UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

 

(Mark One)
ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2005
OR
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from           to
Commission File Number 0-21123

 

SRS LABS, INC.

(Exact name of registrant as specified in its charter)

 

Delaware		33-0714264
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

 

2909 Daimler Street, Santa Ana, California 92705

(Address of principal executive offices) (Zip Code)

 

(949) 442-1070

(Registrant’s telephone number, including area code)

 

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

 

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 April 29, 2005, 14,740,665 of the issuer’s common stock, par value $.001 per share, were outstanding.  In addition, as of April 29, 2005, 592,186 shares of the issuer’s common stock were held as treasury shares.

 

 

SRS LABS, INC.

 

Form 10-Q

For the Period Ended March 31, 2005

 

Index

 

PART I-FINANCIAL INFORMATION
Item 1.	Financial Statements
	Condensed Consolidated Balance Sheets as of March 31, 2005 (Unaudited) and December 31, 2004
	Condensed Consolidated Statements of Operations for the three months ended March 31, 2005 and 2004 (Unaudited)
	Condensed Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the three months ended March 31, 2005 (Unaudited)
	Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2005 and 2004 (Unaudited)
	Notes to the Condensed 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
SIGNATURES

 

2

 

FORWARD-LOOKING INFORMATION

 

This Quarterly Report on Form 10-Q contains forward-looking statements 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

 

		March 31, 2005			December 31, 2004
		(unaudited)
ASSETS
Current Assets
Cash and cash equivalents		$	7,000,241		$	7,011,912
Accounts receivable, net		1,969,922			1,318,665
Inventories, net		548,822			571,280
Prepaid expenses and other current assets		1,383,139			1,337,506
Deferred income taxes		23,406			23,406
Total Current Assets		10,925,530			10,262,769
Investments available for sale		17,001,807			17,261,267
Investment in LLC		2,674,247			2,596,090
Furniture, fixtures and equipment, net		1,835,350			1,995,579
Intangible assets, net		2,653,316			2,660,955
Goodwill		533,031			533,031
Deferred income taxes		209,596			192,750
Total Assets		$	35,832,877		$	35,502,441
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities
Accounts payable		$	1,122,289		$	984,805
Accrued liabilities		1,798,777			1,640,714
Deferred revenue		437,309			436,910
Income taxes payable		—			8,628
Total Current Liabilities		3,358,375			3,071,057
Commitments and contingencies (Note 8)
Stockholders’ Equity
Preferred stock—$.001 par value; 2,000,000 shares authorized; no shares issued or outstanding		—			—
Common stock—$.001 par value; 56,000,000 shares authorized;14,689,028 and 14,671,416 shares issued; and 14,247,153 and 14,229,541 shares outstanding at March 31, 2005 and December 31, 2004, respectively		14,690			14,672
Additional paid-in capital		62,604,392			62,523,292
Accumulated other comprehensive loss		(569,182		)	(309,722		)
Accumulated deficit		(27,631,543		)	(27,853,003		)
Treasury stock at cost, 441,875 shares at March 31, 2005 and December 31, 2004		(1,943,855		)	(1,943,855		)
Total Stockholders’ Equity		32,474,502			32,431,384
Total Liabilities and Stockholders’ Equity		$	35,832,877		$	35,502,441

 

See accompanying notes to the condensed consolidated financial statements

 

4

 

SRS LABS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

		Three Months Ended March 31,
		2005			2004
					(Restated)
Revenues:
Semiconductor		$	1,984,563		$	2,415,718
Licensing		3,264,095			2,927,327
Total revenues		5,248,658			5,343,045
Cost of sales:
Semiconductor		728,240			882,734
Licensing		56,345			26,137
Total cost of sales		784,585			908,871
Gross margin		4,464,073			4,434,174
Operating expenses:
Sales and marketing		1,692,378			1,695,368
Research and development		1,182,069			1,208,687
General and administrative		1,469,228			1,554,197
Total operating expenses		4,343,675			4,458,252
Income (loss) from operations		120,398			(24,078		)
Equity in income of investee		77,332			—
Other income, net		147,932			237,450
Income before income tax expense		345,662			213,372
Income tax expense		124,202			237,903
Net income (loss)		$	221,460		$	(24,531	)
Net income per common share:
Basic		$	0.02		$	0.00
Diluted		$	0.01		$	0.00
Weighted average shares used in the calculation of net income per common share:
Basic		14,241,522			13,746,521
Diluted		15,255,107			16,679,373

 

 See accompanying notes to the condensed consolidated financial statements

 

5

 

SRS LABS, INC.

