DTS 10-Q 2006 Q3 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

Form 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2006

Commission File Number 000-50335

DTS, Inc.

(Exact name of registrant as specified in its charter)

Delaware	77-0467655
(State or other jurisdiction of	(I.R.S. Employer
incorporation or organization)	Identification No.)
5171 Clareton Drive
Agoura Hills, California 91301	(818) 706-3525
(Address of principal executive	(Registrant’s telephone number,
offices and zip code)	including area code)

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 o

Indicate by check mark whether registrant is a large accelerated filer, an accelerated filer or non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  o Accelerated filer  x Non-accelerated filer  o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o   No x

As of October 31, 2006 a total of 17,818,708 shares of the Registrant’s Common Stock, $0.0001 par value, were issued and outstanding.

DTS, INC.

FORM 10-Q

TABLE OF CONTENTS

PART I	FINANCIAL INFORMATION	3
Item 1.	Financial Statements (unaudited):	3
	Consolidated Balance Sheets	3
	Consolidated Statements of Operations	4
	Consolidated Statements of Cash Flows	5
	Notes to Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	18
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	27
Item 4.	Controls and Procedures	28
PART II.	OTHER INFORMATION	29
Item 1.	Legal Proceedings	29
Item 1A.	Risk Factors	29
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	42
Item 3.	Defaults Upon Senior Securities	42
Item 4.	Submission of Matters to a Vote of Security Holders	42
Item 5.	Other Information	42
Item 6.	Exhibits	43
SIGNATURES		44

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DTS, INC.
PART I
FINANCIAL INFORMATION

Item 1.Financial Statements

DTS, Inc.

Consolidated Balance Sheets

	As of		As of
	December 31,		September 30,
	2005		2006
	(Unaudited)
	(Amounts in thousands, except
	share and per share amounts)
ASSETS
Current assets:
Cash and cash equivalents	$	33,254	$	43,328
Short-term investments	78,163		75,610
Accounts receivable, net of allowance for doubtful accounts of $370 and $295 at December 31, 2005 and September 30, 2006, respectively	7,311		6,734
Inventories	3,261		3,587
Deferred income taxes	7,255		7,687
Prepaid expenses and other current assets	3,112		2,307
Income taxes receivable, net	2,654		3,012
Total current assets	135,010		142,265
Property and equipment, net	7,375		9,929
Goodwill	3,585		3,585
Intangible assets, net	11,612		11,766
Deferred income taxes	303		16
Other assets	369		580
Total assets	$	158,254	$	168,141
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	2,634	$	3,104
Accrued expenses	6,983		6,800
Deferred revenue	2,630		126
Total current liabilities	12,247		10,030
Deferred income taxes	1,917		1,218
Other liabilities	—		211
Commitments and contingencies (Note 11)
Stockholders’ equity:
Preferred stock—$0.0001 par value, 5,000,000 shares authorized at December 31, 2005 and September 30, 2006; no shares issued and outstanding at December 31, 2005  and September 30, 2006	—		—
Common stock—$0.0001 par value, 70,000,000 shares authorized at December 31, 2005 and September 30, 2006; 17,472,543 and 17,812,733 shares issued and outstanding at December 31, 2005 and September 30, 2006, respectively	2		2
Additional paid-in capital	122,847		127,447
Retained earnings	21,241		29,233
Total stockholders’ equity	144,090		156,682
Total liabilities and stockholders’ equity	$	158,254	$	168,141

See accompanying notes to consolidated financial statements.

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DTS, Inc.
Consolidated Statements of Operations

	For the Three Months Ended September 30,					For the Nine Months Ended September 30,
	2005		2006			2005		2006
	(Unaudited) (Amounts in thousands, except share and per share amounts)
Revenues:
Technology and film licensing	$	12,611	$	11,727		$	43,910	$	46,314
Product sales and other revenues	4,942		3,526			13,428		14,537
Total revenues	17,553		15,253			57,338		60,851
Cost of goods sold:
Technology and film licensing	1,194		1,050			3,511		3,528
Product sales and other revenues	3,450		3,272			10,626		11,970
Total cost of goods sold	4,644		4,322			14,137		15,498
Gross profit	12,909		10,931			43,201		45,353
Operating expenses:
Selling, general and administrative	8,971		10,374			25,095		30,279
Research and development	2,612		3,300			7,238		9,001
In-process research and development	—		—			2,300		—
Separation costs	—		396			—		396
Total operating expenses	11,583		14,070			34,633		39,676
Income (loss) from operations	1,326		(3,139		)	8,568		5,677
Interest income, net	635		1,376			1,824		3,638
Other income, net	123		14			100		64
Income (loss) before income taxes	2,084		(1,749		)	10,492		9,379
Provision (benefit) for income taxes	890		(851		)	3,926		1, 387
Net income (loss)	1,194		(898		)	6,566		7,992
Net income (loss) per common share:
Basic	$	0.07	$	(0.05	)	$	0.38	$	0.45
Diluted	$	0.07	$	(0.05	)	$	0.36	$	0.44
Weighted average shares used to compute net income (loss) per common share:
Basic	17,411,461		17,653,865			17,275,515		17,565,963
Diluted	18,342,186		17,653,865			18,194,333		18,342,678

See accompanying notes to consolidated financial statements.

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DTS, Inc.
Consolidated Statements of Cash Flows

	For the Nine Months Ended September 30,
	2005			2006
	(Unaudited)
	(Amounts in thousands)
Cash flows from operating activities:
Net income	$	6,566		$	7,992
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	2,691			3,457
Stock-based compensation charges	75			2,686
Allowance for doubtful accounts	5			10
Loss on disposal of property and equipment	—			93
Deferred income taxes	937			(845		)
Excess tax benefits from stock-based compensation	563			(818		)
Write-down of inventory	—			144
In-process research and development	2,300			—
Changes in operating assets and liabilities:
Accounts receivable	(3,845		)	566
Inventories	(408		)	(470		)
Prepaid expenses and other assets	(279		)	795
Accounts payable and accrued expenses	(1,786		)	288
Deferred revenue	655			(2,504		)
Income taxes receivable	(1,286		)	461
Other liabilities	—			211
Net cash provided by operating activities	6,188			12,066
Cash flows from investing activities:
Purchases of investments	(80,703		)	(101,853		)
Maturities of investments	52,277			50,748
Sales of investments	45,998			53,658
Cash paid for business and technology acquisitions, net of cash acquired	(11,000		)	(1,379		)
Purchase of property and equipment	(4,168		)	(4,902		)
Payment for patents and trademarks in process	(115		)	(177		)
Net cash provided by (used in) investing activities	2,289			(3,905		)
Cash flows from financing activities:
Proceeds from the issuance of common stock upon exercise of employee stock options	228			615
Proceeds from the issuance of common stock under employee stock purchase plan	430			480
Excess tax benefits from stock-based compensation	—			818
Net cash provided by financing activities	658			1,913
Net increase in cash and cash equivalents	9,135			10,074
Cash and cash equivalents, beginning of period	21,271			33,254
Cash and cash equivalents, end of period	$	30,406		$	43,328

See accompanying notes to consolidated financial statements.

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DTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

(Amounts in thousands, except share and per share data)

Note 1—Basis of Presentation

The accompanying unaudited consolidated financial statements of DTS, Inc. (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, the unaudited consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, considered necessary for a fair statement of the Company’s financial position at September 30, 2006, and the results of operations and cash flows for the periods presented. All significant intercompany transactions have been eliminated in consolidation. Operating results for the three and nine months ended September 30, 2006 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2006. The information included in this Form 10-Q should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

The Company intends to proceed with the separation of its Cinema and Digital Images businesses from its Consumer licensing business.  The Company believes this separation will enhance stockholder value and better position each business to serve its customer base, go-to-market more rapidly, and be more flexible in this dynamic environment.

Note 2—Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. This statement is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company plans to adopt SFAS No. 157 effective January 1, 2008. The Company is in the process of determining the effect, if any, the adoption of SFAS No. 157 will have on its financial statements.

In September 2006, the Securities and Exchange Commission (“SEC”) staff issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB No. 108 provides guidance on how prior year misstatements should be taken into consideration when quantifying misstatements in current year financial statements for purposes of determining whether the current year’s financial statements are materially misstated. SAB No. 108 is effective for fiscal years ending after November 15, 2006. The Company plans to adopt SAB No. 108 during the fourth quarter of 2006. The Company is in the process of determining the effect, if any, the adoption of SAB No. 108 will have on its financial statements.

In July 2006, the FASB issued FASB Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes,” which prescribes a comprehensive model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return (including a decision whether to file or not to file a return in a particular jurisdiction). The accounting provisions of FIN No. 48 are effective for fiscal years beginning after December 15, 2006. The Company plans to adopt FIN No. 48 effective January 1, 2007. The Company is in the process of determining the effect, if any, the adoption of FIN No. 48 will have on its financial statements.

In June 2006, the FASB Emerging Issues Task Force (“EITF”) issued EITF Issue No. 06-3, “How Sales Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income

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Statement (That Is, Gross Versus Net Presentation),” which states that a company should disclose its accounting policy (i.e., gross or net presentation) regarding presentation of taxes within the scope of this issue. If taxes included in gross revenues are significant, a company should disclose the amount of such taxes for each period for which an income statement is presented. The consensus would be effective for the first annual or interim reporting period beginning after December 15, 2006. The disclosures are required for annual and interim financial statements for each period for which an income statement is presented. The Company plans to adopt this issue effective January 1, 2007. Based on the Company’s current evaluation of this issue, the Company does not expect the adoption of EITF Issue No. 06-3 to have a significant impact on its consolidated results of operations or financial position.

In June 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20, Accounting Changes, and Statement No. 3, Reporting Accounting Changes in Interim Financial Statements.” SFAS No. 154 changes the requirements for the accounting for, and reporting of, a change in accounting principle. Previously, most voluntary changes in accounting principles were required to be recognized by way of a cumulative effect adjustment within net income during the period of the change. SFAS No. 154 requires retrospective application to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005; however, the Statement does not change the transition provisions of any existing accounting pronouncements. The adoption of SFAS No. 154 did not have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

In December 2004, the FASB finalized SFAS No. 123(R), “Share-Based Payment,” which requires companies to measure and recognize compensation costs for all share-based payments (including stock options) at fair value, effective for interim or annual periods beginning after June 15, 2005. On April 15, 2005, the SEC announced a deferral of the effective date of SFAS No. 123(R) until the first interim or annual reporting period of the first fiscal year beginning on or after June 15, 2005. Effective January 1, 2006, the Company adopted the provisions of SFAS No. 123(R) as discussed in Footnote 10, Stock-Based Compensation.

Note 3—Separation Costs

In August 2006, the Company announced that it was studying the potential separation of the Cinema and Digital Images businesses from the Consumer business in order to better address rapidly evolving markets, meet the needs of customers and increase shareholder value. As of September 30, 2006, the Company had incurred approximately $396 in separation costs, consisting primarily of legal and accounting expenses relating to the separation of its business.

