**UNITED STATES********SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

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

 

 

**SRS LABS, INC.**

(Exactname of registrant as specified in its charter)

 

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

 

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

 

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

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date: as of August 1, 2003, 12,988,198 of the issuer’scommon stock, par value $.001 per share, were outstanding. In addition, as ofAugust 1, 2003, 225,300 shares of the issuer’s common stock were held astreasury shares.

 

 

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**SRS LABS, INC.**

 

**Form 10-Q**

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

 

**Index**

 
| **PART I—FINANCIAL INFORMATION** |
|---------------------------------------|
| Item 1.                               | Financial Statements |
|                                  | Condensed  Consolidated Balance Sheets as of June 30, 2003 (Unaudited) and December 31,  2002 |
|                                  | Condensed  Consolidated Statements of Operations for the three months and six months  ended June 30, 2003 and 2002 (Unaudited) |
|                                  | Condensed Consolidated  Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the  six months ended June 30, 2003 (Unaudited) |
|                                  | Condensed  Consolidated Statements of Cash Flows for the six months ended June 30, 2003  and 2002 (Unaudited) |
|                                  | Notes  to the Condensed Interim Consolidated Financial Statements (Unaudited) |
| Item  2.                              | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
| Item 3.                               | Quantitative and Qualitative Disclosures About  Market Risk |
| Item 4.                               | Controls and Procedures |
| **PART  II—OTHER INFORMATION**   |
| Item  4.                              | Submission  of Matters to a Vote of Security Holders |
| Item 6.                               | Exhibits and  Reports on Form 8-K |
|                                  |   |
| SIGNATURES                            |
|                                  |

 

2

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**FORWARD-LOOKING INFORMATION**

 

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

 

3

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**PART I****— FINANCIAL INFORMATION**

 

**Item 1.Financial Statements****.**

 

**SRS LABS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

** **
|                                                                                                                                                                                                                   |   | **June 30, 2003** |       | **December 31, 2002** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------|------------|----------------------------|--------|
|                                                                                                                                                                                                                   |   | **(Unaudited)**   |       |                       |   |
| **ASSETS**                                                                                                                                                                                                             |   |              |       |                       |   |
| **Current Assets**                                                                                                                                                                                                     |   |              |       |                       |   |
| Cash and cash equivalents                                                                                                                                                                                              |   | $                 | 16,787,436 |                       | $      | 15,720,860 |   |
| Accounts receivable, net                                                                                                                                                                                               |   | 930,480           |       | 1,074,421                  |   |
| Inventories, net                                                                                                                                                                                                       |   | 872,794           |       | 807,382                    |   |
| Prepaid expenses and other current assets                                                                                                                                                                              |   | 426,659           |       | 462,442                    |   |
| Deferred income taxes                                                                                                                                                                                                  |   | 36,147            |       | 36,147                     |   |
|                                                                                                                                                                                                                   |   |              |       |                       |   |
| **Total Current Assets**                                                                                                                                                                                               |   | 19,053,516        |       | 18,101,252                 |   |
|                                                                                                                                                                                                                   |   |              |       |                       |   |
| Investments available for sale                                                                                                                                                                                         |   | 5,429,545         |       | 6,630,771                  |   |
| Furniture, fixtures & equipment, net                                                                                                                                                                          |   | 1,780,691         |       | 1,935,424                  |   |
| Goodwill, net                                                                                                                                                                                                          |   | 1,173,102         |       | 533,031                    |   |
| Intangible assets, net                                                                                                                                                                                                 |   | 1,859,311         |       | 1,957,359                  |   |
| Deferred income taxes                                                                                                                                                                                                  |   | 160,267           |       | 149,498                    |   |
|                                                                                                                                                                                                                   |   |              |       |                       |   |
| **Total Assets**                                                                                                                                                                                                       |   | $                 | 29,456,432 |                       | $      | 29,307,335 |   |
|                                                                                                                                                                                                                   |   |              |       |                       |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                         |   |              |       |                       |   |
| **Current Liabilities**                                                                                                                                                                                                |   |              |       |                       |   |
| Accounts payable                                                                                                                                                                                                       |   | $                 | 1,002,052  |                       | $      | 1,011,032 |   |
| Accrued liabilities                                                                                                                                                                                                    |   | 1,757,487         |       | 2,347,702                  |   |
| Income taxes payable                                                                                                                                                                                                   |   | 450,371           |       | 341,172                    |   |
|                                                                                                                                                                                                                   |   |              |       |                       |   |
| **Total Current Liabilities**                                                                                                                                                                                          |   | 3,209,910         |       | 3,699,906                  |   |
| Minority interest                                                                                                                                                                                                      |   | —            |       | 325,371                    |   |
| Commitments and contingencies                                                                                                                                                                                          |   |              |       |                       |   |
|                                                                                                                                                                                                                   |   |              |       |                       |   |
| **Stockholders’ Equity**                                                                                                                                                                                          |   |              |       |                       |   |
| Preferred stock—$.001 par value; 2,000,000 shares authorized; no  shares issued or outstanding                                                                                                                    |   | —            |       | —                     |   |
| Common stock—$.001 par value; 56,000,000 shares authorized;  13,237,830 and 12,876,314 shares issued; and 13,012,530 and 12,651,014 shares  outstanding at June 30, 2003 and December 31, 2002, respectively |   | 13,238            |       | 12,877                     |   |
| Additional paid in capital                                                                                                                                                                                             |   | 57,014,858        |       | 55,966,589                 |   |
| Accumulated other comprehensive loss                                                                                                                                                                                   |   | (181,382          | )          | (88,564                    | )      |
| Accumulated deficit                                                                                                                                                                                                    |   | (29,881,591       | )          | (29,890,243                | )      |
| Treasury stock at cost, 225,300 shares at June 30, 2003 and at  December 31, 2002                                                                                                                                      |   | (718,601          | )          | (718,601                   | )      |
|                                                                                                                                                                                                                   |   |              |       |                       |   |
| Total Stockholders’ Equity                                                                                                                                                                                        |   | 26,246,522        |       | 25,282,058                 |   |
|                                                                                                                                                                                                                   |   |              |       |                       |   |
| Total Liabilities and Stockholders’ Equity                                                                                                                                                                        |   | $                 | 29,456,432 |                       | $      | 29,307,335 |   |

 

Seeaccompanying notes to the condensed interim consolidated financial statements

 

4

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**SRS LABS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
|                                                                                    |   | **Three Months Ended  June 30,** |      | **Six Months Ended  June 30,** |   |
|-----------------------------------------------------------------------------------------|--------|----------------------------------|-----------|--------------------------------|--------|
|                                                                                    |   | **2003**                         |      | **2002**                       |   | **2003** |   | **2002** |   |
|                                                                                    |   |                             |      |                           |   |   |   |   |   |
| Revenues:                                                                               |   |                             |      |                           |   |   |   |   |   |
| Licensing                                                                               |   | $                                | 1,958,279 |                           | $      | 1,435,841 |   | $ | 4,586,590 |   | $ | 3,231,563 |   |
| Semiconductor                                                                           |   | 2,466,941                        |      | 2,365,298                      |   | 4,178,760 |   | 3,836,440 |   |
| Other                                                                                   |   | 100,626                          |      | 227,221                        |   | 230,870 |   | 515,737 |   |
| Total revenues                                                                          |   | 4,525,846                        |      | 4,028,360                      |   | 8,996,220 |   | 7,583,740 |   |
|                                                                                    |   |                             |      |                           |   |   |   |   |   |
| Cost of sales                                                                           |   | 900,565                          |      | 1,114,815                      |   | 1,570,133 |   | 1,908,160 |   |
|                                                                                    |   |                             |      |                           |   |   |   |   |   |
| Gross margin                                                                            |   | 3,625,281                        |      | 2,913,545                      |   | 7,426,087 |   | 5,675,580 |   |
|                                                                                    |   |                             |      |                           |   |   |   |   |   |
| Operating expenses:                                                                     |   |                             |      |                           |   |   |   |   |   |
| Sales and marketing                                                                     |   | 1,271,097                        |      | 923,460                        |   | 2,623,587 |   | 2,193,219 |   |
| Research and development                                                                |   | 970,123                          |      | 937,521                        |   | 2,051,338 |   | 1,902,597 |   |
| General and administrative                                                              |   | 1,210,033                        |      | 889,500                        |   | 2,524,643 |   | 2,113,706 |   |
|                                                                                    |   |                             |      |                           |   |   |   |   |   |
| Total operating expenses                                                                |   | 3,451,253                        |      | 2,750,481                      |   | 7,199,568 |   | 6,209,522 |   |
|                                                                                    |   |                             |      |                           |   |   |   |   |   |
| Income (loss) from operations                                                           |   | 174,028                          |      | 163,064                        |   | 226,519 |   | (533,942 | ) |
|                                                                                    |   |                             |      |                           |   |   |   |   |   |
| Other income, net                                                                       |   | 118,604                          |      | 228,586                        |   | 282,730 |   | 316,550 |   |
| Minority interest                                                                       |   | —                           |      | 20,282                         |   | 5,430 |   | 40,030 |   |
|                                                                                    |   |                             |      |                           |   |   |   |   |   |
| Income (loss) before income tax expense                                                 |   | 292,632                          |      | 411,932                        |   | 514,679 |   | (177,362 | ) |
|                                                                                    |   |                             |      |                           |   |   |   |   |   |
| Income tax expense                                                                      |   | 326,514                          |      | 207,379                        |   | 506,027 |   | 308,815 |   |
|                                                                                    |   |                             |      |                           |   |   |   |   |   |
| Net income (loss)                                                                       |   | $                                | (33,882   | )                              | $      | 204,553 |   | $ | 8,652 |   | $ | (486,177 | ) |
|                                                                                    |   |                             |      |                           |   |   |   |   |   |
| Net income (loss) per common share:                                                     |   |                             |      |                           |   |   |   |   |   |
| Basic                                                                                   |   | $                                | 0.00      |                           | $      | 0.02 |   | $ | 0.00 |   | $ | (0.04 | ) |
|                                                                                    |   |                             |      |                           |   |   |   |   |   |
| Diluted                                                                                 |   | $                                | 0.00      |                           | $      | 0.02  |   | $ | 0.00 |   | $ | (0.04 | ) |
|                                                                                    |   |                             |      |                           |   |   |   |   |   |
| Weighted average shares used in the calculation of net income (loss)  per common share: |   |                             |      |                           |   |   |   |   |   |
| Basic                                                                                   |   | 12,993,305                       |      | 12,682,449                     |   | 12,896,338 |   | 12,675,928 |   |
|                                                                                    |   |                             |      |                           |   |   |   |   |   |
| Diluted                                                                                 |   | 12,993,305                       |      | 12,746,527                     |   | 13,142,519 |   | 12,675,928 |   |