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

 

		Common Stock					Additional Paid-In			Accumulated Other Comprehensive			Accumulated			Treasury						Comprehensive Income (Loss) for the Period
		Shares		Amount			Capital			Loss			Deficit			Stock			Total			Ended
BALANCE, Dec. 31, 2004		14,229,541		$	14,672		$	62,523,292		$	(309,722	)	$	(27,853,003	)	$	(1,943,855	)	$	32,431,384
Proceeds from exercise of stock options		17,612		18			66,269			—			—			—			66,287
Deferred stock option compensation		—		—			14,831			—			—			—			14,831
Unrealized loss on investments available for sale, net of tax		—		—			—			(259,460		)	—			—			(259,460		)	(259,460		)
Net income		—		—			—			—			221,460			—			221,460			221,460
BALANCE, March 31, 2005		14,247,153		$	14,690		$	62,604,392		$	(569,182	)	$	(27,631,543	)	$	(1,943,855	)	$	32,474,502		$	(38,000	)

 

See accompanying notes to the condensed consolidated financial statements

 

6

 

SRS LABS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

		Three Months Ended March 31,
		2005			2004
					(Restated)
Cash Flows From Operating Activities:
Net income (loss)		$	221,460		$	(24,531	)
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		346,537			310,867
Provision for doubtful accounts		7,821			69,603
Provision for obsolete inventory		2,714			40,408
Deferred taxes		(16,846		)	(16,539		)
(Accretion) amortization of (discount) premium on investments available for sale		(508		)	3,095
Net realized gain on sale of investments available for sale		—			(139,375		)
Increase in deferred stock option compensation		14,831			13,600
Loss on disposition of furniture, fixtures and equipment		2,267			31
Impairment on intangible assets		—			3,431
Investment in LLC		(78,157		)	—
Changes in operating assets and liabilities:
Accounts receivable		(659,078		)	376,860
Inventories		19,744			(1,686		)
Prepaid expenses and other current assets		(45,125		)	52,716
Accounts payable		137,484			(557,042		)
Accrued liabilities		158,063			211,971
Deferred revenue		399			(765		)
Income taxes payable		(8,628		)	107,051
Net cash provided by operating activities		102,978			449,695
Cash Flows From Investing Activities:
Purchase of furniture, fixtures and equipment		(37,440		)	(273,889		)
Proceeds from sale of investments available for sale		—			5,375,000
Expenditures related to patents and intangible assets		(143,496		)	(103,790		)
Net cash provided by (used in) investing activities		(180,936		)	4,997,321
Cash Flows From Financing Activities:
Proceeds from exercise of stock options		66,287			2,150,319
Net cash provided by financing activities		66,287			2,150,319
Net Increase (Decrease) in Cash and Cash Equivalents		(11,671		)	7,597,335
Cash and Cash Equivalents, Beginning of Period		7,011,912			12,795,620
Cash and Cash Equivalents, End of Period		$	7,000,241		$	20,392,955
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Income taxes		$	247,559		$	211,961
Supplemental Disclosure of Non-Cash Investing Activities:
Unrealized gain (loss) on investments, net		$	(259,460	)	$	87,938

 

See accompanying notes to the condensed consolidated financial statements

 

7

 

SRS LABS, INC.

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

1.                                      Basis of Presentation and Summary of Significant Accounting Policies and Estimates

 

As used herein, the “Company,” “SRS Labs,” “we,” “us,” or “our” means SRS Labs, Inc. and its wholly-owned subsidiaries, Valence Tech Limited (including its wholly-owned subsidiaries) and SRSWOWcast.com, Inc. (“SRSWOWcast”).  The accompanying unaudited condensed consolidated financial statements have been prepared by the Company 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”) for interim reporting. In the opinion of management, all adjustments (which include only normal recurring adjustments) considered necessary for a fair presentation of our financial position and results of operations have been included. Certain amounts included in the accompanying prior periods’ consolidated financial statements have been reclassified to conform to the current period presentation.

 

The condensed consolidated financial statements include the accounts of SRS Labs, Inc. and its subsidiaries. All inter-company accounts and transactions have been eliminated.

 

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, 2004. Current and future financial statements may not be directly comparable to the Company’s historical financial statements. The results of operations for the interim period is not necessarily indicative of the results to be expected for any other interim period or for the full year.

 

Estimates

 

The preparation of financial statements in accordance with generally accepted accounting principles requires management to make use of certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported periods. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ materially from those estimates. See the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2004 for an additional discussion of the significant accounting policies and estimates used in the preparation of our financial statements.

 

2.                                      Restatement

 

On May 13, 2005, the Company filed a Current Report on Form 8-K announcing that an error had been identified relating to accounting for sales and marketing expenses related to trade shows.  This conclusion was reached in connection with BDO Seidman, LLP’s, it’s independent registered public accounting firm (“BDO Seidman”), financial statement review procedures relating to the Company’s Quarterly Report on Form 10-Q for the first quarter of the year ending December 31, 2005 (“fiscal 2005”).

