DIGITAL THEATER SYSTEMS INC - 10-Q Quarterly Report

FINANCIAL INFORMATION

Item 1. Financial Statements

Digital Theater Systems, Inc.
Condensed Consolidated Balance Sheets

	As of December 31, 2004			As of March 31, 2005
				(Unaudited)
	(Amounts in thousands, except share and per share amounts)
ASSETS
Current assets:
Cash and cash equivalents		$	21,271		$	31,892
Short-term investments		93,040			74,303
Accounts receivable, net of allowance for doubtful accounts of $402 and $406 at December 31, 2004 and March 31, 2005, respectively		4,649			10,664
Inventories		3,669			3,320
Deferred tax assets		9,144			9,090
Prepaid expenses and other		3,651			2,713
Income tax receivable		72			—
Total current assets		135,496			131,982
Long-term investments		2,657			—
Property and equipment, net		3,539			5,722
Goodwill		—			3,853
Intangible assets, net		1,779			12,369
Deferred tax assets		500			1,903
Other assets		718			727
Total assets		$	144,689		$	156,556
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	3,716		$	4,609
Accrued expenses		5,688			6,138
Deferred revenue		519			2,275
Income tax payable		—			656
Total current liabilities		9,923			13,678
Deferred tax liability		—			4,307
Commitments and contingencies (Note 9)
Stockholders’ equity:
Preferred stock—$0.0001 par value, 5,000,000 shares authorized at December 31, 2004 and March 31, 2005; no shares outstanding at December 31, 2004 and March 31, 2005		—			—
Common stock—$0.0001 par value, 70,000,000 shares authorized at December 31, 2004 and March 31, 2005; 17,067,573 and 17,091,980 shares issued and outstanding at December 31, 2004 and March 31, 2005, respectively		2			2
Additional paid-in capital		121,431			121,680
Retained earnings		13,333			16,889
Total stockholders’ equity		134,766			138,571
Total liabilities and stockholders’ equity		$	144,689		$	156,556

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,
	2004			2005
	(Unaudited)
	(Amounts in thousands)
Cash flows from operating activities:
Net income	$	3,440		$	3,556
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	279			809
Stock-based compensation charges	139			5
Allowance for doubtful accounts	2			5
Deferred income taxes	(1,130		)	(43		)
Tax benefit from employee stock plans	1,060			169
In-process research and development	—			2,300
Changes in operating assets and liabilities:
Accounts receivable	(811		)	(5,816		)
Inventories	(1,567		)	349
Prepaid expenses and other assets	(23		)	(233		)
Accounts payable and accrued expenses	1,647			(966		)
Deferred revenue	—			829
Income taxes	1,107			728
Net cash provided by operating activities	4,143			1,692
Cash flows from investing activities:
Sales (purchases) of investments, net	(29,485		)	21,394
Cash paid for acquisitions	—			(10,954		)
Purchase of property and equipment	(521		)	(1,517		)
Payment for patents and trademarks in process	(16		)	(70		)
Net cash provided by (used in) investing activities	(30,022		)	8,853
Cash flows from financing activities:
Follow-on public offering costs	(52		)	—
Proceeds from the issuance of common stock upon exercise of employee stock options	130			76
Net cash provided by financing activities	78			76
Net increase (decrease) in cash and cash equivalents	(25,801		)	10,621
Cash and cash equivalents, beginning of period	39,243			21,271
Cash and cash equivalents, end of period	$	13,442		$	31,892

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 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 for complete financial statements. In the opinion of management, the unaudited condensed consolidated financial statements reflect all adjustments considered necessary for fair statements, 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, 2005 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2005. For further information, refer to the consolidated financial statements and footnotes thereto for the year ended December 31, 2004 filed on Form 10-K filed on March 16, 2005.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States 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.

Reclassification

The Company has reclassified certain auction rate securities and variable rate demand obligations from cash equivalents to short-term marketable securities. Auction rate securities are variable rate bonds tied to short-term interest rates with maturities on the face of the underlying security in excess of 90 days. Auction rate securities have interest rate resets through a modified Dutch auction at predetermined short-term intervals, typically every 7, 28 or 35 days. Interest paid during a given period is based upon the interest rate determined during the prior auction. Variable rate demand obligations generally provide an option to tender securities at par on seven days’ notice. The interest rate resets daily, weekly or depending on the mode of the security.

Although these securities are issued and rated as long-term bonds, they are priced and traded as short-term instruments because of the liquidity provided through the interest rate reset. The Company had historically classified these instruments as cash equivalents if the period between interest rate resets was 90 days or less, which was based on our ability to either liquidate our holdings or roll our investment over to the next reset period. The Company’s re-evaluation of the maturity dates and other provisions associated with the underlying bonds resulted in a reclassification from cash and equivalents to short-term marketable securities of approximately $56,523 on the March 31, 2004 balance sheet. As a result of this balance sheet reclassification, certain amounts were reclassified in the accompanying consolidated statement of cash flows for the three months ended March 31, 2004 to reflect the gross purchases and sales of these securities as investing activities rather than as a component of cash and cash equivalents. This change in classification does not affect previously reported cash flows from operating or from financing activities in the previously reported consolidated statements of cash flows or the previously reported consolidated statements of operations. As of March 31, 2004, before these revisions in classification, $56,523 of these current investments were classified as cash and cash equivalents on the consolidated balance sheet. For the three months ended March 31, 2004, before these revisions in classification, net cash used in investing activities

related to these current investments of $56,523 were included in cash and cash equivalents in the consolidated statement of cash flows.

Note 2—Summary of Significant Accounting Policies

Revenue Recognition

In January 2005, the Company acquired Lowry Digital Images, Inc. (“LDI”). The Company recognizes revenue when all titles subject to a customer order or contract are delivered and accepted by the customer and no significant obligations remain after customer acceptance. The Company typically bills in advance of services. Prices are established in advance of the work performed and are generally fixed in nature. If losses are anticipated on a contract, such losses are recognized immediately.

Acquired In-Process Research and Development

The value assigned to acquired in-process research and development (“IPR&D”) is determined by identifying acquired specific in-process research and development projects that would be continued and for which (1) technological feasibility has not been established at the acquisition date, (2) there is no alternative future use, and (3) the fair value is estimable with reasonable reliability, upon consummation of a business combination.

