | 100 |   | $ | 10,444,206 |   | 100 |   |

 

**11.**          **RecentAccounting Pronouncements**

In July 2006, theFinancial Accounting Standards Board (FASB) issued FASB InterpretationNo. (FIN) 48, **Accounting for Uncertainty in Income Taxes**.FIN 48 is an interpretation of FASB Statement No. 109, “Accounting forIncome Taxes,” and it seeks to reduce the diversity in practice associated withcertain aspects of measurement and recognition in accounting for income taxes.In addition, FIN 48 requires expanded disclosure with respect to theuncertainty in income taxes and is effective as of the beginning of our 2007fiscal year. We are currently evaluating the impact, if any, that FIN 48 willhave on our consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, *Fair Value Measurements,* or SFAS 157.SFAS 157 defines fair value, establishes a framework for measuring fair valuein generally accepted accounting principles and requires enhanced disclosuresabout fair value measurements. SFAS 157 is effective for financial statementsissued for fiscal years beginning

16

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afterNovember 15, 2007 and interim periods within those fiscal years. The Company iscurrently evaluating the impact adoption may have on the consolidated financialstatements of the Company.

**Item 2. Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

Thisinformation should be read in conjunction with the audited consolidatedfinancial statements and notes thereto and Management’s Discussion and Analysisof Financial Condition and Results of Operations contained in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2005, orthe Form 10-K, and the unaudited condensed interim consolidated financialstatements and notes thereto included in this Quarterly Report.

**Overview**

SRS Labs is a leadingdeveloper and provider of audio and voice technology solutions for the homeentertainment, portable media device, personal telecommunications, personalcomputer, automotive, and broadcast markets. Prior to September 29, 2006, theCompany was also a developer and provider of application specific integratedcircuits, or ASICs, and standard integrated circuits, or ICs, through itsformerly owned subsidiary, Valence Tech Limited.

*Licensing:****  ***ThroughSRS Labs, the parent company, and its wholly-owned subsidiary,SRSWOWcast.com, Inc., or SRSWOWcast, we develop and license audio, voiceand surround sound technology solutions to many of the world’s leading OEMs,software providers and semiconductor companies, and license and market hardwareand software products for the Internet and professional audio markets.

*Discontinued Operations:*

*Valence:  *ThroughSRS Labs, Inc.’s formerly wholly-owned subsidiary, ValenceTech Limited, weoperated a fabless semiconductor business which developed, designed andmarketed standard and custom analog ICs, digital signal processors, and mixedsignal integrated circuits primarily to original equipment manufacturers andoriginal design manufacturers, in the Asia Pacific region.

On February 23,2006, the Board approved a plan to sell Valence in order to focus increasedmanagement attention and financial resources on its licensing business. OnJuly 14, 2006, the Company entered into a definitive Sale and PurchaseAgreement (“Purchase Agreement”) to sell Valence to Noblehigh Enterprises Inc.(“Noblehigh”). Noblehigh is owned by Willas Array Electronics (Holding) Limited(“Willas-Array”) as well as certain members of management of Valence(collectively referred to herein as the “Management Buyers”). The saletransaction was completed on September 29, 2006 and accordingly the results ofthe operations of Valence through the date of sale are included in theaccompanying condensed consolidated statements of operations for the three andnine month periods ended September 30, 2006.

The sale to Noblehigh waseffected through two simultaneous transactions: (1) the repurchase by Valenceof approximately 74% of the outstanding shares of Valence from SRS using itsexisting cash and (2) the purchase by Noblehigh of the remainingoutstanding shares of Valence from SRS for $4.3 million. The sale resulted in again on the disposal of discontinued operations of $260,763 in the accompanyingcondensed consolidated statement of operations for the three and nine monthperiods ended September 30, 2006.

Additionally, the Companyrepurchased from the Management Buyers 357,625 shares of SRS common stock,which were obtained through the exercise of vested employee stock options, foran aggregate repurchase price of $2,114,586. Such shares were immediatelycanceled and are therefore not outstanding as of September 30, 2006. Therepurchase price paid for such shares was equal to the average closing price ofSRS common stock for the 7 trading days ending three days prior to the closingdate of the sale of Valence.

*CHS/SRS LLC: *In September 2004, we entered into a strategicalliance with Coming Home Studios LLC, or CHS, to use and promote SRS Labstechnologies, promote CHS productions and to promote each company’s respectivebrands. In connection with the strategic alliance, the Company and CHSestablished a joint venture, CHS/SRS, LLC, or the Joint Venture, to produce anddistribute nine concert videos featuring our Circle Surround technology, or theConcert Videos. Initially, Coming Home Studios LLC was the manager of theCHS/SRS Joint Venture; however, the Company became manager of the Joint Venturein July, 2005. As a result of becoming the manager of, and providing financialsupport to the Joint Venture, the Company was required under FASBInterpretation No. 46, Consolidation of Variable Interest Entities (FIN46R), to consolidate the financial statements of the Joint Venture into ourfinancial statements commencing with the third quarter of fiscal 2005.Previously, we accounted for our 50% equity ownership in the Joint Venture asan investment using the equity method.

17

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In February 2006, our Board of Directors, or theBoard, authorized management to take all reasonable steps to divest our entireequity interest in the Joint Venture. As a result of our decision to sell ourentire equity interest in the Joint Venture, we have accounted for the JointVenture as a discontinued operation in the accompanying condensed consolidatedfinancial statements. On June 30, 2006, the Company completed the sale ofits interest in the Joint Venture to Coming Home Studios, LLC (“CHS”) in exchangefor $200,000, the rights to all cash assets of the joint venture, and apromissory note in the amount of $175,000. As of the close of business onJune 30, 2006, SRS had received $150,000 from CHS and had transferred thecash assets of the joint venture to SRS. The remaining $50,000 was receivedfrom CHS on July 5, 2006.  TheCompany recorded a gain on disposal of its interest in the LLC of $371,295 inthe Company’s second fiscal quarter of 2006. The gain on the sale is included in the accompanying condensedconsolidated statement of operations for the nine month period endedSeptember 30, 2006. Any amounts related to the promissory note will berecorded at the time the cash is received by SRS.

