As Of                Filer                Filing    For·On·As Docs:Size              Issuer               Agent

 3/16/07  DTS, Inc.                         10-K       12/31/06   10:2.5M                                   Merrill Corp-MD/FA

Document/Exhibit                   Description                      Pages   Size 

 1: 10-K        Annual Report                                       HTML   1.47M 
 2: EX-3.7      Articles of Incorporation/Organization or By-Laws   HTML     17K 
 3: EX-10.42.2  Material Contract                                   HTML     48K 
 4: EX-10.72    Material Contract                                   HTML     53K 
 5: EX-21.1     Subsidiaries                                        HTML     31K 
 6: EX-23.1     Consent of Experts or Counsel                       HTML      7K 
 7: EX-31.1     Certification -- Sarbanes-Oxley Act - Sect. 302     HTML     15K 
 8: EX-31.2     Certification -- Sarbanes-Oxley Act - Sect. 302     HTML     15K 
 9: EX-32.1     Certification -- Sarbanes-Oxley Act - Sect. 906     HTML     10K 
10: EX-32.2     Certification -- Sarbanes-Oxley Act - Sect. 906     HTML     10K 

FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K and the documents incorporated herein by reference contain forward-looking statements based on our current expectations, estimates and projections about our industry, beliefs, and certain assumptions made by us. Words such as “believes,” “anticipates,” “estimates,” “expects,” “projections,” “may,” “potential,” “plan,” “continue” and words of similar import, constitute “forward-looking statements.” The forward-looking statements contained in this report involve known and unknown risks, uncertainties and other factors that may cause our actual results to be materially different from those expressed or implied by these statements. These factors include those listed under the “Risk Factors” section contained in Item 1A and elsewhere in this Form 10-K, and the other documents we file with the Securities and Exchange Commission, or SEC, including our most recent reports on Form 8-K and Form 10-Q. We cannot guarantee future results, levels of activity, performance or achievements. We do not undertake any obligation to revise these forward-looking statements to reflect future events or circumstances.

PART I

Item 1.                        Business

Company Overview

We are a leading provider of entertainment technology, products and services to the audio and image entertainment markets worldwide. Multi-channel audio, commonly referred to as surround sound, allows listeners to hear discrete sounds simultaneously through more than two speakers. Our DTS digital multi-channel audio technology enables the delivery of compelling surround sound in theaters and in the home, and has been selected as a required technology in HD-DVD and Blu-ray Disc playback devices. Additionally, we provide image processing services to film studios to prepare and enhance film, television and DVD content for high quality presentation.

We were founded in 1990 and received a key strategic investment in 1993 from investors, including Universal City Studios, Inc. The first DTS audio soundtrack was created for the release of Steven Spielberg’s Jurassic Park in 1993. From this initial release, we established a technical and marketing platform for the development of entertainment technology solutions for the motion picture, home theater, and other consumer markets.

In 1996, we launched our consumer business, in which we license our technology to consumer electronics products manufacturers for inclusion in products such as audio/video receivers, DVD, HD-DVD and Blu-ray Disc players, personal computers, car audio products, video game consoles, and home theater systems. The consumer products market has since grown to become the largest segment of our business. To date, we have entered into licensing agreements with most of the world’s major consumer audio electronics manufacturers. We also license our technology to many major semiconductor manufacturers. Our technology, trademarks, and know-how have been incorporated in hundreds of millions of consumer electronics products worldwide.

We also provide products and services to film studios, production companies, and movie theaters to produce, release, distribute, and play back digital multi-channel film soundtracks, pre-show entertainment content, subtitles, captions and descriptive narration. We currently license our sound technology to all major film distributors in the United States. Most major feature films currently released in the United States include a DTS soundtrack. Our playback systems for DTS-formatted soundtracks have been installed in over 28,000 movie screens worldwide. Increasingly, we are focusing our efforts on providing products and services relating to digital content delivery, including digital cinema encoding and serving as a network integrator and operator to facilitate the delivery of pre-show advertising and motion picture content to theaters. We believe the motion picture industry has begun a wide-scale motion picture industry transition to digital content preparation, delivery and exhibition. In order to position ourselves to capitalize on this opportunity in January 2007 and beyond, we have reorganized our film licensing, cinema hardware

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and digital images activities into a single business, DTS Digital Cinema, which will focus on providing end-to-end solutions for digital cinema. To further this initiative, in November 2006, we entered into a worldwide exclusive license agreement with Avica Technology Corporation (“Avica”), to enable us to exploit its product line of software and hardware products for digital cinema applications.

On February 20, 2007, we further announced that our Board of Directors approved a plan to sell our DTS Digital Cinema business to enable us to focus exclusively on licensing branded entertainment technology to the large and evolving audio, game console, personal computer, portable and broadcast markets. The sales process has begun and is expected to conclude later in 2007.

We develop, market, license and sell our proprietary technology, products and services for the following markets:

Consumer Markets:

·       Home theater and consumer electronics entertainment devices such as audio/video receivers, home-theater-in-a-box, DVD, HD-DVD and Blu-ray Disc players, car audio products, and personal computers.

·       Emerging markets for digital multi-channel audio such as digital home networks, video games and consoles, portable electronics devices, and digital satellite and cable broadcast products.

·       Professional audio products and services for encoding and decoding digital multi-channel content in our proprietary format.

Cinema Markets:

·       Audio and video technology, products and services that enable the production and distribution of soundtracks, subtitles, and pre-show or alternative content in our proprietary format.

·       Systems for playback and distribution of multi-channel audio soundtracks, pre-show, and alternative video content, subtitling, captioning, and descriptive narration for movie theaters and special venues.

·       Services supporting the operation, ingest, delivery and playback of digital content over digital content networks, digital cinema content.

·       Professional products and services for production of content for digital cinema that complies with the technical specifications issued by the Digital Cinema Initiative, LLC, or DCI.

·       Theater hardware, software, and management systems that facilitate the booking, preparation and delivery of advertising and digital motion picture content.

Digital Imaging Markets:

·       Digital image enhancement and restoration services for film and television content to enable high quality presentation in digital cinema, high definition optical media or broadcast applications.

·       Digital intermediate services for the motion picture industry.

·       Digital image services to repair and salvage damaged film and television content, or to correct problems in the production process occurring as a result of errors or anomalies that may occur during filming or digital acquisition of content.

Regardless of the customer or entertainment application that incorporates our technology or services, we facilitate the branded delivery and playback of high-quality digital content. As the transition from analog to digital entertainment technology continues, we believe we are well-positioned to grow our

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licensing, product, and service businesses worldwide. Our goal is to become essential to the ultimate entertainment experience by enabling the creation of compelling, high-quality content and by incorporating our technology into every device that manages, controls or delivers high-quality digital entertainment.

Industry Background

Over the past 15 years, two trends have greatly impacted the entertainment industry: the transition from analog to digital entertainment content, and technological advancements in digital coding, transmission, signal processing, optical storage, and playback. These trends helped create a technical foundation for the widespread adoption of digital multi-channel audio and high definition video for many forms of entertainment.

Adoption and Growth of Digital Multi-Channel Audio in the Motion Picture Industry

Movie soundtracks were originally presented in mono, or one-channel, audio. In the mid-1970s, stereo was introduced. Stereo consists of two channels and presents sound through discrete left and right speakers. Stereo was followed by matrix technology that allowed an inexpensive two-track system to bring surround sound to a large number of movie theaters. However, the audio quality and channel separation were limited.

In the early 1990s, the listening experience of movie audiences was significantly enhanced through the introduction of digital multi-channel surround sound technology. This format, commonly known as 5.1, combined high-quality audio with full separation in five channels: left, center, right, left surround, right surround, plus a channel dedicated to low frequency effects known as a subwoofer. Digital discrete surround sound enables movie directors and producers to create a more enveloping and realistic entertainment environment. Many filmmakers recognized the ability of multi-channel audio to enhance the entertainment experience and promoted its widespread adoption.

Digital multi-channel audio is now an industry standard audio format for feature films. Today, all of the major film studios in the United States, and an increasing number of international film studios, release their feature films with digital multi-channel soundtracks. In 2006, 182 major feature films were released in the United States with a DTS digital multi-channel soundtrack with 871 films, including foreign films and dubbed language versions of films with DTS soundtracks being released worldwide.

Screen Digest Global Media Intelligence, in its December 2006 Cinema Intelligence report, estimates that in 2006 there were more than 148,000 movie theater screens worldwide, and that in 2006 there were approximately 43,000 screens in North America. Screen Digest Global Media Intelligence estimates that in 2006, there were approximately 82,750 digital sound screens worldwide. As film studios have increasingly released films with digital multi-channel soundtracks, many movie theaters have purchased and installed digital multi-channel playback systems and cinema processor equipment for both newly constructed and retrofitted movie theaters. A number of other venues also utilize digital multi-channel playback systems and cinema processor equipment to enhance the entertainment experience. These venues include large-screen format theaters, amusement parks, national parks, and museums.

Proliferation of Home Theater Systems

Consumer demand for digital multi-channel capable home theater systems has been fueled by:

·       the extensive adoption of digital multi-channel audio in movie theaters;

·       declining prices for DVD players, audio/video receivers, and home-theater-in-a-box systems;

·       the superior quality and feature sets of DVDs;

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·       the widespread availability of DVDs released with digital multi-channel soundtracks; and

·       the growth of high definition television displays.

According to the Digital Entertainment Group, or DEG, website at dvdinformation.com, it is estimated that, as of December 31, 2006, over 80% of U.S. households own one or more DVD-Video players. They further estimate that approximately 55% of DVD owners now have more than one player.

Home theater systems generally consist of a display, a DVD-Video player, a digital multi-channel audio/video receiver, five speakers, and a subwoofer. Home-theater-in-a-box systems containing all of these elements, but the display, are increasingly offered to consumers as an all-in-one home theater package for ease of use and installation.

High Definition Displays have been an important driver in the proliferation of home theater systems. Jupiter Research estimates that 31% of U.S. households, or 35 million homes, had an HDTV as of the end of 2006. HDTV penetration is expected to reach over 70% of U.S. households by 2010.

Currently, CEA estimates that 36% of U.S. households (40 million households) own some configuration of a home theater system. High quality sound is viewed by consumers as an important feature of a home theater system. According to a CEA Home Theater Opportunity research report, a significant percentage of online consumers rate sound (80%) and video quality (84%) as important or very important aspects of a home theater system and 83% said that both are equally important factors.

Development of Robust New Markets for Digital Multi-Channel Sound

Digital multi-channel sound is extending into a growing number of consumer electronics environments, including homes, cars, personal computers, video games and consoles, portable electronics devices, and digital satellite and cable broadcast products. Content providers in the film, music and video game markets have recognized that a substantial market opportunity exists for digital multi-channel entertainment content. For example, Nielsen SoundScan estimates that DVD music video sales have grown in unit sales from over 10 million units in 2002 to 24 million units in 2006, a 22% compounded annual growth rate. The DVD Release Report for 2006 estimated that DVD music releases accounted for 14% of total DVD releases with over 8,700 titles released.

Car audio, personal computer, and video game console manufacturers are increasingly incorporating digital multi-channel audio capability into their products. Surround sound technology is also incorporated into portable electronics applications, such as palm-top DVD players, which allow listeners to enjoy a simulated surround sound experience using headphones. These markets represent significant growth opportunities as content providers and consumers become familiar with the capability of digital multi-channel audio to enhance the entertainment experience.

The digital satellite and cable broadcast markets may represent significant opportunities for digital multi-channel audio. ABI Research, in its Q4 2006 quarterly marketing briefing, estimates that digital satellite or digital cable was installed in approximately 59% of U.S. households at the end of 2006, projected to grow to 74% by the end of 2010, and in approximately 36% of Western European households at the end of 2006, projected to grow to 52% by the end of 2010. We believe a significant market opportunity may exist in all sectors of this market including broadcast hardware, high definition set-top boxes, and televisions.

Looking forward, we expect that next generation formats will drive home entertainment growth in the form of high definition DVD players, game consoles and blue laser DVD-ROM Drives for personal computers. We believe that multi-channel audio will play a critical role in expanding this high definition experience.

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According to the DEG, and NPD Group, in the United States, over 750,000 set-top box and game consoles were sold in 2006. The CEA estimates nearly 1 million high definition DVD set-top box units will be shipped in 2007. International Data Corporation, or IDC, estimates that through the end of 2006 over 5 million game consoles were shipped in the United States, projected to grow to a total of 12 million by the end of 2010.

