DIGITAL THEATER SYSTEMS INC - 10-Q Quarterly Report

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

Form 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended March 31, 2004

Commission File Number 000-50335

Digital Theater Systems, Inc.

(Exact name of registrant as specified in its charter)

Delaware		77-0467655
(State or other jurisdiction of incorporation or organization)		(I.R.S. employer identification number)

5171 Clareton Drive Agoura Hills, California 91301		(818) 706-3525
(Address of principal executive offices and zip code)		(Registrant’s telephone number, Including area code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements 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

As of April 30, 2004 a total of 16,802,729 shares of the Registrant’s Common Stock, $0.0001 par value, were issued and outstanding.

DIGITAL THEATER SYSTEMS, INC.

FORM 10-Q

TABLE OF CONTENTS

PART I	FINANCIAL INFORMATION
Item 1.	Financial Statements:
	Condensed Consolidated Balance Sheets
	Condensed Consolidated Statements of Operations
	Condensed Consolidated Statements of Cash Flows
	Notes to Condensed Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures About Market Risk
Item 4.	Controls and Procedures
PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings
Item 2.	Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
Item 3.	Defaults Upon Senior Securities
Item 4.	Submission of Matters to a Vote of Security Holders
Item 5.	Other Information
Item 6.	Exhibits and Reports on Form 8-K
SIGNATURES

DIGITAL THEATER SYSTEMS, INC.

PART I

FINANCIAL INFORMATION

Item 1. Financial Statements

Digital Theater Systems, Inc.

Condensed Consolidated Balance Sheets

	As of December 31, 2003		As of March 31, 2004
			(Unaudited)
	(Amounts in thousands, except share and per share amounts)
ASSETS
Current assets:
Cash and cash equivalents	$	89,341	$	69,965
Short-term investments	10,048		25,587
Accounts receivable, net of allowance for doubtful accounts of $429 and $430 at December 31, 2003 and March 31, 2004, respectively	3,962		4,771
Inventories	7,552		9,119
Deferred tax assets, net	6,025		5,904
Prepaid expenses and other	1,846		1,779
Income tax receivable	660		—

Total current assets	119,434		117,125
Long-term investments	2,998		10,519
Property and equipment, net	3,092		3,353
Patents and trademarks	424		422
Deferred tax assets	1,527		2,778
Other assets	20		109

Total assets	$	127,495	$	134,306

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	2,829	$	4,235
Accrued expenses	5,795		6,037
Income tax payable	—		446

Total current liabilities	8,624		10,718
Commitments and contingencies (Note 6)
Stockholders’ equity:
Preferred stock — $0.0001 par value, 5,000,000 shares authorized at December 31, 2003 and March 31, 2004; no shares outstanding at December 31, 2003 and March 31, 2004	—		—
Common stock — $0.0001 par value, 70,000,000 shares authorized at December 31, 2003 and March 31, 2004; 16,512,885 and 16,681,393 shares issued and outstanding at December 31, 2003 and March 31, 2004, respectively	2		2
Additional paid-in capital	115,512		116,789
Retained earnings	3,357		6,797

Total stockholders’ equity	118,871		123,588

Total liabilities and stockholders’ equity	$	127,495	$	134,306

See accompanying notes to condensed consolidated financial statements.

Digital Theater Systems, Inc.

Condensed Consolidated Statements of Operations

	For the Three Months Ended March 31,
	2003			2004
	(Amounts in thousands, except share and per share amounts)
	(Unaudited)
Revenues:
Technology and film licensing	$	10,124		$	12,497
Product sales and other revenues	1,632			3,100

Total revenues	11,756			15,597
Cost of goods sold:
Technology and film licensing	840			980
Product sales and other revenues	1,573			1,912

Total cost of goods sold	2,413			2,892

Gross profit	9,343			12,705
Operating expenses:
Selling, general and administrative	4,991			6,440
Research and development	1,170			1,332

Total operating expenses	6,161			7,772

Income from operations	3,182			4,933
Interest (income) expense, net	(13		)	(439		)
Other (income) expense, net	80			14

Income before provision for income taxes	3,115			5,358
Provision for income taxes	1,086			1,918

Net income	2,029			3,440
Accretion and accrued dividends on preferred stock	(468		)	—

Net income attributable to common stockholders	$	1,561		$	3,440

Net income attributable to common stockholders per common share:
Basic	$	0.35		$	0.21

Diluted	$	0.15		$	0.19

Weighted average shares used to compute net income attributable to common stockholders per common share:
Basic	4,424,071			16,578,942

Diluted	10,633,577			18,219,289

See accompanying notes to condensed consolidated financial statements.

Digital Theater Systems, Inc.

Condensed Consolidated Statements of Cash Flows

	For the Three Months Ended March 31,
	2003			2004
	(Unaudited)
	(Amounts in thousands)
Cash flows from operating activities:
Net income	$	2,029		$	3,440
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	258			279
Stock-based compensation charges	403			139
Allowance for doubtful accounts	100			2
Deferred income taxes	—			(1,130		)
Tax benefit from employee stock plans	—			1,060
Changes in operating assets and liabilities:
Accounts receivable	2,281			(811		)
Inventories	(655		)	(1,567		)
Prepaid expenses and other assets	19			(23		)
Accounts payable and accrued expenses	(849		)	1,647
Income taxes	(128		)	1,107

Net cash provided by operating activities	3,458			4,143

Cash flows from investing activities:
Purchase of investments	(7		)	(23,060		)
Purchase of property and equipment	(247		)	(521		)
Payment for patents and trademarks in process	(4		)	(16		)

Net cash used in investing activities	(258		)	(23,597		)

Cash flows from financing activities:
Payment of dividends to preferred stockholders	(1,318		)	—
Follow-on public offering costs	—			(52		)
Proceeds from the issuance of common stock upon exercise of employee stock options	1			130
Proceeds from the issuance of common stock upon exercise of warrants	1			—

Net cash provided by (used in) financing activities	(1,316		)	78

Net increase (decrease) in cash and cash equivalents	1,884			(19,376		)
Cash and cash equivalents, beginning of period	1,907			89,341

Cash and cash equivalents, end of period	$	3,791		$	69,965

See accompanying notes to condensed consolidated financial statements.

DIGITAL THEATER SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Amounts in thousands, except share and per share data)

Note 1 — Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of Digital Theater Systems, Inc. (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, the unaudited condensed consolidated financial statements reflect all adjustments considered necessary for a fair presentation, consisting only of normal and recurring adjustments. All significant intercompany transactions have been eliminated in consolidation. Operating results for the three months ended March 31, 2004 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2004. For further information, refer to the consolidated financial statements and footnotes thereto for the year ended December 31, 2003 filed on Form 10-K filed on March 30, 2004.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Note 2 — Recent Accounting Pronouncements

In November 2003, the EITF reached a consensus on Issue No. 03-10, “Application of EITF 02-16 by Resellers to Sales Incentives Offered to Consumers by Manufacturers.” EITF No. 03-10 addresses the accounting for manufacturer sales incentives offered directly to consumers, including manufacturer coupons. EITF No. 03-10 is effective for the first interim period beginning after November 25, 2003. Adoption of the provisions of EITF No. 03-10 did not have a material impact on the Company’s financial position, results of operations, or cash flows for the three months ended March 31, 2004.

Note 3 — Certain Balance Sheet Items

Inventories consist of the following:

	As of December 31, 2003		As of March 31, 2004
			(Unaudited)
Raw materials	$	1,370	$	1,793
Work in process	8		2
Finished goods	6,174		7,324

Total inventories	$	7,552	$	9,119

Property and equipment consist of the following:

	As of December 31, 2003			As of March 31, 2004
				(Unaudited)
Machinery and equipment	$	2,511		$	2,666
Office furniture and fixtures	1,963			2,175
Leasehold improvements	2,599			2,753

	7,073			7,594
Less: Accumulated depreciation	(3,981		)	(4,241		)

Property and equipment, net	$	3,092		$	3,353

Note 4 — Bank Line of Credit

The Company has a $10,000 working capital credit facility with a bank that matures on June 30, 2004. The bank agreement provides for working capital financing and is collateralized by substantially all of the Company’s assets. The bank agreement requires the Company to comply with certain restrictive covenants including maintenance of certain working capital, tangible net worth and profitability levels.

