UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

 

 

 

SRS LABS, INC.

(Exact name of registrant as specified in its charter)

 

 

 

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

 

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

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: as of October 31, 2003, 13,170,360 of the issuer’s common stock, par value $.001 per share, were outstanding. In addition, as of October 31, 2003, 225,300 shares of the issuer’s common stock were held as treasury shares.

 

 

SRS LABS, INC.

 

Form 10-Q

For the Period Ended September 30, 2003

 

Index

 

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

 

2

 

FORWARD-LOOKING INFORMATION

 

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended, reflecting management’s current expectations. Examples of such forward-looking statements include the expectations of the Company with respect to its strategy. Although the Company believes that its expectations are based upon reasonable assumptions, there can be no assurances that the Company’s financial goals will be realized. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Numerous factors may affect the Company’s actual results and may cause results to differ materially from those expressed in forward-looking statements made by or on behalf of the Company. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words, “believes,” “anticipates,” “plans,” “expects” and similar expressions, are intended to identify forward-looking statements. The important factors discussed in Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Factors That May Affect Future Results”, herein, among others, could cause actual results to differ materially from those indicated by forward-looking statements made herein and presented elsewhere by management. Such forward-looking statements represent management’s current expectations and are inherently uncertain. Investors are warned that actual results may differ from management’s expectations. The Company assumes no obligation to update the forward-looking information to reflect actual results or changes in the factors affecting such forward-looking information.

 

3

 

PART I — FINANCIAL INFORMATION

 

Item 1. Financial Statements.

 

SRS LABS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

 

		September 30, 2003			December 31, 2002
		(unaudited)
ASSETS
Current Assets
Cash and cash equivalents		$	11,290,949		$	15,720,860
Accounts receivable, net		1,155,884			1,074,421
Inventories, net		948,816			807,382
Prepaid expenses and other current assets		607,365			462,442
Deferred income taxes		36,147			36,147
Total Current Assets		14,039,161			18,101,252
Investments available for sale		10,687,813			6,630,771
Furniture, fixtures & equipment, net		1,741,506			1,935,424
Goodwill, net		1,173,102			533,031
Intangible assets, net		1,889,577			1,957,359
Deferred income taxes		172,318			149,498
Total Assets		$	29,703,477		$	29,307,335
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities
Accounts payable		$	1,164,736		$	1,011,032
Accrued liabilities		1,204,232			2,347,702
Income taxes payable		591,806			341,172
Total Current Liabilities		2,960,774			3,699,906
Minority interest		—			325,371
Commitments and contingencies
Stockholders’ Equity
Preferred stock—$.001 par value; 2,000,000 shares authorized; no shares issued or outstanding		—			—
Common stock—$.001 par value; 56,000,000 shares authorized; 13,364,198 and 12,876,314 shares issued; and 13,138,898 and 12,651,014 shares outstanding at September 30, 2003 and December 31, 2002, respectively		13,365			12,877
Additional paid in capital		57,366,350			55,966,589
Accumulated other comprehensive loss		(155,646		)	(88,564		)
Accumulated deficit		(29,762,765		)	(29,890,243		)
Treasury stock at cost, 225,300 shares at September 30, 2003 and at December 31, 2002		(718,601		)	(718,601		)
Total Stockholders’ Equity		26,742,703			25,282,058
Total Liabilities and Stockholders’ Equity		$	29,703,477		$	29,307,335

 

See accompanying notes to the condensed interim consolidated financial statements

 

4

 

SRS LABS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2003			2002			2003			2002
Revenues:
Licensing		$	1,854,707		$	2,008,554		$	6,441,297		$	5,240,117
Semiconductor		2,884,248			2,945,687			7,063,008			6,782,127
Other		147,439			457,372			378,309			973,109
Total revenues		4,886,394			5,411,613			13,882,614			12,995,353
Cost of sales		1,242,436			1,505,290			2,812,569			3,413,450
Gross margin		3,643,958			3,906,323			11,070,045			9,581,903
Operating expenses:
Sales and marketing		1,216,568			995,759			3,840,155			3,188,978
Research and development		1,032,100			992,839			3,083,438			2,895,436
General and administrative		1,143,930			1,272,031			3,668,573			3,385,737
Total operating expenses		3,392,598			3,260,629			10,592,166			9,470,151
Income from operations		251,360			645,694			477,879			111,752
Other income, net		131,925			295,332			414,655			611,882
Minority interest		—			19,178			5,430			59,208
Income before income tax expense		383,285			960,204			897,964			782,842
Income tax expense		264,459			364,430			770,486			673,245
Net income		$	118,826		$	595,774		$	127,478		$	109,597
Net income per common share:
Basic		$	0.01		$	0.05		$	0.01		$	0.01
Diluted		$	0.01		$	0.05		$	0.01		$	0.01
Weighted average shares used in the calculation of net income per common share:
Basic		13,076,315			12,623,339			12,956,971			12,659,347
Diluted		14,730,290			12,758,058			13,729,676			12,903,526

 

 See accompanying notes to the condensed interim consolidated financial statements

 

5

 

SRS LABS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND
COMPREHENSIVE INCOME (LOSS) (Unaudited)

 