Markets for Other Digital Technologies in the Motion Picture and Television Industries

Motion picture exhibitors continue to seek new sources of revenue, independent of feature films. As a result, there is growing demand for products and services that facilitate the creation, distribution, control, and playback of digital pre-show advertising and alternative content. Pre-show and alternative content presentation can represent a sizable revenue opportunity for exhibitors who have historically been financially challenged by the high cost of modern theater construction and the limited revenue sources available from theater operation. Screen Digest estimates that pre-show advertisements today account for over 80 percent of theater advertising, which they indicate has shown double-digit growth for the past three years. Screen Digest estimates that revenues from pre-show advertising in North America increased in 2006 to over $600 million.

In response to the growth in sales of high definition displays in homes and the move toward digital cinema presentation, many film and television content owners are seeking to prepare their assets for presentation in high definition. Due to significant resolution differences between the standard and high definition formats, standard definition content often displays poorly when shown on a high definition device. To look compelling, content often must be prepared and enhanced to be appropriate for use in high definition optical media, broadcast, or digital cinema applications. Accordingly, we believe there is a growing market for digital image enhancement and restoration services in the motion picture, television, and home theater markets.

The DTS Solution

Our proprietary DTS digital audio system provides moviegoers with a high-quality, digital multi-channel audio experience. Film studios and production companies use our technology and services to encode the soundtracks of their films using our proprietary digital multi-channel sound format. Theater owners purchase and use our products to playback DTS encoded soundtracks through six or more discrete speakers.

Our competitors imprint their proprietary digital multi-channel audio data directly onto the film. This can result in audio degradation or failure from repetitive use or handling. By contrast, we use a dual-medium system whereby we store audio information on CD-ROM discs, which are synchronized to the motion picture film by the use of our proprietary timecode. The timecode is printed on the film, which enables the correlation of single or multiple events, such as audio, light, or motion, to an individual frame of film. By placing audio data on optical media or hard discs rather than directly on film, we provide reliable high-quality playback that is not subject to film wear or subsequent audio degradation. Our system enables theater operators to easily change audio tracks or languages without changing film prints—a process that can take several hours. The use of DTS audio delivered from discs also allows much more data capacity, and consequently higher audio quality, than data-on-film systems.

In addition, we provide products that enable the transmission, scheduling and playback of video-based pre-show advertising and alternative content and systems for the projection and transmission of subtitles, captions, and descriptive narration. Our recently introduced DTS Cinema Media Network™ is a product suite that will allow exhibitors to purchase a single integrated software and hardware solution for multiple in-theater applications, thereby combining incremental revenue opportunities with cost efficient use of cinema hardware and personnel.

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During 2005, DCI, a consortium of major Hollywood Studios, completed and issued its technical specifications for digital cinema. The specification outlines minimum requirements for distribution and playback of digital motion pictures encoded using JPEG2000 compression technology. We subsequently introduced a DCI-compliant JPEG2000 Variable Bit Rate encoder to meet this need. Our DTS Digital Cinema Encoder™ provides highly efficient, master quality encodes by optimizing bit-allocation according to user-defined parameters.

In 1996, we introduced our Coherent Acoustics technology to bring advanced digital audio entertainment to the home. Coherent Acoustics is an audio compression/decompression algorithm, or codec, that enables the encoding and decoding of audio tracks in the DTS digital multi-channel sound format. The design architecture of our technology allows us to scale or adapt, adding features or performance while maintaining backward compatibility with earlier implementations of the technology. The encoding process reduces the storage space or transmission bandwidth required for the audio information, while maximizing the quality of the sound. The audio information can then be stored on a digital medium, such as a DVD, or transmitted over a broadband connection or broadcast signal. The encoded content can be played back on digital audio electronics products equipped with a DTS Coherent Acoustics decoder, such as a DVD-based home theater system.

The performance and flexibility of our Coherent Acoustics technology enables easy implementation in a variety of consumer electronics products. Our core technology has also been incorporated into sound systems used in homes, cars, personal computers, video games and consoles, portable electronics devices, and digital satellite and cable broadcast products.

The adoption of digital multi-channel audio depends on the availability of compelling content, along with the devices required to play it. Accordingly, we provide products and services to filmmakers, recording artists, producers, and software developers to facilitate the creation and delivery of audio content in our proprietary digital multi-channel format.

We strive to evolve and develop our technology on an ongoing basis. For example, to offer an enhanced experience for existing and new stereo content, we have developed our Neo:6 matrix technology. This technology provides simulated multi-channel playback from stereo content and has been incorporated into home theater, home audio, car electronics, and our movie theater products. More recently, we introduced DTS-HD Master Audio, which extends our technology offerings for the next-generation optical media formats known as HD-DVD and Blu-ray Disc in two ways. First, our lossless coding extension delivers audio which is bit-for-bit identical to the original master content. Secondly, DTS-HD Master Audio includes a low bit rate mode that extends our technology for use in applications where bandwidth and data capacity is much lower than in optical media, such as broadcast and portable devices. Although DTS-HD will be first introduced in HD-DVD and Blu-ray Disc players and home theater systems, these new technologies have application in a wide variety of consumer electronic devices and applications.

In 2005, we entered the image enhancement, restoration and repair market through the acquisition of Lowry Digital Images, a leader in digital image processing. In this division, which is now known as DTS Digital Images, or DTS DI, we apply sophisticated image evaluation and processing algorithms in the digital domain to restore, enhance and repair motion picture and television content for the professional and home entertainment markets. DTS DI processing is used by content owners to restore older content for release on DVD-Video and to repair content damaged in processing or problems encountered during production. Examples of the motion pictures that we have repaired or restored include a number of classic animated features, the original Star Wars trilogy, the Bond series and the Indiana Jones series. In addition, our techniques are increasingly being used to prepare content of all types for distribution in the HD-DVD or Blu-ray Disc formats or high definition theatrical release. DTS DI processing technologies can also be applied to correct or repair a multitude of photographic flaws that can result from the production and

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processing of film and digital image content. These include the correction of out-of-focus sequences due to camera problems and removing scratches or other flaws caused by incorrect processing.

Products and Services

We segment our business into consumer markets, cinema markets and digital images markets. The combination of our cinema and digital images markets creates our new DTS Digital Cinema business. Financial and geographic information for each of our business segments for each of the last three years is included in Footnote 20 to the consolidated financial statements, “Operating Segment and Geographic Information.”

Consumer Markets

In our consumer business segment, we provide technology that enables digital multi-channel surround sound for home theater, home audio, car audio, personal computer, and other emerging segments of the consumer markets. Our Coherent Acoustics technology was designed for the consumer electronics market. This proprietary technology enables delivery of multiple channels of discrete digital audio, but typically is used to provide from two to eight channels. Coherent Acoustics enables consumers to experience high-quality surround sound in their homes, cars, and many other listening environments.

We license our Coherent Acoustics technology to consumer electronics product manufacturers primarily through a two step process. First, we license our software developer kits to semiconductor manufacturers who typically embed our decoding software into their digital signal processor chips. In turn, these semiconductor manufacturers sell DTS-enabled chips only to hardware manufacturers who have entered into consumer manufacturer licenses with us. As part of the licensing terms for both semiconductor and hardware manufacturer licensees, we typically receive fees for access to our developer kits and for our certification, prior to sale, of the quality and performance of their products. Additionally, our business model provides for us to receive a per-unit royalty for hardware products manufactured containing our decoding technology.

Consumer electronics product manufacturers can also design their products to support the passing of a DTS bitstream to another device, such as an audio/video receiver, that contains a DTS decoder. We refer to this pass-through capability as DTS Digital Out. Only devices equipped with a Coherent Acoustics decoder can play back digital multi-channel audio encoded in our format. Similar to our licensing program for decoding technology, our DTS Digital Out trademark licensees typically pay us fees for access to our developer kits and for our certification of their products. Our business model provides that we receive per-unit royalties for products manufactured containing our trademark.

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DTS-enabled audio decoders are embedded in popular home theater products including audio/video receivers, home-theater-in-a-box systems and some DVD players. Our technology is also embedded and supported in new and emerging consumer electronics products that use digital multi-channel audio, including home audio systems, car audio systems, personal computers, video games and consoles, portable electronics devices, and digital satellite and cable broadcast products. Importantly, Coherent Acoustics was selected as a mandatory audio format in both the HD-DVD and Blu-ray Disc optical media formats. As a result, DTS decoding technology will be utilized in at least two-channel form in any consumer product that incorporates either a Blu-ray or HD-DVD disc drive. Our decoders have been embedded in nearly one hundred million audio/video devices.

As we enter new product categories, we fine-tune our business model to meet the specific needs of the relevant industry. In 2005, we launched the DTS-Connect program for the use of our technology in personal computers. DTS-Connect features a real-time DTS encoder and a version of our Neo:6 matrix technology tuned especially for personal computers, which we call Neo:PC. This technology suite not only allows the personal computer user to take advantage of the playback capabilities of nearly one hundred million DTS decoders by encoding audio resident on or streamed to the user’s computer, but also provides a multi-channel playback experience from stereo or mono content. In this business model, integrated circuit manufacturers pay us fixed per unit royalties for each DTS-enabled chipset shipped to a DTS licensed personal computer motherboard manufacturer. Each licensed personal computer motherboard manufacturer reports to us the number of units purchased and manufactured each quarter.

We also market products and services for the creation of digital multi-channel audio content and we produce digital multi-channel audio content primarily for promotional purposes. We sell professional audio encoding products to professional audio equipment dealers. We license our encoding technology to professional and professional/consumer product manufacturers who in turn sell the products to content owners and post-production facilities, enabling them to produce and release audio and audio/video products containing DTS digital multi-channel soundtracks. These content owners include home video producers and distributors, individual music artists, and music labels.

Home Theater

We have historically derived the majority of our consumer market revenue from licensing our technology for incorporation into home theater products. These products include:

·       Audio and Audio/Video Receivers.   Embedded DTS decoders enable these products to decode digital multi-channel audio.

·       DVD-Video Players.   Incorporation of DTS Digital Out capabilities enables these devices to pass-through DTS encoded audio content. In addition, some DVD players contain DTS decoding capability.

·       HD-DVD and Blu-ray Disc Players.   Embedded DTS decoders typically enable these products to decode two channels of digital audio and to pass a multi-channel bit stream through the player to an external device such as an audio/video receiver.

·       Home-Theater-in-a-Box Systems.   All-in-one home theater packages typically consist of a DVD player, audio/video receiver, five speakers, and a sub-woofer.

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New and Emerging Segments of the Consumer Market

The high quality and flexibility of our Coherent Acoustics algorithm provides for a variety of alternative applications. We are expanding into new and emerging markets for consumer electronics and entertainment products that incorporate high-quality digital multi-channel audio, including:

·       Home Audio Systems.   These are centralized home-based entertainment systems and servers that deliver entertainment content to various playback devices throughout the home.

·       Car Audio Systems.   Currently, many major after-market car audio manufacturers sell products that include our digital multi-channel audio technology. In addition, an increasing number of automobile manufacturers have introduced factory-installed digital multi-channel audio systems as either standard or optional equipment for a number of their new models. A DTS digital multi-channel sound system is available on certain Acura, Lexus, Infiniti, Mercedes, Land Rover, BMW, Cadillac, Toyota, Nissan, Honda and Mazda models. We anticipate growth in this market to continue as these and other manufacturers release vehicles that incorporate our technology.

·       Personal Computers.   We have licensed our technology for incorporation into both hardware and software products for the personal computer. In the hardware market, we have licensed our decoding technology to a number of hardware peripherals manufacturers who incorporate our technology into sound cards and speaker systems. In the software market, we have licensed our decoding technology to most of the leading software-based DVD player providers, including Cyberlink Corporation and Intervideo Inc. Additionally, we expect that Nero AG, and ArcSoft, Inc. will incorporate our technology into certain of their products. With the mandatory inclusion of our technology in the Blu-ray Disc and HD-DVD specifications, we expect an increased number of companies to introduce additional DTS-enabled software products in the personal computer space.

·       Video Games and Consoles.   We license our technology for inclusion into gaming hardware and software applications. We believe that the addition of interactive digital multi-channel audio in video games enables a level of realism not provided by conventional audio systems and represents a significant enhancement to the quality of the gaming experience. In the video game hardware market, Sony Corporation’s PlayStation 2 supports our interactive digital multi-channel sound technology when connected to a DTS-capable audio/video receiver. In the game software market, we have entered into licensing relationships with several major game publishers, including Activision, Inc., Atari, Inc., and Electronic Arts, Inc., to incorporate our digital multi-channel encoding technology into their PlayStation 2 games. Importantly, with the release of Sony’s PlayStation 3, DTS decoding technology is now included in each hardware unit, allowing the capability to decode 5.1 channels of digital audio within the player or the pass-through of a multi-channel stream to an external decoder. Similarly, Microsoft’s X-Box 360 now offers an external HD-DVD drive accessory which supports DTS 5.1 decoding capability.

