**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

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| **(Mark One)**                                                                                                                                        |       |                                                                                                |
|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|
| **ý**                                                                                                                                            | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE  SECURITIES EXCHANGE ACT OF 1934**  |
| ** **                                                                                                                                            | ** ** | ** **                                                                                          |
| **For the quarterly period ended June 30, 2004**                                                                                                 |
| ** **                                                                                                                                            |
| **OR**                                                                                                                                                |
| ** **                                                                                                                                            |
| **o**                                                                                                                                                 | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE  SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                            | ** ** | ** **                                                                                          |
| **For the transition period from            to           ** |
| ** **                                                                                                                                            | ** ** | ** **                                                                                          |
| **Commission File Number 0-21123**                                                                                                                    |
|                                                                                                                                                       |            |                                                                                                     |  |

 

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

 

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Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.  Yes ý  No o

 

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

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date: as of July 19, 2004, 14,438,747shares of the issuer’s common stock, par value $.001 per share, wereoutstanding. In addition, as of July 19, 2004, 225,300 shares of theissuer’s common stock were held as treasury shares.

 

 

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**SRS LABS, INC.**

 

**Form 10-Q**

**For the Period Ended June 30, 2004**

 

**Index**

 
| **PART I—FINANCIAL  INFORMATION** |                                                                                                                                              |
|----------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------|
| Item 1.                                | Financial Statements                                                                                                                              |   |
|                                   | Condensed  Consolidated Balance Sheets as of June 30, 2004 (Unaudited) and  December 31, 2003                                           |   |
|                                   | Condensed  Consolidated Statements of Operations for the three months and six months  ended June 30, 2004 and 2003 (Unaudited)               |   |
|                                   | Condensed  Consolidated Statements of Stockholders’ Equity and Comprehensive Income for  the six months ended June 30, 2004 (Unaudited) |   |
|                                   | Condensed  Consolidated Statements of Cash Flows for the six months ended June 30,  2004 and 2003 (Unaudited)                                |   |
|                                   | Notes  to the Condensed Interim Consolidated Financial Statements (Unaudited)                                                                     |   |
| Item  2.                               | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                       |   |
| Item  3.                               | Quantitative  and Qualitative Disclosures About Market Risk                                                                                       |   |
| Item 4.                                | Controls and  Procedures                                                                                                                          |   |
| **PART II—OTHER INFORMATION**     |                                                                                                                                              |
| Item  4                                | Submission  of Matters to a Vote of Security Holders                                                                                              |   |
| Item 6.                                | Exhibits  and Reports on Form 8-K                                                                                                            |   |
|                                   |                                                                                                                                              |   |
| SIGNATURES                             |                                                                                                                                              |
| CERTIFICATIONS                         |                                                                                                                                              |

 

2

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**FORWARD-LOOKING INFORMATION**

 

ThisQuarterly Report on Form 10-Q contains forward-looking statements withinthe meaning of Section 21E of the Securities Exchange Act of 1934, asamended, and Section 27A of the Securities Act of 1933, as amended,reflecting management’s current expectations. Examples of such forward-lookingstatements include the expectations of the Company with respect to itsstrategy. Although the Company believes that its expectations are based uponreasonable assumptions, there can be no assurances that the Company’s financialgoals will be realized. Such forward-looking statements involve known and unknownrisks, uncertainties and other factors that may cause the actual results,performance or achievements of the Company, or industry results, to bematerially different from any future results, performance or achievementsexpressed or implied by such forward-looking statements. Numerous factors mayaffect the Company’s actual results and may cause results to differ materiallyfrom those expressed in forward-looking statements made by or on behalf of theCompany. For this purpose, any statements contained herein that are notstatements of historical fact may be deemed to be forward-looking statements.Without limiting the foregoing, the words, “believes,” “anticipates,” “plans,”“expects” and similar expressions, are intended to identify forward-lookingstatements. The important factors discussed in Part I, Item 2,“Management’s Discussion and Analysis of Financial Condition and Results ofOperations—Factors That May Affect Future Results”, herein, among others, couldcause actual results to differ materially from those indicated byforward-looking statements made herein and presented elsewhere by management.Such forward-looking statements represent management’s current expectations andare inherently uncertain. Investors are warned that actual results may differfrom management’s expectations. The Company assumes no obligation to update theforward-looking information to reflect actual results or changes in the factorsaffecting such forward-looking information.

 

3

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**PART I — FINANCIAL INFORMATION**

 

**Item 1.Financial Statements.**

 

**SRS LABS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                   | ** ** | **June 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                                                                                                   | ** ** | **(unaudited)**        | ** ** | ** **                 | ** ** |
| **ASSETS**                                                                                                                                                                                                                   |       |                   |       |                       |       |
| **Current Assets**                                                                                                                                                                                                           |       |                   |       |                       |       |
| Cash and cash equivalents                                                                                                                                                                                                    |       | $                      | 21,297,168 |                       | $          | 12,795,620 |   |
| Accounts receivable, net                                                                                                                                                                                                     |       | 1,302,283              |       | 1,230,423                  |       |
| Inventories, net                                                                                                                                                                                                             |       | 783,990                |       | 753,020                    |       |
| Prepaid expenses and other current assets                                                                                                                                                                                    |       | 1,319,489              |       | 1,073,696                  |       |
| Deferred income taxes                                                                                                                                                                                                        |       | 23,406                 |       | 23,406                     |       |
|                                                                                                                                                                                                                         |       |                   |       |                       |       |
| **Total Current Assets**                                                                                                                                                                                                     |       | 24,726,336             |       | 15,876,165                 |       |
|                                                                                                                                                                                                                         |       |                   |       |                       |       |
| Investments available for sale                                                                                                                                                                                               |       | 5,148,343              |       | 10,490,210                 |       |
| Furniture, fixtures and equipment, net                                                                                                                                                                                  |       | 1,853,928              |       | 1,661,980                  |       |
| Goodwill                                                                                                                                                                                                                     |       | 533,031                |       | 533,031                    |       |
| Intangible assets, net                                                                                                                                                                                                       |       | 2,736,651              |       | 2,736,810                  |       |
| Deferred income taxes                                                                                                                                                                                                        |       | 213,262                |       | 193,134                    |       |
|                                                                                                                                                                                                                         |       |                   |       |                       |       |
| **Total Assets**                                                                                                                                                                                                             |       | $                      | 35,211,551 |                       | $          | 31,491,330 |   |
|                                                                                                                                                                                                                         |       |                   |       |                       |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                |       |                   |       |                       |       |
| **Current Liabilities**                                                                                                                                                                                                      |       |                   |       |                       |       |
| Accounts payable                                                                                                                                                                                                             |       | $                      | 1,387,929  |                       | $          | 1,503,851 |   |
| Accrued liabilities                                                                                                                                                                                                          |       | 1,873,690              |       | 1,606,069                  |       |
| Income taxes payable                                                                                                                                                                                                         |       | 688,130                |       | 430,949                    |       |
|                                                                                                                                                                                                                         |       |                   |       |                       |       |
| **Total Current Liabilities**                                                                                                                                                                                                |       | 3,949,749              |       | 3,540,869                  |       |
|                                                                                                                                                                                                                         |       |                   |       |                       |       |
| Commitments and contingencies (Note 9)                                                                                                                                                                                       |       |                   |       |                       |       |
|                                                                                                                                                                                                                         |       |                   |       |                       |       |
| **Stockholders’ Equity**                                                                                                                                                                                                |       |                   |       |                       |       |
| Preferred stock—$.001 par value; 2,000,000 shares  authorized; no shares issued or outstanding                                                                                                                          |       | —                 |       | —                     |       |
| Common stock—$.001 par value; 56,000,000 shares  authorized; 14,438,747 and 13,682,282 shares issued; and 14,213,447 and  13,456,982 shares outstanding at June 30, 2004 and December 31,  2003, respectively |       | 14,439                 |       | 13,683                     |       |
| Additional paid-in capital                                                                                                                                                                                                   |       | 61,450,865             |       | 58,423,249                 |       |
| Accumulated other comprehensive loss                                                                                                                                                                                         |       | (436,399               | )          | (336,346                   | )          |
| Accumulated deficit                                                                                                                                                                                                          |       | (29,048,502            | )          | (29,431,524                | )          |
| Treasury stock at cost, 225,300 shares at  June 30, 2004 and December 31, 2003                                                                                                                                     |       | (718,601               | )          | (718,601                   | )          |
|                                                                                                                                                                                                                         |       |                   |       |                       |       |
| **Total Stockholders’ Equity**                                                                                                                                                                                          |       | 31,261,802             |       | 27,950,461                 |       |
|                                                                                                                                                                                                                         |       |                   |       |                       |       |
| **Total Liabilities and  Stockholders’ Equity**                                                                                                                                                                         |       | $                      | 35,211,551 |                       | $          | 31,491,330 |   |

 

See accompanying notes to the condensed interim consolidated financialstatements

 