		Common Stock					Additional Paid-In Capital			Accumulated Other Comprehensive (Loss)			Accumulated Deficit			Treasury Stock			Total			Comprehensive Income (Loss) for the Periods Ended
		Shares		Amount
BALANCE, Dec. 31, 2002		12,651,014		$	12,877		$	55,966,589		$	(88,564	)	$	(29,890,243	)	$	(718,601	)	$	25,282,058
Proceeds from exercise of stock options		5,000		5			13,120			—			—			—			13,125
Deferred stock option compensation		—		—			18,236			—			—			—			18,236
Issuance of Common Stock		332,184		332			959,680			—			—			—			960,012
Unrealized loss on investments available for sale, net of tax		—		—			—			(85,214		)	—			—			(85,214		)	$	(85,214	)
Net income		—		—			—			—			42,534			—			42,534			42,534
BALANCE, March 31, 2003		12,988,198		$	13,214		$	56,957,625		$	(173,778	)	$	(29,847,709	)	$	(718,601	)	$	26,230,751		$	(42,680	)
Proceeds from exercise of stock options		24,332		24			38,997			—			—			—			39,021
Deferred stock option compensation		—		—			18,236			—			—			—			18,236
Unrealized loss on investments available for sale, net of tax		—		—			—			(7,604		)	—			—			(7,604		)	(7,604		)
Net loss		—		—			—			—			(33,882		)	—			(33,882		)	(33,882		)
BALANCE, June 30, 2003		13,012,530		$	13,238		$	57,014,858		$	(181,382	)	$	(29,881,591	)	$	(718,601	)	$	26,246,522		$	(84,166	)
Proceeds from exercise of stock options		126,368		127			333,256			—			—			—			333,383
Deferred stock option compensation		—		—			18,236			—			—			—			18,236
Unrealized loss on investments available for sale, net of tax		—		—			—			25,736			—			—			25,736			25,736
Net income		—		—			—			—			118,826			—			118,826			118,826
BALANCE, Sept. 30, 2003		13,138,898		$	13,365		$	57,366,350		$	(155,646	)	$	(29,762,765	)	$	(718,601	)	$	26,742,703		$	60,396

 

See accompanying notes to the condensed interim consolidated financial statements

 

6

 

SRS LABS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

		Nine Months Ended September 30,
		2003			2002
Cash Flows From Operating Activities:
Net income		$	127,478		$	109,597
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		833,508			943,657
Minority interest		(5,430		)	(59,208		)
Provision for doubtful accounts		(21,151		)	421
Provision for obsolete inventory		(1,268		)	(20,982		)
Deferred Taxes		(22,820		)	—
Increase in deferred stock option compensation		54,708			70,260
Changes in operating assets and liabilities:
Accounts receivable		(60,313		)	135,701
Inventories		(140,166		)	319,440
Prepaid expenses and other current assets		(144,923		)	273,109
Accounts payable		153,707			33,253
Accrued liabilities		(1,143,468		)	472,253
Income taxes payable		250,634			314,161
Net cash provided by (used in) operating activities		(119,504		)	2,591,662
Cash Flows From Investing Activities:
Purchase of furniture, fixtures & equipment		(396,161		)	(565,614		)
Purchase of investments available for sale		(5,232,533		)	(7,289,978		)
Proceeds from sale of investments available for sale		1,108,407			582,556
Expenditures related to patents and intangible assets		(175,649		)	(177,051		)
Net cash used in investing activities		(4,695,936		)	(7,450,087		)
Cash Flows From Financing Activities:
Purchase of treasury stock		—			(242,203		)
Proceeds from exercise of stock options		385,529			31,181
Net cash provided by (used in) financing activities		385,529			(211,022		)
Net Decrease in Cash and Cash Equivalents		(4,429,911		)	(5,069,447		)
Cash and Cash Equivalents, Beginning of Period		15,720,860			19,011,167
Cash and Cash Equivalents, End of Period		$	11,290,949		$	13,941,720
Supplemental Disclosures of Cash Flow Information:
Cash paid during the period for:
Income taxes		$	469,928		$	359,084
Supplemental Disclosure of Non-Cash Investing and Financing Activities:
Unrealized gain (loss) on investments, net		$	(67,082	)	$	7,831
Issuance of Common stock for minority interest		$	960,012		$	—

 

See accompanying notes to the condensed interim consolidated financial statements

 

7

 

NOTES TO THE CONDENSED INTERIM CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

September 30, 2003

 

1.                                      General/Basis of Presentation

 

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

 

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

 

SRS Labs

 

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

 

Products:  The product segment develops and sells consumer products that incorporate proprietary audio and speaker technologies.

 

Valence

 

Semiconductor:  The semiconductor segment develops and sells technology solutions in the form of analog and digital signal processor (“DSP”) ASIC semiconductors or other imbedded custom semiconductor designs to OEMs around the world.

 

Component Distribution:  The component distribution segment is an authorized, non-exclusive distributor of semiconductor components, subassemblies and finished goods for selected OEM customers. The Company is no longer emphasizing this business due to its decision to focus on higher margin revenue. Although the Company expects revenues for this segment to decline further in the current year, it will continue to operate in this segment.

 

SRSWOWcast

 

Internet and Broadcast:  The Company’s Internet and broadcast segment develops and sells software and hardware audio enhancement technology solutions for the Internet and broadcast markets.

 

The accompanying condensed interim consolidated financial statements have been prepared by the Company without audit in conformity with accounting principles generally accepted in the United States of America (“generally accepted accounting principles”) for interim financial information and the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”). In the opinion of management, all adjustments (which include only normal recurring adjustments) considered necessary for a fair presentation have been included. Certain accounts have been reclassified from that previously reported to conform to the current period presentation.

 

Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to SEC rules and regulations for presentation of interim financial information. Therefore, the condensed interim consolidated financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2002. Current and future financial statements may not be directly comparable to the Company’s historical financial statements. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year.

 

2.                                      Goodwill and Intangible Assets

 

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

 

8

 

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

 

Goodwill and intangible assets consist of the following:

 

		September 30, 2003			December 31, 2002
Goodwill & assembled workforce		$	1,173,102		$	533,031
Patents		1,510,660			1,398,565
Accumulated amortization		(647,445		)	(590,365		)
Patents, net		863,215			808,200
Other intangibles		5,088,008			5,030,400
Accumulated amortization		(4,061,646		)	(3,881,241		)
Other intangibles, net		1,026,362			1,149,159
Goodwill and intangible assets, net		$	3,062,679		$	2,490,390

 

In February 2003, SRS Labs completed an exchange offer with the minority shareholders of SRSWOWcast, pursuant to which SRS Labs acquired all 3,000,000 outstanding shares of Series A Convertible Preferred Stock in exchange for the issuance of 332,184 shares of SRS Labs common stock. As a result of the exchange offer, goodwill in the amount of $640,071 was recorded.