 

The accounting issue relates to an interpretation of Accounting Principles Board Opinion No. 28 (“APB 28”), “Interim Financial Reporting.” Commencing in the first quarter of the fiscal year ended December 31, 2004 (“fiscal 2004”), the Company began to capitalize and amortize trade show expenses incurred in the fiscal year to reflect the future economic benefits received during such fiscal year.  Management discussed the issue with the Audit Committee of the Company’s Board of Directors and BDO Seidman and was of the view that capitalization and amortization of trade show expenses was allowable.  As part of its review of the unaudited quarterly financial statements for the first quarter of fiscal 2005, BDO Seidman noted that trade show costs previously capitalized and amortized should have been treated as period expenses in fiscal 2004.  As a result, BDO Seidman expressed its view that (a) trade show costs previously capitalized and amortized during fiscal 2004 should have been treated as period expenses in fiscal 2004; (b) each of the Company’s quarterly reports previously filed in fiscal 2004 should be restated; and (c) no reliance should be placed on the previously issued fiscal 2004 quarterly financial statements.

 

Acting on the recommendation of BDO Seidman, management of the Company determined that the previously issued financial statements contained in the Quarterly Reports on Form 10-Q for the quarters ended March 31, 2004, June 30, 2004 and September 30, 2004 should be restated to correct errors in those financial statements.  Consequently, the condensed consolidated financial statements for the first quarter of 2004 are restated in this Form 10-Q.  These restated condensed consolidated financial statements reflect an adjustment to account for trade show expenses as period expenses.  The adjustment results in a $159,460 increase in sales and marketing expense for the first fiscal quarter of 2004.   The restatement has no impact on the Company’s consolidated net income for fiscal 2004 and does not affect the Company’s historical cash flow.  The Company will amend its annual report on Form 10-K for fiscal 2004 to reflect the disclosures made to the above-referenced restated quarterly reports.

 

The principal effects of this adjustment on the accompanying condensed consolidated financial statements is as follows:

 

8

 

 

		Condensed Consolidated Balance Sheet March 31, 2004
		As restated			As previously reported
Prepaid expenses and other current assets		$	1,020,980		$	1,180,440
Total Current Assets		22,935,599			23,095,059
Total Assets		33,479,871			33,639,331
Accumulated deficit		(29,456,055		)	(29,296,595		)
Total Stockholders’ Equity		30,177,787			30,337,247
Total Liabilities and Stockholders’ Equity		$	33,479,871		$	33,639,331

 

		Condensed Consolidated Statement of Operations for the three months ended March 31, 2004
		As restated			As Previously reported
Increase in sales and marketing expenses		$	159,460		$	—
Total operating expenses		4,458,252			4,298,792
Income (loss) from operations		(24,078		)	135,382
Income before income tax expense		213,372			372,832
Net income (loss)		(24,531		)	134,929
Net income per common share:
Basic		$	0.00		$	0.01
Diluted		$	0.00		$	0.01

 

3.                                      Stock-Based Compensation

 

The Company accounts for stock-based awards to employees under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. The Company provides additional pro forma disclosures as required under Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation” 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 expense been recorded under the provisions of SFAS No. 123, the Company’s net income (loss) and earnings per share would have been the pro forma amounts indicated below:

 

		For the three months ended March 31,
		2005			2004
					(Restated)
Net income (loss)(attributable to common shareholders) — as reported		$	221,460		$	(24,531	)
Add: stock based employee compensation expense included in reported net income, net of 40% tax effect		8,899			8,160
Less fair value of stock-based employee compensation expense		(305,103		)	(393,669		)
Net loss (attributable to common shareholder) — pro forma		$	(74,744	)	$	(410,040	)
Net income (loss) per share:
Basic, as reported		$	0.02		$	0.00
Basic, pro forma		$	(0.01	)	$	(0.03	)
Diluted, as reported		$	0.01		$	0.00
Diluted, pro forma		$	0.00		$	(0.02	)

 

9

 

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 ended March 31, 2005:

 

Risk free interest rate		4.2	%
Expected life		6.25 years
Expected volatility		67	%

 

4.                                      Capitalization of Software Development Costs

 

Costs incurred in the research, design and development of software for sale to others as a separate product or embedded in a product and sold as part of the product as a whole are charged to expense until technological feasibility is established. Under SFAS No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed,” the Company capitalizes software purchased from third parties if the related software product under development has reached technological feasibility or if there are alternative future uses for the purchased software, provided that capitalized amounts will be realized over a period not exceeding five years. Costs incurred prior to the establishment of technological feasibility are charged to research and development expense.

 

Capitalized software as of March 31, 2005 and December 31, 2004 is as follows:

 

		March 31, 2005			December 31, 2004
Capitalized software		$	530,568		$	464,568
Accumulated amortization		(222,532		)	(193,003		)
Capitalized software, net		$	308,036		$	271,565

 

As of March 31, 2005, the weighted average useful life of the Company’s capitalized software is approximately 2.3 years. The following table shows the estimated amortization expense for those assets for the remaining nine months of the current fiscal year end and each of the four succeeding fiscal years.

 

Year ending December 31,		Estimated Expense
2005		$	91,964
2006		119,969
2007		67,689
2008		24,481
2009		3,933

 

5.                                      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 an annual basis.