·       Portable Electronics Devices.   Our technology is incorporated into some portable electronics devices, such as portable DVD players. We intend to aggressively pursue incorporation of our technology, including our new low bit rate technology, into other portable electronics devices such as flash memory players and portable disc players which enable stereo and simulated multi-channel playback via headphones.

·       Digital Satellite and Cable Broadcast Products.   Our technology has been adopted by the European Broadcasting Union’s Digital Video Broadcast Project as one of several formats for digital multi-channel audio delivery. This standards group sets digital cable, satellite, and terrestrial broadcast standards for international markets including Europe. We are actively working with other relevant standards organizations for the inclusion of our technology. Such inclusion would enable us to pursue the incorporation of our technology into broadcast hardware, set-top-boxes, and televisions.

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To date, we have licensed our trademarks and decoding technology for incorporation into television set-top boxes. Additionally, we continue to seek partnerships and strategic alliances to move consumer entertainment forward. In 2005, we entered into a Memorandum of Understanding with Coding Technologies to develop a broadcast solution that provides Coding Technologies, through a Coherent Acoustics real-time DTS encoder, access to our installed base of home theater decoders. Coding Technologies is a leading provider of open standard codecs and is possibly best known for its spectral enhancement which forms the “plus” in aacPlus. In January 2007, Euro 1080, a European high definition media company, entered into an agreement with us to become the first broadcaster to deploy the combined Coding Technologies and DTS solution.

New Technologies for Existing and Emerging Consumer Markets

We continue to evolve and develop our technology for the consumer market. Our Neo:6 matrix technology provides simulated multi-channel play back from stereo, or two-channel, content. This technology increasingly is being incorporated into home theater systems, home audio systems, and car audio systems. Our DTS-HD offering extends our Coherent Acoustics technology to full bit-for-bit accurate lossless performance for applications where the highest quality is required, and adds DTS-HD low bit rate technology for applications such as broadcast, portable and other devices where significant data size and bandwidth limitations exist. These additional technologies provide us with new revenue opportunities from existing and new customers. With DTS-HD, we believe we are uniquely positioned for the future evolution of high quality surround sound audio in the home. While DTS-HD is generally limited to 7.1 channels of audio in both the Blu-ray Disc and HD-DVD specifications, the DTS-HD technology can support more than 2,000 channels at 32-bit data. Current systems are typically limited to 24-bit data.

We continue to develop the synergies between the various market segments in which we operate, such as the incorporation of our Coherent Acoustics technology into our cinema products, to provide higher quality audio delivery for alternative content presentation in the cinema market.

Audio Content

To support the adoption of our technology, we sell, license, and provide professional audio products and services for encoding and decoding digital multi-channel content in our format. In addition, for promotional purposes we also produce, market, and sell a limited number of music titles in our digital multi-channel format.

Professional Audio Products and Services.   We sell, license, and provide a variety of professional audio products and services for content creators. The ultimate customers for these products are recording artists, music labels, and post-production facilities. Over the past two years, we have developed and launched a new set of professional audio products to support the launch of DTS-HD. Additionally, we worked with partners to integrate DTS-HD encoding functionality into a broad array of next generation HD-DVD and Blu-ray Disc authoring systems. The following table lists the professional audio products and services that we currently provide:

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Cinema Markets

In our cinema business segment we license technology and sell products and services to producers and distributors of feature length films and digital content, and to movie theaters and special venues.

Products and Services for Film Producers and Distributors

For film producers and distributors, we license technology to encode a movie’s audio master into our digital multi-channel format and provide audio CD-ROMs for distribution with film prints to movie theaters. To facilitate synchronization to the film print, we provide the studios with equipment and a license to produce a timecode track which is printed on the film. The discs and the film print have corresponding electronic serial numbers to ensure playback of the correct soundtrack.

We also offer products and services for the encoding of movies in the DCI-specified JPEG2000 format. We currently offer hardware and software and offer technical support to motion picture studios, distribution service providers and digital intermediate facilities engaged in preparation of content for digital cinema exhibition.

Products for Movie Theaters and Special Venues

Digital Audio Playback Systems.   In order for a movie theater to play a DTS-encoded soundtrack, the theater must use one of our audio playback systems. These systems are rack-mounted products installed in movie theater projection booths. These playback systems are sold in several configurations that support analog and digital audio play back, and other audio management and theater automation functions.

We sell similar products and services to special venues such as large-format theaters, amusement parks, national parks, and museums. We believe we are a leading supplier in this market due to our high quality and reliability and because we have the only commercially available technology that supports all film sizes and speeds from 8 millimeter to 70 millimeter.

Systems for Subtitling, Captioning, and Descriptive Narration.   We also sell our DTS-CSS system to movie theaters. This system delivers feature-film subtitles, captions, and descriptive narration for foreign language and hearing and visually impaired audiences. We believe this proprietary digital system is a cost-effective method to provide subtitles, captions, and descriptive narration for a film because it eliminates the need to permanently imprint, etch, or overlay the subtitles or captions directly onto the film. The DTS-CSS system enables the delivery of open or closed captioning, depending on the output device utilized. For open captions, the DTS-CSS system uses a separate video projector to render subtitles or captions; for closed captions, the system is utilized in conjunction with a rear-wall display device. This product is designed to address the increasing political and social pressure to provide access to the motion picture experience for the hearing and visually impaired.

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This same family of products is also being used for electronic cinema applications including alternative content presentations and pre-show advertising, incorporating both high definition image and audio playback capabilities. These products enable a theater owner to extend its range of revenue opportunities, and help to maximize the utility of equipment in theater projection rooms, saving expense and space. In the pre-show advertising area, both the CSS system and the DTS XD10 Cinema Media Player can be used when coupled with a color projector. The DTS XD10 has an extensive feature set, which includes networking capability to facilitate its integration into a content distribution system. We also offer the DTS Cinema Media Network™ product suite which incorporates the DTS XD10 Cinema Media Player to manage the creation, transmission/delivery, scheduling, logging, remote system monitoring and playback of all types of digital content including video, audio, subtitles, captions, and descriptive narration.

Systems for Digital Video Preparation, Delivery and Exhibition.   Through our exclusive licensing deal with Avica and initiatives to enhance our ability in the digital cinema arena, we also offer our customers a range of technology, products and services for the preparation, delivery and exhibition of digital cinema content. The Avica FilmStore Platform includes the FilmStore Digital Cinema Player, the FilmStore Central Multiplex Content Manager and the FilmStore Director Theater Management System. The FilmStore Digital Cinema Player supports both single screen and multiplex exhibition and provides simple start, stop, play and status, sophisticated content protection and 4K capability. The FilmStore Central Multiplex Content Manager provides a link to an external network and provides secure movie storage, advanced rights management and centralized show control. The FilmStore Director Theater Management System provides a management system interface enabling local or remote access to control a multiplex and security management for content and users. The Avica StillStore captures and stores high quality, uncompressed still images with functionality that includes up- and down-conversions on-the-fly, networking, Internet export of stills, and machine control interface for industry standard color. The Avica MotionStore captures motion or still images as high definition digital data which can then be instantly recalled for playback or converted for export to a wide variety of formats.

The chart below lists some products that we sell or plan to sell to movie theaters and special venues:

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Image Enhancement, Restoration and Repair Services

In our Digital Images division, we provide enhancement, restoration and repair services for motion pictures captured in analog or digital form. Our services enable current or archived film or television content to be enhanced, restored or repaired to enable high quality, high definition presentation in high definition optical media, broadcast, or digital cinema applications. In addition, we believe that DTS DI is uniquely suited for correcting or repairing a multitude of photographic challenges encountered in the production and processing of film and digital image content. These issues range from the correction of out-of-focus sequences due to camera problems to removing scratches or other flaws caused by incorrect processing.

DTS Technology Platform

Our Coherent Acoustics audio technology platform is designed to capture, store, and reproduce audio signals. There are several technical considerations involved in this process, including the frequency of data sampling, the word length, and the bit rate. These factors can control the quality of audio presentation and are commonly managed through compression techniques.

A fundamental challenge with digital audio distribution is that capturing analog signal representations in digital form requires a tremendous amount of data. Therefore, the storage and subsequent transmission of that data presents physical space, efficiency, and economic challenges. We address this challenge by developing coding technology and products that reduce the amount of data required to store and transmit an audio signal and to subsequently reproduce the audio.

The design, architecture, and implementation of this coding solution are complex. Signal coding requires a thorough and combined understanding of the disciplines of electrical engineering, computer science, and psychoacoustics, coupled with significant practical experience. One of our key technical

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strengths has been our ability to develop a system that enables the transparent reproduction of an original audio signal, meaning that the reproduction sounds indistinguishable from its source.

Emerging applications for digital multi-channel audio, such as video games, the Internet, and recordable media, have limited bandwidth. Our technology architecture is flexible enough to accommodate these needs and optimize quality within the constraints of the application.

We have designed the following attributes into the basic architecture of our technology:

·       scalable, meaning that parameters such as data rate can be set over a very wide range, as applications require;

·       extensible, meaning that the structure itself accommodates additional data for enhancements both anticipated and unknown; and

·       backward compatible, meaning that extensions and enhancements do not preclude the ability of earlier decoders to play the core signal.

Intellectual Property

We have a substantial base of intellectual property assets covering patents, trademarks, copyrights, and trade secrets. We have 31 individual patent families resulting in more than 135 individual patents and more than 82 patent applications throughout the world. We have more than 112 trademarks and more than 42 trademark applications pending worldwide with additional marks in the pre-application phase. We also have a number of federally registered copyrights and maintain a sizeable library of copyrighted software and other technical materials as well as numerous trade secrets. We have targeted our intellectual property coverage to provide protection in the major manufacturing and commercial centers of the world.

We pursue a general practice of filing patent applications for our technology in the United States and various foreign countries where our customers manufacture, distribute, or sell licensed products. We actively pursue new applications to expand our patent portfolio to address new technological innovations. Most of the patents in our patent portfolio have an average life of 20 years from their date of filing with some having begun to expire in 2005 and others expiring through 2009. However, many of our more substantive patents are relatively young and have expiration dates ranging from 2015 to 2018. We have multiple patents covering unique aspects and improvements for many of our technologies. Accordingly, we do not believe that the expiration of any single patent is likely to significantly affect our intellectual property position or our ability to generate licensing revenues.

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The following table lists our key patents and patent applications and the inventions they cover:

 

We generally license our technology on our standard terms through a two-tiered structure: first to integrated circuit semiconductor manufacturers and then to consumer electronics product manufacturers. We generally license on a non-exclusive, worldwide basis. Our business model provides for hardware manufacturers to pay us a license fee for each unit they produce that contains our technology or trademarks. We require that all licensees have their integrated circuits or hardware devices certified by us prior to distribution. We reserve the right to audit their records and quality standards. Licensees are required to use the appropriate DTS trademark on the products they manufacture.

In our consumer business, we have 67 patents issued and 72 patents pending worldwide spanning the entire spectrum of our technology including the encoding and decoding process, the structure of the DTS audio stream, and media containing DTS encoded material. In addition, we have a number of patents and applications covering extensions of our core technology architecture as well as unique implementation approaches for various product applications.

In the cinema market, we have 47 patents issued and nine patents pending worldwide covering our cinema system, the DTS time code, and our subtitling method. These patents cover the technology that is

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utilized in our various cinema products as well as our film license rights. We also have 21 patents and one patent application that span both the consumer products and cinema sectors of our business. These rights primarily cover the process of producing media containing DTS and digital multi-channel audio as well as the individual finished product.

In our Digital Images business, we have historically relied primarily on trade secrets to protect our intellectual property. In the future, we expect to seek patent protection for inventions relating to this business and we currently have several patent applications in development.

We have licensed from Audio Processing Technology Limited the rights to the apt-X algorithm on a perpetual, worldwide, non-exclusive basis. The apt-X algorithm is the audio algorithm used by our cinema products to encode and play back our audio tracks.

Our trademarks consist of over 30 individual word marks, logos, and slogans filed throughout the world. The marks cover our various products, technology, improvements, and features as well as the services that we provide. Our trademarks are an integral part of our licensing program and are required to be used on licensed products to identify the existence of the technology and to provide greater consumer awareness. Our trademarks include the following:

We have a significant amount of copyright protected materials including software, textual materials, and master audio materials used to produce our DTS Entertainment (“DTSE”) products. A number of these products have been federally registered.