At December 31, 2003 and March 31, 2004, there were no balances outstanding under this agreement and there was $10,000 and $10,000, respectively, of available borrowings under this credit facility pursuant to an availability formula based on cash, cash equivalents, short-term investments, 80% of eligible accounts receivable and 20% of inventory (up to a maximum of $1,000). Future borrowings will bear interest at rates ranging from the prime rate, as defined, minus 0.5% to the prime rate plus 1% (3.5% to 5.0% at December 31, 2003 and March 31, 2004). A commitment fee of 0.25% per annum is paid on the daily unused balance under the line of credit.

Note 5 — Income Taxes

For the three months ended March 31, 2004, the Company recorded an income tax provision of $1,918 on pre-tax income of $5,358 resulting in an annualized effective tax rate of 35.8%. For the three months ended March 31, 2003, the Company recorded an income tax provision of $1,086 on pre-tax income of $3,115, resulting in an annualized effective tax rate of 35.0%. These rates differed from the statutory rates primarily due to state income taxes offset by benefits associated with the foreign rate differentials and research and development credits.

Note 6 — Commitments and Contingencies

Indemnities, Commitments and Guarantees

In the normal course of business, the Company makes certain indemnities, commitments and guarantees under which the Company may be required to make payments in relation to certain transactions. These indemnities, commitments and guarantees include, among others, intellectual property indemnities to customers in connection with the sale of products and licensing of technology, indemnities for liabilities associated with the infringement of other parties’ technology based upon the Company’s products and technology, guarantees of timely performance of the Company’s obligations, and indemnities to the Company’ directors and officers to the maximum extent permitted by law. The duration of these indemnities, commitments and guarantees varies, and in certain cases, is indefinite. The majority of these indemnities, commitments and guarantees do not provide for any limitation of the maximum potential future payments that the Company could be obligated to make. The Company has not recorded a liability for these indemnities, commitments or guarantees in the accompanying balance sheets, as future payment is not probable.

Note 7 — Stock-Based Compensation

The Company accounts for its employee stock option and stock purchase plans in accordance with the provisions of Accounting Principals Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” and the related FASB Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation.” Accordingly, compensation expense related to employee stock options is recorded if, on the date of the grant, the fair value of the underlying stock exceeds the exercise price.

To date, options have been granted at exercise prices that equal or exceed the market value of the underlying common stock on the grant date. The following table illustrates the effect on net income attributable to common stockholders and net income per common share if the Company had applied the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation.

	For the Three Months Ended March 31,
	2003			2004
	(Unaudited)
Net income attributable to common stockholders:
As reported	$	1,561		$	3,440
Additional stock-based compensation expense determined under the fair value method, net of tax	(64		)	(449		)

Pro forma	$	1,497		$	2,991

Net income attributable to common stockholders per common share-basic:
As reported	$	0.35		$	0.21
Per share effect of additional stock-based compensation expense determined under the fair value method, net of tax	(0.01		)	(0.03		)

Pro forma	$	0.34		$	0.18

Net income attributable to common stockholders per common share-diluted:
As reported	$	0.15		$	0.19
Per share effect of additional stock-based compensation expense determined under the fair value method, net of tax	(0.01		)	(0.03		)

Pro forma	$	0.14		$	0.16

The Company accounts for stock, stock options and warrants issued to non-employees in accordance with the provisions of SFAS No. 123 and EITF Issue No. 96-18 “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods and Services.” Under SFAS No. 123 and EITF Issue No. 96-18, stock option awards issued to non-employees are accounted for at fair value using the Black-Scholes pricing model. Management believes that the fair value of the stock options is more reliably measured than the fair value of the services received. The fair value of each non-employee equity award is remeasured each period until a commitment date is reached, which is generally the vesting date. For non-employee equity awards, deferred stock-based compensation is not reflected in stockholders’ deficit until a commitment date is reached. For the three months ended March 31, 2003 and 2004, the Company recorded stock-based compensation expense of $403 and $139, respectively, related to non-employee equity awards.

Note 8 — Operating Segment and Geographic Information

The Company operates its business in two reportable segments: the Theatrical business segment and the Consumer business segment. The Theatrical business segment provides digital playback systems and cinema processor equipment to movie theaters, and provides film licensing services to film production and distribution companies. The Company’s Consumer business segment licenses audio technology, trademarks and know-how to consumer electronics, personal computer, broadcast and professional audio companies, and sells multi-channel audio content and products to consumers.

The Company does not have separately identifiable capital expenditures or long-lived assets related to these two business segments.

The Company’s reportable segments and geographical information for the three months ended March 31, 2003 and 2004 are as follows:

	Revenues
	For the Three Months Ended March 31,
	2003		2004
	(Unaudited)
Theatrical business	$	3,480	$	4,800
Consumer business	8,276		10,797

Total revenues	$	11,756	$	15,597

	Gross Profit
	For the Three Months Ended March 31,
	2003		2004
	(Unaudited)
Theatrical business	$	1,554	$	2,462
Consumer business	7,789		10,243

Total gross profit	$	9,343	$	12,705

	Income (Loss) From Operations
	For the Three Months Ended March 31,
	2003			2004
	(Unaudited)
Theatrical business	$	(1,193	)	$	(1,077	)
Consumer business	4,375			6,010

Total income from operations	$	3,182		$	4,933

	Revenues by Geographic Region
	For the Three Months Ended March 31,
	2003		2004
	(Unaudited)
United States	$	2,678	$	4,189
International	9,078		11,408

Total revenues	$	11,756	$	15,597

The following table sets forth, for the periods indicated, long-lived assets by geographic area in which the Company holds assets at December 31, 2003 and March 31, 2004:

	Long-Lived Assets
	As of December 31, 2003		As of March 31, 2004
			(Unaudited)
United States	$	3,150	$	3,145
International	366		630

Total long-lived assets	$	3,516	$	3,775

Note 9 — Net Income Attributable to Common Stockholders Per Common Share

The following table sets forth the computation of basic and diluted net income attributable to common stockholders per common share:

	For the Three Months Ended March 31,
	2003			2004
	(Unaudited)
Basic net income attributable to common stockholders per common share:
Numerator:
Net income	$	2,029		$	3,440
Preferred stock dividends accrued	(392		)	—
Accretion on preferred stock	(76		)	—

Net income attributable to common stockholders	$	1,561		$	3,440

Denominator:
Weighted average common shares outstanding	4,424,071			16,578,942

Basic net income attributable to common stockholders per common share	$	0.35		$	0.21

Diluted net income attributable to common stockholders per common share:
Numerator:
Net income	$	2,029		$	3,440
Preferred stock dividends accrued	(392		)	—
Accretion on preferred stock	(76		)	—

Net income attributable to common stockholders	$	1,561		$	3,440

Denominator:
Weighted average shares outstanding	4,424,071			16,578,942
Effect of dilutive securities:
Common stock options	1,406,847			1,318,156
Common stock warrants	4,802,659			322,191

Diluted shares outstanding	10,633,577			18,219,289

Diluted net income attributable to common stockholders per common share	$	0.15		$	0.19

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

Forward-Looking Statements May Prove Inaccurate

This report and the documents incorporated herein by reference contain forward-looking statements based on our current expectations, estimates and projections about our industry, beliefs, and certain assumptions made by us. Words such as “believes,” “anticipates,” “estimates,” “expects,” “projections,” “may,” “potential,” “plan,” “continue” and words of similar import, constitute “forward-looking statements.” The forward-looking statements contained in this report involve known and unknown risks, uncertainties and other factors that may cause our actual results to be materially different from those expressed or implied by these statements. These factors include those listed under the “Risk Factors” section contained below and in our Form 10-K filed on March 30, 2004 with the Securities and Exchange Commission, or SEC, and the other documents we file with the SEC, including our most recent reports on Form 8-K and Form 10-Q. We cannot guarantee future results, levels of activity, performance or achievements. We do not undertake any obligation to revise these forward-looking statements to reflect future events or circumstances.

You should read the following discussion of our financial condition and results of operations in conjunction with the Form 10-K filed on March 30, 2004. This discussion may contain forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, such as those set forth under “Risk Factors” contained below and in our Form 10-K filed on March 30, 2004.