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 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,
	2004				2005
	(Unaudited)
Net income:
As reported		$	3,440			$3,556
Additional stock-based compensation expense determined under the fair value method, net of tax		(449		)		(489		)
Pro forma		$	2,991			$	3,067
Net income per common share basic:
As reported		$	0.21			$	0.21
Per share effect of additional stock-based compensation expense determined under the fair value method, net of tax		(0.03		)		(0.03		)
Pro forma		$	0.18			$	0.18
Net income per common share—diluted:
As reported		$	0.19			$	0.19
Per share effect of additional stock-based compensation expense determined under the fair value method, net of tax		(0.03		)		(0.03		)
Pro forma		$	0.16			$	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, 2004 and 2005, the Company recorded stock-based compensation expense of $139 and $5, respectively, related to non-employee equity awards.

Note 3—Recent Accounting Pronouncements

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4” (“SFAS 151”). SFAS 151 clarifies the types of costs that should be expensed rather than capitalized as inventory. SFAS 151 also clarifies the circumstances under which fixed overhead costs associated with operating facilities involved in inventory processing should be capitalized. This statement is effective for fiscal years beginning after June 15, 2005. The Company adopted SFAS 151 in the first quarter of fiscal 2005 and the adoption did not have a material impact on the Company’s consolidated financial position or results of operations.

In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment” (“SFAS 123R”), an amendment to SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS 123R requires compensation expense related to stock-based awards to be recognized in the financial statements. The amount of compensation expense will be measured based upon the fair value of the stock-based awards at the date of grant. This statement is effective for public companies as of the first interim or annual reporting period beginning after June 15, 2005. In April 2005, the SEC amended the compliance date for implementing SFAS 123R extending the compliance date to the first fiscal year that begins after June 15, 2005. The Company plans to adopt SFAS 123R beginning in the first quarter of fiscal 2006. The expected effects of the adoption of SFAS 123R on the Company’s financial results for the next five years, based on stock-based awards granted as of March 31, 2004, are as follows:

	Expenses by Fiscal Year
	Remaining Nine Months
	2005			2006		2007		2008		2009
	(unaudited)
	(in thousands)
Additional stock-based compensation expense under SFAS 123R before tax benefit		$	2,100	$	1,513	$	691	$	169	$	—

SFAS 123R also affects the presentation of tax benefits for option exercises in the statement of cash flows. Prior to adoption SFAS 123R, the benefit is classified in cash provided by operating activities. Upon adoption, the tax benefit will be classified in cash provided by financing activities. The Company is in the process of determining the impact the adoption will have on the Company’s consolidated statement of cash flows.

Note 4—Certain Balance Sheet Items

Inventories consist of the following:

	As of December 31, 2004			As of March 31, 2005
				(Unaudited)
Raw materials		$	1,313		$	1,268
Work in process		—			49
Finished goods		2,356			2,003
Total inventories		$	3,669		$	3,320

Property and equipment consist of the following:

	As of December 31, 2004				As of March 31, 2005
					(Unaudited)
Machinery and equipment		$	3,036			$	3,134
Office furniture and fixtures		2,693				4,838
Leasehold improvements		2,926				3,272
		8,655				11,244
Less: Accumulated depreciation		(5,116		)		(5,522		)
Property and equipment, net		$	3,539			$	5,722

Note 5—Business Combinations

In January 2005, the Company completed the acquisition of LDI for $9,600 in cash. In late 2004, the Company loaned LDI a total of $1,250 to enable LDI to satisfy certain liabilities. Neither LDI nor its stockholders were required to repay this loan prior to, or in connection with, the acquisition. The cash portion of the acquisition was funded by working capital. Subsequent to the acquisition, we changed the name of the business to DTS Digital Images, Inc. (“DDI”).

The Merger Agreement also requires the Company to invest approximately $3,500 in the business of LDI on or prior to June 30, 2005 to enable LDI to make certain capital expenditures and, if and to the extent LDI meets specified gross profit milestones, to invest up to an additional $1,500 through the end of 2006.

The estimated total purchase price for the acquisition of all of the outstanding shares of LDI is as follows:

Cash	$	9,642
Bridge loan, including interest	1,261
Estimated direct acquisition costs	1,346
Total estimated purchase price	$	12,249

The LDI acquisition was accounted for under SFAS 141 “Business Combinations” and certain specified provisions of SFAS 142 “Goodwill and Other Intangible Assets.” The results of operations of LDI are included in our Consolidated Statement of Operations from January 3, 2005. The final purchase price is dependent on the actual direct acquisition costs and shares issued, if any, as further discussed below. Under the purchase method of accounting, the total estimated purchase price is allocated to LDI’s net tangible and intangible assets based on their estimated fair value as of the date of completion of the acquisition. Based on the estimated purchase price and the preliminary valuation, the preliminary purchase price allocation, which is subject to change based on the Company’s final analysis, is as follows:

Accounts receivable	$	202
Tangible assets	1,094
Other assets	90
Deferred tax assets	1,441
Amortizable intangible assets:
Existing technology	10,200
Non-compete	400
Backlog	100
Tradename	200
In-process research and development	2,300
Goodwill	3,853
Total assets acquired	19,880
Liabilities assumed:
Accounts payable	(942		)
Accrued liabilities	(952		)
Notes payable	(368		)
Deferred revenues	(928		)
Total liabilities assumed	(3,190		)
Net deferred tax liability for acquired intangibles and purchase accounting	(4,441		)
Total purchase price	$	12,249

A preliminary estimate of $10.9 million has been allocated to amortizable intangible assets consisting of existing technology, non-compete, backlog, and tradenames with useful lives of between one and eleven years.

A preliminary estimate of $3.9 million has been allocated to goodwill. Goodwill represents the excess of the purchase price over the fair market value of the net tangible and amortizable intangible assets acquired. Goodwill will not be amortized and will be tested for impairment at least annually. The preliminary purchase price allocation for LDI is subject to revision as more detailed analysis is completed and additional information on the fair values of LDI’s assets and liabilities become available.

Any change in the fair value of the net assets of LDI will change the amount of the purchase price allocable to goodwill.