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Customers

Consumer Markets

Consumer Electronics Products Manufacturers

We have licensed our Coherent Acoustics technology or our trademarks to approximately 300 consumer electronics products manufacturers for use in hundreds of consumer audio products. Collectively, these manufacturers have sold hundreds of millions of DTS-licensed consumer electronic products worldwide. The following list sets forth some of the consumer electronics product manufacturers that have licensed our technology.

 

 

 

Semiconductor Manufacturers

We have licensed to approximately 50 semiconductor manufacturers the right to incorporate our technology in their semiconductors and to sell semiconductors with DTS technology to our hardware manufacturer licensees. Our major semiconductor-manufacturing customers include the following:

Analog Devices Broadcom Corporation	Fujitsu Limited LSI Logic Recorder Corporation	MediaTek, Inc. Sigma Designs, Inc.
Cirrus Logic, Inc. Freescale Semiconductor, Inc.	Matsushita Electrical Industrial Co., Ltd.	Texas Instruments, Inc. Yamaha Corporation

 

Content Providers

We have also provided our Coherent Acoustics technology to many of the leading home video and music content providers including DreamWorks Home Entertainment, New Line Home Entertainment, Inc., and Warner Bros. Records, Inc. To date, thousands of DVD titles have been produced with DTS digital multi-channel audio tracks.

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Cinema Markets

The major film studios in the United States are all customers of ours. These studios, which released most of their major feature films in the DTS format in 2006, are listed below.

20th Century Fox	Paramount Pictures	Universal Pictures
Buena Vista Pictures	MGM Pictures/Sony/Columbia	Warner Bros. Pictures
DreamWorks SKG	New Line Cinema Corp.

 

In addition, we sell our playback equipment to movie theaters, including the following:

Carmike Cinemas	Odeon Limited	Regal Entertainment
Cinemark	Rave Motion Pictures

 

Digital Images Markets

Our Digital Images division’s customers primarily include major film and television distributors, including:

Disney Worldwide Services	Paramount Pictures / CBS Television	20th Century Fox
LucasFilm	Sony / MGM Pictures	Warner Bros Television

 

Sales, Marketing, and Support

Consumer Products

We have a licensing team that markets our technology directly to large consumer electronic products manufacturers and semiconductor manufacturers. This team includes employees located in the United States, China, England, Hong Kong, Japan, Northern Ireland, and Taiwan. We believe that by locating staff near the leading consumer electronics and semiconductor manufacturers we can enhance our sales and business development efforts.

We market our digital sound encoding equipment directly to the content providers and audio professionals serving the consumer electronics market. We believe that allowing easy access to DTS encoders will result in more DTS content, which we believe will drive consumer demand for DTS-enabled electronics products.

Film Producers and Distributors

Our post-production department, senior management, and liaison offices market our products and services directly to individual film producers and distributors worldwide.

Movie Theaters

We sell our cinema playback systems to movie theaters through a direct sales force and a network of independent dealers. To date, most of our sales and marketing efforts have been focused in the United States, Western Europe, and in targeted markets in Asia and Latin America. We have also begun to focus our efforts on pursuing theater companies that have a large concentration of movie theaters in selected foreign countries such as India, China, and Eastern Europe.

Research and Development

We have a group of 72 engineers and scientists, including seven PhDs, focused on research and development. This group oversees our product development efforts and is responsible for implementing

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our technology into our existing and emerging products. We carry out research and development activities at our corporate headquarters in Agoura Hills, California and at our facilities in Bangor, Northern Ireland; Vancouver, Canada; and Burbank, California.

Our research and development expenses totaled approximately $6.1 million during 2004, $9.9 million during 2005, and $12.3 million during 2006. We expect that we will continue to commit significant resources to applications engineering efforts, particularly in support of the new high definition disc standards, and to research and development in the future.

Governmental and Industry Standards

There are a variety of governmental and industry-related organizations that are responsible for adopting system and product standards. Standards are important in many technology-focused industries as they help to assure compatibility across a system or series of products. Generally, standards adoption occurs on either a mandatory basis, requiring the existence of a particular technology or feature, or an optional basis, meaning that a particular technology or feature may be, but is not required to be, utilized.

We actively participate in a variety of standards organizations worldwide, including the DVD Forum, Blu-ray Disc Association, Digital Video Broadcast Project, International Engineering Consortium, Digital Living Network Alliance, High-Definition Multimedia Interface Standard, Media Oriented Systems Transport Bus, Audio Engineering Society and Society for Motion Picture and Television Engineers. We anticipate being involved in a number of other standards organizations as appropriate to facilitate the implementation of our technology.

We believe the market for audio and audio/video products is very standards driven and our active participation with standards organizations is important as we work to include our technology in standards or change our status from optional to mandatory where possible. We believe our standards involvement also provides us early visibility into future opportunities.

In the consumer products area, we are members of the DVD Forum and Blu-ray Disc Association. In both organizations we are specifically involved in several working groups and expert groups, and have obtained mandatory status in both the HD-DVD and Blu-ray Disc formats. For DVD-Video, we have obtained optional status for our Coherent Acoustics technology. Through our participation in standards setting, we have expanded the supported specification of our codec, increasing the audio quality and number of channels. Our technology has been accepted as an optional format in the DVD-Audio Recordable specification and we are currently involved in the working groups for Interactive DVD and DVD recording specifications for both audio and high definition video.

In the digital broadcast area, we participate in the Digital Video Broadcast Project, or DVB, and the Advanced Television Systems Committee, or ATSC. In late 2002 our technology was accepted as an optional audio format in the DVB Specification.

We actively participate in the major industry associations that publish research and establish standards. These include the Society of Motion Picture and Television Engineers and, in particular, the committees relating to digital cinema, and the Audio Engineering Society.

We have seven employees and consultants focused on standards activities, including one in Europe, one in Japan, one in Korea, and four in the United States. We also employ additional resources as necessary to assist with specific standards-related tasks.

Competition

We face intense competition in each of our markets and expect competition to intensify in the future. Our primary competitor is Dolby Laboratories, who develops and markets digital multi-channel audio

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products and services. Except with respect to image enhancement and restoration, we compete with Dolby in nearly all of our markets and product categories.

Dolby was founded over 40 years ago and for many years was the only significant provider of audio technologies. Dolby’s long-standing market position, brand, business relationships, and inclusion in various industry standards provide it with a strong competitive position.

In addition to Dolby, we also compete in specific product markets with Coding Technologies, Fraunhofer Institut Integrierte Schaltungen, Koninklijke Philips Electronics N.V., Meridian Audio Limited, Microsoft Corporation, Smart Devices, Inc., Sony Corporation, Thomson, Ultra Stereo Labs, Inc., and various consumer electronics products manufacturers. Many of these competitors have longer operating histories and significantly greater resources or greater name recognition than we do.

We believe that the principal competitive factors in each of our markets include some or all of the following:

·       technology performance, flexibility, and range of application;

·       quality and reliability of products and services;

·       brand recognition and reputation;

·       inclusion in industry standards;

·       price;

·       relationships with film producers and distributors and with semiconductor and consumer electronics manufacturers;

·       availability of compatible high-quality audio content; and

·       timeliness and relevance of new product introductions.

We have been successful in penetrating the consumer, cinema, and digital images markets and building and maintaining market share. Most major feature-film releases in the United States are encoded in our format, many top selling and premier edition DVDs contain digital multi-channel soundtracks in our format, a substantial majority of consumer electronics products with digital multi-channel capability incorporate our technology, trademarks, or know-how, and many of the most valuable film properties in the world have been restored using our process. Our success has been due in large part to our ability to position our brand as a premium offering that contains superior proprietary technology, the quality of our customer service, our inclusion in industry standards, and our industry relationships.

We believe there are significant barriers to entry in our key markets. In the film-based cinema market, there are three well-established formats—DTS, Dolby, and Sony—and we believe it would be very difficult for a new entrant to penetrate the market. Key barriers to entry include physical limitations on the film, intellectual property coverage, and the reluctance of the film studios to pay additional license fees and theater operators to purchase additional playback equipment. In the consumer electronics products market, the standards relating to DVD-Video are well established and support a limited number of technologies including DTS Coherent Acoustics. In the digital images market, we believe that we have a significant lead in automating the enhancement and restoration of television and motion picture images through the use of sophisticated proprietary software algorithms.

Recent Developments

On February 20, 2007, we announced that our Board of Directors approved a plan to sell our DTS Digital Cinema business to enable us to focus exclusively on licensing branded entertainment technology to the large and evolving audio, game console, personal computer, portable and broadcast markets. The sales

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process has begun and is expected to conclude later in 2007. The DTS Digital Cinema business will focus on the emerging and potentially large market for digital cinema products and services. Beginning in the first quarter of 2007, we expect to report financial results related to our DTS Digital Cinema business as “discontinued operations.”

On January 30, 2007 we announced an agreement with Digital Cinema Ltd., or DCL, to install and manage a trial deployment of 25 digital cinema systems in Ireland. We believe this was an important milestone for our DTS Digital Cinema business as it enabled us to showcase our many strengths—the breadth of our capabilities, the depth of our knowledge of the cinema environment, and our ability to respond to customer needs.

Employees

As of December 31, 2006, we had 325 employees, which includes 72 employees in engineering, technical services, and research and development, 62 employees in production and operations, 99 employees in sales, marketing, service, and support, 40 employees in accounting and information technology, and 52 employees in senior management and administration. Of the 325 total employees, 239 work in the United States and 86 work in our various international locations, including 59 in the United Kingdom. None of our employees are subject to a collective bargaining agreement, and we have never experienced a work stoppage. We believe our relations with our employees are satisfactory. Our future success depends on our ability to attract, motivate, and retain highly-qualified technical and management personnel. From time to time, we also employ independent contractors to support our product development, sales, marketing, business development, information technology and administration organizations.

Website Access to SEC Filings

We maintain an Internet website at www.dts.com. We make available free of charge through our Internet website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.

Materials we file with the SEC may be read and copied at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet website at www.sec.gov that contains reports, proxy and information statements, and other information regarding our Company that we file electronically with the SEC.

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Item 1A.                Risk Factors

RISK FACTORS

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

Risks Related to Our Business

The sale of our DTS Digital Cinema business or any failure to successfully manage and complete an undertaken sales transaction could adversely affect our business and operating results.

In order to better address rapidly evolving markets, meet the needs of customers and increase stockholder value, we are proceeding with the sale of our DTS Digital Cinema business. The sales process may be costly. The sale might not be accomplished by the end of 2007 or at all. The sales process requires significant time and attention from our management, finance, accounting and legal teams, which could disrupt our day-to-day operations and shift the allocation of these resources away from matters related to our core business. In addition, implementing any transaction would involve a number of operational, legal and, possibly, regulatory steps. Implementation could be costly, cause further disruption to our day-to-day operations, and result in the loss of customers and/or sales revenue, which could cause our business and operating results to suffer. Furthermore, implementation of a sale is a complicated process and there is a risk that we may not be successful in the execution of our sales strategy, which could cause our business to suffer and our stock price to decline.

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.

Establishing, maintaining and strengthening our “DTS” brand is critical to our success. Our brand identity is key to maintaining and expanding our business and entering new markets. Our success depends in large part on our reputation for providing high quality products, services and technologies to the entertainment industry and the consumer electronics products industry. If we fail to promote and maintain our brand successfully, our business and prospects may suffer. Moreover, we believe that the likelihood that our technologies will be adopted in industry standards depends, in part, upon the strength of our brand, because professional organizations and industry participants are more likely to incorporate technologies developed by a well-respected and well-known brand into standards. Maintaining and strengthening our brand will depend heavily on our ability to develop innovative technologies for the entertainment industry, to continue to provide high quality products and services, and manage brand transition in connection with the process of selling the DTS Digital Cinema business, which we may not do successfully.

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

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

·       rapid technological change;

·       new and improved product introductions;

·       changing customer demands;

·       evolving industry standards; and

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·       product obsolescence.

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

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

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

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

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

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

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

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

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

·       efforts to identify and prosecute unauthorized uses of our technology are time consuming, expensive, and divert resources from the operation of our business; and

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

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

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

Companies that participate in the digital audio, digital image processing, consumer electronics, and entertainment industries hold a large number of patents, trademarks, and copyrights, and are frequently

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

We face intense competition. Many of our competitors have greater brand recognition and resources than we do.