Overview

We are a leading provider of entertainment technology, historically focused on high-quality digital multi-channel audio technology, products, and services for entertainment markets worldwide. Multi-channel audio, commonly referred to as surround sound, provides more than two-channels of audio, allowing the listener to simultaneously hear discrete sounds from multiple speakers. Our DTS digital multi-channel audio technology delivers compelling surround sound for the motion picture and consumer electronics markets.

We manage our business through two reportable segments — our theatrical business and our consumer business. Historically, we have derived a majority of our revenues from the theatrical business. Beginning in 2001, however, we have derived a majority of our revenues from our consumer business.

In our consumer business, we derive revenues from licensing our audio technology, trademarks, and know-how under agreements with substantially all of the major consumer audio electronics manufacturers. Our business model provides for these manufacturers to pay us a per-unit amount for DTS-enabled products that they manufacture. We also derive revenues from licensing our technology to consumer semiconductor manufacturers. Through our DTS Entertainment label, we derive revenues from the sale of music titles in our digital multi-channel format.

In our theatrical business, we derive revenues from sales of our playback equipment and cinema processors to movie theaters and special venues. In addition, we sell encoding and duplication services to film producers and distributors for the creation of digital multi-channel motion picture soundtracks. We also derive revenues from the sale of systems and encoding services for pre-show advertising, alternative content, subtitling, captioning, and descriptive narration.

We present revenues in our consolidated financial statements and in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” as derived from (1) technology and film licensing and (2) product sales and other revenues. Our technology and film licensing revenues are derived from each of our consumer and theatrical business segments. Revenues from technology licensing in connection with our consumer business segment include revenues derived from licensing our audio technology, trademarks, and know-how to consumer electronics, personal computer, video game and console, digital satellite and cable broadcast, and professional audio companies as well as to semiconductor manufacturers. Revenues from technology and film licensing in connection with our theatrical business segment include revenues derived from film licensing and services that we provide to film studios for the production of soundtracks in our digital multi-channel format. Our product sales and other revenues also are derived from each of our consumer and theatrical business segments. Revenues from product sales and other revenues in connection with our consumer business segment include revenues derived from sales of music titles that we produce in our digital multi-channel format and sales of our professional audio products and services. Revenues from product sales and other revenues in connection with our theatrical business segment include revenues derived from sales of our digital playback systems, cinema processor equipment, and systems for subtitling, captioning, and descriptive narration to movie theaters and special venues.

We actively engage in intellectual property compliance and enforcement activities focused on identifying third parties who have either incorporated our technology, trademarks, or know-how without a license or who have under-reported to us the amount of royalties owed under license agreements with us. As a result of these activities, from time to time, we recognize royalty revenues that relate to consumer electronics manufacturing activities from prior periods. These royalty recoveries may cause revenues to be higher than expected during a particular reporting period and may not occur in subsequent periods. We cannot predict the amount or timing of such revenues.

Our cost of goods sold consists primarily of amounts paid for products and materials, salaries and related benefits for production personnel, depreciation of production equipment, and payments to third parties for licensing technology and copyrighted material.

Our selling, general, and administrative expenses consist primarily of salaries, commissions, and related benefits for personnel engaged in sales, corporate administration, finance, human resources, information systems, legal, and operations, and costs associated with promotional and other selling activities. Selling, general, and administrative expenses also include professional fees, facility-related expenses, and other general corporate expenses.

Our research and development costs consist primarily of salaries and related benefits for research and development personnel, engineering consulting expenses associated with new product and technology development, and quality assurance and testing costs. Research and development costs are expensed as incurred.

In our consumer business, we have a licensing team that markets our technology directly to large consumer electronics products manufacturers and semiconductor manufacturers. This team includes employees located in the United States, China, England, Japan, and Northern Ireland. We sell music content released under our DTS Entertainment label through distributors. In the United States and Canada, Navarre Corporation is our exclusive distributor of DTS Entertainment label products to major national retail accounts and in Europe, Cadiz Music Limited is our exclusive distributor of DTS Entertainment label products. We also employ consultants to coordinate sales to independent retailers. We are in the process of establishing distribution channels in other international territories. We expect that distribution in Asia will be handled through established distributors located in Asia. We also sell this music directly to consumers through an online store and other web-based retailers. We intend to expand the number of retail outlets that carry our products and broaden our distribution network worldwide.

In our theatrical business, our post-production department, senior management, and liaison offices market our products and services directly to individual film producers and distributors worldwide. We sell our digital multi-channel playback systems to movie theaters through a direct sales force and a network of independent dealers. To date, most of our sales and marketing efforts have been focused in the United States and Canada, Western Europe, and in targeted markets in Asia and Latin America. We have also begun to focus our efforts on pursuing theater companies that have a large concentration of movie theaters in selected foreign countries such as India, China, and in Eastern Europe.

Critical Accounting Policies and Estimates

Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of our financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, estimates are evaluated, including those related to revenue recognition, allowance for doubtful accounts, inventories, deferred taxes, impairment of long-lived assets, product warranty, stock-based compensation, and contingencies and litigation. These estimates are based on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates. There has been no material change to our critical accounting policies and estimates from the information provided in our Form 10-K filed on March 30, 2004.

Results of Operations

Revenues

Total revenues for the three months ended March 31, 2004 increased 33% to $15.6 million from $11.8 million for the three months ended March 31, 2003. The increase in revenues in 2004 resulted from a 23% increase in technology and film licensing revenues to $12.5 million for the three months ended March 31, 2004 from $10.1 million for the three months ended March 31, 2003 and a 90% increase in our product sales and other revenues to $3.1 million for the three months ended March 31, 2004 from $1.6 million for the three months ended March 31, 2003. The increase in revenues from technology and film licensing was primarily attributable to continued growth in consumer electronics licensing, driven by an increase in the number of DVD-based home entertainment systems that incorporate DTS technology, such as audio/video receivers, DVD players, and home-theater-in-a-box systems, and by revenues recognized as a result of intellectual property compliance and enforcement activities. In addition, our film licensing revenues increased moderately due to revenues generated from increases in the number of U.S. films released, foreign language dubbed versions of major U.S. films, and foreign original-version films released with a DTS soundtrack. Shipments of our XD-10 Cinema Media Player contributed to the increase in revenues from product sales quarter over quarter, as did an increase in sales by our DTS Entertainment label.

Revenues from our consumer business totaled $10.8 million for the three months ended March 31, 2004, an increase of 30% from $8.3 million in the first quarter of the prior year. The increase in revenues was driven by the growth in consumer electronics technology licensing as mentioned above. Theatrical revenues were $4.8 million for the three months ended March 31, 2004, up 38% from the same period last year due primarily to growth in product sales, primarily the XD-10 Cinema Media Player.

Gross Profit

Consolidated gross profit improved to 81% of revenues for the three months ended March 31, 2004, from 79% for the three months ended March 31, 2003. The increase is due to an increase in gross profit in product sales and other revenues.

Gross profit associated with technology and film licensing revenues remained constant at 92% of related revenues for the three months ended March 31, 2004 and 2003. Gross profit associated with product sales and other revenues improved to 38% of related revenues for the three months ended March 31, 2004 from 4% in the prior year period due primarily to increased shipment volumes.

Gross profit for our consumer business improved to 95% of related revenues for the three months ended March 31, 2004, from 94% in the prior year period. The increase is due to the growth of our higher margin technology licensing revenues. Theatrical business gross profit increased to 51% of related revenues for the quarter ended March 31, 2004 from 45% in the prior year period due to the growth in sales of our XD-10 Cinema Media Player mentioned above.

We expect our consolidated gross profit as a percentage of sales to decrease to between 70% and 75% for the full fiscal year 2004 as we expect that the sales growth rate in our theatrical business will exceed that of our higher margin consumer business.

Selling, General and Administrative

Selling, general and administrative expenses increased 29% to $6.4 million for the quarter ended March 31, 2004, compared to $5.0 million in the prior year quarter. The increase is primarily due to increases in salaries and related costs of $776,000 as we increased headcount to support our growth, and professional services of $380,000 which includes costs associated with our increased intellectual property compliance and enforcement activities and additional costs associated with operating as a public company. The quarter to quarter increase also includes increases in advertising and promotion costs related to new product introductions, and insurance costs. Salaries and related costs includes stock-based compensation.