 

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

 

		Three months ended September 30,						Nine months ended September 30,
		2003			2002			2003			2002
Patents		$	37,592		$	34,324		$	108,519		$	98,988
Other intangibles		57,477			85,831			180,405			324,159
Total intangible amortization expense		$	95,069		$	120,155		$	288,924		$	423,147

 

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

 

 

3.                                      Investments Available for Sale

 

The Company has classified its investments as available-for-sale in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” The following table summarizes the Company’s investment securities available for sale:

 

		September 30, 2003			December 31, 2002
U.S. Government securities available for sale:
Cost		$	10,762,157		$	6,638,033
Unrealized loss		(74,344		)	(7,262		)
Estimated fair value		$	10,687,813		$	6,630,771

 

9

 

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

 

		September 30, 2003						December 31, 2002
		Cost			Estimated Fair Value			Cost			Estimated Fair Value
U.S. Government securities available for sale:
Due in one to five years		$	10,762,157		$	10,687,813		$	6,638,033		$	6,630,771

 

4.                                      Inventories

 

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

 

5.                                      Minority Interest

 

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

 

6.                                      Stock-Based Compensation

 

The Company accounts for stock-based awards to employees under the recognition and measurement principles of APB No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. The Company provides additional pro forma disclosures as required under SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) and SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure — an Amendment of SFAS No. 123.” Accordingly, no stock-based employee compensation cost is reflected in net income (loss), as all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. Had compensation cost for the Company’s stock option plan been determined based on the fair value at the grant date for awards for the three months and nine months ended September 30, 2003 and 2002, consistent with the provisions of SFAS No. 123, the Company’s net income and earnings per share would have been decreased to the pro forma amounts indicated below:

 

		For the three months ended September 30,						For the nine months ended September 30,
		2003			2002			2003			2002
Net income as reported		$	118,826		$	595,774		$	127,478		$	109,597
Add: deferred compensation expense already recognized		18,236			42,854			54,708			70,260
Less fair value of stock-based employee compensation expense, net of related tax effects		(563,564		)	(392,051		)	(1,671,514		)	(1,221,683		)
Net income (loss) pro forma		$	(426,502	)	$	246,577		$	(1,489,328	)	$	(1,041,826	)
Net income per share (basic and diluted)—as reported		$	0.01		$	0.05		$	0.01		$	0.01
Net income (loss) per share (basic and diluted)—pro forma		$	(0.03	)	$	0.02		$	(0.12	)	$	(0.08	)

 

The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants during the quarter and nine months ended September 30, 2003.

 

 

10

 

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

 

7.                                      Net Income Per Common Share

 

The Company applies SFAS No. 128, “Earnings per Share,” which requires the disclosure of basic and diluted net income or loss per share for all current and prior periods. Basic net income or loss per common share is computed by dividing net income or loss available to common stockholders by the weighted average number of common shares outstanding during each year. Diluted net income or loss per common share reflects the maximum dilution, based on the average price of the Company’s common stock each period, and is computed similar to basic income or loss per share except that the denominator is increased to include the number of additional shares that would have been outstanding if potentially dilutive stock options and warrants had been exercised.

 

Basic and diluted net income per share computed in accordance with SFAS 128 for the three and nine months ended September 30, are as follows:

 

		For the three months ended September 30,						For the nine months ended September 30,
		2003			2002			2003			2002
BASIC EPS
Net income		$	118,826		$	595,774		$	127,478		$	109,597
Denominator: weighted average common shares outstanding		13,076,315			12,623,339			12,956,971			12,659,347
Net income per share—basic		$	0.01		$	0.05		$	0.01		$	0.01
DILUTED EPS
Net income		$	118,826		$	595,774		$	127,478		$	109,597
Denominator: weighted average common shares outstanding		13,076,315			12,623,339			12,956,971			12,659,347
Common equivalent shares outstanding:
Options		1,653,975			134,719			772,705			244,179
Total diluted shares		14,730,290			12,758,058			13,729,676			12,903,526
Net income per share—diluted		$	0.01		$	0.05		$	0.01		$	0.01

 

There were 1,109,881 and 4,085,067 potentially dilutive options outstanding for the quarters ending September 30, 2003 and 2002, respectively, and there were 2,113,419 and 4,050,750 potentially dilutive options outstanding for the nine months ending September 30, 2003 and 2002, respectively, that were not included in the table above because they would be anti-dilutive.

 

8.                                      Commitments and Contingencies

 

The Company is subject to legal proceedings and claims that arise in the normal course of business. While the outcome of these proceedings and claims cannot be predicted with certainty, management does not believe that the outcome of any of these matters will have a material adverse effect on the Company’s consolidated financial position or results of operations.

 

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

 

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

 

11

 

9.                                      Stockholders’ Equity

 

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

 

10.                               Segment Information

 

The Company operates its three operating units in the following five business segments: (a) SRS Labs:  (i) the licensing of technologies developed by the Company to OEMs and semiconductor manufacturers, and (ii) the sale of consumer products incorporating SRS proprietary technologies; (b) Valence: (i) the development and marketing of technology either in the form of ASICs or other imbedded custom semiconductor designs, and (ii) the component distribution business; and (c) SRSWOWcast:  the sale of hardware and software solutions to the Internet and broadcast audio markets. The Company does not allocate corporate operating expenses or specific assets to these segments. Therefore, the segment information that follows includes only net revenues, cost of sales and gross margins of the identified segments:

 