4

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**SRS LABS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                                       | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                       | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                             |       |                                  |       |                                |       |   |   |   |   |
| Revenues:                                                                        |       |                                  |       |                                |       |   |   |   |   |
| Semiconductor                                                                    |       | $                                     | 2,932,495  |                                | $          | 2,513,320 |   | $ | 5,348,213 |   | $ | 4,277,400 |   |
| Licensing                                                                        |       | 2,485,404                             |       | 2,012,526                           |       | 5,412,731 |   | 4,718,820 |   |
| Total revenues                                                                   |       | 5,417,899                             |       | 4,525,846                           |       | 10,760,944 |   | 8,996,220 |   |
|                                                                             |       |                                  |       |                                |       |   |   |   |   |
| Cost of sales                                                                    |       | 1,086,440                             |       | 900,565                             |       | 1,995,311 |   | 1,570,133 |   |
|                                                                             |       |                                  |       |                                |       |   |   |   |   |
| Gross margin                                                                     |       | 4,331,459                             |       | 3,625,281                           |       | 8,765,633 |   | 7,426,087 |   |
|                                                                             |       |                                  |       |                                |       |   |   |   |   |
| Operating expenses:                                                              |       |                                  |       |                                |       |   |   |   |   |
| Sales and marketing                                                              |       | 1,241,676                             |       | 1,271,097                           |       | 2,777,584 |   | 2,623,587 |   |
| Research and development                                                         |       | 1,144,926                             |       | 970,123                             |       | 2,353,613 |   | 2,051,338 |   |
| General and administrative                                                       |       | 1,484,299                             |       | 1,210,033                           |       | 3,038,496 |   | 2,524,643 |   |
|                                                                             |       |                                  |       |                                |       |   |   |   |   |
| Total operating expenses                                                         |       | 3,870,901                             |       | 3,451,253                           |       | 8,169,693 |   | 7,199,568 |   |
|                                                                             |       |                                  |       |                                |       |   |   |   |   |
| Income from operations                                                           |       | 460,558                               |       | 174,028                             |       | 595,940 |   | 226,519 |   |
|                                                                             |       |                                  |       |                                |       |   |   |   |   |
| Other income, net                                                                |       | 98,774                                |       | 118,604                             |       | 336,224 |   | 282,730 |   |
| Minority interest                                                                |       | —                                |       | —                              |       | — |   | 5,430 |   |
|                                                                             |       |                                  |       |                                |       |   |   |   |   |
| Income before income tax expense                                                 |       | 559,332                               |       | 292,632                             |       | 932,164 |   | 514,679 |   |
|                                                                             |       |                                  |       |                                |       |   |   |   |   |
| Income tax expense                                                               |       | 311,239                               |       | 326,514                             |       | 549,142 |   | 506,027 |   |
|                                                                             |       |                                  |       |                                |       |   |   |   |   |
| Net income (loss)                                                                |       | $                                     | 248,093    |                                | $          | (33,882 | ) | $ | 383,022 |   | $ | 8,652 |   |
|                                                                             |       |                                  |       |                                |       |   |   |   |   |
| Net income per common share:                                                     |       |                                  |       |                                |       |   |   |   |   |
|                                                                             |       |                                  |       |                                |       |   |   |   |   |
| Basic                                                                            |       | $                                     | 0.02       |                                | $          | 0.00 |   | $ | 0.03 |   | $ | 0.00 |   |
|                                                                             |       |                                  |       |                                |       |   |   |   |   |
| Diluted                                                                          |       | $                                     | 0.02       |                                | $          | 0.00 |   | $ | 0.02 |   | $ | 0.00 |   |
|                                                                             |       |                                  |       |                                |       |   |   |   |   |
| Weighted average shares used in the  calculation of net income per common share: |       |                                  |       |                                |       |   |   |   |   |
| Basic                                                                            |       | 14,175,127                            |       | 12,993,305                          |       | 13,960,824 |   | 12,896,338 |   |
|                                                                             |       |                                  |       |                                |       |   |   |   |   |
| Diluted                                                                          |       | 15,348,428                            |       | 12,993,305                          |       | 16,267,317 |   | 13,142,519 |   |

 

 See accompanying notes to thecondensed interim consolidated financial statements

 

5

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**SRS LABS, INC.**

### **CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITYANDCOMPREHENSIVE INCOME (Unaudited)**

 
| ** **                                                     | ** ** | ** **       | ** ** | **Additional  Paid-In** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Accumulated**   | ** ** | **Treasury** | ** ** | ** ** | ** ** | **Comprehensive  Income  for the Periods** | ** ** |
|----------------------------------------------------------------|------------|------------------|------------|-------------------------|------------|---------------------------------------|------------|-------------------|------------|--------------|------------|------------|------------|--------------------------------------------|------------|
| ** **                                                     | ** ** | **Common Stock** |
| ** **                                                     | ** ** | **Shares**       | ** ** | **Amount**              | ** ** | **Capital**                           | ** ** | **Income (Loss)** | ** ** | **Deficit**  | ** ** | **Stock**  | ** ** | **Total**                                  | ** ** | **Ended** | ** ** |
|                                                           |       |             |       |                    |       |                                  |       |              |       |         |       |       |       |                                       |       |   |   |
| BALANCE, Dec. 31, 2003                                         |       | 13,456,982       |       | $                       | 13,683     |                                  | $          | 58,423,249        |       | $            | (336,346   | )          | $          | (29,431,524                                | )          | $ | (718,601 | ) | $ | 27,950,461 |   | $ | — |   |
| Proceeds from exercise of stock options                        |       | 573,611          |       | 573                     |       | 2,149,746                             |       | —            |       | —       |       | —     |       | 2,150,319                                  |       | — |   |
| Deferred stock option compensation                             |       | —           |       | —                  |       | 13,600                                |       | —            |       | —       |       | —     |       | 13,600                                     |       | — |   |
| Unrealized gain on investments available for sale,  net of tax |       | —           |       | —                  |       | —                                |       | 87,938            |       | —       |       | —     |       | 87,938                                     |       | 87,938 |   |
| Net income                                                     |       | —           |       | —                  |       | —                                |       | —            |       | 134,929      |       | —     |       | 134,929                                    |       | 134,929 |   |
|                                                           |       |             |       |                    |       |                                  |       |              |       |         |       |       |       |                                       |       |   |   |
| BALANCE, March 31, 2004                                   |       | 14,030,593       |       | $                       | 14,256     |                                  | $          | 60,586,595        |       | $            | (248,408   | )          | $          | (29,296,595                                | )          | $ | (718,601 | ) | $ | 30,337,247 |   | $ | 222,867 |   |
| Proceeds from exercise of stock options                        |       | 182,854          |       | 183                     |       | 837,669                               |       | —            |       | —       |       | —     |       | 837,852                                    |       | — |   |
| Deferred stock option compensation                             |       | —           |       | —                  |       | 26,601                                |       | —            |       | —       |       | —     |       | 26,601                                     |       | — |   |
| Unrealized loss on investments available for sale,  net of tax |       | —           |       | —                  |       | —                                |       | (187,991          | )          | —       |       | —     |       | (187,991                                   | )          | (187,991 | ) |
|                                                           |       |             |       |                    |       |                                  |       |              |       |         |       |       |       |                                       |       |   |   |
| Net income                                                     |       | —           |       | —                  |       | —                                |       | —            |       | 248,093      |       | —     |       | 248,093                                    |       | 248,093 |   |
|                                                           |       |             |       |                    |       |                                  |       |              |       |         |       |       |       |                                       |       |   |   |
| BALANCE June 30,2004                                      |       | 14,213,447       |       | $                       | 14,439     |                                  | $          | 61,450,865        |       | $            | (436,399   | )          | $          | (29,048,502                                | )          | $ | (718,601 | ) | $ | 31,261,802 |   | $ | 282,969 |   |

 

See accompanying notes to the condensedinterim consolidated financial statements

 

6

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**SRS LABS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                         | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                            | ** ** | **2003** | ** ** |
|                                                                               |       |                                |       |   |   |
| **Cash Flows From Operating  Activities:**                                         |       |                                |       |   |   |
| Net income                                                                         |       | $                                   | 383,022    |   | $ | 8,652 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                                |       |   |   |
| Depreciation and amortization                                                      |       | 622,288                             |       | 561,519 |   |
| Minority interest                                                                  |       | —                              |       | (5,430 | ) |
| Provision (Benefit) for doubtful accounts                                          |       | 84,564                              |       | (3,894 | ) |
| (Benefit) Provision for obsolete inventory                                         |       | (57,451                             | )          | 17,541 |   |
| Deferred taxes                                                                     |       | (20,128                             | )          | (10,769 | ) |
| Amortization of premium on investments available  for sale                         |       | 6,188                               |       | — |   |
| Increase in deferred stock option compensation                                     |       | 40,201                              |       | 36,472 |   |
| Loss on disposition of furniture, fixtures and  equipment                          |       | 31                                  |       | — |   |
| Impairment on intangible assets                                                    |       | 3,431                               |       | — |   |
| Changes in operating assets and liabilities:                                       |       |                                |       |   |   |
| Accounts receivable                                                                |       | (156,424                            | )          | 147,834 |   |
| Inventories                                                                        |       | 26,481                              |       | (82,953 | ) |
| Prepaid expenses and other current assets                                          |       | (245,793                            | )          | 35,782 |   |
| Accounts payable                                                                   |       | (115,922                            | )          | (8,978 | ) |
| Accrued liabilities                                                                |       | 267,620                             |       | (590,213 | ) |
| Income taxes payable                                                               |       | 257,181                             |       | 109,199 |   |
|                                                                               |       |                                |       |   |   |
| Net cash provided by operating activities                                          |       | 1,095,289                           |       | 214,762 |   |
|                                                                               |       |                                |       |   |   |
| **Cash Flows From Investing Activities:**                                          |       |                                |       |   |   |
| Purchase of furniture, fixtures and equipment                                      |       | (569,688                            | )          | (212,932 | ) |
| Purchase of investments available for sale                                         |       | —                              |       | (15,754,116 | ) |
| Proceeds from sale of investments available for  sale                              |       | 5,235,626                           |       | 16,862,523 |   |
| Expenditures related to patents and intangible  assets                             |       | (247,850                            | )          | (95,807 | ) |
|                                                                               |       |                                |       |   |   |
| Net cash provided by investing activities                                          |       | 4,418,088                           |       | 799,668 |   |
|                                                                               |       |                                |       |   |   |
| **Cash Flows From Financing  Activities:**                                         |       |                                |       |   |   |
| Proceeds from exercise of stock options                                            |       | 2,988,171                           |       | 52,146 |   |
|                                                                               |       |                                |       |   |   |
| Net cash provided by financing activities                                          |       | 2,988,171                           |       | 52,146 |   |
|                                                                               |       |                                |       |   |   |
| **Net Increase in Cash and Cash  Equivalents**                                     |       | 8,501,548                           |       | 1,066,576 |   |
| **Cash and Cash Equivalents,  Beginning of Period**                                |       | 12,795,620                          |       | 15,720,860 |   |
|                                                                               |       |                                |       |   |   |
| **Cash and Cash Equivalents, End  of Period**                                      |       | $                                   | 21,297,168 |   | $ | 16,787,436 |   |
|                                                                               |       |                                |       |   |   |
| **Supplemental Disclosures of  Cash Flow Information:**                            |       |                                |       |   |   |
| Cash paid during the period for:                                                   |       |                                |       |   |   |
| Income taxes                                                                       |       | $                                   | 360,741    |   | $ | 379,581 |   |
| **Supplemental Disclosure of  Non-Cash Investing and Financing Activities:**       |       |                                |       |   |   |
| Unrealized loss on investments, net                                                |       | $                                   | (100,053   | ) | $ | (92,818 | ) |
| Issuance of Common stock for minority  interest                                    |       | $                                   | —     |   | $ | 960,012 |   |