Note 4—Certain Balance Sheet Items

Inventories consist of the following:

	As of December 31, 2005		As of September 30, 2006
Raw materials	$	1,062	$	1,133
Finished goods	2,199		2,454
Total inventories	$	3,261	$	3,587

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Property and equipment consist of the following:

	As of December 31, 2005			As of September 30, 2006
Machinery and equipment	$	6,847		$	8,370
Office furniture and fixtures	3,588			3,281
Leasehold improvements	3,697			3,903
Software	590			2,837
	14,722			18,391
Less: Accumulated depreciation	(7,347		)	(8,462		)
Property and equipment, net	$	7,375		$	9,929

Note 5—Capitalized Software Costs

The Company capitalizes the costs of computer software developed or obtained for internal use in accordance with Statement of Position 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” Capitalized computer software costs consist of purchased software licenses, implementation costs, consulting costs and payroll-related costs for certain projects that qualify for capitalization. The Company expenses costs related to preliminary project assessment, training and application maintenance as incurred, and amortizes the capitalized computer software costs on a straight-line basis over the estimated useful life of the software upon being placed in service.

Note 6—Acquired Technology

On April 17, 2006, the Company acquired for $1,000 the Digital Booking Systems technology (“DBS”) from FilmStew International, Inc. DBS is an application that enables cinema exhibitors and distributors to manage entertainment content via the internet. DBS allows exhibitors and distributors to conduct business online by accelerating the process of booking playdates, scheduling showtimes, programming trailers, tracking data and facilitating film rental payments. Intangible assets, net, includes $929 for the purchase of this asset, which represents the net present value of the total acquisition cost.

Note 7—Business Combinations

In January 2005, the Company completed the acquisition of Lowry Digital Images, Inc., and subsequently changed its name to DTS Digital Images, Inc. (“DTS DI”). DTS DI was acquired for a total estimated purchase price of $12,249, including $9,642 in cash, forgiveness of a loan and interest of $1,261 and acquisition costs of $1,346. DTS DI provides image enhancement and restoration services for film producers and distributors for home or professional playback of high quality, high definition presentations in digital cinema, high definition optical media or broadcast applications.

The DTS DI acquisition was accounted for as a purchase business combination. The results of operations of DTS DI are included in our Consolidated Statement of Operations from January 3, 2005. The final purchase price will be dependent on shares issued, if any, as further discussed. The former shareholders of DTS DI are entitled to receive shares of the Company’s common stock if certain gross profit targets in 2006 are met. In the event that the targets are met in full, an aggregate of up to approximately 653,000 shares of the Company’s common stock will be issued. The value of these shares will be accounted for as an addition to goodwill.

In July 2004, the Company completed the acquisition of QDesign Corporation for $1,500 in cash. Under the terms of the acquisition, the Company also contingently agreed to pay an additional amount up to a maximum of $450 in cash, which is held by the Company in a restricted account. The Company classifies the restricted cash in other current and non-current assets. The contingent payment is being accounted for as compensation expense ratably over the three-year period ending July 2007, and will be paid out if certain criteria are met. Two payments of $150 each were made, one in 2005 and the other in 2006.

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Note 8—Bank Line of Credit

The Company has a $10,000 unsecured working capital facility that expires on June 30, 2007, and is renewable annually. The bank agreement requires the Company to comply with certain covenants including a tangible effective net worth of $60,000, increasing by 50% of net income on an annual basis. The covenants also require the Company to keep $2,000 in cash or securities at the issuing bank. At September 30, 2006, the Company was compliant with all covenants under the bank agreement.

At September 30, 2006, there was no balance outstanding and $10,000 of available borrowings under this credit facility. Future borrowings will bear interest based on either of the two options the Company selects at the time of advances 1) a rate equal to 2% above the bank’s LIBOR, or 2) a rate equal to the Base Rate as quoted from the bank less one-half percent. The annual commitment fee for this line of credit is not material.

Note 9—Income Taxes

For the three months ended September 30, 2006, the Company recorded an income tax benefit of $851 on pre-tax loss of $1,749. For the nine months ended September 30, 2006, the Company recorded an income tax provision of $1,387 on pre-tax income of $9,379. This resulted in an annualized effective tax rate of 14.8%. During the second quarter of 2006, the Internal Revenue Service (“IRS”) completed an examination of the federal income tax return filed by the Company for the year ended December 31, 2003. The Company achieved a favorable resolution with the IRS regarding the Extraterritorial Income Exclusion (“ETI”) that resulted in a tax benefit of $1,710. As a result of these items, the current income tax rate differs from the statutory rate. At September 30, 2006, the Company’s annualized effective tax rate was approximately 42.4%, which included approximately 5.0% for non-deductible costs related to the separation of its business. For the three and nine months ended September 30, 2005, the Company recorded an income tax provision of $890 and $3,926, respectively, on pre-tax income of $2,084 and $10,492, respectively. This resulted in an annualized effective tax rate of 37.4%. These rates differed from the statutory rates primarily due to state income taxes offset by benefits associated with the foreign rate differentials.

Note 10—Stock-Based Compensation

Adoption of SFAS No. 123(R)

Prior to January 1, 2006, the Company accounted for its employee stock option and stock purchase plans in accordance with the provisions of Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees” and the related FIN No. 44, “Accounting for Certain Transactions Involving Stock Compensation,” and complied with the disclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” Under the provisions of these pronouncements, all options granted under those plans had an exercise price equal to or greater than the market value of the underlying common stock on the date of grant, which resulted in no recognition of stock-based compensation expense. For the three and nine months ended September 30, 2005, the company recognized no stock-based employee compensation cost from stock options or employee stock purchase plans.

Effective January 1, 2006, the Company adopted the provisions of SFAS No. 123(R), using the modified-prospective-transition method. Under the transition method, compensation expense recognized beginning January 1, 2006 includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, and (b) compensation cost for all share-based payments granted on or after January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). The Company did not restate its results for prior periods.

As a result of adopting SFAS No. 123(R) on January 1, 2006, the Company’s loss before taxes and net loss for the three months ended September 30, 2006, were approximately $847 and $394 higher, respectively, than if

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it had continued to account for share-based compensation under APB No. 25. Basic and diluted loss per share for the three months ended September 30, 2006 would have been $(0.03), if it had not adopted SFAS No. 123(R), compared to reported basic and diluted loss per share of $(0.05). The total stock-based compensation cost that has been recognized in the Consolidated Statements of Operations was $931 and $16 for the three months ended September 30, 2006 and 2005, respectively, was recorded to cost of goods sold, and selling, general and administrative expenses, and research and development expenses. Stock-based compensation cost recorded to cost of goods sold for the three months ended September 30, 2006 and 2005 was $17 and $0, respectively. Stock-based compensation cost recorded to selling, general and administrative expenses for the three months ended September 30, 2006 and 2005 was $794 and $16, respectively. Stock-based compensation cost recorded to research and development expenses for the three months ended September 30, 2006 and 2005 was $120 and $0, respectively. The total income tax benefit recognized was $498 and $7 for the three months ended September 30, 2006 and 2005, respectively.

The Company’s income before taxes and net income for the nine months ended September 30, 2006, were approximately $2,539 and $1,504 lower, respectively, than if it had continued to account for share-based compensation under APB No. 25. Basic and diluted earnings per share for the nine months ended September 30, 2006 would have been $0.54 and $0.52, respectively, if it had not adopted SFAS No. 123(R), compared to reported basic and diluted earnings per share of $0.45 and $0.44, respectively. The total stock-based compensation cost that has been recognized in the Consolidated Statements of Operations was $2,686 and $75 for the nine months ended September 30, 2006 and 2005, respectively, was recorded to cost of goods sold, and selling, general and administrative expenses, and research and development expenses. Stock-based compensation cost recorded to cost of goods sold for the nine months ended September 30, 2006 and 2005 was $109 and $0, respectively. Stock-based compensation cost recorded to selling, general and administrative expenses for the nine months ended September 30, 2006 and 2005 was $2,237 and $75, respectively. Stock-based compensation cost recorded to research and development expenses for the nine months ended September 30, 2006 and 2005 was $340 and $0, respectively. The total income tax benefit recognized was $1,096 and $28 for the nine months ended September 30, 2006 and 2005, respectively.

Prior to adoption of SFAS No. 123(R), the Company presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in the Consolidated Statements of Cash Flows. SFAS No. 123(R) requires the cash flows resulting from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows. The $818 excess tax benefit classified as a financing cash inflow would have been classified as an operating cash inflow if we had not adopted SFAS No. 123(R). During the nine months ended September 30, 2006, the Company received $615 in cash from stock option exercises.

In November 2005, the FASB issued FASB Staff Position No. FAS 123(R)-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards,” (“FSP 123(R)-3”). The Company has elected to adopt the alternative transition method provided in FSP 123(R)-3 for calculating the tax effects of stock-based compensation pursuant to SFAS No. 123(R). The alternative transition method includes a simplified method to establish the beginning balance of the additional paid-in capital (“APIC pool”) related to the tax effects of employee and director stock-based compensation, and to determine the subsequent impact on the APIC pool and the consolidated statements of cash flows of the tax effects of employee and director stock-based awards that are outstanding upon adoption of SFAS No. 123(R).

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If the Company had elected to recognize compensation cost for stock options based on their fair value at the grant dates, consistent with the method prescribed by SFAS No. 123, net income and net income per share for the three and nine months ended September 30, 2005 would have been as follows:

	For the Three			For the Nine
	Months Ended			Months Ended
	September 30,			September 30,
	2005			2005
Net income:
As reported	$	1,194		$	6,566
Additional stock-based compensation expense determined under the fair value method, net of tax	(680		)	(1,707		)
Pro forma	$	514		$	4,859
Net income per common share—basic:
As reported	$	0.07		$	0.38
Per share effect of additional stock-based compensation expense determined under the fair value method, net of tax	(0.04		)	(0.10		)
Pro forma	$	0.03		$	0.28
Net income per common share—diluted:
As reported	$	0.07		$	0.36
Per share effect of additional stock-based compensation expense determined under the fair value method, net of tax	(0.04		)	(0.09		)
Pro forma	$	0.03		$	0.27

The Company has historically recognized compensation cost over the nominal vesting period, whereby if an employee retired before the end of the vesting period, the Company would recognize any remaining unrecognized compensation cost at the date of retirement. The FASB clarified in SFAS No. 123(R) that the fair value of such stock options should be expensed based on recognition under a non-substantive vesting period approach, requiring compensation expense recognition when an employee is eligible to retire. Company employees are eligible to retire after age 60. For those employees that retire and are eligible, their options may continue to vest upon the original vesting schedules. The SEC recently clarified that companies should continue the vesting method they have been using until adoption of SFAS 123(R), then apply the accelerated non-substantive vesting approach to all subsequent grants to those employees whose options continue to vest after the date of retirement eligibility. For the three and nine months ended September 30, 2005, had the Company been accounting for such stock options using the non-substantive vesting approach for retirement-eligible employees, the Company would have not recognized additional stock-based compensation expense.

Various Stock Plans

In 1997, the Company adopted a stock option plan (the “1997 Plan”) for eligible employees, directors and consultants. In 2002, the Company adopted a stock option plan (the “2002 Plan”) for management and certain key employees. Options granted under the plans may be incentive stock options intended to satisfy the requirements of Section 422 of the Internal Revenue Code of 1986, as amended, and the regulations thereunder, or non-qualified options. Options generally become exercisable over a four-year period and expire in ten years. The total number of shares of common stock that may be issued under both plans amounted to a maximum of 2,071,051. Options granted prior to 2002 were granted at exercise prices equal to the preferred stock financing prices, which were in excess of the estimated fair value of the underlying common stock.