Costs of compliance with the Sarbanes-Oxley Act, particularly Section 404 of that Act, are anticipated to cause an estimated increase in administration costs of between $700,000 and $900,000 during 2004, up to half of which represents recurring costs for compliance.

Research and Development

Research and development expenses increased to $1.3 million for the three months ended March 31, 2004, compared to $1.2 million for the three months ended March 31, 2003. The increase is primarily due to increased labor costs associated with new product initiatives and the optimization of our Coherent Acoustics technology for new consumer electronics applications.

We expect quarterly research and development expenses in 2004 to increase in absolute dollars relative to the prior year.

Interest (Income) Expense, Net

Interest income, net, for the three months ended March 31, 2004 increased to $439,000 from $13,000 for the prior year same period. This favorable increase was due to increased investment income subsequent to the initial and follow-on public offerings along with the recognition of $164,000 in interest for late payment of royalties from a licensee that covered the period of July 2000 through September 2003.

Income Taxes

For the three months ended March 31, 2004, the Company recorded an income tax provision of $1,918 on per-tax income of $5,358 resulting in an annualized effective tax rate of 35.8%. This rate differs from the Company’s statutory rate primarily due to state income taxes offset by benefits associated with the foreign rate differential and research and development credits.

Liquidity and Capital Resources

At March 31, 2004, we had cash, cash equivalents and short-term investments of $95.6 million, compared to $99.4 million at December 31, 2003.

Net cash provided by operating activities was $4.1 million for the three months ended March 31, 2004, compared to $3.5 million for the three months ended March 31, 2003. The improvement in cash flows from operations was primarily a result of increased net income generated in the first three months of 2004 relative to the same period in the prior year. Accounts receivable increased $811,000 for the three months ended March 31, 2004 due to accruals related to consumer license fees. Inventory increased $1.6 million for the three months ended March 31, 2004 as a result of inventory purchases related to our new product offerings. Accounts payable and accrued expenses increased $1.6 million primarily related to the timing of inventory purchases, an unusually large proportion of which occurred very late in first quarter of 2004.

Net cash used in investing activities totaled $23.6 million and $258,000 for the three months ended March 31, 2004 and 2003, respectively. The increase in cash used in investing activities for the three months ended March 31, 2004 is primarily a result of the purchases of investment instruments with maturities greater than 90 days of $23.1 million and purchases of property and equipment related to the establishment of an office in Japan.

Net cash provided by financing activities totaled $78,000 for the three months ended March 31, 2004 and net cash used by financing activities was $1.3 million for the three months ended March 31, 2003. Net cash provided by financing activities for the three months ended March 31, 2004 primarily consisted of cash received from option exercises, partially offset by cash paid for offering costs related to the follow-on public offering in 2003. Net cash used by financing activities for the three months ended March 31, 2003 consisted of payments of dividends to preferred stockholders. The preferred stock was redeemed in the third quarter of 2003.

We believe that our cash, cash equivalents, short-term investments, funds available under our existing bank line of credit facility, and cash flows from operations will be sufficient to satisfy our working capital and capital expenditure requirements for at least the next twelve months. Beyond the next twelve months, additional financing may be required to fund working capital and capital expenditures. Changes in our operating plans, lower than anticipated revenues, increased expenses, acquisition of companies, products or technologies or other events, including those described in “Risk Factors” included in our Form 10-K filed on March 30, 2004 and in and other filings may cause us to seek additional debt or equity financing on an accelerated basis. Financing may not be available on acceptable terms, or at all, and our failure to raise capital when needed could negatively impact our growth plans and our financial condition and results of operations. Additional equity financing may be dilutive to the holders of our common stock and debt financing, if available, may involve significant cash payment obligations and financial or operational covenants that restrict our ability to operate our business.

Recently Issued Accounting Standards

In November 2003, the EITF reached a consensus on Issue No. 03-10, “Application of EITF 02-16 by Resellers to Sales Incentives Offered to Consumers by Manufacturers.” EITF No. 03-10 addresses the accounting for manufacturer sales incentives offered directly to consumers, including manufacturer coupons. EITF No. 03-10 is effective for the first interim period beginning after November 25, 2003. Adoption of the provisions of EITF No. 03-10 did not have a material impact on our financial position, results of operations, or cash flows for the three months ended March 31, 2004.

RISK FACTORS

Set forth below and elsewhere in this report and in other documents we file with the Securities and Exchange Commission are risks and uncertainties that could cause our actual results to differ materially from the results contemplated by the forward-looking statements contained in this report and other public statements we make. If any of the following risks actually occurs, our business, financial condition, or results of operations could suffer. In that case, the trading price of our common stock could decline, and you may lose all or part of your investment.

Risks Related to Our Business

We face intense competition from companies with greater brand recognition and resources.

The digital audio, consumer electronics, and entertainment markets are intensely competitive, subject to rapid change, and significantly affected by new product introductions and other market activities of industry participants. Our principal competitor is Dolby Laboratories, Inc., who competes with us in most of our markets. We also compete with other companies offering:

• digital audio technology incorporated into consumer electronics products and entertainment mediums, including Fraunhofer Institut Integrierte Schaltungen, Koninklijke Philips Electronics N.V. (Philips), Meridian Audio Limited, Microsoft Corporation, Sony Corporation, and Thomson; and

• products for theatrical markets, such as Smart Devices, Inc., Sony Corporation, and Ultra Stereo Labs, Inc.

Many of our current and potential competitors, including Dolby, enjoy substantial competitive advantages, including:

• greater name recognition;

• a longer operating history;

• more developed distribution channels and deeper relationships with semiconductor and consumer electronics products manufacturers;

• a more extensive customer base;

• digital technologies that offer greater compression and require less storage capacity;

• broader product and service offerings;

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

• more technicians and engineers.

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

In addition to the competitive advantages described above, Dolby also enjoys other unique competitive strengths relative to us. For example, it introduced multi-channel audio technology before we did. It has a larger base of installed movie theaters for its cinema playback equipment. Its technology has been incorporated in significantly more DVD-Video films than our technology. It has also achieved mandatory standard status in a few product categories, including DVD-Video and DVD-Audio Recordable, for its stereo technology and terrestrial digital television broadcasts in the United States. As a result of these factors, Dolby has a competitive advantage in selling its digital multi-channel technology to consumer electronics products manufacturers.

Sony Corporation is both a competitor and a significant customer in all of our markets. If Sony decides to eliminate the use of our technology in its products or to compete with us more aggressively in our markets, the revenues that we derive from Sony would be lower than expected.

Current and future governmental and industry standards may significantly limit our business opportunities.

Technology standards are important in the audio industry as they help to assure compatibility across a system or series of products. Generally, standards adoption occurs on either a mandatory basis, requiring a particular audio technology to be available in a particular product or medium, or an optional basis, meaning that a particular audio technology may be, but is not required to be, utilized. For example, Dolby’s technology for stereo playback has been selected as a mandatory standard for DVD-Video and DVD-Audio Recordable. Both Dolby’s and our digital multi-channel technology have optional status in the DVD-Video standard.

Various national governments have adopted or are in the process of adopting standards for all digital television broadcasts, including cable, satellite, and terrestrial. In the United States, Dolby’s technology has been selected as the sole, mandatory standard for terrestrial digital television broadcasts. As a result, all digital terrestrial television broadcasts in the United States must include Dolby’s technology and must exclude any other format, including ours. We do not know whether this standard will be reopened or amended. If it is not, our technology may never be included. Certain large and developing markets, such as China, have not fully developed their digital television standards. Our technology may or may not ultimately be included in these standards.

Adoption of our technology is not mandatory as part of any governmental or industry accepted standards in any specific entertainment medium or format. As such, there can be no assurance that our technology will continue to be used in current and future applications.

As new technologies and entertainment mediums emerge, including future generations of DVD technology, new standards relating to these technologies or mediums may develop. New standards may also emerge in existing markets that are currently characterized by competing formats, such as the market for personal computers. We may not be successful in our efforts to include our technology in any such standards.

We may not be able to evolve our technology, products, and services or develop new technology, products, and services that are acceptable to our customers or the changing market.