 

See accompanying notes to the condensed interim consolidated financialstatements

 

7

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

**June 30, 2004**

 

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

 

SRS Labs is a leading developer and provider of application specificintegrated circuits (“ASICs”), standard integrated circuits (“ICs”) and audioand voice technology solutions for the home theater, portable audio, wireless,computer, game, automotive, broadcast, Internet and telecommunicationsmarkets.  The Company operates in thefollowing two business segments:

 

*Semiconductor:* Through SRS Labs, Inc.’s wholly-owned subsidiary, ValenceTech Limited, andValenceTech Limited’s wholly-owned subsidiaries (collectively “Valence”), thesemiconductor segment develops, designs and markets standard and custom, applicationspecific technology solutions in the form of analog, digital signal processors(“DSPs”), and mixed signal, integrated circuits primarily to original equipmentmanufacturers (“OEMs”), in the Asia Pacific region.

 

*Licensing**:*** Through SRS Labs, the parent company, and its wholly-owned subsidiary,SRSWOWcast.com, Inc., doing business as SRSWOWcast Technologies (“SRSWOWcast”),the licensing segment develops and licenses audio and voice technologysolutions to many of the world’s leading OEMs, software providers andsemiconductor companies, and licenses and markets hardware and software products for the Internet and professionalaudio markets.

 

As used herein, the “Company,” “SRS Labs,” “we,” “us,” or “our” means SRS Labs,Inc. and its wholly-owned subsidiaries, including Valence and SRSWOWcast.

 

Theaccompanying condensed interim consolidated financial statements have beenprepared by the Company without audit in conformity with accounting principlesgenerally accepted in the United States of America (“generally acceptedaccounting principles”) for interim financial information and the rules andregulations of the U.S. Securities and Exchange Commission (“SEC”). In theopinion of management, all adjustments (which include only normal recurringadjustments) considered necessary for a fair presentation have been included.The Company previously reported five business segments  (see Note 11). Certain accounts have beenreclassified from that previously reported to conform to the current periodpresentation.

 

Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with generally accepted accounting principles have beencondensed or omitted pursuant to SEC rules and regulations for presentation ofinterim financial information. Therefore, the condensed interim consolidatedfinancial statements should be read in conjunction with the Company’s AnnualReport on Form 10-K for the fiscal year ended December 31, 2003.Current and future financial statements may not be directly comparable to theCompany’s historical financial statements. The results of operations for theinterim periods are not necessarily indicative of the results to be expectedfor the full year.

 

**2.****                                     ****Capitalization of softwaredevelopment costs**

 

Costs incurred in the research, design and development of software forsale to others as a separate product or embedded in a product and sold as partof the product as a whole are charged to expense until technologicalfeasibility is established. Under SFAS No. 86, “Accounting for the Costsof Computer Software to be Sold, Leased or Otherwise Marketed,” the Companycapitalizes software purchased from third parties if the related softwareproduct under development has reached technological feasibility or if there arealternative future uses for the purchased software, provided that capitalizedamounts will be realized over a period not exceeding five years. Costs incurredprior to the establishment of technological feasibility are charged to researchand development expense. The establishment of technological feasibility andongoing assessment of recoverability of capitalized software development costsrequire considerable judgment by management with respect to certain externalfactors, including, but not limited to, anticipated future revenues, estimatedeconomic life and changes in software and hardware technologies. Upon thegeneral release of the software product to customers, capitalization ceases andsuch costs are amortized to cost of sales using the straight-line method on aproduct-by-product basis over the estimated life, which is generally threeyears. To the extent that amounts capitalized for research and developmentbecome impaired due to a decline in demand or the introduction of newtechnology, such amounts will be written-off. All other research anddevelopment expenditures are charged to research and development expense in theperiod incurred.

 

8

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Capitalized software as of June 30, 2004 and December 31,2003 is as follows:

 
| ** **                | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|---------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Capitalized software      |       | $                       | 464,015    |                        | $          | 342,760 |   |
| Accumulated amortization  |       | (139,046                | )          | (96,401                     | )          |
| Capitalized software, net |       | $                       | 324,969    |                        | $          | 246,359 |   |

 

The Company’s weighted average amortization period for capitalizedsoftware is approximately 5 years. The following table shows the estimatedamortization expense for those assets for the current year and each of the foursucceeding fiscal years.

 
| **Year  ending December 31,** | ** ** | **Estimated  Expense** | ** ** |
|------------------------------------|------------|------------------------|------------|
| 2004                               |       | $                      | 90,913     |   |
| 2005                               |       | 94,419                 |       |
| 2006                               |       | 83,376                 |       |
| 2007                               |       | 39,338                 |       |
| 2008                               |       | 14,522                 |       |
| Thereafter                         |       | 2,401                  |       |
|                                    |            |                        |            |  |

 

**3.****                                     ****Goodwill and IntangibleAssets**

 

On February 28, 2003, the Company completed an exchange offer withthe minority shareholders of SRSWOWcast, pursuant to which SRS Labsacquired all 3,000,000 shares of Series A Convertible Preferred Stock inexchange for the issuance of 332,184 shares of SRS Labs common stocktrading at $2.89 per share at the close of day on the transaction date. Theacquisition resulted in a purchase price of $960,012.

 

SRSWOWcast develops and markets professional software and hardwareproducts and consumer software plugins that incorporate proprietary audioenhancement and voice and surround sound technologies. SRS Labs, as themajority shareholder, has consistently included the results of SRSWOWcast inall of the previously reported consolidated financial statements. Theacquisition to acquire all of the outstanding common stock of SRSWOWcast was astrategic initiative, which we believe will allow us to better deploy andmarket the Circle Surround technology and compete with other competitors.  SRSWOWcast holds an exclusive license to usethe Circle Surround technology.

 

The following table summarizes the stated values of the assets acquiredand liabilities assumed at the date of acquisition:

 
| Current Assets           |   | $       | 324,002 |   |
|--------------------------|--------|---------|---------|--------|
| Property & Equipment |   | 3,774   |    |
| Current Liabilities      |   | (7,835  | )       |
| Intangible Assets        |   | 640,071 |    |
| Purchase Price           |   | $       | 960,012 |   |

 

Current assets primarily consisted of cash, accounts receivable andprepaid expenses and current liabilities were valued at stated value. Propertyand equipment was valued at net book value. The $640,071 of acquired intangibleassets was assigned to a license agreement between SRS Labs, Inc andSRSWOWcast, which is being amortized over 10 years.

 

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

 

9

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Inaccordance with SFAS No. 142, all of the Company’s intangible assets thathave definite lives are being amortized on a straight-line basis over theirestimated useful lives and goodwill is evaluated to determine if fair value ofthe asset has decreased below its carrying value. At December 31, 2003,the Company evaluated goodwill and determined that no adjustment to impairgoodwill was necessary.

 

Goodwill and intangible assets consist of the following:

 
| ** **                                                                       | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Goodwill                                                                         |       | $                       | 533,031    |                        | $          | 533,031 |   |
| Patents                                                                          |       | 1,881,168               |       | 1,760,236                   |       |
| Accumulated amortization                                                         |       | (804,536                | )          | (739,792                    | )          |
| Patents, net                                                                     |       | 1,076,632               |       | 1,020,444                   |       |
| Other intangibles                                                                |       | 6,014,485               |       | 5,893,229                   |       |
| Accumulated amortization                                                         |       | (4,354,466              | )          | (4,176,863                  | )          |
| Other intangibles, net (including software  development costs — see note 2) |       | 1,660,019               |       | 1,716,366                   |       |
| Goodwill and intangible assets, net                                              |       | $                       | 3,269,682  |                        | $          | 3,269,841 |   |

 

Amortizationperiods range from three to eleven years depending on the estimated useful lifeof the asset. Amortization expense consists of the following:

 
| ** **                 | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|----------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                 | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                       |       |                                  |       |                                |       |   |   |   |   |
| Patents                    |       | $                                     | 23,929     |                                | $          | 35,913 |   | $ | 64,744 |   | $ | 70,926 |   |
| Other intangibles          |       | 95,144                                |       | 57,477                              |       | 177,603 |   | 122,928 |   |
| Total amortization expense |       | $                                     | 119,073    |                                | $          | 93,390 |   | $ | 242,347 |   | $ | 193,854 |   |

 

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

 

| **Year  ending  December 31,** | ** ** | **Estimated expense** | ** ** |
|-------------------------------------|------------|-----------------------|------------|
|                                |       |                  |       |
| 2004                                |       | $                     | 558,037    |   |
| 2005                                |       | $                     | 558,683    |   |
| 2006                                |       | $                     | 540,112    |   |
| 2007                                |       | $                     | 409,439    |   |
| 2008                                |       | $                     | 156,604    |   |

 

**4.**                                      **Investments Available forSale**

 

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

 
| ** **           | ** ** | **June 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|----------------------|------------|------------------------|------------|----------------------------|------------|
|                 |       |                   |       |                       |       |
| Cost                 |       | $                      | 5,503,440  |                       | $          | 10,745,254 |   |
| Unrealized loss      |       | (355,097               | )          | (255,044                   | )          |
| Estimated fair value |       | $                      | 5,148,343  |                       | $          | 10,490,210 |   |

 

10

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The contractual maturities of investments are shown below. Actualmaturities may differ from contractual maturities.