		Business Segments
		SRS Labs						Valence						SRS WOWcast
		Licensing			Products			ASIC			Components			Product and Internet Sales			Total
Three Months Ended September 30, 2003
Total revenues		$	1,854,707		$	(1,951	)	$	2,884,248		$	82,675		$	66,715		$	4,886,394
Cost of sales		11,525			(1,278		)	1,123,509			102,898			5,782			1,242,436
Gross margin		$	1,843,182		$	(673	)	$	1,760,739		$	(20,223	)	$	60,933		$	3,643,958
Three Months Ended September 30, 2002
Total revenues		$	2,008,554		$	8,510		$	2,945,687		$	433,100		$	15,762		$	5,411,613
Cost of sales		69,905			2,962			1,020,491			407,365			4,567			1,505,290
Gross margin		$	1,938,649		$	5,548		$	1,925,196		$	25,735		$	11,195		$	3,906,323

 

		Business Segments
		SRS Labs						Valence						SRSWOWcast
		Licensing			Products			ASIC			Components			Product and Internet Sales			Total
Nine Months Ended September 30, 2003
Total revenues		$	6,441,297		$	3,696		$	7,063,008		$	181,315		$	193,298		$	13,882,614
Cost of sales		35,410			2,574			2,501,599			248,838			24,148			2,812,569
Gross margin		$	6,405,887		$	1,122		$	4,561,409		$	(67,523	)	$	169,150		$	11,070,045
Nine Months Ended September 30, 2002
Total revenues		$	5,240,117		$	53,979		$	6,782,127		$	875,297		$	43,833		$	12,995,353
Cost of sales		113,068			45,719			2,379,501			863,806			11,356			3,413,450
Gross margin		$	5,127,049		$	8,260		$	4,402,626		$	11,491		$	32,477		$	9,581,903

 

The following schedule presents the Company’s revenue by geographic area. For product sales, revenue is allocated based on the country to which the product was shipped. For licensing-related revenue, the allocation is based on the location of the licensee’s corporate headquarters. The Americas region includes North, Central and South America.

 

12

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2003			2002			2003			2002
Geographic Area Revenue:
Asia Pacific		$	4,405,427		$	5,313,454		$	12,654,677		$	12,102,767
Americas		179,521			66,572			736,567			545,162
Europe		301,446			31,587			491,370			347,424
Total		$	4,886,394		$	5,411,613		$	13,882,614		$	12,995,353

 

11.                               Recent Accounting Pronouncements

 

In July 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which addressed financial accounting and reporting for costs associated with exit or disposal activities and supercedes Emerging Issues Task Force (EITF) Issue 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring).” SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized at the date of an entity’s commitment to an exit plan. SFAS 146 also establishes that the liability should initially be measured and recorded at fair value. The Company has adopted the provisions of SFAS 146 for exit or disposal activities effective January 1, 2003. The adoption of SFAS No. 146 did not have a material impact on the Company’s consolidated results of operations, financial position or cash flows.

 

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure—an Amendment to SFAS No. 123.” SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method on accounting for stock-based employee compensation. SFAS 148 also requires that disclosures of the pro forma effect of using the fair value method of accounting for stock-based employee compensation be displayed more prominently and in a tabular format. Additionally, SFAS 148 requires disclosures of the pro forma effect in interim financial statements. The Company has not currently adopted SFAS No. 123 and accordingly the implementation of SFAS No. 148 has not had a material effect on the Company’s consolidated financial position or results of operations. The Company has adopted the disclosure provision of SFAS 148.

 

In November 2002, the FASB issued interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees. Including indirect Guarantees of Indebtedness of Others,” which disclosures are effective for financial statements for periods ending after December 15, 2002. While the Company has various guarantees included in contracts in the normal course of business, primarily in the form of indemnities, these guarantees would only result in immaterial increases in future costs, but do not represent significant commitments or contingent liabilities of the indebtedness of others.

 

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

 

In April 2003, the FSAB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.”  This statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.”  This statement is effective for contracts entered into or modified after June 30, 2003.  Adoption of this statement is not expected to have a significant effect on the Company’s financial position or results of operations.

 

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” This statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity.  This statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective for the first interim period beginning after June 15, 2003.  The adoption of SFAS No. 150 is not expected to have a significant effect on the Company’s financial position, results of operations, or cash flows.

 

13

 

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

 

This information should be read in conjunction with the audited consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002 (the “Form 10-K”), the audited consolidated financial statements and the notes thereto included in the Form 10-K and the unaudited condensed interim consolidated financial statements and notes thereto included in this Quarterly Report.

 

Overview

 

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

 

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

 

SRS Labs

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

 

Products:  The product segment develops and sells consumer products that incorporate proprietary audio and speaker technologies.

 

Valence

Semiconductor:  The semiconductor segment develops and sells technology solutions in the form of analog and digital signal processor (“DSP”) ASIC semiconductors or other imbedded custom semiconductor designs to OEMs around the world.

 

Component Distribution:  The component distribution segment is an authorized, non-exclusive distributor of semiconductor components, subassemblies and finished goods for selected OEM customers. The Company is no longer emphasizing this business due to its decision to focus on higher margin revenue. Although the Company expects revenues for this segment to decline further in the current year, it will continue to operate in this segment.

 

SRSWOWcast

Internet and Broadcast:  The Company’s Internet and broadcast segment develops and sells software and hardware audio enhancement technology solutions for the Internet and broadcast markets.

 

Critical Accounting Policies

 

The Company has prepared the accompanying condensed interim consolidated financial statements without audit in conformity with accounting principles generally accepted in the United States for interim financial information.

 

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

 

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

 

14

 

Allowance for Doubtful Accounts

 

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We evaluate the ability to collect upon our accounts receivable based on specific customer circumstances, current economic trends, historical experience and the age of past due receivables. Unanticipated changes in the liquidity or financial position of our customers may require additional provisions for doubtful accounts.