In-process research and development, relating to development projects which had not reached technological feasibility and that were of no future alternative use, was expensed upon consummation of the acquisition. Other identifiable intangible assets are being amortized with the following useful lives:

	Estimated Useful Life (Years)
Existing technology		11
Non-compete		3
Backlog		2
Tradename		1

Developed technology and in-process research and development were identified and valued through extensive interviews, analysis of data provided by LDI concerning development projects, their stage of development, the time and resources needed to complete them, if applicable, and their expected income generating ability and associated risks. Where development projects had reached technological feasibility, they were classified as developed technology and the value assigned to developed technology was capitalized. The income approach, which includes an analysis of the cash flows and risks associated with achieving such cash flows, was the primary technique utilized in valuing acquired in-process research and development. Key assumptions for in-process research and development included a discount rate of 30% and estimates of revenue growth, cost of sales, operating expenses and taxes.

The former shareholders of LDI are entitled to receive shares of DTS common stock if certain gross profit targets in 2005 and/or 2006 are met. In the event that the targets are met in full, an aggregate of up to 857,213 shares of DTS common stock will be issued. The value of these shares will be accounted for as an addition to goodwill.

The results of operations of LDI are included in our Consolidated Statements of Operations from January 3, 2005, the date of acquisition. For the purposes of presenting the unaudited pro forma financial information, the Company used the income statements of LDI for the three-months ended March 31, 2004. If the Company had acquired LDI at the beginning of fiscal year 2004, the Company’s unaudited pro forma net revenues, net income and net income per share for the three months ended March 31, 2004 would have been as follows:

	Three Months
	Ended
	March 31, 2004
Revenue		$	16,214
Net income		$	2,937
Net income per share—Basic		$	0.17
Net income per share—Diluted		$	0.16

Note 6—Goodwill and Intangibles

In accordance with SFAS 142, our goodwill is not amortized, but is tested for impairment at least annually, or sooner, if circumstances indicate its value may no longer be recoverable. SFAS 142 prescribes a two-step process for impairment testing of goodwill. For the first step, we screen for impairment and, if any impairment exists, we undertake a second step of measuring such impairment. We plan to perform our goodwill impairment test annually in our fourth fiscal quarter. SFAS 142 requires impairment testing based on reporting units. In the period ended March 31, 2005, we added $3,853 to goodwill in connection with our acquisition of LDI. The Company did not have goodwill prior to the acquisition of LDI.

Included in cost of sales is $244 of amortization relating to existing technologies and backlog for the three months ended March 31, 2005. Included in operating expenses is $129 of amortization relating to non-compete and tradename. The following table summarizes the weighted average lives and the carrying values of our acquired intangible assets by category:

			As of March 31, 2005										As of December 31, 2004
	Weighted Average Life (Years)		Gross Amount			Accumulated Amortization				Net Carrying Amount			Gross Amount			Accumulated Amortization				Net Carrying Amount
Existing technology		10.6		$	11,627		$	(366	)		$	11,261		$	1,427		$	(89	)		$	1,338
Non-compete		3		400			(33		)		367			—			—				—
Backlog		2		100			(13		)		87			—			—				—
Tradename		1		200			(50		)		150			—			—				—
Total				$	12,327		$	(462	)		$	11,865		$	1,427		$	(89	)		$	1,338

As of March 31, 2005, we expect the amortization of acquired intangible assets for future periods to be as follows:

	Estimated Amortization Expense
Remainder of the year ending December 31, 2005		$	1,117
2006		1,289
2007		1,239
2008		1,106
2009		1,106
Thereafter		6,008
Total		$	11,865

Note 7—Bank Line of Credit

The Company replaced its prior working capital credit facility with a new $10,000 facility that expires on June 30, 2005. This facility automatically renews for a one year term. The bank agreement provides for working capital financing and is unsecured. The bank agreement requires the Company to comply with certain covenants including a tangible effective net worth of $60,000, increasing by 50% of net income on an annual basis. The covenants also require the Company to keep $2,000 in cash or securities at the bank.

At March 31, 2005, there were no balances outstanding under this agreement and there was $10,000 of available borrowings under this credit facility. Future borrowings will bear interest based on either of the two options the Company selects at the time of advances 1) a rate equal to 2% above the Bank’s LIBOR, or 2) a rate equal to the Base Rate as quoted from the bank less one-half percent. A commitment fee of $10 was paid for this line of credit.

Note 8—Income Taxes

For the three months ended March 31, 2005, the Company recorded an income tax provision of $1,942 on pre-tax income of $5,498 resulting in an annualized effective tax rate of 35.3%. 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%. 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 9—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.

In March 2005, in connection with the U.S. Internal Revenue Service’s (“IRS”) regular examination of the Company’s tax return for the year ended December 31, 2002, the IRS proposed adjustments related to certain items included in the Company’s return. In March 2005, the Company settled with the IRS and agreed to pay approximately $704,000. This amount was paid in April 2005 and did not have a material impact on our results of operations for the three months ended March 31, 2005.

In connection with the Company’s enforcement activities relating to its intellectual property rights and to stop unauthorized use of its technology and trademarks, the Company terminated its license agreement with Sunplus Technology Co., Ltd. (“Sunplus”). In response, Sunplus filed suit against the Company alleging breach of contract arising from the Company’s termination of their license agreement. The Company has prevailed on several preliminary motions by Sunplus seeking to enjoin the Company from terminating the license agreement. The Company has filed a cross-complaint seeking a judicial declaration that the Company properly terminated the license agreement and to recover damages arising from Sunplus’ breach of the agreement. The Company believes Sunplus’ claim is without merit and intends to vigorously defend the case.

Note 10—Operating Segment and Geographic Information

The Company operates its business in three reportable segments: the Cinema business segment, previously referred to as the Theatrical business, the Consumer business segment and the Digital Images business segment. The Cinema 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’s Digital Images business provides processing, enhancement and restoration services for cinema, home video and broadcast television content.

The Company does not separately identify and manage capital expenditures or long-lived assets related to these three business segments.