 
| ** **                                      | ** ** | **June 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|-------------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                                      | ** ** | **Cost**               | ** ** | **Estimated  Fair Value**  | ** ** | **Cost** | ** ** | **Estimated  Fair Value** | ** ** |
|                                            |       |                   |       |                       |       |   |   |   |   |
| U.S. Government securities available for  sale: |       |                   |       |                       |       |   |   |   |   |
| Due in one to five years                        |       | $                      | 5,503,440  |                       | $          | 5,148,343 |   | $ | 10,745,254 |   | $ | 10,490,210 |   |
|                                                 |            |                        |            |                            |            |  |  |  |  |  |  |  |  |

 

The following table summarizes sales of available for sale securitiesfor the three months and six months ended June 30, 2004 and 2003. Specificidentification was used to determine costs in computing realized gains orlosses.

 
| ** **         | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **         | ** ** | **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Proceeds from sale |       | $                                    | —     |                               | $          | 8,317,410 |   | $ | 5,235,626 |   | $ | 16,862,523 |   |
| Realized gains     |       | —                               |       | 2,550                              |       | 139,375 |   | 33,836 |   |
|                    |            |                                      |            |                                    |            |  |  |  |  |  |  |  |  |

 

**5.**                                      **Inventories**

 

Inventories, which consist of finished goods, are stated at the lowerof cost or net realizable value. Cost is calculated using the weighted averagemethod and is comprised of material costs and, where applicable, subcontractingand overhead costs that have been incurred in bringing the inventories to theirpresent location and condition. Net realizable value represents the estimatedselling price less costs to be incurred in selling and distribution. Market isdetermined by comparison with recent purchases or net realizable value. Netrealizable value is based on forecasts for sales of the Company’s products inthe ensuing years. Should demand for the Company’s products prove to besignificantly less than anticipated, the ultimate realizable value of theCompany’s inventories could be substantially less than the amount shown on theaccompanying consolidated balance sheets.

 

**6.**                                      **Minority Interest**

 

Minority interest in consolidated subsidiary represents the minoritystockholders’ proportionate share of the equity of SRSWOWcast, which was approximately 13% atDecember 31, 2002. In February 2003, SRS Labs completed anexchange offer with the minority shareholders of SRSWOWcast, pursuant to whichSRS Labs acquired all 3,000,000 outstanding shares of Series A ConvertiblePreferred Stock in exchange for the issuance of 332,184 shares of SRS Labscommon stock.  As a result of theexchange offer, SRSWOWcast became a wholly-owned subsidiary of SRS Labs.  An intangible asset in the amount of $640,071was recorded representing the prior “minority interest” portion of the CircleSurround license agreement held by SRSWOWcast. The proforma effect of thetransaction, as if it had occurred at the beginning of the quarter endedMarch 31, 2003, would have been immaterial.

 

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

 

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

 

11

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Basicand diluted net income per share computed in accordance with SFAS 128 forthe three months and six months ended June 30, 2004 are as follows:

 
| ** **                                               | ** ** | **For the three months  ended June 30,** | ** ** | **For the six months  Ended June 30,** | ** ** |
|----------------------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                               | ** ** | **2004**                                      | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| BASIC EPS                                                |       |                                          |       |                                        |       |   |   |   |   |
| Net income (loss)                                        |       | $                                             | 248,093    |                                        | $          | (33,882 | ) | $ | 383,022 |   | $ | 8,652 |   |
| Denominator: weighted average common shares  outstanding |       | 14,175,127                                    |       | 12,993,305                                  |       | 13,960,824 |   | 12,896,338 |   |
| Net income per share—basic                          |       | $                                             | 0.02       |                                        | $          | 0.00 |   | $ | 0.03 |   | $ | 0.00 |   |
| DILUTED EPS                                              |       |                                          |       |                                        |       |   |   |   |   |
| Net income (loss)                                        |       | $                                             | 248,093    |                                        | $          | (33,882 | ) | $ | 383,022 |   | $ | 8,652 |   |
| Denominator: weighted average common shares  outstanding |       | 14,175,127                                    |       | 12,993,305                                  |       | 13,960,824 |   | 12,896,338 |   |
| Common equivalent shares outstanding:                    |       |                                          |       |                                        |       |   |   |   |   |
|                                                     |       |                                          |       |                                        |       |   |   |   |   |
| Options                                                  |       | 1,173,301                                     |       | —                                      |       | 2,306,493 |   | 246,181 |   |
| Total diluted shares                                     |       | 15,348,428                                    |       | 12,993,305                                  |       | 16,267,317 |   | 13,142,519 |   |
| Net income per share—diluted                        |       | $                                             | 0.02       |                                        | $          | 0.00 |   | $ | 0.02 |   | $ | 0.00 |   |

 

Therewere 1,672,625 and 3,921,531 potentially dilutive options outstanding for thequarters ending June 30, 2004 and 2003, respectively and there were260,000 and 4,058,712 potentially dilutive options outstanding for the sixmonths ending June 30, 2004 and 2003, respectively, that were not includedin the table above because they would be anti-dilutive.

 

**8.**                                      **Stock-Based Compensation**

 

TheCompany accounts for stock-based awards to employees under the recognition andmeasurement principles of APB No. 25, “Accounting for Stock Issued toEmployees,” and related interpretations. The Company provides additional pro forma disclosures as required underSFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) and SFASNo. 148, “Accounting for Stock-Based Compensation — Transition andDisclosure — an Amendment of SFAS No. 123.” Accordingly, no stock-based employee compensation cost is reflected innet income (loss), as all options granted under the plan had an exercise priceequal to the market value of the underlying common stock on the date of grant.Had compensation cost for the Company’s stock option plan been determined basedon the fair value at the grant date for awards for the three months endedJune 30, 2004 and 2003, consistent with the provisions of SFASNo. 123, the Company’s net income and earnings per share would have beendecreased to the pro forma amounts indicated below:

 
| ** **                                                                                         | ** ** | **For the three months ended  June 30,** | ** ** | **For the six months ended  June 30****,** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                         | ** ** | **2004**                                      | ** ** | **2003**                                        | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                               |       |                                          |       |                                            |       |   |   |   |   |
| Net income (loss) (attributable to common  shareholder) – as reported                         |       | $                                             | 248,093    |                                            | $          | (33,882 | ) | $ | 383,022 |   | $ | 8,652 |   |
| Add: stock based employee compensation  expense included in reported net income, net of tax effect |       | 15,715                                        |       | 18,236                                          |       | 23,875 |   | 36,472 |   |
| Less fair value of stock-based employee  compensation expense                                      |       | (441,215                                      | )          | (593,085                                        | )          | (834,883 | ) | (1,107,950 | ) |
| Net loss (attributable to common  shareholder) - pro forma                                         |       | $                                             | (177,407   | )                                               | $          | (608,731 | ) | $ | (427,986 | ) | $ | (1,062,826 | ) |
| Net income (loss) per share:                                                                       |       |                                          |       |                                            |       |   |   |   |   |
| Basic, as reported                                                                                 |       | $                                             | 0.02       |                                            | $          | 0.00 |   | $ | 0.03 |   | $ | 0.00 |   |
| Basic, pro forma                                                                                   |       | $                                             | (0.01      | )                                               | $          | (0.05 | ) | $ | (0.03 | ) | $ | (0.08 | ) |
| Diluted, as reported                                                                               |       | $                                             | 0.02       |                                            | $          | 0.00 |   | $ | 0.02 |   | $ | 0.00 |   |
| Diluted, pro forma                                                                                 |       | $                                             | (0.01      | )                                               | $          | (0.05 | ) | $ | (0.03 | ) | $ | (0.08 | ) |

 

Thefair value of each option grant was estimated on the date of grant using theBlack-Scholes option-pricing model with the following weighted averageassumptions used for grants during the quarter ended June 30, 2004:

 

12

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| Risk free interest rate |   | 3.6     | %      |
|-------------------------|--------|---------|--------|
| Expected life           |   | 5 years |   |
| Expected volatility     |   | 76      | %      |

 

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

 

**9.**                                      **Commitments andContingencies**

 

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

 

TheCompany has contractual obligations and commitments with regards to operatinglease arrangements. The following table quantifies the expected contractualobligations and commitments subsequent to December 31, 2003:

 
| **Year  ending December 31,** | ** ** | **Facility** | ** ** | **Facility-Related  Party** | ** ** | **Office  Equipment** | ** ** | **Total** | ** ** |
|------------------------------------|------------|--------------|------------|-----------------------------|------------|-----------------------|------------|-----------|------------|
| 2004                               |       | $            | 138,333    |                        | $          | 210,600               |       | $         | 10,504     |   | $ | 359,437 |   |
| 2005                               |       | 145,250      |       | 87,750                      |       | 7,030                 |       | 240,030   |       |
| 2006                               |       | 159,083      |       | —                      |       | 6,534                 |       | 165,617   |       |
| 2007                               |       | —       |       | —                      |       | 6,534                 |       | 6,534     |       |
| 2008                               |       | —       |       | —                      |       | 2,995                 |       | 2,995     |       |
|                               |       | $            | 442,666    |                        | $          | 298,350               |       | $         | 33,597     |   | $ | 774,613 |   |

 

**10.**                               **Stockholders’ Equity**

 

OnMay 9, 2002, the Company’s Board of Directors authorized the repurchase ofup to 500,000 of the outstanding shares of the Company’s common stock for aperiod from May 10, 2002 to November 10, 2002 (the “2002 RepurchaseProgram”). As of March 31, 2004, 225,300 shares had been repurchased at acost of $718,601 under the 2002 Repurchase Program. On June 30, 2004, theCompany’s Board of Directors authorized a stock repurchase program (the “2004Repurchase Program”).  Under the 2004 RepurchaseProgram the company may acquire up to $3,000,000 of its outstanding commonstock for a six-month period from July 1, 2004 to December 31, 2004.  Purchases may be made from time to time in theopen market, block purchases or privately-negotiated transactions, depending onmarket conditions, share price and other factors.  All repurchased shares are reflected astreasury stock in the accompanying consolidated balance sheets.