 

Inventory Obsolescence Reserves

 

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

 

Valuation of Intangible Assets

 

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

 

Income Taxes

 

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

 

Results of Operations

 

Three Months Ended September 30, 2003 Compared to Three Months Ended September 30, 2002

 

Revenues

 

Semiconductor revenues consists of (a) design fees relating to, and sales of, ASICs for third parties by Valence to OEMs; and (b) sales of general purpose integrated circuits (“ICs”) designed by Valence under the brand name ASP. Licensing revenues are royalties generated primarily from the license of SRS Labs’ audio and voice technologies. License and royalty agreements generally provide for the license of technologies for a specified period of time for either a single fee or a fee based on the number of units distributed by the licensee. Component distribution revenue consists of the distribution of semiconductor products, manufacturing components and sub-assemblies to OEMs for the Hong Kong and People’s Republic of China (“PRC”) markets. Product sales represent sales of consumer products incorporating one or more of SRS Labs’ proprietary technologies. Internet and broadcast revenues consist of the sale of hardware and software applications involving the Internet and broadcast audio markets.

 

Total revenues for the three months ended September 30, 2003 were $4,886,394 compared to $5,411,613 for the three months ended September 30, 2002, a decrease of $525,219 or 9.7%. Licensing revenues were $1,854,707 for the three months ended September 30, 2003 compared to $2,008,554 for the three months ended September 30, 2002, a decrease of $153,847 or 7.7%.  The company attributes this decrease to reduction of revenue received from a customer who accounted for a significant portion of the company’s revenue from the DVD player segment of the home theater market.  A majority of the decrease was offset by revenues related to new product categories such as portable audio devices and our increased penetration of SRS Labs technologies within the home theater market.  In addition, the lingering effects of the outbreak and spread of Severe Acute Respiratory Syndrome (“SARS”) condition, continued to adversely affect the company’s licensing business, which is reported one quarter in arrears.

 

15

 

Semiconductor revenues were $2,884,248 for the three months ended September 30, 2003 compared to $2,945,687 for the three months ended September 30, 2002, a decrease of $61,439 or 2.1%. Revenue was slightly down from previous year’s comparable quarter, due to lingering negative effects from SARS, as business travel and sales calls returned to a more normal level during the quarter.

 

Other revenues were $147,439 for the three months ended September 30, 2003 compared to $457,372 for the three months ended September 30, 2002, a decrease of $309,933 or 67.8%.  Other revenues are comprised of the following components for the quarters ended September 30, 2003 and 2002, respectively:  component distribution — 56% and 95%; product revenues — (1)% and 2%; internet and broadcast business — 45% and 3%.  Component distribution revenues were $82,675 for the three months ended September 30, 2003 compared to $433,100 for the three months ended September 30, 2002, a decrease of $350,425 or 80.9%. This decrease was due to the Company’s decision to focus on higher margin semiconductor and licensing revenues and de-emphasize certain lower margin distribution activities. Product revenues were $(1,951) for the three months ended September 30, 2003 compared to $8,510 for the comparable period in 2002, a decrease of $10,461 or 122.9%. This decrease was due to the decrease of on-line merchandising and returns.  Revenues generated by the Company’s Internet and broadcast based business were $66,715 for the three months ended September 30, 2003 compared to $15,762 for the three months ended September 30, 2002, an increase of $50,953 or 323.3%.  This increase was attributable to the sales of professional hardware equipment to the broadcast market.

 

Gross Margin

 

Cost of sales consists primarily of fabrication costs, assembly and test costs, and the cost of materials and overhead from operations. The gross margin percentage for the three months ended September 30, 2003 increased to 74.6% as a percentage of total revenue as compared to 72.2% for the three months ended September 30, 2002. The increase is attributable to continued efforts by the Company to focus the revenue base towards higher margin semiconductor and licensing revenues and away from lower margin component distribution. Gross margins for the licensing business for the quarters ended September 30, 2003 and 2002 were 99% and 97% respectively. Licensing revenues accounted for 38% of total revenues as compared to 37% for the three months ended September 30, 2003 and 2002, respectively. Gross margins for the semiconductor business for the quarters ended September 30, 2003 and 2002 were 61% and 65%, respectively. This decrease in gross margin can be attributed to competitive pricing in the ASIC business. Semiconductor revenues accounted for 59% of total revenues as compared to 54% for the three months ended September 30, 2003 and 2002, respectively. Gross margins for other revenues for the quarters ended September 30, 2003 and 2002 were 27% and 9%, respectively.  Other revenues accounted for 3% of total revenues as compared to 9% for the three months ended September 30, 2003 and 2002, respectively. Gross margins may fluctuate in future quarters depending on the mix of products sold and services provided, royalties earned, competitive pricing, new product introduction costs and other factors.

 

Sales and Marketing

 

Sales and marketing expenses consist primarily of employee salaries, sales consultants’ fees and related expenses, sales commissions and product promotion costs. Sales and marketing expenses were $1,216,568 for the three months ended September 30, 2003 compared to $995,759 for the same prior year period, an increase of $220,809 or 22.2%. The net increase in sales and marketing expenses for the three months ended September 30, 2003 is primarily attributable to increased investments in branding and promotion of our technologies in new markets designed to increase future revenues. As a percentage of total revenues, sales and marketing expenses increased from 18.4% for the quarter ended September 30, 2002, to 24.9% for the same period in 2003.

 

Research and Development

 

Research and development expenses consist of salaries and related costs of employees engaged in ongoing research, design and development activities and costs for engineering materials and supplies. Research and development expenses were $1,032,100 for the three months ended September 30, 2003 compared to $992,839 for the same prior year period, an increase of $39,261, or 4.0%. The increase in research and development costs is primarily due to the addition of research and development personnel.  As a percentage of total revenues, research and development expenses increased from 18.3% for the quarter ended September 30, 2002, to 21.1% for the same period in 2003.

 

General and Administrative

 

General and administrative (“G&A”) expenses consist primarily of employee-related expenses, legal costs associated with the administration of intellectual property and other professional fees. G&A expenses were $1,143,930 for the three months ended September 30, 2003 compared to $1,272,031 for the same prior year period, a decrease of $128,101 or 10.1%. The decrease was primarily attributable to decreased professional fees.  As a percentage of total revenues, G&A expenses decreased from 23.5% for the quarter ended September 30, 2002, to 23.4% for the same period in 2003.