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

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

·       products for cinema markets, such as Smart Devices, Inc., Ultra Stereo Labs, Inc., Eastman Kodak Company, Screenvision Cinema Network LLC, National CineMedia LLC, Doremi Labs, Inc. and Unique Digital Ltd.;

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

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

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

·       greater name recognition;

·       a longer operating history;

·       more developed distribution channels and deeper relationships with our common customer base;

·       a more extensive customer base;

·       digital technologies that provide features that ours do not;

·       broader product and service offerings;

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

·       more technicians and engineers; and

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·       greater technical support.

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

In addition to the competitive advantages described above, Dolby also enjoys other unique competitive strengths relative to us. For example, it introduced multi-channel audio technology before we did and has a larger base of installed movie theaters for its cinema playback equipment. Its technology has been incorporated in significantly more DVD-Video films than our technology. It has also achieved mandatory standard status in product categories that we have not, including DVD-Video and DVD-Audio Recordable, for its stereo technology and terrestrial digital television broadcasts in the United States. It also currently has more depth in digital cinema. As a result of these factors, Dolby has a competitive advantage in selling its digital multi-channel audio technology to consumer electronics products manufacturers and in selling products and services designed for use in the digital cinema space.

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

We do not expect sales of traditional consumer DVD players to sustain their past growth rates. To the extent that sales of DVD players and home theater systems level off or decline, or alternative technologies in which we do not participate replace DVDs as a dominant medium for consumer video entertainment, our business will be adversely affected.

Growth in our business over the past several years is due in large part to the rapid growth in sales of DVD players and home theater systems incorporating our technologies. As the markets for DVD players mature, we do not expect sales of traditional consumer DVD players to sustain their past growth rates. To the extent that sales of DVD players and home theater systems level off or decline, our business will be adversely affected. Additionally, the release and consumer adoption of next-generation optical disc players has only just begun. There are currently two potential, incompatible formats for high-definition optical disc format, and consumers may not react favorably to having to make a choice between formats. There is also the risk of consumer confusion and frustration over the inability of a given format player to play a disc in the competing format. The slow uptake by consumers of these new formats, as well as the inability of traditional DVD players to sustain their past growth rates, could adversely affect our business, as revenue and earnings derived from these new players and associated home theater system sales may not fully replace the anticipated decline in revenue and earnings associated with traditional DVD players and home theater systems. Even assuming resolution of the competing disc format conflict, the rate of consumer adoption and ultimate penetration of next-generation optical disc players is uncertain and may be slower than past growth rates of traditional DVD players. In addition, if new technologies are developed for use with DVDs or new technologies are developed that substantially compete with or replace DVDs as a dominant medium for consumer video entertainment, our business, operating results and prospects will be adversely affected.

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

We are dependent on our customers and licensees—including consumer electronics products manufacturers, semiconductor manufacturers, movie theaters, producers and distributors of content for music, films, videos, and games and builders and integrators of digital cinema networks—to incorporate our technology in their products, purchase our products and services, or release their content in our proprietary DTS audio format. Although we have contracts and license agreements with many of these

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companies other than builders and integrators of digital cinema networks, these agreements do not require any minimum purchase commitments, are on a non-exclusive basis, and do not require incorporation or use of our technology, trademarks or services. Our customers, licensees and other manufacturers might not utilize our technology or services in the future.

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

We expect to derive a significant percentage of our revenues from the technology, products, and services that we offer to manufacturers of consumer electronics products. To date, the most significant driver for the use of our technology in the home theater market has been the release of major movie titles with DTS audio soundtracks. We also believe that demand for our DTS audio technology in emerging markets for multi-channel audio, including homes, cars, personal computers, and video games and consoles, will be based on the number, quality, and popularity of the audio DVDs, computer software programs, and video games released with DTS audio soundtracks. Although we have existing relationships with many leading providers of movie, music, computer, and video game content, we do not have contracts that require any of these parties to develop and release content with DTS audio soundtracks. In addition, we may not be successful in maintaining existing relationships or developing relationships with other existing providers or new market entrants that provide content. As a result, we cannot assure you that a significant amount of content in movies, audio DVDs, computer software programs, video games, or other entertainment mediums will be released with DTS audio soundtracks. If the amount, variety, and popularity of entertainment content released with DTS audio soundtracks do not increase, consumer electronics products manufacturers that pay us per-unit licensing fees may discontinue offering DTS playback capabilities in the consumer electronics products that they sell.

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

The market for consumer electronics products is intensely competitive and price sensitive. Retail prices for consumer electronics products that include our DTS audio technology, such as DVD players and home theater systems, have decreased significantly and we expect prices to continue to decrease for the foreseeable future. Declining prices for consumer electronics products could create downward pressure on the licensing fees we currently charge our customers who integrate our technology into the consumer electronics products that they sell and distribute. Most of the consumer electronics products that include our audio technology also include Dolby’s multi-channel audio technology. As a result of pricing pressure, consumer electronics products manufacturers who manufacture products in which our audio technology is not a mandatory standard could decide to exclude our DTS audio technology from their products altogether.

The market for consumer video products is also intensely competitive and price sensitive. Retail prices for consumer video products have experienced price pressure and we expect this price pressure to continue for the foreseeable future. Declining retail prices for such video products could create downward pressure on the fees we charge our customers for the image processing, enhancement and restoration services we provide. If the motion picture studios, content owners, producers or distributors were to believe that the existing image quality is satisfactory or that the pricing for our services is too high, they could decide to not use our services altogether.

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Our licensing revenue depends in large part upon semiconductor manufacturers incorporating our technologies into integrated circuits, or ICs, for sale to our consumer electronics product licensees and if, for any reason, our technologies are not incorporated in these ICs or fewer ICs are sold that incorporate our technologies, our operating results would be adversely affected.

Our licensing revenue from consumer electronics product manufacturers depends in large part upon the availability of ICs, that implement our technologies. IC manufacturers incorporate our technologies into these ICs, which are then incorporated in consumer electronics products. We do not manufacture these ICs, but rather depend on IC manufacturers to develop, produce and then sell them to licensed consumer electronics product manufacturers. We do not control the IC manufacturers’ decisions whether or not to incorporate our technologies into their ICs, and we do not control their product development or commercialization efforts. If these IC manufacturers are unable or unwilling, for any reason, to implement our technologies into their ICs, or if, for any reason, they sell fewer ICs incorporating our technologies, our operating results will be adversely affected.

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

A significant percentage of our revenues are generated from our consumer electronics products manufacturer customers who license and incorporate our technology in their consumer electronics products. Under our existing arrangements, these customers pay us per-unit licensing fees based on the number of consumer electronics products manufactured that incorporate our technology. We rely on our customers to accurately report the number of units manufactured in collecting our license fees, preparing our financial reports, projections, budgets, and directing our sales and product development efforts. Most of our license agreements permit us to audit our customers, but audits are generally expensive, time consuming, difficult to manage effectively, dependent in large part on the cooperation of our licensees and the quality of the records they keep, and could harm our customer relationships. If any of our customer reports understate the number of products they manufacture, we may not collect and recognize revenues to which we are entitled.

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

Although we have been in business since 1990, we have only achieved annual profitability since fiscal 2001. We expect our operating expenses to increase as we, among other things:

·       expand our domestic and international sales and marketing activities;

·       develop and roll out our digital cinema products and services;

·       proceed with the sale of our DTS Digital Cinema business;

·       restructure our international operations;

·       adopt a more product-centric business model which is expected to entail additional hiring;

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

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

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

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

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

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

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

Our capital requirements will depend on many factors, including:

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

·       the costs of developing new products or technology;

·       the extent to which we invest in new technology and research and development projects, including without limitation, digital cinema;

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

·       the extent to which we deploy our digital cinema products to theaters;

·       the costs associated with our expansion, if any; and

·       the sale of our DTS Digital Cinema business.

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

We have a limited operating history in our new and evolving markets.

Although the first movie with a DTS audio soundtrack was released in 1993, we did not enter the home theater market until 1996, and our technology has only recently been incorporated into other consumer electronics markets, such as car audio, personal computers, video games and consoles, portable electronics devices, and digital satellite and cable broadcast products. In addition, while we have completed over 100 digital image processing, enhancement and restoration film projects, it is only recently that a large number of these projects have been completed. As a result, the demand for our technology, products, and services and the income potential of these businesses are unproven. In addition, because the market for digital audio technology and image services is relatively new and rapidly evolving, we have limited insight into trends that may emerge and affect our business. We may make errors in predicting and reacting to relevant business trends, which could harm our business. Before investing in our common stock, you should consider the risks, uncertainties, and difficulties frequently encountered by companies in new and rapidly evolving markets such as ours. We may not be able to successfully address any or all of these risks.

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

Our technology or products could contain errors that could cause our products or technology to operate improperly and could cause unintended consequences. If our products or technology contain errors we could be required to replace them, and if any such errors cause unintended consequences we could face claims for product liability. Although we generally attempt to contractually limit our exposure to incidental and consequential damages, as well as provide insurance coverage to such events, if these contract provisions are not enforced or are unenforceable for any reason, if liabilities arise that are not

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effectively limited, or if our insurance coverage is inadequate to satisfy the liability, we could incur substantial costs in defending and/or settling product liability claims.

Issues arising from the implementation of our new enterprise resource planning system could affect our operating results and ability to manage our business effectively.

We recently began to implement an enterprise resource planning, or ERP, system to enhance operating efficiencies and provide more effective management of our business operations. Implementing a new ERP system is costly and involves risks inherent in the conversion to a new computer system, including disruption to our normal accounting procedures and internal control over financial reporting and problems achieving accuracy in the conversion of electronic data. Failure to properly or adequately address these issues could result in increased costs, the diversion of management’s and employees’ attention and resources and could materially adversely affect our operating results, internal control over financial reporting and ability to manage our business effectively. While the ERP system is intended to improve and enhance our information systems, large scale implementation of new information systems exposes us to the risks of start up of the new system and integration of that system with our existing systems and processes, including possible disruption of our financial reporting, which could lead to a failure to make required filings under the federal securities laws on a timely basis. In addition, if we fail to implement the ERP system or fail to implement the ERP system successfully, we will continue to rely on our current information systems.

We cannot be certain of the future effectiveness of our internal controls over financial reporting or the impact thereof on our operations or the market price of our common stock.

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we are required to include in our annual reports on Form 10-K our assessment of the effectiveness of our internal controls over financial reporting. We cannot assure you that our system of internal controls will be effective in the future as our operations and control environment change. If we cannot adequately maintain the effectiveness of our internal controls over financial reporting, our financial reporting may be inaccurate. If reporting errors actually occur, we could be subject to sanctions or investigation by regulatory authorities, such as the SEC. These results could adversely affect our financial results or the market price of our common stock. If our independent registered public accounting firm is unable to provide us with an unqualified report as to the adequacy of our internal controls over financial reporting as required by Section 404 of the Sarbanes Oxley Act of 2002, investors could lose confidence in the reliability of our financial statements, which could result in a decrease in the value of our stock.

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

We market and sell our products and services outside the United States, and currently have employees located in more than ten countries worldwide. Many of our customers and licensees are located outside the United States. As a key component of our business strategy, we intend to expand our international sales. During fiscal 2006, approximately 71% of our revenues were derived internationally. We face numerous risks in doing business outside the United States, including:

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

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

·       difficulties in staffing and managing foreign operations;

·       competition from foreign companies;

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·       dependence on foreign distributors and their sales channels;

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

·       less effective and less predictable protection of intellectual property;

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

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

·       potentially adverse tax consequences.

Such factors could cause our future international sales to decline.

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

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

We face risks in expanding our business operations in China.

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

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

A prolonged economic downturn could materially harm our business.

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

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

We acquired DTS DI in January 2005, and we expect to consider additional opportunities to acquire or make investments in other technologies, products, and businesses that could enhance our technical capabilities, complement our current products and services, or expand the breadth of our markets, including without limitation the potential acquisition of substantially all of the assets of Avica. We have a limited history of acquiring and integrating businesses. Acquisitions and strategic investments involve numerous risks, including:

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

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

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

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

·       unanticipated costs associated with the acquisition, including accounting charges, capital expenditures, and transaction expenses;

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

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

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

·       unanticipated or unknown liabilities relating to the acquired businesses;

·       the need to integrate accounting, management information, manufacturing, human resources and other administrative systems to permit effective management; and

·       potential loss of key employees of acquired organizations.