 

**11.**                               **Segment Information**

 

TheCompany operates two business segments –semiconductors and licensing.  In 2003, the Company reported its revenues inthe following five segments: licensing; semiconductors; component distribution;product sales; and Internet and broadcast. In 2004, the Company decided to reduce its segments because the revenueattributable to the discontinued segments were not material compared torevenues relating to semiconductors and licensing.  Segment information for the 2003 segments hasbeen restated to conform to the current year presentation.  Revenue from the component distributionsegment is now reported in the semiconductor segment and revenues from productsales and Internet and broadcast segments are now reported in the licensingsegment. The Company does not allocate corporate operating expenses or specificassets to these segments. Therefore, the segment information that followsincludes only net revenues, cost of sales and gross margins of the identifiedsegments:

 
| ** **                                 | ** ** | **Valence  Semiconductor** | ** ** | **SRS Labs  Licensing** | ** ** | **Total** | ** ** |
|--------------------------------------------|------------|----------------------------|------------|-------------------------|------------|-----------|------------|
| **Three Months Ended  June 30, 2004** |       |                       |       |                    |       |      |       |
| Total revenues                             |       | $                          | 2,932,495  |                    | $          | 2,485,404 |       | $ | 5,417,899 |   |
| Cost of sales                              |       | 1,066,033                  |       | 20,407                  |       | 1,086,440 |       |
|                                       |       |                       |       |                    |       |      |       |
| Gross margin                               |       | $                          | 1,866,462  |                    | $          | 2,464,997 |       | $ | 4,331,459 |   |
|                                       |       |                       |       |                    |       |      |       |
| **Three Months Ended  June 30, 2003** |       |                       |       |                    |       |      |       |
| Total revenues                             |       | $                          | 2,513,320  |                    | $          | 2,012,526 |       | $ | 4,525,846 |   |
| Cost of sales                              |       | 881,442                    |       | 19,123                  |       | 900,565   |       |
|                                       |       |                       |       |                    |       |      |       |
| Gross margin                               |       | $                          | 1,631,878  |                    | $          | 1,993,403 |       | $ | 3,625,281 |   |

 

13

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| ** **                               | ** ** | **Valence  Semiconductor** | ** ** | **SRS Labs  Licensing** | ** ** | **Total** | ** ** |
|------------------------------------------|------------|----------------------------|------------|-------------------------|------------|-----------|------------|
| **Six Months Ended June 30,  2004** |       |                       |       |                    |       |      |       |
| Total revenues                           |       | $                          | 5,348,213  |                    | $          | 5,412,731 |       | $ | 10,760,944 |   |
| Cost of sales                            |       | 1,948,767                  |       | 46,544                  |       | 1,995,311 |       |
|                                     |       |                       |       |                    |       |      |       |
| Gross margin                             |       | $                          | 3,399,446  |                    | $          | 5,366,187 |       | $ | 8,765,633 |   |
|                                     |       |                       |       |                    |       |      |       |
| **Six Months Ended June 30,  2003** |       |                       |       |                    |       |      |       |
| Total revenues                           |       | $                          | 4,277,400  |                    | $          | 4,718,820 |       | $ | 8,996,220 |   |
| Cost of sales                            |       | 1,524,029                  |       | 46,104                  |       | 1,570,133 |       |
|                                     |       |                       |       |                    |       |      |       |
| Gross margin                             |       | $                          | 2,753,371  |                    | $          | 4,672,716 |       | $ | 7,426,087 |   |

 

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

 
| ** **                    | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                    | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Geographic  Area Revenue:** |       |                                  |       |                                |       |   |   |   |   |
|                          |       |                                  |       |                                |       |   |   |   |   |
| Asia Pacific                  |       | $                                     | 4,838,606  |                                | $          | 4,357,278 |   | $ | 9,033,736 |   | $ | 8,323,965 |   |
| Americas                      |       | 526,359                               |       | 49,169                              |       | 1,311,971 |   | 521,266 |   |
| Europe                        |       | 52,934                                |       | 119,399                             |       | 415,237 |   | 150,989 |   |
| Total                         |       | $                                     | 5,417,899  |                                | $          | 4,525,846 |   | $ | 10,760,944 |   | $ | 8,996,220 |   |

 

**12.**                               **Recent AccountingPronouncements**

 

In December 2003, the SEC issued Staff Accounting Bulletin (SAB)No. 104, Revenue Recognition (SAB No. 104), which codifies, revisesand rescinds certain sections of SAB No. 101, Revenue Recognition, inorder to make this interpretive guidance consistent with current authoritativeaccounting and auditing guidance and SEC rules and regulations. The changesnoted in SAB No. 104 did not have a material effect on the Company’sresults of operations, financial position or cash flows.

 

In March 2004, the Emerging Issues Task Force (EITF) reached aconsensus on EITF No. 03-06, Participating Securities and Two-Class Methodunder FASB Statement No. 128, Earnings per Share. EITF No. 03-06 addresses anumber of questions regarding the computation of earnings per share (EPS) bycompanies that have issued securities other than common stock thatcontractually entitle the holder to participate in dividends and earnings ofthe company when, and if, it declares dividends on its common stock. The issuealso provides further guidance in applying the two-class method of calculatingEPS. It clarifies what constitutes a participating security and how to applythe two-class method of computing EPS once it is determined that a security isparticipating, including how to allocate undistributed earnings to such asecurity. The consensus reached on EITF No. 03-06 is effective for fiscalperiods beginning after March 31, 2004. Prior period earnings per shareamounts will be restated to conform to the consensus to ensure comparabilityyear over year. The adoption of EITF No. 03-06 did not have any impact on ourresults of operations or financial condition.

 

14

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**Item2.  Management’s Discussion and Analysisof Financial 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, 2003 (the“Form 10-K”), the audited consolidated financial statements and the notesthereto included in the Form 10-K and the unaudited condensed interimconsolidated financial statements and notes thereto included in this QuarterlyReport.

 

**Overview**

 

SRS Labs is a leading developer and provider of application specificintegrated circuits (“ASICs”), standard integrated circuits (“ICs”) and audioand voice technology solutions for the home theater, portable audio, wireless,computer, game, automotive, broadcast, Internet and telecommunications markets.The Company operates in the following two business segments:

 

*Semiconductor:* Through SRS Labs, Inc.’s wholly-owned subsidiary, ValenceTech Limited, andValenceTech Limited’s wholly-owned subsidiaries (collectively “Valence”), thesemiconductor segment develops, designs and markets standard and custom,application specific technology solutions in the form of analog, digital signalprocessors (“DSPs”), and mixed signal, integrated circuits primarily tooriginal equipment manufacturers (“OEMs”), in the Asia Pacific region.

 

*Licensing**:*** Through SRS Labs, the parent company, and its wholly-owned subsidiary,SRSWOWcast.com, Inc., doing business as SRSWOWcast Technologies (“SRSWOWcast”),the licensing segment develops and licenses audio and voice technologysolutions to many of the world’s leading OEMs, software providers andsemiconductor companies, and licenses and markets hardware and software products for the Internet and professionalaudio markets.

 

In2003, the Company reported its revenues in the following five segments:licensing; semiconductors; component distribution; product sales; and Internetand broadcast.  In 2004, the Companydecided to reduce its segments because of the materiality of the revenuesattributable to the other three segments. Revenue from the component distribution segment is now reported in thesemiconductor segment and revenues from product sales and Internet and broadcastsegments are now reported in the licensing segment.  As used herein, the “Company,” “SRS Labs,” “we,” “us,” or “our” means SRS Labs,Inc. and its wholly-owned subsidiaries, including Valence and SRSWOWcast.

 

Wehave determined that the most effective strategy for the creation of stable andsustainable revenue growth is to diversify our revenue base.  In our licensing segment, our goal is todiversify our revenue base from our historical concentration in hometheater.  We believe that the mobilephone, portable audio, PC and automotive areas within the consumer electronicsmarket present new high volume, high growth opportunities for application ofour audio technologies.  Ourdiversification strategy also extends to our semiconductor segment in which wehave refocused our team away from the heavy concentration on custom applicationspecific projects for a few customers. In addition, we are now also focused on marketing our standard brandedchips, including new chips that embed SRS Labs’ technologies, with particularattention toward the large manufacturing market in China.

 

**Critical Accounting Policies**

 

Our discussion and analysis of our results of operations and liquidityand capital resources are based on our consolidated financial statements whichhave been prepared in accordance with accounting principles generally acceptedin the United States.

 

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

 

The following represents a summary of our critical accounting policies,defined as those policies that we believe are: (a) the most important tothe portrayal of our financial condition and results of operations; and(b) that require management’s most difficult, subjective or complexjudgments, often as a result of the need to make estimates about the mattersthat are inherently uncertain. Our most critical accounting estimates includevaluation of accounts receivable, which impacts operating expenses; valuationof inventory, which impacts gross margin; valuation of intangible assets andcapitalization of software, which primarily impacts operating expenses when weimpair assets or accelerate their depreciation; and recognition

 

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and measurement of current and deferred income tax assets andliabilities, which impacts our tax provision. Below, we discuss these policiesfurther, as well as the estimates and judgments involved. We also have otherpolicies that we consider key accounting policies, such as our policies forrevenue recognition; however, these policies do not meet the definition ofcritical accounting estimates, because they do not generally require us to makeestimates or judgments that are difficult or subjective.

 

*Accounts Receivable*

 

We perform ongoing credit evaluations of our customers and adjustcredit limits based upon payment history, the customer’s current creditworthiness and various other factors, as determined by our review of theircurrent credit information. We continuously monitor collections and paymentsfrom our customers and maintain allowances for doubtful accounts based uponspecific customer circumstances, current economic trends, historical experienceand the age of past due receivables. While such credit losses have historicallybeen within our expectations and the provisions established, we cannotguarantee that we will continue to experience the same credit loss rates thatwe have in the past. Unanticipated changes in the liquidity or financialposition of our customers may require additional provisions for doubtfulaccounts.