 

16

 

Income (Loss) From Operations

 

Income from operations decreased by $394,334 to $251,360 for the quarter ended September 30, 2003 as compared to income from operations of $645,694 for the quarter ended September 30, 2002.  The decrease in income from operations is due to a decrease in revenue and increase in operating expenses.

 

Other Income, Net

 

Other income, net, consists primarily of interest income, gain or (loss) on sale of securities and foreign currency transaction gains and losses. Other income, net, was $131,925 for the three months ended September 30, 2003 compared to $295,332 for the same prior year period, a decrease of $163,407 or 55.3%. Other income net was substantially higher in the three months ended September 30, 2002 due to a recognized gain on the sale of investments in the amount of $130,000 and higher interest income earned on investment balances.

 

Minority Interest

 

Minority interest represents the minority shareholders’ proportionate share of losses in SRSWOWcast. Minority interest was $0 for the three months ended September 30, 2003 compared to $19,178 for the three months ended September 30, 2002. In February 2003, SRS Labs completed an exchange offer with the minority shareholders of SRSWOWcast, pursuant to which SRS Labs acquired all of the outstanding shares of Series A Convertible Preferred Stock in exchange for the issuance of shares of SRS Labs common stock. As a result of the exchange offer, SRSWOWcast became a wholly-owned subsidiary of SRS Labs.

 

Provision for Income Taxes

 

The income tax expense for the three months ended September 30, 2003 was $264,459 compared to tax expense of $364,430 for the same prior year period, a decrease of $99,971 or 27.4%. The decrease results from the decrease in pre-tax income of $576,919.

 

Nine Months Ended September 30, 2003 Compared to Nine Months Ended September 30, 2002

 

Revenues

 

Total revenues for the nine months ended September 30, 2003 were $13,882,614 compared to $12,995,353 for the nine months ended September 30, 2002, an increase of $887,261 or 6.8%. Licensing revenues were $6,441,297 for the nine months ended September 30, 2003 compared to $5,240,117 for the nine months ended September 30, 2002, an increase of $1,201,180 or 22.9%. This increase was attributable to revenues generated from new product categories such as portable audio devices, and expanding our penetration of SRS Labs technologies within our key home theater market. These revenues from new product categories and our increased penetration of the home theater market reflect upon the Company’s strategy to diversify its customer base. The increase in licensing revenue provided much higher gross margins which resulted in higher operating income for the nine months ended September 30, 2003 as compared to the same period in 2002.

 

Semiconductor revenues were $7,063,008 for the nine months ended September 30, 2003 compared to $6,782,127 for the nine months ended September 30, 2002, an increase of $280,881 or 4.1%. This increase was attributable to expansion of Valence’s customer base, increased design wins and new chip offerings.

 

Other revenues were $378,309 for the nine months ended September 30, 2003 compared to $973,109 for the nine months ended September 30, 2002, a decrease of $594,800 or 61.1%.  Other revenues are comprised of the following components for the nine month periods ended September 30, 2003 and 2002, respectively:  component distribution — 48% and 90%; product revenues — 1% and 6% ; Internet and broadcast business — 51% and 5%.  Component distribution revenues were $181,315 for the nine months ended September 30, 2003 compared to $875,297 for the nine months ended September 30, 2002, a decrease of $693,982 or 79.3%. This decrease was due to the Company’s decision to focus on higher margin ASIC and licensing revenues and de-emphasize certain lower margin distribution activities. Product revenues were $3,696 for the nine months ended September 30, 2003 compared to $53,979 for the comparable period in 2002, a decrease of $50,283 or 93.2 %. This decrease was due to the decrease of the on-line merchandising of SRS products.  Revenues generated by the Company’s Internet and broadcast based business were $193,298 for the nine months ended September 30, 2003 compared to $43,833 for the nine months ended September 30, 2002, an increase of $149,465 or 341%.  This increase was attributable to the sales of professional hardware equipment to the broadcast market.

 

17

 

Gross Margin

 

Cost of sales consists primarily of fabrication costs, assembly and test costs, and the cost of materials and overhead from operations. The gross margin percentage for the nine months ended September 30, 2003 increased to 80% as a percentage of total revenue as compared to 74% for the nine months ended September 30, 2002. Gross margins for the licensing business for the nine months ended September 30, 2003 and 2002 were 100% and 98%, respectively. Licensing revenues accounted for 46% of total revenues as compared to 40% for the nine months ended September 30, 2003 and 2002, respectively. Gross margins for the semiconductor business for the periods ended September 30, 2003 and 2002 were 65% and 65%, respectively.  Semiconductor revenues accounted for 51% of total revenues as compared to 52% for the nine months ended September 30, 2003 and 2002, respectively. Gross margins for other revenues for the nine months ended September 30, 2003 and 2002 were 27% and 0%, respectively. Other revenues accounted for 3% of total revenues as compared to 7% for the nine months ended September 30, 2003 and 2002, respectively. The increase is attributable to continued efforts by the Company to focus the revenue base towards higher margin semiconductor and licensing revenues and away from lower margin component distribution. Gross margins may fluctuate in future quarters depending on the mix of products sold and services provided, royalties earned, competitive pricing, new product introduction costs and other factors.

 

Sales and Marketing

 

Sales and marketing expenses consist primarily of employee salaries, sales consultants’ fees and related expenses, sales commissions and product promotion costs. Sales and marketing expenses were $3,840,155 for the nine months ended September 30, 2003 compared to $3,188,978 for the same prior year period, an increase of $651,177 or 20.4%. The net increase in sales and marketing expenses for the nine months ended September 30, 2003 is primarily attributable to investments in branding and promotion of our technologies in new markets designed to increase future revenues. As a percentage of total revenues, sales and marketing expenses increased from 24.5% for the nine months ended September 30, 2002, to 27.7% for the same period in 2003.