The market for our technology, products, and services is characterized by:

• rapid technological change;

• new and improved product introductions;

• changing customer demands;

• evolving industry standards; and

• product obsolescence.

Our future success will depend on our ability to enhance our existing technology, products, and services and to develop acceptable new technology, products, and services on a timely basis. The development of enhanced and new technology, products, and services is a complex and uncertain process requiring high levels of innovation, highly-skilled engineering and development personnel, and the accurate anticipation of technological and market trends. We may not be able to identify, develop, market, or support new or enhanced technology, products, or services on a timely basis, if at all. Furthermore, our new technology, products, and services may never gain market acceptance, and we may not be able to respond effectively to evolving consumer demands, technological changes, product announcements by competitors, or emerging industry standards. For example, we may not be able to effectively address concerns in the film and music industries relating to piracy in our current or future products. Any failure to respond to these changes or concerns would likely prevent our technology, products, and services from gaining market acceptance or maintaining market share.

If we fail to protect our intellectual property rights, our ability to compete could be harmed.

Protection of our intellectual property is critical to our success. Patent, trademark, copyright, and trade secret laws and confidentiality and other contractual provisions afford only limited protection and may not adequately protect our rights or permit us to gain or keep any competitive advantage. We face numerous risks in protecting our intellectual property rights, including the following:

• our patents may be challenged or invalidated by our competitors;

• our pending patent applications may not issue, or, if issued, may not provide meaningful protection for related products or proprietary rights;

• we may not be able to prevent the unauthorized disclosure or use of our technical knowledge or other trade secrets by employees, consultants, and advisors;

• the laws of foreign countries may not protect our intellectual property rights to the same extent as the laws of the United States, and mechanisms for enforcement of intellectual property rights may be inadequate in foreign countries;

• our competitors may produce competitive products or services that do not unlawfully infringe upon our intellectual property rights; and

• we may be unable to successfully identify or prosecute unauthorized uses of our technology.

As a result, we cannot assure you that our means of protecting our intellectual property rights and brands will be adequate. Furthermore, despite our efforts, third parties may violate, or attempt to violate, our intellectual property rights. Infringement claims and lawsuits would likely be expensive to resolve and would require management’s time and resources. In addition, we have not sought, and do not intend to seek, patent and other intellectual property protections in all foreign countries. In countries where we do not have such protection, products incorporating our technology may be lawfully produced and sold without a license.

We may be sued by third parties for alleged infringement of their proprietary rights.

Companies that participate in the digital audio, consumer electronics, and entertainment industries hold a large number of patents, trademarks, and copyrights, and are frequently involved in litigation based on allegations of patent infringement or other violations of intellectual property rights. Intellectual property disputes frequently involve highly complex and costly scientific matters, and each party generally has the right to seek a trial by jury which adds additional costs and uncertainty. Accordingly, intellectual property contests, with or without merit, could be costly and time consuming to litigate or settle, and could divert management’s attention from executing our business plan. In addition, our technology and products may not be able to withstand any third-party claims or rights against their use. If we were unable to obtain any necessary license following a determination of infringement or an adverse determination in litigation or in interference or other administrative proceedings, we may need to redesign some of our products to avoid infringing a third party’s patent and could be required to temporarily or permanently discontinue licensing our products.

If we are unable to maintain and increase the amount of entertainment content released with DTS audio soundtracks, demand for the technology, products, and services that we offer to consumer electronics products manufacturers may significantly decline.

We expect to derive a significant percentage of our revenues from the technology, products, and services that we offer to manufacturers of consumer electronics products. To date, the most significant driver for the use of our technology in the home theater market has been the release of major movie titles with DTS audio soundtracks. We also believe that demand for our DTS audio technology in emerging markets for multi-channel audio, including homes, cars, personal computers, and video games and consoles, will be based on the number, quality, and popularity of the audio DVDs, computer software programs, and video games released with DTS audio soundtracks. Although we have existing relations with many leading providers of movie, music, computer, and video game content, none of our existing contracts require these parties to develop and release content with DTS audio soundtracks. In addition, we may not be successful in maintaining existing relationships or developing relationships with other existing providers or new market entrants that provide content. As a result, we cannot assure you that a significant amount of content in movies, audio DVDs, computer software programs, video games, or other entertainment mediums will be released with DTS audio soundtracks. If the amount, variety, and popularity of entertainment content released with DTS audio soundtracks do not increase, consumer electronics products manufacturers that pay us per-unit licensing fees may discontinue offering DTS playback capabilities in the consumer electronics products that they sell.

If our DTS-CSS system for subtitles, captions, and descriptive narration for films is not adopted widely, our business may be harmed.

Our DTS-CSS system for subtitles, captions, and descriptive narration for films is a key new product. To date, sales and revenues from this system have been immaterial and we have limited experience to indicate whether or not this system will be widely adopted. Nonetheless, we have anticipated significant future sales of this system and our revenue and growth projections contemplate that it will generate significant future revenues. If we are unsuccessful in selling our DTS-CSS system, our future revenues will be lower than expected and we may be required to write-down or reserve against obsolete or excess systems in inventory.

If our independent auditors are unable to provide us with an unqualified report as to of the adequacy of our internal controls over financial reporting as of December 31, 2004 and future year-ends as required by Section 404 of the Sarbanes-Oxley Act of 2002, investors could lose confidence in the reliability of our financial statements, which could result in a decrease in the value of our shares.

As directed by Section 404 of the Sarbanes-Oxley Act of 2002, the SEC adopted rules requiring public companies to include a report of management on the company’s internal controls over financial reporting in their annual reports on Form 10-K that contains an assessment by our management of the effectiveness of internal controls over financial reporting. In addition, the public accounting firm auditing our financial statements must attest to and report on our management’s assessment of the effectiveness of internal controls over financial reporting. This requirement may apply to our annual report on Form 10-K for the fiscal year ending December 31, 2004. While we intend to conduct a rigorous review of our internal controls over financial reporting in order to assure compliance with the Section 404 requirements, our independent auditors may interpret the Section 404 requirements and the related rules and regulations differently from us or our independent auditors may not be satisfied with our internal controls over financial reporting or with the level at which these controls are documented, operated or reviewed. Moreover, in the event we make a significant acquisition, or a series of insignificant acquisitions, we may face significant challenges in implementing the required processes and procedures in the acquired operations. As a result, our independent auditors may decline to attest to management’s assessment or may issue a qualified report. This could result in an adverse reaction in the financial markets due to a loss of confidence in the reliability of our financial statements, which could cause the market price of our shares to decline.

We have limited experience in licensing, re-mixing, marketing, and directly selling multi-channel audio content.

Although we have established relations with a number of artists and music labels, we do not have any contractual agreements that require artists or music labels to provide us with music content to re-mix and release in our proprietary DTS audio format. Music companies may in the future be unwilling to license titles from their music catalogs to us. In addition, our audio content competes with other multi-channel formats, including Super Audio CD, which is a format developed jointly by Philips and Sony Corporation. As a result, we may have difficulty in obtaining rights to release a significant amount of audio content, and any content that we do release may not be commercially successful.

Declining retail prices for consumer electronics products could force us to lower the license fees we charge our customers.

The market for consumer electronics products is intensely competitive and price sensitive. Retail prices for consumer electronics products that include our DTS audio technology, such as DVD players and home theater systems, have decreased significantly and we expect prices to continue to decrease for the foreseeable future. Declining prices for consumer electronics products could create downward pressure on the licensing fees we currently charge our customers who integrate our technology into the consumer electronics products that they sell and distribute.

Most of the consumer electronics products that include our audio technology also include Dolby’s multi-channel audio. As a result of pricing pressure, consumer electronics products manufacturers could decide to exclude our DTS audio technology from their products altogether.

We have limited control over existing and potential customers’ and licensees’ decision to include our technology in their product offerings.

We are dependent on our customers and licensees—including consumer electronics products manufacturers, semiconductor manufacturers, movie theaters, and producers and distributors of content for music, films, videos, and games—to incorporate our technology in their products, purchase our products and services, or release their content in our proprietary DTS audio format. Although we have license agreements with many of these companies, these license agreements do not require any minimum purchase commitments, and are on a non-exclusive basis, and do not require incorporation of our technology or trademarks in their products. Our licensees and other manufacturers might not utilize our technology in the future.