In March 2002, the Company offered a stock option replacement program for employees, directors and non-employee consultants participating in the existing plan. Under the stock option replacement program, participants were able to elect to cancel their current options and have those options replaced after six months and one day with options that will have an exercise price equal to the stock’s then-current fair value. Options to purchase a total of 930,250 shares were cancelled under the stock option replacement program. On September 30, 2002, six months and 15 days after the cancellation of options exchanged under the option replacement program, the

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Company granted options to purchase a total of 929,250 shares of common stock as replacement awards at an exercise price of $1.02, which represented the fair value of the Company’s common stock on that date.

In April 2003, the Company’s Board adopted the 2003 Equity Incentive Plan (the “2003 Plan”) under which an additional 928,949 shares were authorized for future issuances of common stock. Additionally, the shares available for issuances of common stock options under the 1997 and 2002 Plans were transferred to the 2003 Plan for future issuances of common stock options. The 2003 Plan contains a provision for an automatic increase in the number of shares available for grant starting January 1, 2004 and each January thereafter until and including January 1, 2013, subject to certain limitations, by a number of shares equal to the lesser of: 1) four percent of the number of shares issued and outstanding on the immediately preceding December 31, 2) 1,500,000 shares, or 3) a number of shares set by the Board of Directors.

The fair value of each employee option grant is estimated on the date of the grant using the Black-Scholes option pricing model with the following weighted average key assumptions:

	Nine Months Ended September 30,
	2005		2006
Risk free interest rate	3.8	%	4.4	%
Expected lives (years)	4		5.8
Dividend yield	0	%	0	%
Expected volatility	50	%	58	%

The dividend yield was not calculated because the Company does not currently expect to pay a dividend. The expected life of the options granted was derived from the historical activity of the Company’s options and represented the period of time that options granted were expected to be outstanding. Expected volatility was based on a blend of the historical volatility of the Company’s common stock and publicly traded peer companies. The risk-free interest rate was the average interest rates of U.S. government bonds of comparable term to the options on the dates of the option grants.

There were 352,000 and 669,400 options granted during the nine months ended September 30, 2006 and 2005, respectively. The weighted average fair value of options granted during the nine months ended September 30, 2006 and 2005 was $18.69 and $17.70, respectively. Stock-based compensation expense for stock options for the three and nine months ended September 30, 2006, was calculated based on their fair value at the grant dates, consistent with the method prescribed by SFAS No. 123 adjusted by estimated forfeitures as prescribed by SFAS 123(R). Compensation expense for stock options was $614 and $1,904 for the three and nine months ended September 30, 2006, respectively.

The following table summarizes information about stock option activity during the nine months ended September 30, 2006:

	Options Outstanding		Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Life (Years)	Aggregate Intrinsic Value
Options outstanding at December 31, 2005	2,321,552		$	12.73
Granted	352,000		18.69
Exercised	(190,466	)	3.23
Expired or cancelled	(47,968	)	19.10
Options outstanding at September 30, 2006	2,435,118		$	14.21	7.56	$	17,620,000
Options exercisable at September 30, 2006	1,627,090		$	12.39	6.91	$	14,302,000

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					Options Outstanding				Options Exercisable
Range of Exercise Prices					Number Outstanding at September 30, 2006	Weighted Average Remaining Contractual Life	Weighted Average Exercise Price		Number Exercisable at  September 30,  2006	Weighted Average Exercise Price
$	1.02	–	$	3.07	690,048	5.99	$	1.02	688,798	$	1.02
	3.08	–		6.16	7,625	2.57	4.15		7,122	4.11
	6.17	–		9.23	10,250	6.45	8.02		7,687	8.02
	9.24	–		12.31	2,750	6.55	10.59		2,687	10.57
	12.32	–		15.40	66,500	7.91	14.15		29,559	13.89
	15.41	–		18.47	758,875	8.68	17.08		239,185	16.47
	18.48	–		21.55	315,070	8.82	19.75		68,052	19.91
	21.56	–		24.63	548,000	7.37	23.11		548,000	23.11
	24.64	–		27.71	28,500	7.17	25.94		28,500	25.94
	27.72	–		30.79	7,500	7.02	30.79		7,500	30.79
$	1.02	–	$	30.79	2,435,118	7.56	$	14.21	1,627,090	$	12.39

On November 17, 2005, the Compensation Committee (the “Committee”) of the Board of Directors of the Company approved the acceleration of the unvested portion of certain stock options held by employees, officers and directors of the Company. The options that were accelerated have exercise prices greater than $21.00 per share, which is higher than the $14.76 closing price of the Company’s common stock as quoted on the Nasdaq National Market on November 17, 2005. These options would have vested and become exercisable from time to time over the next 32 months. As a result of the acceleration, all of these options became fully vested and immediately exercisable. All other terms and conditions applicable to outstanding stock option grants remain in effect. Shares received upon the exercise of accelerated options held by members of the Company’s Board of Directors and by the Company’s President and Chief Executive Officer and its Executive Vice Presidents may not be sold or otherwise transferred prior to the earlier of the original vesting date of such options or their termination of employment or service. The Committee’s decision to accelerate the vesting of the affected stock options was based upon the required adoption of SFAS No. 123(R).

The aggregate intrinsic value of options exercised during the nine months ended September 30, 2006 was $3,049. As of September 30, 2006, total remaining unearned compensation related to unvested stock options was approximately $5,922, which will be amortized over the weighted-average remaining service period of two years.

In accordance with the evergreen provision in the 2003 Plan and as approved by the Board of Directors, effective January 1, 2006, the number of shares reserved under the 2003 Plan was increased by 698,901 shares.

On April 17, 2003, the Company’s board adopted the 2003 Employee Stock Purchase Plan and the 2003 Foreign Subsidiary Employee Stock Purchase Plan (“ESPP”), under which, subject to certain limitations, the initial aggregate number of shares of stock that may be issued is 500,000, cumulatively increased on January 1, 2004 and each January 1 thereafter until and including January 1, 2013 by the lesser of: 1) 500,000 shares, 2) one percent of the number of shares of all classes of common stock of the Company outstanding on that date, or 3) a lesser amount determined by the Board of Directors. Under the ESPP, shares are only issued during the second and fourth quarter of each year. The values were estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average key assumptions for 2005 and 2006:

	2005		2006
Risk free interest rate	2.6	%	4.5	%
Expected lives (years)	1.3		0.7
Dividend yield	0	%	0	%
Expected volatility	50	%	63	%

The dividend yield was not calculated because the Company does not currently expect to pay a dividend. The expected life represented the service period. Expected volatility was based on a blend of the historical volatility of the

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Company’s common stock and publicly traded peer companies. The risk-free interest rate was the average interest rates of U.S. government bonds of comparable term to the service period.

In accordance with the evergreen provision in the ESPP, the Board of Directors approved an increase in the number of shares reserved under the ESPP by 100,000 shares, effective January 1, 2006. Compensation expense under the ESPP was $103 and $294 for the three and nine months ended September 30, 2006.

On February 23, 2006, the Committee approved a grant of 68,500 shares of restricted stock to executive officers pursuant to the 2003 Plan. The shares of restricted stock to executive officers generally vest in equal annual installments on February 15 of each of the four years following the date of grant. On May 18, 2006, in accordance with the 2003 Plan, 12,500 shares, in total, of restricted stock were automatically issued to the outside directors. The shares of restricted stock to outside directors generally vest on May 15 of the year following the date of grant. On August 16, 2006, the Committee approved a grant of 17,500 shares of restricted stock to employees pursuant to the 2003 Plan. The shares of restricted stock to employees vest in equal annual installments on August 15 of each of the four years following the date of grant. Compensation expense on these shares was $130 and $341 for the three and nine months ended September 30, 2006, respectively.

The following table summarizes information about restricted stock activity during the nine months ended September 30, 2006:

	Number of Shares		Weighted- Average Grant-Date Fair Value
Granted	98,500		$	18.53
Vested	(5,000	)	18.32
Forfeited	—		—
Nonvested stock at September 30, 2006	93,500		$	18.54

As of September 30, 2006, total remaining unearned compensation related to restricted stock was $1,217, which will be amortized over the weighted-average remaining service period of two years.

Non-Employee Equity Awards

During 2000 and 2001, options to purchase 50,000 and 5,000 shares, respectively, were granted to non-employee directors or consultants.

In 2002, the Company granted options to purchase 265,500 shares of common stock to non-employee consultants, all of which were re-grants under the stock option replacement program. In February, 2005, the Company granted options to purchase 25,000 shares of common stock to a non-employee consultant. The Company accounts for stock, stock options and warrants issued to non-employees in accordance with the provisions of SFAS No. 123 and EITF Issue No. 96-18 “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods and Services.” Under SFAS No. 123 and EITF Issue No. 96-18, stock option awards issued to non-employees are accounted for at fair value using the Black-Scholes pricing model. Management believes that the fair value of the stock options is more reliably measured than the fair value of the services received. Compensation expense related to the fair value of stock options granted to non-employees is recognized over the service period and was determined using the Black-Scholes option pricing model using the following assumptions: risk-free interest rate of 4.4%; contractual life ranging from five to ten years; dividend yield of 0%; and expected volatility of 58%. At each reporting date, the Company revalues the stock-based compensation expense related to unvested non-employee options using the Black-Scholes option pricing model. As a result, stock-based compensation will fluctuate with changes in the fair value of the Company’s common stock. In connection with the grant of stock options and restricted stock to consultants, the Company recorded stock-based compensation expense in selling, general and administrative expense of $16 and $84 for the three months ended September 30, 2005 and 2006, respectively. The Company recorded stock-based compensation expense in selling, general and administrative expense of $75 and $147 for the nine months ended September 30, 2005 and 2006, respectively.

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Note 11—Commitments and Contingencies

Indemnities, Commitments and Guarantees

In the normal course of business, the Company makes certain indemnities, commitments and guarantees under which the Company may be required to make payments in relation to certain transactions. These indemnities, commitments and guarantees include, among others, intellectual property indemnities to customers in connection with the sale of products and licensing of technology, indemnities for liabilities associated with the infringement of other parties’ technology based upon the Company’s products and technology, guarantees of timely performance of the Company’s obligations, and indemnities to the Company’s directors and officers to the maximum extent permitted by law. The duration of these indemnities, commitments and guarantees varies, and in certain cases, is indefinite. The majority of these indemnities, commitments and guarantees do not provide for any limitation of the maximum potential future payments that the Company could be obligated to make. The Company has not recorded a liability for these indemnities, commitments or guarantees in the accompanying balance sheets, as future payment is not probable.

Note 12—Operating Segment and Geographic Information

The Company operates its business in three reportable segments: the Consumer business segment, the Cinema business segment and the Digital Images business segment. The Company’s Consumer business segment licenses audio technology, trademarks and know-how to consumer electronics, personal computer, broadcast and professional audio companies, and sells multi-channel audio content and products to consumers. The Cinema business segment licenses technology and sells products and services to producers and distributors of feature length films and digital content, and to movie theaters and special venues. The Company’s Digital Images business segment provides enhancement, restoration and repair services for moving pictures captured on film or in digital form, television content, and other forms of image content.

