SRS Labs 10-K 2007
Documents found in this filing:
Washington, D.C. 20549
ANNUAL REPORT PURSUANT TO SECTION 13 OR
For the fiscal year ended December 31, 2006
Commission File Number: 0-21123
SRS LABS, INC.
(Exact name of registrant as specified in its charter)
2909 Daimler Street, Santa Ana, California 92705
(Address of principal executive offices) (Zip Code)
(Registrants telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer ¨ Accelerated filer ¨ Non-accelerated filer x
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No ý
The aggregate market value of the registrants voting Common Stock held by non-affiliates of the registrant was approximately $58,137,678 (computed using the closing price of $4.99 per share of Common Stock on June 30, 2006, as reported by the NASDAQ Stock Market).
As of March 9, 2007, 16,745,403 shares of the registrants Common Stock, par value $0.001 per share, were outstanding. Of that amount, 674,098 shares were held as treasury shares.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrants Proxy Statement prepared in connection with the Annual Meeting of Stockholders to be held in 2007 are incorporated by reference in Part III of this Form 10-K.
SRS LABS, INC.
As used herein, the Company, SRS Labs, SRS, we, us, or our means SRS Labs, Inc., its wholly-owned subsidiary SRSWOWcast.com, Inc. and, for the applicable periods, its former subsidiary ValenceTech Limited (collectively with its direct and indirect wholly-owned subsidiaries, Valence) and the former joint venture with Coming Home Studios LLC, CHS/SRS LLC. Circle Surround®, Circle Surround II, Circle Surround Automotive, SRS Xspace 3D, SRS WOW, SRS WOW XT, SRS WOW HD, SRS TruBass®, SRS FOCUS®, SRS Headphone, SRS DialogClarity, SRS TruSurround® XT, TruSurround® HD, SRS 3D® Sound, SRS CS Auto and VIP are our United States trademarks. All other trademarks and trade names appearing are the property of their respective owners.
Some of the statements in this Annual Report on Form 10-K contain forward-looking statements regarding our assumptions, projections, expectations, targets, intentions or beliefs about future events, which involve risks and uncertainties. All statements other than statements of historical facts included in this Annual Report, relating to expectation of future financial performance, continued growth, changes in economic conditions or capital markets and changes in customer usage patterns and preferences, are forward-looking statements. In some cases, you can identify forward-looking statements by terms such as may, will, should, expect, plan, intend, forecast, anticipate, believe, estimate, predict, potential, continue or the negative of these terms or other comparable terminology. The forward-looking statements contained in this Annual Report involve known and unknown risks, uncertainties and situations that may cause our or our industrys actual results, level of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these statements. Factors that might cause actual events or results to differ materially from those indicated by these forward-looking statements may include the matters listed in this Annual Report, including, but not limited to, those listed under Risk Factors in Item 1A.
SRS Labs is a leading developer and provider of audio and voice technology solutions for the home entertainment, portable media device, personal telecommunications, personal computer, automotive, and broadcast markets. Prior to September 29, 2006, the Company was also a developer and provider of application specific integrated circuits and standard integrated circuits through its formerly wholly-owned subsidiary, Valence.
Licensing: Our operations are conducted through SRS Labs Inc., the parent company, and its wholly-owned subsidiary, SRSWOWcast.com, Inc. Our business is focused on developing and licensing audio, voice and surround sound technology solutions to many of the worlds leading original equipment manufacturers (OEMs), software providers and semiconductor companies, and licensing and marketing hardware and software products for the Internet and professional audio markets.
Valence: Through SRS Labs, Inc.s formerly wholly-owned subsidiary, Valence, we operated a fabless semiconductor business which developed, designed and marketed standard and custom analog integrated circuits, digital signal processors, and mixed signal integrated circuits primarily to OEMs and original design manufacturers (ODMs), in the Asia Pacific region.
On February 23, 2006, our Board of Directors (the Board) approved a plan to sell Valence in order to focus managements attention and financial resources on our licensing business. On July 14, 2006, we entered into a definitive Sale and Purchase Agreement to sell Valence to Noblehigh Enterprises Inc. (Noblehigh). Noblehigh is owned by Willas Array Electronics (Holding) Limited as well as certain members of management of Valence (collectively referred to herein as the Management Buyers). The sale transaction was completed on September 29, 2006.
The sale to Noblehigh was effected through two simultaneous transactions: (1) the repurchase by Valence of approximately 74% of the outstanding shares of Valence from SRS using its existing cash and (2) the purchase by Noblehigh of the remaining outstanding shares of Valence from SRS for $4.3 million. The sale resulted in a gain on the disposal of discontinued operations of $237,625.
Additionally, we repurchased from the Management Buyers 357,625 shares of our common stock, which were obtained through the exercise of vested employee stock options, for an aggregate repurchase price of $2,114,586. Such shares were immediately canceled and are therefore not outstanding as of December 31, 2006. The repurchase price per share paid for such shares was equal to the average closing price of our common stock for the seven trading days ending three days prior to the closing date of the sale of Valence.
CHS/SRS LLC: In September 2004, we entered into a strategic alliance with Coming Home Studios LLC (CHS) to use and promote SRS Labs technologies, to promote CHS productions and to promote each companys respective brands. In connection with the strategic alliance, SRS and CHS established a joint venture, CHS/SRS, LLC (the Joint Venture), to produce and distribute nine concert videos featuring our Circle Surround technology. Initially, CHS was the manager of the Joint Venture; however, SRS became the manager of the Joint Venture in July 2005.
The Company recorded an asset impairment charge of $3.3 million related to its investment in the Joint Venture in the fourth quarter of fiscal 2005 based on managements estimates of the recoverability of the related assets. On February 23, 2006, the Board authorized management to take all reasonable steps to divest our entire equity interest in the Joint Venture. On June 30, 2006, we completed the sale of our
interest in the Joint Venture to CHS in exchange for $200,000, the rights to all cash assets of the Joint Venture, and a promissory note in the amount of $175,000. We received $200,000 from CHS and the cash assets of the Joint Venture. Any amounts related to the promissory note and accrued interest thereon will be recorded at the time the cash is received by us. We recorded a gain on disposal of our interest in the Joint Venture of $387,021.
Further financial information for business segments, geographic areas and customer concentration is included in this Annual Report on Form 10-K under Item 8. Financial Statements and Supplemental Data and in Notes 1 and 8 to the Notes to Consolidated Financial Statements. Reference also is made to Item 1A. Risk Factors for a discussion relating to certain risks relating to our business.
We were incorporated in the State of California on June 23, 1993 and reincorporated in the State of Delaware on June 28, 1996. Our executive offices are located at 2909 Daimler Street, Santa Ana, California 92705. Our telephone number is (949) 442-1070.
Our licensing business is focused on developing and marketing audio rendering, voice and surround sound technologies to OEMs, ODMs, semiconductor manufacturers, and software providers in the home entertainment, portable media devices, personal telecommunications, personal computers and automotive markets. Our portfolio of licensable technologies includes a wide range of techniques for the processing and delivery of audio, voice and surround sound, including the following:
· Surround SoundOur surround sound technology, Circle Surround, is a complete encoding and decoding format. Circle Surround encoding enables the distribution of up to 6.1 channels of audio over existing two-channel carriers such as digital media files, standard definition and high-definition television, FM radio, and CDs. Circle Surround decoding decodes Circle Surround encoded material for multi-channel playback or creates up to 6.1 channels of audio from older formats of material, including mono, stereo, 4-channel surround or other matrix surround formats. Circle Surround decoding is available in three solutions: Circle Surround, Circle Surround II and Circle Surround Automotive.
· Audio RenderingOur audio rendering technologies optimize device audio output and enable the presentation of 3D and multichannel audio content over two speakers. These technologies include the ability to render 5.1 multichannel content over two speakers, to create a wider sound stage for more natural audio, to improve the perceived bass response in small speakers, to dynamically position audio sources in a virtual 3D space using headphones, and to reposition the audio image for non-optimally placed speakers. Our audio technologies include SRS Xspace 3D, SRS WOW, SRS WOW XT, SRS WOW HD, SRS TruBass, SRS FOCUS, SRS Headphone, SRS DialogClarity, SRS TruSurround XT, TruSurround HD, SRS 3D Sound and SRS CS Auto.
· Voice ProcessingOur VIP and Noise Reduction technologies, dramatically reduce noise to produce much clearer and crisper dialog over wireless communication devices and improve the intelligibility of the human voice in a variety of listening situations, including high ambient background environments.
Our portfolio of technologies can address a broad spectrum of product applications within the vertical markets that we have targeted. Our technologies may be implemented in a variety of methods, including discrete analog components, chip modules, analog semiconductors, DSPs and software. These various implementation options offer customers flexibility when incorporating our technologies into products.
We license our technologies throughout the Western Hemisphere, the Asia Pacific region and in Europe. The following table presents our revenue by geographic area. For licensing-related revenue, the allocation is based on the location of the licensees corporate headquarters. For product and on-line sales, revenue is allocated to the Americas.