**CriticalAccounting Policies**

Our discussion and analysis of our resultsof operations and liquidity and capital resources are based on our consolidatedfinancial statements which have been prepared in accordance with accountingprinciples generally accepted in the United States of America.

The preparation of thesefinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenues and expenses, anddisclosure of contingent assets and liabilities. We base our estimates onhistorical and anticipated results and trends and on various other assumptionsthat we believe are reasonable under the circumstances, including assumptionsas to future events. These estimates form the basis for making judgmentsabout the carrying value of assets and liabilities that are not readilyapparent from other sources. By their nature, estimates are subject to aninherent degree of uncertainty. Actual results may materially differ fromour estimates.

*Stock BasedCompensation*

In December 2004,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 123 (revised 2004), “Share-BasedPayment,” ** **(“SFAS 123R”). This Statement requires companies to expense theestimated fair value of stock options and similar equity instruments issued toemployees over the requisite service period. SFAS 123R eliminates thealternative to use the intrinsic method of accounting provided for inAccounting Principles Board Opinion No. 25, Accounting for Stock Issued toEmployees (“APB 25”), which generally resulted in an immaterial amount ofcompensation expense recorded in the financial statements related to the grantof stock options to employees if certain conditions were met. The pro formaimpact from recognition of the estimated fair value of stock options granted toemployees has been disclosed in our footnotes as required under previousaccounting rules.

Effective for the firstquarter of fiscal 2006, we adopted SFAS 123R using the modified prospectivemethod, which requires us to record compensation expense for all awards grantedafter the date of adoption, and for the unvested portion of previously grantedawards that remain outstanding at the date of adoption. Accordingly, priorperiod amounts presented herein have not been restated to reflect the adoptionof SFAS 123R.

The fair value conceptswere not changed significantly in SFAS 123R; however, in adopting this SFAS123R, companies must choose among alternative valuation models and amortizationassumptions. After assessing alternative valuation models and amortizationassumptions, we are continuing to use both the Black-Scholes-Merton (“BSM”)option-pricing formula and straight-line amortization of compensation expenseover the requisite service period of the grant. We will reconsider use of thismodel if additional information becomes available in the future that indicatesanother model would be more appropriate for us, or if grants issued in futureperiods have characteristics that cannot be reasonably estimated using thismodel. Under SFAS No. 123, “Accounting for Stock Based Compensation” (“SFAS123”), we were not required to estimate forfeitures in our expense calculationfor the stock compensation pro forma footnote disclosure; however, SFAS 123Rrequires an estimate of forfeitures and upon adoption we changed ourmethodology to include an estimate of forfeitures.

The following tableillustrates the effect on net income and income per share if we had applied thefair value recognition provisions of SFAS 123 as of January 1, 2005 to optionsgranted under our stock option plans. For purposes of this pro formadisclosure, the fair value of the options is estimated using a BSMoption-pricing formula and amortized on a straight-line basis to expense overthe options’ vesting period:

18

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| ** **                                                                                                                     | ** ** | ****Three Months  Ended  September 30,  2005**** | ** ** | ****Nine Months  Ended  September 30,  2005**** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
|                                                                                                                           |       |                                                       |       |                                                      |       |
| Net income - as  reported                                                                                                      |       | $                                                          | 704,194    |                                                      | $          | 1,439,388 |   |
| Add: Share-based  employee compensation expense included in net income, net of related tax  effects - as reported              |       | 4,829                                                      |       | 19,571                                                    |       |
| Deduct:  Share-based employee compensation expense determined under fair value method,  net of related tax effects - pro forma |       | (273,860                                                   | )          | (854,137                                                  | )          |
| Net income - pro  forma                                                                                                        |       | $                                                          | 435,163    |                                                      | $          | 604,822 |   |
| Basic - as  reported                                                                                                           |       | $                                                          | 0.05       |                                                      | $          | 0.10 |   |
| Basic - pro  forma                                                                                                             |       | $                                                          | 0.03       |                                                      | $          | 0.04 |   |
| Diluted - as  reported                                                                                                         |       | $                                                          | 0.05       |                                                      | $          | 0.10 |   |
| Diluted - pro forma                                                                                                            |       | $                                                          | 0.03       |                                                      | $          | 0.04 |   |

 

The fair value of each share-based award is estimatedon the grant date using the BSM option-pricing formula. Expected volatilitiesare based on the historical volatility of the Company’s stock price. Theexpected term of options granted subsequent to the adoption of SFAS 123R isderived using the simplified method as defined in the SEC’s Staff AccountingBulletin 107, “Implementation of FASB 123R.” The risk-free rate for periodswithin the contractual life of the option is based on the U.S. Treasuryinterest rates in effect at the time of grant.

