**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-Q**

----

| **(Mark One)**                                                                                                                                        |                                                                                                |
|-------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------|
| **ý**                                                                                                                                            | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934**  |
| **For the quarterly period ended September 30, 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 itscharter)
| **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) |

 

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

 

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

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date: as of October 27, 2004, 14,645,253 of the issuer’scommon stock, par value $.001 per share, were outstanding.  In addition, as of October 27, 2004, 258,957shares of the issuer’s common stock were held as treasury shares.

 

 

 

----

 

**SRSLABS, INC.**

 

**Form 10-Q**

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

 

**Index**

 
| **PART I—FINANCIAL  INFORMATION** | ** **                                                                                                                                                |
|----------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|
| Item 1.                                | Financial Statements                                                                                                                                      |   |
|                                   | Condensed  Consolidated Balance Sheets as of September 30, 2004 (Unaudited) and December  31, 2003                                                        |   |
|                                   | Condensed  Consolidated Statements of Operations for the three months and nine months  ended September 30, 2004 and 2003 (Unaudited)                      |   |
|                                   | Condensed  Consolidated Statements of Stockholders’ Equity and Comprehensive Income  (Loss) for the nine months ended September 30, 2004 (Unaudited) |   |
|                                   | Condensed  Consolidated Statements of Cash Flows for the nine months ended September 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  2.                               | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                              |   |
| Item 6.                                | Exhibits                                                                                                                                                  |   |
|                                   |                                                                                                                                                      |
| SIGNATURES                             |                                                                                                                                                      |

 

 

----

 

**FORWARD-LOOKING INFORMATION**

 

ThisQuarterly Report on Form 10-Q contains forward-looking statementsreflecting 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 andunknown risks, uncertainties and other factors that may cause the actualresults, 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-looking statements.The important factors discussed in Part I, Item 2, “Management’sDiscussion and Analysis of Financial Condition and Results of Operations—FactorsThat May Affect Future Results”, herein, among others, could cause actualresults to differ materially from those indicated by forward-looking statementsmade herein and presented elsewhere by management. Such forward-lookingstatements represent management’s current expectations and are inherentlyuncertain. Investors are warned that actual results may differ from management’sexpectations. The Company assumes no obligation to update the forward-lookinginformation to reflect actual results or changes in the factors affecting suchforward-looking information.

 

 

1

----

 

 

**PART I — FINANCIALINFORMATION**

 

**Item 1.Financial Statements.**

 

**SRS LABS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                                                                                                                                       | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                                                                                                       | ** ** | **(unaudited)**             | ** ** |
| **ASSETS**                                                                                                                                                                                                                       |       |                        |       |                       |       |
| **Current Assets**                                                                                                                                                                                                               |       |                        |       |                       |       |
| Cash and cash equivalents                                                                                                                                                                                                        |       | $                           | 16,020,285 |                       | $          | 12,795,620 |   |
| Accounts receivable, net                                                                                                                                                                                                         |       | 1,258,982                   |       | 1,230,423                  |       |
| Inventories, net                                                                                                                                                                                                                 |       | 767,006                     |       | 753,020                    |       |
| Prepaid expenses and other current assets                                                                                                                                                                                        |       | 991,828                     |       | 1,073,696                  |       |
| Deferred income taxes                                                                                                                                                                                                            |       | 23,406                      |       | 23,406                     |       |
|                                                                                                                                                                                                                             |       |                        |       |                       |       |
| **Total Current Assets**                                                                                                                                                                                                         |       | 19,061,507                  |       | 15,876,165                 |       |
|                                                                                                                                                                                                                             |       |                        |       |                       |       |
| Investments available for sale                                                                                                                                                                                                   |       | 10,281,176                  |       | 10,490,210                 |       |
| Investment in LLC                                                                                                                                                                                                                |       | 2,025,626                   |       | —                     |       |
| Furniture, fixtures and equipment, net                                                                                                                                                                                      |       | 1,956,784                   |       | 1,661,980                  |       |
| Goodwill                                                                                                                                                                                                                         |       | 533,031                     |       | 533,031                    |       |
| Intangible assets, net                                                                                                                                                                                                           |       | 2,748,289                   |       | 2,736,810                  |       |
| Deferred income taxes                                                                                                                                                                                                            |       | 213,647                     |       | 193,134                    |       |
|                                                                                                                                                                                                                             |       |                        |       |                       |       |
| **Total Assets**                                                                                                                                                                                                                 |       | $                           | 36,820,060 |                       | $          | 31,491,330 |   |
|                                                                                                                                                                                                                             |       |                        |       |                       |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                                                                   |       |                        |       |                       |       |
| **Current Liabilities**                                                                                                                                                                                                          |       |                        |       |                       |       |
| Accounts payable                                                                                                                                                                                                                 |       | $                           | 1,481,449  |                       | $          | 1,503,851 |   |
| Accrued liabilities                                                                                                                                                                                                              |       | 2,218,691                   |       | 1,606,069                  |       |
| Income taxes payable                                                                                                                                                                                                             |       | 538,751                     |       | 430,949                    |       |
|                                                                                                                                                                                                                             |       |                        |       |                       |       |
| **Total Current Liabilities**                                                                                                                                                                                                    |       | 4,238,891                   |       | 3,540,869                  |       |
|                                                                                                                                                                                                                             |       |                        |       |                       |       |
| Commitments and contingencies (Note 10)                                                                                                                                                                                          |       |                        |       |                       |       |
|                                                                                                                                                                                                                             |       |                        |       |                       |       |
| **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;14,626,922  and 13,682,282 shares issued; and 14,367,965 and 13,456,982 shares  outstanding at September 30, 2004 and December 31, 2003,  respectively |       | 14,627                      |       | 13,683                     |       |
| Additional paid-in capital                                                                                                                                                                                                       |       | 62,058,625                  |       | 58,423,249                 |       |
| Accumulated other comprehensive loss                                                                                                                                                                                             |       | (297,523                    | )          | (336,346                   | )          |
| Accumulated deficit                                                                                                                                                                                                              |       | (28,311,498                 | )          | (29,431,524                | )          |
| Treasury stock at cost, 258,957 and 225,300 shares at  September 30, 2004 and December 31, 2003 respectively                                                                                                           |       | (883,062                    | )          | (718,601                   | )          |
|                                                                                                                                                                                                                             |       |                        |       |                       |       |
| **Total Stockholders’ Equity**                                                                                                                                                                                              |       | 32,581,169                  |       | 27,950,461                 |       |
|                                                                                                                                                                                                                             |       |                        |       |                       |       |
| **Total Liabilities and Stockholders’ Equity**                                                                                                                                                                              |       | $                           | 36,820,060 |                       | $          | 31,491,330 |   |

 

See accompanying notes to the condensed interim consolidated financialstatements

 

4

----

 

**SRSLABS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**
| ** **                                                                       | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                       | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues:                                                                        |       |                                       |       |                                      |       |   |   |   |   |
| Semiconductor                                                                    |       | $                                          | 3,644,298  |                                      | $          | 2,966,923 |   | $ | 8,992,511 |   | $ | 7,244,323 |   |
| Licensing                                                                        |       | 2,727,861                                  |       | 1,919,471                                 |       | 8,140,592 |   | 6,638,291 |   |
| Total revenues                                                                   |       | 6,372,159                                  |       | 4,886,394                                 |       | 17,133,103 |   | 13,882,614 |   |
|                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Cost of sales:                                                                   |       |                                       |       |                                      |       |   |   |   |   |
| Semiconductor                                                                    |       | 1,320,855                                  |       | 1,226,407                                 |       | 3,269,622 |   | 2,750,437 |   |
| Licensing                                                                        |       | 100,342                                    |       | 16,029                                    |       | 146,886 |   | 62,132 |   |
| Total cost of sales                                                              |       | 1,421,197                                  |       | 1,242,436                                 |       | 3,416,508 |   | 2,812,569 |   |
|                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Gross margin                                                                     |       | 4,950,962                                  |       | 3,643,958                                 |       | 13,716,595 |   | 11,070,045 |   |
|                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Operating expenses:                                                              |       |                                       |       |                                      |       |   |   |   |   |
| Sales and marketing                                                              |       | 1,372,303                                  |       | 1,216,568                                 |       | 4,149,887 |   | 3,840,155 |   |
| Research and development                                                         |       | 1,266,606                                  |       | 1,032,100                                 |       | 3,620,219 |   | 3,083,438 |   |
| General and administrative                                                       |       | 1,452,236                                  |       | 1,143,930                                 |       | 4,490,732 |   | 3,668,573 |   |
|                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Total operating expenses                                                         |       | 4,091,145                                  |       | 3,392,598                                 |       | 12,260,838 |   | 10,592,166 |   |
|                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Income from operations                                                           |       | 859,817                                    |       | 251,360                                   |       | 1,455,757 |   | 477,879 |   |
|                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Other income, net                                                                |       | 118,908                                    |       | 131,925                                   |       | 455,132 |   | 414,655 |   |
| Minority interest                                                                |       | —                                     |       | —                                    |       | — |   | 5,430 |   |
|                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Income before income tax expense                                                 |       | 978,725                                    |       | 383,285                                   |       | 1,910,889 |   | 897,964 |   |
|                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Income tax expense                                                               |       | 241,721                                    |       | 264,459                                   |       | 790,863 |   | 770,486 |   |
|                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Net income                                                                       |       | $                                          | 737,004    |                                      | $          | 118,826 |   | $ | 1,120,026 |   | $ | 127,478 |   |
|                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Net income per common share:                                                     |       |                                       |       |                                      |       |   |   |   |   |
|                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                                                            |       | $                                          | 0.05       |                                      | $          | 0.01 |   | $ | 0.08 |   | $ | 0.01 |   |
|                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Diluted                                                                          |       | $                                          | 0.05       |                                      | $          | 0.01 |   | $ | 0.07 |   | $ | 0.01 |   |
|                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Weighted average shares used in the calculation of net income per  common share: |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                                                            |       | 14,278,589                                 |       | 13,076,315                                |       | 14,045,162 |   | 12,956,971 |   |
|                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Diluted                                                                          |       | 15,395,792                                 |       | 14,730,290                                |       | 15,991,331 |   | 13,729,676 |   |

 

 

 

 See accompanying notes to thecondensed interim consolidated financial statements

 

5

----

 