Our revenues from film producers and distributors and from the products and services that we offer to movie theaters would decline if the major U.S. film producers and distributors decrease the number of films they release with DTS audio soundtracks.

Although all nine major film producers and distributors are customers of ours, we generally do not have contractual arrangements that require them to use our DTS audio technology. Our theatrical business depends on our having good relations with these film studios. A deterioration in our relationship with any of these film studios could cause these customers to stop using our DTS audio technology. Any significant decline in the release of motion pictures with DTS audio soundtracks would decrease the demand for and revenues from the playback products and services that we offer to movie theaters. In addition, other film studios throughout the world generally adopt the technologies used by the major U.S. film studios. Therefore, if the major U.S. film studios stop using our technology, we would not only lose the per-movie licensing fee we receive from these customers, but may also lose per-movie licensing fees from other film studios throughout the world.

If the movie industry adopts new digital cinema technology in place of current film technology, demand for our theatrical products and services could decline.

The movie theater industry may transition from film-based media to electronic-based, or digital, media. If this transition occurs, we may be unable to meaningfully respond with competitive product offerings. In addition, if the film industry broadly adopts digital cinema, our technology and current product offerings could be rendered obsolete. In such an event, demand by movie theaters for our playback systems, cinema processors, and systems for subtitling, captioning, and descriptive narration would decline.

The movie theater industry has suffered and may continue to suffer from an oversupply of screens, which has affected and may continue to affect demand for the products and services we offer to movie theaters.

Our theatrical business depends in part on the construction of new screens and the renovation of existing theaters that install our DTS playback systems and cinema processors. In recent years, aggressive building of megaplexes by companies that operate movie theaters has generated significant competition and resulted in an oversupply of screens in some domestic and international markets. The resulting oversupply of screens led to significant declines in revenues per screen and, eventually, to an inability by many major film exhibitors to satisfy their financial obligations. Several major movie theater operators have reorganized through bankruptcy proceedings, and many movie theaters have closed. As a result, our playback systems and cinema processors that we previously sold to movie theaters that have reorganized and closed have been relocated to other theaters or have been available for resale in the secondary market to movie theaters that might otherwise have purchased these products directly from us. If movie theater operators decide to close a significant number of screens in the future or cut their capital spending, demand for our playback systems and cinema processors will decline.

We are dependent on our management team and key technical employees, and the loss of any of them could harm our business.

Our success depends, in part, upon the continued availability and contributions of our management team, particularly Jon Kirchner, our President and Chief Executive Officer, and W. Paul Smith, our Senior Vice President, Research and Development. We also rely on the skills and talents of our engineering and technical personnel because of the complexity of our products and services. Several of our key engineers have been instrumental in the development of our technology. Important factors that could cause the loss of key personnel include:

• our existing employment agreements with the members of our management team allow such persons to terminate their employment with us at any time;

• we do not have employment agreements with a majority of our key engineering and technical personnel;

• we do not maintain key-man life insurance on any of our employees;

• significant portions of the stock options held by the members of our management team are vested; and

• many of the stock options held by our executive officers provide for accelerated vesting in the event of a sale or change of control of our company.

The loss of key personnel or an inability to attract qualified personnel in a timely manner could slow our technology and product development and harm our ability to execute our business plan.

We have a limited operating history in many of our key markets.

Although the first movie with a DTS audio soundtrack was released in 1993, we did not enter the home theater market until 1996, and our technology has only recently been incorporated into other consumer electronics markets, such as car audio, personal computers, video games and consoles, portable electronics devices, and digital satellite and cable broadcast products. As a result, the demand for our technology, products, and services and the income potential of these businesses are unproven. In addition, because the market for digital audio technology is relatively new and rapidly evolving, we have limited insight into trends that may emerge and affect our business. We may make errors in predicting and reacting to relevant business trends, which could harm our business. Before investing in our common stock, you should consider the risks, uncertainties, and difficulties frequently encountered by companies in new and rapidly evolving markets such as ours. We may not be able to successfully address any or all of these risks.

Our technology and products are complex and may contain errors that could cause us to lose customers, damage our reputation, or incur substantial costs.

Our technology or products could contain errors that could cause our products or technology to operate improperly and could cause unintended consequences. If our products or technology contain errors we could be required to replace them, and if any such errors cause unintended consequences we could face claims for product liability. Although we generally attempt to contractually limit our exposure to incidental and consequential damages, if these contract provisions are not enforced or are unenforceable for any reason, or if liabilities arise that are not effectively limited, we could incur substantial costs in defending and/or settling product liability claims.

Because we expect our operating expenses to increase in the future, we may not be able to sustain or increase our profitability.

Although we have been in business since 1990, we have only achieved profits from our business operations in the last eleven fiscal quarters. We expect our operating expenses to increase as we, among other things:

• expand our domestic and international sales and marketing activities;

• increase our research and development efforts to advance our existing technology, products, and services and develop new technology, products, and services;

• hire additional personnel, including engineers and other technical staff;

• upgrade our operational and financial systems, procedures, and controls;

• continue to implement the requirements of the Sarbanes-Oxley Act; and

• continue to assume the responsibilities of being a public company.

As a result, we will need to grow our revenues in order to maintain and increase our profitability. In addition, we may fail to accurately estimate and assess our increased operating expenses as we grow.

We are subject to additional risks associated with our international operations.

We market and sell our products and services outside the United States, and currently have employees located in China, England, Japan, Mexico, Northern Ireland, and Spain. Many of our customers and licensees are located outside the United States. As a key component of our business strategy, we intend to expand our international sales. We face numerous risks in doing business outside the United States, including:

• unusual or burdensome foreign laws or regulatory requirements or unexpected changes to those laws or requirements;

• tariffs, trade protection measures, import or export licensing requirements, trade embargos, and other trade barriers;

• difficulties in staffing and managing foreign operations;

• dependence on foreign distributors and their sales channels;

• longer accounts receivable collection cycles and difficulties in collecting accounts receivable;

• less effective and less predictable protection of intellectual property;

• changes in the political or economic condition of a specific country or region, particularly in emerging markets;

• fluctuations in the value of foreign currency versus the U.S. dollar and the cost of currency exchange; and

• potentially adverse tax consequences.

Such factors could cause our future international sales to decline.

Our business practices in international markets are also subject to the requirements of the Foreign Corrupt Practices Act. If any of our employees is found to have violated these requirements, we could be subject to significant fines and other penalties.

Our international revenue is mostly denominated in U.S. dollars. As a result, fluctuations in the value of the U.S. dollar and foreign currencies may make our technology, products, and services more expensive for international customers, which could cause them to decrease their purchases from us. Expenses for our subsidiaries are denominated in their respective local currencies. Significant fluctuations in the value of the U.S. dollar and foreign currencies could have a material impact on our consolidated financial statements. We do not currently engage in currency hedging activities to limit the risk of exchange rate fluctuations.

We face risks in expanding our business operations in China.

One of our key strategies is to expand our business operations in China. However, we may be unsuccessful in implementing this strategy as planned or at all. Factors that could inhibit our successful expansion into China include its historically poor recognition of intellectual property rights and poor performance in stopping counterfeiting and piracy activity. If we are unable to successfully stop unauthorized use of our intellectual property and assure compliance by our Chinese licensees, we could experience increased operational and enforcement costs both inside and outside China.

Even if we are successful in expanding into China, we may be greatly impacted by the political, economic, and military conditions in China, Taiwan, North Korea, and South Korea. These countries have recently conducted military exercises in or near the other’s territorial waters and airspace. Such disputes may continue or escalate, resulting in economic embargos, disruptions in shipping, or even military hostilities. This could severely harm our business by interrupting or delaying production or shipment of our products.

We depend on single suppliers, manufacturers, and distributors for some of our products, and the loss of any of these suppliers, manufacturers, or distributors could harm our business.

We purchase a small number of parts from sole-source suppliers. In addition, our professional audio encoding devices and movie theater playback systems are manufactured according to our specifications by single third-party manufacturers. Because we have no direct control over these third-party suppliers and manufacturers, interruptions or delays in the products and services provided by these third parties may be difficult to remedy in a timely fashion. In addition, if such suppliers or manufacturers are incapable of or unwilling to deliver the necessary parts or products, we may be unable to redesign our technology to work without such parts or find alternative suppliers or manufacturers. In such events, we could experience interruptions, delays, increased costs, or quality control problems.