 

 See accompanying notes to the condensedinterim consolidated financial statements

 

5

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**SRSLABS, INC.**

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

 
|                                                           |   |             |   |        |         |              |   | **Accumulated**  |   |         |           |      |   |                |   | **Comprehensive** |           |
|----------------------------------------------------------------|--------|------------------|--------|-------------|--------------|-------------------|--------|------------------|--------|--------------|----------------|-----------|--------|---------------------|--------|-------------------|----------------|
|                                                           |   |             |   |        |         | **Additional**    |   | **Other**        |   |         |           |      |   |                |   | **Income (Loss)** |           |
|                                                           |   | **Common Stock** |   | **Paid-In** |         | **Comprehensive** |   | **Accumulated**  |   | **Treasury** |           |      |   | **for the Periods** |   |
|                                                           |   | **Shares**       |   | **Amount**  |         | **Capital**       |   | **(Loss)**       |   | **Deficit**  |           | **Stock** |   | **Total**           |   | **Ended**         |           |
|                                                           |   |             |   |        |         |              |   |             |   |         |           |      |   |                |   |              |           |
| BALANCE, Dec 31, 2002                                          |   | 12,651,014       |   | $           |  12,877 |              | $      |  55,966,589 |   | $            |  (88,564  | )         | $      |  (29,890,243   | )      | $                 |  (718,601 | ) | $ |  25,282,058 |   | $ |  791,843 |   |
| Proceeds from exercise of  stock options                       |   | 5,000            |   | 5           |         | 13,120            |   | —           |   | —       |           | —    |   | 13,125              |   |              |           |
| Deferred stock option  compensation                            |   | —           |   | —      |         | 18,236            |   | —           |   | —       |           | —    |   | 18,236              |   |              |           |
| Issuance of Common Stock                                       |   | 332,184          |   | 332         |         | 959,680           |   | —           |   | —       |           | —    |   | 960,012             |   |              |           |
| Unrealized loss on investments  available for sale, net of tax |   | —           |   | —      |         | —            |   | (85,214          | )      | —       |           | —    |   | (85,214             | )      | $                 |  (85,214  | ) |
| Net income                                                     |   | —           |   | —      |         | —            |   | —           |   | 42,534       |           |      |   | 42,534              |   | 42,534            |           |
|                                                           |   |             |   |        |         |              |   |             |   |         |           |      |   |                |   |              |           |
| BALANCE, March 31, 2003                                        |   | 12,988,198       |   | $           |  13,214 |              | $      |  56,957,625 |   | $            |  (173,778 | )         | $      |  (29,847,709   | )      | $                 |  (718,601 | ) | $ |  26,230,751 |   | $ |  (42,680 | ) |
| Proceeds from exercise of  stock options                       |   | 24,332           |   | 24          |         | 38,997            |   | —           |   | —       |           | —    |   | 39,021              |   |              |           |
| Deferred stock option  compensation                            |   | —           |   | —      |         | 18,236            |   | —           |   | —       |           | —    |   | 18,236              |   |              |           |
| Unrealized loss on  investments available for sale, net of tax |   | —           |   | —      |         | —            |   | (7,604)          |   | —       |           | —    |   | (7,604)             |   | (7,604            | )              |
| Net loss                                                       |   | —           |   | —      |         | —            |   | —           |   | (33,882      | )              | —    |   | (33,882             | )      | (33,882           | )              |
|                                                           |   |             |   |        |         |              |   |             |   |         |           |      |   |                |   |              |           |
| BALANCE, June 30, 2003                                         |   | 13,012,530       |   | $           | 13,238       |              | $      | 57,014,858       |   | $            | (181,382       | )         | $      | (29,881,591         | )      | $                 | (718,601       | ) | $ | 26,246,522 |   | $ | (84,166 | ) |

 

See accompanying notes to thecondensed interim consolidated financial statements

 

6

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**SRS LABS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
|                                                                                       |   | **Six Months Ended  June 30,** |       |
|--------------------------------------------------------------------------------------------|--------|--------------------------------|------------|
|                                                                                       |   | **2003**                       |       | **2002** |   |
|                                                                                       |   |                           |       |   |   |
| **Cash Flows From Operating Activities:**                                                  |   |                           |       |   |   |
| Net income  (loss)                                                                         |   | $                              | 8,652      |   | $ | (486,177 | ) |
| Adjustments to reconcile net loss to net cash (used in) provided by  operating activities: |   |                           |       |   |   |
| Depreciation and amortization                                                              |   | 561,519                        |       | 604,837 |   |
| Minority interest                                                                          |   | (5,430                         | )          | (40,030 | ) |
| Provision for doubtful accounts                                                            |   | (3,894                         | )          | 9,362 |   |
| Provision for obsolete inventory                                                           |   | 17,541                         |       | 30,332 |   |
| Deferred Taxes                                                                             |   | (10,769                        | )          | — |   |
| Increase in deferred stock option compensation                                             |   | 36,472                         |       | 27,406 |   |
| Changes in operating assets and liabilities:                                               |   |                           |       |   |   |
| Accounts receivable                                                                        |   | 147,834                        |       | 12,636 |   |
| Inventories                                                                                |   | (82,953                        | )          | (212,543 | ) |
| Prepaid expenses and other current assets                                                  |   | 35,782                         |       | 71,727 |   |
| Accounts payable                                                                           |   | (8,978                         | )          | 596,572 |   |
| Accrued liabilities                                                                        |   | (590,213                       | )          | 466,964 |   |
| Income taxes payable                                                                       |   | 109,199                        |       | 133,520 |   |
|                                                                                       |   |                           |       |   |   |
| Net cash provided by operating activities                                                  |   | 214,762                        |       | 1,214,606 |   |
|                                                                                       |   |                           |       |   |   |
| **Cash Flows From Investing Activities:**                                                  |   |                           |       |   |   |
| Purchase of furniture, fixtures & equipment                                            |   | (212,932                       | )          | (209,520 | ) |
| Purchase of investments available for sale                                                 |   | —                         |       | (14,034,560 | ) |
| Proceeds from sale of investments available for sale                                       |   | 1,108,407                      |       | 582,556 |   |
| Expenditures related to patents and intangible assets                                      |   | (95,807                        | )          | (165,734 | ) |
|                                                                                       |   |                           |       |   |   |
| Net cash provided by (used in) investing activities                                        |   | 799,668                        |       | (13,827,258 | ) |
|                                                                                       |   |                           |       |   |   |
| **Cash Flows From Financing Activities:**                                                  |   |                           |       |   |   |
| Purchase of treasury stock                                                                 |   | —                         |       | (117,917 | ) |
| Proceeds from exercise of stock options                                                    |   | 52,146                         |       | 28,381 |   |
|                                                                                       |   |                           |       |   |   |
| Net cash provided by (used in) financing activities                                        |   | 52,146                         |       | (89,536 | ) |
|                                                                                       |   |                           |       |   |   |
| **Net Increase (Decrease) in Cash and Cash Equivalents**                                   |   | 1,066,576                      |       | (12,702,188 | ) |
| **Cash and Cash Equivalents, Beginning of Period**                                         |   | 15,720,860                     |       | 19,011,167 |   |
|                                                                                       |   |                           |       |   |   |
| **Cash and Cash Equivalents, End of Period**                                               |   | $                              | 16,787,436 |   | $ | 6,308,979 |   |
|                                                                                       |   |                           |       |   |   |
| **Supplemental Disclosures of Cash Flow Information:**                                     |   |                           |       |   |   |
| Cash paid during the period for:                                                           |   |                           |       |   |   |
| Income taxes                                                                               |   | $                              | 379,581    |   | $ | 205,857 |   |
| **Supplemental Disclosure of Non-Cash Investing and  Financing Activities:**               |   |                           |       |   |   |
| Unrealized loss on investments, net                                                        |   | $                              | (92,818    | ) | $ | (62,485 | ) |
| Issuance of Common stock for minority  interest                                            |   | $                              | 960,012    |   | $ | — |   |
|                                                                                            |        |                                |            |  |  |  |  |  |