Through our licensing business, we market our portfolio of technologies to the following vertical markets: home entertainment, portable media devices, personal telecommunications, personal computers and automotive. Our license agreements typically have multi-year or automatic renewal terms, and either require per-unit royalty payments for all products implementing our technologies or provide for a fixed annual or quarterly royalty payment. The license agreements also specify the use of our trademarks and logos on the product, within the packaging and in the users manual, and require our review and approval of the product to guarantee the quality of the technology implementation and the correct usage of our logos and trademarks. We believe these terms ensure the quality and consistency of the technology and elevate the awareness of the SRS brand in the marketplace. Most of our licensing agreements do not have volume requirements and may be terminated by the licensees or us without substantial financial penalty.
The following chart shows the percentage of our licensing revenue we received in 2006 and 2005 from each of these markets.
Home entertainment products represent the largest current market for our technologies and have in recent years been the largest revenue contributor. Manufacturers in this market utilize our technologies to differentiate their products from their competitors while improving functionality and product performance. In many instances, manufacturers license multiple technologies from us for multiple product lines and divisions. Product categories within this market include HD televisions (such as LCD and Plasma televisions), set-top boxes, DVD players, audio/video receivers, and complete home-theater-in-a-box systems.
Televisions. Our audio technologies are widely used by television manufacturers as a differentiating feature and as a solution to audio challenges that manufacturers encounter. As television makers continue to migrate from bulky tube models to thinner digital displays, manufacturers are finding that they have less room for speakers, which may compromise the overall audio quality of the television. We provide manufacturers with patented solutions for accurately presenting surround sound, improving bass response, increasing dialog clarity, and creating a more natural sound stage. These solutions improve the audio quality of the television set without the expense of additional equipment or larger speakers. In 2006, our technologies continued to grow in popularity for use in flat panel televisions from companies such as LG, Samsung, Toshiba and Sony.
DVD Players & Set-top Boxes. Although they present surround sound content, DVD players and set-top-boxes are typically connected to televisions with two-channel speakers. Our SRS TruSurround XT technology creates a surround sound experience over any existing two-speaker system, including the internal speakers of a television. This technology also creates a virtual surround experience from stereo material.
We provide the personal telecommunications market with both voice and audio rendering technologies. Mobile phones are incorporating more multimedia features and functionality at a rapid pace. New services include digital music downloads, ring-tones and true-tones, streaming video, gaming, and television viewing. Our strong presence in the home entertainment market, our suite of voice technologies, and our entry into the mobile market with customers like NEC present a growth opportunity for us. Our solutions address specific needs in the mobile market. For example, our technologies address needs like voice intelligibility in noisy environments, clarity of dialog in video content, poor bass-response of small speakers, hampered stereo imaging in narrow-set speakers, and 3D positioning audio for interactive gaming. Our technologies are licensed by telecommunications companies such as Motorola, Samsung, Pantech and NEC.
MP3 players and other portable media players enable consumers to enjoy audio and video content while on the go. The audio contents are stored in a compressed industry standard MP3 audio standard. As such, when the contents are decoded and played back through miniature earphones, the contents generally suffer loss of audio quality. Our technologies such as WOW and WOW HD are capable of improving the audio quality during playback. Our Mobile HD technologies also enable rendering of surround sound through earphones when playing back surround sound encoded contents often used along with contemporary video contents. Associated with the increasing popularity of MP3 players, including Apples iPOD, there has been a noticeable growth in the market for accessories, such as docking stations and miniature speaker systems. Thee small footprint of these devices limits speaker size and speaker spacing. Our solutions enable vendors of these devices to increase the quality of their audio output generally without increasing hardware component costs. In 2006, we significantly expanded our efforts in licensing our technologies to companies designing and manufacturing accessories for the portable media market.
Personal computers (PCs) in the home are often used as media hubs. Through PCs, users enjoy and manage collections of music and movies, along with downloaded and recorded television programming. This content is now being distributed through the home using networked media adapter products. Throughout these systems, there is a need for optimizing playback on the computer speakers, presenting a home theater experience on a laptop, transmitting surround sound around the home, and enjoying content on headphones. Technology solutions from SRS are well positioned to fill these needs.
We have invested in research to create solutions specific to the needs of the automotive market. Within vehicles, audio and video content is played from multiple sources and then presented on both speakers and headphones. Stereo content from sources like CDs, MP3 players, and High Definition Radio needs to be presented on all speakers in the car, some of which may not be optimally placed and may not have strong bass response. Surround sound content from DVDs, radio, and downloaded music needs to be rendered on both car speakers with a maximum sweet spot and on rear-seat headphones. Our automotive solutions like SRS CS Auto, SRS Circle Surround II, and SRS TruSurround XT meet these needs and provide manufacturers in this segment with a fully tunable solution.
For fiscal year 2006, Samsung and Sony accounted for approximately 17% and 11% of our consolidated revenues, respectively. For fiscal year 2005, Samsung and Sony each accounted for approximately 13% of our consolidated revenues. For fiscal year 2004, Sony and ST Micro accounted for approximately 14% and 10% of our consolidated revenues, respectively. Given the significant amount of revenues derived from these customers, the loss of any such customer or the uncollectibility of related receivables could have a material adverse effect on our consolidated financial condition and consolidated results of operations.
Our sales strategy is to identify high-growth markets, develop needed technology solutions and features and work with software and semiconductor platform partners to make these technologies widely available and easy to implement by OEMs and ODMs. We believe that we will continue to strengthen our market position as a leader in audio and voice technology by employing the strategy of providing a stream of patented audio and voice technologies, penetrating new licensing accounts, expanding relationships with existing licensees, creating a broad platform of software and semiconductor partners and developing strong awareness of the SRS brand.
The mission of our licensing platform efforts is to achieve broad coverage for our technology solutions within all of our targeted product markets in order to expand sales and licensing opportunities. By developing strong relationships with leading software and semiconductor companies, our audio technologies can be delivered to customers worldwide across high growth and high volume product applications.
We work together with our platform partners (leading semiconductor manufacturers and middleware or firmware software providers) to provide our mutual customers with the technology that best fits their needs. We also together solicit other new customers to consider using the platform. Many times, a platform will become enabled with our technology due to customer requests.
As a technology licensing company, the strength of our brand is an important asset. Since brand recognition drives licensing sales, we have invested in strategies designed to increase consumer awareness of SRS Labs with the ultimate goal of establishing our brand with both product manufacturers and consumers around the world as the symbol for high-quality audio. The three primary vehicles that we use to further the proliferation of our brand are: (a) placement of the SRS logo by OEMs on products and in co-marketing programs; (b) online branding programs; and (c) use, and recognition of use, of SRS technology by content and broadcast professionals.
OEM Marketing Programs. In the majority of products which use SRS technologies, our logo is either prominently displayed on the product itself or, in the case of software products and mobile phones, featured in the graphical user interface. We believe this logo exposure is a key tool in reaching consumers
worldwide. In addition, we work with our OEM customers as they launch new products that feature SRS technologies. We supply complete SRS corporate and technology tool kits with a wide array of material, including SRS logos, illustrations, technology explanations and suggested demonstration material. In 2006, for example, we worked with Sharper Image to prominently display products with the SRS logo in their retail stores, catalogs, SkyMall magazines and on their website.
Online Branding. Online exposure has also been an important part of our branding strategy. One benefit of our relationship with Microsoft is that the SRS logo displayed in the audio control panel of Microsofts Windows Media Player links to an SRS technology page. As a result, we have received significant traffic and opportunities to create brand awareness with consumers and educate consumers on the benefits of our technology. Our online efforts also include the direct sale of plug-ins for Windows Media Player. Revenue from the sale of these products is not significant, but gives us a valuable demonstration platform to showcase our audio technologies.
Use of SRS Technology by Content and Broadcast Professionals. We develop, license and sell professional hardware and software products to enable content companies, broadcasters and music publishers to encode their material using our Circle Surround technology. When Circle Surround is professionally used, the logo is often displayed within the content itself, on the packaging material or, in the case of radio, an announcement that the broadcast is being delivered in Circle Surround. We have concentrated on three key market segments in the professional audio space: television, radio and music; and we have developed a line of hardware and software products to address these markets. These products are sold directly to professional customers and are also available from selected dealers and distributors servicing the professional audio and broadcast markets. We did not generate significant revenue from the sale of professional hardware equipment in 2006; however, we believe that these facilitate the licensing of our technology to OEMs that benefit from enhanced audio transmissions.
We have two types of revenue collection systems with our licenseesbundled or non-bundled. Under a bundled agreement, royalty revenue may be collected by our platform partner at the time the solution is sold to an OEM or ODM. Most often, however, we license our technologies directly to OEMs and ODMs and collect revenue directly from them. These licensing arrangements with OEMs or ODMs authorize them to design, build and sell products containing our technology. Under this licensing approach, the licensees are free to choose a semiconductor solution from the platform partner that best suits their technical and cost requirements. We receive royalties directly from the licensed OEM or ODM for the use of our technologies in licensed products manufactured and shipped by the OEM or ODM. Many major OEMs have licenses or purchase products manufactured by a licensed ODM for the use of one or more of our technologies and for the use and display of our trademarks. In the case of the platform partner who bundles our technology within their solution, the cost of the solution includes our royalty at the time it is sold. The platform partner remits that royalty directly back to us on behalf of the licensee.