 

*Inventory*

 

Inventory is stated at the lower of cost or net realizable value. Weperiodically assess our inventory for potential obsolescence and lower-of-cost-or-marketissues. We make estimates of inventory obsolescence, providing reserves whennecessary, based on, among other factors, demand for inventory based onbacklog, product pricing, the ability to liquidate or sell older inventory andthe impact of introducing new products. If actual market conditions or ourcustomer’s product demands are less favorable than those projected, additionalprovisions may be required.

 

*Intangible Assets & Capitalizationof Software*

 

In accordance with Statement of Financial Accounting Standards (“SFAS”)No. 142, “Goodwill and Other Intangible Assets,” we assess potentialimpairments to intangible assets when there is evidence that events or changesin circumstances indicate that the carrying amount of an asset may not be recovered.Our judgments regarding the existence of impairment indicators and future cashflows related to intangible assets are based on operational performance of ouracquired businesses, market conditions and other factors. If the carrying valueof a reporting unit exceeds its fair value, goodwill is considered impaired anda second test is performed to measure the amount of impairment loss, if any.For fiscal 2003, an independent valuation of goodwill and other intangibles wasperformed. To date, we have not recognized any impairment of our goodwill andother intangible assets in connection with our adoption of SFAS 142.However, no assurances can be given that future evaluation of goodwill will notresult in charges as a result of future impairment.

 

Costs incurred in the research, design and development of software forsale to others as a separate product or embedded in a product and sold as partof the product as a whole are charged to expense until technologicalfeasibility is established. Under SFAS No. 86, “Accounting for the Costsof Computer Software to be Sold, Leased or Otherwise Marketed,” we capitalizesoftware purchased from third parties if the related software product underdevelopment has reached technological feasibility or if there are alternativefuture uses for the purchased software, provided that capitalized amounts willbe realized over a period not exceeding five years. Costs incurred prior to theestablishment of technological feasibility are charged to research anddevelopment expense. The establishment of technological feasibility and ongoingassessment of recoverability of capitalized software development costs requireconsiderable judgment by management with respect to certain external factors,including, but not limited to, anticipated future revenues, estimated economiclife and changes in software and hardware technologies. Upon the generalrelease of the software product to customers, capitalization ceases and suchcosts are amortized to cost of sales using the straight-line method on aproduct-by-product basis over the estimated life, which is generally threeyears. To the extent that amounts capitalized for research and developmentbecome impaired due to a decline in demand or the introduction of newtechnology, such amounts will be written-off. All other research anddevelopment expenditures are charged to research and development expense in theperiod incurred.

 

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*Income Taxes*

 

In preparing our consolidated financial statements, we go through aprocess to estimate our income taxes in each of the countries in which weoperate. The process includes an assessment of the current tax expense, theresults from tax examinations and the effects of temporary differencesresulting from the different treatment of transactions for tax and financialaccounting purposes. These differences result in deferred tax assets andliabilities, which are included in the Consolidated Balance Sheet. We accountfor income taxes in accordance with Statement of Financial Accounting StandardsNo. 109, or SFAS 109, “Accounting for Income Taxes,” which requiresthat deferred tax assets and liabilities be recognized using enacted tax ratesfor the effect of temporary differences between the book and tax bases ofrecorded assets and liabilities. SFAS 109 also requires that deferred taxassets be reduced by a valuation allowance if it is more likely than not thatsome portion or all of the deferred tax asset will not be realized. We evaluatethe reliability of our deferred tax assets by assessing our valuation allowanceand by adjusting the amount of such allowance, if necessary. AtDecember 31, 2003, we had net deferred tax assets primarily resulting fromtemporary differences between the book and tax bases of assets and liabilities,and loss and credit carry forwards. We continue to provide a valuationallowance on certain deferred tax assets based on an assessment of thelikelihood of their realization. In reaching our conclusion, we evaluatedcertain relevant criteria including deferred tax liabilities that can be usedto offset deferred tax assets, estimates of future taxable income ofappropriate character within the carry forward period available under the taxlaw and tax planning strategies. Our judgments regarding future taxable incomemay change due to market conditions, changes in U.S. or international tax laws,and other factors. These changes, if any, may require material adjustments tothese deferred tax assets, resulting in either a tax benefit, if it isestimated that future taxable income is likely, or a reduction in the value ofthe deferred tax assets, if it is determined that their value is impaired,resulting in a reduction in net income or an increase in net loss in the periodwhen such determinations are made.

 

Our income tax provision is based on calculations and assumptions thatwill be subject to examination by the taxing authorities in the jurisdictionsin which we operate. Should the actual results differ from our estimates, wewould have to adjust the income tax provision in the period in which the factsand circumstances that give rise to the revision become known. Tax law and ratechanges are reflected in the income tax provision in the period in which suchchanges are enacted.

 

**Results of Operations**

 

**Three Months Ended June 30, 2004 Compared to ThreeMonths Ended June 30, 2003**

 

*Revenues*

 

Semiconductorrevenues consists of (a) design fees relating to, and sales of, applicationspecific integrated circuits (“ASIC”) for third parties by Valence to originalequipment manufacturers (“OEMs”); and (b) sales of general purpose integrated circuits (“ICs”) designed byValence under the brand name ASP. Licensing revenues consist primarily of royalties generated from thelicense of SRS Labs’ audio and voice technologies.  License and royalty agreements generallyprovide for the license of technologies for a specified period of time foreither a single fee or a fee based on the number of units distributed by the licensee.Also included in licensing revenue are revenues generated from the sale ofhardware and software applications into the broadcast audio markets.

 

Totalrevenues for the three months ended June 30, 2004 were $5,417,899 comparedto $4,525,846 for the three months ended June 30, 2003, an increase of$892,053 or 19.7%.  Semiconductorrevenues were $2,932,495 for the three months ended June 30, 2004 comparedto $2,513,320 for the three months ended June 30, 2003, an increase of$419,175 or 16.7%. This increase was attributable to increased sales of ASPchips to the TV and portable audio markets. Licensing revenues were $2,485,404 for the three months endedJune 30, 2004, compared to $2,012,526 for the three months endedJune 30, 2003, an increase of $472,878 or 23.5%.  The sales growth was attributable to theexpanded use of our technologies in the PC and mobile phone markets.

 

*Gross Margin*

 

Cost of sales consists primarily of fabrication costs, assembly andtest costs, and the cost of materials and overhead from operations. Grossmargins are dependent on the mix of products sold, services provided androyalties earned. Thegross margin percentage for the three months ended June 30, 2004 decreasedto 79.9% as a percentage of total revenue as compared to 80.1% for the threemonths ended June 30, 2003. Gross margins for the semiconductor business for the quarter endedJune 30, 2004 were 63.6% compared to 64.9% for the same period in 2003.Semiconductor revenues accounted for 54.1% of total revenues for the quarterended June 30, 2004 compared to 55.5% for the same period in 2003. Withinsemiconductors, the slight decrease in gross margin can be attributable to themix of ASIC and ASP chips.  ASP chipshave a gross margin of approximately 57% and accounted for 31% of revenues thisyear compared to 16% last year.  ASICshave a gross margin of approximately 67% and accounted for 69% of revenue ascompared to 84% last year.  Gross marginsfor the licensing business for the quarter ended June 30, 2004 were 99.2%compared to 99.0% for the same period in 2003. Licensing revenues accounted for45.9% the quarter ended June 30, 2004 compared to 44.5% for the sameperiod in 2003.

 

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*Sales and Marketing*

 

Salesand marketing expenses consist primarily of employee salaries, salesconsultants’ fees and related expenses, sales commissions and product promotioncosts. Sales and marketing expenses were $1,241,676 for the three months endedJune 30, 2004 compared to $1,271,097 for the same prior year period, a decreaseof $29,421 or 2.3%. As a percentage of total revenues, sales andmarketing expenses decreased from 28.1% for the quarter ended June 30,2003 to  22.9% for the same period thisyear.

 

*Research and Development*

 

Research and development expenses consist of salaries and related costsof employees engaged in ongoing research, design and development activities andcosts for engineering materials and supplies. Research and development expenseswere $1,144,926 for the three months ended June 30, 2004 compared to $970,123for the same prior year period, an increase of $174,803 or 18.0%. The increasein research and development costs is primarily due to the addition of researchand development personnel added in the fourth quarter of 2003.  As a percentage of total revenues, researchand development expenses decreased from 21.4% for the quarter endedJune 30, 2003, to 21.1% for the same period this year.

 

*General and Administrative*

 

General and administrative (“G&A”) expenses consist primarily ofemployee-related expenses, legal costs associated with the administration ofintellectual property and other professional fees. G&A expenses were$1,484,299 for the three months ended June 30, 2004 compared to $1,210,033for the same prior year period, an increase of $274,266 or 22.7%. The increasewas primarily attributable to increased professional fees and public companyexpenses.  As a percentage of totalrevenues, G&A expenses increased from 26.7% for the quarter ended June 30,2003, to 27.4% for the same period this year. We expect that G&A will increase in absolute dollars in futureperiods as we intensify our effort on the SOX 404 project, but such expenseswill fluctuate as a percentage of revenue due to changes in revenue.

 

*Income From Operations*

 

Income from operations increased by $286,530 to $460,558 for thequarter ended June 30, 2004, as compared to $174,028 for the quarter endedJune 30, 2003.  The increase inincome from operations is due to an increase in revenue, partially offset by anincrease in operating expenses.

 

*Other Income, Net*

 

Other income, net, consists primarily of interest income, gain or(loss) on sale of securities, interest expense and foreign currency transactiongains and losses. Other income, net, was $98,774 for the three months endedJune 30, 2004, compared to $118,604 for the same prior year period, adecrease of $19,830 or 16.7%. The decrease is primarily attributable to lowerinterest rates in 2004.