 

Seeaccompanying notes to the condensed interim consolidated financial statements

 

7

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Notes to the Condensed Interim Consolidated FinancialStatements (Unaudited)

** **

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

 

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

 

 

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

 

***SRS Labs***

 

*Licensing**:***  TheCompany’s licensing segment develops and licenses audio and voice technologiesto many of the world’s leading original equipment manufacturers (“OEMs”),software providers and semiconductor manufacturers.

 

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

 

***Valence***

 

*Semiconductor:*  Thesemiconductor segment develops and sells technology solutions in the form ofanalog and digital signal processor (“DSP”) ASIC semiconductors or otherimbedded custom semiconductor designs to OEMs around the world.

 

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

 

***SRSWOWcast***

 

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

 

The accompanying condensedinterim consolidated 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 with the rules and regulations of the U.S. Securitiesand Exchange Commission (“SEC”). In the opinion of management, all adjustments(which include only normal recurring adjustments) considered necessary for afair presentation have been included. Certain accounts have been reclassifiedfrom that previously reported to conform to the current period presentation.

 

Certain information andfootnote disclosures normally included in financial statements prepared inaccordance with generally accepted accounting principles have been condensed oromitted pursuant to SEC rules and regulations for presentation of interimfinancial information. Therefore, the condensed interim consolidated financialstatements should be read in conjunction with the Company’s Annual Report onForm 10-K for the fiscal year ended December 31, 2002. Current andfuture financial statements may not be directly comparable to the Company’shistorical financial statements. The results of operations for the interimperiods are not necessarily indicative of the results to be expected for thefull year.

 

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

 

On January 1, 2002 theCompany adopted SFAS No. 142 “Goodwill and Other Intangible Assets”,which, among other things, establishes new standards for goodwill acquired in abusiness combination, eliminates the amortization of goodwill and requires thecarrying value of goodwill and identifiable intangibles to be evaluated forimpairment on at least an annual basis. Identifiable intangible assets with adeterminable useful life are amortized over that period.

 

8

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In accordance with SFASNo. 142, all of the Company’s intangible assets that have definite livesare being amortized on a straight-line basis over their estimated useful livesand goodwill is evaluated to determine if fair value of the asset has decreasedbelow its carrying value. At December 31, 2002, the Company evaluatedgoodwill and determined that no adjustment to impair goodwill was necessary.

 

Goodwill and intangible assets consist of the following:

 
|                                 |   | **June 30, 2003** |      | **December 31, 2002** |   |
|--------------------------------------|--------|-------------------|-----------|-----------------------|--------|
|                                 |   |              |      |                  |   |
| Goodwill &  assembled workforce  |   | $                 | 1,173,102 |                  | $      | 533,031 |   |
| Patents                              |   | 1,442,934         |      | 1,398,565             |   |
| Accumulated  amortization            |   | (609,852          | )         | (590,365              | )      |
| Patents, net                         |   | 833,082           |      | 808,200               |   |
| Other  intangibles                   |   | 5,030,400         |      | 5,030,400             |   |
| Accumulated  amortization            |   | (4,004,171        | )         | (3,881,241            | )      |
| Other  intangibles, net              |   | 1,026,229         |      | 1,149,159             |   |
| Goodwill and  intangible assets, net |   | $                 | 3,032,413 |                  | $      | 2,490,390 |   |

 

In February 2003, SRSLabs completed an exchange offer with the minority shareholders of SRSWOWcast,pursuant to which SRS Labs acquired all 3,000,000 outstanding shares ofSeries A Convertible Preferred Stock in exchange for the issuance of332,184 shares of SRS Labs common stock. As a result of the exchange offer,goodwill in the amount of $640,071 was recorded.

 

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

 
|                                   |   | **Three months ended  June 30,** |   | **Six months ended  June 30,** |   |
|----------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                                   |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
|                                   |   |                             |   |                           |   |   |   |   |   |
| Patents                                |   | $                                | 35,913 |                           | $      | 31,913 |   | $ | 70,926 |   | $ | 64,664 |   |
| Other  intangibles                     |   | 57,477                           |   | 85,831                         |   | 122,928 |   | 238,328 |   |
| Total  intangible amortization expense |   | $                                | 93,390 |                           | $      | 117,744 |   | $ | 193,854 |   | $ | 302,992 |   |

 

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

 

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

 

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

 

The Company has classifiedits investments as available-for-sale in accordance with SFAS No. 115,“Accounting for Certain Investments in Debt and Equity Securities.”

 

The following table summarizes the Company’sinvestment securities available for sale:

 
|                                            |   | **June 30, 2003** |      | **December 31, 2002** |   |
|-------------------------------------------------|--------|-------------------|-----------|-----------------------|--------|
|                                            |   |              |      |                  |   |
| U.S. Government  securities available for sale: |   |              |      |                  |   |
| Cost                                            |   | $                 | 5,529,625 |                  | $      | 6,638,033 |   |
| Unrealized  losses                              |   | (100,080          | )         | (7,262                | )      |
| Estimated fair  value                           |   | $                 | 5,429,545 |                  | $      | 6,630,771 |   |

 

9

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

 
|                                            |   | **June 30, 2003** |      | **December 31, 2002**     |   |
|-------------------------------------------------|--------|-------------------|-----------|---------------------------|--------|
|                                            |   | **Cost**          |      | **Estimated  Fair Value** |   | **Cost** |   | **Estimated  Fair Value** |   |
|                                            |   |              |      |                      |   |   |   |   |   |
| U.S. Government  securities available for sale: |   |              |      |                      |   |   |   |   |   |
| Due in one to  five years                       |   | $                 | 5,529,625 |                      | $      | 5,429,545 |   | $ | 6,638,033 |   | $ | 6,630,771 |   |
|                                                 |        |                   |           |                           |        |  |  |  |  |  |  |  |  |

 

**4.****                                     ****Inventories**

 

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

 

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

 

Minority interest representsthe minority stockholders’ proportionate share of the equity in theconsolidated subsidiary SRSWOWcast. At December 31, 2002, the Company ownedapproximately 87% of the outstanding capital stock of SRSWOWcast. In February 2003,SRS Labs completed an exchange offer with the minority shareholders ofSRSWOWcast, pursuant to which SRS Labs acquired all 3,000,000 outstandingshares of Series A Convertible Preferred Stock in exchange for theissuance of 332,184 shares of SRS Labs common stock. As a result of theexchange offer, SRSWOWcast became a wholly-owned subsidiary of SRS Labs.  The proforma effect of the transaction as ifit had occurred at the beginning of this quarter and the beginning of last yearwould have been immaterial.

 

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

 

The Company accounts forstock-based awards to employees under the recognition and measurementprinciples of APB No. 25, “Accounting for Stock Issued to Employees,” andrelated interpretations. The Company has adopted the disclosure-only provisionsof FAS No. 123. Accordingly, no stock-based employee compensation cost isreflected in net income (loss), as all options granted under the plan had anexercise price equal to the market value of the underlying common stock on thedate of grant. Had compensation cost for the Company’s stock option plan beendetermined based on the fair value at the grant date for awards for the threemonths ended June 30, 2003 and 2002, consistent with the provisions of FASNo. 123, the Company’s net income (loss) and earnings (loss) per sharewould have been increased to the pro forma amounts indicated below:

 
|                                                                                      |   | **For the  three months endedJune 30,** |     | **For the six months ended** June 30, |     |
|-------------------------------------------------------------------------------------------|--------|-----------------------------------------|----------|--------------------------------------------|----------|
|                                                                                      |   | **2003**                                |     | **2002**                                   |     | **2003** |   | **2002** |   |
|                                                                                      |   |                                    |     |                                       |     |   |   |   |   |
| Net income  (loss) as reported                                                            |   | $                                       | (33,882  | )                                          | $        | 204,553 |   | $ | 8,652 |   | $ | (486,177 | ) |
| Add: deferred  compensation expense already recognized                                    |   | 18,236                                  |     |     

13,703                |     | 36,472 |   |               27,406 |   |
| Less fair value  of stock-based employee compensation expense, net of related tax effects |   | (593,085                                | )        |  

(373,083                           | )        | (1,107,950 | ) | (829,631 | ) |
|                                                                                      |   |                                    |     |                                       |     |   |   |   |   |
| Net (loss) pro  forma                                                                     |   | $                                       | (608,731 | )                                          | (154,827 | ) | (1,062,826 | ) | (1,288,402 | ) |
| Net (loss) per  share (basic and diluted)—as reported                                |   | $                                       | 0.00     |                                       | $        | 0.02 |   | $ | 0.00 |   | $ | (0.04 | ) |
| Net income  (loss) per share (basic and diluted)—pro forma                           |   | $                                       | (0.05    | )                                          | $        | (0.01 | ) | $ | (0.08 | ) | $ | (0.10 | ) |

 

The fair value of eachoption grant was estimated on the date of grant using the Black-Scholesoption-pricing model with the following weighted average assumptions used forgrants during the quarter and six months ended June 30, 2003.