 

In accordance with SFAS No. 142, all of our intangible assets that have definite lives are being amortized on a straight-line basis over their estimated useful lives and goodwill is evaluated at least annually to determine if fair value of the asset has decreased below its carrying value. At December 31, 2004, we performed our annual assessment of goodwill and determined that no adjustment to impair goodwill was necessary.

 

10

 

Goodwill and intangible assets consist of the following:

 

		March 31, 2005			December 31, 2004
Goodwill		$	533,031		$	533,031
Patents		$	2,116,077		$	2,038,582
Accumulated amortization		(941,115		)	(891,178		)
Patents, net		1,174,962			1,147,404
Other Intangibles:
Assets acquired in the purchase of our subsidiary Valence Technology in 1998: Covenant not to compete, Developed Technology, ASP brand name, Cell Library, and Customer List		4,910,400			4,910,400
License agreements acquired in purchase of our subsidiary SRSWOWcast in February 2003		640,071			640,071
Poly Planar purchased technology for speaker products		120,000			120,000
Capitalized software and hardware for several technologies		460,841			394,840
Total of Other Intangibles		6,131,312			6,065,311
Accumulated amortization, other intangibles		(4,652,958		)	(4,551,760		)
Other intangibles, net		1,478,354			1,513,551
Intangible assets, net		$	2,653,316		$	2,660,955

 

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

 

 

As of March 31, 2005, the weighted average useful life of the Company’s patents and intangible assets is approximately 3.5 years. The following table shows the estimated amortization expense for those assets for the remaining nine months of the current fiscal year and each of the four succeeding fiscal years:

 

 

11

 

6.                                      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:

 

		March 31, 2005			December 31, 2004
Cost		$	17,489,688		$	17,489,688
Unrealized loss		(487,881		)	(228,421		)
Estimated fair value		$	17,001,807		$	17,261,267

 

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

 

		March 31, 2005						December 31, 2004
		Cost			Estimated Fair Value			Cost			Estimated Fair Value
U.S. Government securities available for sale:
Due in one to five years		$	17,489,688		$	17,001,807		$	17,489,688		$	17,261,267

 

The following table summarizes sales of available for sale securities for quarters ended March 31. Specific identification was used to determine costs in computing realized gains or losses.

 

 

7.                                      Investment in LLC

 

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

 

In the Strategic Alliance Agreement, CHS and the Company agree to work together to identify and implement co-promotional opportunities, including trade shows, movie theatres, video streaming, concert DVDs, artist endorsements, bundling and premium deals, web-based promotional clips and road shows.  The initial term of the agreement expires on July 9, 2006 and is automatically renewable for successive one-year terms.

 

The Operating Agreement governs CHS/SRS, LLC, which is a joint venture between CHS and the Company formed to complete and distribute concert videos featuring Duran Duran, Boz Scaggs— Jazz, Boz Scaggs— Greatest Hits, Godsmack and All Access.

 

12

 

Pursuant to the Operating Agreement each of CHS and the Company contributed capital with a value of $2,346,621. CHS is the managing member of the joint venture and is entitled to receive a 5% management fee of all net revenues received. CHS’ capital contribution to CHS/SRS, LLC consists of the artist agreements and related contracts pursuant to which CHS/SRS, LLC will produce and distribute the above-referenced concert videos. The Company’s capital contribution is an aggregate of $2,346,621, consisting of a $700,000 bridge loan that the Company extended to CHS on July 9, 2004 in anticipation of the strategic alliance, which converted to equity on September 23, 2004, plus $1,646,621 in new cash.  In addition, the Company capitalized $177,936 consisting of costs associated with the formation of the LLC and co-promotional projects. CHS’ capital contribution consisted of the artist agreements with Duran Duran, Boz Scaggs, Godsmack and All Access pursuant to which the concert videos are filmed, produced and distributed. CHS/SRS, LLC contracted with CHS to complete production of the concert videos pursuant to the Production Services Agreement. Profits from the distribution of the concert videos and related assets will be allocated and distributed in the following manner and order: (i) 100% to the Company until such time as the Company has received 130% of the 133,000 additional advance that the Company provided to the CHS/SRS, LLC to fund the Godsmack acoustical project ; (ii) equally until the Company and CHS have each both received 1.75 times their original capital contributions; and thereafter (iii) 90% to CHS and 10% to the Company. The joint venture is accounted for using the equity method and profits are recognized following the guidance for equity method accounting. As of March 31, 2005, two of the concert videos, Boz Scaggs and Godsmack have been released. Profits of $77,332 generated from these videos have been recognized and included in “Equity in Income of Investee” in the Consolidated Statements of Operations for the three months ended March 31, 2005.

 

Under the Warrant Agreement, the Company paid CHS $40,000 to acquire a warrant to purchase up to 122,000 units of Class A membership interests in CHS, which represents approximately 10% of the equity of CHS, for an exercise price of $9.836 per unit, subject to adjustment based on valuation of CHS at the time of an additional funding. The warrant is immediately vested and exercisable for up to two years. It is transferable and contains customary antidilution and price protection provisions for warrants of this type.