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

The Company’s reportable segments and geographical information for the three and nine months ended September 30, 2005 and 2006 are as follows:

	Revenues
	For the Three Months Ended September 30,				For the Nine Months Ended September 30,
	2005		2006		2005		2006
Consumer business	$	10,213	$	9,514	$	37,728	$	39,776
Cinema business	5,742		4,768		15,676		15,095
Digital Images business	1,598		971		3,934		5,980
Total revenues	$	17,553	$	15,253	$	57,338	$	60,851

	Gross Profit
	For the Three Months Ended September 30,					For the Nine Months Ended September 30,
	2005		2006			2005			2006
Consumer business	$	9,799	$	9,129		$	36,284		$	38,630
Cinema business	3,089		2,372			7,497			7,175
Digital Images business	21		(570		)	(580		)	(452		)
Total gross profit	$	12,909	$	10,931		$	43,201		$	45,353

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	Income (Loss) From Operations
	For the Three Months Ended September 30,						For the Nine Months Ended September 30,
	2005			2006			2005			2006
Consumer business	$	3,282		$	1,708		$	17,929		$	16,902
Cinema business	(742		)	(2,730		)	(3,365		)	(6,476		)
Digital Images business	(1,214		)	(2,117		)	(5,996		)	(4,749		)
Total income (loss) from operations	$	1,326		$	(3,139	)	$	8,568		$	5,677

Included in the Cinema business segment’s loss for the three and nine months ended September 30, 2006 is the $396 of separation costs. Included in the Digital Images business segment’s loss for the nine months ended September 30, 2005 is the $2,300 charge related to in-process research and development.

	Revenues by Geographic Region
	For the Three Months Ended September 30,				For the Nine Months Ended September 30,
	2005		2006		2005		2006
United States	$	6,101	$	4,336	$	21,144	$	17,265
International	11,452		10,917		36,194		43,586
Total revenues	$	17,553	$	15,253	$	57,338	$	60,851

The following table sets forth, for the periods indicated, long-lived tangible assets by geographic area in which the Company holds assets at December 31, 2005 and September 30, 2006:

	Long-Lived Assets
	As of December 31, 2005		As of September 30, 2006
United States	$	5,859	$	8,358
International	1,516		1,571
Total long-lived tangible assets	$	7,375	$	9,929

Note 13—Net Income Per Common Share

Basic net income per common share is calculated by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income per common share is calculated by dividing net income by the sum of the weighted average number of common shares outstanding plus the dilutive effect of unvested restricted stock, outstanding stock options, common stock warrants, and the ESPP using the “treasury stock” method. Due to the net loss for the three months ended September 30, 2006, all potential common shares are excluded from the diluted shares outstanding for the three months ended September 30, 2006.

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The following table sets forth the computation of basic and diluted net income (loss) per common share:

	For the Three Months Ended September 30,					For the Nine Months Ended September 30,
	2005		2006			2005		2006
Basic net income (loss) per common share:
Numerator:
Net income (loss)	$	1,194	$	(898	)	$	6,566	$	7,992
Denominator:
Weighted average common shares outstanding	17,411,461		17,653,865			17,275,515		17,565,963
Basic net income (loss) per common share	$	0.07	$	(0.05	)	$	0.38	$	0.45
Diluted net income (loss) per common share:
Numerator:
Net income (loss)	$	1,194	$	(898	)	$	6,566	$	7,992
Denominator:
Weighted average shares outstanding	17,411,461		17,653,865			17,275,515		17,565,963
Effect of dilutive securities:
Common stock options	908,720		—			897,136		748,375
Common stock warrants	22,005		—			21,682		16,978
Restricted stock	—		—			—		6,436
ESPP	—		—			—		4,926
Diluted shares outstanding	18,342,186		17,653,865			18,194,333		18,342,678
Diluted net income (loss) per common share	$	0.07	$	(0.05	)	$	0.36	$	0.44

For the three months ended September 30, 2005 and 2006, 817,150 and 2,528,618 shares, respectively, of the Company’s stock options and restricted stock were excluded from the calculation of diluted earnings per share because their inclusion would have been anti-dilutive. For the nine months ended September 30, 2005 and 2006, 845,150 and 1,314,263 shares, respectively, of the Company’s stock options and restricted stock were excluded from the calculation of diluted earnings per share because their inclusion would have been anti-dilutive.

Note 14—Stock Repurchase Plan

In August 2006, the Company’s Board of Directors authorized, subject to certain business and market conditions, the purchase of up to one million shares of the Company’s common stock in the open market or in privately negotiated transactions. At September 30, 2006, there were no shares purchased under this authorization. Any shares repurchased would be considered treasury stock.

Note 15—Subsequent Events

In November 2006, the Company announced that it intends to proceed with the separation of its Cinema and Digital Images businesses from its Consumer licensing business.

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

Forward-Looking Statements May Prove Inaccurate

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

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

Overview

We are a leading provider of entertainment technology, products and services to the audio and image entertainment markets worldwide. Historically we have been focused on high quality digital multi-channel audio, commonly referred to as surround sound, which provides more than two-channels of audio, allowing the listener to simultaneously hear discrete sounds from multiple speakers. Our DTS digital multi-channel audio technology delivers compelling surround sound for the motion picture and consumer electronics markets. With our January 2005 acquisition of Lowry Digital Images, Inc., now DTS Digital Images, Inc., or DTS DI, we have expanded our business into high quality digital image processing, enhancement and restoration services for motion pictures, digital cinema, and television content.

We intend to proceed with the separation of our Cinema and Digital Images businesses from our Consumer licensing business.  We believe this separation will enhance stockholder value and better position each business to serve its customer base, go-to-market more rapidly, and be more flexible in this dynamic environment.

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

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

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

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

We present revenues in our consolidated financial statements and in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” as derived from (1) technology and film licensing and (2) product sales and other revenues. Our technology and film licensing revenues are derived from each of our consumer and cinema business segments. Revenues from technology licensing in connection with our consumer business segment include revenues derived from licensing our audio technology, trademarks, and

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know-how to consumer electronics, personal computer, video game and console, digital satellite and cable broadcast, and professional audio companies as well as to semiconductor manufacturers. Revenues from technology and film licensing in connection with our cinema business segment include revenues derived from film licensing and services that we provide to film studios for the production of soundtracks in our digital multi-channel format. Our product sales and other revenues are derived from our consumer, cinema and digital images business segments. Revenues from product sales and other revenues in connection with our consumer business segment include revenues derived from sales of music titles that we produce in our digital multi-channel format and sales of our professional audio products and services. Revenues from product sales and other revenues in connection with our cinema business segment include revenues derived from sales of our digital playback systems, cinema processor equipment, and systems for subtitling, captioning, and descriptive narration to movie theaters and special venues. Revenues from product sales and other revenues in connection with our digital images business segment include fees for processing, enhancing and restoring cinema, home video and broadcast television content.

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

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

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

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

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

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

In our digital images business, our senior management team markets our services directly to directors, producers and content owners. The sales process typically involves an evaluation of the cinema, home video or broadcast television content to be enhanced or restored and a determination of the scope of services required to

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achieve the desired result. Our digital images services enable current or archived film content to be enhanced or restored for high quality, high definition presentation in digital cinema, high definition optical media or broadcast applications.

Management Discussion Regarding Trends, Opportunities, and Challenges

New Strategic Initiatives

The trend in the motion picture industry and movie exhibition market toward digital delivery of entertainment content continues to gain momentum and we believe it presents a long-term opportunity for us to expand our cinema business. As part of our strategy to pursue opportunities in the digital cinema market, we signed an exclusive license agreement and an option agreement with Avica Technology Corporation, a provider of products and services for the digital cinema market. Under the exclusive license agreement we will acquire a worldwide, exclusive license (even as to Avica) to substantially all of Avica’s intellectual property in all fields of use other than with respect to military applications. Under the option agreement, we may elect, in our sole discretion, to acquire all or substantially all of the assets of Avica for a fixed purchase price. The closing under these agreements has not yet been consummated and remains subject to the satisfaction or our waiver of certain closing conditions. We believe Avica’s suite of digital cinema technologies, products and services will complement our existing cinema product offerings and will accelerate our entry into the digital cinema market.

Additionally, we intend to proceed with the separation of our Cinema and Digital Images businesses from our Consumer licensing business. We believe this separation will enhance stockholder value and better position each business to serve its customer base, go-to-market more rapidly, and be more flexible in this dynamic environment.

Trends, Opportunities, and Challenges by Business Segment

Consumer Segment

Revenue from our consumer segment constitutes the majority of our total revenue, representing 62% and 58% of total revenues for the quarters ended September 30, 2006 and 2005, respectively. Our consumer revenue is primarily dependent upon the home theater and DVD player markets, which have experienced rapid growth over the past several years. However, we have recently experienced softness in our DVD player trademark licensing program, and expect growth rates in this area to decline from recent levels. The success of DVD-Video-based systems and products has fueled a demand for higher quality entertainment in the home, and this demand is extending to the car audio and personal computer markets as well. In addition, we expect the recent acceleration of the market for high definition televisions to drive demand for high definition optical disc players beginning in late 2006, although licensing revenues to us based on sales of these high definition players will be minimal for the year. Because we have been selected as a mandatory technology for next generation players, our consumer revenue growth should more closely track the growth rate for sales of these players over the next several years. We expect that the market for high definition players will yield new growth that provides an offset to the expected decline in the overall growth in DVD player shipments. Further, we believe that expected mandatory inclusion in next generation optical disc standards will help to improve the adoption rate of our technologies in other consumer products such as next generation video game consoles, personal audio and video players, personal computers and in-car entertainment systems. If we are removed from mandatory status in next generation high definition optical disc standards, it would cause revenue growth in our consumer business to be significantly lower than expected and would have a material adverse effect on our business.

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

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believe that the broad and robust nature of this offering improves the probability of inclusion of our technologies in next generation products.

Cinema Segment

Revenue from our cinema segment represented 31% and 33% of total revenues for the quarters ended September 30, 2006 and 2005, respectively. We expect our cinema audio hardware business to decline slightly throughout the remainder of 2006 from prior year levels, as the cinema exhibition community has begun to defer purchases of digital multi channel audio equipment as they evaluate the pace of progress in the emerging digital cinema market as discussed below. We also believe that the cinema exhibition community has recognized that pre-show entertainment represents a significant revenue growth opportunity that will lead to investment in pre-show solutions over the next several years. Because our XD10 Cinema Media Player can be configured to perform audio playback along with pre-show and subtitling presentation, we believe that we are well-positioned to participate in the anticipated growth in this market.

A trend that we believe will affect our cinema business segment is the long-term trend toward digital distribution of content. We believe this trend will involve the near-term adoption of digital pre-show and/or electronic cinema solutions, followed by longer-term adoption of higher quality digital cinema. Digital distribution of content offers the motion picture industry a means to achieve substantial cost savings, including the printing and distribution of movies, help in combating piracy, and will enable movies to be played repeatedly without degradation. It also provides additional revenue opportunities for cinema operators, as digital content such as advertisements, concerts and sporting events could be shown in or broadcast to digitally equipped theaters. In recent months, there has been increasing momentum in the digital cinema industry, as product and service vendors attempt to find a viable business model. We believe that these activities are primarily vendor-financed trials at this point, but represent an important and significant step in the transition. We believe this represents an opportunity for us as we seek to provide products and services in support of the transition from film-based content towards digital cinema. However, our current digital cinema offerings are limited and we may not be successful in developing or selling competitive product offerings. We believe that the addition of our Cinema Media Network and variable bit rate JPEG 2000 encoding tools, along with the services provided by our digital images business, and the pre-show and alternative content capabilities of our XD10 Cinema Media Player, combined with the addition of the products, technologies and know-how to be obtained under our exclusive license agreement with Avica, will enhance our ability to participate in the industry transition to high definition sound and images for digital cinema.