Total compensation costrecognized in the three and nine months ending September 30, 2006 is asfollows:
| ** **                                                     | ** ** | **Three Months** | ** ** | **Nine Months** | ** ** |
|----------------------------------------------------------------|------------|-----------------------|------------|----------------------|------------|
| Continuing  Operations:                                        |       |                  |       |                 |       |
| Sales and Marketing                                            |       | $                     | 140,228    |                 | $          | 438,740 |   |
| Research and Development                                       |       | 67,383                |       | 269,544              |       |
| General and Administrative                                     |       | 175,793               |       | 362,520              |       |
| Total  compensation cost recognized in Continuing Operations   |       | $                     | 383,404    |                 | $          | 1,070,804 |   |
|                                                           |       |                  |       |                 |       |
| Total  compensation cost recognized in Discontinued Operations |       | $                     | —     |                 | $          | 101,143 |   |
| Total compensation cost  recognized                            |       | $                     | 383,404    |                 | $          | 1,171,947 |   |

 

**Results ofContinuing Operations**

**Three Months EndedSeptember 30, 2006 Compared to Three Months Ended September 30, 2005**

*Revenues*

Licensingrevenues consist primarily of royalties generated from the license of SRS Labs’audio and voice technologies. License and royalty agreements generally providefor the license of technologies for a fee based on the number of unitsdistributed 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 nominal revenues generated from the sale of hardware and softwareapplications.

Licensingrevenues were $4,910,203 for the three months ended September 30, 2006,compared to $3,640,134 for the three months ended September 30, 2005, anincrease of $1,270,069 or 34.9%. The sales growth in licensing was primarilyattributable to continued strong sales in the Home Entertainment and Automotivesegments. Within the Home Entertainment segment, revenue growth is due toincreased licensing fees related to flat panel monitors and televisions.  We continue to benefit from increased salesof such products by our larger OEM customers.

Also attributable to thegrowth in Home Entertainment segment revenue was royalty recoveries ofapproximately $250,000 from intellectual property compliance activities.  These activities, which include audits ofshipments by certain of our licensees, resulted in additional royalty paymentsdue to the Company.

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The followingtable presents the Company’s licensing revenues mix by market segment:
|                                                           | ** ** | **Three Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| Home  Entertainment (TV, Set Top Box, A/V Receiver, DVD)  |       | 66                                                   | %          | 48 | % |
| Portable Media  Devices (Digital Media Player, Headphone) |       | 15                                                   | %          | 29 | % |
| Personal  Telecommunications (Mobile phone, PDA)          |       | 5                                                    | %          | 11 | % |
| PC (Software,  Hardware)                                  |       | 9                                                    | %          | 9 | % |
| Automotive                                                |       | 5                                                    | %          | 3 | % |

 

*Sales and Marketing*

Sales and marketingexpenses consist primarily of employee salaries, sales consultants’ fees andrelated expenses, sales commissions and product promotion costs. Sales andmarketing expenses were $1,743,660 for the three months endedSeptember 30, 2006, compared to $1,087,025 for the same prior year period,an increase of $656,635 or 60.4 %. This increase is primarily attributable toincreased sales headcount in overseas markets, increased training activitiesand increased sales and marketing personnel. In addition, the increase is attributable to $140,228 in stock optionexpense that was recognized due to the adoption of FAS 123R in the currentfiscal year. As a percentage of total revenues, sales and marketing expenses increasedfrom 29.9% for the quarter ended September 30, 2005 to****35.5%for the same period this year.

*Research and Development*

Research and developmentexpenses consist of salaries and related costs of employees engaged in ongoingresearch, design and development activities and costs for engineering materialsand supplies. Research and development expenses were $628,227 for the threemonths ended September 30, 2006, compared to $584,008 for the same prioryear period, an increase of $44,219 or 7.6%. This increase is primarilyattributable to $67,383 in stock option expense that was recognized due to theadoption of FAS 123R in the current fiscal year.  As a percentage of total revenues, researchand development expenses were 16.0% for the quarter ended September 30,2005, and 12.8% for the same period this year.

*General and Administrative*

General andadministrative (“G&A”) expenses consist primarily of employee-relatedexpenses, legal costs associated with the administration of intellectualproperty and other professional fees. G&A expenses were $1,277,601 for thethree months ended September 30, 2006, compared to $1,198,433 or the sameprior year period, an increase of $79,168 or 6.6%. The increase is primarilyattributable to the Company recognizing $175,793 in stock option expense due tothe adoption of FAS 123R in the current fiscal year, partially offset byreduced legal and accounting expenditures. As a percentage of total revenues,G&A expenses decreased from 32.9% for the quarter ended September 30,2005, to 26.0% for the sameperiod this year.

*Other Income, Net*

Other income, net,consists primarily of interest income. Other income, net, was $291,236 for thethree months ended September 30, 2006, compared to $176,707 for the sameprior year period, an increase of $114,529 or 64.8%. This increase is primarilyattributable to higher interest income on larger cash balances invested athigher rates of interest.

*Provision for Income Taxes*

The income tax expense for the three months endedSeptember 30, 2006 was $231,620, compared to tax expense of $200,420 forthe same prior year period. This provision consists primarily of taxes paid onlicensing revenues sourced from countries requiring foreign tax withholdings,principally Korea and Taiwan.

*DiscontinuedOperations*

As a result of our decision to sell Valence and ourentire equity interest in the Joint Venture, we have accounted for thesemiconductor business segment and the Joint Venture as discontinuedoperations. All prior periods have been reclassified to conform to thecurrent period presentation.