If we fail to properly evaluate and execute acquisitions and strategic investments, our management team may be distracted from our day-to-day operations, our business may be disrupted, and our operating results may suffer. In addition, if we finance acquisitions by issuing equity or convertible debt securities, our existing stockholders would be diluted. Foreign acquisitions involve unique risks in addition to those mentioned above, including those related to integration of operations across different geographies, cultures and languages, currency risks and risks associated with the particular economic, political and regulatory environment in specific countries. Also, the anticipated benefit of our acquisitions may not materialize, whether because of failure to obtain stockholder approval or otherwise. Future acquisitions could result in potentially dilutive issuances of our equity securities, the incurrence of debt, contingent liabilities or amortization expenses, or write-offs of goodwill, any of which could harm our operating results or financial condition. Future acquisitions may also require us to obtain additional equity or debt financing, which may not be available on favorable terms or at all.

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

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

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

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

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

·       manage multiple concurrent development projects; and

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

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

We may experience fluctuations in our operating results.

We have historically experienced moderate seasonality in our business due to our business mix and the nature of our products. In our consumer business, consumer electronics manufacturing activities are generally lowest in the first calendar quarter of each year, and increase progressively throughout the remainder of the year. Manufacturing output is generally strongest in the third and fourth quarters as our technology licensees increase manufacturing to prepare for the holiday buying season. Since recognition of revenues in our consumer business generally lags manufacturing activity by one quarter, our revenues and earnings from the consumer business are generally lowest in the second quarter. Film licensing revenues are generally strongest in the second and fourth quarters due to the abundance of movies typically released during the summer and year-end holiday seasons. The introduction of new products and inclusion of our technologies in new and rapidly growing markets can distort and amplify the seasonality described above. For example, the introduction of next generation optical disc players may result in an overall near-term slowdown in our business as sales of standard definition players slow in anticipation of purchasing next generation products, but purchases of next generation products are in an early-adopter only phase. Similar issues may affect our cinema hardware business during the expected transition to digital cinema. Our revenues may continue to be subject to fluctuations, seasonal or otherwise, in the future. Unanticipated fluctuations, whether due to seasonality, product cycles, or otherwise, could cause us to miss our earnings projections, or could lead to higher than normal variation in short-term earnings, either of which could cause our stock price to decline.

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

Even if our technologies are adopted as an industry standard for a particular market, market participants may not widely adopt our technologies.

Even if a standards-setting body mandates our technologies for a particular market, our technologies may not be the sole technologies adopted for that market as an industry standard. Accordingly, our business may depend upon participants in that market choosing to adopt our technologies instead of or in addition to competitive technologies that also may be acceptable under such standard.

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Our licensing of industry standard technologies can be subject to limitations that could adversely affect our business and prospects.

When a standards-setting body adopts our technologies as explicit industry standards, we generally must agree to license such technologies on a fair, reasonable and non-discriminatory basis, which could limit our control over the use of these technologies. In these situations, we may be required to limit the royalty rates we charge for these technologies, which could adversely affect our business. Furthermore, we may be unable to limit to whom we license such technologies, and may be unable to restrict many terms of the license. From time to time, we may be subject to claims that our licenses of our industry standard technologies may not conform to the requirements of the standards-setting body. Claimants in such cases could seek to restrict or change our licensing practices or our ability to license our technologies in ways that could injure our reputation and otherwise materially and adversely affect our business, operating results and prospects.

Our ability to develop proprietary technology in markets in which “open standards” are adopted may be limited, which could adversely affect our ability to generate revenue.

Standards-setting bodies, such as those for digital cinema technologies, may require the use of so-called “open standards,” meaning that the technologies necessary to meet those standards are publicly available. The use of open standards may reduce our opportunity to generate revenue, as open standards technologies are based upon non-proprietary technology platforms in which no one company maintains ownership over the dominant technologies.

We are dependent on our management team and technical talent.

Our success depends, in part, upon the continued availability and contributions of our management team and engineering and technical personnel because of the complexity of our products and services. Important factors that could cause the loss of key personnel include:

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

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

·       significant portions of the equity awards held by the members of our management team are vested; and

·       equity awards held by some of our executive officers provide for accelerated vesting in the event of a sale or change of control of our company.

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

A loss of one or more of our key customers or licensees in any of our markets could adversely affect our business.

From time to time, one or a small number of our customers or licensees may represent a significant percentage of our revenue. Although we have agreements with many of these customers, these agreements typically do not require any material minimum purchases or minimum royalty fees and do not prohibit customers from purchasing products and services from competitors. A decision by any of our major customers or licensees not to use our technologies, or their failure or inability to pay amounts owed to us in a timely manner, or at all, could have a significant adverse effect on our business.

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We may have additional tax liabilities.

We are subject to income taxes in both the United States and foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. We may come under audit by tax authorities. Although we believe our tax estimates are reasonable, the final determination of tax audits and any related litigation could be materially different from our historical income tax provisions and accruals. Based on the results of an audit or litigation, a material effect on our income tax provision, net income or cash flows in the period or periods for which that determination is made could result.

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

Technology standards are important in the audio and video industry as they help to assure compatibility across a system or series of products. Generally, standards adoption occurs on either a mandatory basis, requiring a particular technology to be available in a particular product or medium, or an optional basis, meaning that a particular technology may be, but is not required to be, utilized. For example, both our digital multi-channel audio technology and Dolby’s have optional status in Standard and High Definition-DVD and Blu-ray. In the standards for High Definition-DVD and Blu-ray, both DTS and Dolby technologies have been selected as mandatory standards for two-channel output. However, if either or both of these standards are re-examined or a new standard is developed, we may not be included as mandatory in any such new or revised standard which would cause revenue growth in our consumer business to be significantly lower than expected and could have a material adverse affect on our business.

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

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

We have limited experience in image processing, enhancement and restoration.

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

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

Although the major U.S. film producers and distributors are customers of ours, we generally do not have contractual arrangements that require them to use our DTS audio technology or our digital image services. Our cinema and digital images business depends on our having good relations with these film

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studios and other content owners. A deterioration in our relationship with any of these customers could cause them to stop using our DTS audio technology or our digital image enhancement services. Any significant decline or delay in the release of motion pictures with DTS audio soundtracks would decrease the demand for and revenues from the playback products and services that we offer to movie theaters. In addition, other motion picture studios, content owners, producers, and distributors throughout the world generally adopt and use the processes and the technologies used by the major U.S. film studios. Therefore, if the major U.S. motion picture studios, content owners, producers or distributors stop using our technology, we would not only lose the per-movie licensing fee we receive from these customers, but may also lose per-movie licensing fees from other film studios throughout the world. Furthermore, poor box-office performance caused by a weak film release calendar or declining consumer interest in the films being released could have a negative impact on the demand for the products and services we sell to the motion picture industry.

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

Our cinema business depends in part on the construction of new screens and the renovation of existing theaters that install our DTS playback systems and cinema processors. Over the past decade, aggressive building of megaplexes by companies that operate movie theaters has generated significant competition and resulted in an oversupply of screens in some domestic and international markets. The resulting oversupply of screens led to significant declines in revenues per screen and, eventually, to an inability by many major film exhibitors to satisfy their financial obligations. Several major movie theater operators have reorganized through bankruptcy proceedings, and many movie theaters have closed. As a result, our playback systems and cinema processors that we previously sold to movie theaters that have reorganized and closed have been relocated to other theaters or have been available for resale in the secondary market to movie theaters that might otherwise have purchased these products directly from us. More recently, the industry has experienced a decline in movie theater attendance. If this decline were to continue, exhibitors could see a decline in revenue per screen and, potentially, an inability to satisfy their financial obligations resulting in the closure of screens. If movie theater operators decide to close a significant number of screens in the future or cut their capital spending, demand for our playback systems and cinema processors will decline. Additionally, the expected transition to digital cinema could harm our legacy cinema business because operators may decide to delay procurement decisions as they wait to evaluate the widespread roll out of digital cinema, operators may decide to purchase digital cinema systems that do not require our existing products and services, and as existing screens are repurposed to digital cinema, the quantity of our existing products on the secondary market may increase significantly. These developments may harm our business and operating results.

The demand for our current or “legacy” cinema products and production services could decline if the film industry broadly adopts digital cinema.

If the film industry broadly adopts digital cinema, the demand for our current or “legacy” cinema products and production services could decline. If, in such circumstances, we are unable to adapt our professional products and production services or replace such business with new products for the market for digital cinema successfully, our business could be materially adversely affected.

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

We purchase a small number of parts from sole-source suppliers. In addition, our professional audio encoding devices and movie theater playback systems are manufactured according to our specifications by single third-party manufacturers. Because we have no direct control over these third-party suppliers and

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manufacturers, interruptions or delays in the products and services provided by these third parties may be difficult to remedy in a timely fashion. In addition, if such suppliers or manufacturers are incapable of or unwilling to deliver the necessary parts or products, we may be unable to redesign our technology to work without such parts or find alternative suppliers or manufacturers. In such events, we could experience interruptions, delays, increased costs, or quality control problems.

We are subject to various environmental laws and regulations that could impose substantial costs upon us and may adversely affect our business, operating results and financial condition.

Some of our operations use substances regulated under various federal, state, local and international laws governing the environment, including those governing the discharge of pollutants into the air and water, the management, disposal and labeling of hazardous substances and wastes and the cleanup of contaminated sites. We could incur costs, fines and civil or criminal sanctions, third-party property damage or personal injury claims, or could be required to incur substantial investigation or remediation costs, if we were to violate or become liable under environmental laws. Liability under environmental laws can be joint and several and without regard to comparative fault. The ultimate costs under environmental laws and the timing of these costs are difficult to predict.

We also face increasing complexity in our product design as we adjust to new and future requirements relating to the materials composition of our products, including the restrictions on lead and other hazardous substances that apply to specified electronic products put on the market in the European Union, or EU, as of July 1, 2006 (Restriction on the Use of Hazardous Substances Directive 2002/95/EC, also known as the “RoHS Directive”) and similar legislation proposed for China.

For some products, substituting particular components containing regulated hazardous substances can be difficult or costly, and redesign efforts could result in production delays. Selected products that we maintain in inventory may be rendered obsolete if not in compliance with the RoHS Directive, which could negatively impact our ability to generate revenue from those products. We could also face significant costs and liabilities in connection with product take-back legislation. The European Union Directive 2002/96/EC as amended by 2003/108/EC (Waste Electrical and Electronic Equipment Directive also known as the “WEEE Directive”) requires producers of particular electrical and electronic equipment, including broadcast equipment, to be financially responsible for specified collection, recycling, treatment and disposal of past and future covered products. As of December 2006, not all member states within the EU have enacted enabling legislation under the WEEE Directive, and in the absence of such legislation, it is difficult to determine the costs to comply with the WEEE Directive.

Other countries, such as China and the United States, may enact similar product-content and take-back legislation, the cumulative impact of which could significantly increase our operating costs and adversely affect our operating results. We also expect that our operations, whether manufacturing or licensing, will be affected by other new environmental laws and regulations on an ongoing basis. Although we cannot predict the ultimate impact of any such new laws and regulations, they will likely result in additional costs or decreased revenue, and could require that we redesign or change how we manufacture our products, any of which could have a material adverse effect on our business.

Risks Related to Our Common Stock

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

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

·       actual or anticipated fluctuations in our results of operations;

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·       market perception of our progress toward announced objectives, including without limitation, the sale of our DTS Digital Cinema business;

·       announcements of technological innovations by us or our competitors or technology standards;

·       announcements of significant contracts by us or our competitors;

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

·       developments with respect to intellectual property rights;

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

·       the commencement of or our involvement in litigation;

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

·       conditions and trends in technology industries;

·       changes in market valuation or earnings of our competitors;

·       the trading volume of our common stock;

·       announcements of potential acquisitions;

·       the adoption rate of new products incorporating our or our competitors’ technologies, including next generation optical disc players;

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

·       general economic conditions.

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

Shares of our common stock are relatively illiquid.

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

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

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

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

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

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

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

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

Item 1B.               Unresolved Staff Comments

None.

Item 2.                        Properties

Our corporate headquarters and principal offices are located in Agoura Hills, California, where we lease approximately 54,000 square feet. This space is leased under four different leases, one of which expires in October 2007 and the other three of which expire in November 2008. We also lease smaller facilities in other locations including the United States, Canada, China, England, France, Italy, Northern Ireland, Hong Kong and Japan. We believe that our existing space is adequate for our current operations. We believe that suitable replacement and additional space will be available in the future on commercially reasonable terms.

Item 3.                        Legal Proceedings

In the ordinary course of our business, we actively pursue legal remedies to enforce our intellectual property rights and to stop unauthorized use of our technology and trademarks.

We are not a party to any material legal proceedings. We may, however, become subject to lawsuits from time to time in the course of our business.

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

We did not submit any matters to a vote of security holders during the fourth quarter of the year ended December 31, 2006.