Our process for selecting particular platform partners for distributing our technology is based on several criteria including: (a) segment leadershipwe target platform partners that hold preeminent positions in market segments characterized by high growth, volume and/or margins; (b) volumewe seek platforms that will maximize exposure of our technologies to a large number of potential OEMs; (c) synergywe seek platforms which serve to position our technologies along with compatible and additive technologies for integrated delivery; and (d) convergence potentialwe target arrangements that will enable us to establish a presence on platforms that intersect merging functional features. An example of this convergence would be the platforms for new personal multifunctional devices that include mobile phone, personal digital assistant, and music capabilities.
To implement our licensing sales strategy within our identified vertical markets, we have established a direct sales force and a worldwide network of independent sales agents. In North America, we employ a direct sales force to market our portfolio of audio and voice technologies to the OEM community. Internationally, we maintain offices in Japan, Hong Kong, Taiwan, China, Spain and Korea to support our multi-national OEM customers. We actively promote the use of our trademarks and logos and direct customers to prominently display the appropriate SRS technology logo on products and packaging and in advertising. We work closely with our licensees to enhance their success in selling finished products and semiconductor products that incorporate our technologies through a variety of licensee support programs. These programs include engineering support, sales training, tradeshow support, publicity and media relations programs, customized marketing materials, advertising, speaking engagements and industry conferences. Where possible, we use the Internet to provide technology demonstrations. We conduct in-person technology demonstrations or presentations for the press and other companies to promote our technologies and products.
We also regularly participate in tradeshows and conferences to increase awareness of our technologies and to market our technologies and products. We work closely with our licensees and platform partners to actively explore additional opportunities to place our technologies in new products and/or markets.
We license our products in markets that are characterized by rapidly changing technology and continuous improvements in products and services. Our research and development expenditures in 2006, 2005, and 2004 were $2,572,577, $2,224,237 and $2,261,886, respectively. These expenses consist of salaries and related costs of employees and consultants engaged in ongoing research, design and development activities and costs for engineering materials and supplies.
As of December 31, 2006, we had 12 employees in our research and development group, representing 31% of our total employees. Our software, hardware and application engineers focus on developing intellectual property, technology solutions and consumer products. All engineers are based in the U.S. and support our licensing business.
Competition in the audio, voice and surround sound technology licensing business includes other licensing companies who offer competing technologies as well as the internal engineering departments of our licensees, who may develop audio technologies for use in their own products.
In the field of audio improvement, we compete directly with other audio providers, including Audistry by Dolby, DTS, BBE Sound, and Qsound. Our 3D positional audio technology directly competes with technologies from QSound and Synoptic. We believe that our bass technology, TruBass, competes directly with several technologies, including MaxxBass from Waves, Ltd, Vi.B.E from Spatializer, and non-proprietary bass systems, such as Bass Boost, that are included on a variety of electronics products, including televisions, portable stereos and speaker products. Additionally, many of our OEM customers maintain their own audio improvement technologies. Because our audio technologies work with any existing recorded material, whether mono, stereo or surround sound, most of our audio technologies, including SRS 3D, SRS FOCUS, SRS TruBass and SRS Dialog Clarity, can be used either as an alternative or as a complement to most competing audio technologies.
Our surround sound rendering technologies compete primarily with Dolby Virtual Speaker, and our surround sound format competes directly with the Dolby ProLogic technologies. However, our surround sound decoders and renderers are compatible with third party content formats.
Many companies in the wireless and telecommunications industry are investigating methods to increase the quality of a voice signal; but we believe that their development work focuses on techniques to reduce noise and provide echo cancellation. Our voice technology, VIP, processes the actual voice signal to improve intelligibility. We are aware of one recently introduced technology by NXP that direct competes with VIP.
Many of the companies referenced above have, or may have, substantially greater resources than us to devote to advancing their existing technologies and developing new products and technologies. We believe that we compete based primarily on the quality and performance of our proprietary technologies, brand name awareness, the ease and cost of implementing our technologies, the ability to meet OEMs needs to differentiate their products, and the strength of our licensee relationships. We believe we compete favorably based on these factors; however, there can be no assurance that we will continue to be competitive with the existing or future products or technologies of our competitors.
In the broadcast and professional audio markets, our Circle Surround technology competes directly with surround sound formats from Dolby and DTS, which market professional products for the encoding and creation of multichannel content. Both of these companies have more established reputations, greater technical, sales, marketing and distribution capabilities and stronger brand presence in the movie/cinema, television broadcast and music recording segments of professional audio. These competitors also have established or may establish strategic relationships with potential customers of our Circle Surround technology, which may affect our customers decisions to purchase products or license technology from us.
We operate in industries where innovation, investment in new ideas and protection of intellectual property rights are important for success. We rely on a variety of intellectual property protections for our products and services, including patent, copyright, trademark and trade secret laws and contractual obligations. We pursue a policy of enforcing such rights. There can be no assurance, however, that our intellectual property rights will be adequate to ensure our competitive position or that competitors will not be able to produce non-infringing competitive products or services. There can be no assurance that third parties will not assert infringement claims against us, or that if required to obtain any third party licenses as a result of an infringement dispute, we will be able to obtain such licenses.
In order to protect the underlying technology concepts, we have filed and/or obtained patents for all of our marketed technologies including technologies marketed under the trademarks SRS, TruSurround, TruSurround XT, FOCUS, Circle Surround, Circle Surround II, WOW, VIP and TruBass. In addition, we have numerous issued patents and patents pending for speaker and other acoustic reproduction technologies. We pursue a general practice of filing patent applications for our technologies in the United States and various foreign countries where our licensees manufacture, distribute or sell licensed products. We continue to update and add new applications to our patent portfolio to address changing worldwide market conditions and our new technological innovations. The range of expiration dates for our patents extend between the years 2007 to 2016. We have multiple patents covering unique aspects and improvements for many of our technologies. Accordingly, the expiration of any single patent may not significantly affect our intellectual property position or the ability to generate licensing revenue.
We also routinely file U.S. federal and foreign trademark applications for the various word names and logos used to market our technology solutions to licensees and the general public. The duration of the U.S. and foreign registered trademarks can typically be maintained indefinitely, provided that proper maintenance fees are paid and the trademarks are continually used or licensed by us.
Due to the dependence on the consumer electronics market, we experience seasonal fluctuation in sales and earnings. In particular, we believe that our business experiences seasonality relating to the holiday season, resulting in higher revenues in the fourth and first quarters. We have moved toward diversifying our key market segments in the consumer electronics industry in an effort to reduce the impact of our seasonal fluctuations.
As of December 31, 2006, we employed 39 persons, including 10 in finance and administration, 12 in research and development, engineering and product development, and 17 in sales and marketing. None of our employees are covered by a collective bargaining agreement or are presently represented by a labor union. We have not experienced any labor problems or a work stoppage and believe we have good relations with our employees.
Our Internet address is www.srslabs.com. There we make available, free of charge, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably practicable after we electronically file such material with or furnish it to the SEC. Our SEC reports can be accessed through the investor relations section of our website. The information found on our website is not part of this or any other report we file with or furnish to the SEC.
You should carefully consider the risk factors described below, as well as the other information included in this Annual Report on Form 10-K, prior to making a decision to invest in our securities. The risks and uncertainties described below are not the only ones facing our company. Additional risks and uncertainties not presently known or that we currently believe to be less significant may also adversely affect us.
We are exposed to risks in our licensing business related to product and customer concentration.
Currently, we generate a majority of our revenue in the home theater market, principally through the inclusion of SRS technology inside LCD, Plasma and CRT televisions, and set-top boxes. We expect that the consumer home entertainment market will continue to account for a significant portion of our licensing revenues for the foreseeable future. While consumer spending in general on consumer electronic products has increased, retail prices for certain consumer electronics products that include our audio technology, have decreased significantly. Indications are that this trend will continue for the foreseeable future. From time to time, certain of our OEM and semiconductor manufacturer customers may account for a significant portion of our revenue from a particular product application. For example, for the year ended December 31, 2006, Samsung and Sony accounted for approximately 18% and 11% of our consolidated revenues, respectively. Consumer electronics products manufacturers could decide to exclude our audio rendering technology from their products altogether in an effort to reduce cost. The loss of any such customer could have a material adverse affect on our financial condition and results of operations.
Our business is highly dependent on the consumer electronics market, which is characterized by short product life cycles, fluctuations in demand and seasonality, and is subject to risks related to product transitions and supply of other components.
The consumer electronics market is characterized by intense competition, rapidly evolving technology, and ever-changing consumer preferences. These factors result in the frequent introduction of new
products, short product life cycles and significant price competition. As a result, we may need to develop new products or technologies to integrate with the new products and technologies developed by our customers. If we are unable to develop the necessary technologies to meet the changing needs of our customers or provide such technologies at competitive prices, our customers may reduce their use of our technologies and our revenues may decline. In addition, the dynamic nature of this market limits our, as well as our customers, ability to accurately forecast quarterly and annual sales. If we, or our customers, are unable to adequately manage product transitions, our business and results of operations could be negatively affected.