**SRSLABS, INC.**

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

 
| ** **                                                     | ** ** | **Common Stock** | ** ** | **Additional Paid-In** | ** ** | **Accumulated Other Comprehensive** | ** ** | **Accumulated**   | ** ** | **Treasury** | ** ** | ** ** | ** ** | **Comprehensive Income  for the Periods** | ** ** |
|----------------------------------------------------------------|------------|------------------|------------|------------------------|------------|-------------------------------------|------------|-------------------|------------|--------------|------------|------------|------------|-------------------------------------------|------------|
| ** **                                                     | ** ** | **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 |   |
| Proceeds from  exercise of stock options                       |       | 154,518          |       | 188                    |       | 581,568                             |       | —            |       | —       |       | —     |       | 581,756                                   |       | — |   |
| Deferred stock  option compensation                            |       | —           |       | —                 |       | 26,192                              |       | —            |       | —       |       | —     |       | 26,192                                    |       | — |   |
| Treasury stock                                                 |       | —           |       | —                 |       | —                              |       | —            |       | —       |       | (164,461   | )          | (164,461                                  | )          | — |   |
| Unrealized gain  on investments available for sale, net of tax |       | —           |       | —                 |       | —                              |       | 138,876           |       | —       |       | —     |       | 138,876                                   |       | 138,876 |   |
| Net income                                                     |       | —           |       | —                 |       | —                              |       | —            |       | 737,004      |       | —     |       | 737,004                                   |       | 737,004 |   |
|                                                           |       |             |       |                   |       |                                |       |              |       |         |       |       |       |                                      |       |   |   |
| BALANCE,Sept. 30,  2004                                   |       | 14,367,965       |       | $                      | 14,627     |                                | $          | 62,058,625        |       | $            | (297,523   | )          | $          | (28,311,498                               | )          | $ | (883,062 | ) | $ | 32,581,169 |   | $ | 1,158,849 |   |

 

See accompanying notes to the condensedinterim consolidated financial statements

 

 

6

----

 

**SRSLABS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**
| ** **                                                                         | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| **Cash Flows From Operating Activities:**                                          |       |                                      |       |   |   |
| Net income                                                                         |       | $                                         | 1,120,026  |   | $ | 127,478 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |       |                                      |       |   |   |
| Depreciation and amortization                                                      |       | 966,692                                   |       | 833,508 |   |
| Minority interest                                                                  |       | —                                    |       | (5,430 | ) |
| Provision for doubtful accounts                                                    |       | 153,859                                   |       | 21,410 |   |
| (Benefit) Provision for obsolete inventory                                         |       | (44,600                                   | )          | 39,453 |   |
| Deferred taxes                                                                     |       | (20,513                                   | )          | (22,820 | ) |
| Amortization of premium on investments available for sale                          |       | 5,981                                     |       | — |   |
| Increase in deferred stock option compensation                                     |       | 66,393                                    |       | 54,708 |   |
| Loss on disposition of furniture, fixtures and equipment                           |       | 6,791                                     |       | — |   |
| Impairment on intangible assets                                                    |       | 12,163                                    |       | — |   |
| Changes in operating assets and liabilities:                                       |       |                                      |       |   |   |
| Accounts receivable                                                                |       | (182,417                                  | )          | (102,874 | ) |
| Inventories                                                                        |       | 30,612                                    |       | (180,887 | ) |
| Prepaid expenses and other current assets                                          |       | 81,868                                    |       | (144,923 | ) |
| Accounts payable                                                                   |       | (22,402                                   | )          | 153,707 |   |
| Accrued liabilities                                                                |       | 612,623                                   |       | (1,143,468 | ) |
| Income taxes payable                                                               |       | 107,802                                   |       | 250,634 |   |
|                                                                               |       |                                      |       |   |   |
| Net cash provided by (used in) operating activities                                |       | 2,894,878                                 |       | (119,504 | ) |
|                                                                               |       |                                      |       |   |   |
| **Cash Flows From Investing Activities:**                                          |       |                                      |       |   |   |
| Purchase of furniture, fixtures and equipment                                      |       | (874,737                                  | )          | (396,161 | ) |
| Proceeds from sales of furniture, fixtures and equipment                           |       | 550                                       |       | — |   |
| Purchase of investments available for sale                                         |       | —                                    |       | (5,232,533 | ) |
| Proceeds from sale of investments available for sale                               |       | 241,876                                   |       | 1,108,407 |   |
| Investment in LLC                                                                  |       | (2,025,626                                | )          | — |   |
| Expenditures related to patents and intangible assets                              |       | (417,742                                  | )          | (175,649 | ) |
|                                                                               |       |                                      |       |   |   |
| Net cash used in investing activities                                              |       | (3,075,679                                | )          | (4,695,936 | ) |
|                                                                               |       |                                      |       |   |   |
| **Cash Flows From Financing Activities:**                                          |       |                                      |       |   |   |
| Purchase of treasury stock                                                         |       | (164,461                                  | )          | — |   |
| Proceeds from exercise of stock options                                            |       | 3,569,927                                 |       | 385,529 |   |
|                                                                               |       |                                      |       |   |   |
| Net cash provided by financing activities                                          |       | 3,405,466                                 |       | 385,529 |   |
|                                                                               |       |                                      |       |   |   |
| **Net Increase (Decrease) in Cash and Cash  Equivalents**                          |       | 3,224,665                                 |       | (4,429,911 | ) |
| **Cash and Cash Equivalents, Beginning of Period**                                 |       | 12,795,620                                |       | 15,720,860 |   |
|                                                                               |       |                                      |       |   |   |
| **Cash and Cash Equivalents, End of Period**                                       |       | $                                         | 16,020,285 |   | $ | 11,290,949 |   |
|                                                                               |       |                                      |       |   |   |
| **Supplemental Disclosures of Cash Flow  Information:**                            |       |                                      |       |   |   |
| Cash paid during the period for:                                                   |       |                                      |       |   |   |
| Income taxes                                                                       |       | $                                         | 456,600    |   | $ | 469,928 |   |
| **Supplemental Disclosure of Non-Cash Investing  and Financing Activities:**       |       |                                      |       |   |   |
| Unrealized gain on investments, net                                                |       | $                                         | 38,823     |   | $ | (67,082 | ) |
| Issuance of Common stock for minority interest                                     |       | $                                         | —     |   | $ | 960,012 |   |

 

See accompanying notes to the condensed interim consolidated financialstatements

 

7

----

 

**NOTESTO THE CONDENSED INTERIM CONSOLIDATED FINANCIAL STATEMENTS****(Unaudited)**

**September 30, 2004**

 

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

 

Asused herein, the “Company,” “SRS Labs,” “we,” “us,” or “our” means SRS Labs,Inc. and its wholly-owned subsidiaries, Valence Tech Limited (including itswholly-owned subsidiaries) and SRSWOWcast.com, Inc. ("SRSWOWcast").  The accompanying condensed interimconsolidated financial statements have been prepared by the Company withoutaudit in conformity with accounting principles generally accepted in the UnitedStates of America (“generally accepted accounting principles”) for interimfinancial information and the rules and regulations of the U.S. Securities andExchange Commission (“SEC”). In the opinion of management, all adjustments(which include only normal recurring adjustments) considered necessary for afair presentation have been included. The Company previously reported fivebusiness segments (see Note 12). Certain accounts have been reclassified fromthat previously reported to conform to the current period presentation.

 

Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with generally accepted accounting principles have beencondensed or omitted pursuant to SEC rules and regulations for presentation ofinterim financial information. Therefore, the condensed interim consolidatedfinancial statements should be read in conjunction with the Company’s AnnualReport on Form 10-K for the fiscal year ended December 31, 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.

#### ** **

Certain amounts includedin the accompanying prior periods’ consolidated financial statements have beenreclassified to conform to the current period presentation.

 

**Estimates**

The preparation offinancial statements in accordance with accounting principles generallyaccepted in the United States of America requires management to make use ofcertain estimates and assumptions that affect the reported amounts of assetsand liabilities and disclosure of contingent assets and liabilities at the dateof the financial statements and the reported amounts of revenues and expensesduring the reported periods. We base our estimates on historical experience andon various other assumptions that we believe are reasonable under thecircumstances, the results of which form the basis for making judgments aboutcarrying values of assets and liabilities that are not readily apparent fromother sources. Actual results could differ from those estimates. See theaudited consolidated financial statements and notes thereto included in ourAnnual Report on Form 10-K for the year ended December 31, 2003 for anadditional discussion of the most significant accounting policies and estimatesused in the preparation of our financial statements.

 

 

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

 

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 disclosuresas required under SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS123”) and SFAS No. 148, “Accounting for Stock-Based Compensation —Transition and Disclosure — an Amendment of SFAS No. 123.” Accordingly,no stock-based employee compensation cost is reflected in net income (loss), asall options granted under the plan had an exercise price equal to the marketvalue of the underlying common stock on the date of grant. Had compensationexpense been recorded under the provisions of SFAS No. 123, the Company’snet income, (loss) and earnings per share would have been the pro forma amountsindicated below:

 
| ** **                                                                                             | ** ** | **For the three months ended  September 30,** | ** ** | **For the nine months ended  September 30****,** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                                             | ** ** | **2004**                                           | ** ** | **2003**                                              | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income (attributable to common shareholder) — as reported                                     |       | $                                                  | 737,004    |                                                  | $          | 118,826 |   | $ | 1,120,026 |   | $ | 127,478 |   |
| Add: stock based employee compensation expense included in reported  net income, net of 40% tax effect |       | 15,715                                             |       | 18,236                                                |       | 39,590 |   | 54,708 |   |
| Less fair value of stock-based employee compensation expense                                           |       | (380,894                                           | )          | (563,564                                              | )          | (1,215,778 | ) | (1,671,514 | ) |
| Net income (loss) (attributable to common shareholder) — pro forma                                |       | $                                                  | 371,825    |                                                  | $          | (426,502 | ) | $ | (56,162 | ) | $ | (1,489,328 | ) |
| Net income (loss) per share:                                                                           |       |                                               |       |                                                  |       |   |   |   |   |
| Basic, as reported                                                                                     |       | $                                                  | 0.05       |                                                  | $          | 0.01 |   | $ | 0.08 |   | $ | 0.01 |   |
| Basic, pro forma                                                                                       |       | $                                                  | 0.03       |                                                  | $          | (0.03 | ) | $ | 0.00 |   | $ | (0.12 | ) |
| Diluted, as reported                                                                                   |       | $                                                  | 0.05       |                                                  | $          | 0.01 |   | $ | 0.07 |   | $ | 0.01 |   |
| Diluted, pro forma                                                                                     |       | $                                                  | 0.02       |                                                  | $          | (0.03 | ) | $ | 0.00 |   | $ | (0.12 | ) |

 

8

----

 

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 September 30, 2004:

 

| Risk free interest rate |   | 3.3      | %      |
|-------------------------|--------|----------|--------|
| 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.