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Income fromdiscontinued operations consists of direct revenues and direct expenses ofValence and CHS/SRS LLC. General corporate overhead costs have not beenallocated to discontinued operations. A summary of the operating results ofValence and the Joint Venture included in discontinued operations in theaccompanying condensed consolidated statements of operation is as follows:
|                                                       | ** ** | **For the three months  ended September 30,** | ** ** |
|-------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                            | ** ** | **2006**                                                               | ** ** | **2005** | ** ** |
| **Semiconductors:**                                   | ** ** | ** **                                                             | ** ** | ** ** | ** ** |
| Revenues                                              |       | $                                                                      | 3,312,397  |   | $ | 1,929,605 |   |
| Cost of sales                                         |       | 1,493,004                                                              |       | 753,730 |   |
| Gross margin                                          |       | 1,819,393                                                              |       | 1,175,875 |   |
| Total operating expenses                              |       | 983,356                                                                |       | 1,318,696 |   |
| Income (loss)  from operations                        |       | 836,037                                                                |       | (142,821 | ) |
| Other income  (expense), net                          |       | 23,806                                                                 |       | (2,512 | ) |
| Income (loss)  before income tax expense              |       | 859,843                                                                |       | (145,333 | ) |
| Income tax  expense (benefit)                         |       | 2,936                                                                  |       | (120,533 | ) |
| **Net  income (loss) from semiconductors**            |       | 856,907                                                                |       | (24,800 | ) |
| **Net  (loss) income from CHS/SRS LLC**               |       | (3,384                                                                 | )          | 21,843 |   |
| **Subtotal**                                          |       | 853,523                                                                |       | (2,957 | ) |
| **Gain on  Sale of Valence**                          |       | 260,763                                                                |       | — |   |
| **Total income (loss) from  discontinued operations** |       | $                                                                      | 1,114,286  |   | $ | (2,957 | ) |

 

Semiconductor revenues were $3,312,397, in the periodJuly 1, 2006 through September 29, 2006 compared to $1,929,605 in the threemonths ended September 30, 2005, an increase of $1,382,792 or 71.7%. ASPrevenues increased $1,112,540 due to the introduction of one new ASP chip andincreased sales of chips that include SRS audio technology. ASIC revenuesincreased $270,252, due to an increase in ASIC product demand specificallyrelated to the introduction of three new chips. Gross margin decreased from 61%to 55% in the quarters ended September 30, 2005 and 2006, respectively,due to an increase in lower margin ASP sales as a percentage of total sales.Operating expenses decreased $335,340 primarily due to decreased head count andrelated expenses and the discontinuation of depreciation in accordance with FAS144. Other income (expense), net and income tax expense were comparable withthe prior period.

**Nine Months EndedSeptember 30, 2006 Compared to Nine Months Ended September 30, 2005**

*Revenues*

Licensing revenueswere $13,505,710 for the nine months ended September 30, 2006, compared to$10,444,206 for the nine months ended September 30, 2005, an increase of$3,061,504 or 29.3%. The sales growth in licensing was attributable to ourcontinued strong sales in all five of our market segments with four of the fivesegments achieving year over year growth. The Home Entertainment segment continuesto grow in total revenues due to increases in Advanced Display revenues,partially offset by a decrease in Set Top Box and CRT revenues. The followingtable presents the Company’s licensing revenues mix by market segment:
|                                                           | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
| Home  Entertainment (TV, Set Top Box, A/V Receiver, DVD)  |       | 58                                                      | %          | 53 | % |
| Portable Media  Devices (Digital Media Player, Headphone) |       | 18                                                      | %          | 22 | % |
| Personal  Telecommunications (Mobile phone, PDA)          |       | 9                                                       | %          | 12 | % |
| PC (Software,  Hardware)                                  |       | 9                                                       | %          | 10 | % |
| Automotive                                                |       | 6                                                       | %          | 3 | % |

 

*Sales and Marketing*

Sales and marketing expenses consist primarily ofemployee salaries, sales consultants’ fees and related expenses, salescommissions and product promotion costs. Sales and marketing expenses were$5,494,445 for the nine months ended September 30, 2006, compared to$3,295,949 for the same prior year period, an increase of $2,198,496 or 66.7%.This increase is primarily attributable to increased headcount and relatedexpenses, increased commissions on higher revenues, increased trainingactivities, and increased marketing activities related to efforts to enhancethe Company’s brand.  Additionally, theCompany recorded $438,740 in stock option expense that was recognized due tothe adoption of FAS 123R in the current fiscal year. As a percentage of totalrevenues, sales and marketing expenses increased from 31.6% for the nine monthsended September 30, 2005 to****40.7% for the same period this year.

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*Research andDevelopment*

Research and development expenses consist of salariesand related costs of employees engaged in ongoing research, design anddevelopment activities and costs for engineering materials and supplies.Research and development expenses were $1,914,255 for the nine months ended September 30,2006, compared to $1,708,000 for the same prior year period, an increase of$206,255 or 12.1%. This increase is primarily attributable to $269,544 in stockoption expense that was recognized due to the adoption of FAS 123R in the currentfiscal year, offset by decreased head count and related expenses.  As a percentage of total revenues, researchand development expenses were 16.4% for the nine months endedSeptember 30, 2005, and 14.2% for the same period this year.

*General andAdministrative*

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 $4,272,598 for the nine months ended September 30, 2006,compared to $3,898,785 for the same prior year period, an increase of $373,813or 9.6%. This increase is primarily attributable to increased professionalfees, costs associated with the Company’s separation from its former ChiefFinancial Officer and consulting agreements related to human resourcesactivities. In addition, the increase is attributable to $362,520 in stockoption expense that was recognized due to the adoption of FAS 123R in thecurrent fiscal year. As a percentage of total revenues, G&A expensesdecreased from 37.3% for the nine months ended September 30, 2005, to 31.6% for the same period this year.

*Other Income, Net*

Other income, net, consists primarily of interestincome. Other income, net, was $694,954 for the nine months endedSeptember 30, 2006, compared to $486,318 for the same prior year period,an increase of $208,636 or 42.9%. This increase is primarily attributable tohigher interest income on larger cash balances invested.