 

Research and Development

 

Research and development expenses consist of salaries and related costs of employees engaged in ongoing research, design and development activities and costs for engineering materials and supplies. Research and development expenses were $3,083,438 for the nine months ended September 30, 2003 compared to $2,895,436 for the same prior year period, an increase of $188,002, or 6.5%. The increase in research and development costs is primarily due to the addition of research and development personnel and increased costs associated with the increased semiconductor business activity.  As a percentage of total revenues, research and development expenses decreased from 22.3% for the nine months ended September 30, 2002, to 22.2% for the same period in 2003.

 

General and Administrative

 

G&A expenses consist primarily of employee-related expenses, legal costs associated with the administration of intellectual property and other professional fees. G&A expenses were $3,668,573 for the nine months ended September 30, 2003 compared to $3,385,737 for the same prior year period, an increase of $282,836 or 8.4%. The increase was primarily attributable to additions to infrastructure and personnel for management of our foreign operations, increased professional fees and public company expenses. As a percentage of total revenues, G&A expenses increased from 26.1% for the nine months ended September 30, 2002, to 26.4% for the same period in 2003.

 

Income From Operations

 

Income from operations increased by $366,127 to $477,879 for the nine months ended September 30, 2003, as compared to income from operations of $111,752 for the same period ended September 30, 2002.  The increase in income from operations is due to an increase in gross profit, partially offset by an increase in operating expenses.

 

Other Income, Net

 

Other income, net, consists primarily of interest income, gain or loss on sale of securities and foreign currency transaction gains and losses. Other income, net, was $414,655 for the nine months ended September 30, 2003 compared to $611,882 for the same prior year period, a decrease of $197,227 or 32.2%. Other income, net was higher for the nine months ended September 30, 2002 due to realized gains on sales of investments and higher interest income earned on investment balances.

 

Minority Interest

 

Minority interest represents the minority shareholders’ proportionate share of losses in SRSWOWcast. Minority interest was $5,430 for the nine months ended September 30, 2003 compared to $59,208 for the nine months ended September 30, 2002, a decrease of $53,778 or 90.8%. In February 2003, SRS Labs completed an exchange offer with the minority shareholders of SRSWOWcast, pursuant to which SRS Labs acquired all of the outstanding shares of Series A Convertible Preferred Stock in exchange for the issuance of shares of SRS Labs common stock. As a result of the exchange offer, SRSWOWcast became a wholly-owned subsidiary of SRS Labs.

 

18

 

Provision for Income Taxes

 

The income tax expense for the nine months ended September 30, 2003 was $770,486 compared to tax expense of $673,245 for the same prior year period, an increase of $97,241 or 14.4%. The increase results from the increase in the Hong Kong tax rate from 16.5% to 17.5%, effective January 1, 2003, the higher levels of foreign tax on higher licensing revenues sourced from countries requiring foreign tax withholdings, and higher pretax income of $897,964.

 

Liquidity and Capital Resources

 

The Company’s principal source of liquidity to fund ongoing operations at September 30, 2003 consisted of cash, cash equivalents and long-term investments aggregating $21,978,762. At September 30, 2003, the Company had cash and cash equivalents of $11,290,949 and long-term investments of $10,687,813. Cash and cash equivalents generally consist of cash, money market funds and other money market instruments with original maturities of three months or less. Investments consist of U.S. government securities rated AAA.

 

Cash used by operating activities for the nine months ended September 30, 2003 was $119,504.  Net cash used by operations resulted from a net increase in accounts receivable, inventory and prepaid expenses and other current assets and a decrease in accrued liabilities associated with commissions, bonus, product promotion costs as well as professional fees.  These decreases were partially offset by increases in accounts payable and income taxes payable, as well as certain adjustments to reconcile net income to cash used in operating activities including depreciation and amortization.  Net cash used by investing activities for the nine months ended September 30, 2003 was $4,695,936, resulting primarily from the purchase of U.S. government securities and purchases of furniture, fixtures and equipment and expenditures related to intangible assets. Net cash provided by financing activities for the nine months ended September 30, 2003 was $385,529, reflecting the proceeds from sale of common stock pursuant to exercise of employee stock options.

 

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

 

Factors That May Affect Future Results

 

Our quarterly results may fluctuate

 

Our operating results may fluctuate from those in prior quarters and will continue to be subject to quarterly and other fluctuations due to a variety of factors, including the extent to which our licensees incorporate our technologies into their products; the timing of orders from, and the shipments to, major customers; the timing of new product introductions; the gain or loss of significant customers; competitive pressures on selling prices; the market acceptance of new or enhanced versions of our technologies; the rate that our semiconductor licensees manufacture and distribute chips to product manufacturers; and fluctuations in general economic conditions, particularly those affecting the consumer electronics market. Due to our dependence on the consumer electronics market, the substantial seasonality of sales in the market could impact our revenues and net income. In particular, we believe that there is seasonality relating to the Christmas season generally and the Chinese New Year within the Asia region, which fall into the fourth and first quarters respectively. As a result, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied on as indications of future performance.

 

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

 

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

 

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Business revenue from ASICs is concentrated in a limited number of customers in the areas of consumer electronics, communications products, computers and computer peripherals. The business generated from any one customer may be for a fixed length or quantity. As such, it is customary in our ASIC business to have a certain amount of customer turnover as new ASIC projects are obtained for different customers. However, it is possible that the loss of any particular customer or any bad debt arising from such customer may have a material adverse impact on our financial condition and results of operation.

 

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

 

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

 

We have significant operations in Hong Kong, the PRC and other parts of Asia that require refinement to adapt to the changing market conditions in that region. Our customers geographically located in the Asia Pacific markets accounted for approximately 90% and 98% of total Company sales in the quarters ended September 30, 2003 and 2002, respectively; and 91% and 93% of total Company sales in the nine months ended September 30, 2003 and 2002, respectively; and are expected to continue to account for a substantial percentage of sales in the future. Because we rely on sales to customers in Asia for a substantial portion of our revenue, our business is very likely to be adversely impacted by economic downturns and instability in that region. In addition, international sales are subject to risks, including, but not limited to:

 

•                                          fluctuations in foreign exchange rates;

•                                          changes in legal and regulatory requirements;

•                                          political and economic instability and acts of terrorism;

•                                          any public health crisis such as SARS;

•                                          difficulties in staffing and managing international operations;

•                                          foreign trade disputes; and

•                                          potentially adverse tax consequences.