The Company’s reportable segments and geographical information for the three months ended March 31, 2004 and 2005 are as follows:

	Revenues
	For the Three Months Ended March 31,
	2004		2005
	(Unaudited)
Cinema business	$	4,800	$	4,796
Consumer business	10,797		16,541
Digital Images business	—		720
Total revenues	$	15,597	$	22,057

	Gross Profit
	For the Three Months Ended March 31,
	2004		2005
	(Unaudited)
Cinema business	$	2,462	$	2,173
Consumer business	10,243		16,001
Digital Images business	—		(580		)
Total gross profit	$	12,705	$	17,594

	Income (Loss) From Operations
	For the Three Months Ended March 31,
	2004			2005
	(Unaudited)
Cinema business	$	(1,077	)	$	(1,019	)
Consumer business	6,010			10,113
Digital Images business	—			(3,938		)
Total income from operations	$	4,933		$	5,156

Included in the Digital Images business segment’s loss for the three months ended March 31, 2005 is the $2,300 charge related to in-process research and development.

	Revenues by Geographic Region
	For the Three Months Ended March 31,
	2004			2005
	(Unaudited)
United States		$	4,189		$	9,379
International		11,408			12,678
Total revenues		$	15,597		$	22,057

The majority of international revenues are generated from Japan and are primarily denominated in United States dollars.

The following table sets forth, for the periods indicated, long-lived tangible assets by geographic area in which the Company holds assets at December 31, 2004 and March 31, 2005:

	Long-Lived Assets
	As of December 31, 2004			As of March 31, 2005
				(Unaudited)
United States		$	2,657		$	4,640
International		882			1,082
Total long-lived assets		$	3,539		$	5,722

Note 11—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,
	2004		2005
	(Unaudited)
Basic net income per common share:
Numerator:
Net income	$	3,440	$	3,556
Denominator:
Weighted average common shares outstanding	16,578,942		17,080,005
Basic net income per common share	$	0.21	$	0.21
Diluted net income per common share:
Numerator:
Net income	$	3,440	$	3,556
Denominator:
Weighted average shares outstanding	16,578,942		17,080,005
Effect of dilutive securities:
Common stock options	1,318,156		946,957
Common stock warrants	322,191		239,132
Diluted shares outstanding	18,219,289		18,266,094
Diluted net income per common share	$	0.19	$	0.19

Weighted average common shares outstanding, assuming dilution, include the incremental shares that would be issued upon the assumed exercise of stock options. For the three months ended March 31, 2004 and 2005, 37,250 and 738,268 shares, with a weighted average exercise prices of $26.91 and $22.39 of the Company’s stock options were excluded from the calculation of diluted earnings per share because the exercise prices of the stock options were greater than or equal to the average price of the common shares, and therefore their inclusion would have been anti-dilutive. These options could be dilutive in the future if the average share price increases and is equal to or greater than the exercise price of these options.

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

Forward-Looking Statements May Prove Inaccurate

This Form 10-Q and the documents incorporated herein by reference contain forward-looking statements based on our current beliefs, expectations, estimates and projections about our industry, 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 elsewhere in this Form 10-Q, and the other documents we file with the Securities and Exchange Commission, or SEC, including our most recent reports on Form 8-K and Form 10-K. 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 consolidated financial statements and the notes to those statements included elsewhere in this Form 10-Q. 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” and elsewhere in this Form 10-Q.

Overview

We are a leading provider of entertainment technology, products and services to the audio and image entertainment markets worldwide. Historically we have been focused on high quality digital multi-channel audio, commonly referred to as surround sound, which 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. With our January 2005 acquisition of Lowry Digital Images, Inc., now DTS Digital Images, Inc. or DDI, we have expanded our business into high quality digital image processing, enhancement and restoration for the cinema, home video, and broadcast television markets.

We manage our business through three reportable segments—our consumer business, our cinema business, which we previously described as our theatrical business and our digital images business. Prior to 2001, we derived a majority of our revenues from the cinema 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 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 multi-channel music titles in our digital multi-channel format.

In our cinema business, we derive revenues from sales of our playback equipment and cinema processors to movie theaters and special venues. In addition, we license technology and 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.

In our recently acquired digital images business, we derive revenues from the processing, enhancement and restoration of cinema, home video and broadcast television content. We provide these

services to motion picture and television studios and other content owners. We offer our services on either a fixed fee or time and materials basis.

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 cinema 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 cinema 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 are derived from our consumer, cinema and digital images 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 cinema 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. Revenues from product sales and other revenues in connection with our digital images business segment include fees for processing, enhancing and restoring cinema, home video and broadcast television content.

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. We continue to invest in our compliance and enforcement infrastructure to support the value of our intellectual property to us and our licensees and to improve the long-term realization of our intellectual property. 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. While we consider such revenues to be a regular part our normal operations, 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. Disc Union serves as our exclusive distributor in Japan. We also employ consultants to coordinate sales to independent retailers. We are in the process of establishing distribution channels in other international territories. We intend to engage one or more additional distributors with an established presence in Asia to handle distribution in other Asian territories. 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 cinema 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 and China, and in Eastern Europe.

In our digital images business, our senior management team markets our services directly to directors, producers and content owners. The sales process typically involves an evaluation of the cinema, home video or broadcast television content to be enhanced or restored and a determination of the scope of services required to achieve the desired result. This enables current or archived content to be enhanced or restored for high quality, high definition presentation in digital cinema, high definition optical media or broadcast applications.

Management Discussion Regarding Trends, Opportunities, and Challenges

Consumer Segment

Revenue from our consumer segment constitutes the majority of our total revenue, representing 75% and 69% of total revenues for the quarters ended March 31, 2005 and 2004, respectively. Our consumer revenue is primarily dependent upon the home theater and DVD player markets, which have experienced rapid growth over the past several years, however, we have begun to experience softness in our DVD player trademark licensing program, which may cause growth rates in this area to decline from recent levels. The success of DVD-Video-based systems and products has fueled a demand for ever-higher quality entertainment in the home, and this demand is extending to the car and PC markets as well. We expect the recent acceleration of the market for high definition televisions to drive demand for high definition optical disc players beginning in 2006. Because we expect to be a mandatory technology for the next generation players, our consumer revenue growth should more closely track the growth rate of these players over the next several years. We expect that the market for high definition players will yield new growth that provides an offset to the expected decline in the overall growth in DVD player shipments. Further, we believe that expected mandatory inclusion in next generation optical disc standards will help to improve the adoption rate of our technologies in other consumer products such as next generation video game consoles, personal audio and video players, personal computers and in-car entertainment systems. Failure to attain mandatory status in next generation high definition optical disc standards could cause revenue growth in our consumer business to be significantly lower than expected and could have a material adverse effect on our business.