 

*Provision for Income Taxes*

 

The income tax expense forthe three months ended June 30, 2004 was $311,239, compared to tax expenseof $326,514 for the same prior year period, a decrease of $15,275 or 4.7%. Theprovision consists primarily of taxes paid on licensing revenues sourced fromcountries requiring foreign tax withholdings and taxes paid on profits in HongKong at the rate of 17.5%.  The decreasein income tax for the quarter ended June 30, 2004 was attributable tohigher licensing revenues sourced in the Americas, which are not subject to foreignwithholding taxes.  We expect that the taxrate will be lower in the second half of the year, due to the US Japan tax treaty that went into effect onJuly 1, 2004 and eliminates source-country withholdings on royalties.

 

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**Six Months Ended June 30, 2004 Compared to Six MonthsEnded June 30, 2003**

 

*Revenues*

 

Totalrevenues for the six months ended June 30, 2004 were $10,760,944 comparedto $8,996,220 for the six months ended June 30, 2003, an increase of$1,764,724 or 19.6%. Semiconductor revenues were $5,348,213 for the six monthsended June 30, 2004 compared to $4,277,400 for the six months endedJune 30, 2003, an increase of $1,070,813 or 25.0%. This increase wasattributable to expansion of Valence’s customer base, increased design wins andnew chip offerings. Licensing revenues were $5,412,731 for the six months endedJune 30, 2004, compared to $4,718,820 for the six months endedJune 30, 2003, an increase of $693,911 or 14.7%. This increase wasattributable to revenues generated in new product categories such as mobilephones, portable audio devices, and PCs and increased penetration in theCompany’s key home theater market, including set top boxes and televisions,which incorporate SRS Labs’ technologies.

 

###### ***Gross Margin***

 

Costof sales consists primarily of fabrication costs, assembly and test costs, andthe cost of materials and overhead from operations. The gross margin percentagefor the six months ended June 30, 2004 decreased to 81.5% as a percentageof total revenue as compared to 82.5% for the six months ended June 30,2003. Gross margins for the semiconductor business for the six months endedJune 30, 2004 and 2003 were 63.6% and 64.9%, respectively.  Semiconductor revenues accounted for 49.7% oftotal revenues as compared to 47.5% for the six months ended June 30, 2004and 2003, respectively. Within semiconductors, the slight decrease ingross margin can be attributable to the mix of ASIC and ASP chips.  ASP chips have a gross margin ofapproximately 56% and accounted for 32% of revenues for the six months endedJune 30, compared to 21% last year for the same period.  ASIC’s have a gross margin of approximately67% and accounted for 69% of revenue compared to 79% last year.  Grossmargins for the licensing business for the six months ended June 30, 2004and 2003 were 99.1% and 99.0%, respectively. Licensing revenues accounted for50.3% of total revenues as compared to 52.4% for the six months endedJune 30, 2004 and 2003, respectively.

 

*Sales and Marketing*

 

Sales and marketing expenses consist primarily of employee salaries,sales consultants’ fees and related expenses, sales commissions and productpromotion costs. Sales and marketing expenses were $2,777,584 for the sixmonths ended June 30, 2004 compared to $2,623,587 for the same prior yearperiod, an increase of $153,997 or 5.9%. The net increase in sales andmarketing expenses for the six months ended June 30, 2004 is primarilyattributable to increased promotion costs associated with higher licensingrevenue and investments in branding and promotion of our technologies in newmarkets designed to increase future revenues. As a percentage of totalrevenues, sales and marketing expenses decreased from 29.2% for the six monthsended June 30, 2003, to 25.8% for the same period this year.

 

*Research and Development*

 

Researchand development expenses consist of salaries and related costs of employeesengaged in ongoing research, design and development activities and costs forengineering materials and supplies. Research and development expenses were$2,353,613 for the six months ended June 30, 2004 compared to $2,051,338for the same prior year period, an increase of $302,275 or 14.7%. The increasein research and development costs is primarily due to the addition of researchand development personnel and increased costs associated with the increasedsemiconductor business activity.  As apercentage of total revenues, research and development expenses decreased from22.8% for the six months ended June 30, 2003, to 21.9% for the same periodthis year.

 

*General and Administrative*

 

G&A expenses consist primarily of employee-related expenses, legalcosts associated with the administration of intellectual property and otherprofessional fees. G&A expenses were $3,038,496 for the six months endedJune 30, 2004 compared to $2,524,643 for the same prior year period, anincrease of $513,853 or 20.4%. The increase was primarily attributable toincreased professional fees and public company expenses. As a percentage oftotal revenues, G&A expenses increased from 28.1% for the six months endedJune 30, 2003, to 28.2% for the same period this year.  We expect that G&A will increase inabsolute dollars in future periods as we intensify our effort on the SOX 404project, but such expenses will fluctuate as a percentage of revenue due tochanges in revenue.

 

*Income From Operations*

 

Income from operations increased by $369,421 to $595,940 for the sixmonths ended June 30, 2004, as compared to income from operations of$226,519 for the same period last year. The increase in income from operations is due to an increase in revenue,partially offset by an increase in operating expenses.

 

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*Other Income, Net*

 

Other income, net, consists primarily of interest income, gain or(loss) on sale of securities, interest expense and foreign currency transactiongains and losses. Other income, net, was $336,224 for the six months endedJune 30, 2004, compared to $282,730 for the same prior year period, anincrease of $53,494 or 18.9%. The increase is primarily attributable toinvestment gains from sales of US Treasury in 2004.

 

###### ***Minority Interest***

###### ** **

Minority interest represents the minority shareholders’ proportionateshare of losses in SRSWOWcast. Minority interest was $0 for the six monthsended June 30, 2004, compared to $5,430 for the six months endedJune 30, 2003. In February 2003, SRS Labs completed an exchange offerwith the minority shareholders of SRSWOWcast, pursuant to which SRS Labsacquired all of the outstanding shares of Series A Convertible PreferredStock in exchange for the issuance of shares of SRS Labs common stock. As aresult of the exchange offer, SRSWOWcast became a wholly-owned subsidiary ofSRS Labs.

 

*Provision for Income Taxes*

 

The income tax expense forthe six months ended June 30, 2004 was $549,142, compared to tax expenseof $506,027 for the same prior year period, an increase of $43,115 or 8.5%. Theprovision consists primarily of taxes paid on licensing revenues sourced fromcountries requiring foreign tax withholdings and taxes paid on profits in HongKong at the rate of 17.5%.  The increasein income tax for the six months ended June 30, 2004 was attributable tohigher profits in Hong Kong.  We expect that the tax rate will be lower inthe second half of the year, due to the US Japan tax treaty that went into effect on July 1 and eliminatessource-country withholdings on royalties.

 

**Liquidity and Capital Resources**

 

The Company’s principal source of liquidity to fund ongoing operationsat June 30, 2004 consisted of cash, cash equivalents and long-terminvestments aggregating $26,445,511.  AtJune 30, 2004, the Company had cash and cash equivalents of $21,297,168and long-term investments aggregating $5,148,343. Cash and cash equivalentsgenerally consist of cash, money market funds and other money marketinstruments with original maturities of three months or less. Investmentsconsist of U.S. government securities rated AAA.

 

Cashand cash equivalents increased $8,501,548 during the six months endedJune 30, 2004 to $21,297,168.  Theincrease was primarily due to the net cash provided by operating activities of$1,095,289, investing activities from the sale of long-term investments of$5,235,626 and financing activities from the exercise of stock options of $2,988,171partially offset by net cash used for capital expenditures and patents of$817,538.

 

OnJune 30, 2004, the Company's Board of Directors authorized a stock repurchase program.  Under the repurchase program, the Company mayacquire up to $3,000,000 of its outstanding common stock for a period of sixmonths from July 1, 2004 to December 31, 2004. Purchases may be made from time to time in the open market, blockpurchases or privately-negotiated transactions, depending on market conditions,share price and other factors.

 

Based on current plans and business conditions, the Company expectsthat its cash, cash equivalents and investments together with any amountsgenerated from operations will be sufficient to meet the Company’s cashrequirements for the foreseeable future. However, there can be no assurancethat the Company will not be required to seek other financing sooner or thatsuch financing, if required, will be available on terms satisfactory to theCompany.

 

**Factors That May Affect Future Results**

 

*We are exposed to risks in our licensing business related to productand customer concentration*

 

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

 

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operations.

 

Declining prices of consumer electronic products could put pressure onour licensing fees that are charged to manufacturers. Also, given the currenteconomic environment, consumer spending on DVD players and other homeelectronic products may not increase as expected. Such declines in consumerspending, should they occur, and continued decreases in consumer productpricing for electronic goods may have a significant negative impact on ourfinancial results. The Company’s strategy is to diversify its customer base inan effort to decrease the impact from the loss of a particular customer,product segment or change in market trend.

 

*Our quarterly results may fluctuate*

 

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

 

*We rely on revenue contribution from our ASIC and standard IC business*

 

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

 

Business revenue from ASICs is concentrated in a limited number ofcustomers in the areas of consumer electronics, communications products,computers and computer peripherals. The business generated from any onecustomer may be for a fixed length or quantity. As such, it is customary in ourASIC business to have a certain amount of customer turnover as new ASICprojects are obtained for different customers. However, it is possible that theloss of any particular customer or any bad debt arising from such customer mayhave a material adverse impact on our financial condition and results ofoperation. Beginning in fiscal 1999, Valence began to exit from certain lowermargin product offerings in the distribution side of the business and hasplaced more emphasis on developing and distributing products that are relatedto, or incorporate, our proprietary technologies. As a result, the immediateloss in revenue of the low margin distribution business will not be entirelyoffset by the new proprietary technology based products, which will take timeto develop and be introduced into the marketplace. There can be no assurancethat we will be able to quickly introduce new products to offset the loss inrevenue or that the new products developed will receive a favorable marketacceptance.