*Provision forIncome Taxes*

The income tax expense for the nine months endedSeptember 30, 2006 was $558,788, compared to tax expense of $487,950 forthe same prior year period, an increase of $70,838 or 14.5%. This provisionconsists primarily of taxes paid on licensing revenues sourced from countriesrequiring foreign tax withholdings, principally Korea and Taiwan.

*DiscontinuedOperations*

As a result of our decision to sell Valence and ourentire equity interest in the Joint Venture, we have accounted for thesemiconductor business segment and the Joint Venture as discontinuedoperations. All prior periods have been reclassified to conform to thecurrent period presentation.

Income fromdiscontinued operations consists of direct revenues and direct expenses ofValence and CHS/SRS LLC. General corporate overhead costs have not beenallocated to discontinued operations. A summary of the operating results ofValence and the Joint Venture included in discontinued operations in theaccompanying condensed consolidated statements of operation is as follows:
|                                                | ** ** | **For the nine months  ended September 30,** | ** ** |
|------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                     | ** ** | **2006**                                                              | ** ** | **2005** | ** ** |
| **Semiconductors:**                            | ** ** | ** **                                                            | ** ** | ** ** | ** ** |
| Revenues                                       |       | $                                                                     | 7,682,931  |   | $ | 6,435,342 |   |
| Cost of sales                                  |       | 3,562,750                                                             |       | 2,481,136 |   |
| Gross margin                                   |       | 4,120,181                                                             |       | 3,954,206 |   |
| Total operating expenses                       |       | 3,193,519                                                             |       | 4,093,504 |   |
| Income (loss)  from operations                 |       | 926,662                                                               |       | (139,298 | ) |
| Other income,  net                             |       | 31,669                                                                |       | 2,102 |   |
| Income (loss)  before income tax expense       |       | 958,331                                                               |       | (137,196 | ) |
| Income tax  expense (benefit)                  |       | 33,632                                                                |       | (114,792 | ) |
| **Net  income (loss) from semiconductors**     |       | 924,699                                                               |       | (22,404 | ) |
| **Net  income from CHS/SRS LLC**               |       | 92,380                                                                |       | 112,939 |   |
| **Subtotal**                                   |       | 1,017,079                                                             |       | 90,535 |   |
| **Gain on  Sale of Valence**                   |       | 260,763                                                               |       | — |   |
| **Gain on  Sale of CHS/SRS LLC**               |       | 371,295                                                               |       | — |   |
| **Total income from discontinued  operations** |       | $                                                                     | 1,649,137  |   | $ | 90,535 |   |

 

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Semiconductor revenues were $7,682,931 for the ninemonths ended September 30, 2006 compared to $6,435,342 for the nine monthsended September 30, 2005, an increase of $1,247,589 or 19.4%. ASP revenuesincreased $1,960,888 due to the introduction of several new ASP chips andhigher demand for ASP chips that include SRS audio technology. The increase inASP revenues was offset by a decrease in ASIC revenues of $713,299. Thisdecrease was due to a decline in ASIC product demand by one specific customerdue to a decrease in demand of the customer’s products and also end of lifeissues at another customer. Gross margin decreased from 61% to 54% in the ninemonths ended September 30, 2005 and 2006, respectively, due to an increasein sales of lower margin ASP sales and the write down of certain slow movinginventory. Operating expenses decreased $899,985 or 22.0% primarily due todecreased head count and related expenses, and the discontinuation ofdepreciation in accordance with FAS 144. Other income, net and income taxexpense were materially consistent with the prior period. Net income fromCHS/SRS LLC was comparable to the prior period. The Company recognized a gainon the sale of its interest in Valence and CHS/SRS LLC of $260,763 and$371,295, respectively, in the nine months ended September 30, 2006.

**Liquidity andCapital Resources**

The Company’sprincipal source of liquidity to fund ongoing operations at September 30,2006 consisted of cash, cash equivalents and long-term investments of$33,331,489. At September 30, 2006, the Company had cash and cashequivalents and short term investments of $28,120,194 and long-term investments of $5,211,295. Cash and cash equivalents generally consist of cash,money market funds and other money market instruments with original maturitiesof three months or less. Investments consist of U.S. government securitiesrated AAA.

Net cashprovided by operating activities was $2,044,316 and $2,269,843 during the ninemonths ended September 30, 2006 and September 30, 2005, respectively.The decrease in our operating cash flows in 2006 is primarily the result of ouraccounts receivable increasing $401,462 during the nine months ended September30, 2006 due to the increase in revenues and due to timing of billing and cashreceipts.  Accrued liabilities increased$312,031 and $966,741 during the nine months ended September 30, 2006 and2005, respectively. The changes in liability accounts generally relate toincreases in professional fees, commissions and bonus and the timing ofpayments to vendors and employees.

Our net cash provided by investing activities was $13,836,919 for the nine months ended September 30, 2006 and our net cash used in investing activities from continuing operations was $1,106,542 during the nine months ended September 30, 2005. The increase in the net cash used in investing activities is primarily due to the Company receiving proceeds of $9,993,748 from the sale of its available for sale investment in fiscal 2006.  In addition, the Company sold Valence and its equity interest in CHS/SRS LLC in the current fiscal year for cash consideration of $4,300,000 and $371,295, respectively.

Our net cash provided by financing activities was $1,493,341 during the nine months ended September 30, 2006 and our net cash used in financing activities from continuing operations was $354,880 during the nine months ended September 30, 2005. The increase in net cash provided by financing activities for the nine months ended September 30, 2006 was attributable to an increase in stock option exercises, specifically due to Management Buyers exercising 357,625 vested stock options as part of the Valence transaction.  After Management Buyers exercised their stock options, the Company repurchased the 357,625 shares for $2,114,586 and immediately canceled the shares.