 

Under the Production Services Agreement, CHS/SRS, LLC contracted with CHS as an independent contractor to perform all production services and to provide all other services, personnel, materials and elements for the production, completion and delivery of the concert videos. CHS, as the independent contractor, shall receive an aggregate of $365,000 in production fees for all of its services under the Production Services Agreement. CHS is responsible for payment of all costs and expenses in connection with the production and completion of the concert videos.

 

8.                                      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 months ended March 31, are as follows:

 

 

There were 1,404,000 and 40,000 potentially dilutive options outstanding for the quarters ending March 31, 2005 and 2004, respectively, that were not included in the table above because they would be anti-dilutive.

 

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9.                                      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.

 

10.                               Stockholders’ Equity

 

On June 30, 2004, the Company’s Board of Directors authorized  the repurchase of up to $3,000,000 of its outstanding common stock for a period from July 1, 2004 to December 31, 2004 (the “2004 Repurchase Program”).  The Company repurchased 216,575 shares at a cost of $1,225,254 under the 2004 Repurchase Program.

 

On March 24, 2005, the Company’s Board of Directors authorized the repurchase of up to $3,000,000 of the outstanding shares of the Company’s common stock for a period from January 1, 2005 to December 31, 2005 (the “2005 Repurchase Program”). As of March 31, 2005, no shares had been repurchased under the 2005 Repurchase Program. Purchases may be made from time to time in the open market, block purchases or privately negotiated transactions, depending on market conditions, share price and other factors.  All repurchased shares are reflected as treasury stock in the accompanying consolidated balance sheets.

 

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11.                               Segment Information

 

The Company operates two business segments — semiconductors and licensing.  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:

 

		Valence Semiconductor			SRS Labs Licensing			Total
Three Months Ended March 31, 2005
Total revenues		$	1,984,563		$	3,264,095		$	5,248,658
Cost of sales		728,240			56,345			784,585
Gross margin		$	1,256,323		$	3,207,750		$	4,464,073
Three Months Ended March 31, 2004
Total revenues		$	2,415,718		$	2,927,327		$	5,343,045
Cost of sales		882,734			26,137			908,871
Gross margin		$	1,532,984		$	2,901,190		$	4,434,174

 

For the three months ending March 31, 2005, one customer accounted for approximately 11% of consolidated revenues, or $562,426, in the semiconductor segment. For the same period in the prior year, two customers accounted for approximately 18% and 10% of consolidated revenues, or $968,890 and $542,389, in the semiconductor segment, respectively. There was no significant customer in the licensing segment for the three months ended March 31, 2005 and March 31, 2004.

 

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.                               Recent Accounting Pronouncements

 

In March 2005, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations—an interpretation of FASB Statement No. 143”  (“FIN 47”).   FIN 47 clarifies the term “conditional asset retirement obligation” as used in FASB Statement No. 143.  This Interpretation also clarifies that an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably estimated.  The FIN also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation.  This Interpretation is effective for the Company beginning December 31, 2005.  The Company does not expect the adoption of FIN 47 to have a significant impact on its consolidated financial position, results of operations or cash flows.

 

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In December 2004, the FASB  issued SFAS No. 123(R), “Share-Based Payment”. This statement replaces SFAS No. 123, “Accounting for Stock-Based Compensation” and supersedes APB No. 25, “Accounting for Stock Issued to Employees.” SFAS 123(R) requires all stock-based compensation to be recognized as an expense in the financial statements and that such cost be measured according to the fair value of stock options. In April 2005, the SEC announced that the implementation of SFAS 123(R) has been delayed and will now be effective for the Company beginning January 1, 2006. The adoption of SFAS 123R will have a significant impact on the Company’s results of operations, as demonstrated by the SFAS 123 pro-forma disclosures at Footnote 2.  The adoption of the standard will have no impact on the Company’s cash flows.

 

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, 2004 (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, or ASICs, standard integrated circuits, or ICs, and audio and voice technology solutions for the home entertainment, portable media device, personal telecommunications, personal computer, automotive and broadcast markets. We operate in the following two business segments:

 

Semiconductors:   Through SRS Labs, Inc.’s wholly-owned subsidiary, ValenceTech Limited, and ValenceTech Limited’s wholly-owned subsidiaries (collectively “Valence”), we operate a fabless semiconductor business which develops, designs and markets standard and custom analog ICs, digital signal processors, or DSPs, and mixed signal integrated circuits primarily to original equipment manufacturers, or OEMs, and original design manufacturers , or ODMs, in the Asia Pacific region.

 

Licensing:   Through SRS Labs, the parent company, and its wholly-owned subsidiary, SRSWOWcast.com, Inc., doing business as SRSWOWcast Technologies (“SRSWOWcast”), the licensing segment develops and licenses audio, voice and surround sound technology solutions to many of the world’s leading OEMs, software providers and semiconductor companies, and licenses and markets hardware and software products for the Internet and professional audio markets.

 

As used herein, the “Company,” “SRS Labs,” “we,” “us,” or “our” means SRS Labs, Inc. and its wholly owned subsidiaries, including Valence and SRSWOWcast.com Inc.