 

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

 

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

 

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

 

Hong Kong, and other regions of Asia, have been particularly affected by the outbreak and spread of SARS which, in turn, has impacted the economic landscape of these regions and companies that conduct business in the same regions.  While it is difficult to conclusively quantify the impact of SARS on our business, based on discussions we have had with our customers we believe and it appears that the growth of our licensing revenue and expansion of our semiconductor business have been negatively impacted.  Although employees of our Hong Kong operations were subject to temporary travel restrictions in the second quarter of 2003 that are now lifted, it is impossible to predict the precise economic impact of SARS and whether such impact will have a continuing or significant long-term effect on the Company.  Accordingly, the Company remains potentially at risk from the effects of SARS, or similar health emergencies, which restrict travel and may otherwise negatively impact the ability to routinely conduct and expand business in those areas affected by SARS.

 

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We are exposed to risks in our licensing business related to product and customer concentration

 

Currently, our licensing revenue is concentrated in the home theater market with the majority of revenue generated from the inclusion of SRS technology inside televisions, DVD players and set-top boxes. We expect that the consumer home entertainment market will continue to account for a significant portion of our licensing revenues for the foreseeable future. While consumer spending in general on consumer electronic products has increased, retail prices for certain consumer electronics products that include our audio technology, such as DVD players have decreased significantly and indications are that this trend will continue for the foreseeable future. In addition, from time to time, certain of our original equipment manufacturer and semiconductor manufacturer customers may account for a significant portion of revenue from a particular product application, such as DVD players, set-top boxes or televisions.  Consumer electronics products manufacturers could decide to exclude our audio enhancement technology from their home theater products altogether in an effort to reduce cost.  The loss of any such customer could have a material adverse affect on the company’s financial condition and results of operations.

 

Declining prices of consumer electronic products could put pressure on our licensing fees that are charged to the manufacturers.  Also, given the current economic environment, consumer spending on DVD players and other home electronic products may not increase as expected.  Such declines in consumer spending, should they occur, and continued decreases in consumer product pricing for electronic goods may have a significant negative impact on our financial results. The company's strategy is to diversify its customer base in an effort to decrease the impact from the loss of a particular customer, product segment or change in market trend.

 

We are exposed to certain risks in producing professional and consumer products

 

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

 

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

 

Our results of operations may be adversely affected by a slowdown in the global economy

 

Over the past year, the global economy experienced a slowdown due to many factors, including decreased consumer confidence, unemployment, the ongoing threat and cost of terrorism and reduced corporate profits and capital spending. Recent political events, including the U.S. military action in the Middle East, have put further pressure on economic conditions. The potential turmoil that may result from such events contribute to the uncertainty of the economic climate, further reducing predictability and our ability to develop and implement long-term strategic plans. Although the U.S. and other major economies have recently showed signs of growth, the future remains uncertain and the impact of political, military, terrorism and similar events may have a material adverse impact on our operating results and financial position.

 

We are subject to competitive pressures

 

Our existing and potential competitors include both large and emerging domestic and international companies that have substantially greater financial, manufacturing, technical, marketing, distribution and other resources. Present or future competitors may be able to develop products and technologies comparable or superior to ours, and to adapt more quickly than us to new technologies or evolving market needs. We believe that the competitive factors affecting the market for our products and technologies include product performance, price and quality; product functionality and features; the ease of integration; and implementation of the products and technologies with other hardware and software components in the OEM’s products. In addition, the markets in which we compete are intensely competitive and are characterized by rapid technological changes, declining average sales prices and rapid product obsolescence. Accordingly, there can be no assurance that we will be able to continue to compete effectively in all of our existing markets, that competition will not intensify or that future competition will not have a material adverse effect on our business, operating results, cash flows and financial condition.

 

We strongly rely on our intellectual property

 

Our ability to compete may be affected by our ability to protect our proprietary information. We have filed numerous U.S. and foreign patent applications and, to date, have a number of issued U.S. and foreign patents covering various aspects of our technologies.  There can be no assurance that the steps taken by SRS Labs to protect our intellectual property will be adequate to prevent misappropriation of our technology or that our competitors will not independently develop technologies that are substantially equivalent or superior to our technology. In addition, the laws of certain foreign countries may not protect our intellectual property rights to the same extent, as do the laws of the U.S. The semiconductor industry is characterized by frequent claims and litigation regarding patent and other property rights. We are not currently a party to any claims of this nature. There can be no assurances that third parties will not assert claims or initiate litigation against the Company or our customers with respect to existing or future products. In addition, we may initiate claims or litigation against third parties for infringement of our proprietary rights or to determine the scope and validity of our proprietary rights.

 

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We depend on our executive officers and other key personnel

 

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

 

The market price of our common stock is volatile

 

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

 

Item 3.  Quantitative and Qualitative Disclosures about Market Risk

 

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

 

Item 4.  Controls and Procedures

 

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

 

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PART II—OTHER INFORMATION

 

Item 6.  Exhibits and Reports on Form 8-K.

 

(a)                                  Exhibits.

 

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

 

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

 

(b)                                 Reports on Form 8-K.

 

On August 12, 2003, SRS Labs, Inc. (the “Company”) issued a press release announcing its operating results for the three and six months ended June 30, 2003.

 

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SIGNATURES

 

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

 

	SRS LABS, INC., a Delaware corporation
Date: November 14, 2003	By:	/s/ THOMAS C.K. YUEN
		Thomas C.K. Yuen
		Chairman of the Board and Chief Executive Officer
		(Principal Executive Officer)
Date: November 14, 2003	By:	/s/ JANET M. BISKI
		Janet M. Biski
		Chief Financial Officer
		(Principal Financial and Accounting Officer)

 

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