In July 2004, we acquired QDesign Corporation, or QDesign, a company focused on lower-bit rate audio delivery technology. The market for higher quality entertainment is expanding into portable devices that require the use of low-bit rate audio coding systems including portable audio players, PDAs and wireless handset applications. Concurrent with this trend, there is a growing need for a good link between home and portable devices that preserves as much quality as possible and allows consumers a seamless technology solution for the storage and playback of their content. In October 2004, leveraging our existing

research and development efforts and the intellectual property acquired in the QDesign acquisition, we launched DTS-HD, a scalable coding system. This technology allows content to be played in home and portable devices. We believe that the broad and robust nature of this offering improves the probability of inclusion of our technologies in next generation products.

Cinema Segment

Revenue from our cinema segment represented 22% and 31% of total revenues for the quarters ended March 31, 2005 and 2004, respectively. In our cinema business, 2004 was a solid year for sales of our playback hardware, marking a return to growth for cinema product sales. We expect growth in our cinema audio hardware to continue at a modest pace in 2005. We also believe that the cinema exhibition community has recognized that pre-show entertainment represents a significant revenue growth opportunity that will lead to investment in pre-show solutions over the next several years. Because our XD10 Cinema Media Player can be configured to perform audio playback along with pre-show and subtitling presentation, we believe that we are well-positioned to participate in the growth in this market.

A factor that we believe will affect our cinema business segment is the long-term trend toward digital distribution of content. We believe this trend will involve the near-term adoption of digital pre-show and/or electronic cinema solutions, followed by longer-term adoption of higher quality digital cinema. Digital distribution of content offers the motion picture industry a means to achieve substantial cost savings, including the printing and distribution of movies, help in combating piracy, and will enable movies to be played repeatedly without degradation. It also provides additional revenue opportunities for cinema operators, as digital content such as advertisements, concerts and sporting events could be shown in or broadcast to digitally equipped theaters. We believe the widespread adoption of digital cinema will be longer-term because of the significant capital investment that will be required by cinema operators to purchase new equipment and solutions. We believe this represents an opportunity for us as we seek to provide products and services in support of the transition from film-based content towards digital cinema. However, we do not currently offer digital cinema products and may not be successful in developing or selling competitive product offerings. We believe that the addition of the services provided by our digital images business, coupled with the pre-show and alternative content capabilities of our XD10 Cinema Media Player, will enhance our ability to play a role in the industry transition to high definition sound and images for digital cinema.

Sales of cinema products and film licensing tend to fluctuate based on the underlying trends in the motion picture industry. For instance, in the late 1990s various cinema operators aggressively built megaplexes, which 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, many theaters were closed. As the theater industry has regained health in the last several years, sales of our DTS playback systems and cinema processors have improved. Our film licensing revenues are also subject to fluctuations based on industry trends, most significantly, the number of films being made by studios and independent filmmakers.

Digital Images Segment

Revenue from our digital images segment represented 3% of total revenues for the quarter ended March 31, 2005. We believe that the growing market for high resolution and high definition content in the cinema and the home will create a substantial demand for the services provided by DDI. We believe that we have a technological advantage over many of our competitors based on the sophistication of our processes and level of automation used to enhance the image quality of entertainment content. Revenues in this business totaled $720,000 for the three months ended March 31, 2005. This was lower than originally anticipated, as distractions related to the acquisition and integration of this business, coupled with certain process development initiatives, slowed the pace of selected larger projects during the quarter. To date,

this business has restored and/or enhanced over 100 feature films, including such recent major DVD releases as Star Wars and Indiana Jones. Major motion picture and television studios possess libraries containing thousands of titles, which we believe represent a sizable market opportunity for DDI’s service.

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, goodwill and intangible assets, 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. With the exceptions of the revenue recognition and in-process research and development in connection with the recent acquisition of LDI, now DDI, as described below, 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 16, 2005.

DDI Revenue Recognition

Revenue is recognized when all titles subject to a customer order or contract are delivered and accepted by the customer and no significant obligations remain after customer acceptance. We typically bill in advance of services. Prices are established in advance of the work performed and are generally fixed in nature. If losses are anticipated on a contract, such losses are recognized immediately.

Acquired In-Process Research and Development

The value assigned to acquired in-process research and development, or IPR&D, is determined by identifying acquired specific in-process research and development projects that would be continued and for which (1) technological feasibility has not been established at the acquisition date, (2) there is no alternative future use, and (3) the fair value is estimable with reasonable reliability, upon consummation of a business combination.

Results of Operations

Revenues

Technology and Film Licensing

Technology and film licensing revenues for the three months ended March 31, 2005 increased 48% to $18.5 million from $12.5 million for the three months ended March 31, 2004. The increase in revenues from technology and film licensing was primarily attributable to an increase in royalty recoveries of $5.0 million from intellectual property compliance and enforcement activities. These activities, which included audits of shipments by certain of our licensees of products containing our technology, trademarks and/or know-how and legal actions taken against licensees and parties who are not our licensees, resulted in recoveries of royalty payments relating to prior periods. We expect such royalty recoveries to continue and that this activity will continue to improve revenue realization in our licensing business going forward. Also contributing to the increase is the continued growth in consumer electronics licensing, particularly in the car and personal computer markets. Overall, we expect technology licensing revenues to continue to grow in 2005, based primarily on the expected continuation of growth in the home theater market. Our film

licensing revenues decreased slightly for the three months ended March 31, 2005 compared to the prior year period due to fewer international releases in the DTS format and changes in the timing of major feature film releases. Film licensing is expected to to grow modestly in 2005.

Product Sales and Other

Product sales and other revenues increased 16% to $3.6 million for the three months ended March 31, 2005 from $3.1 million for the three months ended March 31, 2004. This increase was primarily attributable to revenues generated by DDI, which we acquired in January 2005. Cinema hardware sales were up slightly from a strong performance in the first quarter of 2004. Interest in our XD10 Cinema Media Player continued to build during the first quarter of 2005, with revenue from shipments totalling approximately $417,000 deferred pending completion of a software deliverable, which we expect to be completed by the third quarter of 2005. The adoption of our multi-channel music continues to be slower than expected. Product sales and other revenue is expected to grow at a modest rate, as we continue to expect the market for pre-show entertainment to develop at a measured pace throughout the rest of 2005.