 

Critical Accounting Policies

 

Our discussion and analysis of our results of operations and liquidity and capital resources are based on our consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States of America.

 

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 materially differ from our estimates.

 

Results of Operations

 

Three Months Ended March 31, 2005 Compared to Three Months Ended March 31, 2004

 

Revenues

 

Semiconductor revenues consists of (a) design fees relating to, and sales of, application specific integrated circuits (“ASIC”) for third parties by Valence to original equipment manufacturers (“OEMs”); and  (b) sales of general purpose integrated circuits (“ICs”) designed by Valence under the brand name ASP.  Licensing revenues consist primarily of royalties generated from the license of SRS Labs’ audio and voice technologies.  License and royalty agreements generally provide for the license of technologies for a fee based on the number of units distributed by the licensee.  However, we have in the past

 

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and may again in the future, enter into a license agreement for a one-time fee. Also included in licensing revenue are revenues generated from the sale of hardware and software applications into the broadcast audio markets.

 

Total revenues for the three months ended March 31, 2005 were $5,248,658 compared to $5,343,045 for the three months ended March 31, 2004, a decrease of $94,387 or 1.8%.  Semiconductor revenues were $1,984,563 for the three months ended March 31, 2005 compared to $2,415,718 for the three months ended March 31, 2004, a decrease of $431,155 or 17.8%. Within semiconductor revenue, ASIC accounted for $1,469,463 or 74.0% for the three months ended March 31, 2005 compared to $1,649,131 or 68.3% for the same period last year, a decrease of $179,668 or 10.9%. ASP chips accounted for $515,100, or 26.0% for the three months ended March 31, 2005 compared to $766,587 or 31.7% for the same period last year, a decrease of $251,487 or 32.8%.  Within ASP revenues, SRS chips accounted for 64.0% for the three months ended March 31, 2005 compared to 37.5% for the same period last year. The decrease in ASIC and ASP  sales can be primarily attributed to competitive pressures and the ramp up period for the new sales organization.

 

Licensing revenues were $3,264,095 for the three months ended March 31, 2005, compared to $2,927,327 for the three months ended March 31, 2004, an increase of $336,768 or 11.5%.  The sales growth in licensing was attributable to our continued diversification strategy, which expanded the use of our technologies in the portable devices, PC, mobile phone and automotive markets. The following table presents the Company’s licensing revenues mix by market segment:

 

		Three Months Ended March 31,
		2005		2004
Home Entertainment (TV, Set Top Box, A/V Receiver, DVD)		64	%	71	%
Portable Media Devices (Digital Media Player, Headphone)		13	%	9	%
PC (Software, Hardware)		12	%	15	%
Personal Telecommunications (Mobile phone, PDA)		9	%	4	%
Automotive		2	%	1	%

 

Gross Margin

 

Cost of sales consists primarily of fabrication costs, assembly and test costs, and the cost of materials and overhead from operations. Gross margins are dependent on the mix of products sold, services provided and royalties earned. The following table presents the Company’s gross margin percentages for the three months ended March 31:

 

		Three Months Ended March 31,
		2005		2004
Semiconductor
ASIC revenue as a percentage of total semiconductor revenue		74.0	%	68.3	%
ASIC gross margin		66.5	%	67.4	%
ASP revenue as a percentage of total semiconductor revenue		26.0	%	31.7	%
ASP gross margin		54.2	%	55.0	%
Total semiconductor revenue as a percentage of total revenue		37.8	%	45.2	%
Total semiconductor gross margin		63.3	%	63.5	%
Licensing
Licensing revenue as a percentage of total revenue		62.2	%	54.8	%
Licensing gross margin		98.3	%	99.1	%
Total Gross Margin		85.1	%	83.0	%

 

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 $1,692,378 for the three months ended March 31, 2005, essentially unchanged from $1,695,368 for the same prior year period.  As a percentage of total revenues, sales and marketing expenses increased from 31.7% for the quarter ended March 31, 2004 to 32.2% for the same period this year.

 

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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 $1,182,069 for the three months ended March 31, 2005, essentially unchanged from $1,208,687 for the same prior year period. As a percentage of total revenues, research and development expenses were  22.6% for the quarter ended March 31, 2004, and 22.5% for the same period this year.

 

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 $1,469,228 for the three months ended March 31, 2005 compared to $1,554,197 for the same prior year period, a decrease of $84,969 or 5.5%. The decrease is primarily attributable to a decrease in bad debt expense.  As a percentage of total revenues, G&A expenses decreased from 29.1% for the quarter ended March 31, 2004, to 28.0% for the same period this year.