 

| Risk free  interest rate |   | 2.45          | %      |
|--------------------------|--------|---------------|--------|
| Expected life            |   | 5 years  |   |
| Expected  volatility     |   | 86            | %      |

 

10

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Because FAS No. 123 hasnot been applied to options granted prior to January 1, 1995, theresulting pro forma compensation cost may not be representative of that to beexpected in future years.

 

**7.****                                     ****Net Income (Loss) Per CommonShare**

 

The Company applies SFASNo. 128, “Earnings per Share,” which requires the disclosure of basic anddiluted net income or loss per share for all current and prior periods. Basicnet income or loss per common share is computed by dividing net income or lossavailable to common stockholders by the weighted average number of commonshares outstanding during each year. Diluted net income or loss per commonshare reflects the maximum dilution, based on the average price of theCompany’s common stock each period and is computed similar to basic income orloss per share except that the denominator is increased to include the numberof additional shares that would have been outstanding if potentially dilutivestock options and warrants had been exercised.

 

Basic and diluted net income(loss) per share computed in accordance with SFAS 128 for the three andsix months ended June 30 are as follows: 

 

|                                                     |   | **For the three months  ended June 30,** |    | **For the six months  ended June 30,** |   |
|----------------------------------------------------------|--------|-----------------------------------------------|---------|----------------------------------------|--------|
|                                                     |   | **2003**                                      |    | **2002**                               |   | **2003** |   | **2002** |   |
|                                                     |   |                                          |    |                                   |   |   |   |   |   |
| BASIC EPS                                                |   |                                          |    |                                   |   |   |   |   |   |
| Net income  (loss)                                       |   | $                                             | (33,882 | )                                      | $      | 204,553 |   | $ | 8,652 |   | $ | (486,177 | ) |
| Denominator:  weighted average common shares outstanding |   | 12,993,305                                    |    |  

12,682,449                     |   | 12,896,338 |   | 12,675,928 |   |
| Net income  (loss) per share—basic                  |   | $                                             | 0.00    |                                   | $      | 0.02 |   | $ | 0.00 |   | $ | (0.04 | ) |
|                                                     |   |                                          |    |                                   |   |   |   |   |   |
| DILUTED EPS                                              |   |                                          |    |                                   |   |   |   |   |   |
| Net income  (loss)                                       |   | $                                             | (33,882 | )                                      | $      | 204,553 |   | $ | 8,652 |   | $ | (486,177 | ) |
| Denominator:  weighted average common shares outstanding |   | 12,993,305                                    |    |  

12,682,449                     |   | 12,896,338 |   |  

12,675,928 |   |
| Common  equivalent shares outstanding:                   |   |                                          |    |                                   |   |   |   |   |   |
| Options                                                  |   | —                                        |    | 64,078                                 |   | 246,181 |   | — |   |
| Total diluted  shares                                    |   | 12,993,305                                    |    | 12,746,527                             |   | 13,142,519 |   | 12,675,928 |   |
| Net income  (loss) per share—diluted                |   | $                                             | 0.00    |                                   | $      | 0.02 |   | $ | 0.00 |   | $ | (0.04 | ) |
|                                                          |        |                                               |         |                                        |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

There were 3,921,531 and5,274,744 potentially dilutive options outstanding for the quarters ending June30, 2003 and 2002, respectively, and there were 4,058,712 and 4,108,870 potentiallydilutive options outstanding for the six months ending June 30, 2003 and 2002,respectively, that were not included above because they would be anti-dilutive.

 

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

 

The Company is subject tolegal proceedings and claims that arise in the normal course of business. Whilethe outcome of these proceedings and claims cannot be predicted with certainty,management does not believe that the outcome of any of these matters will havea material adverse effect on the Company’s consolidated financial position orresults of operations.

 

The Company has contractualobligations and commitments with regards to operating lease arrangements. Thefollowing table quantifies the expected contractual obligations and commitmentssubsequent to December 31, 2002:

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

 

11

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

 

On May 9, 2002, theCompany’s Board of Directors authorized the repurchase of up to 500,000 of theoutstanding shares of the Company’s common stock for a period from May 10,2002 to November 10, 2002 (the “2002 Repurchase Program”). As of June 30,2003, 225,300 shares had been repurchased at a cost of $718,601 under the 2002Repurchase Program. All repurchased shares under all the Repurchase Programsare reflected as treasury stock in the accompanying consolidated balancesheets.

 

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

 

The Company operates itsthree operating units in the following five business segments: (i) SRSLabs:  (a) the licensing of technologiesdeveloped by the Company to OEMs and semiconductor manufacturers, and (b)the sale of consumer products incorporating SRS proprietary technologies; (ii) Valence:(a) the development and marketing of technology either in the form of ASICs orother imbedded custom semiconductor designs, and (b) the componentdistribution business; and (iii) SRSWOWcast:  the sale of hardware and software solutions to the Internet andbroadcast audio markets. The Company does not allocate corporate operatingexpenses or specific assets to these segments. Therefore, the segmentinformation that follows includes only net revenues, cost of sales and grossmargins of the identified segments:

 
|                                 |   | **Business Segments** |      |         |   |
|--------------------------------------|--------|-----------------------|-----------|--------------|--------|
|                                 |   | **SRS Labs**          |      | **Valence**  |   | **SRS WOWcast** |   |   |   |
|                                 |   | **Licensing**         |      | **Products** |   | **ASIC** |   | **Components** |   | **Product and  Internet Sales** |   | **Total** |   |
|                                 |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| **Three Months Ended June 30, 2003** |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| Total revenues                       |   | $                     | 1,958,279 |         | $      | 4,399 |   | $ | 2,466,941 |   | $ | 46,379 |   | $ | 49,848 |   | $ | 4,525,846 |   |
| Cost of sales                        |   | 12,103                |      | 3,000        |   | 810,342 |   | 71,100 |   | 4,020 |   | 900,565 |   |
|                                 |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| Gross margin                         |   | $                     | 1,946,176 |         | $      | 1,399 |   | $ | 1,656,599 |   | $ | (24,721 | ) | $ | 45,828 |   | $ | 3,625,281 |   |
|                                 |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| **Three Months Ended June 30, 2002** |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| Total revenues                       |   | $                     | 1,435,841 |         | $      | 20,550 |   | $ | 2,365,298 |   | $ | 207,266 |   | $ | (595 | ) | $ | 4,028,360 |   |
| Cost of sales                        |   | 16,891                |      | 24,790       |   | 844,189 |   | 222,224 |   | 6,721 |   | 1,114,815 |   |
|                                 |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| Gross margin                         |   | $                     | 1,418,950 |         | $      | (4,240 | ) | $ | 1,521,109 |   | $ | (14,958 | ) | $ | (7,316 | ) | $ | 2,913,545 |   |

 

 
|                               |   | **Business Segments** |      |         |   |
|------------------------------------|--------|-----------------------|-----------|--------------|--------|
|                               |   | **SRS Labs**          |      | **Valence**  |   | **SRSWOWcast** |   |   |   |
|                               |   | **Licensing**         |      | **Products** |   | **ASIC** |   | **Components** |   | **Product and  Internet Sales** |   | **Total** |   |
|                               |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| **Six Months Ended June 30, 2003** |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| Total revenues                     |   | $                     | 4,586,590 |         | $      | 5,647 |   | $ | 4,178,760 |   | $ | 98,640 |   | $ | 126,583 |   | $ | 8,996,220 |   |
| Cost of sales                      |   | 23,885                |      | 3,852        |   | 1,378,090 |   | 145,939 |   | 18,367 |   | 1,570,133 |   |
|                               |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| Gross margin                       |   | $                     | 4,562,705 |         | $      | 1,795 |   | $ | 2,800,670 |   | $ | (47,299 | ) | $ | 108,216 |   | $ | 7,426,087 |   |
|                               |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| **Six Months Ended June 30, 2002** |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| Total revenues                     |   | $                     | 3,231,563 |         | $      | 45,469 |   | $ | 3,836,440 |   | $ | 442,197 |   | $ | 28,071 |   | $ | 7,583,740 |   |
| Cost of sales                      |   | 43,163                |      | 42,757       |   | 1,359,010 |   | 456,441 |   | 6,789 |   | 1,908,160 |   |
|                               |   |                  |      |         |   |   |   |   |   |   |   |   |   |
| Gross margin                       |   | $                     | 3,188,400 |         | $      | 2,712 |   | $ | 2,477,430 |   | $ | (14,244 | ) | $ | 21,282 |   | $ | 5,675,580 |   |

 

The following schedulepresents the Company’s revenue by geographic area. For product sales, revenueis allocated based on the country to which the product was shipped. Forlicensing-related revenue, the allocation is based on the location of thelicensee’s corporate headquarters. The Americas region includes North, Centraland South America.