 

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

 

*We are exposed to risks in our Valence business related to productfabrication outsourcing to third parties*

 

Valence is a “fabless” semiconductor company meaning that Valencedesigns, develops and markets our selection of custom and standard integratedcircuits but we rely on third party contractors to manufacture, assemble andtest our products. Currently, there is a shortage of foundry capacity which isaffecting the semiconductor industry. Although we believe our relationships are generally good, we do not havelong-term supply agreements with our third-party vendors and they are notobligated to perform services or supply products to us for any particularperiod or in any particular quantities, except as provided in each separatepurchase order accepted by them. The increased demand for our products coupledwith the demand for foundry services, is, and will continue to be for theforeseeable future, a challenge for us. In these times of high demand,

 

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there are significant risks associated with our reliance on third-partyvendors including: reallocation of capacity to other foundry customers,potential price increases, delays and interruptions in order deliveries,reduced control over product quality and increased risk of misappropriation ofintellectual property.

 

*We conduct operations in a number of countries and are subject to risksof international operations, particularly in Asia and the PRC*

 

We have significant operations in Hong Kong, the PRC and other parts ofAsia that require refinement to adapt to the changing market conditions in thatregion. Our operations in Asia, and international operations in general, aresubject to risks of unexpected changes in, or impositions of, legislative orregulatory requirements.

 

Our customers geographically located in the Asia Pacific marketsaccounted for approximately 93%, 90% and 90% of total Company sales in 2003,2002 and 2001, respectively and are expected to continue to account for asubstantial percentage of sales in the future. The economic climate in Asiacontinues to be impacted by increases in unemployment, declines in consumerspending, currency devaluation and bank failures. Any of these factors, shouldthey continue, could significantly reduce the demand for the end user goods inwhich our products and technologies are used.

 

The PRC economy has experienced significant growth in the past decade;but such growth has been uneven across geographic and economic sectors. Therecan be no assurance that such growth will continue or that any potentialcurrency devaluation in the region will not have a negative effect on ourbusiness, including Valence. The PRC economy has also experienced deflation inthe past, which may continue in the future. The current economic situation mayadversely affect our profitability over time as expenditures for consumerelectronics products and information technology may decrease due to the resultsof slowing domestic demand and deflation.

 

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

 

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

 

*We are exposed to currency fluctuations and instability in the Asianmarkets*

 

We expect that international sales will continue to represent asignificant portion of our total revenues. To date, all of our licensingrevenues have been denominated in U.S. dollars and most costs have beenincurred in U.S. dollars. It is our expectation that licensing revenues willcontinue to be denominated in U.S. dollars for the foreseeable future. BecauseValence’s business is primarily focused in Asia and because of our anticipatedexpansion of business in the PRC and other parts of Asia, our consolidatedresults of operations and financial position could be significantly affected byrisks associated with international activities, including economic and laborconditions, political instability, tax laws (including U.S. taxes on foreignsubsidiaries) and changes in the value of the U.S. dollar versus the localcurrency in which the products are sold. In addition, our valuation of assets recorded as a result of the Valenceacquisition may also be adversely impacted by the currency fluctuationsrelative to the U.S. dollar.  We intendto actively monitor our****foreignexchange exposure and to implement strategies to reduce our foreign exchangerisk at such time that we determine the benefits of such strategies outweighthe associated costs. However, there is no guarantee that we will take steps toinsure against such risks, and should such risks occur, there is no guaranteethat we will not be significantly impacted. Countries in the Asia Pacific region have experienced weakness in theircurrency, banking and equity markets. These weaknesses could adversely affectconsumer demand for Valence’s products, the U.S. dollar value of the Company’sand its subsidiaries’ foreign currency denominated sales, the availability andsupply of product components to Valence and ultimately, our consolidatedresults of operations.

 

*We are subject to competitive pressures*

 

Our existing and potential competitors include both large and emergingdomestic and international companies that have substantially greater financial,manufacturing, technical, marketing, distribution and other resources. Presentor future competitors may be able to develop products and technologiescomparable or superior to ours, and to adapt more quickly than us to newtechnologies or evolving market needs. We believe that the competitive factorsaffecting the market for our products and technologies include productperformance, price and quality; product functionality and features; the ease ofintegration; and implementation of the products and technologies with otherhardware and software components in the

 

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OEM’s products. In addition, the markets in which we compete areintensely competitive and are characterized by rapid technological changes,declining average sales prices and rapid product obsolescence. Accordingly,there can be no assurance that we will be able to continue to competeeffectively in its respective markets, that competition will not intensify orthat future competition will not have a material adverse effect on ourbusiness, operating results, cash flows and financial condition.

 

*We strongly rely on our intellectual property*

 

Our ability to compete may be affected by our ability to protect ourproprietary information. We have filed numerous U.S. and foreign patentapplications and to date have a number of issued U.S. and foreign patentscovering various aspects of our technologies. There can be no assurance thatthe steps taken by SRS Labs to protect our intellectual property will beadequate to prevent misappropriation of our technology or that our competitorswill not independently develop technologies that are substantially equivalentor superior to our technology. In addition, the laws of certain foreigncountries may not protect our intellectual property rights to the same extent,as do the laws of the U.S. The semiconductor industry is characterized byfrequent claims and litigation regarding patent and other property rights. Weare not currently a party to any claims of this nature. There can be noassurances that third parties will not assert claims or initiate litigationagainst the Company or our customers with respect to existing or futureproducts. In addition, we may initiate claims or litigation against thirdparties for infringement of our proprietary rights or to determine the scopeand validity of our proprietary rights.

 

*We depend on our executive officers and other key personnel*

 

Our future success depends to a large extent upon the continued serviceof our executives, as well as key engineering, sales, and marketing staff,including highly skilled semiconductor design personnel. We anticipate that anyfuture growth will require us to recruit and hire a number of new personnel inengineering, operations, finance, sales and marketing. Competition for suchpersonnel during times of economic growth is intense, and there can be noassurance that we can recruit and retain necessary personnel to operate its businessand support future growth.

 

*The market price of our common stock is volatile*

 

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

 

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

 

There have been no material changes to the information called for bythis Item 3 from the disclosures set forth in Part II, Item 7A in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2003.

 

**Item4.  Controls and Procedures**

 

*Evaluation of Disclosure Controls and Procedures.*  Our Chief Executive Officer and ChiefFinancial Officer have concluded, based on their evaluation as of the end ofthe period covered by this report, that our disclosure controls and procedures(as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, asamended) are effective to ensure that all information required to be disclosedby the Company in the reports filed or submitted by it under the SecuritiesExchange Act is recorded, processed, summarized and reported within the timeperiods specified by the Securities and Exchange Commission’s (the “SEC”) rulesand forms, and include controls and procedures designed to ensure thatinformation required to be disclosed by the Company in such reports isaccumulated and communicated to the Company’s management, including the ChiefExecutive Officer and the Chief Financial Officer, as appropriate, and allowtimely decisions regarding required disclosure.

 

*Changes in Internal Controls.*  Inconnection with the above-referenced evaluation, no change in the Company’sinternal control over financial reporting occurred during the period covered bythis report that has materially affected, or is reasonably likely to materiallyaffect, the Company’s internal control over financial reporting.

 

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**PART II — OTHER INFORMATION**

 

**Item4.  Submission of Matters to a Vote ofSecurity Holders**

 

The Annual Meeting of Stockholders of SRSLabs, Inc. was held on June 30, 2004 for the purpose of (a) electingone Class II director to the Board of Directors and (b) voting on aproposal to ratify the appointment of BDO Seidman LLP as independent auditorsfor the fiscal year ending December 31, 2004.

 

David R. Dukes was elected to serve as aClass II Director of the Company for a three-year term expiring at the 2007Annual Meeting of Stockholders.  WinstonHickman continued as a Class I Director and Stephen V. Sedmak, Sam Yau andThomas C.K. Yuen continued in office as Class III Directors.  The tabulation of the votes cast for theelection of Mr. Dukes was as follows:

 
| **Votes  For** | ** ** | **Votes Withheld** | ** ** |
|----------------|------------|--------------------|------------|
| 12,099,633     |       | 156,172            |       |

 

The proposal to ratify the appointment of BDOSeidman LLP as independent auditors for the fiscal year endingDecember 31, 2004 was approved.  Thetabulation of votes was as follows:

 
| **Votes  For** | ** ** | **Votes Against** | ** ** | **Abstentions** | ** ** | **Broker Non-Votes** | ** ** |
|----------------|------------|-------------------|------------|-----------------|------------|----------------------|------------|
| 12,161,478     |       | 84,421            |       | 9,906           |       | 0                    |       |

 

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

 

(a)                                  *Exhibits*.

 

Theexhibits listed below are hereby filed with the SEC as part of this Report.

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                              |
|---------------------|------------|------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                         |
| 31.1                |       | Certification of Chief Executive Officer of SRS Labs, Inc., pursuant  to Rule 13a-14 of the Securities Exchange Act.         |
|                |       |                                                                                                                         |
| 31.2                |       | Certification of Chief Financial Officer of SRS Labs, Inc., pursuant  to Rule 13a-14 of the Securities Exchange Act.         |
|                |       |                                                                                                                         |
| 32.1                |       | Certification of Chief Executive Officer of SRS Labs, Inc., pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002. |
|                |       |                                                                                                                         |
| 32.2                |       | Certification of Chief Financial Officer of SRS Labs, Inc., pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

 

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

 

On May 13, 2004, SRS Labs filed a report on Form 8-K dated May 13, 2004announcing its operating results for the first quarter of the fiscal yearending December 31, 2004.

 

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**SIGNATURES**

 

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

 
|                                   | SRS  LABS, INC., a Delaware corporation |
|----------------------------------------|----------------------------------------------|
|                                   |                                         |   |
| Date:  August 16,  2004 | By:                                          | /s/ THOMAS C.K. YUEN |
|                                   |                                         | Thomas C.K. Yuen |
|                                   |                                         | Chairman of the Board and Chief Executive Officer |
|                                   |                                         | (Principal Executive Officer) |
| ** **                             | ** **                                   | ** ** |
| ** **                             | ** **                                   | ** ** |
| Date:  August 16,  2004 | By:                                          | /s/ JANET M. BISKI |
|                                   |                                         | Janet M. Biski |
|                                   |                                         | Chief Financial Officer |
|                                   |                                         | (Principal Financial and Accounting Officer) |

 

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