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PART II

Item 5.                        Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

PRICE RANGE OF COMMON STOCK

Our common stock is traded on the Nasdaq Global Select Market under the symbol “DTSI.” Prior to July 1, 2006 our common stock was listed on the Nasdaq National Market since our initial public offering on July 9, 2003. The following table sets forth, for the periods indicated, the high and low sales prices for our common stock as reported by the Nasdaq National Market for periods prior to July 1, 2006, and Nasdaq Global Select Market from July 1, 2006 through December 31, 2006:

 

As of February 20, 2007 there were approximately 3,400 stockholders of record of our common stock. We believe that the number of beneficial owners is substantially greater than the number of record holders because a large portion of our common stock is held of record through brokerage firms in “street name.”

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STOCK PERFORMANCE GRAPH

The following graph compares the cumulative total stockholder return on our common stock to that of the NASDAQ Market Index and the Russell 2000® Index from July 9, 2003 (the date our common stock began to trade publicly) through December 31, 2006, the date of our fiscal year end. The graph assumes that a $100 investment was made at the close of trading on July 9, 2003 in our common ctock and in each index, and that dividends, if any, were reinvested. The stock price performance shown on the graph below should not be considered indicative of future price performance.

 

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DIVIDEND POLICY

We have never declared or paid any cash dividends on our common stock. We currently intend to retain all available funds to support our operations and to finance the growth and development of our business. We do not anticipate paying any cash dividends in the foreseeable future. Any future determination relating to dividend policy will be made at the discretion of our Board of Directors and will depend on a number of factors, including our future earnings, capital requirements, financial condition, future prospects, and other factors as the Board of Directors may deem relevant.

USE OF INITIAL PUBLIC OFFERING PROCEEDS

On July 9, 2003, we completed our initial public offering for the sale of 4,091,410 shares of common stock at a price to the public of $17.00 per share, which resulted in net proceeds of approximately $63.0 million after payment of the underwriters’ commissions and deductions of offering expenses. All of the shares of common stock sold in the offering were registered under the Securities Act of 1933, as amended, (the “Securities Act”) on a Registration Statement on Form S-1 (Reg. No. 333-104761) that was declared effective by the SEC on July 9, 2003 and a Registration Statement filed pursuant to Rule 462(b) under the Securities Act that was filed on July 9, 2003 (Reg. No. 333-106920). Subsequent to the offering, we used approximately $22.5 million of our net proceeds to redeem all outstanding shares of redeemable preferred stock and to pay all accrued but unpaid dividends on such shares through the date of redemption. The remaining proceeds to us have conformed with our intended use outlined in the prospectus related to the offering.

ISSUER PURCHASES OF EQUITY SECURITIES

On August 1, 2006, our Board of Directors authorized, subject to certain business and market conditions, the purchase of up to one million shares of our common stock in the open market or in privately negotiated transactions. Through March 16, 2007, there were no shares purchased under this authorization. Any shares repurchased would be considered treasury stock.

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Item 6.                        Selected Financial Data

SELECTED CONSOLIDATED FINANCIAL DATA

In the table below, we provide you with historical selected consolidated financial data of DTS, Inc. We derived the following historical data from our audited consolidated financial statements. It is important that you read the selected consolidated financial data set forth below in conjunction with our consolidated financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Form 10-K. Our historical results are not necessarily indicative of the operating results that may be expected in the future. We have described various risks and uncertainties that could affect future operating results under the heading “Risk Factors” included elsewhere in this Form 10-K.

(1)             Includes the results of operations for DTS Digital Images, Inc. We acquired this business in January 2005. In connection with this acquisition, we incurred a $2,300 charge for in-process research and development.

(2)             Includes $134, $2,989 and $463 in cost of goods sold, selling, general and administrative and research and development, respectively, due to the adoption of Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment” on January 1, 2006. For additional information regarding SFAS 123(R), refer to Footnote 16 of our consolidated financial statements, “Stock-Based Compensation.” Also includes the impact of consolidating Avica, as discussed in Footnote 3 of our consolidated financial statements, “Consolidation of Avica as a Variable Interest Entity.”

(3)             Includes $1,145, $3,000 and $758 for the separation of our business, the early termination of a business agreement and the write-down of DTSE inventory and other assets, respectively.

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(1)             Includes the impact of consolidating Avica, as discussed in Footnote 3 of our consolidated financial statements, “Consolidation of Avica as a Variable Interest Entity.”

Item 7.                        Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Annual Report on Form 10-K and the documents incorporated herein by reference contain forward-looking statements based on our current expectations, estimates and projections about our industry, beliefs, and certain assumptions made by us. Words such as “believes,” “anticipates,” “estimates,” “expects,” “projections,” “may,” “potential,” “plan,” “continue” and words of similar import, constitute “forward-looking statements.” The forward-looking statements contained in this report involve known and unknown risks, uncertainties and other factors that may cause our actual results to be materially different from those expressed or implied by these statements. These factors include those listed under the “Risk Factors” section contained in Item 1A and elsewhere in this Form 10-K, and the other documents we file with the Securities and Exchange Commission, or SEC, including our most recent reports on Form 8-K and Form 10-Q. We cannot guarantee future results, levels of activity, performance or achievements. We do not undertake any obligation to revise these forward-looking statements to reflect future events or circumstances.

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

Overview

We are a leading provider of entertainment technology, products and services to the audio and image entertainment markets worldwide. Historically we have been focused on high quality digital multi-channel audio, commonly referred to as surround sound, which provides more than two-channels of audio, allowing the listener to simultaneously hear discrete sounds from multiple speakers. Our DTS digital multi-channel audio technology delivers compelling surround sound for the consumer electronics and motion picture markets. We also provide high quality digital image processing, enhancement and restoration services for motion pictures, digital cinema, and television content.

We manage our business through three reportable segments—our consumer business, our cinema business, and our digital images business.

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

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

In our digital images business, we derive revenues from the processing, enhancement and restoration of cinema, home video and broadcast television content. We provide these services for motion picture and television studios and other content owners. We offer our services on either a fixed fee or time and materials basis.

In January 2007, we combined our Cinema and Digital Images businesses into a single business known as DTS Digital Cinema. In February 2007, our Board of Directors approved a plan to sell our DTS Digital Cinema business to enable us to focus exclusively on licensing branded entertainment technology to the large and evolving audio, game console, personal computer, portable and broadcast markets. The sales process has begun and is expected to conclude later in 2007. The DTS Digital Cinema business will focus on the potentially large and emerging market for digital cinema products and services.

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

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

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

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

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

In our consumer business, we have a licensing team that markets our technology directly to large consumer electronics products manufacturers and semiconductor manufacturers. This team includes employees located in the United States, China, England, Japan, Hong Kong, Northern Ireland, and Taiwan. We sell music content released under our DTS Entertainment label through exclusive distribution arrangements in the United States, Canada, Europe and Japan. We employ consultants to coordinate sales to independent retailers and we sell this music directly to consumers through an online store and other web-based retailers.

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

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

Management Discussion Regarding Trends, Opportunities, and Challenges

New Strategic Initiatives

In January 2007, Euro 1080, a European high definition media company, entered into an agreement with us to become the first broadcaster to deploy the combined Coding Technologies and DTS solution.

On February 20, 2007, we announced that our Board of Directors approved a plan to sell our DTS Digital Cinema business to enable us to focus exclusively on licensing branded entertainment technology to the large and evolving audio, game console, personal computer, portable and broadcast markets. The sales process has begun and is expected to conclude later in 2007. The DTS Digital Cinema business will focus on the emerging and potentially large market for digital cinema products and services. Beginning in the first quarter of 2007, we expect to report financial results related to our DTS Digital Cinema business as “discontinued operations.”

The trend in the motion picture industry and movie exhibition market toward digital delivery of entertainment content continues to gain momentum and we believe it presents a long-term opportunity for the expansion of our cinema business. As part of our strategy to pursue opportunities in the digital cinema market, we signed an exclusive license agreement and an option agreement with Avica, a provider of products and services for the digital cinema market. We believe Avica’s suite of digital cinema technologies, products and services will complement our existing cinema product offerings and will accelerate our entry into the digital cinema market.

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Trends, Opportunities, and Challenges by Business Segment

Consumer Segment

Revenue from our consumer segment constitutes the majority of our total revenues, representing 68%, 64% and 64% of total revenues for the years ended December 31, 2004, 2005 and 2006, respectively. Our consumer revenue is primarily dependent upon the home theater and DVD player markets, which have experienced rapid growth over the past several years. However, we have recently experienced softness in our DVD player trademark licensing program, and expect declines from recent levels in this area. The success of DVD-Video-based systems and products has fueled a demand for higher quality entertainment in the home, and this demand is extending to the car audio and personal computer markets as well. In addition, we expect the recent acceleration of the market for high definition televisions to drive demand for high definition optical disc players. Because we have been selected as a mandatory technology for HD-DVD and Blu-ray players, our consumer revenue growth should more closely track the growth rate for sales of these players over the next several years. We expect that the market for high definition players will yield new growth that provides an offset to the expected decline in the overall growth in standard definition DVD player shipments. Further, we believe that expected mandatory inclusion in HD-DVD and Blu-ray optical disc standards will help to improve the adoption rate of our technologies in other consumer products such as next generation video game consoles, personal audio and video players, personal computers, broadcast applications and in-car entertainment systems.

In July 2004, we acquired QDesign Corporation, or QDesign, a company focused on lower bit-rate audio delivery technology. The market for higher quality entertainment is expanding into portable devices that require the use of low-bit rate audio coding systems including portable audio players, PDAs and wireless handset applications. Concurrent with this trend, there is a growing need for a good link between home and portable devices that preserves as much quality as possible and allows consumers a seamless technology solution for the storage and playback of their content. In October 2004, leveraging our existing research and development efforts and the intellectual property acquired in the QDesign acquisition, we launched our DTS-HD initiative. This technology is a scalable coding system that will allow content to be played in home and portable devices. We believe that the broad and robust nature of this offering improves the probability of inclusion of our technologies in next generation products.

Cinema Segment

Revenue from our cinema segment represented 32%, 29% and 26% of total revenues for the years ended December 31, 2004, 2005 and 2006, respectively. Sales of cinema products and film licensing tend to fluctuate based on the underlying trends in the motion picture industry. We believe that the cinema exhibition community has begun to defer purchases of digital multi-channel audio equipment as they evaluate the pace of progress in the emerging digital cinema market as discussed below. Accordingly, we expect our cinema hardware business to continue to decline as exhibitors evaluate their digital cinema alternatives. We also believe that the cinema exhibition community has recognized that pre-show entertainment represents a significant revenue growth opportunity that will lead to investment in pre-show solutions over the next several years. Because our XD10 Cinema Media Player can be configured to perform audio playback along with pre-show and subtitling presentation, we believe that we are well-positioned to participate in the anticipated growth in this market.

A trend that we believe will affect our cinema business segment is the long-term trend toward digital distribution of content. We believe this trend will involve the near-term adoption of digital pre-show and/or electronic cinema solutions, and increasingly the adoption of higher quality digital cinema. Digital distribution of content offers the motion picture industry a means to achieve substantial cost savings, including with respect to the printing and distribution of movies, help in combating piracy, and will enable movies to be played repeatedly without degradation. It also provides additional revenue opportunities for cinema operators, as digital content such as advertisements, concerts and sporting events could be shown in or broadcast to digitally equipped theaters. In recent months, there has been increasing momentum in

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the digital cinema industry, as product and service vendors attempt to find a viable business model. We believe that these activities represent an important and significant step in the transition. We believe this represents an opportunity for us as we seek to provide products and services in support of the transition from film-based content towards digital cinema. However, our current digital cinema offerings are limited and we may not be successful in developing or selling competitive product offerings. We believe that the addition of our Cinema Media Network and variable bit rate JPEG 2000 encoding tools, along with the services provided by our digital images business, and the pre-show and alternative content capabilities of our XD10 Cinema Media Player, combined with the addition of the products, technologies and know-how obtained under our exclusive license agreement with Avica, will enhance our ability to participate in the industry transition to high definition sound and images for digital cinema. Already in 2007, we have installed a trial deployment of 25 digital cinema systems in Ireland, which allows the exhibition of digital cinema content. The content was digitally enhanced, encoded, packaged and delivered by our digital images and content services group in a fully DCI compliant form.