 

12

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|                          |   | **Three Months Ended  June 30,** |      | **Six Months  Ended  June 30,** |
|-------------------------------|--------|----------------------------------|-----------|---------------------------------|
|                          |   | **2003**                         |      | **2002**                        |   | **2003** |   | **2002** |
| **Geographic  Area Revenue:** |   |                             |      |                            |   |   |   |   |
|                          |   |                             |      |                            |   |   |   |   |
| Asia Pacific                  |   | $                                | 4,357,278 |                            | $ | 3,725,614 |   | $ | 8,323,965 |   | $ | 6,789,313 |
| Americas                      |   | 49,169                           |      | 21,853                          |   | 521,266 |   | 478,590 |
| Europe                        |   | 119,399                          |      | 280,893                         |   | 150,989 |   | 315,837 |
|                          |   |                             |      |                            |   |   |   |   |
| Total                         |   | $                                | 4,525,846 |                            | $ | 4,028,360 |   | $ | 8,996,220 |   | $ | 7,583,740 |

 

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

 

In July 2002, theFinancial Accounting Standards Board (“FASB”) issued SFAS 146, “Accountingfor Costs Associated with Exit or Disposal Activities,” which addressedfinancial accounting and reporting for costs associated with exit or disposalactivities and supercedes Emerging Issues Task Force (EITF) Issue 94-3,“Liability Recognition for Certain Employee Termination Benefits and OtherCosts to Exit an Activity (Including Certain Costs Incurred in aRestructuring).” SFAS 146 requires that a liability for a cost associatedwith an exit or disposal activity be recognized at the date of an entity’scommitment to an exit plan. SFAS 146 also establishes that the liabilityshould initially be measured and recorded at fair value. The Company hasadopted the provisions of SFAS 146 for exit or disposal activitieseffective January 1, 2003. The adoption of SFAS No. 146 did not have amaterial impact on the Company’s consolidated results of operations, financialposition or cash flows.

 

In December 2002, theFASB issued SFAS No. 148, “Accounting for Stock-BasedCompensation—Transition and Disclosure—an Amendment to SFAS No. 123.” SFASNo. 148 provides alternative methods of transition for a voluntary changeto the fair value based method on accounting for stock-based employeecompensation. The Company has not currently adopted SFAS No. 123 andaccordingly the implementation of SFAS No. 148 has not had a material effect onthe Company's consolidated financial position or results of operations.

 

In November 2002, theFASB issued interpretation No. 45, “Guarantor’s Accounting and DisclosureRequirements for Guarantees. Including indirect Guarantees of Indebtedness ofOthers,” which disclosures are effective for financial statements for periodsending after December 15, 2002. While the Company has various guaranteesincluded in contracts in the normal course of business, primarily in the formof indemnities, these guarantees would only result in immaterial increases infuture costs, but do not represent significant commitments or contingentliabilities of the indebtedness of others.

 

In January 2003, theFASB issued interpretation No. 46, “Consolidation of Variable InterestEntities” (FIN 46), which requires the consolidation of variable interestentities, as defined. FIN 46 is applicable to financial statements to be issuedby the Company after 2002; however, disclosures are required currently if theCompany expects to consolidate any variable interest entities. No materialentities were consolidated as a result of FIN 46.

 

In April 2003, SFAS No. 149, “Amendment of Statement 133 onDerivative Instruments and Hedging Activities” was issued.  This statement amends and clarifies financialaccounting and reporting for derivative instruments, including certainderivative instruments embedded in other contracts (collectively referred to asderivatives) and for hedging activities under SFAS No. 133, “Accounting forDerivative Instruments and Hedging Activities.”  This statement is effective for contracts entered into ormodified after June 30, 2003.  Adoptionof this statement is not expected to have a significant effect on the Company’sfinancial position or results of operations.

 

In May 2003, SFAS No. 150, “Accounting for CertainFinancial Instruments with Characteristics of Both Liabilities and Equity” wasissued.  This statement establishesstandards for how an issuer classifies and measures certain financialinstruments with characteristics of both liabilities and equity.  This statement is effective for financialinstruments entered into or modified after May 31, 2003.  The adoption of SFAS No. 150 is not expectedto have a significant effect on the Company’s financial position, results ofoperations, or cash flows.

 

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

 

This information should beread in conjunction with the unaudited condensed interim consolidated financialstatements and the notes thereto included in this Quarterly Report, and theaudited consolidated financial statements and notes thereto and 

 

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Management’s Discussion and Analysis ofFinancial Condition and Results of Operations contained in the Company’s AnnualReport on Form 10-K for the year ended December 31, 2002.

 

**Overview**

 

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

 

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

 

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

 

*Licensing:*  The Company’s licensing segment developsand licenses audio and voice technologies to many of the world’s leadingoriginal equipment manufacturers (“OEMs”), software providers and semiconductormanufacturers.

 

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

 

***Valence***

 

*Semiconductor**:***  Thesemiconductor segment develops and sells technology solutions in the form ofanalog and digital signal processor (“DSP”) ASIC semiconductors or otherimbedded custom semiconductor designs to OEMs around the world.

 

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

 

***SRSWOWcast***

 

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

 

**CriticalAccounting Policies**

 

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

 

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

 

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

 

*Allowance forDoubtful Accounts*

 

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

 

14

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*InventoryObsolescence Reserves*

 

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

 

*Valuation ofIntangible Assets*

 

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

 

*Income Taxes*

 

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

 

**Results ofOperations**

 

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

 

*Revenues*

 

The Company generatesrevenues in three operating business units in five business segments.Semiconductor revenues consists of (a) design fees relating to, and salesof, ASICs for third parties by Valence to OEMs; and (b) sales of generalpurpose integrated circuits (“ICs”) designed by Valence under the brand nameASP. Licensing revenues are royalties generated primarily from the license ofSRS Labs’ audio and voice technologies. License and royalty agreementsgenerally provide for the license of technologies for a specified period oftime for either a single fee or a fee based on the number of units distributedby the licensee. Component distribution revenue consists of (a) themanufacture and sale of Valence’s own branded product line of VCD players,amplifiers and game products and (b) the distribution of semiconductorproducts, manufacturing components and sub-assemblies to OEMs for the HongKong and People’s Republic of China (“PRC”) markets. Product sales representsales of consumer products incorporating one or more of SRS Labs’ proprietarytechnologies. Internet and broadcast revenues consist of the sale of hardwareand software applications involving the Internet and broadcast audio markets.

 

Total revenues for the threemonths ended June 30, 2003 were $4,525,846 compared to $4,028,360 for the threemonths ended June 30, 2002, an increase of $497,486 or 12.3%. Licensingrevenues were $1,958,279 for the three months ended June 30, 2003, compared to$1,435,841 for the three months ended June 30, 2002, an increase of $522,438 or36.4%. This increase was attributable to revenues generated in new productcategories such as car audio, portable audio devices, and PCs and increasedpenetration in its key home theater market, including DVD players, set topboxes, and televisions, which incorporate SRS Labs’ technologies. 

 

Semiconductor revenues were$2,466,941 for the three months ended June 30, 2003 compared to $2,365,298 forthe three months ended June 30, 2002, an increase of $101,643 or 4.3%. Thisincrease was attributable to expansion of Valence’s ASP customer base and newASP chip offerings.  

 

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Other revenues were $100,626for the three months ended June 30, 2003 compared to $227,221 for the threemonths ended June 30, 2002, a decrease of $126,595 or 55.7%.  Other revenues are comprised of thefollowing components for the quarters ended June 30, 2003 and 2002, respectively:  component distribution — 46% and 91%;product revenues — 4% and 9% ; internet and broadcast business — 50% and0%.  Component distribution revenueswere $46,379 for the three months ended June 30, 2003 compared to $207,266 forthe three months ended June 30, 2002, a decrease of $160,887 or 77.6%. Thisdecrease was due to the Company’s decision to focus on higher marginsemiconductor and licensing revenues and de-emphasize certain lower margindistribution activities. Product revenues were $4,399 for the three monthsended June 30, 2003 compared to $20,550 for the comparable period in 2002, adecrease of $16,152 or 78.6%. This decrease was due to the decrease of theon-line merchandising of the WOW Thing processor box.  Revenues generated by the Company’s Internet and broadcast basedbusiness were $49,848 for the three months ended June 30, 2003 compared to aloss of $595 for the three months ended June 30, 2002, an increase of$50,433.  This increase was attributableto the sales of professional hardware equipment to the broadcast market.