 

**3.             Capitalizationof Software Development Costs**

 

Costsincurred in the research, design and development of software for sale to othersas a separate product or embedded in a product and sold as part of the productas a whole are charged to expense until technological feasibility isestablished. Under SFAS No. 86, “Accounting for the Costs of ComputerSoftware to be Sold, Leased or Otherwise Marketed,” the Company capitalizessoftware 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.

 

Capitalizedsoftware as of September 30, 2004 and December 31, 2003 is as follows:

 
| ** **                | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|---------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Capitalized software      |       | $                            | 489,015    |                        | $          | 342,760 |   |
| Accumulated amortization  |       | (170,570                     | )          | (96,401                     | )          |
| Capitalized software, net |       | $                            | 318,445    |                        | $          | 246,359 |   |

 

TheCompany’s weighted average amortization period for capitalized software isapproximately three to five 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                              |       | $                      | 31,434     |   |
| 2005                              |       | 105,352                |       |
| 2006                              |       | 100,669                |       |
| 2007                              |       | 48,365                 |       |
| 2008                              |       | 28,692                 |       |
| Thereafter                        |       | 3,933                  |       |
|                                   |            |                        |            |  |

 

 

**4.             Goodwilland Intangible Assets**

 

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.  At December 31, 2003, the Companyevaluated goodwill and determined that no adjustment to impair goodwill wasnecessary.  In accordance with SFASNo. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,”all of the Company’s intangible assets that have definite lives are beingamortized on a straight-line basis over their estimated useful lives.

 

9

----

 

Anintangible asset in the amount of $640,071 was recorded representing the prior “minorityinterest” portion of the Circle Surround license agreement held by SRSWOWcast(See Note 8).

 

Goodwilland intangible assets consist of the following:

 
| ** **                                                                                                                                                                     | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Goodwill                                                                                                                                                                       |       | $                            | 533,031    |                        | $          | 533,031 |   |
|                                                                                                                                                                           |       |                         |       |                        |       |
| Patents                                                                                                                                                                        |       | $                            | 1,959,199  |                        | $          | 1,760,236 |   |
| Accumulated amortization                                                                                                                                                       |       | (843,010                     | )          | (739,792                    | )          |
| Patents, net                                                                                                                                                                   |       | 1,116,189                    |       | 1,020,444                   |       |
| Other Intangibles:                                                                                                                                                             |       |                         |       |                        |       |
| Assets acquired in the purchase of our subsidiary Valence Technology  in 1998: Covenant not to compete, Developed Technology, ASP brand name, Cell  Library, and Customer List |       | 4,910,400                    |       | 4,910,400                   |       |
| Asset acquired in purchase of our subsidiary SRSWOWcast in February  2003                                                                                                      |       | 640,071                      |       | 640,071                     |       |
| Poly Planar purchased technology for speaker products                                                                                                                          |       | 120,000                      |       | 120,000                     |       |
| Capitalized software and hardware for several technologies                                                                                                                     |       | 419,287                      |       | 222,758                     |       |
| Total of Other Intangibles                                                                                                                                                     |       | 6,089,758                    |       | 5,893,229                   |       |
| Accumulated amortization, other intangibles                                                                                                                                    |       | (4,457,658                   | )          | (4,176,863                  | )          |
| Other intangibles, net                                                                                                                                                         |       | 1,632,100                    |       | 1,716,366                   |       |
| Intangible assets, net                                                                                                                                                         |       | $                            | 2,748,289  |                        | $          | 2,736,810 |   |

 

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

 
| ** **                                                                                     | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                     | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Patents                                                                                        |       | $                                     | 46,331     |                                 | $          | 37,592 |   | $ | 113,307 |   | $ | 108,519 |   |
| Other intangibles:                                                                             |       |                                  |       |                                 |       |   |   |   |   |
| Covenant not to compete, developed technology, ASP brand name, cell  library and customer list |       | 67,479                                |       | 51,477                               |       | 202,436 |   | 162,405 |   |
| Poly Planar purchased technology                                                               |       | 6,000                                 |       | 6,000                                |       | 18,000 |   | 18,000 |   |
| Capitalized software and hardware                                                              |       | 29,713                                |       | —                               |       | 60,358 |   | — |   |
| Total intangible amortization expense                                                          |       | $                                     | 149,523    |                                 | $          | 95,069 |   | $ | 394,101 |   | $ | 288,924 |   |
|                                                                                                |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |  |  |

 

TheCompany’s weighted average amortization period for patents and otherintangibles is approximately three to ten years. The following table showsthe estimated amortization expense for those assets for the current year andeach of the four succeeding fiscal years:

 

| **Year ending   December 31,** | ** ** | **Estimated expense** | ** ** |
|-------------------------------------|------------|-----------------------|------------|
| 2004                                |       | $                     | 569,691    |   |
| 2005                                |       | $                     | 580,279    |   |
| 2006                                |       | $                     | 567,785    |   |
| 2007                                |       | $                     | 498,313    |   |
| 2008                                |       | $                     | 268,625    |   |

 

 

10

----

 

**5.**             **Investments Availablefor Sale**

 

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’sinvestment securities available for sale:

 
| ** **           | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|----------------------|------------|-----------------------------|------------|----------------------------|------------|
| Cost                 |       | $                           | 10,497,397 |                       | $          | 10,745,254 |   |
| Unrealized loss      |       | (216,221                    | )          | (255,044                   | )          |
| Estimated fair value |       | $                           | 10,281,176 |                       | $          | 10,490,210 |   |
|                      |            |                             |            |                            |            |  |  |  |  |

 

 

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

 
| ** **                                     | ** ** | **September 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                       |       | $                      | 10,497,397 |                       | $          | 10,281,176 |   | $ | 10,745,254 |   | $ | 10,490,210 |   |
|                                                |            |                        |            |                            |            |  |  |  |  |  |  |  |  |

 

Thefollowing table summarizes sales of available for sale securities for the threemonths and nine months ended September 30, 2004 and 2003. Specificidentification was used to determine costs in computing realized gains orlosses.

 
| ** **         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **         | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Proceeds from sale |       | $                                          | —     |                                      | $          | — |   | $ | 5,235,626 |   | $ | 16,862,523 |   |
| Realized gains     |       | —                                     |       | —                                    |       | 139,375 |   | 36,739 |   |
|                    |            |                                            |            |                                           |            |  |  |  |  |  |  |  |  |

 

**6.**             **Inventories**

 

Inventories,which consist of finished goods, are stated at the lower of cost or netrealizable value. Cost is calculated using the weighted average method and iscomprised of material costs and, where applicable, subcontracting and overheadcosts that have been incurred in bringing the inventories to their presentlocation and condition. Net realizable value represents the estimated sellingprice 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.

 

**7.             Investmentin LLC**

 

On September 23, 2004, theCompany entered into a strategic alliance with Coming Home Studios LLC (“CHS”)to produce and sell concert DVD’s which include the Company’s Circle Surroundtechnology.   In connection with thestrategic alliance, SRS and CHS entered into four agreements:  a StrategicAlliance Agreement, the CHS/SRS LLC Operating Agreement, a Warrant Agreementand a Production Services Agreement.

 

In the Strategic AllianceAgreement, CHS and SRS agree to work together to identify and implementco-promotional opportunities, including trade shows, movie theatres, videostreaming, concert DVDs, artist endorsements, bundling and premium deals,web-based promotional clips and road shows.  The initial term of theagreement expires on July 9, 2006 and is automatically renewable for successiveone-year terms.

 

The Operating Agreementgoverns CHS/SRS, LLC, which is a joint venture between CHS and SRS formed tocomplete and distribute concert videos featuring Duran Duran, Boz Scaggs— Jazz,Boz Scaggs— Greatest Hits, Godsmack and All Access.

 

11

----

 

Pursuant to the OperatingAgreement each of CHS and SRS contributed capital with a value of$1,800,000.  CHS is the managing memberof the joint venture.  CHS’ capitalcontribution to CHS/SRS, LLC consists of the artist agreements and relatedcontracts pursuant to which CHS/SRS, LLC will produce and distribute theabove-referenced concert videos.  SRS’ capital contribution is anaggregate of $1,800,000, consisting of a $700,000 bridge loan that SRS extendedto CHS on July 9, 2004 in anticipation of the strategic alliance, plus$1,100,000 in new cash.  In addition, the Company capitalized $185,626consisting of costs associated with the formation of the LLC and co-promotionalprojects.  CHS’ capital contributionconsisted of the artist agreements with Duran Duran, Boz Scaggs, Godsmack andAll Access pursuant to which the concert videos are filmed, produced anddistributed.  CHS/SRS, LLC contractedwith CHS to complete production of the concert videos pursuant to theProduction Services Agreement.

 

Profits from thedistribution of the concert videos and related assets will be allocated anddistributed equally until SRS and CHS have both received 1.75 times theiroriginal $1,800,000 capital contributions, after which profits will beallocated and distributed 90% to CHS and 10% to SRS.  Profits will berecognized upon cash distributions.

 

Under the Warrant Agreement,SRS paid CHS $40,000 to acquire a warrant to purchase up to 122,000 units ofClass A membership interests in CHS, which represents approximately 10% of theequity of CHS, for an exercise price of $9.836 per unit, subject to adjustmentbased on valuation of CHS at the time of an additional funding.  Thewarrant is immediately vested and exercisable for up to two years.  It istransferable and contains customary antidilution and price protectionprovisions for warrants of this type.

 

Under the ProductionServices Agreement, CHS/SRS, LLC contracted with CHS as an independentcontractor to perform all production services and to provide all otherservices, personnel, materials and elements for the production, completion anddelivery of the concert videos.  CHS, as the independent contractor, shallreceive an aggregate of $365,000 in production fees for all of its servicesunder the Production Services Agreement.  CHS is responsible for paymentof all costs and expenses in connection with the production and completion ofthe concert videos.