Our net cash used by operating activities from discontinued operations was $1,922,668 and $1,172,702 during the nine months ended September 30, 2006 and September 30, 2005, respectively.  Additionally, the net cash used in investing activities of discontinued operations was $180,216 and $78,546 during the nine months ended September 30, 2006 and September 30, 2005, respectively.  Since the discontinued operations were sold in the nine months ended September 30, 2006, we do not estimate at this time any future cash expenditures that the Company will incur related to the discontinued operations.

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

Based on current plans and business conditions, theCompany expects that its cash, cash equivalents and investments together withany amounts generated from operations will be sufficient to meet the Company’scash requirements for the next twelve months. However, there can be noassurance that the Company will not be required to seek other financing sooneror that such financing, if required, will be available on terms satisfactory tothe Company.

Our operations and financial results are subject tovarious risks and uncertainties that could adversely affect our business,financial condition and results of operations and the trading price of ourcommon stock. Please refer to Part II, Item 1A, “Risk Factors” for informationconcerning these and other uncertainties that could negatively impact theCompany.

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

There have been no material changes to the informationcalled for by this Item 3 from the disclosures set forth in Part II, Item7A in the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2005.

**Item 4. Controlsand Procedures**

*Evaluationof Disclosure Controls and Procedures.**  *Our Chief Executive Officer andPresident and our Chief Financial Officer have evaluated the effectiveness ofour disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15 (e) under the Securities Exchange Act of 1934, asamended) as of the end of the period covered by this Quarterly Report onForm 10-Q and, based on this evaluation, have concluded that ourdisclosure controls and procedures are effective.

*Changesin Internal Controls.**  *Therehave been no changes in our internal controls over financial reporting thatoccurred during our third quarter ended September 30, 2006 that havematerially affected, or are reasonably likely to materially affect, ourinternal controls over financial reporting.

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**PART II -OTHER INFORMATION**

**Item 1.A. RiskFactors**

*We are exposed torisks in our licensing business related to product and customer concentration.*

Currently, ourlicensing revenue is concentrated in the home theater market with the majorityof revenue generated from the inclusion of SRS technology inside televisionsand monitors. We expect that the consumer home entertainment market willcontinue to account for a significant portion of our licensing revenues for theforeseeable future. While consumer spending in general on consumer electronicproducts has increased, retail prices for certain consumer electronics productsthat include our audio technology have historically decreased over time.Indications are that this trend will continue for the foreseeable future. Fromtime to time, certain of our OEM and semiconductor manufacturer customers mayaccount for a significant portion of revenue from a particular productapplication. Consumer electronics products manufacturers could decide to excludeour audio rendering technology from their home theater products altogether inan effort to reduce cost. The loss of any such customer could have a materialadverse affect on our financial condition and results of operations.

*Ourbusiness is highly dependent on the consumer electronics market, which ischaracterized by short product life cycles, fluctuations in demand andseasonality, and is subject to risks related to product transitions and supplyof other components.*

The consumerelectronics market is characterized by intense competition, rapidly evolvingtechnology, and ever-changing consumer preferences. These factors result in thefrequent introduction of new products, short product life cycles andsignificant price competition. The dynamic nature of this market limits our, aswell as our customers’ ability to accurately forecast quarterly and annualsales. If we, or our customers, are unable to manage product transitions, ourbusiness and results of operations could be negatively affected.

*Pricingpressures on the consumer electronics product manufacturers, who incorporateour technologies into their products, could limit the licensing fees we chargefor our technologies, which could adversely affect our revenues.*

The markets forthe consumer electronics products in which our technologies are incorporatedare intensely competitive and price sensitive. Retail prices for consumerelectronics products have historically decreased over time, and we expectprices to continue to decrease for the foreseeable future. In response,manufacturers have sought to reduce their product costs, which can result indownward pressure on the licensing fees we charge our customers who incorporateour technologies. A decline in the licensing fees we charge could materially andadversely affect our operating results. Additionally, in order to reduce costs, manufacturers may develop theirown technologies and include them in their products, thereby eliminating theneed for our technologies.

*Weconduct operations in a number of countries and are subject to risks ofinternational operations, particularly in Asia and the People’s Republic of China.*

We havesignificant operations in Hong Kong, the People’s Republic of China (PRC) andother parts of Asia that require refinement to adapt to the changing marketconditions in those regions. Our operations in Asia and internationaloperations in general, are subject to risks of unexpected changes in, orimpositions of, legislative or regulatory requirements.

Our customersgeographically located in the Asia Pacific markets accounted for approximately89%, 86%, and 91% of total Company sales in 2005, 2004 and 2003, respectivelyand are expected to continue to account for a substantial percentage of salesin the future. The economic climate in Asia continues to be impacted byincreases in unemployment, declines in consumer spending, currency devaluationand bank failures. Any of these factors, should they continue, couldsignificantly reduce the demand for the end user goods in which our productsand technologies are used.

The PRC economyhas experienced significant growth in the past decade; but such growth has beenuneven across geographic and economic sectors. There can be no assurance thatsuch growth will continue or that any potential currency devaluation in theregion will not have a negative effect on our business, including Valence. ThePRC economy has also experienced deflation in the past, which may continue inthe future. The current economic situation may adversely affect our profitabilityover time as expenditures for consumer electronics products and informationtechnology may decrease due to the results of slowing domestic demand anddeflation.

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Hong Kong is a Special Administrative Region of thePRC with its own government and legislature. Hong Kong enjoys a high degree ofautonomy from the PRC under the principle of “one country, two systems.” It ispossible that Hong Kong may not continue to enjoy autonomy from the PRC.