 

Hong Kong, andother regions of Asia, have been particularly affected by the outbreak andspread of SARS which, in turn, has impacted the economic landscape of theseregions and companies that conduct business in the same regions.  Certain of our licensing and semiconductordesign customers have reported a negative impact from the effects of SARS.  While it is difficult to conclusivelyquantify the impact of SARS on our business, we believe that the slower growthin our semiconductor business was attributable to restricted business traveland reduced order rate during the period of economic uncertainty caused bySARS.  Based on discussions we have hadwith our customers, we believe that the growth of our licensing revenue and theexpansion of our semiconductor business were both negatively impacted.

 

*GrossMargin*

 

Cost of sales consistsprimarily of fabrication costs, assembly and test costs, and the cost ofmaterials and overhead from operations. The gross margin percentage for thethree months ended June 30, 2003 increased to 80.1% as a percentage of totalrevenue as compared to 72.3% for the three months ended June 30, 2002. Theincrease is attributable to continued efforts by the Company to focus therevenue base towards higher margin semiconductor and licensing revenues andaway from lower margin component distribution. Gross margins for the licensingbusiness for the quarters ended June 30, 2003 and 2002 were 99% and 99%respectively. Licensing revenues accounted for 43% of total revenues ascompared to 36% for the three months ended June 30, 2003 and 2002 respectively.Gross margins for the semiconductor business for the quarters ended June 30,2003 and 2002 were 67% and 64% respectively. Semiconductor revenues accountedfor 55% of total revenues as compared to 59% for the three months ended June30, 2003 and 2002 respectively. Gross margins for other revenues for thequarters ended June 30, 2003 and 2002 were 22% and (12)% respectively.  Other revenues accounted for 2% of totalrevenues as compared to 6% for the three months ended June 30, 2003 and 2002respectively. Gross margins may fluctuate in future quarters depending on themix of products sold and services provided, royalties earned, competitivepricing, new product introduction costs and other factors.

 

*Sales andMarketing*

 

Sales and marketing expensesconsist primarily of employee salaries, sales consultants’ fees and relatedexpenses, sales commissions and product promotion costs. Sales and marketing expenseswere $1,271,097 for the three months ended June 30, 2003 compared to $923,460for the same prior year period, an increase of $347,637 or 37.6%. The netincrease in sales and marketing expenses for the three months ended June 30,2003 is primarily attributable to 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 increased from 22.9%for the quarter ended June 30, 2002, to 28.1% for the same period this year.

 

*Researchand Development*

 

Research and developmentexpenses consist of salaries and related costs of employees engaged in ongoingresearch, design and development activities and costs for engineering materialsand supplies. Research and development expenses were $970,123 for the threemonths ended June 30, 2003 compared to $937,521 for the same prior year period,an increase of $32,602, or 3.5%. The increase in research and development costsis primarily due to the addition of research and development personnel.  As a percentage of total revenues, researchand development expenses decreased from 23.3% for the quarter ended June 30,2002, to 21.4% for the same period this year.

 

*Generaland Administrative*

 

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 $1,210,033 for the three months endedJune 30, 2003 compared to $889,500 for the same prior year period, an increaseof $320,533 or 36.0%. The increase was primarily attributable to additions toinfrastructure and personnel for management of our foreign operations,increased professional fees and public company expenses.  As a percentage of total revenues, G&Aexpenses increased from 22.1% for the quarter ended June 30, 2002, to 26.6% forthe same period this year.

 

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*Income(Loss) From Operations*

 

Income from operationsincreased by $10,964 to $174,028 for the quarter ended June 30, 2003, ascompared to income from operations of $163,064 for the quarter ended June 30,2002.  The increase in income fromoperations is due to an increase in gross profit of $711,736, offset by anincrease in sales and marketing, research and development and general andadministrative expenses of $700,772.

 

*OtherIncome, Net*

 

Other income, net, consistsprimarily of interest income, gain or (loss) on sale of securities and foreigncurrency transaction gains and losses. Other income, net, was $118,604 for thethree months ended June 30, 2003, compared to $228,586 for the same prior yearperiod, a decrease of $109,982 or 48.1%. Other income net was substantiallyhigher in the three months ended June 30, 2002 due to a recognized gain on thesale of investments in the amount of $98,224 and higher interest income earnedon investment balances.  

 

*MinorityInterest*

 

Minority interest representsthe minority shareholders’ proportionate share of losses in SRSWOWcast.Minority interest was $0 for the three months ended June 30, 2003, compared to$20,282 for the three months ended June 30, 2002. In February 2003, SRSLabs completed an exchange offer with the minority shareholders of SRSWOWcast,pursuant to which SRS Labs acquired all of the outstanding shares ofSeries A Convertible Preferred Stock in exchange for the issuance ofshares of SRS Labs common stock. As a result of the exchange offer, SRSWOWcastbecame a wholly-owned subsidiary of SRS Labs.

 

*Provisionfor Income Taxes*

 

The income tax expense forthe three months ended June 30, 2003 was $326,514, compared to tax expense of$207,379 for the same prior year period, an increase of $119,135 or 57.4%. Theincrease results from the increase in the Hong Kong tax rate from 16.5% to17.5%, effective January 1, 2003, and the higher levels of foreign tax onhigher licensing revenues sourced from countries requiring foreign taxwithholdings.

 

**Six MonthsEnded June 30, 2003 Compared to Six Months Ended June 30, 2002**

 

*Revenues*

 

Total revenues for the sixmonths ended June 30, 2003 were $8,966,220 compared to $7,583,740 for the sixmonths ended June 30, 2002, an increase of $1,412,480 or 18.6%. Licensingrevenues were $4,586,590 for the six months ended June 30, 2003, compared to$3,231,563 for the six months ended June 30, 2002, an increase of $1,355,027 or41.9%. This increase was attributable to revenues generated in new productcategories such as car audio, portable audio devices, and PCs and increasedpenetration in its key home theater market, including DVD players, set topboxes, and televisions, which incorporate SRS Labs’ technologies. The increasein licensing revenue provided much higher gross margins which resulted inhigher operating income for the six months ended June 30, 2003 as compared tothe same period in 2002.

 

Semiconductor revenues were$4,178,760 for the six months ended June 30, 2003 compared to $3,836,440 forthe six months ended June 30, 2002, an increase of $342,320 or 8.9%. Thisincrease was attributable to expansion of Valence’s customer base, increaseddesign wins and new chip offerings.  

 

Other revenues were $230,870for the six months ended June 30, 2003 compared to $515,737 for the six monthsended June 30, 2002, a decrease of $284,867 or 55.2%.  Other revenues are comprised of the following components for theperiods ended June 30, 2003 and 2002, respectively:  component distribution — 43% and 86%; product revenues — 2% and9% ; Internet and broadcast business — 55% and 5%.  Component distribution revenues were $98,640 for the six monthsended June 30, 2003 compared to $442,197 for the six months ended June 30,2002, a decrease of $343,557 or 77.7%. This decrease was due to the Company’sdecision to focus on higher margin ASIC and licensing revenues and de-emphasizecertain lower margin distribution activities. Product revenues were $5,647 forthe six months ended June 30, 2003 compared to $45,469 for the comparable periodin 2002, a decrease of $39,823 or 87.6%. This decrease was due to the decreaseof the on-line merchandising of the WOW Thing processor box.  Revenues generated by the Company’s Internetand broadcast based business were $126,583 for the six months ended June 30,2003 compared to $28,071 for the six months ended June 30, 2002, an increase of$98,512.  This increase was attributableto the sales of professional hardware equipment to the broadcast market.

 

Hong Kong, andother regions of Asia, have been particularly affected by the outbreak andspread of SARS which, in turn, has 

 

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impacted the economic landscapeof these regions and companies that conduct business in the same regions.  Certain of our licensing and semiconductordesign customers have reported a negative impact from the effects of SARS.   While it is difficult to conclusivelyquantify the impact of SARS on our business, we believe that the slower growthin our semiconductor business was attributable to restricted business traveland reduced order rate during the period of economic uncertainty caused bySARS.  Based on discussions we have hadwith our customers, we believe that the growth of our licensing revenue and theexpansion of our semiconductor business were both negatively impacted.