 

**8.**             **Minority Interest**

 

Minorityinterest in consolidated subsidiary represents the minority stockholders’proportionate share of the equity of SRSWOWcast, which was 13% atDecember 31, 2002.  OnFebruary 28, 2003, the Company completed an exchange offer with theminority shareholders representing 13% of SRSWOWcast, pursuant to whichSRS Labs acquired all 3,000,000 shares of Series A ConvertiblePreferred Stock in exchange for the issuance of 332,184 shares of SRS Labscommon stock trading at $2.89 per share at the closing price on the transactiondate. The acquisition resulted in a purchase price of $960,012.  As a result of the exchange offer, SRSWOWcastbecame a wholly owned subsidiary of SRS Labs.

 

SRSWOWcastdevelops and markets professional software and hardware products and consumersoftware plug-ins that incorporate proprietary audio enhancement and voice andsurround sound technologies. SRS Labs, as the majority shareholder, hasconsistently included the results of SRSWOWcast in all of the previouslyreported consolidated financial statements.

 

Thefollowing table summarizes the stated values of the assets acquired andliabilities 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 |   |

 

Currentassets primarily consisted of cash, accounts receivable and prepaid expensesand current liabilities were valued at stated value. Property and equipment wasvalued at net book value. The $640,071 of acquired intangible assets wasassigned to a license agreement between SRS Labs, Inc and SRSWOWcast,which is being amortized over 10 years.  The proformaeffect of the transaction, as if it had occurred at the beginning of thequarter ended March 31, 2003, would have been immaterial.

 

**9.**             **Net Income Per CommonShare**

 

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 by 

 

12

----

 

dividingnet income or loss available to common stockholders by the weighted averagenumber of common shares outstanding during each year. Diluted net income orloss per common share reflects the maximum dilution, based on the average priceof the Company’s common stock each period, and is computed similar to basicincome or loss per share except that the denominator is increased to includethe number of additional shares that would have been outstanding if potentiallydilutive stock options and warrants had been exercised.

 

Basicand diluted net income per share computed in accordance with SFAS 128 forthe three months and nine months ended September 30, 2004 and 2003 are asfollows:

 
| ** **                                              | ** ** | **For the three months  ended September 30,** | ** ** | **For the nine months  ended September 30,** | ** ** |
|---------------------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                              | ** ** | **2004**                                      | ** ** | **2003**                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| BASIC EPS                                               |       |                                          |       |                                         |       |   |   |   |   |
| Net income                                              |       | $                                             | 737,004    |                                         | $          | 118,826 |   | $ | 1,120,026 |   | $ | 127,478 |   |
| Denominator: weighted average common shares outstanding |       | 14,278,589                                    |       | 13,076,315                                   |       | 14,045,162 |   | 12,956,971 |   |
| Net income per share—basic                         |       | $                                             | 0.05       |                                         | $          | 0.01 |   | $ | 0.08 |   | $ | 0.01 |   |
|                                                    |       |                                          |       |                                         |       |   |   |   |   |
| DILUTED EPS                                             |       |                                          |       |                                         |       |   |   |   |   |
| Net income                                              |       | $                                             | 737,004    |                                         | $          | 118,826 |   | $ | 1,120,026 |   | $ | 127,478 |   |
| Denominator: weighted average common shares outstanding |       | 14,278,589                                    |       | 13,076,315                                   |       | 14,045,162 |   | 12,956,971 |   |
| Common equivalent shares outstanding:                   |       |                                          |       |                                         |       |   |   |   |   |
| Options                                                 |       | 1,117,203                                     |       | 1,653,975                                    |       | 1,946,169 |   | 772,705 |   |
| Total diluted shares                                    |       | 15,395,792                                    |       | 14,730,290                                   |       | 15,991,331 |   | 13,729,676 |   |
| Net income per share—diluted                       |       | $                                             | 0.05       |                                         | $          | 0.01 |   | $ | 0.07 |   | $ | 0.01 |   |

 

 

Therewere 1,308,500 and 1,109,881 potentially dilutive options outstanding for thequarters ending September 30, 2004 and 2003, respectively and there were164,000 and 2,113,419 potentially dilutive options outstanding for the ninemonths ending September 30, 2004 and 2003, respectively, that were notincluded in the table above because they would be anti-dilutive.

 

**10.**          **Commitmentsand Contingencies**

 

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

 

**11.**          **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 2004Repurchase Program the Company may acquire up to $3,000,000 of its outstanding 

 

13

----

 

commonstock for a six-month period from July 1, 2004 to December 31,2004.  Purchases may be made from time totime in the open market, block purchases or privately negotiated transactions,depending on market conditions, share price and other factors.  The following table shows activity under the2004 Repurchase Program for the quarter ending September 30, 2004:

 
| ** **                      | ** ** | **September 30, 2004** | ** ** |
|---------------------------------|------------|-----------------------------|------------|
| Shares repurchased              |       | 33,957                      |       |
| Average price per share         |       | $                           | 4.84       |   |
| Total repurchase authorized     |       | $                           | 3,000,000  |   |
| Repurchases under the plan      |       | $                           | 164,461    |   |
| Authorized repurchase remaining |       | $                           | 2,835,539  |   |

 

Allrepurchased shares are reflected as treasury stock in the accompanyingconsolidated balance sheets.

 

**12.****      ****SegmentInformation**

 

The Company operates two business segments — semiconductors andlicensing.  In 2003, the Company reportedits revenues in the following five segments: licensing; semiconductors;component distribution; product sales; and Internet and broadcast.  In 2004, the Company decided to reduce itssegments because the revenue attributable to the discontinued segments were notmaterial compared to revenues relating to semiconductors and licensing.  Segment information for the 2003 segments hasbeen restated to conform to the current year presentation.  Revenue from the component distribution segmentis now reported in the semiconductor segment and revenues from product salesand Internet and broadcast segments are now reported in the licensing segment.The Company does not allocate corporate operating expenses or specific assetsto these segments. Therefore, the segment information that follows includesonly net revenues, cost of sales and gross margins of the identified segments:

 
| ** **                               | ** ** | **Valence  Semiconductor** | ** ** | **SRS Labs  Licensing** | ** ** | **Total** | ** ** |
|------------------------------------------|------------|----------------------------|------------|-------------------------|------------|-----------|------------|
| **Three Months Ended Sept 30, 2004**     |       |                       |       |                    |       |      |       |
| Total revenues                           |       | $                          | 3,644,298  |                    | $          | 2,727,861 |       | $ | 6,372,159 |   |
| Cost of sales                            |       | 1,320,855                  |       | 100,342                 |       | 1,421,197 |       |
|                                     |       |                       |       |                    |       |      |       |
| Gross margin                             |       | $                          | 2,323,443  |                    | $          | 2,627,519 |       | $ | 4,950,962 |   |
|                                     |       |                       |       |                    |       |      |       |
| **Three Months Ended Sept 30, 2003**     |       |                       |       |                    |       |      |       |
| Total revenues                           |       | $                          | 2,966,923  |                    | $          | 1,919,471 |       | $ | 4,886,394 |   |
| Cost of sales                            |       | 1,226,407                  |       | 16,029                  |       | 1,242,436 |       |
|                                     |       |                       |       |                    |       |      |       |
| Gross margin                             |       | $                          | 1,740,516  |                    | $          | 1,903,442 |       | $ | 3,643,958 |   |
|                                     |       |                       |       |                    |       |      |       |
|                                     |       |                       |       |                    |       |      |       |
| ** **                               | ** ** | **Valence  Semiconductor** | ** ** | **SRS Labs  Licensing** | ** ** | **Total** | ** ** |
| **Nine Months Ended Sept 30, 2004** |       |                       |       |                    |       |      |       |
| Total revenues                           |       | $                          | 8,992,511  |                    | $          | 8,140,592 |       | $ | 17,133,103 |   |
| Cost of sales                            |       | 3,269,622                  |       | 146,886                 |       | 3,416,508 |       |
|                                     |       |                       |       |                    |       |      |       |
| Gross margin                             |       | $                          | 5,722,889  |                    | $          | 7,993,706 |       | $ | 13,716,595 |   |
|                                     |       |                       |       |                    |       |      |       |
| **Nine Months Ended Sept 30, 2003** |       |                       |       |                    |       |      |       |
| Total revenues                           |       | $                          | 7,244,323  |                    | $          | 6,638,291 |       | $ | 13,882,614 |   |
| Cost of sales                            |       | 2,750,437                  |       | 62,132                  |       | 2,812,569 |       |
|                                     |       |                       |       |                    |       |      |       |
| Gross margin                             |       | $                          | 4,493,886  |                    | $          | 6,576,159 |       | $ | 11,070,045 |   |

 

 

Forthe three months ending September 30, 2004, one customer accounted forapproximately 12% of revenues, or $757,886, in the semiconductor segment. Forthe same period in the prior year, one customer accounted for approximately 

 

14

----

 

13%of revenues, or $620,766, in the semiconductor segment. There was no significantcustomer in the licensing segment for the three months ended September 30, 2004and September 30, 2003.  For the ninemonths ending September 30, 2004, no single customer accounted for more than10% of revenues in either segment. For the same period in the prior year, onecustomer accounted for approximately 11% of revenues, or $1,517,953, in thesemiconductor segment.

 

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  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                       | ** ** | **2004**                              | ** ** | **%**                                | ** ** | **2003** | ** ** | **%** | ** ** | **2004** | ** ** | **%** | ** ** | **2003** | ** ** | **%** | ** ** |
| **Geographic Area Revenue****:** |       |                                  |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Hong Kong                        |       | $                                     | 3,283,202  |                                 | 52         | % | $ | 2,619,125 |   | 48 | % | $ | 8,264,269 |   | 54 | % | $ | 6,323,620 |   | 46 | % |
| Japan                            |       | 1,098,643                             |       | 17                                   | %          | 933,546 |   | 22 | % | 3,756,473 |   | 19 | % | 4,173,863 |   | 30 | % |
| China                            |       | 797,074                               |       | 13                                   | %          | 453,442 |   | 9 | % | 1,590,754 |   | 9 | % | 1,315,920 |   | 9 | % |
| Americas                         |       | 512,699                               |       | 8                                    | %          | — |   | 10 | % | 1,824,668 |   | 3 | % | 736,567 |   | 5 | % |
| Other Asia Pacific               |       | 502,769                               |       | 7                                    | %          | 399,314 |   | 8 | % | 1,103,930 |   | 9 | % | 841,274 |   | 6 | % |
| Europe                           |       | 177,772                               |       | 3                                    | %          | — |   | 3 | % | 593,009 |   | 6 | % | 491,370 |   | 4 | % |
|                             |       |                                  |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total                            |       | $                                     | 6,372,159  |                                 | 100        | % | $ | 4,886,394 |   | 100 | % | $ | 17,133,103 |   | 100 | % | $ | 13,882,614 |   | 100 | % |

 

 

**13.**          **RecentAccounting Pronouncements**

 

InDecember 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.