Pricing pressures on the consumer electronics product manufacturers, who incorporate our technologies into their products, could limit the licensing fees we charge for our technologies, which could reduce our revenues.
The markets for the consumer electronics products in which our technologies are incorporated are intensely competitive and price sensitive. Retail prices for consumer electronics products that include our technologies, have decreased significantly, and we expect prices to continue to decrease for the foreseeable future. In response, manufacturers have sought to reduce their product costs, which can result in downward pressure on the licensing fees we charge our customers who incorporate our technologies into their products. Alternatively, our customers may seek to eliminate our technologies in their products in favor of internally developed technologies. A decline in the licensing fees we charge could materially and adversely affect our operating results.
We face intense competition from companies with greater brand recognition and resources.
The digital audio, consumer electronics, and entertainment markets are intensely competitive, subject to rapid change, and significantly affected by new product introductions and other market activities of industry participants
Many of our current and potential competitors enjoy substantial competitive advantages, including:
· greater name recognition;
· a longer operating history;
· more developed distribution channels and deeper relationships with consumer electronics products designers and manufacturers;
· a more extensive customer base;
· broader product and service offerings;
· greater resources for competitive activities, such as research and development, strategic acquisitions, alliances, joint ventures, sales and marketing, and lobbying industry and government standards; and
· more technicians and engineers.
As a result, these current and potential competitors may be able to respond more quickly and effectively than we can to new or changing opportunities, technologies, standards, or customer requirements.
We are subject to risks associated with substantial international operations.
We conduct sales and customer support operations in a number of countries throughout the world that require refinement to adapt to the changing market conditions on a regional basis. In addition, many of our significant customers are headquartered in the Asia Pacific region, particularly Japan and Korea. Approximately 91%, 84% and 74% of our sales were derived from customers with headquarters located in
the Asia Pacific markets during the years ended December 31, 2006, 2005 and 2004, respectively. We expect to continue to derive a significant portion of our net sales from sales to customers in these markets for the foreseeable future. Also, a substantial number of products incorporating our technologies are manufactured, assembled and tested by third parties in Asia. As a result, we are subject to a number of risks of conducting business outside of the United States, any of which could have a material adverse impact on our results of operations, including:
· political, social and economic instability, and the risk of war, terrorist activities or other international incidents in Asia and elsewhere abroad;
· difficulties and costs of staffing and managing foreign operations;
· unexpected changes in, or impositions of, government requirements;
· adverse changes in tariffs and other protectionist laws and business practices that favor local competitors;
· potentially longer payment cycles and greater difficulty in collecting receivables from foreign entities;
· the burdens of complying with a variety of non-U.S. laws and reduced protection of our intellectual property in some countries;
· potentially adverse tax consequences and the complexities of foreign value added tax systems; and
· other factors beyond our control, including natural disasters and major health concerns.
Our ability to generate revenues and meet with customers may be affected by widespread illness.
Widespread illnesses such as the SARS illness and the Avian Influenza, or Asia Bird Flu, could impact our operations or our consumer electronics licensees operations. For example, our ability to visit our customers, our ability to conduct sales meetings or presentations, and sell through rates of electronics products to end consumers may be dramatically effected by either widespread or perceived potential illnesses.
If the sale of consumer electronics products incorporating our technologies does not grow in emerging markets, our ability to increase our licensing revenue may be limited.
We also expect that growth in our licensing revenue will depend, in part, upon the growth of sales of consumer electronics products incorporating our technologies in other countries, including China and India, as consumers in these markets have more disposable income and are increasingly purchasing entertainment products with surround sound capabilities. These countries have rapidly expanding and growing economies that are less mature than economies of other regions in which we derive significant portions of our revenue. Because of this, changes to employment patterns, currency fluctuations and political uncertainties could impact our ability to grow our licensing revenues in these regions.
We have a long and unpredictable sales cycle, which can result in uncertainty and delays in generating additional revenues.
Historically, because of the complexity of our technologies, it can take a significant amount of time and effort to explain the benefits of our technologies to potential new customers and to negotiate a sale. For example, it typically takes six to nine months after our first contact with a prospective customer before we start licensing our technology to that customer. In addition, purchases of our products are usually made in connection with new design starts by our customers, the timing of which is outside of our control. Accordingly, we may be unable to predict accurately the timing of any significant future sales of our
products. We may also spend substantial time and management attention on potential license agreements that are not consummated, or in which the consumer electronic product ultimately does not sell in large quantities, thereby foregoing other higher revenue opportunities.
If our patents and other intellectual property rights do not adequately protect our products, we may lose market share to our competitors and be unable to operate our business profitably.
Our ability to compete may be affected by our ability to protect our proprietary information. We have filed numerous U.S. and foreign patent applications and to date have a number of issued U.S. and foreign patents covering various aspects of our technologies. There can be no assurance that the steps taken by us to protect our intellectual property will be adequate to prevent misappropriation of our technology or that our competitors will not independently develop technologies that are substantially equivalent or superior to our technology. In addition, the laws of certain foreign countries may not protect our intellectual property rights to the same extent as do the laws of the U.S. It is possible that third parties may assert claims or initiate litigation against us or our customers with respect to existing or future products. In addition, we may initiate claims or litigation against third parties for infringement of our proprietary rights or to determine the scope and validity of our proprietary rights. Claims and litigation brought against us or initiated by us could be costly and time consuming and could divert our management from our business.
If we lose the services of our key personnel, or if we are unable to attract and retain other key personnel, we may not be able to manage our operations or meet our growth objectives.
Our future success depends to a large extent upon the continued service of key personnel, including engineering, sales and administrative staff. We anticipate that any future growth will require us to recruit and hire a number of new personnel in engineering, operations, finance, sales and marketing. Competition for such personnel can be intense, and it is possible that we may not be able to recruit and retain necessary personnel to operate our business and support future growth.
The market price of our common stock is volatile and your investment in our common stock could suffer a decline in value.
The trading price of our common stock has been, and will likely continue to be, subject to wide fluctuations in response to quarterly variations in our operating results, announcements of new products or technological innovations by us or our competitors, strategic alliances between us and third parties, general market fluctuations and other events and factors. Changes in earnings estimates made by brokerage firms and industry analysts relating to the markets in which we do business, or relating to us specifically, have in the past resulted in, and could in the future result in, an immediate and adverse effect on the market price of the common stock. Even though our stock is quoted on the NASDAQ Global Market, our stock has had and may continue to have low trading volume and high volatility. The historically low trading volume of our stock makes it more likely that a severe fluctuation in volume, either up or down, will significantly impact the stock price. Because of the relatively low trading volume of our stock, our stockholders may have difficulty selling our common stock.
Our certificate of incorporation and bylaws as well as Delaware law contain provisions that could discourage transactions resulting in a change in control, which may negatively affect the market price of our common stock.
Our certificate of incorporation, our bylaws and Delaware law contain provisions that might enable our management to discourage, delay or prevent a change in control. In addition, these provisions could limit the price that investors would be willing to pay in the future for shares of our common stock.
Our worldwide headquarters are located in Santa Ana, California, in a 23,400 square foot facility consisting of office and warehouse space. The lease is for a term of three years scheduled to expire on May 31, 2008. We lease this facility from Daimler Commerce Partners, L.P., the general partner of which is Conifer Investments, Inc. The sole shareholders of Conifer are Thomas C.K. Yuen, our Chairman, Chief Executive Officer and President, and his spouse, Misako Yuen, as co-trustees of the Thomas Yuen Family Trust. Mr. and Mrs. Yuen also serve as the executive officers of Conifer. Mr. and Mrs. Yuen, as co-trustees of the trust, beneficially own a significant amount of our outstanding shares of common stock. We paid the Daimler Commerce Partners rent of $230,256, $222,066 and $210,600 in 2006, 2005 and 2004, respectively. We believe the terms and conditions of the lease are competitive based on a review of similar properties in the area with similar terms and conditions.
Our worldwide headquarters house personnel responsible for the development of our technologies and the administration of the licensing business. We believe that our current facilities are adequate to support our current requirements.
From time to time we may be involved in various disputes and litigation matters arising in the normal course of business. We are currently not involved in any legal proceedings that are expected to have a material adverse effect on our consolidated financial position, results of operations or cash flows.
Our common stock trades on the NASDAQ Global Market under the symbol SRSL. The table below reflects the high and low sales prices of our common stock as reported by The NASDAQ Stock Market, Inc. for the periods indicated.
At March 9, 2007, the last sale price our common stock was $11.01 per share.
At March 9, 2007, there were 403 stockholders of record.
We have never paid cash dividends on our common stock. We currently intend to retain our available funds for future growth and, therefore, we do not anticipate paying any dividends in the foreseeable future.