 

###### *Gross Margin*

 

Cost of sales consistsprimarily of fabrication costs, assembly and test costs, and the cost ofmaterials and overhead from operations. The gross margin percentage for the sixmonths ended June 30, 2003 increased to 82.5% as a percentage of total revenueas compared to 74.8% for the six months ended June 30, 2002. Gross margins forthe licensing business for the six months ended June 30, 2003 and 2002 were99.0% and 99%, respectively. Licensing revenues accounted for 51% of totalrevenues as compared to 43% for the six months ended June 30, 2003 and 2002,respectively. Gross margins for the semiconductor business for the quartersended June 30, 2003 and 2002 were 67% and 65%, respectively.  Semiconductor revenues accounted for 46% oftotal revenues as compared to 51% for the six months ended June 30, 2003 and2002, respectively. Gross margins for other revenues for the six months endedJune 30, 2003 and 2002 were 27% and (3)%, respectively. Other revenuesaccounted for 3% of total revenues as compared to 7% for the six months endedJune 30, 2003 and 2002, respectively. The increase is attributable to continuedefforts by the Company to focus the revenue base towards higher marginsemiconductor and licensing revenues and away from lower margin componentdistribution. Gross margins may fluctuate in future quarters depending on themix of products sold and services provided, royalties earned, competitivepricing, new product introduction costs and other factors.

 

*Sales andMarketing*

 

Sales andmarketing expenses consist primarily of employee salaries, sales consultants’fees and related expenses, sales commissions and product promotion costs. Salesand marketing expenses were $2,623,587 for the six months ended June 30, 2003compared to $2,193,219 for the same prior year period, an increase of $430,368or 19.6%. The net increase in sales and marketing expenses for the six monthsended June 30, 2003 is primarily attributable to increased promotion costsassociated with higher licensing revenue and investments in branding andpromotion of our technologies in new markets designed to increase futurerevenues. As a percentage of total revenues, sales and marketing expensesincreased from 28.9% for the six months ended June 30, 2002, to 29.2% for thesame period this year.

 

*Researchand Development*

 

Research and developmentexpenses consist of salaries and related costs of employees engaged in ongoingresearch, design and development activities and costs for engineering materialsand supplies. Research and development expenses were $2,051,338 for the sixmonths ended June 30, 2003 compared to $1,902,597 for the same prior yearperiod, an increase of $148,741, or 7.8%. The increase in research anddevelopment costs is primarily due to the addition of research and developmentpersonnel and increased costs associated with the increased semiconductorbusiness activity.  As a percentage oftotal revenues, research and development expenses decreased from 25.1% for thesix months ended June 30, 2002, to 22.8% for the same period this year.

 

*Generaland Administrative*

 

G&A expenses consistprimarily of employee-related expenses, legal costs associated with theadministration of intellectual property and other professional fees. G&Aexpenses were $2,524,643 for the six months ended June 30, 2003 compared to$2,113,706 for the same prior year period, an increase of $410,937 or 19.4%.The increase was primarily attributable to additions to infrastructure andpersonnel for management of our foreign operations, increased professional feesand public company expenses. As a percentage of total revenues, G&Aexpenses increased from 27.9% for the six months ended June 30, 2002, to 28.1%for the same period this year.

 

*Income(Loss) From Operations*

 

Income from operationsincreased by $760,461 to $226,519 for the six months ended June 30, 2003, ascompared to a loss from operations of $533,942 for the same period ended June30, 2002.  The increase in income fromoperations is due to an increase in gross profit of $1,750,507, partiallyoffset by an increase in sales and marketing, research and development andgeneral and administrative expenses of $990,046.

 

*OtherIncome, Net*

 

Other income, net, consistsprimarily of interest income, gain or (loss) on sale of securities and foreigncurrency transaction gains and losses. Other income, net, was $282,730 for thesix months ended June 30, 2003, compared to $316,550 for the same prior 

 

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year period, a decrease of $33,820 or 10.7%.Other income, net was higher for the six months ended June 30, 2002 due torealized gains on sales of investments and higher interest income earned oninvestment balances.  

 

*MinorityInterest*

 

Minority interest representsthe minority shareholders’ proportionate share of losses in SRSWOWcast.Minority interest was $5,430 for the six months ended June 30, 2003, comparedto $40,030 for the six months ended June 30, 2002, a decrease of $34,600 or86.4%. In February 2003, SRS Labs completed an exchange offer with theminority shareholders of SRSWOWcast, pursuant to which SRS Labs acquired all ofthe outstanding shares of Series A Convertible Preferred Stock in exchangefor the issuance of shares of SRS Labs common stock. As a result of theexchange offer, SRSWOWcast became a wholly-owned subsidiary of SRS Labs.

 

*Provisionfor Income Taxes*

 

The income tax expense forthe six months ended June 30, 2003 was $506,027, compared to tax expense of$308,815 for the same prior year period, an increase of $197,212 or 63.9%. Theincrease results from the increase in the Hong Kong tax rate from 16.5% to17.5%, effective January 1, 2003, and the higher levels of foreign tax onhigher licensing revenues sourced from countries requiring foreign taxwithholdings.

 

**Liquidityand Capital Resources**

 

The Company’s principalsource of liquidity to fund ongoing operations at June 30, 2003 consisted ofcash, cash equivalents and long-term investments aggregating $22,216,981. AtJune 30, 2003, the Company had cash and cash equivalents of $16,787,436 andlong-term investments of $5,429,545. Cash and cash equivalents generallyconsist of cash, money market funds and other money market instruments withoriginal maturities of three months or less. Investments consist of U.S.government securities rated AAA.

 

Cash provided by operatingactivities for the six months ended June 30, 2003 was $214,762.  Net cash provided by operations resultedfrom a net decrease in accounts receivable and prepaid expenses and othercurrent assets and an increase in income taxes payable partially offset byincreases in inventories and decreases in accounts payable and accruedliabilities, as well as certain adjustments to reconcile net income to cashused in operating activities including depreciation and amortization.  Net cash provided by investing activitiesfor the six months ended June 30, 2003 was $799,668, resulting primarily fromthe sale of U.S. government securities offset by purchases of furniture,fixtures and equipment and expenditures related to intangible assets. Net cashprovided by financing activities for the six months ended June 30, 2003 was$52,146, reflecting the proceeds from sale of common stock pursuant to exerciseof employee stock options.

 

Based on current plans andbusiness conditions, the Company expects that its cash, cash equivalents andinvestments together with any amounts generated from operations will besufficient to meet the Company’s cash requirements for the foreseeable future.However, there can be no assurance that the Company will not be required toseek other financing sooner or that such financing, if required, will beavailable on terms satisfactory to the Company.

 

**FactorsThat May Affect Future Results**

* *

*Our quarterlyresults may fluctuate*

 

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

 

*We rely on revenuecontribution from our ASIC and standard IC business*

 

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

 

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Business revenue from ASICs is concentrated in a limited number ofcustomers in the areas of consumer electronics, communications products,computers and computer peripherals. The business generated from any one customermay be for a fixed length or quantity. As such, it is customary in our ASICbusiness to have a certain amount of customer turnover as new ASIC projects areobtained for different customers. However, it is possible that the loss of anyparticular customer or any bad debt arising from such customer may have amaterial adverse impact on our financial condition and results of operation.Beginning in fiscal 1999, Valence began to exit from certain lower marginproduct offerings in the distribution side of the business and has placed moreemphasis on developing and distributing products that are related to orincorporate our proprietary technologies. As a result, the immediate loss inrevenue of the low margin distribution business will not be entirely offset bythe new proprietary technology based products, which will take time to developand be introduced into the marketplace. There can be no assurance that we willbe able to quickly introduce new products to offset the loss in revenue or thatthe new products developed will receive a favorable market acceptance.

 

Valence adds significant diversity to our overall business structureand opportunities. We recognize that in the presence of such corporatediversity, and in particular with regard to the semiconductor industry, therewill always exist a potential for a conflict among sales channels between theCompany and our technology licensees. Although the operations of our licensingbusiness and those of Valence are generally complementary, there can be no assurancesthat sales 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 conduct operationsin a number of countries and are subject to risks of international operations,particularly in Asia and the PRC*

 

We havesignificant operations in Hong Kong, the PRC and other parts of Asia thatrequire refinement to adapt to the changing market conditions in that region.Our customers geographically located in the Asia Pacific markets accounted forapproximately 96%, and 93% of total Company sales in the quarters ended June30, 2003 and 2002, respectively and 93%, and 93% of total Company sales in thesix months ended June 30, 2003 and 2002, respectively  and are expected to continue to account for a substantialpercentage of sales in the future. Because we rely on sales to customers inAsia for a substantial portion of our revenue, our business is very likely tobe adversely impacted by economic downturns and instability in that region. Inaddition, international sales are subject to risks, including, but not limitedto:

 

•                           fluctuations in foreign exchange rates;

•                           changes in legal and regulatory requirements;

•                           political and economic instability and acts ofterrorism;

•                           any public health crisis such as SARS; 

•                           difficulties in staffing and managinginternational operations;

•                           foreign trade disputes; and

•                           potentially adverse tax consequences.