The Hong Kongdollar has remained relatively constant due to the U.S. dollar peg and currencyboard system that has been in effect in Hong Kong since 1983. Since mid-1997,interest rates in Hong Kong have fluctuated significantly and real estate andretail sales have declined. It is possible that the Hong Kong economy maydeteriorate or that the historical currency peg of the Hong Kong dollar to theU.S. dollar may not be maintained. Continued declining consumer spending inHong Kong, deflation or the discontinuation of the currency peg could adverselyaffect our business.

*Ourability to generate revenues and meet with customers may be effected bywidespread illness*

Widespreadillnesses such as the SARS illness and the Avian Influenza, or Asia Bird Flu,could impact our operations or our consumer electronics licensee’s operations.For example, our ability to visit our customers, our ability to conduct salesmeetings or presentations, and sell through rates of electronics products toend consumers may be dramatically effected by either widespread or perceivedpotential illnesses.

*If thesale of consumer electronics products incorporating our technologies does notgrow in emerging markets, our ability to increase our licensing revenue may belimited.*

We also expectthat growth in our licensing revenue will depend, in part, upon the growth ofsales of consumer electronics products incorporating our technologies in othercountries, including China and India, as consumers in these markets have moredisposable income and are increasingly purchasing entertainment products with surroundsound capabilities. However, if our licensing revenue from the use of ourtechnologies in these new markets or geographic areas does not expand, ourprospects could be adversely affected.

*We have along and unpredictable sales cycle, which can result in uncertainty and delaysin generating additional revenues.*

Historically,because of the complexity of our technologies, it can take a significant amountof time and effort to explain the benefits of our technologies and to negotiatea sale. For example, it typically takes six to nine months after our firstcontact with a prospective customer before we start licensing our technology tothat customer. In addition, purchases of our products are usually made inconnection with new design starts, the timing of which is outside of ourcontrol. Accordingly, we may be unable to predict accurately the timing of anysignificant future sales of our products. We may also spend substantial timeand management attention on potential license agreements that are not consummated,thereby foregoing other opportunities.

*If ourpatents and other intellectual property rights do not adequately protect ourproducts, we may lose market share to our competitors and be unable to operateour business profitably.*

Our ability to competemay be affected by our ability to protect our proprietary information. We havefiled numerous U.S. and foreign patent applications and to date have a numberof issued U.S. and foreign patents covering various aspects of ourtechnologies. There can be no assurance that the steps taken by us to protectour intellectual property will be adequate to prevent misappropriation of ourtechnology or that our competitors will not independently develop technologiesthat are substantially equivalent or superior to our technology. In addition,the laws of certain foreign countries may not protect our intellectual propertyrights to the same extent, as do the laws of the U.S. It is possible that thirdparties may assert claims or initiate litigation against us or our customerswith respect to existing or future products. In addition, we may initiateclaims or litigation against third parties for infringement of our proprietaryrights or to determine the scope and validity of our proprietary rights.

*If welose the services of our key personnel, or if we are unable to attract andretain other key personnel, we may not be able to manage our operations or meetour growth objectives.*

Our future successdepends to a large extent upon the continued service of key personnel, includingengineering, sales and marketing staff, and international salesconsultants.   We anticipate that anyfuture growth will require us to recruit and hire a number of new personnel inengineering, operations, finance, sales and marketing. Competition for suchpersonnel can be intense, and it is possible that we may not be able to recruitand retain necessary personnel to operate our business and support futuregrowth.

*Themarket price of our common stock is volatile and your investment in our common stockcould suffer a decline in value.*

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The trading price of our common stock has been, andwill likely continue to be, subject to wide fluctuations in response toquarterly variations in our operating results, announcements of new products ortechnological innovations by us or our competitors, strategic alliances betweenus and third parties, general market fluctuations and other events and factors.Changes in earnings estimates made by brokerage firms and industry analystsrelating to the markets in which we do business, or relating to usspecifically, have in the past resulted in, and could in the future result in,an immediate and adverse effect on the market price of the common stock. Eventhough our stock is quoted on the NASDAQ Stock Market, our stock has had andmay continue to have low trading volume and high volatility. The historicallylow trading volume of our stock makes it more likely that a severe fluctuationin volume, either up or down, will significantly impact the stock price. Sinceour shares are thinly traded, our shareholders may have difficulty selling ourcommon stock.

*Ourcertificate of incorporation and bylaws as well as Delaware law containprovisions that could discourage transactions resulting in a change in control,which may negatively affect the market price of our common stock.*

Our certificate ofincorporation, our bylaws and Delaware law contain provisions that might enableour management to discourage, delay or prevent change in control. In addition,these provisions could limit the price that investors would be willing to payin the future for shares of our common stock.

*We faceintense competition from companies with greater brand recognition andresources.*

The digital audio,consumer electronics, and entertainment markets are intensely competitive,subject to rapid change, and significantly affected by new productintroductions and other market activities of industry participants

Many of our current and potential competitors enjoysubstantial competitive advantages, including:

·  greater name recognition;

·  a longer operating history;

·  more developed distribution channels anddeeper relationships with semiconductor and consumer electronics productsmanufacturers;

·  a more extensive customer base;

·  broader product and service offerings;

·  greater resources for competitive activities,such as research and development, strategic acquisitions, alliances, jointventures, sales and marketing, and lobbying industry and government standards;and

·  more technicians and engineers.

As a result, thesecurrent and potential competitors may be able to respond more quickly andeffectively than we can to new or changing opportunities, technologies,standards, or customer requirements.

**Item 2.Unregistered Sales of Equity Securities and Use of Proceeds.**

Therewere no sales of unregistered securities by us during the three months endedSeptember 30, 2006.