Digital Images Segment

Revenue from our digital images segment, which we acquired in January 2005, represented 7% and 10% of total revenues for the years ended December 31, 2005 and 2006, respectively. We believe that the growing market for high resolution and high definition content in the cinema and the home will create a substantial demand for the type of services provided by DTS DI. A relatively new application for our process is the correction of problems encountered with the use of digital cameras, enabling our involvement at the earliest stages of digital content development. We believe that we provide leading digital lab capabilities, including digital enhancement, restoration and other pre-compression services and that we have a technological advantage over many of our competitors based on the sophistication of our processes and level of automation used to enhance the image quality of entertainment content. During 2006, as a result of the enhancement of the technology platform, we were able to complete more than three times the number of projects than in 2005, improve gross margins and gain access to newer and faster growing markets including pre-compression processing and digital cinema content preparation. To date, this business has enhanced and/or restored over 100 feature films, including such major DVD releases as Star Wars, James Bond and Indiana Jones. Major motion picture and television studios possess libraries containing thousands of titles, which we believe represent a sizable market opportunity for the services performed by DTS DI.

Critical Accounting Policies and Estimates

Management’s Discussion and Analysis of Financial Condition and Results of Operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of our financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, estimates and judgments are evaluated, including those related to revenue recognition, allowance for doubtful accounts, inventories, goodwill and intangible assets, income taxes, impairment of long-lived assets, product warranty, and stock-based compensation. These estimates and judgments are based on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, which form the basis for our judgments about the carrying values of assets and liabilities not readily apparent from other sources. By their nature, estimates are subject to an inherent degree of uncertainty. Actual results may differ from these estimates.

We believe the following critical accounting policies, among others, affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

·       Revenue Recognition.   We recognize revenues in accordance with the guidelines of the SEC Staff Accounting Bulletin, or SAB, No. 101 as amended by SAB No. 104 “Revenue Recognition in

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Financial Statements.” Revenues from multiple-element arrangements involving license fees, up-front payments and milestone payments, which are received and/or billable by us in connection with other rights and services that represent continuing obligations of ours, are deferred until all of the elements have been delivered or until we have established objective and verifiable evidence of the fair value of the undelivered elements.

Arrangements with multiple elements or deliverables must be segmented into individual units of accounting based on the separate deliverables only if there is objective and verifiable evidence of fair value to allocate the consideration received to the deliverables. Accordingly, revenues from multiple-element arrangements involving license fees, up-front payments and milestone payments, which are received and/or billable in connection with other rights and services that represent continuing obligations of ours, are deferred until all of the multiple elements have been delivered or until objective and verifiable evidence of the fair value of the undelivered elements has been established. Upon establishing objective and verifiable evidence of the fair value of the elements in multiple-element arrangements, the fair value is allocated to each element of the arrangement, such as products or additional add-ons, based on the relative fair values of the elements. We determine the fair value of each element in multiple-element arrangements based on objective and verifiable evidence of fair value, which is determined for each element based on the price charged when the same element is sold separately to a third party. If objective and verifiable evidence of fair value of all undelivered elements exists but objective and verifiable evidence of fair value does not exist for one or more delivered elements, then revenue is recognized using the residual method. Under the residual method, the revenues from delivered elements are not recognized until the fair value of the undelivered element(s) have been determined. Significant contract interpretation is sometimes required to determine the appropriate accounting, including whether the deliverables specified in a multiple element arrangement should be treated as separate units of accounting for revenue recognition purposes, and if so, how the price should be allocated among the deliverable elements, when to recognize revenue for each element, and the period over which revenue should be recognized. Changes in the allocation of the sales price between delivered to undelivered elements might impact the timing of revenue recognition, but would not change the total revenue recognized on the contract.

We are responsible for the licensing and enforcement of our patented technologies and pursue third parties that are utilizing our intellectual property without a license or who have under-reported the amount of royalties owed under a license agreement with us. As a result of these activities, from time to time, we may recognize royalty revenues that relate to infringements that occurred in prior periods. These royalty recoveries may cause revenues to be higher than expected during a particular reporting period and may not occur in subsequent periods. Differences between amounts initially recognized and amounts subsequently audited or reported as an adjustment to those amounts due from licensees, will be recognized in the period such adjustment is determined or contracted, as appropriate, as a change in accounting estimate.

We make estimates and judgments when determining whether the collectibility of license fees receivable from licensees is reasonably assured. We assess the collectibility of accrued license fees based on a number of factors, including past transaction history with licensees and the credit-worthiness of licensees. If it is determined that collection is not reasonably assured, the fee is recognized when collectibility becomes reasonably assured, assuming all other revenue recognition criteria have been met, which is generally upon receipt of cash. Management estimates regarding collectibility impact the actual revenues recognized each period and the timing of the recognition of revenues. Our assumptions and judgments regarding future collectibility could differ from actual events, thus materially impacting our financial position and results of operations.

Revenues from the sale of cinema hardware products are recorded upon shipment, assuming title and risk of loss has transferred to the customer, we have no significant obligations remaining, prices

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are fixed or determinable, and collection of the related receivable is reasonably assured. The licensing, encoding and duplication of motion picture soundtracks for use in our playback systems is undertaken under arrangements with major film studios. Revenues arising from the licensing and duplication of soundtracks are recognized upon completion, assuming prices are fixed or determinable, we have no significant obligations remaining, and collection of the related receivable is reasonably assured.

Revenues from licensing audio technology, trademarks, and know-how are generated from licensing agreements with consumer electronics products manufacturers that generally pay a per-unit license fee for products manufactured under those license agreements. Licensees generally report manufacturing information within 30 to 60 days after the end of the quarter in which such activity takes place. Consequently, we recognize revenue from these licensing agreements on a three-month lag basis, generally in the quarter following the quarter of manufacture, provided amounts are fixed or determinable and collection is reasonably assured. Use of this lag method allows for the receipt of licensee royalty reports prior to the recognition of revenue, since we cannot reliably estimate the amount of revenue earned prior to our receipt of such reports. Revenues from the sale of digital multi-channel audio and video content are recorded upon shipment to retail accounts or end customers, assuming title and risk of loss has transferred, prices are fixed or determinable, we have no significant obligations remaining, and collection of the related receivable is reasonably assured. We provide for returns on product sales based on historical experience and adjust such reserves as considered necessary. To date, there have been no significant sales returns.

Revenues from digital image enhancement, restoration and repair are recognized when elements of a customer order or contract are delivered and accepted by the customer and no significant obligations remain. Prices are established in advance of the work performed and are generally fixed in nature. Revenue related to time and materials contracts is recognized as services are rendered at contract labor rates plus material and other direct costs incurred. If losses are anticipated on a contract, such losses are recognized immediately.

We believe these to be critical accounting policies because if actual results vary from our estimates and assumptions, it could have a material impact on our reported sales and results of operations.

·       Inventories.   Inventory levels are based on projections of future demand and market conditions. Any sudden decline in demand and/or rapid product improvements and technological changes can result in excess and/or obsolete inventories. On an ongoing basis, inventories are reviewed and written down for estimated obsolescence or unmarketable inventories equal to the difference between the costs of inventories and the estimated net realizable value based upon forecasts for future demand and market conditions. Estimates could be influenced by sudden declines in demand due to economic downturns, rapid product improvements, and technological changes. We believe this to be a critical accounting policy because if actual market conditions are less favorable than our forecasts, additional inventory reserves may be required which could have a material impact on our results of operations.

·       Goodwill.   We currently evaluate goodwill, in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” for impairment whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. We also evaluate goodwill for impairment on an annual basis during the fourth quarter of each year. In assessing the recoverability of goodwill, we must make assumptions regarding estimated future cash flows and other factors, including the discount rate used, to calculate the fair value of the respective assets. Assumptions about estimated future cash flows require significant judgments around future revenues, future expenses, working capital investments, capital expenditures based on industry norms, and the current state of the economy. In calculating the estimated fair value of our reporting units, we have used a discounted

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cash flow model. We believe this to be a critical accounting policy because if those estimates or related assumptions change in the future, we may be required to record impairment charges for these assets which could have a material impact on our results of operations. While we believe the likelihood of an impairment of our Cinema and Digital Images reporting units is remote, there can be no assurance that our decision to sell these assets subsequent to year end will not result in an impairment.

·       Impairment of Long-Lived Assets and Intangibles.   We periodically assess potential impairments of our long-lived assets and intangibles in accordance with the provisions of SFAS 144, “Accounting for the Impairment or Disposal of Long-lived Assets.” An impairment review is performed whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors considered by us include, but are not limited to, significant underperformance relative to expected historical or projected future operating results; significant changes in the manner of use of the acquired assets or the strategy for our overall business; and significant negative industry or economic trends. We believe this to be a critical accounting policy because if those estimates or related assumptions change in the future, we may be required to record impairment charges for these assets which could have a material impact on our results of operations. While we believe the likelihood of an impairment of our Cinema and Digital Images reporting units is remote, there can be no assurance that our decision to sell these assets subsequent to year end will not result in an impairment.

·       Stock-based Compensation.   Upon adoption of SFAS 123(R) in January of 2006, we began incurring significant charges to the statement of operations for stock-based compensation. These charges are based upon the fair value of each employee option on the date of grant using the Black-Scholes option pricing model. This model requires that we estimate a risk free interest rate, expected lives, dividend yield, and the expected volatility of our stock. In March 2005, the SEC issued Staff Accounting Bulletin (“SAB”) No. 107 relating to SFAS 123(R). We have applied the provisions of SAB 107 in our adoption of SFAS 123(R). We believe this to be a critical accounting policy because if any of the estimates above require significant changes, these changes could result in expenses that could have a material impact on our results of operations.

·       Income taxes.   We must make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of certain tax assets and liabilities, which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes.

We must assess the likelihood that we will be able to recover our deferred tax assets. If recovery is not likely, we must increase our provision for taxes by recording a valuation allowance against the deferred tax assets that we estimate will not ultimately be recoverable. As of December 31, 2006, we believe that all of the deferred tax assets recorded on our balance sheet would ultimately be recovered. We believe this to be a critical accounting policy because should there be a change in our ability to recover our deferred tax assets, our tax provision would increase in the period in which we determine that the recovery is not probable, which could have a material impact on our results of operations.

Income taxes receivable, net, at December 31, 2005 and 2006, includes estimated tax contingencies of $1.4 million and $0.7 million, respectively, for both domestic and foreign issues. Inherent uncertainties exist in estimating tax contingencies due to the progress of income tax audits and changes in tax law, both legislated and concluded through the various jurisdictions’ tax court systems.

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Segment and Geographic Information

During the first quarter of 2007, we announced that our Board of Directors approved a plan to sell our DTS Digital Cinema business, which is comprised of our Cinema business segment and Digital Images business segment. Therefore, we have included a subtotal representing the DTS Digital Cinema business.

Our reportable segment and geographic information is as follows (in thousands):

 

 

 

 

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The following table sets forth, for the periods indicated, long-lived assets by geographic region:

 

Results of Operations

Revenues

 

Technology and Film Licensing

Technology and film licensing revenues for the year ended December 31, 2006 increased compared to the year ended December 31, 2005 primarily due to strong growth in the car audio systems and personal computer markets, which posted year over year growth totals of 81% and 20%, respectively. However, we remain cautious in our revenue outlook due to uncertainties surrounding the expected transition to high definition optical disc formats. Overall, we continue to expect technology licensing revenues to grow modestly for 2007, based primarily on the expected continuation of growth in our decoder licensing program and our mandatory inclusion in both the HD-DVD and Blu-ray disc formats. Our film licensing revenues increased slightly in 2006 compared to the prior year due to additional releases in the DTS format and the timing of major feature film releases. Film licensing revenue is expected to remain relatively flat in 2007.

Technology and film licensing revenues for the year ended December 31, 2005 increased compared to the year ended December 31, 2004 primarily driven due to an increase in royalty recoveries of $7.3 million from intellectual property compliance and enforcement activities in 2005 relative to the prior year. These activities, which included audits of shipments by certain of our licensees and legal actions taken against licensees and parties who are not our licensees, resulted in recoveries of royalties due from prior periods. We experienced good growth in our personal computer licensing and in car audio systems, which posted year over year growth totals of 150% and 21%, respectively, in 2005. Our film licensing revenues increased slightly in 2005 compared to the prior year due to additional releases in the DTS format and the timing of major feature film releases.

Product Sales and Other

Product sales and other revenues increased for the year ended December 31, 2006 compared to the year ended December 31, 2005 primarily due to a 50% increase in revenues generated by DTS DI as a result of the completion of certain significant projects, and ongoing improvements in our digital enhancement and restoration processes. Partially offsetting the growth in DTS DI revenues is a decrease in U.S. hardware sales for 2006 resulting from the exhibition community’s hesitation to purchase cinema hardware during the early stages of the industry’s transition to digital cinema.

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