The following equity compensation plans have been approved by our stockholders: the SRS Labs, Inc. Stock Option, Nonqualified Stock Option and Restricted Stock Purchase Plan (the 1993 Plan), the SRS Labs, Inc. Amended and Restated 1996 Long-Term Incentive Plan (the 1996 Plan), the SRS Labs, Inc. Amended and Restated 1996 Non-employee Directors Stock Option Plan (the Non-employee Directors Plan) and the SRS Labs, Inc. 2006 Stock Incentive Plan (the 2006 Plan). A description of the material features of each of these plans is included in Note 7 to the Notes to Consolidated Financial Statements under the caption Stock Award/Option Plans/Warrants. No options have been granted under the 1993 plan since June 7, 1996. The 1993 plan expired on December 10, 2003 and no options or other rights to acquire equity are outstanding under that plan. On June 22, 2006, the Companys stockholders voted to approve the 2006 Plan, and to discontinue the issuance of any awards under the 1996 Plan. We do not have any equity compensation plans other than those approved by our stockholders. The following table sets forth information regarding the number of shares of our common stock that may be issued pursuant to our equity compensation plans or arrangements as of December 31, 2006.
(1) Represents shares of common stock that may be issued pursuant to outstanding options granted under the following plans: 2,105,088 shares under the 1996 Plan, 130,000 shares under the Non-employee Directors Plan and 125,000 shares under the 2006 Plan.
(2) Represents shares of common stock that may be issued pursuant to future grants under the following plans: 340,000 shares under the Non-employee Directors Plan and 1,375,000 shares under the 2006 Plan.
On June 30, 2004, the Board authorized the repurchase of up to $3,000,000 of our outstanding common stock for a period from July 1, 2004 to December 31, 2004 (the 2004 Repurchase Program). We repurchased 216,575 shares of our common stock at a cost of $1,225,254 under the 2004 Repurchase Program.
On March 25, 2005, the Board adopted a stock repurchase program authorizing the purchase of up to $3,000,000 of our common stock during the period from April 2005 to March 2006. As of March 31, 2006 (the end of the repurchase program), total purchases under the program since inception were 232,223 shares at an average purchase price of $4.56 per share.
In connection with the sale of Valence on September 29, 2006, we repurchased 357,625 shares of our common stock at an aggregate cost of $2,114,586, which were immediately cancelled.
The following selected financial information as of and for the dates and periods indicated have been derived from our audited consolidated financial statements. The information set forth below is not necessarily indicative of results of future operations, and should be read in conjunction with Managements Discussion and Analysis of Financial Condition and Results of Operations in Part II, Item 7 of this Annual Report on Form 10-K and our consolidated financial statements and related notes included elsewhere in this Report.
SRS Labs is a leading developer and provider of audio and voice technology solutions for the home entertainment, portable media device, personal telecommunications, personal computer, automotive, and broadcast markets. Prior to September 29, 2006, the Company was also a developer and provider of application specific integrated circuits and standard integrated circuits through its formerly wholly-owned subsidiary, Valence Tech Limited.
Licensing: Our operations are conducted through SRS Labs, Inc., the parent company, and its wholly-owned subsidiary, SRSWOWcast.com, Inc. Our business is focused on developing and licensing audio, voice and surround sound technology solutions to many of the worlds leading OEMs, software providers and semiconductor companies, and license and marketing hardware and software products for the Internet and professional audio markets.
Valence: Through SRS Labs, Inc.s formerly wholly-owned subsidiary, ValenceTech Limited, we operated a fabless semiconductor business which developed, designed and marketed standard and custom analog integrated circuits, digital signal processors, and mixed signal integrated circuits primarily to OEMs and ODMs, in the Asia Pacific region.
On February 23, 2006, our Board approved a plan to sell Valence in order to focus managements attention and financial resources on our licensing business. On July 14, 2006, we entered into a definitive Sale and Purchase Agreement to sell Valence to Noblehigh Enterprises Inc. Noblehigh is owned by Willas Array Electronics (Holding) Limited as well as certain members of management of Valence (collectively referred to herein as the Management Buyers). The sale transaction was completed on September 29, 2006 and accordingly the results of the operations of Valence through the date of sale are included as discontinued operations in the accompanying consolidated statement of operations for the years ended December 31, 2006, 2005 and 2004. The transaction did not require approval from SRS stockholders.
The sale to Noblehigh was effected through two simultaneous transactions: (1) the repurchase by Valence of approximately 74% of the outstanding shares of Valence from SRS using its existing cash and (2) the purchase by Noblehigh of the remaining outstanding shares of Valence from SRS for $4.3 million. The sale resulted in a gain on the disposal of discontinued operations of $237,625 in the accompanying consolidated statement of operations for the year ended December 31, 2006.
Additionally, we repurchased from the Management Buyers 357,625 shares of our common stock, which were obtained through the exercise of vested employee stock options, for an aggregate repurchase price of $2,114,586. Such shares were immediately canceled and are therefore not outstanding as of December 31, 2006. The repurchase price per share paid for such shares was equal to the average closing price of our common stock for the seven trading days ending three days prior to the closing date of the sale of Valence. See Note 11 of our Notes to the Consolidated Financial Statements.
CHS/SRS LLC: In September 2004, we entered into a strategic alliance with Coming Home Studios LLC to use and promote SRS Labs technologies, to promote CHS productions and to promote each companys respective brands. In connection with the strategic alliance, SRS and CHS established a Joint Venture, CHS/SRS, LLC, to produce and distribute nine concert videos featuring our Circle Surround technology. Initially, CHS was the manager of the Joint Venture; however, SRS became the manager of the Joint Venture in July 2005. As a result of becoming the manager of, and providing financial support to, the Joint Venture, we were required under Financial Accounting Standards Board Interpretation No. 46, Consolidation of Variable Interest Entities, to consolidate the financial statements of the Joint Venture into our consolidated financial statements commencing with the third quarter of fiscal 2005. Previously, we accounted for our 50% equity ownership in the Joint Venture as an investment using the equity method.
The Company recorded an asset impairment charge of $3.3 million related to our investment in the Joint Venture in the fourth fiscal quarter of 2005. On February 23, 2006, our Board authorized management to take all reasonable steps to divest our entire equity interest in the Joint Venture. On June 30, 2006, we completed the sale of our interest in the Joint Venture to CHS in exchange for $200,000, the rights to all cash assets of the Joint Venture, and a promissory note in the amount of $175,000. We received $200,000 from CHS and the cash assets of the joint venture. Any amounts related to the promissory note and accrued interest thereon will be recorded at the time the cash is received by us. We recorded a gain on disposal of our interest in the Joint Venture of $387,021 in the accompanying consolidated statement of operations for the year ended December 31, 2006.
Our discussion and analysis of our results of operations and liquidity and capital resources are based on our consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States.
The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and disclosure of contingent assets and liabilities. We base our estimates on historical and anticipated results and trends and on various other assumptions that we believe are reasonable under the circumstances, including assumptions as to future events. These estimates form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. By their nature, estimates are subject to an inherent degree of uncertainty. Actual results may differ from our estimates.
The following represents a summary of our critical accounting policies, defined as those policies that we believe are: (a) the most important to the portrayal of our financial condition and results of operations, and (b) that require managements most difficult, subjective or complex judgments, often as a result of the need to make estimates about the matters that are inherently uncertain. Our most critical accounting estimates include revenue recognition; valuation of accounts receivable, which impacts operating expenses; valuation of intangible assets and capitalization of software, which primarily impacts operating expenses when we impair assets or accelerate their depreciation; recognition and measurement of current and deferred income tax assets and liabilities, which impacts our tax provision; and stock based compensation, which impacts operating expenses. We discuss each of these policies below, as well as the estimates and judgments involved. We also have other policies that we consider key accounting policies; however, these policies do not meet the definition of critical accounting estimates, because they do not generally require us to make estimates or judgments that are difficult or subjective.
Royalty revenues associated with ongoing royalty license agreements are recognized upon receipt of reports from licensees stating the number of products implementing SRS patented technologies on which royalties are due, generally one quarter in arrears. The Company also has arrangements under which license fees are prepaid upfront, in addition to ongoing per-unit license fees. In such cases, the prepaid fees are recorded as deferred revenues and recognized as revenue upon receipt of reports from licensees stating the number of products shipped on which royalties are due. Licensing revenues for one-time technology transfer fees are recognized in the period in which the license agreement is consummated and the related technology and passage of title is transferred. Revenue from product sales is generally recognized upon shipment at which point title passes. Certain products may be sold under consignment agreements, and revenue is recognized upon reported distributor sales. Design revenue under design contracts is recognized on the percentage-of-completion method. Estimates are reviewed and revised periodically throughout the lives of the contracts. Any revisions are recorded in the accounting period in which the revisions are made.
We perform ongoing credit evaluations of our customers and adjust credit limits based upon payment history, the customers current credit worthiness and various other factors, as determined by our review of their current credit information. We continuously monitor collections and payments from our customers and maintain allowances for doubtful accounts based upon specific customer circumstances, current economic trends, historical experience and the age of past due receivables. While such credit losses have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past. Unanticipated changes in the liquidity or financial position of our customers may require additional provisions for doubtful accounts.