In addition, we have entered into agreements with two companies to serve as our sole distributors for our DTS Entertainment products in the United States and Canada and in Europe, respectively. We have no direct control over these distributors and any problems with their performance may take time to identify and/or remedy, and any remedial measures that we take may be unsuccessful. In addition, if either or both of these distributors were to go out of business, as our last distributor did, or otherwise becomes incapable of continuing as our distributor, we could experience delays in distributing our DTS Entertainment products to the retail market, loss of inventory, and loss of revenue.

We rely on the accuracy of our customers’ manufacturing reports for reporting and collecting our revenues, and if these reports are untimely or incorrect, our revenues could be delayed or inaccurately reported.

A significant percentage of our revenues are generated from our consumer electronics products manufacturer customers who license and incorporate our technology in their consumer electronics products. Under our existing arrangements, these customers pay us a per-unit licensing fee based on the number of consumer electronics products manufactured that incorporate our technology. We rely on our customers to accurately report the number of units manufactured in collecting our license fees, preparing our financial reports, projections, budgets, and directing our sales and product development efforts. Most of our license agreements permit us to audit our

customers, but audits are generally expensive and time consuming and could harm our customer relationships. If any of our customer reports understate the number of products they manufacture, we may not collect and recognize revenues to which we are entitled.

A prolonged economic downturn could materially harm our business.

Negative trends in the general economy, including trends resulting from actual or threatened military action by the United States and threats of terrorist attacks on the United States and abroad, could cause a decrease in consumer spending on entertainment in general. Any reduction in consumer confidence or disposable income in general may affect the demand for consumer electronics products that incorporate our digital audio technology, audio DVDs that we produce and distribute through our DTS Entertainment label, and demand by film studios and movie theaters for our theatrical products and services.

We may not successfully address problems encountered in connection with any future acquisitions.

We expect to consider opportunities to acquire or make investments in other technologies, products, and businesses that could enhance our technical capabilities, complement our current products and services, or expand the breadth of our markets. We have not made any acquisitions or strategic investments to date, and therefore our ability as an organization to make acquisitions or strategic investments is unproven. Acquisitions and strategic investments involve numerous risks, including:

• problems assimilating the purchased technologies, products, or business operations;

• problems maintaining uniform standards, procedures, controls, and policies;

• unanticipated costs associated with the acquisition, including accounting charges and transaction expenses;

• diversion of management’s attention from our core business;

• adverse effects on existing business relationships with suppliers and customers;

• risks associated with entering markets in which we have no or limited prior experience; and

• potential loss of key employees of acquired organizations.

If we fail to properly evaluate and execute acquisitions and strategic investments, our management team may be distracted from our day-to-day operations, our business may be disrupted, and our operating results may suffer. In addition, if we finance acquisitions by issuing equity or convertible debt securities, our existing stockholders would be diluted.

We may have difficulty managing any growth that we might experience.

We expect to continue to experience growth in the scope of our operations and the number of our employees. If this growth continues, it will place a significant strain on our management team and on our operational and financial systems, procedures, and controls. Our future success will depend in part on the ability of our management team to manage any growth effectively. This will require our management to:

• hire and train additional personnel in the United States and internationally;

• implement and improve our operational and financial systems, procedures, and controls;

• maintain our cost structure at an appropriate level based on the revenues we generate;

• manage multiple, concurrent development projects; and

• manage operations in multiple time zones with different cultures and languages.

Any failure to successfully manage our growth could distract management’s attention, and result in our failure to execute our business plan. For instance, the establishment of our operations in Guangzhou, China has required significant time and attention from our management team. Any future growth could cause similar management challenges or create distractions.

We may experience fluctuations in our operating results.

We have historically experienced moderate seasonality in our business due to our business mix and the nature of our products. In our consumer business, consumer electronics manufacturing activities are generally lowest in the first calendar quarter of each year, and increase progressively throughout the remainder of the year. Manufacturing output is generally strongest in the third and fourth quarters

as our technology licensees increase manufacturing to prepare for the holiday buying season. Since recognition of revenues in our consumer business generally lags manufacturing activity by one quarter, our revenues and earnings from the consumer business are generally lowest in the second quarter. Film licensing revenues are generally strongest in the second and fourth quarters due to the abundance of movies typically released during the summer and year-end holiday seasons. The introduction of new products and inclusion of our technologies in new and rapidly growing markets can distort the moderate seasonality described above. Our revenues may continue to be subject to seasonal fluctuations in the future. Unanticipated fluctuations in seasonality could cause us to miss our earnings projections which could cause our stock price to decline.

In addition, we actively engage in intellectual property compliance and enforcement activities focused on identifying third parties who have either incorporated our technology, trademarks, or know-how without a license or who have underreported to us the amount of royalties owed under license agreements with us. As a result of these activities, from time to time, we recognize royalty revenues that relate to consumer electronics manufacturing activities from prior periods. These royalty recoveries may cause revenues to be higher than expected during a particular reporting period and may not recur in future reporting periods. Such fluctuations in our revenues and operating results may cause declines in our stock price.

Risks Related to Our Common Stock

We expect that the price of our common stock will fluctuate substantially.

The market price of our common stock is likely to be highly volatile and may fluctuate substantially due to many factors, including:

• actual or anticipated fluctuations in our results of operations;

• announcements of technological innovations or technology standards;

• announcements of significant contracts by us or our competitors;

• changes in our pricing policies or the pricing policies of our competitors;

• developments with respect to intellectual property rights;

• the introduction of new products or product enhancements by us or our competitors;

• the commencement of or our involvement in litigation;

• our sale of common stock or other securities in the future;

• conditions and trends in technology industries;

• changes in market valuation or earnings of our competitors;

• the trading volume of our common stock;

• changes in the estimation of the future size and growth rate of our markets; and

• general economic conditions.

In addition, the stock market in general, and the Nasdaq National Market and the market for technology companies in particular, has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. Further, the market prices of securities of technology companies have been particularly volatile. These broad market and industry factors may materially harm the market price of our common stock, regardless of our operating performance. In the past, following periods of volatility in the market price of a company’s securities, securities class-action litigation has often been instituted against that company. Such litigation, if instituted against us, could result in substantial costs and a diversion of management’s attention and resources.

Shares of our common stock are relatively illiquid.

As of March 31, 2004, we have 16,681,393 shares of common stock outstanding. As a result of our relatively small public float, our common shares may be less liquid than the common shares of companies with broader public ownership. Among other things, trading of a relatively small volume of our common shares may have a greater impact on the trading price for our shares than would be the case if our public float were larger.

Our future capital needs are uncertain and we may need to raise additional funds in the future, and such funds may not be available on acceptable terms or at all.

Our capital requirements will depend on many factors, including:

• acceptance of, and demand for, our products and technology;

• the costs of developing new products or technology;

• the extent to which we invest in new technology and research and development projects;

• the number and timing of acquisitions and other strategic transactions; and

• the costs associated with our expansion, if any.

In the future, we may need to raise additional funds, and such funds may not be available on favorable terms, or at all. Furthermore, if we issue equity or debt securities to raise additional funds, our existing stockholders may experience dilution, and the new equity or debt securities may have rights, preferences, and privileges senior to those of our existing stockholders. If we cannot raise funds on acceptable terms, we may not be able to develop or enhance our products and services, execute our business plan, take advantage of future opportunities, or respond to competitive pressures or unanticipated customer requirements. This may materially harm our business, results of operations, and financial condition.

Anti-takeover provisions under our charter documents and Delaware law could delay or prevent a change of control and could also limit the market price of our stock.

Our Restated Certificate of Incorporation and Restated Bylaws contain provisions that could delay or prevent a change of control of our company or changes in our Board of Directors that our stockholders might consider favorable. Some of these provisions:

• authorize the issuance of preferred stock which can be created and issued by the board of directors without prior stockholder approval, with rights senior to those of the common stock;

• provide for a classified Board of Directors, with each director serving a staggered three-year term;

• prohibit stockholders from filling board vacancies, calling special stockholder meetings, or taking action by written consent; and

• require advance written notice of stockholder proposals and director nominations.