 

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

 

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

 

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

 

Hong Kong, andother regions of Asia, have been particularly affected by the outbreak andspread of Severe Acute Respitory Syndrome (“SARS”) which in turn has impactedthe economic landscape of these regions and companies that conduct business inthe same regions.  While it is difficultto conclusively quantify the impact of SARS on our business, based ondiscussions we have had with our customers we believe and it appears that thegrowth of our licensing revenue and expansion of our semiconductor businesswere both negatively impacted.  Althoughemployees of our Hong Kong operations were subject to temporary travelrestrictions in Q2 of 2003 that are now lifted, it is impossible to predict theprecise economic impact of SARS and whether such impact will have a continuingor significant 

 

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long-term effect on theCompany.  Accordingly, the Companyremains potentially at risk from the effects of SARS, or similar healthemergencies, which restrict travel and may otherwise negatively impact theability to routinely conduct and expand business in those areas affected bySARS.

* *

*We are exposed to risks in our licensing business related to productconcentration*

 

Currently, our licensingrevenue is concentrated in the home theater market with the majority of revenuegenerated from the inclusion of SRS technology inside televisions, DVD playersand set-top boxes. We expect that the consumer home entertainment market willcontinue to account for a significant portion of our licensing revenues for theforeseeable future. While consumer spending in general on consumer electronicproducts has increased, retail prices for certain consumer electronics productsthat include our audio technology, such as DVD players have decreasedsignificantly and indications are that this trend will continue for the foreseeablefuture. Declining prices of consumer electronic products could put pressure onour licensing fees that are charged to the manufacturers.  In addition, consumer electronics productsmanufacturers could decide to exclude our audio enhancement technology fromtheir home theater products altogether in an effort to reduce cost.  Also,given the current economic environment, consumer spending on DVD players andother home electronic products may not increase as expected.  Such declines in consumer spending, shouldthey occur, and continued decreases in consumer product pricing for electronicgoods may have a significant negative impact on our financial results.

 

*We are exposed tocertain risks in producing professional and consumer products*

 

We intend to continue to develop and offer high-end audio enhancementproducts, including professional and consumer hardware and software products.We have also developed a line of speakers that incorporate proprietary flatpanel designs, which have been marketed to OEMs and industry retailbuyers. There can be no assurance that our products will be accepted in themarket or that we will be able to develop an effective distribution channel andbuild acceptable brand recognition as a product manufacturer. As the business increases,it is anticipated that significant capital will be required to finance productinventory and accounts receivable. As a result, we are subject to risks ofproduct obsolescence, bad debt and insufficient finance to grow the business.

 

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

 

*Our results ofoperations may be adversely affected by the ongoing slowdown in the globaleconomy*

 

Over the pastyear, the global economy has been experiencing a slowdown due to many factors,including decreased consumer confidence, unemployment, the ongoing threat andcost of terrorism and reduced corporate profits and capital spending. Recentpolitical events, including the U.S. military action in the Middle East, haveput further pressure on economic conditions. The potential turmoil that mayresult from such events contribute to the uncertainty of the economic climate,further reducing predictability and our ability to develop and implementlong-term strategic plans. The impact of these or future similar events may havea material adverse impact on our operating results and financial position.

 

*We are subject tocompetitive pressures*

 

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

 

Our ability to compete may be affected by our ability to protect ourproprietary information. We have filed numerous U.S. and foreign patent applicationsand to date have a number of issued U.S. and foreign patents covering variousaspects of our technologies.  There canbe no assurance that the steps taken by SRS Labs to protect our intellectualproperty will be adequate to prevent misappropriation of our technology or thatour competitors will not independently develop technologies that aresubstantially equivalent or superior to our technology. In addition, the lawsof certain foreign countries may not protect our intellectual property rights tothe same extent, as do the laws of the U.S. The semiconductor industry ischaracterized by frequent claims and litigation regarding patent and otherproperty rights. We are not currently a party to any claims of this nature.There can be no assurances that third parties will not assert claims orinitiate litigation against the Company or our customers with respect toexisting or future products. In addition, we may initiate claims or litigationagainst third parties for infringement of our proprietary rights or todetermine the scope and validity of our proprietary rights.

 

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*We depend on ourexecutive officers and other key personnel*

 

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

 

*The market price ofour common stock is volatile*

 

The trading price of our Common Stock has been, and will likelycontinue to be, subject to wide fluctuations in response to quarterlyvariations in our operating results, announcements of new products ortechnological innovations by the Company or our competitors, strategicalliances between SRS Labs and third parties, general market fluctuations andother events and factors. Changes in earnings estimates made by brokerage firmsand industry analysts relating to the markets in which we do business, or relatingto the Company specifically, have in the past resulted in, and could in thefuture result in, an immediate and adverse effect on the market price of theCommon Stock. Even though our stock is quoted on the NASDAQ Stock Market, ourstock has had and may continue to have low trading volume and high volatility.The historically low trading volume of our stock makes it more likely that asevere fluctuation in volume, either up or down, will significantly impact thestock price. Since our shares are thinly traded, our shareholders may havedifficulty selling our common stock.

 

**Item 3****.  Quantitativeand Qualitative Disclosures about Market Risk**

 

There havebeen no material changes to information called for by this Item 3 from thedisclosures set forth in Part II, Item 7A in the Company’s Annual Report onForm 10-K for the year ended December 31, 2002.

** **

**Item 4****.  Controls and Procedures**

 

Based on an evaluation ofthe effectiveness of our disclosure controls and procedures (as defined inRules 13a-15(e) and 15d-15(e) under the Securities Act of 1934, as amended),our Chief Executive Officer and Chief Financial Officer have concluded thatsuch controls and procedures were effective as of the period covered by thisreport. In connection with such evaluation, no change in our internal controlover financial reporting occurred during the period covered by this report thathas materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

 

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**PARTII—OTHER INFORMATION**

 

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

 

The Annual Meeting of Stockholders of SRSLabs, Inc. was held on June 18, 2003 for the purpose of (a) electingone Class I director to the Board of Directors, (b) voting on a proposalto approve an amendment to the SRS Labs, Inc. Amended and Restated 1996Long-Term Incentive Plan (the “Option Plan”) to increase the number of sharesof common stock available for issuance thereunder by 1,500,000, and (c)votingon a proposal to ratify the appointment of BDO Seidman LLP as independentauditors for the fiscal year ending December 31, 2003.

 

Winston E. Hickman was elected to serve as aClass I Director of the Company for a three-year term expiring at the 2006Annual Meeting of Stockholders. John Tu continued in office as a Class IIDirector and Stephen V. Sedmak, Sam Yau and Thomas C.K. Yuen continued inoffice as Class III Directors.  Thetabulation of the votes cast for the election of Mr. Hickman  was as follows:

 
| **Votes For** |   | **Votes  Withheld** |
|---------------|--------|---------------------|
| 11,986,065    |   | 339,043             |

 

The proposal to amend the Option Plan was notapproved.  The tabulation of votes wasas follows:

 
| **Votes For** |   | **Votes  Against** |   | **Abstentions** |   | **Broker Non-Votes** |
|---------------|--------|--------------------|--------|-----------------|--------|----------------------|
| 5,953,131     |   | 1,866,594          |   | 15,111          |   | 4,508,872            |

 

The proposal to ratify the appointment of BDOSeidman LLP as independent auditors for the fiscal year ending December 31,2003 was approved.  The tabulation ofvotes was as follows:

 
| **Votes For** |   | **Votes  Against** |   | **Abstentions** |   | **Broker Non-Votes** |
|---------------|--------|--------------------|--------|-----------------|--------|----------------------|
| 12,310,350    |   | 3,731              |   | 11,027          |   | 0                    |

 

 

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

 

(a)                                  *Exhibits*.

 

The exhibit listed below is hereby filed withthe Commission as part of this Report.

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

         |   | Certification  of Chief Financial Officer of SRS Labs, Inc., Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

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

 

On May 13, 2003, SRS Labsfiled a report on Form 8-K dated May 13, 2003 announcing its operating resultsfor the first quarter of the fiscal year ending December 31, 2003. 

 

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**SIGNATURES**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.

 

 
|                  | SRS LABS, INC.,  a Delaware corporation |
|-----------------------|----------------------------------------------|
|                  |                                         |
| Date: August 12, 2003 | By:                                          | /s/ THOMAS C.K. YUEN |
|                  |                                         | **Thomas C.K. Yuen** |
|                  |                                         | **Chairman of the Board and Chief Executive  Officer** |
|                  |                                         | **(Principal Executive Officer)** |
|                  |                                         |   |
|                  |                                         |   |
| Date: August 12, 2003 | By:                                          | /s/ JANET M. BISKI |
|                  |                                         | **Janet M. Biski** |
|                  |                                         | **Chief Financial Officer** |
|                  |                                         | **(Principal Financial and Accounting  Officer)** |

 

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