Intangible Assets, Capitalization of Software and Impairment of Long-Lived Assets
In accordance with Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS No. 144), all of our intangible assets that have definite lives are being amortized on a straight-line basis over their estimated useful lives. Costs paid by us related to the establishment and transfer of patents, primarily legal costs, are capitalized and amortized over ten years. We annually evaluate the recoverability of our patents and intangible assets based on the estimated future undiscounted cash flows. Should the carrying value of patents or intangible assets exceed the estimated future undiscounted cash flows for the expected periods of benefit, such assets will be written down to fair value. As discussed further in Note 4 to the Notes to the Consolidated Financial Statements, based upon our most recent assessment as of December 31, 2006, we have determined there was no impairment in the value of our long-lived assets.
Costs incurred in the research, design and development of software for sale to others as a separate product or embedded in a product and sold as part of the product as a whole are charged to expense until technological feasibility is established. Under Statement of Financial Accounting Standards No. 86, Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed (SFAS No. 86), we capitalize software purchased from third parties if the related software product under development has reached technological feasibility or if there are alternative future uses for the purchased software, provided that capitalized amounts will be realized over a period of approximately three years. Costs incurred prior to the establishment of technological feasibility are charged to research and development expense. The establishment of technological feasibility and ongoing assessment of recoverability of capitalized software development costs require considerable judgment by management with respect to certain external factors, including, but not limited to, anticipated future revenues, estimated economic life and changes in software and hardware technologies. Under SFAS No. 86, annual amortization of software development costs are equal to the greater of (a) the ratio that current gross revenues for a product bear to the total of current and anticipated future gross revenues for that product or (b) the straight-line method over the remaining estimated economic life of the product including the period being reported on. We are using the straight-line method of amortization because the software can be used for many products and the estimates required to be made under the ratio that current gross revenues for products bear to the total of the current and anticipated future gross revenues for that product could result in under reporting of expense. Upon the general release of the software product to customers, capitalization ceases and such costs are amortized to cost of sales using the straight-line method on a product-by-product basis over the estimated life, which is generally three years. To the extent that amounts capitalized for software development costs become impaired due to a decline in demand or the introduction of new technology, such amounts will be written-off. All other research and development expenditures are charged to research and development expense in the period incurred.
In preparing our consolidated financial statements, we estimate our income taxes in each of the countries in which we operate. The process used to make these estimates includes an assessment of the
current tax expense, the results from tax examinations and the effects of temporary differences resulting from the different treatment of transactions for tax and financial accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our consolidated balance sheet. We account for income taxes in accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (SFAS No. 109), which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. SFAS No. 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will not be realized. We evaluate the reliability of our deferred tax assets by assessing our valuation allowance and by adjusting the amount of such allowance, if necessary. At December 31, 2006, we had net deferred tax assets primarily resulting from temporary differences between the book and tax bases of assets and liabilities, and loss and credit carry forwards. We continue to provide a valuation allowance on certain deferred tax assets based on an assessment of the likelihood of their realization. In reaching our conclusion, we evaluated certain relevant criteria including deferred tax liabilities that can be used to offset deferred tax assets, estimates of future taxable income of appropriate character within the carry-forward period available under the tax law, and tax planning strategies. Our judgments regarding future taxable income may change due to market conditions, changes in U.S. or international tax laws, and other factors. These changes, if any, may require material adjustments to these deferred tax assets, resulting either in a tax benefit, if it is estimated that future taxable income is likely, or a reduction in the value of the deferred tax assets, if it is determined that their value is impaired, resulting in a reduction in net income or an increase in net loss in the period when such determinations are made.
Our income tax provision is based on calculations and assumptions that will be subject to examination by the taxing authorities in the jurisdictions in which we operate. Should the actual results differ from our estimates, we would have to adjust the income tax provision in the period in which the facts and circumstances that give rise to the revision become known. Tax law and rate changes are reflected in the income tax provision in the period in which such changes are enacted.
Stock Based Compensation
On January 1, 2006, we adopted the provisions of SFAS No. 123(R), Share-Based Payment (SFAS No. 123R) using the modified prospective application transition method. SFAS No. 123R requires measurement of all employee stock based compensation awards using a fair-value method and recording of such expense in the consolidated financial statements over the requisite service period. Previously, we had applied the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) and related interpretations and elected to utilize the disclosure option of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS No. 123). In fiscal 2006, we recorded stock-based compensation expense of $1,460,910 under the fair-value provisions of SFAS No. 123R, compared to $55,802 in fiscal 2005 and $92,585 in fiscal 2004 under the provisions of APB 25 and related interpretations.
To determine the expected term of our employee stock options granted in fiscal 2006, we utilized the simplified approach as defined by SEC Staff Accounting Bulletin No. 107, Share-Based Payment (SAB 107). This approach resulted in an expected term of 6.25 years for options that vest over four years. To determine the risk-free interest rate, we utilized an average interest rate based on U.S. Treasury instruments whose term was consistent with the expected term of our awards. To determine the expected stock price volatility, we examined the historical volatilities for our common stock and those of our peers. See Note 7 (Stockholders Equity and Stock-Based Compensation) of our Notes to Consolidated Financial Statements for further discussion.
The following table sets forth certain consolidated operating data as a percentage of total revenue for the years ended December 31, 2006, 2005, and 2004:
Total revenues for fiscal 2006 were $18,547,529 compared to $14,608,478 in fiscal 2005, an increase of $3,939,051 or 27%. This increase is primarily attributable to increases in royalties related to the sales of flat panel televisions and monitors, which grew by $5,282,295 or 133%, and increases in the automotive market, which grew by $602,786 or 130%. The majority of the increases in flat panel televisions and monitors revenues are the direct result of our receipt of larger royalty payments from many of the multinational television OEMs, including Sony, Samsung, LG and Toshiba, or their respective manufacturers. It is our understanding that the global unit volumes of flat panel televisions and monitors is expected to continue to increase in 2007 and for the foreseeable future. While we continue to have good relationships with many of the major global television OEMs and are not aware of any significant customer losses, there can be no assurance that we will be successful in growing or maintaining this market of our business. Revenues in the automotive market increased substantially in 2006 as compared to 2005. This is primarily due to increased revenues from one customer in Japan who provides line install, dealer option and after market automotive audio systems to many of the significant Japanese automotive manufactures, including Toyota, Honda, Subaru and Nissan. We expect the revenues in this segment to grow in 2007; however, at a slower rate of increase. While we continue to be notified of design wins in this segment, revenues can be delayed significantly due to the length of time between design win and production. Revenues in our portable media devices segment and personal telecommunications segments fell by 13% and 6%, respectively. The decrease in revenue in portable media devices is primarily attributable to the loss of one customer. Revenues from that customer continued in the first and second quarters of fiscal 2006; however, no substantive revenues were received from that customer in the third and fourth quarters
of 2006, nor do we expect at this time to receive significant revenues from this customer in the future. The decrease in personal telecommunications revenues is primarily attributable to one customer who has experienced a decrease in its sales of handset units. We continue to be included in the customers products; however, sales of these products were at lower levels in 2006 than during 2005. The following table represents our mix of licensing revenues by market source:
Sales and Marketing
Sales and marketing expenses consist primarily of employee salaries, sales consultants fees and related expenses, sales commissions and costs associated with branding activities. Sales and marketing expenses were $7,345,133 for fiscal year 2006, as compared to $5,192,090 for fiscal year 2005. Overall sales and marketing expenses were $2,153,043, or 41%, higher in fiscal 2006 due in large part to increased staffing as we added sales personnel/consultants in the United States, Europe, Taiwan and Korea. The Company hired a Vice President of Sales-Licensing in August 2005 and an Executive Vice President of Marketing and Business Development in December 2005 (who separated from the company in July 2006). Additionally, we increased staffing at the corporate level to support our branding and marketing activities. Some of these staffing increases were moderated during the second half of fiscal 2006 as the Company increased its branding and marketing activities at the local level, and reduced expenditures at the corporate level. We also noted increased commissions on higher licensing revenues. Lastly, we recorded $515,762 in stock based compensation expense for sales and marketing personnel during 2006 as compared to zero in 2005, due to the adoption of SFAS No. 123R at the beginning of fiscal 2006. In 2007, we expect to continue to invest in our sales and marketing activities, particularly by hiring additional sales personnel and increasing our branding efforts. As a percentage of total revenues, sales and marketing expenses increased from 36% for fiscal year 2005, to 39% for fiscal year 2006.
Research and Development
Research and development expenses consist of salaries and related costs of employees engaged in ongoing research, design and development activities and costs for engineering materials and supplies. Research and development expenses were $2,572,577 for fiscal year 2006, as compared to $2,224,237 for fiscal year 2005. The overall increase in research and development expenses of $348,340, or 16%, is primarily attributable to $331,480 in stock based compensation expense for engineering personnel during 2006 as compared to zero in 2005, due to the adoption of SFAS No. 123R at the beginning of fiscal 2006. We expect that research and development expenses will increase substantially in 2007 as we continue to expand our intellectual property portfolio, which we believe is critical to our business, and as we seek to accelerate the implementation of our technology with a greater number of customers and devices. We expect that research and development expenses will fluctuate as a percentage of revenue due to fluctuations in our revenues. As a percentage of total revenues, research and development expenses decreased from 15% for fiscal year 2005, to 14% for fiscal year 2006.