Sales of cinema products and film licensing tend to fluctuate based on the underlying trends in the motion picture industry. For instance, in the late 1990s various cinema operators aggressively built megaplexes, which resulted in an oversupply of screens in some domestic and international markets. The resulting oversupply of screens led to significant declines in revenues per screen, and eventually, many theaters were closed. As a result of the closures, sales of our playback systems and cinema processors suffered. As the theater industry has regained health in the last several years, sales of our DTS playback systems and cinema processors have improved. Our film licensing revenues are also subject to fluctuations based on industry trends, most significantly, the number of films being made by studios and independent filmmakers.

Digital Images Segment

Revenue from our digital images segment represented 6% and 9% of total revenues for the quarters ended September 30, 2006 and 2005, respectively. We believe that the growing market for high resolution and high definition content in the cinema and the home will create a substantial demand for the type of services provided by DTS DI. A relatively new application for our process is the correction of problems encountered with the use of digital cameras, enabling our involvement at the earliest stages of digital content development. We believe that we provide leading digital lab capabilities, including digital enhancement, restoration and other pre-compression services and that we have a technological advantage over many of our competitors based on the sophistication of our processes and level of automation used to enhance the image quality of entertainment content. Revenues for our digital images segment totaled $1.0 million and $1.6 million for the quarter ended September 30, 2006 and 2005, respectively. To date, this business has enhanced and/or restored over 100 feature films, including such

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major DVD releases as Star Wars and Indiana Jones. Major motion picture and television studios possess libraries containing thousands of titles, which we believe represent a sizable market opportunity for the services performed by DTS DI.

Critical Accounting Policies and Estimates

Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of our financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, estimates are evaluated, including those related to revenue recognition, allowance for doubtful accounts, inventories, goodwill and intangible assets, taxes, impairment of long-lived assets, product warranty, stock-based compensation, and contingencies and litigation. These estimates are based on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates. There has been no material change to our critical accounting policies and estimates from the information provided in our Form 10-K filed on March 16, 2006, except for the adoption of SFAS No. 123(R).

Results of Operations

Revenues

Technology and Film Licensing

Technology and film licensing revenues for the three months ended September 30, 2006 decreased 7% to $11.7 million from $12.6 million for the three months ended September 30, 2005. The decrease in revenues from technology and film licensing was primarily attributable to a decrease in royalty recoveries of $1.2 million from intellectual property compliance and enforcement activities. We are experiencing strong growth in the personal computer and car audio systems markets, which posted quarter over quarter growth totals of 4% and 90%, respectively, during the third quarter of 2006 and are up 18% and 77%, respectively, for the year. However, we remain cautious in our outlook due to uncertainties surrounding the consumer electronics market. Overall, we continue to expect technology licensing revenues to grow modestly for 2006, based primarily on the expected continuation of growth in our decoder licensing program and from our license enforcement activities. Our film licensing revenues decreased 6% for the three months ended September 30, 2006 compared to the prior year period due primarily to the timing of major feature film releases. Film licensing is expected to remain relatively flat for the remainder of 2006.

Technology and film licensing revenues for the nine months ended September 30, 2006 increased 5% to $46.3 million from $43.9 million for the nine months ended September 30, 2005. The increase in revenues from technology and film licensing was primarily attributable to strong growth in the personal computer and car audio systems markets, as described above. Also, royalty recoveries increased $0.9 million over the prior year period from intellectual property compliance and enforcement activities. These activities, which include audits of shipments by certain of our licensees and legal actions taken against licensees and parties who are not our licensees, resulted in recoveries of royalty payments relating to prior periods.

Product Sales and Other

Product sales and other revenues decreased 29% to $3.5 million for the three months ended September 30, 2006 from $4.9 million for the three months ended September 30, 2005. This decrease was primarily attributable to deferred revenue of approximately $0.8 million being recognized during the third quarter of 2005 which was not recognized during the current quarter. Also, revenue from our Digital Images segment declined 39% for the three months ended September 30, 2006, to $1.0 million as a result of process improvements implemented in the prior quarter, which resulted in an acceleration of certain restoration projects into our second quarter and corresponding reduction of backlog for the third quarter. We expect product sales and other revenue to improve in the fourth quarter of 2006.

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Product sales and other revenues increased 8% to $14.5 million for the nine months ended September 30, 2006 from $13.4 million for the nine months ended September 30, 2005. This increase was primarily attributable to growth in revenues generated by DTS DI, partially offset by a decrease in Cinema hardware sales resulting in part from the recognition of deferred revenue related to our arrangement with Cinecom during 2005.

Segment Sales

Revenues from our consumer business totaled $9.5 million for the three months ended September 30, 2006, a decrease of 7% from $10.2 million for the three months ended September 30, 2005. The decrease in revenues was primarily attributable to a decrease in royalty recoveries of $1.2 million from intellectual property compliance and enforcement activities. Cinema revenues totaled $4.8 million for the three months ended September 30, 2006, a decrease of 17% from $5.7 million for the three months ended September 30, 2005. The decrease in revenue was primarily due to a slowdown in U.S. hardware sales, as described above. Revenues from our digital images business totaled $1.0 million for the three months ended September 30, 2006, a significant decrease from revenues of $1.6 million for the three months ended September 30, 2005. The decrease in revenues was primarily due to the completion of a significant project in the prior year, coupled with ongoing improvements in our digital enhancement and restoration processes, which resulted in significant improvements in throughput during the prior quarter and the resultant reduction in backlog for the third quarter.

Revenues from our consumer business totaled $39.8 million for the nine months ended September 30, 2006, an increase of 5% from $37.7 million for the nine months ended September 30, 2005. The increase in revenues was driven primarily by an increase in royalty recoveries mentioned above as well as the overall growth in our personal computer and car audio markets. Cinema revenues totaled $15.1 million for the nine months ended September 30, 2006, a decrease of 4% from $15.7 million for the nine months ended September 30, 2005. The decrease in revenue was primarily due to a slowdown in Cinema hardware sales during 2006. Revenues from our digital images business totaled $6.0 million for the nine months ended September 30, 2006, a significant increase from revenues of $3.9 million for the nine months ended September 30, 2005. The increase in revenues was primarily due to the completion of certain significant projects, and ongoing improvements in our digital enhancement and restoration processes.

Gross Profit

Consolidated gross profit decreased to 72% of revenues for the three months ended September 30, 2006, from 74% for the three months ended September 30, 2005. Consolidated gross profit was 75% of revenues for the nine months ended September 30, 2006 and 2005. We expect consolidated gross margins in the 70% to 75% range for 2006 primarily as a result of the incorporation of DTS DI into our consolidated results of operations.

Technology and Film Licensing

Gross profit associated with technology and film licensing revenues was 91% of related revenues for the three months ended September 30, 2006 and 2005.

Gross profit associated with technology and film licensing revenues was 92% of related revenues for the nine months ended September 30, 2006 and 2005.

Product Sales and Other

Gross profit associated with product sales and other revenues decreased to 7% of related revenues for the three months ended September 30, 2006 from 30% in the prior year period primarily as a result of a slowdown in U.S. hardware sales and low revenues from our Digital Images business, as described above.

Gross profit associated with product sales and other revenues decreased to 18% of related revenues for the nine months ended September 30, 2006 from 21% in the prior year period primarily as a result of a slowdown in U.S. hardware sales, as described above.

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Segment Gross Profit

Gross profit for our consumer business was 96% of related revenues for the three months ended September 30, 2006 and 2005. Our cinema business gross profit decreased to 50% of related revenues for the three months ended September 30, 2006 from 54% in the prior year period primarily due to a slowdown in U.S. hardware sales, as described above, and a less favorable mix of hardware sales and film licensing. Our digital images business gross profit was negative for the three months ended September 30, 2006 compared to 1% of related revenues in the prior year.

Gross profit for our consumer business increased slightly to 97% of related revenues for the nine months ended September 30, 2006 compared to 96% for the same period in 2005. Our cinema business gross profit was 48% of related revenues for the nine months ended September 30, 2006 and 2005. Our digital images business gross profit was negative for the nine months ended September 30, 2006 and 2005.

Selling, General and Administrative

Selling, general and administrative expenses increased 16% to $10.4 million for the three months ended September 30, 2006, compared to $9.0 million in the prior year period. The increase is primarily due to an increase in compensation expense of $1.4 million due to additional employees and the inclusion of $0.7 million in stock based compensation costs under SFAS No. 123(R).

Selling, general and administrative expenses increased 21% to $30.3 million for the nine months ended September 30, 2006, compared to $25.1 million in the prior year period. The increase is primarily due to an increase in compensation expense of $4.6 million due to additional employees and the inclusion of $2.1 million in stock based compensation costs under SFAS No. 123(R).

We expect selling, general and administrative expenses to increase due to our separation activities and to support our growth initiatives including acquisitions, international expansion and intellectual property enforcement activities related to the launch of our DTS-HD initiative.

Research and Development

For the three months ended September 30, 2006, research and development expenses were $3.3 million, compared to $2.6 million for the three months ended September 30, 2005. For the nine months ended September 30, 2006, research and development expenses were $9.0 million, compared to $7.2 million for the nine months ended September 30, 2005. The increase for both periods is primarily due to increased labor costs associated with new product and technology initiatives, the optimization of our Coherent Acoustics technology, and the development of tools associated with next generation optical disc standards. In addition, SFAS No. 123(R) related compensation expenses totaled $0.1 million and $0.3 million for the three and nine months ended September 30, 2006, respectively.

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

In-Process Research and Development

In-process research and development of $2.3 million for the nine months ended September 30, 2005 relates to development projects that had not reached technological feasibility and were of no future alternative use and expensed upon consummation of the acquisition of DTS DI. Developed technology and in-process research and development were identified and valued through extensive interviews, analysis of data provided by DTS DI concerning development projects, their stage of development, the time and resources needed to complete them, if applicable, and their expected income generating ability and associated risks. Where development projects had reached technological feasibility, they were classified as developed technology and the value assigned to developed technology was capitalized. The income approach, which includes an analysis of the cash flows and risks associated with achieving such cash flows, was the primary technique utilized in valuing acquired in-

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process research and development. Key assumptions for in-process research and development included a discount rate of 30% and estimates of revenue growth, cost of sales, operating expenses and taxes.

Separation Costs

Separation costs for the three and nine months ended September 30, 2006 were $0.4 million. In August 2006, we announced that we intend to study the potential separation of the Cinema and Digital Images businesses from the Consumer business in order to better address rapidly evolving markets, meet the needs of customers and increase shareholder value. The separation costs consist primarily of legal and accounting expenses relating to the separation of our business. We will continue to incur these costs as we proceed with the separation of the business.

Interest Income, Net

Interest income, net, for the three and nine months ended September 30, 2006 increased due to the increase in interest rates in 2006 and higher average investment balances.

Income Taxes

For the three months ended September 30, 2006, we recorded an income tax benefit of $0.9 million on pre-tax loss of $1.7 million. For the three months ended September 30, 2005, we recorded an income tax provision of $0.9 million on pre-tax income of $2.1 million.