 

InMarch 2004, the Emerging Issues Task Force (EITF) reached a consensus onEITF No. 03-06, Participating Securities and Two-Class Method under FASBStatement No. 128, Earnings per Share. EITF No. 03-06 addresses a number ofquestions regarding the computation of earnings per share (EPS) by companiesthat have issued securities other than common stock that contractually entitlethe holder to participate in dividends and earnings of the company when, andif, it declares dividends on its common stock. The issue also provides furtherguidance in applying the two-class method of calculating EPS. It clarifies whatconstitutes a participating security and how to apply the two-class method ofcomputing EPS once it is determined that a security is participating, includinghow to allocate undistributed earnings to such a security. The consensus reachedon EITF No. 03-06 is effective for fiscal periods beginning afterMarch 31, 2004. Prior period earnings per share amounts will be restatedto conform to the consensus to ensure comparability year over year. Theadoption of EITF No. 03-06 did not have any impact on our results of operationsor financial condition.

 

The Financial Accounting Standard Board (“FASB”)issued an exposure draft entitled “ *Share-BasedPayment, an Amendment of FASB Statements Nos. 123 and 95.”*Thisexposure draft would require stock-based compensation to employees to berecognized as a cost in the financial statements and that such cost be measuredaccording to the fair value of the stock options. In the absence of anobservable market price for the stock awards, the fair value of the stockoptions would be based upon a valuation methodology that takes intoconsideration various factors, including the exercise price of the option, theexpected term of the option, the current price of the underlying shares, theexpected volatility of the underlying share price, the expected dividends onthe underlying shares and the risk-free interest rate. The proposedrequirements in the exposure draft would be effective for the first fiscal yearbeginning after June 15, 2005.  SeeNote 2 for pro forma disclosures regarding the effect on net income andearnings per share if we had applied the fair value recognition provisions ofthe exposure draft and SFAS No. 123.  Wewill continue to monitor communications on this subject from the FASB in order todetermine the impact on our consolidated financial statements.

 

15

----

 

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

This information should be read in conjunction withthe audited consolidated financial statements and notes thereto and Management’sDiscussion and Analysis of Financial Condition and Results of Operationscontained in the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2003 (the “Form 10-K”), the audited consolidated financialstatements and the notes thereto included in the Form 10-K and the unauditedcondensed interim consolidated financial statements and notes thereto includedin this Quarterly Report.

**Overview**

SRS Labs is a leading developer and provider ofapplication specific integrated circuits (“ASICs”), standard integrated circuits (“ICs”) andaudio and voice technology solutions for the home theater, portable audio,wireless, computer, game, automotive, broadcast, Internet andtelecommunications markets. The Company operates in the following two businesssegments:

*Semiconductor:*  ThroughSRS Labs, Inc.’s wholly-owned subsidiary, ValenceTech Limited, and ValenceTechLimited’s wholly-owned subsidiaries (collectively “Valence”), the semiconductorsegment 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, theparent company, and its wholly-owned subsidiary, SRSWOWcast.com, Inc., doingbusiness as SRSWOWcast Technologies (“SRSWOWcast”), the licensing segmentdevelops and licenses audio and voice technology solutions tomany of the world’s leading OEMs, software providers and semiconductor companies,and licenses and markets hardware and software products for the Internet andprofessional audio markets.

In 2003, the Company reported its revenues in thefollowing five segments: licensing; semiconductors; component distribution;product sales; and Internet and broadcast. In 2004, the Company decided to reduce its segments because of themateriality of the revenues attributable to the other three segments.  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.  As used herein, the “Company,”“SRS Labs,” “we,” “us,” or “our” means SRS Labs, Inc. and its wholly ownedsubsidiaries, including Valence and SRSWOWcast.

We have determined that the most effectivestrategy for the creation of stable and sustainable revenue growth is todiversify our revenue base.  In ourlicensing segment, our goal is to diversify our revenue base from ourhistorical concentration in home theater. We believe that the mobile phone, portable audio, PC and automotiveareas within the consumer electronics market present new high volume, highgrowth opportunities for application of our audio technologies.  Our diversification strategy also extends toour semiconductor segment in which we have refocused our team away from theheavy concentration on custom application specific projects for a fewcustomers.  In addition, we are now alsofocused on marketing our standard branded chips, including new chips that embedSRS Labs’ technologies, with particular attention toward the largemanufacturing market in China.

In September 2004, we entered into astrategic alliance with Coming Home Studios LLC (“CHS”) to produce and sellconcert DVD’s which include our Circle Surround technology.  In connection with the strategic alliance,SRS and CHS entered into four agreements: a Strategic Alliance Agreement, the CHS/SRS LLC Operating Agreement, aWarrant Agreement and a Production Services Agreement.  In the Strategic Alliance Agreement, CHS andSRS agree to work together to identify and implement co-promotionalopportunities, including trade shows, movie theatres, video streaming, concertDVDs, artist endorsements, bundling and premium deals, web-based promotionalclips and road shows.  The initial termof the agreement expires on July 9, 2006 and is automatically renewable forsuccessive one-year terms. 

Pursuant to the Operating Agreement each ofCHS and us contributed capital with a value of $1,800,000.  In connection with this strategic alliance,we capitalized $185,626 consisting of costs associated with the formation ofthe LLC and co-promotional projects. Profits from the distribution of the concert videos and related assetswill be allocated and distributed equally until we and CHS have each received1.75 times their original capital contribution, after which profits will beallocated and distributed 90% to CHS and 10% to SRS.  Revenues will be recognized upon profitdistributions.  Under the WarrantAgreement, we paid CHS $40,000 to acquire a warrant to purchase up to 122,000units of Class A membership interests in CHS, which represents approximately10% of the equity of CHS, for an exercise price of $9.836 per unit, subject toadjustment based on a valuation of CHS at the time of an additionalfunding.  The warrant is immediatelyvested and exercisable for up to two years. It is transferable and contains customary anti-dilution and priceprotection provisions for warrants of this type.

 

16

----

 

**Critical Accounting Policies**

Our discussion and analysisof our results of operations and liquidity and capital resources are based onour consolidated financial statements which have been prepared in accordancewith accounting principles generally accepted in the United States.

The preparation of these financial statementsrequires us to make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses, and disclosure of contingent assetsand liabilities. We base our estimates on historical and anticipated resultsand trends and on various other assumptions that we believe are reasonableunder the 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 criticalaccounting policies, defined as those policies that we believe are:(a) the most important to the portrayal of our financial condition andresults of operations; and (b) that require management’s most difficult,subjective or complex judgments, often as a result of the need to makeestimates about the matters that are inherently uncertain. Our most criticalaccounting estimates include valuation of accounts receivable, which impactsoperating expenses; valuation of inventory, which impacts gross margin;valuation of intangible assets and capitalization of software, which primarilyimpacts operating expenses when we impair assets or accelerate theirdepreciation; and recognition and measurement of current and deferred incometax assets and liabilities, which impacts our tax provision.  We discuss these policies, as well as theestimates and judgments involved in greater detail below. 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 require us to make estimatesor judgments that are difficult or subjective.

 

*Accounts Receivable*

 

Weperform ongoing credit evaluations of our customers and adjust credit limitsbased upon payment history, the customer’s current credit worthiness andvarious other factors, as determined by our review of their current creditinformation. We continuously monitor collections and payments from ourcustomers and maintain allowances for doubtful accounts based upon specificcustomer circumstances, current economic trends, historical experience and theage of past due receivables. While such credit losses have historically beenwithin our expectations and the provisions established, we cannot guaranteethat we will continue to experience the same credit loss rates that we have inthe past. Unanticipated changes in the liquidity or financial position of ourcustomers may require additional provisions for doubtful accounts.

 

*Inventory*

 

Inventoryis stated at the lower of cost or net realizable value. We periodically assessour inventory for potential obsolescence and lower-of-cost-or-market issues. Wemake estimates of inventory obsolescence, providing reserves when necessary,based on, among other factors, demand for inventory based on backlog, productpricing, the ability to liquidate or sell older inventory and the impact ofintroducing new products. If actual market conditions or our customer’s productdemands are less favorable than those projected, additional provisions may berequired.

 

*Intangible Assets & Capitalization of Software*

 

In accordance with SFASNo. 142, “Goodwill and Other Intangible Assets”, goodwill and intangible assetsdeemed to have indefinite lives are no longer amortized, but are instead testedfor impairment annually or sooner if circumstances indicate they may no longerbe recoverable.  Our judgments regardingthe existence of impairment indicators and future cash flows related tointangible assets are based on operational performance of our acquiredbusinesses, market conditions and other factors. If the carrying value of areporting unit exceeds its fair value, goodwill is considered impaired and asecond test is performed to measure the amount of impairment loss, if any. Forfiscal 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 not resultin charges as a result of future impairment. In accordance with SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets,” all of the Company’sintangible assets that have definite lives are being amortized on astraight-line basis over their estimated useful lives.

 

Costsincurred in the research, design and development of software for sale to othersas a separate product or embedded in a product and sold as part of the productas a whole are charged to expense until technological feasibility isestablished. Under SFAS No. 86, “Accounting for the Costs of ComputerSoftware to be Sold, Leased or Otherwise 

 

17

----

 

Marketed,”we capitalize 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.