General and Administrative
General and administrative expenses consist primarily of employee-related expenses, legal costs associated with the administration of intellectual property, and other professional fees and costs associated with being a publicly held company. General and administrative expenses were $5,660,260 for fiscal year 2006 as compared to $5,170,256 for fiscal year 2005. The overall increase of $490,004, or 9%, was primarily attributable to $512,525 in stock based compensation expense for corporate employees and directors during 2006 as compared to $55,802 in 2005, due to the adoption of SFAS No. 123R at the beginning of fiscal 2006. During 2007, the Company will be required to comply with the Sarbanes-Oxley 404 requirements, including independent auditor certification. The cost of such compliance is not yet known and may increase overall public company expenses in 2007 as compared to fiscal 2006. As a percentage of total revenues, general and administrative expenses decreased from 35% for fiscal year 2005, to 31% for fiscal year 2006.
Other Income, Net
Other income, net, consists principally of interest income. Other income, net, was $1,135,870 for fiscal year 2006, compared to $673,132 for fiscal year 2005, an increase of $462,738 or 69%. This increase is primarily attributable to the increase of interest income due to higher interest rates and higher cash balances.
Provision for Income Taxes
The income tax provision for fiscal 2006 was $868,203 compared to $795,919 for fiscal 2005 an increase of $72,284 or 9%. The provision consists primarily of taxes paid on licensing revenues sourced from countries requiring foreign tax withholdings, principally Korea and Taiwan.
We had federal and state net operating loss carry-forwards at December 31, 2006 of $17,621,730 and $7,992,523, respectively. The net operating loss carry-forwards began expiring in 2003 and will continue through 2026. In addition, we had federal tax credit carry-forwards of approximately $2,865,936, at December 31, 2006, which begin to expire in 2010, and federal and state tax capital loss carryforwards of approximately $16,219,585, which begin to expire in 2011. As of December 31, 2006, we continue to have a valuation allowance of $15,089,937 against our deferred tax assets, which was established primarily due to our cumulative losses in recent years and based on our assessment of our future ability to realize certain deferred tax assets.
Total revenues for fiscal 2005 were $14,608,478 compared to $10,831,704 in fiscal 2004, an increase of $3,776,774 or 35%. This increase is primarily attributable to our diversification strategy, which generated revenues in new product categories such as mobile phones, portable audio devices, and PCs and increased penetration in the home theater market, including set-top boxes and televisions, which incorporate SRS Labs technologies. The following table presents the Companys licensing revenues mix by market source:
Sales and Marketing
Sales and marketing expenses consist primarily of employee salaries, sales consultants fees and related expenses, sales commissions and product promotion costs. Sales and marketing expenses were $5,192,090 for fiscal year 2005 compared to $4,550,101 for fiscal year 2004. Overall, sales and marketing expenses were $641,989, or 14%, higher in fiscal 2005 due to increased staffing, increased commissions on higher licensing revenues and continued advertising campaigns to enhance our brand. As a percentage of total revenues, sales and marketing expenses decreased from 42% for fiscal year 2004, to 36% for fiscal year 2005.
Research and Development
Research and development expenses consist of salaries and related costs of employees engaged in ongoing research, design and development activities and costs for engineering materials and supplies. Research and development expenses were $2,224,237 for fiscal year 2005 compared to $2,261,886 for fiscal year 2004. The overall decrease in research and development expenses of $37,649, or 2%, was primarily attributable to minor adjustments in staffing. We expect that research and development will continue to be critical to our business as we introduce new products, but such expenses will fluctuate as a percentage of revenue due to fluctuations in our total revenues. As a percentage of total revenues, research and development expenses decreased from 21% for fiscal year 2004 to 15% for fiscal year 2005 due to the increase in licensing revenues.
General and Administrative
General and administrative expenses consist primarily of employee-related expenses, legal costs associated with the administration of intellectual property and other professional fees. General and administrative expenses were $5,170,256 for fiscal year 2005 compared to $4,621,522 for fiscal year 2004. The overall increase of $548,734, or 12%, was primarily attributable to increased professional fees, public company expenses, including costs incurred for Sarbanes-Oxley 404 compliance that was ultimately delayed until 2007, and increased amortization associated with the increased capitalization of patents and purchased technology absorbed by the licensing segment. As a percentage of total revenues, general and administrative expenses decreased from 43% for fiscal year 2004 to 35% for fiscal year 2005.
Other Income, Net
Other income, net, consists principally of interest income. Other income, net, was $673,132 for fiscal year 2005 compared to $594,922 for fiscal year 2004, an increase of $78,210 or 13%. This increase was primarily due to higher invested cash balances.
Provision for Income Taxes
The income tax provision for fiscal 2005 was $795,919 compared to $523,128 for fiscal 2004, an increase of $272,791 or 52%. The provision consists primarily of taxes paid on licensing revenues sourced from countries requiring foreign tax withholdings. In 2005, we benefited from the U.S. Japan tax treaty, which eliminated source-country withholdings on royalties. That treaty became effective on July 1, 2004. The decrease in withholding in revenue sourced from Japan was offset by an increase in withholding amounts on revenue sourced from Korea.
We had federal and state net operating loss carry-forwards at December 31, 2005 of approximately $18,686,000 and $9,333,000, respectively. The net operating loss carry-forwards began expiring in 2003 and will continue through 2025. In addition, we had federal tax credit carry-forwards of approximately $1,914,000, at December 31, 2005, which begin to expire in 2011. As of December 31, 2005, a valuation
allowance of $11,668,869 was established primarily due to our recent cumulative losses and based on our assessment of our future ability to realize certain deferred tax assets.
The following table sets forth certain quarterly summary consolidated financial data for the eight quarters in the period ended December 31, 2006. The quarterly information is based upon financial statements prepared by us on a basis consistent with our audited consolidated financial statements and, in managements opinion, includes all adjustments, consisting only of normal recurring adjustments necessary for a fair presentation of the information for the periods presented. This information should be read in conjunction with our audited consolidated financial statements and notes thereto appearing elsewhere in this Report. Our quarterly operating results have varied significantly in the past and are expected to vary significantly in the future. Due to rounding differences, the quarters in a given year may not add precisely to the annual numbers for that year.
At December 31, 2006 cash and cash equivalents and investments available for sale were $40,238,130 compared to $25,829,509 as of December 31, 2005, an increase of $14,408,621. The Companys cash and cash equivalents were $35,011,425 as of December 31, 2006, an increase of $26,259,086 from cash and cash equivalents of $8,752,339 held at December 31, 2005. The increase is primarily a result of positive cash flow generated by operating activities, the sale of our interest in Valence and the exercise of employee stock options. Cash and cash equivalents generally consist of cash, money market funds and other money market instruments with original maturities of three months or less. We held $5,226,705 in investments available for sale at December 31, 2006, as compared to $17,077,170 at December 31, 2005, a decrease of $11,850,465. The decrease in investments available for sale is due to investments maturing and the Company investing the proceeds in cash equivalents. Investments consist of U.S. government securities rated AAA. In fiscal 2006, 2005 and 2004, operations were funded primarily from cash from operating activities.
Net cash provided by operating activities was $4,950,707 and $2,994,327 for fiscal 2006 and 2005, respectively. The $1,956,380 increase in net cash provided by operating activities in fiscal year 2006, compared to fiscal year 2005, was primarily a result of net income for the year and non-cash items of depreciation and amortization of $727,773 and deferred stock compensation of $1,359,767, offset by net cash used by discontinued operations of $1,945,807 and a non-cash gain on disposal of discontinued operations of $624,646. Accounts receivable decreased by $725,495 during fiscal 2006 due to collection of several significant accounts prior to year end. The total days sales outstanding were 23 days at December 31, 2006 compared to 46 days at December 31, 2005. In fiscal 2006, accrued liabilities increased $493,338 primarily due to an increase in accrued commissions and amounts due to employees under the 2006 Bonus and Profit Sharing Plan.
Our investing activities provided cash of $15,768,382 in 2006 and used cash of $1,184,323 in 2005. The increase in cash from investing activities during 2006 is primarily due to the sale of investments held for sale and proceeds received from the sale of our interests in Valence and the Joint Venture. These amounts were partially offset by expenditures related to our patents and intangible assets of $520,881, purchases of property and equipment of $214,459, and discontinued operations of $180,216. The cash used for investing activities in fiscal 2005 is due primarily to purchases of furniture, fixtures and equipment of $154,851, expenditures related to patents and intangible assets of $440,515, and discontinued operations of $597,706.