 

Equity in Income of Investee

 

Equity in income of investee represents the Company’s proportionate share of profit from the CHS/SRS,LLC joint venture we entered into with Coming Home Studios. On September 23, 2004, the Company entered into a strategic alliance with Coming Home Studios LLC (“CHS”) to produce and sell concert DVDs featuring Duran Duran, Boz Scaggs, Godsmack and All Access, which include the Company’s Circle Surround technology. Profits from the distribution of the concert videos and related assets will be allocated and distributed in the following manner and order: (i) 100% to the Company until such time as the Company has received 130% of the $133,000 additional advance that the Company provided to the CHS/SRS, LLC to fund the Godsmack acoustical project; (ii) equally until the Company and CHS have each both received 1.75 times their original capital contributions; and thereafter (iii) 90% to CHS and 10% to the Company. The joint venture is accounted for using the equity method and profits are recognized following the guidance for equity method accounting. We recognize and accrue profits as we get sales and/or royalty reports. For the three months ended March 31, 2005, the profit recognized under the agreement was $77,332.

 

Other Income, Net

 

Other income, net, consists primarily of interest income, gain on sale of securities and foreign currency transaction gains and losses. Other income, net, was $147,932 for the three months ended March 31, 2005, compared to $237,450 for the same prior year period, a decrease of $89,518 or 37.7%. The decrease is primarily attributable to lower cash and investment balances in 2005 due to the company’s repurchase of treasury shares in 2004.

 

Provision for Income Taxes

 

The income tax expense for the three months ended March 31, 2005 was $124,202, compared to tax expense of $237,903 for the same prior year period, a decrease of $113,701 or 47.8%. The provision consists primarily of taxes paid on licensing revenues sourced from countries requiring foreign tax withholdings and taxes paid on profits in Hong Kong at the rate of 17.5%.  The lower tax expense in fiscal 2005 resulted from decreased taxable income in our foreign subsidiary.  In addition,  we benefited from the U.S. Japan tax treaty, which eliminated source-country withholdings on royalties. That treaty became effective on July 1, 2004.

 

Liquidity and Capital Resources

 

The Company’s principal source of liquidity to fund ongoing operations at March 31, 2005 consisted of cash, cash equivalents and long-term investments of $24,002,048. At March 31, 2005, the Company had cash and cash equivalents of $7,000,241 and long-term investments of $17,001,807. 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.

 

Net cash provided by operating activities was $102,978 and $449,695 during the three months ended March 31, 2005 and March 31, 2004, respectively. The decrease in our operating cash flows is primarily the result of an increase in accounts receivable associated with increased licensing activity.  Prepaids and other assets also increased in the quarter due to annual premiums associated with insurance.  Offsetting those increases, our inventories decreased $19,744 for the three months ended March 31, 2005 as opposed to an increase of $1,686 for the same period last year, as we sold through our existing inventory.  Our reserve for slow moving and obsolete inventory as a percentage of total inventory was 23.8% and 29.7% as of March 31, 2005 and December 31, 2004, respectively.  We monitor and analyze our inventory for obsolescence and adjust this reserve accordingly.  Our accounts payable increased $137,484 and decreased $557,042 during the three months ended March 31, 2005 and 2004, respectively.  Our accrued liabilities  increased $158,063  and $211,971 during the

 

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three months ended March 31, 2005 and 2004, respectively.  The changes in liability accounts generally relate to increases in professional fees, commissions and bonus and the timing of payments to vendors and employees.

 

Our net cash used for and provided by investing activities was $180,936 and $4,997,321 during the three months ended March 31, 2005 and March 31, 2004, respectively. The shift from net cash provided by investing activities during the quarter ended March 31, 2004, as compared to net cash used in investing activities during the quarter ended March 31, 2005, was attributable primarily to a $5,375,000 decrease in proceeds from sales of investments available for sale, $39,706 increase in cash used in expenditures related to patents and intangible assets, offset by $236,449 decrease in purchases of furniture, fixtures and equipment.

 

We expect expenditures related to patents and intangible assets to increase in the future consistent with the growth in our licensing business, as we continue to invest in the development of new technologies.

 

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

 

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. Indications are that this trend will continue for the foreseeable future. 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 our financial condition and results of operations.

 

Our business is highly dependent on the consumer electronics market, which is characterized by short product life cycles, fluctuations in demand and seasonality, and subject to risks related to product transitions and supply of other components

 

The consumer electronics market is characterized by intense competition, rapidly evolving technology, and ever-changing consumer preferences. These factors result in the frequent introduction of new products, short product life cycles and significant price competition. The dynamic nature of this market limits our, as well as our customers’, ability to accurately forecast quarterly and annual sales. If we, or our customers, are unable to manage product transitions, our business and results of operations could be negatively affected.

 

Pricing pressures on the consumer electronics product manufacturers who incorporate our technologies into their products could limit the licensing fees we charge for our technologies, which could adversely affect our revenues

 

The markets for the consumer electronics products in which our technologies are incorporated are intensely competitive and price sensitive. Retail prices for consumer electronics products that include our technologies, such as DVD players and home theater systems, have decreased significantly, and we expect prices to continue to decrease for the foreseeable future. In response, manufacturers have sought to reduce their product costs, which can result in downward pressure on the licensing fees we charge our customers who incorporate our technologies. A decline in the licensing fees we charge could materially and adversely affect our operating results.