Segment Sales

Revenues from our consumer business totaled $16.5 million for the three months ended March 31, 2005, an increase of 53% from $10.8 million for the three months ended March 31, 2004. The increase in revenues was driven primarily by royalty recoveries and the growth in consumer electronics technology licensing as mentioned above. Cinema revenues were $4.8 million for the three months ended March 31, 2005, essentially unchanged from the same period last year as a slight increase in hardware revenues was offset by a slight decrease in film licensing revenues. Revenues from our digital images business were $720,000 for the three months ended March 31, 2005, the first quarter these revenues have been included in our results of operations. Revenues from this business segment were lower than anticipated due to normal distractions related to this acquisition and revenue deferrals under the completed contract methodology.

Gross Profit

Consolidated gross profit decreased to 80% of revenues for the three months ended March 31, 2005, from 81% for the three months ended March 31, 2004. We expect consolidated gross margins in the 70% to 75% range in 2005 primarily as a result of the incorporation of DDI into our consolidated results of operations.

Technology and Film Licensing

Gross profit associated with technology and film licensing revenues increased slightly to 93% for the three months ended March 31, 2005 from 92% of related revenues for the prior year same period.

Product Sales and Other

Gross profit associated with product sales and other revenues decreased to 11% of related revenues for the three months ended March 31, 2005 from 38% in the prior year period primarily as a result of negative margins relating to our digital images business.

Segment Gross Profit

Gross profit for our consumer business increased to 97% of related revenues for the quarter ended March 31, 2005 from 95% in the prior year period. Our cinema business gross profit decreased to 45% of related revenues for the quarter ended March 31, 2005 from 51% in the prior year period primarily due the change in mix to lower margin product sales from the higher margin film licensing. Our digital images business experienced negative gross margins due to lower than anticipated revenues and the amortization

of acquired intangibles of $244,000. We expect margins in the digital images business to improve as revenues increase throughout the remainder of the year.

Selling, General and Administrative

Selling, general and administrative expenses increased 25% to $8.0 million for the three months ended March 31, 2005, compared to $6.4 million in the prior year period. The increase is primarily due to increases in professional services of $1.1 million, which includes costs associated with our increased intellectual property compliance and enforcement activities, Sarbanes-Oxley related costs and other costs associated with operating as a public company. Also contributing to the increase was $503,000 relating to the inclusion of DDI in our results of operations. Included in the increase related to DDI is amortization of acquired intangibles of $83,000.

We expect selling, general and administrative expenses to increase as a whole to support our growth initiatives including acquisitions, international expansion and intellectual property enforcement activities.

Research and Development

For the three months ended March 31, 2005, research and development expenses were $2.1 million, compared to $1.3 million for the three months ended March 31, 2004. The change is primarily due to increased labor costs associated with new product initiatives, the optimization of our Coherent Acoustics technology, and the development of tools associated with next generation optical disc standards. Also contributing to the increase was the inclusion of DDI research and development activities totaling $179,000.

We expect to continue to increase our investment in applications engineering and research and development activities overall and will accelerate those initiatives in future quarters to support the roll out of next generation optical disc standards and the continued optimization of our Coherent Acoustics technology.

In-Process Research and Development

In-process research and development of $2.3 million relates to development projects that had not reached technological feasibility and were of no future alternative use and expensed upon consummation of the acquisition of LDI. Developed technology and in-process research and development were identified and valued through extensive interviews, analysis of data provided by LDI concerning development projects, their stage of development, the time and resources needed to complete them, if applicable, and their expected income generating ability and associated risks. Where development projects had reached technological feasibility, they were classified as developed technology and the value assigned to developed technology was capitalized. The income approach, which includes an analysis of the cash flows and risks associated with achieving such cash flows, was the primary technique utilized in valuing acquired in-process research and development. Key assumptions for in-process research and development included a discount rate of 30% and estimates of revenue growth, cost of sales, operating expenses and taxes.

Interest (Income) Expense, Net

Interest income, net, for the three months ended March 31, 2005 decreased due to the inclusion of interest income related to a royalty settlement in the first quarter of 2004, partially offset by increasing interest rates in 2005.

Income Taxes

For the three months ended March 31, 2005, we recorded an income tax provision of $1.9 million on pre-tax income of $5.5 million. This resulted in an annualized effective tax rate of 35.3%. For the three months ended March 31, 2004, we recorded an income tax provision of $1.9 million on pre-tax income of

$5.4 million. This resulted in an annualized effective tax rate of 35.8%. 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. We expect the effective tax rate for 2005 will be approximately 35%.

Liquidity and Capital Resources

At March 31, 2005, we had cash, cash equivalents and short- and long-term investments of $106.2 million, compared to $117.0 million at December 31, 2004.

Net cash provided by operating activities was $1.7 million for the three months ended March 31, 2005, compared to $4.1 million for the three months ended March 31, 2004. The decrease in cash flows from operations was primarily a result of an increase in accounts receivable and a reduced tax benefit relating to options. Accounts receivable, net of acquired accounts receivable, increased $5.8 million for the three months ended March 31, 2005 due primarily to accrued consumer license fees, $4.7 million of which was collected by April 2005. Our tax benefit from the exercise of options decreased $891,000 for the three months ended March 31, 2005 as a result of the decrease in the market value of our common stock relative to the same period in the prior year.

Net cash provided by investing activities totaled $8.9 million for the three months ended March 31, 2005. Net cash used in investing activities totaled $30.0 million for the three months ended 2004. The increase in cash used in investing activities for the three months ended March 31, 2005 is primarily a result of the net sales of investments of $21.4 million, offset by the acquisition of LDI of $11.0 million and purchases of property and equipment of $1.5 million.

Net cash provided by financing activities totaled $76,000 and $78,000 for the three months ended March 31, 2005 and 2004, respectively, and primarily consists of the exercise of stock options.

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 16, 2005 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 2004, the Financial Accounting Standards Board, or FASB issued Statement of Financial Accounting Standards, or SFAS, No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4”, or SFAS 151. SFAS 151 clarifies the types of costs that should be expensed rather than capitalized as inventory. SFAS 151 also clarifies the circumstances under which fixed overhead costs associated with operating facilities involved in inventory processing should be capitalized. This statement is effective for fiscal years beginning after June 15, 2005. We adopted SFAS 151 in the three months ended 2005 and the adoption did not have a material impact on our consolidated financial position or results of operations.