For the nine months ended September 30, 2006, we recorded an income tax provision of $1.4 million on pre-tax income of $9.4 million. This resulted in an annualized effective tax rate of 14.8%. During the second quarter of 2006, the Internal Revenue Service, or IRS, completed an examination of the federal income tax return filed by us for the year ended December 31, 2003. We achieved a favorable resolution with the IRS regarding the Extraterritorial Income Exclusion, or ETI, that resulted in a tax benefit of $1.7 million.  As a result of these items, the current income tax rate differs from the statutory rate. At September 30, 2006, our annualized effective tax rate was approximately 42.4%, which included approximately 5.0% for non-deductible costs related to the separation of the business. For the nine months ended September 30, 2005, we recorded an income tax provision of $3.9 million on pre-tax income of $10.5 million, representing an annualized effective tax rate of 37.4%. These rates differed from the statutory rates primarily due to state income taxes offset by benefits associated with the foreign rate differentials. We expect the effective tax rate for 2006 to be 17% to 19%. However, we expect future tax rates to more closely approximate the statutory rates.

Liquidity and Capital Resources

At September 30, 2006, we had cash, cash equivalents and short-term investments of $118.9 million, compared to $111.4 million at December 31, 2005.

Net cash provided by operating activities was $12.1 million for the nine months ended September 30, 2006, compared to $6.2 million for the nine months ended September 30, 2005. The primary source of operating cash flow for the nine months ended September 30, 2006 was net income of $8.0 million, adjusted for non-cash items including depreciation and amortization expense and stock-based compensation charges.

Net cash used in investing activities totaled $3.9 million for the nine months ended September 30, 2006, compared to net cash provided by investing activities of $2.3 million for the nine months ended September 30, 2005. Cash used in investing activities for the nine months ended September 30, 2006 primarily consists of purchases of property and equipment of $4.9 million offset by net sales of investments of $2.6 million.

Net cash provided by financing activities totaled $1.9 million and $0.7 million for the nine months ended September 30, 2006 and 2005, respectively, and consists of the exercise of stock options and related excess tax

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benefits and purchases of stock under our employee stock purchase plan. Prior to adoption of SFAS No. 123(R), excess tax benefits from exercise of stock options were shown as an operating cash inflow.

In 2005, we entered into an agreement for the purchase and implementation of a new enterprise resource planning system, or ERP, for approximately $0.7 million. We expect that we will incur additional costs in the range of $2 million to $4 million over the next several years in connection with our ERP implementation. Through September 30, 2006, we incurred approximately $2.1 million, which has been capitalized to software.

On August 1, 2006, our Board of Directors authorized, subject to certain business and market conditions, the purchase of up to one million shares of our common stock in the open market or in privately negotiated transactions. At September 30, 2006, there were no shares purchased under this authorization. Any shares repurchased would be considered treasury stock.

In August 2006, we announced that we were studying the potential separation of our business and in November 2006, we announced our intent to proceed with the separation of our Cinema and Digital Images businesses from our Consumer licensing business. Through September 30, 2006, we incurred approximately $0.4 million in separation costs, consisting primarily of legal and accounting expenses relating to the separation of our business. The separation of our business may require us to allocate a significant portion of our cash to the Cinema and Digital Images business.

On August 8, 2006, we entered into an Exclusive License Agreement and an Option Agreement with Avica. The closing under these agreements has not yet been consummated and remains subject to the satisfaction or our waiver of certain closing conditions. Under the Exclusive License Agreement, Avica will grant to us an exclusive license to all or substantially all of Avica’s intellectual property and technology in all fields of use other than military applications. To acquire the exclusive license under the Exclusive License Agreement, we will be required to pay initial aggregate consideration of $5 million. Thereafter, we will be required to pay up to an additional $2.9 million to Avica in the event that we recognize revenues with respect to the sale of certain Avica products to third parties during the three-year period following the date of the Exclusive License Agreement. The term of Exclusive License Agreement will commence when we complete the license closing upon payment of the initial aggregate consideration of $5 million (the “License Closing”) and will last until three years following completion by Avica of certain clean-up conditions identified in the Exclusive License Agreement to our reasonable satisfaction. Under the Option Agreement, we will acquire the exclusive option to acquire the assets of Avica during the period beginning upon the License Closing and ending on the expiration or earlier termination of the license term. In the event that we exercise our exclusive option under the Option Agreement, we will be required to pay up to $1.5 million to Avica, which may be payable in cash or in restricted common stock pursuant to the terms set forth in the Option Agreement.

We believe that our cash, cash equivalents, short-term investments, funds available under our existing bank line of credit facility, and cash flows from operations will be sufficient to satisfy our working capital and capital expenditure requirements for at least the next twelve months. Beyond the next twelve months, additional financing may be required to fund working capital and capital expenditures. Changes in our operating plans including lower than anticipated revenues, increased expenses, acquisition of companies, products or technologies or other events, including those described in “Risk Factors” included elsewhere herein, in our Form 10-K filed on March 16, 2006 and in other filings may cause us to seek additional debt or equity financing on an accelerated basis. Financing may not be available on acceptable terms, or at all, and our failure to raise capital when needed could negatively impact our growth plans and our financial condition and results of operations. Additional equity financing may be dilutive to the holders of our common stock and debt financing, if available, may involve significant cash payment obligations and financial or operational covenants that restrict our ability to operate our business.

Recently Issued Accounting Standards

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. This statement is effective for financial statements issued for fiscal years beginning after November 15, 2007. We plan to adopt SFAS No. 157 effective January 1, 2008. We are in the process of determining the effect, if any, the adoption of SFAS No. 157 will have on our financial statements.

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In September 2006, the SEC staff issued SAB No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB 108 provides guidance on how prior year misstatements should be taken into consideration when quantifying misstatements in current year financial statements for purposes of determining whether the current year’s financial statements are materially misstated. SAB No. 108 is effective for fiscal years ending after November 15, 2006. We plan to adopt SAB No. 108 during the fourth quarter of 2006. We are in the process of determining the effect, if any, the adoption of SAB No. 108 will have on our financial statements.

In July 2006, the FASB issued FIN No. 48, “Accounting for Uncertainty in Income Taxes,” which prescribes a comprehensive model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return (including a decision whether to file or not to file a return in a particular jurisdiction). The accounting provisions of FIN No. 48 are effective for fiscal years beginning after December 15, 2006. We plan to adopt FIN No. 48 effective January 1, 2007. We are in the process of determining the effect, if any, the adoption of FIN No. 48 will have on our financial statements.

In June 2006, the EITF issued EITF Issue No. 06-3, “How Sales Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross Versus Net Presentation),” which states that a company should disclose its accounting policy (i.e., gross or net presentation) regarding presentation of taxes within the scope of this Issue. If taxes included in gross revenues are significant, a company should disclose the amount of such taxes for each period for which an income statement is presented. The consensus would be effective for the first annual or interim reporting period beginning after December 15, 2006. The disclosures are required for annual and interim financial statements for each period for which an income statement is presented. We plan to adopt EITF Issue No. 06-3 effective January 1, 2007. Based on our current evaluation, we do not expect the adoption of EITF Issue No. 06-3 to have a significant impact on our consolidated results of operations or financial position.

In June 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20, Accounting Changes, and Statement No. 3, Reporting Accounting Changes in Interim Financial Statements.” SFAS No. 154 changes the requirements for the accounting for, and reporting of, a change in accounting principle. Previously, most voluntary changes in accounting principles were required to be recognized by way of a cumulative effect adjustment within net income during the period of the change. SFAS No. 154 requires retrospective application to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005; however, the Statement does not change the transition provisions of any existing accounting pronouncements. The adoption of SFAS No. 154 did not have a material effect on our consolidated financial position, results of operations or cash flows.

In December 2004, the FASB finalized SFAS No. 123(R), “Share-Based Payment,” which requires companies to measure and recognize compensation costs for all share-based payments (including stock options) at fair value, effective for interim or annual periods beginning after June 15, 2005. On April 15, 2005, the SEC announced a deferral of the effective date of SFAS No. 123(R) until the first interim or annual reporting period of the first fiscal year beginning on or after June 15, 2005. Effective January 1, 2006, we adopted the provisions of SFAS No. 123(R) as discussed in Footnote 10, Stock-Based Compensation.

Prior to adoption of SFAS No. 123(R), we presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in the Consolidated Statements of Cash Flows. SFAS No. 123(R) requires the cash flows resulting from the tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows.

Item 3.Quantitative and Qualitative Disclosures About Market Risk

Market risk represents the risk of loss arising from adverse changes in market rates and foreign exchange rates. At September 30, 2006, we did not have any balances outstanding under our bank line of credit arrangement; however, the amount of outstanding debt at any time may fluctuate and we may from time to time be subject to refinancing risk.

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Our interest income is sensitive to changes in the general level of U.S. interest rates, particularly since a significant portion of our investments are and will be in short-term marketable securities, U.S. government securities and corporate bonds. Due to the nature and maturity of our short-term investments, we have concluded that there is no material market risk exposure to our principal. The average maturity of our investment portfolio is less than one month. As of September 30, 2006, a 1% change in interest rates throughout a one-year period would have an annual effect of approximately $1.2 million on our income before income taxes.

We derive in the range of half to three-quarters of our revenues from sales outside the United States, and maintain research, sales, marketing, or business development offices in nine countries. Therefore, our results could be negatively affected by such factors as changes in foreign currency exchange rates, trade protection measures, longer accounts receivable collection patterns, and changes in regional or worldwide economic or political conditions. The risks of our international operations are mitigated in part by the extent to which our revenues are denominated in U.S. dollars and, accordingly, we are not exposed to significant foreign currency risk on these items. We do have limited foreign currency risk on certain revenues and operating expenses such as salaries and overhead costs of our foreign operations and a small amount of cash maintained by these operations. Revenues denominated in foreign currencies accounted for approximately 8% of total revenues during the nine months ended September 30, 2006. Operating expenses, including cost of sales, for our foreign subsidiaries were approximately $10.0 million in the nine months ended September 30, 2006. Based upon the expenses for the nine months ended September 30, 2006, a 1% change in foreign currency rates throughout a one-year period would have an annual effect of approximately $0.1 million on operating income.

Our international business is subject to risks, including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions, and foreign exchange rate volatility when compared to the United States dollar. Accordingly, our future results could be materially impacted by changes in these or other factors.

We are also affected by exchange rate fluctuations as the financial statements of our foreign subsidiaries are translated into the United States dollar in consolidation. As exchange rates vary, these results, when translated, may vary from expectations and could adversely or positively impact overall profitability. During the nine months ended September 30, 2006, the positive impact of foreign exchange rate fluctuations related to translation of our foreign subsidiaries’ financial statements was $0.1 million on retained earnings.

Item 4.Controls and Procedures

Disclosure Controls and Procedures

We maintain disclosure controls and procedures (as defined in Rules 13a-l5(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) that are designed to ensure that information required to be disclosed in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.

We carried out an evaluation, under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on such evaluation, our chief executive officer and chief financial officer concluded that as of the end of the period covered by this report our disclosure controls and procedures were effective.

There has been no change in our internal control over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II

OTHER INFORMATION

Item 1.Legal Proceedings

None.