Our financing activities provided cash of $5,539,997 during 2006 and used cash of $69,577 during 2005. During 2006, we received cash of $7,654,583 as the result of the exercise of employee stock options. This was partially offset by our purchase of $2,114,586 of outstanding stock as part of the sale of our interest in Valence. Our financing activities during 2005 primarily consisted of proceeds from the exercise of employee stock options of $990,013, offset by the purchase of outstanding stock for $1,059,590.
We believe our existing cash balances and investments together with cash generated from operating activities will be sufficient to meet our anticipated cash needs for at least the next twelve months. Our future capital requirements will depend on many factors, including our level of revenues, the timing and extent of spending to support product development efforts, the expansion of sales and marketing activities, the timing of introductions of new products, the costs to ensure access to adequate manufacturing capacity, and the continuing market acceptance of our products. We could be required, or could elect, to seek additional funding through public or private equity or debt financing. It is possible that such additional funds will not be available on terms acceptable to us or at all.
We have contractual obligations and commitments with regards to operating lease arrangements. The following table quantifies our expected contractual obligations and commitments subsequent to December 31, 2006:
In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48). FIN 48 is an interpretation of FASB Statement No. 109, Accounting for Income Taxes, and it seeks to reduce the diversity in practice associated with certain aspects of measurement and recognition in accounting for income taxes. In addition, FIN 48 requires expanded disclosure with respect to the uncertainty in income taxes and is effective as of the
beginning of our 2007 fiscal year. We do not expect the adoption of FIN 48 to have a material impact on our consolidated financial position or results of operations.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS No. 157). The purpose of SFAS No. 157 is to define fair value, establish a framework for measuring fair value and enhance disclosures about fair value measurements. The measurement and disclosure requirements are effective for periods beginning after November 15, 2007. We do not expect the adoption of SFAS No. 157 will have a material effect on our consolidated financial position or results of operations.
In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (SAB 108). SAB 108 provides interpretive guidance on how to evaluate the materiality of an uncorrected misstatement in the current year financial statements using both an income statement approach (the rollover approach) and a balance sheet approach (the iron curtain approach). The rollover approach quantifies a misstatement based on the amount of the error originating in the current year income statement while the iron curtain approach quantifies a misstatement based on the effects of correcting the cumulative misstatement existing in the balance sheet at the end of the current year. SAB 108 is effective for periods ending after November 15, 2006. We do not expect the adoption of SAB 108 to have a material impact on our financial position or results of operations.
Our exposure to market risk includes changes in interest rates, which relates primarily to our invested balances of cash, cash equivalents and investments. Our investment policy specifies excess funds are to be invested in a manner that preserves capital, provides liquidity and generates the highest available after-tax return. To limit exposure to market risk, we place our cash in banks, cash equivalents in high quality, short-term commercial paper and money market funds and investments consisting of U.S. government securities and U.S government-backed securities. We do not invest in any derivative instruments. All cash, cash equivalents and investments are carried at fair value, which approximates cost.
The financial statement information, including the Report of Independent Registered Public Accounting Firm, required by this Item 8 is set forth on pages 42 to 65 of this Annual Report on Form 10-K and is hereby incorporated into this Item 8 by reference. The quarterly financial information required by this Item 8 is set forth in Item 7 of this Annual Report on Form 10-K and is hereby incorporated into this Item 8 by reference.
On December 5, 2006, we engaged Squar, Milner, Peterson, Miranda & Williamson, LLP, Newport Beach, California (Squar Milner) as our independent registered public accounting firm to audit our financial statements beginning with the fiscal year ending December 31, 2006. On that date, we advised BDO Seidman, LLP (BDO) of our decision to dismiss BDO as our independent registered public accounting firm. Our Audit Committee unanimously approved the engagement of Squar Milner and the dismissal of BDO on December 5, 2006.
The Audit Committee believes the change of our independent registered public accounting firm is in the best interest of the Company and the recent simplification of our business model makes this an appropriate time for the change.
The reports of BDO on the Companys financial statements for the years ended December 31, 2004 and 2005 did not contain any adverse opinion or disclaimer of opinion, and were not otherwise qualified as to uncertainty, audit scope or accounting principles.
During our two most recent fiscal years and through December 5, 2006, there were no disagreements with BDO on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which disagreements if not resolved to the satisfaction of BDO would have caused them to make reference thereto in their reports on the financial statements for such years.
During our two most recent fiscal years and through December 5, 2006, we did not consult Squar Milner regarding either (i) the application of accounting principles to a specified transaction, either completed or proposed, or the type of audit opinion that might be rendered on the Companys financial statements; or (ii) any matter that was either the subject of a disagreement or a reportable event (each as defined in Item 304(a)(1) of Regulation S-K) or (iii) any of the matters or events set forth in Item 304(a)(2)(i) and (ii) of Regulation S-K.
Evaluation of Disclosure Controls and Procedures. Our Chief Executive Officer and President and our Chief Financial Officer have evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this Annual Report on Form 10-K and, based on this evaluation, have concluded that our disclosure controls and procedures are effective.
Changes in Internal Controls. There have been no changes in our internal controls over financial reporting that occurred during our fourth quarter ended December 31, 2006 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
The information set forth under the captions Election of Directors, Information About the Board of Directors and Committees of the Board and Transactions with Management and OthersSection 16(a) Beneficial Ownership Reporting Compliance in our definitive proxy statement (the Proxy Statement) for the Annual Meeting of Stockholders that is scheduled to occur in June 2007 is incorporated herein by reference. The Proxy Statement will be filed with the Securities and Exchange Commission (SEC) no later than 120 days after the end of fiscal year 2006.
Except as specifically provided, the information set forth under the captions Compensation of Executive Officers and Information About the Board of Directors and Committees of the BoardCompensation of Directors in the Proxy Statement is incorporated herein by reference. The Proxy Statement will be filed with the SEC not later than 120 days after the end of fiscal year 2006.
Information regarding security ownership of certain beneficial owners and management is incorporated by reference to the information set forth under the caption Security Ownership of Certain Beneficial Owners and Management in the Proxy Statement. The Proxy Statement will be filed with the SEC no later than 120 days after the end of fiscal year 2006.
Information regarding equity compensation plans required by this Item 12 is included in Item 5 of Part II of this Annual Report on Form 10-K and is incorporated into this Item by reference.
The information set forth under the captions Transactions with Management and Others and Information About the Board of Directors and Committees of the Board in the Proxy Statement is incorporated herein by reference. The Proxy Statement will be filed with the SEC not later than 120 days after the end of fiscal year 2006.
Information regarding principal accounting fees and services is incorporated by reference to the information set forth under the caption Relationship of the Company with Independent Registered Public Accounting Firm in the Proxy Statement. The Proxy Statement will be filed with the SEC not later than 120 days after the end of fiscal year 2006.
The financial statement schedule included on page 65 to this Annual Report on Form 10-K and in Part II, Item 8 herein is filed as part of this Annual Report on Form 10-K. All other schedules are omitted because they are not applicable or the required information is shown in the consolidated financial statements or related notes.
The exhibits listed below are hereby filed with the SEC as part of this Annual Report on Form 10-K. We will furnish a copy of any exhibit upon request, but a reasonable fee will be charged to cover our expenses in furnishing such exhibit.
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
To the Board of Directors and Stockholders
We have audited the accompanying consolidated balance sheet of SRS Labs, Inc. and Subsidiaries as of December 31, 2006, and the related consolidated statements of operations, stockholders equity and comprehensive income (loss) and cash flows for the year then ended. Our audit also included 2006 information in the financial statement schedule listed in Item 15(2) herein. These financial statements and financial statement schedule are the responsibility of the Companys management. Our responsibility is to express an opinion on the financial statements and schedule based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and financial statement schedule are free of material misstatement. The Company was not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Companys internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and schedule, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements and financial statement schedule. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of SRS Labs, Inc. and Subsidiaries as of December 31, 2006, and the consolidated results of their operations and their cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.
Also, in our opinion, the aforementioned financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the 2006 financial information set forth therein.
As discussed in Note 1 to the financial statements, in 2006, the Company changed its method of accounting for stock-based compensation to conform to Financial Accounting Standards Board Statement No. 123(R), Share-Based Payment.
Newport Beach, California
To the Board of Directors and Stockholders of
We have audited the accompanying consolidated balance sheet of SRS Labs, Inc. and Subsidiaries as of December 31, 2005, and the related consolidated statements of operations, stockholders equity and comprehensive (loss) income and cash flows for each of the two years in the period ended December 31, 2005. We have also audited the schedule listed in the accompanying index, Item 15(2). These consolidated financial statements and schedule are the responsibility of the Companys management. Our responsibility is to express an opinion on the consolidated financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements and the schedule are free of material misstatement. The Company is not required to have, nor are we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Companys internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and schedule, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements and schedule. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of SRS Labs, Inc. and Subsidiaries as of December 31, 2005, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America.
Also, in our opinion, the consolidated financial statement schedule presents fairly, in all material respects, the information set forth therein.
Costa Mesa, California
February 24, 2006
See accompanying notes to the consolidated financial statements.
See accompanying notes to the consolidated financial statements.
SRS LABS, INC. AND SUBSIDIARIES