 

*IncomeTaxes*

In preparing our consolidated financial statements,we go through a process to estimate our income taxes in each of the countries inwhich we operate. The process includes an assessment of the current taxexpense, the results from tax examinations and the effects of temporarydifferences resulting from the different treatment of transactions for tax andfinancial accounting purposes. These differences result in deferred tax assetsand liabilities, which are included in the Consolidated Balance Sheet. Weaccount for income taxes in accordance with Statement of Financial AccountingStandards No. 109, or SFAS 109, “Accounting for Income Taxes,” whichrequires that deferred tax assets and liabilities be recognized using enactedtax rates for the effect of temporary differences between the book and taxbases of recorded assets and liabilities. SFAS 109 also requires thatdeferred tax assets be reduced by a valuation allowance if it is more likelythan not that some portion or all of the deferred tax asset will not berealized. We evaluate the reliability of our deferred tax assets by assessingour valuation allowance and by adjusting the amount of such allowance, ifnecessary. At December 31, 2003, we had net deferred tax assets primarilyresulting from temporary differences between the book and tax bases of assetsand 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 calculationsand assumptions that will be subject to examination by the taxing authoritiesin the jurisdictions in which we operate. Should the actual results differ fromour estimates, we would have to adjust the income tax provision in the periodin which the facts and circumstances that give rise to the revision becomeknown. Tax law and rate changes are reflected in the income tax provision inthe period in which such changes are enacted.

 

 

 

**Results of Operations**

 

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

 

*Revenues*

 

Semiconductor revenues consists of (a) design feesrelating to, and sales of, application specific integrated circuits (“ASIC”)for third parties by Valence to original equipment manufacturers (“OEMs”);and  (b) sales of general purposeintegrated circuits (“ICs”) designed by Valence under the brand name ASP.  Licensing revenues consist primarily ofroyalties generated from the license of SRS Labs’ audio and voicetechnologies.  License and royaltyagreements generally provide for the license of technologies for a fee based onthe number of units distributed by the licensee.  However, we have in the past and may again inthe future, enter into a license agreement for a one-time fee. Also included inlicensing revenue are revenues generated from the sale of hardware and softwareapplications into the broadcast audio markets.

Total revenues for the three months endedSeptember 30, 2004 were $6,372,159 compared to $4,886,394****for the three months endedSeptember 30, 2003, an increase of $1,485,765 or 30.4%.  Semiconductor revenues were $3,644,298 forthe three months ended September 30, 2004 compared to $2,966,923for the threemonths ended September 30, 2003, an increase of $677,375 or 22.8%. Withinsemiconductor revenue, ASIC accounted for $2,526,417 or 69.3% for the three 

 

18

----

 

monthsended September 30, 2004 compared to $2,310,406 or 77.9% for same period lastyear, an increase of $216,011 or 9.3%. ASP chips accounted for $1,117,881, or30.7% for the three months ended September 30, 2004 compared to $656,517 or22.1% for the same period last year, an increase of $461,364 or 70.3%.  Within ASP revenues, SRS chips accounted for49.5% this year compared to 22.9% last year, a growth of 60.8%.  The increase in semiconductor sales can beprimarily attributed to traditional seasonality and the increased sales of ASPchips to the TV and portable audio markets. Semiconductor revenue also improveddue to the movement of backlog, which built up in Q2 due to foundry capacityconstraints.

Licensing revenues were $2,727,861 for the threemonths ended September 30, 2004, compared to $1,919,471****for the three months endedSeptember 30, 2003, an increase of $808,390 or 42.1%.  The sales growth in licensing wasattributable to our continued diversification strategy, which expanded the useof our technologies in the portable devices, PC, mobile phone and automotivemarkets. The following table presents the Company’s Licensing revenues mix bymarket segment:

 

| ** **                                               | ** ** | **Three Months Ended Sept 30,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                               | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| Home Entertainment (TV, Set Top Box, A/V Receiver, DVD)  |       | 69                                   | %          | 74 | % |
| Portable Media Devices (Digital Media Player, Headphone) |       | 13                                   | %          | 12 | % |
| PC (Software, Hardware)                                  |       | 8                                    | %          | 7 | % |
| Personal Telecommunications (Mobile phone, PDA)          |       | 7                                    | %          | 6 | % |
| Automotive                                               |       | 3                                    | %          | 1 | % |

 

*Gross Margin*

 

Cost of sales consists primarily of fabricationcosts, assembly and test costs, and the cost of materials and overhead fromoperations. Gross margins are dependent on the mix of products sold, servicesprovided and royalties earned. The following table presentsthe Company’s gross margin percentages for the three months ended September 30,2004 compared to September 30, 2003:

 

| ** **                                                   | ** ** | **Three Months  Ended Sept 30,** | ** ** |
|--------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                   | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| **Semiconductor**                                            |       |                                  |       |   |   |
| ASIC revenue as a percentage of total semiconductor revenue  |       | 69.3                                  | %          | 77.9 | % |
| ASIC gross margin                                            |       | 63.0                                  | %          | 58.5 | % |
|                                                         |       |                                  |       |   |   |
| ASP revenue as a percentage of total semiconductor revenue   |       | 30.7                                  | %          | 22.1 | % |
| ASP gross margin                                             |       | 65.5                                  | %          | 59.3 | % |
|                                                         |       |                                  |       |   |   |
| Total semiconductor revenue as a percentage of total revenue |       | 57.2                                  | %          | 60.7 | % |
| Total semiconductor gross margin                             |       | 63.8                                  | %          | 58.7 | % |
|                                                         |       |                                  |       |   |   |
| **Licensing**                                                |       |                                  |       |   |   |
| Licensing revenue as a percentage of total revenue           |       | 42.8                                  | %          | 39.3 | % |
| Licensing gross margin                                       |       | 96.3                                  | %          | 99.2 | % |
|                                                         |       |                                  |       |   |   |
| **Total Gross Margin**                                       |       | 77.7                                  | %          | 74.6 | % |

 

ASIC gross margins increased due to increase indesign fees and sales of component inventory previously written off.  The increase in ASP gross margins can beattributable to new chips with higher gross margins representing 43.6% of totalASP chip sales.  The slight decrease inlicensing gross margins is attributable to the write-off of speaker inventory,which was deemed to be obsolete, and the cost of logo materials for licenseeproducts.

 

19

----

 

 

*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 $­­1,372,303 for the three monthsended September 30, 2004 compared to $1,216,568**for the same prior year period, an increase of $155,735 or 12.8%. The increase in salesexpenses can be primarily attributed to severance costs and increased travelrelated to customer support and co-promotional activities.  As a percentage of totalrevenues, sales and marketing expenses decreased from 24.9% for the quarterended September 30, 2003 to 21.5% for the same period this year.

 

*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 $1,266,606 for the three months ended September 30, 2004 compared to$1,032,100****for the same prior yearperiod, an increase of $234,506 or 22.7%. The increase in research anddevelopment costs is primarily due to the addition of research and developmentpersonnel added in the fourth quarter of 2003. As a percentage of total revenues, research and development expensesdecreased from 21.1% for thequarter ended September 30, 2003, to 19.9% for the same period this year.

 

*General and Administrative*

 

Generaland administrative (“G&A”) expenses consist primarily of employee-relatedexpenses, legal costs associated with the administration of intellectualproperty and other professional fees. G&A expenses were $1,452,236 for thethree months ended September 30, 2004 compared to $1,143,930 for the sameprior year period, an increase of $308,306 or 27.0%. The increase isattributable to increases in professional fees, public company costs, bad debtand increases in amortization associated with increased capitalization ofpatents and purchased technology.  As apercentage of total revenues, G&A expenses decreased from 23.4% for thequarter ended September 30, 2003, to 22.8% for the same period this year.

 

*Income From Operations*

 

Incomefrom operations increased by $608,457 to $859,817 for the quarter endedSeptember 30, 2004 as compared to income from operations of $251,360 for thequarter ended September 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 $118,908 for the three months endedSeptember 30, 2004, compared to $131,925 for the same prior year period, adecrease of $13,017 or 9.9%. The decrease is primarily attributable to lowerinterest rates in 2004.

 

*Provision for Income Taxes*

 

The income tax expense forthe three months ended September 30, 2004 was $241,721, compared to tax expenseof $264,459 for the same prior year period, a decrease of $22,738 or 8.6%. 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 September 30, 2004 was attributable tothe U.S. Japan taxtreaty that went into effect on July 1, 2004 and eliminates source-countrywithholdings on royalties. Congress passed the American Jobs Creation Act of2004 on October 22, 2004 (“the Act”). The Act contains numerous changes to existing tax laws including, butnot limited to, incentives to repatriate foreign accumulated earnings and otherinternational tax provisions regarding foreign tax credits.  The company has not yet evaluated anddetermined what impact, if any, the Act may have on our results of operationsand financial condition in the future.

 

 

**Nine Months Ended September 30, 2004 Compared to Nine MonthsEnded September 30, 2003**

 

*Revenues*

 

Total revenues for the nine months endedSeptember 30, 2004 were $17,133,103 compared to $13,882,614**for the nine months endedSeptember 30, 2003, an increase of $3,250,489 or 23.4%. Semiconductorrevenues were $8,992,511 for 

 

20

----

 

thenine months ended September 30, 2004 compared to $7,244,323 for the nine monthsended September 30, 2003, an increase of $1,748,188 or 24.1%. Withinsemiconductor revenue, ASIC accounted for $6,188,486 or 68.8% for the ninemonths ended September 30, 2004 compared to $5,696,957 or 78.6% for the ninemonths ended September 30, 2003, an increase of $491,529 or 8.6%. ASP chipsaccounted for $2,804,025 or 31.2% for the nine months ended September 30, 2004compared to $1,547,366 or 21.4% for the nine months ended September 30, 2003,an increase of $1,256,659 or 81.2%, of which SRS technology chips accounted for62.4% of ASP growth. This increase in semiconductor sales is attributable tonew design wins with new chip offerings including SRS chips. Licensing revenueswere $8,140,592 for the nine months ended September 30, 2004, compared to$6,638,291 for the nine months ended September 30, 2003, an increase of$1,502,301 or 22.6%. This increase is attributable to our diversificationstrategy and 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. The following table presentsthe Company’s Licensing revenues mix by market segment:

 

| ** **                                               | ** ** | **Nine Months Ended Sept 30,** | ** ** |
|----------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                               | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| Home Entertainment (TV, Set Top Box, A/V Receiver, DVD)  |       | 68                                  | %          | 84 | % |
| Portable Media Devices (Digital Media Player, Headphone) |       | 10                                  | %          | 7 | % |
| PC (Software, Hardware).                                 |       | 11                                  | %          | 4 | % |
| Personal Telecommunications (Mobile phone, PDA)          |       | 10                                  | %          | 4 | % |
| Automotive.                                              |       | 1                                   | %          | 1 | % |

 

###### *Gross Margin*

 

Cost of sales consists primarily offabrication costs, assembly and test costs, and the cost of materials andoverhead from operations. The following table presents the Company’s grossmargin percentages for the nine months ended September 30, 2004 compared toSeptember 30, 2003:

 

| ** **                                                   | ** ** | **Nine Months  Ended Sept 30,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                   | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| **Semiconductor**                                            | ** ** | ** **                           | ** ** | ** ** | ** ** |
| ASIC revenue as a percentage of total semiconductor revenue  |       | 68.8                                 | %          | 78.6 | % |
| ASIC gross margin                                            |       | 65.4                                 | %          | 62.0 | % |
|                                                         |       |                                 |       |   |   |
| ASP revenue as a percentage of total semiconductor revenue   |       | 31.2                                 | %          | 21.4 | % |
| ASP gross margin                                             |       | 59.8                                 | %          | 62.2 | % |
|                                                         |       |                                 |       |   |   |
| Total semiconductor revenue as a percentage of total revenue |       | 52.5                                 | %          | 52.2 | % |
| Total semiconductor gross margin                             |       | 63.6                                 | %          | 62.0 | % |
|                                                         |       |                                 |       |   |   |
| **Licensing**                                                | ** ** | ** **                           | ** ** | ** ** | ** ** |
| Licensing revenue as a percentage of total revenue           |       | 47.5                                 | %          | 47.8 | % |
| Licensing gross margin                                       |       | 98.2                                 | %          | 99.1 | % |
|                                                         |       |                                 |       |   |   |
| **Total Gross Margin**                                       |       | 80.1                                 | %          | 79.7 | % |

 

*Sales and Marketing*

 

Sales and marketing expenses consistprimarily of employee salaries, sales consultants’ fees and related expenses,sales commissions and product promotion costs. Sales and marketing expenseswere $4,149,887 for the nine months ended September 30, 2004 compared to$3,840,155**for the same prioryear period, an increase of $309,732 or 8.1%. The net increase in sales andmarketing expenses for the nine months ended September 30, 2004 isattributable to severance costs and 

 

21

----

 

increased promotion costs associated withhigher licensing revenue and investments in branding and promotion of ourtechnologies in new markets designed to increase future revenues. As apercentage of total revenues, sales and marketing expenses decreased from 27.7%for the nine months ended September 30, 2003, to 24.2% for the same periodthis year.

 

*Research and Development*

 

Research and development expenses consist ofsalaries and related costs of employees engaged in ongoing research, design anddevelopment activities and costs for engineering materials and supplies.Research and development expenses were $3,620,219 for the nine months endedSeptember 30, 2004 compared to $3,083,438 for the same prior year period, anincrease of $536,781 or 17.4%. The increase in research and development costsis primarily due to the addition of research and development personnel andincreased costs associated with the increased semiconductor business activity.  As a percentage of total revenues, researchand development expenses decreased from 22.2% for the nine months endedSeptember 30, 2003, to 21.1% for the same period this 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 $4,490,732 for the nine months endedSeptember 30, 2004 compared to $3,668,573 for the same prior year period,an increase of $822,159 or 22.4%. The increase was primarily attributable toincreased professional fees, public company expenses, and increasedamortization associated with the increased capitalization of patents andpurchased technology. As a percentage of total revenues, G&A expensesdecreased from 26.4% for the nine months ended September 30, 2003, to26.2% for the same period this year.

 

*Income From Operations*

 

Incomefrom operations increased by $977,878 to $1,455,757 for the nine months endedSeptember 30, 2004, as compared to income from operations of $477,879 for the sameperiod last year.  The increase in incomefrom operations is due to an increase in revenue, partially offset by anincrease in operating expenses.

 

*Other Income, Net*

 

Other income, net, consists primarily ofinterest income, gain or (loss) on sale of securities, interest expense andforeign currency transaction gains and losses. Other income, net, was $455,132for the nine months ended September 30, 2004, compared to $414,655 for thesame prior year period, an increase of $40,477 or 9.8%. The increase isprimarily attributable to investment gains from sales of U.S. Treasury in 2004.

 

###### *Minority Interest*

 

Minority interest represents the minorityshareholders’, 13%, proportionate share of losses in SRSWOWcast. Minorityinterest was $0 for the nine months ended September 30, 2004, compared to$5,430 for the nine months ended September 30, 2003. InFebruary 2003, SRS Labs completed an exchange offer with the minorityshareholders of SRSWOWcast, pursuant to which SRS Labs acquired all of theoutstanding shares of Series A Convertible Preferred Stock in exchange forthe issuance of shares of SRS Labs common stock. As a result of the exchangeoffer, SRSWOWcast became a wholly owned subsidiary of SRS Labs.

 

*Provision for Income Taxes*

 

The income tax expense forthe nine months ended September 30, 2004 was $790,863, compared to taxexpense of $770,486 for the same prior year period, an increase of $20,377 or2.6%. The provision consists primarily of taxes paid on licensing revenuessourced from countries requiring foreign tax withholdings and taxes paid onprofits in Hong Kong at the rate of 17.5%. The increase in income tax for the nine months ended September 30, 2004was attributable to higher profits in Hong Kong offset by the U.S. Japan tax treaty that went intoeffect on July 1, 2004, which eliminated source-country withholdings onroyalties.

 

22

----

 

**Liquidity and Capital Resources**

 

The Company’s principal source of liquidityto fund ongoing operations at September 30, 2004 consisted of cash, cashequivalents and long-term investments of $26,301,461.  At September 30, 2004, the Company hadcash and cash equivalents of $16,020,285 and long-term investments of $10,281,176.Cash and cash equivalents generally consist of cash, money market funds andother money market instruments with original maturities of three months orless. Investments consist of U.S. government securities rated AAA.

Cash and cash equivalents increased $3,224,665during the nine months ended September 30, 2004 to $16,020,285.  The increase was primarily due to the netcash provided by operating activities of $2,894,878, and financing activitiesof $3,405,466 derived primarily from the exercise of stock options, offset bynet cash used in investing activities of $3,075,679 relating primarily to aninvestment in a strategic alliance for $2,025,626, as well as capital andpatent expenditures of $1,292,479. Net cash provided by operating activitieswas $2,894,878 versus net cash used of $119,504 for the nine months endedSeptember 30, 2004 and 2003 respectively. The improvement in our operating cashflows is primarily the result of increased revenues, gross margins and netincome. Our inventories decreased $30,612 and increased $180,887 for the ninemonths ended September 30, 2004 and 2003 respectively.  The decrease in 2004 resulted from increasedsemiconductor sales and the sell off of backlog, which built up in Q2 due tofoundry capacity constraints.  Also,during the quarter, the company sold component inventory, which was previouslyreserved for in our provision for slow moving and obsolete inventory.  The reversal of the provision, provided abenefit of $160,855 for the nine months ended September 30, 2004, which wasoffset by increases in the reserve of $116,255 associated with our periodicassessment of inventory to arrive at a net benefit of $44,600.  Accrued liabilities increased $612,623 anddecreased $1,143,468 during the nine months ended September 30, 2004 and 2003respectively.  These changes relate toprofessional fees, commissions and bonus and the timing of payments to vendorsand employees.

Our net cash used for investing activities was$3,075,679 and $4,695,936 during the nine months ended September 30, 2004 andSeptember 30, 2003 respectively. Investing activities in 2004 primarily represented an investment in thestrategic alliance with Coming Home Studios LLC, referenced above under thecaption “Overview,” and purchases of capital equipment, patents and intangibleassets.  Investing activities in 2003primarily represented purchases of investments available for sale and capitalequipment. Our financing activities, primarily consisted of proceeds from theexercise of employee stock options, provided $3,405,466 and $385,529 during thenine months ended September 30, 2004 and September 30, 2003 respectively.

 On June 30,2004, the Company’s Board of Directors authorized a stock repurchaseprogram.  Under the repurchase program,the Company may acquire up to $3,000,000 of its outstanding common stock for aperiod of six months from July 1, 2004 to December 31, 2004.  Purchases may be made from time to time inthe open market, block purchases or privately negotiated transactions,depending on market conditions, share price and other factors.

Congresspassed the American Jobs Creation Act of 2004 on October 22, 2004 (the “Act”).  The Act contains numerous changes to existingtax laws including, but not limited to, incentives to repatriate foreignaccumulated earnings and other international tax provisions regarding foreigntax credits.  The Company is in theprocess of evaluating what impact, if any, the Act may have on our results ofoperations and financial condition in the future.

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

 

**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 inthe home theater market with the majority of revenue generated from theinclusion of SRS technology inside televisions, DVD players and set-top boxes.We expect that the consumer home entertainment market will continue to accountfor a significant portion of our licensing revenues for the foreseeable future.While consumer spending in general on consumer electronic products hasincreased, retail prices for certain consumer electronics products that includeour audio technology, 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 operations.

 

23

----

 

Decliningprices of consumer electronic products could put pressure on our licensing feesthat are charged to manufacturers. Also, given the current economicenvironment, consumer spending on DVD players and other home electronicproducts may not increase as expected. Such declines in consumer spending,should they occur, and continued decreases in consumer product pricing forelectronic goods may have a significant negative impact on our financialresults. The Company’s strategy is to diversify its customer base in an effortto decrease the impact from the loss of a particular customer, product segmentor change in market trend.

 

*Our quarterly results may fluctuate*

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

 

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

We derive a significant amount of our revenue fromValence’s ASIC business. Valence’s engineering team focuses on the design ofcustom ASICs to meet specific customers’ requirements and outsources theproduction of the design to mask houses, foundries and packaging houses locatedprimarily in Asia. The operations of Valence could be affected by a variety offactors, including the timing of customer orders, the timing of developmentrevenue, changes in the mix of products distributed and the mix of distributionchannels employed, the emergence of a new industry standard, productobsolescence and changes in pricing policies by the Company, its competitors orits suppliers.

Business revenue from ASICs is concentrated in alimited number of customers in the areas of consumer electronics,communications products, computers and computer peripherals. The businessgenerated from any one customer may be for a fixed length or quantity. As such,it is customary in our ASIC business to have a certain amount of customerturnover as new ASIC projects are obtained for different customers. However, itis possible that the loss of any particular customer or any bad debt arisingfrom such customer may have a material adverse impact on our financial conditionand results of operation. Beginning in fiscal 1999, Valence began to exit fromcertain lower margin product offerings in the distribution side of the businessand has placed more emphasis on developing and distributing products that arerelated to, or incorporate, our proprietary technologies. As a result, theimmediate loss in revenue of the low margin distribution business will not beentirely offset by the new proprietary technology based products, which willtake time to develop and be introduced into the marketplace. There can be noassurance that we will be able to quickly introduce new products to offset theloss in revenue or that the new products developed will receive a favorablemarket acceptance.