In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment”, or SFAS 123R, an amendment to SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS 123R requires

compensation expense related to stock-based awards to be recognized in the financial statements. The amount of compensation expense will be measured based upon the fair value of the stock-based awards at the date of grant. This statement is effective for public companies as of the first interim or annual reporting period beginning after June 15, 2005. In April 2005, the SEC amended the compliance date for implementing SFAS 123R extending the compliance date to the first fiscal year that begins after June 15, 2005. We plan to adopt SFAS 123R beginning in the first quarter of fiscal 2006. The expected effects of the adoption of SFAS 123R on our financial results for the next five years, based on stock-based awards granted as of March 31, 2004, are as follows:

	Expenses by Fiscal Year
	Remaining
	Nine
	Months
	2005			2006		2007		2008		2009
	(unaudited)
	(In thousands)
Additional stock-based compensation expense under SFAS 123R before tax benefit		$	2,100	$	1,513	$	691	$	169	$	—

SFAS 123R also affects the presentation of tax benefits for option exercises in the statement of cash flows. Prior to adoption SFAS 123R, the benefit is classified in cash provided by operating activities. Upon adoption, the tax benefit will be classified in cash provided by financing activities. We are in the process of determining the impact the adoption will have on our consolidated statement of cash flows.

RISK FACTORS

Set forth below and elsewhere in this report and in other documents we file with the SEC 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, digital imaging, 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 Coding Technologies, Fraunhofer Institut Integrierte Schaltungen, Koninklijke Philips Electronics N.V. (Philips), Meridian Audio Limited, Microsoft Corporation, Sony Corporation, and Thomson;

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

· digital image processing, enhancement and restoration services, including Ascent Media Group, EFILM LLC, Imax Corporation, Laser Pacific Media Corporation, Modern Video Film, Inc., Sunset Digital, Technicolor Media Services, and Warner Bros. Entertainment, Inc.

· products for image processing including da Vinci Systems, LLC, Digital Vision AB, Mathematical Technologies, Inc., Pixel Farm Ltd., Snell and Wilcox, Teranex Incorporated, and The Foundry Visionmongers Ltd.

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 our common customer base;

· a more extensive customer base;

· digital technologies that provide features that ours do not;

· 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.

Warner Bros. is both a competitor and a significant customer in the image processing, enhancement and restoration markets. If Warner Bros. decides to compete directly with us in the image processing, enhancement and restoration market, the revenues that we derive from Warner Bros. 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 and video 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 technology to be available in a particular product or medium, or an optional basis, meaning that a particular technology may be, but is not required to be, utilized. For example, both our digital multi-channel audio technology and Dolby’s have optional status in the HD-DVD standard. In the emerging standard for HD-DVD, both DTS and Dolby technologies have been selected as mandatory standards. Recently, however, there has been discussion regarding merging the two competing next generation optical disc HD-DVD standards. If either or both of these standards are re-examined as a result of these discussions or a new standard is developed, we may not be included as mandatory in any new or revised 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 audio technology has been selected as the sole, mandatory audio standard for terrestrial digital television broadcasts. As a result, the audio for 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 audio technology may never be included in that standard. 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.

As new technologies and entertainment mediums emerge, 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;

· we may not be able to practice our trade secrets as a result of patent protection afforded a third-party for such product, technique or processes;

· 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, our means of protecting our intellectual property rights and brands may not 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, digital image processing, 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 rights 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 relationships with many leading providers of movie, music, computer, and video game content, we do not have contracts that require any of 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 independent registered public accounting firm is unable to provide us with an unqualified report as to the adequacy of our internal controls over financial reporting for 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 all public companies, including us, to include a report by management on internal control over financial reporting in all annual reports on Form 10-K that contains an assessment by management of the effectiveness of internal control 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 control over financial reporting and the effectiveness of internal control over financial reporting. While we conduct rigorous reviews of our internal control over financial reporting in order to comply with the Section 404 requirements, our registered public accounting firm may interpret the Section 404 requirements and the related rules and regulations differently from us, or our registered public accounting firm or management may not be satisfied with our internal control over financial reporting or with the level at which these controls are documented, executed or reviewed. In addition, many uncertainties remain regarding the requirements for auditor attestation, and guidance provided by the public accounting profession has changed frequently and materially to date and may continue to change such that we may not be able to comply with these new requirements. Further, the demand for competent audit resources has grown dramatically as a result of the requirements of Section 404, and such demand may exceed available supply. In addition, in January 2005, we acquired Lowry Digital Images, Inc., or LDI, a privately held company with limited financial resources that had not implemented sufficient internal control over financial reporting. We may in the future make additional acquisitions which may be significant to our operations either individually or in the aggregate. We may face significant challenges in implementing the required processes and procedures in the acquired operations of LDI or any other businesses that we may acquire. As a result, our registered public accounting firm may issue an adverse report or a disclaimer on managements assesment of internal control over financial reporting. Management may also identify material weaknesses which would cause management to conclude internal control over financial reporting is not effective. 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 relationships 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.

We have limited experience in image processing, enhancement and restoration

Although we have established relationships with a number of motion picture studios, content owners, producers and distributors, we do not have any contractual agreements that require them to provide us image content for processing. Further, the demand for image processing, enhancement and restoration of cinema, home video or broadcast television content may not materialize or accelerate as we anticipate, which would have a negative impact on our business.

Declining retail prices for consumer electronics products or video content could force us to lower the license or other 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.

The market for consumer video products is also intensely competitive and price sensitive. Retail prices for consumer video products that that have been processed, enhanced or restored by us, such as movies, concerts or animated content released on DVD or other media, have experienced price pressure and we expect this price pressure to continue for the foreseeable future. Declining prices for such video products could create downward pressure on the fees we currently charge our customers for the image processing, enhancement and restoration services we provide. If the motion picture studios, content owners, producers or distributors were to believe that the existing image quality is satisfactory or that the pricing for our services are too high, they could decide to not use our services 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, 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 contracts and license agreements with many of these companies, these agreements do not require any minimum purchase commitments, and are on a non-exclusive basis, and do not require incorporation or use of our technology, trademarks or services. Our customers, licensees and other manufacturers might not utilize our technology or services 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 using DTS technology or services.