Inconnection with the closing of the sale of Valence, we repurchased 357,625shares of SRS common stock from certain employees of Valence for a repurchaseprice of approximately $5.91 per share or an aggregate of $2,114,586.  This repurchase of shares was not conductedpursuant to a publicly announced repurchase program.

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**Item 6. Exhibits**

The exhibits listed below are hereby filed with theU.S. Securities and Exchange Commission (the “SEC”) as part of thisReport.
| Exhibit  Number |   | **Description**                                                                                                                                                                                                                                                                                                                                                                                                              |
|-----------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1             |   | Certificate of Incorporation of the Company,  previously filed with the SEC as Exhibit 3.1 to the Company’s Registration  Statement on Form SB-2, specifically included in Amendment No. 1 to  such Registration Statement filed with the SEC on July 3, 1996 (File  No. 333-4974-LA), which is incorporated herein by reference.                                                              |
| 3.2             |   | Bylaws of the Company, previously filed with the SEC  as Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q for  the period ended September 30, 1999, filed with the SEC on  November 12, 1999, which is incorporated herein by reference.                                                                                                                                                  |
| 10.1            |   | Separation Agreement and General Release dated July  12, 2006 between SRS Labs, Inc and David Frerichs, previously filed as  Exhibit 10.1 to the Company’s Form 8-K filed with the Securities and Exchange  Commission on July 12, 2006, which is incorporated herein by reference.                                                                                                                                     |
| 10.2            |   | Sale and Purchase Agreement Relating to Ordinary  Shares in the Issued Share Capital of Valence Technology Limited dated July  14, 2006 between SRS Labs, Inc. and Noblehigh Enterprises, Inc. and  Willas-Array Electronic (Holdings) Ltd, previously, filed as Exhibit 2.1 to  the Company’s Form 8-K filed with the Securities and Exchange Commission on  July 14, 2006, which is incorporated herein by reference. |
| 10.3            |   | Deed of Indemnity between SRS Labs, Inc. and  Noblehigh Enterprises, Inc., filed as Exhibit 2.2 to the Company’s Form 8-K  filed with the Securities and Exchange Commission on July 14, 2006, which is  incorporated herein by reference.                                                                                                                                                                              |
| 31.1            |   | Certification of Chief Executive Officer of SRS  Labs, Inc., pursuant to Rule 13a-14 of the Securities Exchange Act.                                                                                                                                                                                                                                                                                               |
| 31.2            |   | Certification of Chief Financial Officer of SRS  Labs, Inc., pursuant to Rule 13a-14 of the Securities Exchange Act.                                                                                                                                                                                                                                                                                               |
| 32.1            |   | Certification of Chief Executive Officer of SRS  Labs, Inc., pursuant to Section 906 of the Sarbanes-Oxley Act of  2002.                                                                                                                                                                                                                                                                                           |
| 32.2            |   | Certification of Chief Financial Officer of SRS  Labs, Inc., pursuant to Section 906 of the Sarbanes-Oxley Act of  2002.                                                                                                                                                                                                                                                                                           |

 

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**SIGNATURES**

Pursuant to the requirementsof the Securities Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.
|                                         | SRS LABS, INC., a Delaware corporation |
|-----------------------------------------|---------------------------------------------|
|                                    |                                        |   |
| Date:  November 7,  2006 | By:                                         | /S/ THOMAS C.K.  YUEN |
|                                    |                                        | Thomas C.K. Yuen |
|                                    |                                        | Chairman of the Board and Chief Executive Officer |
|                                    |                                        | (Principal Executive Officer) |
| ** **                              | ** **                                  | ** ** |
| ** **                              | ** **                                  | ** ** |
| Date:   November 7, 2006           | By:                                         | /S/ ULRICH  GOTTSCHLING |
|                                    |                                        | Ulrich Gottschling |
|                                    |                                        | Chief Financial Officer |
|                                    |                                        | (Principal Financial and Accounting Officer) |

 

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**EXHIBIT INDEX**

The exhibitslisted below are hereby filed with the SEC as part of this Report.
| Exhibit  Number |   | **Description**                                                                                                                                                                                                                                                                                                                                                                                                              |
|-----------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1             |   | Certificate of Incorporation of the Company,  previously filed with the SEC as Exhibit 3.1 to the Company’s  Registration Statement on Form SB-2, specifically included in Amendment  No. 1 to such Registration Statement filed with the SEC on July 3,  1996 (File No. 333-4974-LA), which is incorporated herein by reference.                                                              |
| 3.2             |   | Bylaws of the Company, previously filed with the SEC  as Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q for  the period ended September 30, 1999, filed with the SEC on  November 12, 1999, which is incorporated herein by reference.                                                                                                                                                  |
| 10.1            |   | Separation Agreement and General Release dated July  12, 2006 between SRS Labs, Inc and David Frerichs, previously filed as  Exhibit 10.1 to the Company’s Form 8-K filed with the Securities and Exchange  Commission on July 12, 2006, which is incorporated herein by reference.                                                                                                                                     |
| 10.2            |   | Sale and Purchase Agreement Relating to Ordinary  Shares in the Issued Share Capital of Valence Technology Limited dated July  14, 2006 between SRS Labs, Inc. and Noblehigh Enterprises, Inc. and  Willas-Array Electronic (Holdings) Ltd, previously, filed as Exhibit 2.1 to  the Company’s Form 8-K filed with the Securities and Exchange Commission on  July 14, 2006, which is incorporated herein by reference. |
| 10.3            |   | Deed of Indemnity between SRS Labs, Inc. and  Noblehigh Enterprises, Inc., filed as Exhibit 2.2 to the Company’s Form 8-K  filed with the Securities and Exchange Commission on July 14, 2006, 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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