Valenceadds significant diversity to our overall business structure and opportunities.We recognize that in the presence of such corporate diversity, and inparticular with regard to the semiconductor industry, there will always exist apotential for conflict among sales channels between the Company and ourtechnology licensees. Although the operations of our licensing business andthose of Valence are generally complementary, there can be no assurances thatsales channel conflicts will not arise. If such potential conflicts domaterialize, we may or may not be able to mitigate the effect of such perceivedconflicts, which, if not resolved, may impact the results of operations.

 

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

Valenceis a “fabless” semiconductor company meaning that Valence designs, develops andmarkets our selection of custom and standard integrated circuits but we rely onthird party contractors to manufacture, assemble and test our products. Fromtime to time there can be foundry capacity issues due to global demands thataffect the semiconductor industry. Although we believe our relationships 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, there are significant risks associatedwith our reliance on third-party vendors including: reallocation of capacity toother foundry customers, potential price increases, delays and interruptions inorder deliveries, reduced control over product quality and increased risk ofmisappropriation of intellectual property.

 

24

----

 

*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 PRCand other parts of Asia that require refinement to adapt to the changing marketconditions in that region. Our operations in Asia, and international operationsin general, are subject to risks of unexpected changes in, or impositions of,legislative or regulatory requirements.

Our customers geographically located in the AsiaPacific markets accounted for approximately 93%, 90% and 90% of total Companysales in 2003, 2002 and 2001, respectively and are expected to continue toaccount for a substantial percentage of sales in the future. The economicclimate in Asia continues to be impacted by increases in unemployment, declinesin consumer spending, currency devaluation and bank failures. Any of thesefactors, should they continue, could significantly reduce the demand for theend user goods in which our products and technologies are used.

The PRC economy has experienced significant growthin the past decade; but such growth has been uneven across geographic andeconomic sectors. There can be no assurance that such growth will continue orthat any potential currency devaluation in the region will not have a negative effecton our business, including Valence. The PRC economy has also experienceddeflation in the past, which may continue in the future. The current economicsituation may adversely affect our profitability over time as expenditures forconsumer electronics products and information technology may decrease due tothe results of slowing domestic demand and deflation.

Hong Kong is a Special Administrative Region of thePRC with its own government and legislature. Hong Kong enjoys a high degree ofautonomy from the PRC under the principle of “one country, two systems.” We cangive no assurance that Hong Kong will continue to enjoy autonomy from the PRC.

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

 

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

Weexpect that international sales will continue to represent a significantportion of our total revenues. To date, all of our licensing revenues have beendenominated in U.S. dollars and most costs have been incurred in U.S. dollars.It is our expectation that licensing revenues will continue to be denominatedin U.S. dollars for the foreseeable future. Because Valence’s business isprimarily focused in Asia and because of our anticipated expansion of businessin the PRC and other parts of Asia, our consolidated results of operations andfinancial position could be significantly affected by risks associated withinternational activities, including economic and labor conditions, politicalinstability, tax laws (including U.S. taxes on foreign subsidiaries) andchanges in the value of the U.S. dollar versus the local currency in which theproducts are sold.  In addition, ourvaluation of assets recorded as a result of the Valence acquisition may also beadversely impacted by the currency fluctuations relative to the U.S.dollar.  We intend to actively monitorour****foreign exchange exposure andto implement strategies to reduce our foreign exchange risk at such time thatwe determine the benefits of such strategies outweigh the associated costs.However, there is no guarantee that we will take steps to insure against suchrisks, and should such risks occur, there is no guarantee that we will not besignificantly impacted.  Countries in theAsia Pacific region have experienced weakness in their currency, banking andequity markets. These weaknesses could adversely affect consumer demand forValence’s products, the U.S. dollar value of the Company’s and its subsidiaries’foreign currency denominated sales, the availability and supply of productcomponents to Valence and ultimately, our consolidated results of operations.

 

*We are subject to competitive pressures*

Ourexisting and potential competitors include both large and emerging domestic andinternational companies that have substantially greater financial,manufacturing, technical, marketing, distribution and other resources. Presentor future competitors may be able to develop products and technologiescomparable or superior to ours, and to adapt more quickly than us to newtechnologies or evolving market needs. We believe that the competitive factorsaffecting the market for our products and technologies include productperformance, price and quality; product functionality and features; the ease ofintegration; and implementation of the products and technologies with otherhardware and software components in the OEM’s products. In addition, themarkets in which we compete are intensely competitive and are characterized byrapid technological changes, declining average sales prices and rapid productobsolescence. Accordingly, there can be no assurance that we will be able tocontinue to compete effectively in its respective markets, that competitionwill not intensify or that future competition will not have a material adverseeffect on our business, operating results, cash flows and financial condition.

 

*We strongly rely on our intellectual property*

Our ability to compete may be affected by ourability to protect our proprietary information. We have filed numerous U.S. andforeign patent applications and to date have a number of issued U.S. andforeign patents covering various 

 

25

----

 

aspectsof our technologies. There can be no assurance that the steps taken by SRS Labsto protect our intellectual property will be adequate to preventmisappropriation of our technology or that our competitors will notindependently develop technologies that are substantially equivalent orsuperior to our technology. In addition, the laws of certain foreign countriesmay not protect our intellectual property rights to the same extent, as do thelaws of the U.S. The semiconductor industry is characterized by frequent claimsand litigation regarding patent and other property rights. We are not currentlya party to any claims of this nature. There can be no assurances that thirdparties will not assert claims or initiate litigation against the Company orour customers with respect to existing or future products. In addition, we mayinitiate claims or litigation against third parties for infringement of ourproprietary rights or to determine the scope and validity of our proprietaryrights.

 

*We depend on our key personnel*

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

 

*The market price of our common stock is volatile*

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

 

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

 

Therehave been no material changes to the information called for by this Item 3 fromthe disclosures set forth in Part II, Item 7A in the Company’s Annual Report onForm 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.

*Changesin Internal Controls.*  In connection with the above-referencedevaluation, no change in the Company’s internal control over financialreporting occurred during the period covered by this report that has materiallyaffected, or is reasonably likely to materially affect, the Company’s internalcontrol over financial reporting.

 

26

----

 

**PART II—OTHER INFORMATION**

 

**Item 2.  Unregistered Sales of Equity Securities andUse of Proceeds.**

                The following table details our common stockrepurchases for the three months ended September 30, 2004:  
| **Issuer Purchases of Equity Securities** | ** ** |
|-------------------------------------------|------------|
| ** **                                | ** ** | **(a)** | ** ** | **(b)** | ** ** | **(c)** | ** ** | **(d)** | ** ** |
| **Period**                                | ** ** | **Total Number of Shares (or Units) Purchased** | ** ** | **Average Price Paid per Share (or Unit)** | ** ** | **Total Number of Shares (or Units) Purchased as Part of Publicly  Announced Plans or Programs** | ** ** | **Maximum Number (or Approximate Dollar Value) of Shares (or Units)  that May Yet Be Purchased Under the Plans or Programs** | ** ** |
| July 1 — 31, 2004                    |       | — |   | — |   | — |   | $ | 3,00,000 |   |
| August 1 — 31, 2004                  |       | 31,114 |   | $ | 4.87 |   | 31,114 |   | $ | 2,848,330 |   |
| September 1 — 30, 2004               |       | 2,543 |   | $ | 5.03 |   | 33,657 |   | $ | 2,835,539 |   |
|                                           |            |  |  |  |  |  |  |  |  |  |  |  |

----

(1)                                  On June 30, 2004, the Company’sBoard of Directors authorized a stock repurchase program (the “2004 RepurchaseProgram”).  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 inthe open market, block purchases or privately negotiated transactions,depending on market conditions, share price and other factors.

 

**Item6.  Exhibits**

 

(a)           *Exhibits*.

 

Theexhibits listed below are hereby filed with the U.S. Securities and ExchangeCommission as part of this Report.

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                       |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                |       | Strategic Alliance  Agreement between SRS Labs, Inc. and Coming Home Studios, LLC dated September  23, 2004, previously filed with the Securities and Exchange Commission (the  “Commission”) on September 28, 2004 as Exhibit 10.1 to the Company’s Current  Report on Form 8-K dated September 23, 2004, which is incorporated herein by  reference. |
| ** **          | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                            |
| 10.2                |       | CHS/SRS, LLC Operating  Agreement between SRS Labs, Inc. and Coming Home Studios, LLC dated September  23, 2004, previously filed with the Commission on September 28, 2004 as  Exhibit 10.2 to the Company’s Current Report on Form 8-K dated September 23,  2004, which is incorporated herein by reference.                                                   |
| ** **          | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                            |
| 10.3                |       | Warrant Agreement** **between SRS Labs, Inc. and Coming Home  Studios, LLC dated September 23, 2004, previously filed with the Commission  on September 28, 2004 as Exhibit 10.3 to the Company’s Current Report on Form  8-K dated September 23, 2004, which is incorporated herein by reference.                                                          |
| ** **          | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                            |
| 10.4                |       | Production Services  Agreement between CHS/SRS, LLC and Coming Home Studios, LLC dated September  23, 2004, previously filed with the Commission on September 28, 2004 as  Exhibit 10.4 to the Company’s Current Report on Form 8-K dated September 23,  2004, which is incorporated herein by reference.                                                        |

 

27

----

 
|   |   |                                                                                                                          |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------|
| 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. |

 

 

28

----

 

**SIGNATURES**

 

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

 
|                                     | SRS  LABS, INC., a Delaware corporation |
|------------------------------------------|----------------------------------------------|
|                                     |                                         |   |
| Date:  November  12, 2004      | By:                                          | /s/ THOMAS C.K. YUEN |
|                                     |                                         | Thomas C.K. Yuen |
|                                     |                                         | Chairman  of the Board and Chief Executive Officer |
|                                     |                                         | (Principal  Executive Officer) |
| ** **                               | ** **                                   | ** ** |
| ** **                               | ** **                                   | ** ** |
| Date:  November 12,  2004 | By:                                          | /s/ JANET M. BISKI |
|                                     |                                         | Janet M. Biski |
|                                     |                                         | Chief  Financial Officer |
|                                     |                                         | (Principal  Financial and Accounting Officer) |

 

 

 

29

----