Item 1A.Risk Factors

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

The risk factors described below do not contain any material changes from the Risk Factors described under Item 1A of Part I of our Annual Report on Form 10-K for the fiscal year ended December 31, 2005, which was filed with the SEC on March 16, 2006, except as follows:

·We have added two new risk factors under the following headings:

·“The separation of our businesses and/or any failure to successfully manage and complete an undertaken separation transaction could adversely affect our business and operating results.”

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

·Following our adoption of SFAS 123(R) on January 1, 2006, we have deleted the risk factor that was titled “Accounting for employee stock options using the fair value method will reduce our net income.”

Risks Related to Our Business

We face intense competition from companies with greater brand recognition and resources.

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

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

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

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

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

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

·greater name recognition;

·a longer operating history;

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

·a more extensive customer base;

·digital technologies that provide features that ours do not;

·broader product and service offerings;

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

·more technicians and engineers.

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

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

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

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

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

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

As new technologies and entertainment media emerge, new standards relating to these technologies or media may develop. New standards may also emerge in existing markets that are currently characterized by competing

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formats, such as the market for personal computers. We may not be successful in our efforts to include our technology in any such standards.

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

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

·rapid technological change;

·new and improved product introductions;

·changing customer demands;

·evolving industry standards; and

·product obsolescence.

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

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

The market for consumer electronics products is intensely competitive and price sensitive. Retail prices for consumer electronics products that include our DTS audio technology, such as DVD players and home theater systems, have decreased significantly and we expect prices to continue to decrease for the foreseeable future. Declining prices for consumer electronics products could create downward pressure on the licensing fees we currently charge our customers who integrate our technology into the consumer electronics products that they sell and distribute. Most of the consumer electronics products that include our audio technology also include Dolby’s multi-channel audio. As a result of pricing pressure, consumer electronics products manufacturers could decide to exclude our DTS audio technology from their products altogether.

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

The separation of our businesses and/or any failure to successfully manage and complete an undertaken separation transaction could adversely affect our business and operating results.

In order to better address rapidly evolving markets, meet the needs of customers and increase shareholder value, we are proceeding with the separation of our Cinema and Digital Images businesses from our Consumer licensing business. The separation process may be costly. We may during this separation process elect not to

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separate the business. This separation process may require significant time and attention from our management team, which could disrupt our day-to-day operations. In addition, implementing any transaction would involve a number of operational, legal and, possibly, regulatory steps. Furthermore, implementation could be costly, cause further disruption to our day-to-day operations, and result in the loss of customers and/or sales revenue, which could cause our business and operating results to suffer.

If the movie industry adopts new digital cinema technology in place of current film technology, demand for our cinema products and services could decline.

The movie theater industry may transition from film-based media to electronic-based, or digital, media. If this transition occurs, we may be unable to meaningfully respond with competitive product offerings. In addition, if the film industry broadly adopts digital cinema, our technology and current product and service offerings could be rendered obsolete. In such an event, demand by movie theaters for our playback systems, cinema processors, and systems for subtitling, captioning, and descriptive narration as well as film licensing revenue would decline.

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

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

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

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

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

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

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

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

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

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

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

Companies that participate in the digital audio, digital image processing, consumer electronics, and entertainment industries hold a large number of patents, trademarks, and copyrights, and are frequently involved in litigation based on allegations of patent infringement or other violations of intellectual property rights. Intellectual property disputes frequently involve highly complex and costly scientific matters, and each party generally has the right to seek a trial by jury which adds additional costs and uncertainty. Accordingly, intellectual property disputes, with or without merit, could be costly and time consuming to litigate or settle, and could divert management’s attention from executing our business plan. In addition, our technology and products may not be able to withstand any third-party claims or rights against their use. If we were unable to obtain any

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necessary license following a determination of infringement or an adverse determination in litigation or in interference or other administrative proceedings, we may need to redesign some of our products to avoid infringing a third party’s rights and could be required to temporarily or permanently discontinue licensing our products.

Our operating results may be adversely affected as a result of required compliance with the recently adopted European Union Directives on Waste Electrical and Electronic Equipment and the Restriction of the Use of Hazardous Substances in electrical and electronic equipment.

In February 2003, the European Union enacted Directive 2002/96/EC on Waste Electrical and Electronic Equipment Directive, known as the WEEE Directive. The WEEE Directive requires producers of certain electrical and electronic equipment to be financially responsible for the future disposal costs of this equipment. Our cinema products may fall within the scope of this Directive and as such we may incur some financial responsibility for the collection, recycling, treatment and disposal of both new products sold, and products already sold prior to the WEEE Directive’s enforcement date, to customers within the European Union. The Directive potentially increases our financial liabilities by requiring producers to adopt new approaches for improving sustainable product design and for encouraging recycling or re-use at the end of the product’s life.

At the same time, the European Union also enacted Directive 2002/95/EC on the Restriction of the use of Hazardous Substances in electrical and electronic equipment, known as the RoHS Directive. This Directive restricts the use of certain hazardous substances, including mercury, lead, cadmium, hexavalent chromium and certain flame retardants, used in the construction of component parts of electrical and electronic equipment. We may need to change our manufacturing processes, and to redesign or reformulate products regulated under the RoHS Directive to eliminate these hazardous substances in our products, in order to be able to continue to offer them for sale within the European Union. For some products, substituting certain components containing regulated hazardous substances may be more difficult or costly, and the additional redesign efforts could result in production delays.

Individual European Union member states are required to transpose the Directives into national legislation. Although not all European Union member states have enacted legislation to implement these two directives, we continue to review the applicability and impact of both directives on the sale of our cinema products within the European Union.

We may incur increased manufacturing costs or production delays to comply with future legislation which implements these directives, but we cannot currently estimate the extent of such increased costs or production delays. However, to the extent that such cost increases or delays are substantial, our operating results could be materially adversely affected. In addition, we are aware of similar legislation which may be enacted in other countries, such as China, and possible new federal and state legislation in the United States, the cumulative impact of which could significantly increase our operating costs and adversely affect our operating results.

The WEEE Directive and the RoHS Directive are aimed mainly at mass market consumer electronics and thus, will impact many of our customers who license our technology and pay us royalties upon the manufacture of electronic products. If the directives result in fewer licensed consumer electronics products being sold, whether due to price increases, production delays, compromised product performance due to reformulation or redesign, or for other reasons, then we will receive less revenue in royalties. If the directives materially impair or inhibit such sales, the reduction in licensing revenue could adversely affect our operating results.

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

We expect to derive a significant percentage of our revenues from the technology, products, and services that we offer to manufacturers of consumer electronics products. To date, the most significant driver for the use of our technology in the home theater market has been the release of major movie titles with DTS audio soundtracks. We also believe that demand for our DTS audio technology in emerging markets for multi-channel audio, including homes, cars, personal computers, and video games and consoles, will be based on the number,

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quality, and popularity of the audio DVDs, computer software programs, and video games released with DTS audio soundtracks. Although we have existing relationships with many leading providers of movie, music, computer, and video game content, we do not have contracts that require any of these parties to develop and release content with DTS audio soundtracks. In addition, we may not be successful in maintaining existing relationships or developing relationships with other existing providers or new market entrants that provide content. As a result, we cannot assure you that a significant amount of content in movies, audio DVDs, computer software programs, video games, or other entertainment mediums will be released with DTS audio soundtracks. If the amount, variety, and popularity of entertainment content released with DTS audio soundtracks is not maintained, consumer electronics products manufacturers that pay us per-unit licensing fees may discontinue offering DTS playback capabilities in the consumer electronics products that they sell.

If our independent registered public accounting firm is unable to provide us with an unqualified report as to the adequacy of our internal controls over financial reporting for future year-ends as required by Section 404 of the Sarbanes-Oxley Act of 2002, investors could lose confidence in the reliability of our financial statements, which could result in a decrease in the value of our shares.

As directed by Section 404 of the Sarbanes-Oxley Act of 2002, the SEC adopted rules requiring all public companies, including us, to include a report by management on internal control over financial reporting in all annual reports on Form 10-K that contains an assessment by management of the effectiveness of internal control over financial reporting. In addition, the independent registered public accounting firm auditing our financial statements must attest to and report on our management’s assessment of the effectiveness of internal control over financial reporting and the effectiveness of internal control over financial reporting. While we conduct rigorous reviews of our internal control over financial reporting in order to comply with the Section 404 requirements, our independent registered public accounting firm may interpret the Section 404 requirements and the related rules and regulations differently from us, or our independent registered public accounting firm or management may not be satisfied with our internal control over financial reporting or with the level at which these controls are documented, executed or reviewed. In addition, many uncertainties remain regarding the requirements for auditor attestation, and guidance provided by the public accounting profession has changed frequently and materially to date and may continue to change such that we may not be able to comply with these new requirements. Further, the demand for competent audit resources has grown dramatically as a result of the requirements of Section 404, and such demand may exceed available supply. In addition, in January 2005, we acquired DTS DI, a privately held company with limited financial resources that may not have implemented sufficient internal control over financial reporting. We may in the future make additional acquisitions which may be significant to our operations either individually or in the aggregate. We may face significant challenges in implementing the required processes and procedures in the acquired operations of DTS DI or any other businesses that we may acquire. As a result, our independent registered public accounting firm may issue an adverse report or a disclaimer on management’s assessment of internal control over financial reporting. Management may also identify material weaknesses which would cause management to conclude internal control over financial reporting is not effective. This could result in an adverse reaction in the financial markets due to a loss of confidence in the reliability of our financial statements, which could cause the market price of our shares to decline.

We have limited experience in licensing, re-mixing, marketing, and directly selling multi-channel audio content.

Although we have established relationships with a number of artists and music labels, we do not have any contractual agreements that require artists or music labels to provide us with music content to re-mix and release in our proprietary DTS audio format. Music companies may in the future be unwilling to license titles from their music catalogs to us. In addition, our audio content competes with other multi-channel formats, including Super Audio CD, which is a format developed jointly by Philips and Sony Corporation. As a result, we may have difficulty in obtaining rights to release a significant amount of audio content, and any content that we do release may not be commercially successful.

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

Although we have established relationships with a number of motion picture studios, content owners, producers and distributors, we do not have any contractual agreements that require them to provide us image

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content for processing. Further, the demand for image processing, enhancement and restoration of cinema, home video or broadcast television content may not materialize or accelerate as we anticipate, which would have a negative impact on our business.

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

We are dependent on our customers and licensees—including consumer electronics products manufacturers, semiconductor manufacturers, movie theaters, producers and distributors of content for music, films, videos, and games—to incorporate our technology in their products, purchase our products and services, or release their content in our proprietary DTS audio format. Although we have contracts and license agreements with many of these companies, these agreements do not require any minimum purchase commitments, and are on a non-exclusive basis, and do not require incorporation or use of our technology, trademarks or services. Our customers, licensees and other manufacturers might not utilize our technology or services in the future.

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

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

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

Our cinema business depends in part on the construction of new screens and the renovation of existing theaters that install our DTS playback systems and cinema processors. In recent years, aggressive building of megaplexes by companies that operate movie theaters has generated significant competition and resulted in an oversupply of screens in some domestic and international markets. The resulting oversupply of screens led to significant declines in revenues per screen and, eventually, to an inability by many major film exhibitors to satisfy their financial obligations. Several major movie theater operators have reorganized through bankruptcy proceedings, and many movie theaters have closed. As a result, our playback systems and cinema processors that we previously sold to movie theaters that have reorganized and closed have been relocated to other theaters or have been available for resale in the secondary market to movie theaters that might otherwise have purchased these products directly from us. More recently, the industry has experienced a decline in movie theater attendance. If this decline were to continue, exhibitors could see a decline in revenue per screen and, potentially, an inability to satisfy their financial obligations resulting in the closure of screens. If movie theater operators decide to close a significant number of screens in the future or cut their capital spending, demand for our playback systems and cinema processors will decline.