In addition, we are governed by the provisions of Section 203 of the Delaware General Corporate Law, which may prohibit certain business combinations with stockholders owning 15% or more of our outstanding voting stock. These and other provisions in our Restated Certificate of Incorporation, Restated Bylaws and Delaware law could make it more difficult for stockholders or potential acquirors to obtain control of our Board or initiate actions that are opposed by the then-current Board, including delay or impede a merger, tender offer, or proxy contest involving our company. Any delay or prevention of a change of control transaction or changes in our Board could cause the market price of our common stock to decline.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Market risk represents the risk of loss arising from adverse changes in market rates and foreign exchange rates. At March 31, 2004, we did not have any balances outstanding under our bank line of credit arrangement; however, the amount of outstanding debt at any time may fluctuate and we may from time to time be subject to refinancing risk.

Our interest income is sensitive to changes in the general level of U.S. interest rates, particularly since a significant portion of our investments are and will be in short-term marketable securities, U.S. government securities and corporate bonds. Due to the nature and maturity of our short-term investments, we have concluded that there is no material market risk exposure to our principal. The average maturity of our investment portfolio is less than one month. As of March 31, 2004, a 1% change in interest rates throughout a one-year period would have an annual effect of approximately $1.1 million on our income.

We derive more than half of our revenues from sales outside the United States, and maintain research, sales, marketing, or business development offices in six countries. Therefore, our results could be negatively affected by such factors as changes in foreign currency exchange rates, trade protection measures, longer accounts receivable collection patterns, and changes in regional or worldwide economic or political conditions. The risks of our international operations are mitigated in part by the extent to which our revenues are denominated in U.S. dollars and, accordingly, we are not exposed to significant foreign currency risk on these items. We do have limited foreign currency risk on certain revenues and operating expenses such as salaries and overhead costs of our foreign operations and a small amount of cash maintained by these operations. Revenues denominated in foreign currencies accounted for approximately 16% of total revenues during the first quarter of 2004. Operating expenses, including cost of sales, for our foreign subsidiaries were approximately $1.3 million in the first quarter of 2004. Based upon the expenses for the first quarter of 2004, a 1% change in foreign currency rates throughout a one-year period would have an annual effect of approximately $50,000.

Our international business is subject to risks, including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions, and foreign exchange rate volatility when compared to the United States dollar. Accordingly, our future results could be materially impacted by changes in these or other factors.

We are also affected by exchange rate fluctuations as the financial statements of our foreign subsidiaries are translated into the United States dollar in consolidation.

As exchange rates vary, these results, when translated, may vary from expectations and could adversely impact overall profitability. During the first quarter of 2004 the impact of foreign exchange rate fluctuations related to translation of our foreign subsidiaries’ financial statements was not significant.

Item 4. Controls and Procedures

Disclosure Controls and Procedures

Evaluation of disclosure controls and procedures. Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) or 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this Report, our disclosure controls and procedures are adequately designed to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded processed, summarized and reported within the time periods specified in applicable rules and forms.

PART II

OTHER INFORMATION

Item 1. Legal Proceedings

None.

Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

(a) During the first quarter of 2004, pursuant to the exemption from registration provided in Section 3(a)(9) of the Securities Act, the Registrant issued an aggregate of 40,950 shares of common stock to various holders upon the cashless exercise of warrants to purchase an aggregate of 70,152 shares of common stock.

(b) On July 15, 2003, we closed the sale of an aggregate of 4,091,410 shares of our Common Stock, $0.0001 par value, in our initial public offering, which included the sale of 251,410 shares of our Common Stock pursuant to the exercise of the underwriters’ overallotment option in the offering. The offering also included the sale by certain of our stockholders of an aggregate of 324,590 shares of our Common Stock in connection with the exercise by the underwriters of their overallotment option. The managing underwriters in the offering were SG Cowen Securities Corporation, William Blair & Company, L.L.C., and Thomas Weisel Partners LLC. All of the shares of Common Stock sold in the offering were registered under the 1933 Act on a Registration Statement on Form S-1 (Reg. No. 333-104761) that was declared effective by the SEC on July 9, 2003 and a Registration Statement filed pursuant to Rule 462(b) under the Securities Act that was filed on July 10, 2003 (Reg. No. 333-106920). All 4,416,000 shares of Common Stock registered under the Registration Statement, including shares sold by us and by selling stockholders upon exercise of the overallotment option, were sold at a price per share of $17.00.

The aggregate price of the offering amount registered on our behalf was $69.6 million. In connection with the offering, we paid an aggregate of $4.9 million in underwriting discounts and commissions to the underwriters and incurred approximately $1.7 million in other offering expenses. After deducting the underwriting discounts and commissions and offering expenses, we received net proceeds from the offering of approximately $63.0 million. Subsequent to the offering, we used approximately $22.5 million of our net proceeds to redeem all outstanding shares of redeemable preferred stock and to pay all accrued but unpaid dividends on such shares through the date of redemption. The remaining proceeds to us have conformed with our intended use outlined in the prospectus related to the offering. As of March 31, 2004, we have approximately $41.8 million remaining from the proceeds of the offering.

Item 3. Defaults Upon Senior Securities

None.

Item 4. Submission of Matters to a Vote of Security Holders

None.

Item 5. Other Information

During the first quarter of 2004, certain of our executives implemented individual stock selling plans in accordance with SEC Rule 10b5-1 to sell a portion of their company holdings over time as part of their individual long-term strategy for asset diversification and liquidity, while avoiding conflicts of interest or the appearance of any such conflict that might arise from their positions with the company. The executives that have implemented such plans are Chief Executive Officer Jon Kirchner, Executive Vice President, Finance and Chief Financial Officer Melvin Flanigan, Executive Vice President, Operations Andrea Nee, Executive Vice President, Legal and General Counsel, Blake Welcher, Senior Vice President, Research and Development W. Paul Smith, Senior Vice President, Strategy and Business Development Patrick Watson, Senior Vice President, Engineering and Product Development Jan Wissmuller, Vice President, DTS Entertainment Jeffrey Skillen, Vice President, Consumer/Pro Audio Brian Towne and Chairman of the Board of Directors Dan Slusser.

Under the Rule 10b5-1 trading plans, the DTS executives may each sell up to 20% of the stock and exercisable stock options held by such person as of the effective date of the plan during the one-year term of the plan; however, the executive shall not sell more than 50% of such shares in any one calendar quarter. Sales under these plans may be executed no more than once per month. Sales under these plans commenced in February 2004.

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits:

Exhibit Number		Exhibit Description

10.41+		Letter Agreement dated March 9, 2004 by and between the Registrant and In Focus Corporation amending the Purchase-Sales Agreement between such parties dated as of March 12, 2002
31.1		Certification of the Chief Executive Officer under Securities Exchange Act Rules 13a-14(a) and 15d-14(a)
31.2		Certification of the Chief Financial Officer under Securities Exchange Act Rules 13a-14(a) and 15d-14(a)
32.1		Certification of the Chief Executive Officer under Securities Exchange Act Rules 13a-14(b) and 15d-14(b) and Section 1350 of 18 U.S.C. 1350
32.2		Certification of the Chief Financial Officer under Securities Exchange Act Rules 13a-14(b) and 15d-14(b) and Section 1350 of 18 U.S.C. 1350

+ Certain confidential portions of this Exhibit were omitted by means of reducting a portion of the text (the “Mark”). This Exhibit has been filed seperately with the Secretary of the Commission without the Mark pursuant to the Registrant Application Requesting Confidential Treatment under Rule 24b-2 under the Securities Exchange Act of 1934.

(b) Reports on Form 8-K:

On February 12, 2004, we filed on Form 8-K a press release announcing our financial results for the fourth quarter of 2003.

SIGNATURES

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

	DIGITAL THEATER SYSTEMS, INC.


	By:	/s/ JON E. KIRCHNER
		Jon E. Kirchner
		President and Chief Executive Officer
		(Duly Authorized Officer)

Date: May 17, 2004

	By:	/s/ MELVIN L. FLANIGAN
		Melvin L. Flanigan
		Executive Vice President, Finance and
		Chief Financial Officer
		(Principal Financial and Accounting Officer)

Date: May 17, 2004