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 or our image services. Our cinema and images business depends on our having good relations with these film studios and other content owners. A deterioration in our relationship with any of these customers could cause them to stop using our DTS audio technology or our image enhancement services. 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 motion picture studios, content owners, producers, and distributors throughout the world generally adopt and use the processes and the technologies used by the major U.S. film studios. Therefore, if the major U.S. motion picture studios, content owners, producers or distributors 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 cinema 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 cinema 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, W. Paul Smith, our Senior Vice President, Research and Development, and John Lowry, our Chief Technologist of DTS Digital Images who became an employee upon our acquisition of LDI. 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 have key-man life insurance only for a limited numbers 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. In addition, while we have completed over 100 digital image processing, enhancement and restoration film projects, it is only recently that a large number of these projects have been completed. 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 and image services are 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 fifteen fiscal quarters. We expect our operating expenses to increase as we, among other things:

· expand our domestic and international sales and marketing activities;

· acquire businesses or technologies and integrate them into our existing organization;

· 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; 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 Canada, 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 or products that incorporate our technology.

We depend on several 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 three companies to serve as our sole distributors for our DTS Entertainment products in the United States and Canada, Europe and Japan. 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 any of these distributors were to go out of business, as one of our previous distributors 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 cinema products and services.

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

We acquired LDI in January 2005, and we expect to consider additional 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 a limited history of acquiring and integrating businesses. Acquisitions and strategic investments involve numerous risks, including:

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

· significant future charges relating to in-process research and development and the amortization of intangible assets;

· significant amount of goodwill that is not amortizable and is subject to annual impairment review;

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

· unanticipated costs associated with the acquisition, including accounting charges, capital expenditures, 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, our acquisition of LDI 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.

Accounting for employee stock options using the fair value method will reduce our net income.

There has been ongoing public debate whether stock options granted to employees should be treated as compensation expense and, if so, how to properly value such charges. Currently, we account for options using the intrinsic value method, which results in no compensation expense, since we grant employee

options with exercise prices equal to the fair market value of the underlying stock at the time of grant. If, however, we had used the fair value method of accounting for stock options granted to employees using a Black-Scholes option valuation formula, our net income for the three months ended March 31, 2005, would have been reduced by $489,000, from $3.5 million to $3.1 million for the three months ended March 31, 2005. When we adopt FAS 123R in the first quarter of 2006, we will have on-going accounting charges significantly greater than those we would have recorded under our current method of accounting for stock options, which will have a material adverse affect on our operating results.

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, 2005, we have 17,091,980 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, 2005, 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, 2005, 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 3% of total revenues during the first quarter of 2005. Operating expenses, including cost of sales, for our foreign subsidiaries were approximately $1.5 million in the first quarter of 2005. Based upon the expenses for the first quarter of 2005, a 1% change in foreign currency rates throughout a one-year period would have an annual effect of approximately $62,000.

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 2005 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 appropriately and within the time periods specified in applicable rules and forms.

Changes in internal controls. During the first quarter of 2005 we began integrating the accounting operations of LDI, now DDI. Prior to our acquisition of LDI in January 2005, LDI was a privately held company operating with limited financial resources that had not implemented sufficient internal controls over financial reporting. We are in the process of implementing changes to improve the internal controls at LDI. We do not believe the integration of the accounting operations of LDI has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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)

PART I	FINANCIAL INFORMATION	3
Item 1.	Financial Statements:	3
	Condensed Consolidated Balance Sheets	3
	Condensed Consolidated Statements of Operations	4
	Condensed Consolidated Statements of Cash Flows	5
	Notes to Condensed Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	36
Item 4.	Controls and Procedures	37
PART II.	OTHER INFORMATION	38
Item 1.	Legal Proceedings	38
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	38
Item 3.	Defaults Upon Senior Securities	38
Item 4.	Submission of Matters to a Vote of Security Holders	38
Item 5.	Other Information	38
Item 6.	Exhibits	39
SIGNATURES		40

Exhibit Number				Exhibit Description
31.1				Certification of the Chief Executive Officer under Securities Exchange Act Rules 13a-14(a) or 15d-14(a)
31.2				Certification of the Chief Financial Officer under Securities Exchange Act Rules 13a-14(a) or 15d-14(a)
32.1				Certification of the Chief Executive Officer under Securities Exchange Act Rules 13a-14(b) or 15d-14(b) and 18 U.S.C. 1350
32.2				Certification of the Chief Financial Officer under Securities Exchange Act Rules 13a-14(b) or 15d-14(b) and 18 U.S.C. 1350

		DIGITAL THEATER SYSTEMS, INC.
	by:	/s/ JON E. KIRCHNER
		Jon E. Kirchner
		President and Chief Executive Officer
		(Duly Authorized Officer)
Date: May 10, 2005
	by:	/s/ MELVIN L. FLANIGAN
		Melvin L. Flanigan
		Executive Vice President, Finance and
		Chief Financial Officer
		(Principal Financial and Accounting Officer)
Date: May 10, 2005

	For the Three Months Ended March 31,
	2004			2005
	(Amounts in thousands, except share and per share amounts)
	(Unaudited)
Revenues:
Technology and film licensing	$	12,497		$	18,464
Product sales and other revenues	3,100			3,593
Total revenues	15,597			22,057
Cost of goods sold:
Technology and film licensing	980			1,282
Product sales and other revenues	1,912			3,181
Total cost of goods sold	2,892			4,463
Gross profit	12,705			17,594
Operating expenses:
Selling, general and administrative	6,440			8,044
Research and development	1,332			2,094
In-process research and development	—			2,300
Total operating expenses	7,772			12,438
Income from operations	4,933			5,156
Interest income, net	439			354
Other expense, net	(14		)	(12		)
Income before provision for income taxes	5,358			5,498
Provision for income taxes	1,918			1,942
Net income	3,440			3,556
Net income per common share:
Basic	$	0.21		$	0.21
Diluted	$	0.19		$	0.19
Weighted average shares used to compute net income per common share:
Basic	16,578,942			17,080,005
Diluted	18,219,289			18,266,094