 

Our business and prospects depend on the strength of our brand, and if we do not maintain and strengthen our brand, our business will be materially harmed

 

Maintaining and strengthening the “SRS” brand is critical to maintaining and expanding both our products and services business and our technology licensing business, as well as to our ability to enter new markets for our audio and other technologies. Our continued success is due, in part, to our reputation for providing high quality products, services and technologies across multiple consumer electronics product segments. If we fail to effectively promote and maintain the SRS brand, our business and prospects will suffer.

 

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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 are subject to the highly cyclical nature of the semiconductor industry

 

The semiconductor industry is highly cyclical. The industry has experienced significant downturns, often in connection with, or in anticipation of, maturing product cycles (of both semiconductor companies’ and their customers’ products) and declines in general economic conditions. These downturns have been characterized by production overcapacity, high inventory levels and accelerated erosion of average selling prices. Any future downturns could significantly harm our sales or reduce our profitability for a prolonged period of time. From time to time, the semiconductor industry also has experienced periods of increased demand and production capacity constraints. We may experience substantial changes in future operating results due to general semiconductor industry conditions, general economic conditions and other factors.

 

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 us, our competitors or our suppliers.

 

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 materially 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 conflict among sales channels between us 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.

 

Potential channel conflict with existing semiconductor partners could cause us to lose future business

 

As we bring out more and more Valence semiconductors with SRS audio technologies embedded in them, our current semiconductor partners may perceive those new devices as threats to their own products. The semiconductor partners may respond by reducing or eliminating the volumes of business they presently do with us, which would have an adverse effect on our licensing revenue.

 

We are exposed to risks in our Valence business related to product fabrication outsourcing to third parties

 

Valence is a “fabless” semiconductor company meaning that Valence designs, develops and markets our selection of custom and standard integrated circuits but we rely on third-party contractors to manufacture, assemble and test our products. From time to time there can be foundry capacity issues due to global demands that affect the semiconductor industry. Although we believe our relationships are generally good, we do not have long-term supply agreements with our third-party vendors and they are not obligated to perform services or supply products to us for any particular period or in any particular quantities, except as provided in each separate purchase order accepted by them. The increased demand for our products coupled with the demand for foundry services, is, and will continue to be for the foreseeable future, a challenge for us. In

 

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times of high demand, there are significant risks associated with our reliance on third-party vendors including: reallocation of capacity to other foundry customers, potential price increases, delays and interruptions in order deliveries, reduced control over product quality and increased risk of misappropriation of intellectual property.

 

We conduct operations in a number of countries and are subject to risks of international operations, particularly in the People’s Republic of China (PRC) and other parts of Asia

 

We have significant operations in the PRC and other parts of Asia that require refinement to adapt to the changing market conditions in those regions. Our operations in Asia, and international operations in general, are subject to risks of unexpected changes in, or impositions of, legislative or regulatory requirements.

 

Our customers geographically located in the Asia Pacific markets accounted for approximately 86%, 93% and 90% of total Company sales in 2004, 2003 and 2002, respectively and are expected to continue to account for a substantial percentage of sales in the future.

 

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. The PRC economy has also experienced deflation in the past, which may continue in the future. The current economic situation may adversely affect our profitability over time as expenditures for consumer electronics products and information technology may decrease due to the results of slowing domestic demand and deflation.

 

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.

 

We are exposed to currency fluctuations and instability in the Asian markets

 

We expect that international sales will continue to represent a significant portion of our total revenues. To date, all of our licensing revenues have been denominated in U.S. dollars and most costs have been incurred in U.S. dollars. It is our expectation that licensing revenues will continue to be denominated in U.S. dollars for the foreseeable future. Because Valence’s business is primarily focused in Asia and because of our anticipated expansion of business in the PRC and other parts of Asia, our consolidated results of operations and financial position could be significantly affected by risks associated with international activities, including economic and labor conditions, political instability, tax laws (including U.S. taxes on foreign subsidiaries) and changes in the value of the U.S. dollar versus the local currency in which the products are sold. In addition, our valuation of assets recorded as a result of the Valence acquisition may also be adversely impacted by the currency fluctuations relative to the U.S. dollar. We intend to actively monitor our foreign exchange exposure and to implement strategies to reduce our foreign exchange risk at such time that we determine the benefits of such strategies outweigh the associated costs. However, there is no guarantee that we will take steps to insure against such risks, and should such risks occur, there is no guarantee that we will not be significantly impacted.

 

If the sale of consumer electronics products incorporating our technologies does not grow in emerging markets, our ability to increase our licensing revenue may be limited

 

We also expect that growth in our licensing revenue will depend, in part, upon the growth of sales of consumer electronics products incorporating our technologies in other countries, including China and India, as consumers in these markets have more disposable income and are increasingly purchasing entertainment products with surround sound capabilities. However, if our licensing revenue from the use of our technologies in these new markets or geographic areas does not expand, our prospects could be adversely affected.

 

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

 

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