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We are dependent on our management team and key technical employees, and the loss of any of them could harm our business.

Our success depends, in part, upon the continued availability and contributions of our management team, particularly Jon Kirchner, our President and Chief Executive Officer and W. Paul Smith, our Senior Vice President, Research and Development. We also rely on the skills and talents of our engineering and technical personnel because of the complexity of our products and services. Several of our key engineers have been instrumental in the development of our technology. Important factors that could cause the loss of key personnel include:

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

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

·significant portions of the stock options held by the members of our management team are vested; and

·stock options held by certain executive officers provide for accelerated vesting in the event of a sale or change of control of our company.

The loss of key personnel or an inability to attract qualified personnel in a timely manner could slow our technology and product development and harm our ability to execute our business plan. We do not generally carry key-man life insurance on any of our employees, with the exception that we are the beneficiary of a $10 million key-man life insurance policy for John Lowry, who is Chief Technologist of our DTS Digital Images business.

We have a limited operating history in many of our key markets.

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

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

Our technology or products could contain errors that could cause our products or technology to operate improperly and could cause unintended consequences. If our products or technology contain errors we could be required to replace them, and if any such errors cause unintended consequences we could face claims for product liability. Although we generally attempt to contractually limit our exposure to incidental and consequential damages, if these contract provisions are not enforced or are unenforceable for any reason, or if liabilities arise that are not effectively limited, we could incur substantial costs in defending and/or settling product liability claims.

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

We recently began to implement an enterprise resource planning, or ERP, system to enhance operating efficiencies and provide more effective management of our business operations. Implementing a new ERP system

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is costly and involves risks inherent in the conversion to a new computer system, including disruption to our normal accounting procedures and internal control over financial reporting and problems achieving accuracy in the conversion of electronic data. Failure to properly or adequately address these issues could result in increased costs, the diversion of management’s attention and resources and could materially adversely affect our operating results, internal control over financial reporting and ability to manage our business effectively.

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

Although we have been in business since 1990, we have only achieved profits from our business operations since the third quarter of 2001. We expect our operating expenses to increase as we, among other things:

·expand our domestic and international sales and marketing activities;

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

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

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

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

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

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

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

We market and sell our products and services outside the United States, and currently have employees located in Canada, China, England, France, Japan, Hong Kong, Italy, Northern Ireland, and Spain. Many of our customers and licensees are located outside the United States. As a key component of our business strategy, we intend to expand our international sales. We face numerous risks in doing business outside the United States, including:

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

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

·difficulties in staffing and managing foreign operations;

·dependence on foreign distributors and their sales channels;

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

·less effective and less predictable protection of intellectual property;

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

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

·potentially adverse tax consequences.

Such factors could cause our future international sales to decline.

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

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

We face risks in expanding our business operations in China.

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

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

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

We purchase a small number of parts from sole-source suppliers. In addition, our professional audio encoding devices and movie theater playback systems are manufactured according to our specifications by single third-party manufacturers. Because we have no direct control over these third-party suppliers and manufacturers, interruptions or delays in the products and services provided by these third parties may be difficult to remedy in a timely fashion. In addition, if such suppliers or manufacturers are incapable of or unwilling to deliver the necessary parts or products, we may be unable to redesign our technology to work without such parts or find alternative suppliers or manufacturers. In such events, we could experience interruptions, delays, increased costs, or quality control problems.

In addition, we have entered into agreements with three companies to serve as our sole distributors for our DTS Entertainment products in the United States and Canada, Europe and Japan. We have no direct control over these distributors and any problems with their performance may take time to identify and/or remedy, and any remedial measures that we take may be unsuccessful. In addition, if any of these distributors were to go out of business, as one of our previous distributors did, or otherwise becomes incapable of continuing as our distributor, we could experience delays in distributing our DTS Entertainment products to the retail market, loss of inventory, and loss of revenue.

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

A significant percentage of our revenues are generated from our consumer electronics products manufacturer customers who license and incorporate our technology in their consumer electronics products. Under our existing arrangements, these customers pay us per-unit licensing fees based on the number of consumer electronics products manufactured that incorporate our technology. We rely on our customers to accurately report the number of units manufactured in collecting our license fees, preparing our financial reports,

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projections, budgets, and directing our sales and product development efforts. Most of our license agreements permit us to audit our customers, but audits are generally expensive and time consuming and could harm our customer relationships. If any of our customer reports understate the number of products they manufacture, we may not collect and recognize revenues to which we are entitled.

A prolonged economic downturn could materially harm our business.

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

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

We acquired DTS DI in January 2005, and we expect to consider additional opportunities to acquire or make investments in other technologies, products, and businesses that could enhance our technical capabilities, complement our current products and services, or expand the breadth of our markets. We have a limited history of acquiring and integrating businesses. Acquisitions and strategic investments involve numerous risks, including:

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

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

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

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

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

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

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

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

·potential loss of key employees of acquired organizations.

If we fail to properly evaluate and execute acquisitions and strategic investments, our management team may be distracted from our day-to-day operations, our business may be disrupted, and our operating results may suffer. In addition, if we finance acquisitions by issuing equity or convertible debt securities, our existing stockholders would be diluted.

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

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

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

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

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

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·manage multiple concurrent development projects; and

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

Any failure to successfully manage our growth could distract management’s attention, and result in our failure to execute our business plan.

We may experience fluctuations in our operating results.

We have historically experienced moderate seasonality in our business due to our business mix and the nature of our products. In our consumer business, consumer electronics manufacturing activities are generally lowest in the first calendar quarter of each year, and increase progressively throughout the remainder of the year. Manufacturing output is generally strongest in the third and fourth quarters as our technology licensees increase manufacturing to prepare for the holiday buying season. Since recognition of revenues in our consumer business generally lags manufacturing activity by one quarter, our revenues and earnings from the consumer business are generally lowest in the second quarter. Film licensing revenues are generally strongest in the second and fourth quarters due to the abundance of movies typically released during the summer and year-end holiday seasons. The introduction of new products and inclusion of our technologies in new and rapidly growing markets can distort the moderate seasonality described above. Our revenues may continue to be subject to seasonal fluctuations in the future. Unanticipated fluctuations in seasonality could cause us to miss our earnings projections which could cause our stock price to decline.

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

Risks Related to Our Common Stock

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

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

·actual or anticipated fluctuations in our results of operations;

·announcements of technological innovations or technology standards;

·announcements of significant contracts by us or our competitors;

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

·developments with respect to intellectual property rights;

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

·the commencement of or our involvement in litigation;

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

·conditions and trends in technology industries;

·changes in market valuation or earnings of our competitors;

·the trading volume of our common stock;

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

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·general economic conditions.

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

Shares of our common stock are relatively illiquid.

As of September 30, 2006, we had 17,812,733 shares of common stock outstanding. As a result of our relatively small public float, our common shares may be less liquid than the common shares of companies with broader public ownership. Among other things, trading of a relatively small volume of our common shares may have a greater impact on the trading price for our shares than would be the case if our public float were larger.

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

Our capital requirements will depend on many factors, including:

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

·the costs of developing new products or technology;

·the extent to which we invest in new technology and research and development projects;

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

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

·the separation of our business.

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

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

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

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

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

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

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

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

Item 2.Unregistered Sales of Equity Securities and Use of Proceeds

(b) On July 15, 2003, we completed our initial public offering for the sale of 4,091,410 shares of common stock at a price to the public of $17.00 per share, which resulted in net proceeds of approximately $63.0 million after payment of the underwriters’ commissions and deductions of offering expenses. All of the shares of common stock sold in the offering were registered under the Securities Act of 1933, as amended (the “Securities Act”) on a Registration Statement on Form S-1 (Reg. No. 333-104761) that was declared effective by the SEC on July 9, 2003 and a Registration Statement filed pursuant to Rule 462(b) under the Securities Act that was filed on July 10, 2003 (Reg. No. 333-106920). Subsequent to the offering, we used approximately $22.5 million of our net proceeds to redeem all outstanding shares of redeemable preferred stock and to pay all accrued but unpaid dividends on such shares through the date of redemption. The remaining proceeds to us have conformed with our intended use outlined in the prospectus related to the offering. As of September 30, 2006, we have approximately $40.5 million remaining from the proceeds of the offering.

(c) In August 2006, our Board of Directors approved the repurchase of up to one million shares of our common stock in the open market or in privately negotiated transactions, depending upon market conditions and other factors. We have not made any purchases under this program and did not repurchase any shares under the program during the quarter ended September 30, 2006. As of September 30, 2006, we had authority to repurchase up to one million shares under that program.

Item 3.Defaults Upon Senior Securities

None.

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

None.

Item 5.Other Information

On August 8, 2006, we entered into an Exclusive License Agreement and an Option Agreement with Avica. The closing under these agreements has not yet been consummated and remains subject to the satisfaction or our waiver of certain closing conditions. Under the Exclusive License Agreement, Avica will grant to us an exclusive license to all or substantially all of Avica’s intellectual property and technology in all fields of use other than military applications. To acquire the exclusive license under the Exclusive License Agreement, we will be required to pay initial aggregate consideration of $5 million. Thereafter, we will be required to pay up to an additional $2.9 million to Avica in the event that we recognize revenues with respect to the sale of certain Avica products to third parties during the three-year period following the date of the Exclusive License Agreement. The term of Exclusive License Agreement will commence when we complete the license closing upon payment of the initial aggregate consideration of $5 million (the “License Closing”) and will last until three years following completion by Avica of certain clean-up conditions identified in the Exclusive License Agreement to our reasonable satisfaction. Under the Option Agreement, we will acquire the exclusive option to acquire the assets of Avica during the period beginning upon the License Closing and ending on the expiration or earlier termination of the license term. In the event that we exercise our exclusive option under the Option Agreement, we will be required to pay up to $1.5 million to Avica, which may be payable in cash or in restricted common stock pursuant to the terms set forth in the Option Agreement.

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Item 6.Exhibits

Exhibit Number	Exhibit Description
10.69	Exclusive License Agreement between the Company and Avica Technology Corporation, dated as of August 8, 2006†
10.70	Option Agreement between the Company and Avica Technology Corporation, dated as of August 8, 2006†
31.1	Certification of the Chief Executive Officer under Securities Exchange Act Rules 13a-14(a) or 15d-14(a)
31.2	Certification of the Chief Financial Officer under Securities Exchange Act Rules 13a-14(a) or 15d-14(a)
32.1	Certification of the Chief Executive Officer under Securities Exchange Act Rules 13a-14(b) or 15d-14(b) and 18 U.S.C. 1350
32.2	Certification of the Chief Financial Officer under Securities Exchange Act Rules 13a-14(b) or 15d-14(b) and 18 U.S.C. 1350
†	Certain confidential portions of this Exhibit were omitted by means of redacting a portion of the text (the “Mark”). This Exhibit has been filed separately with the Secretary of the Commission without the Mark pursuant to the Registrant’s Application Requesting Confidential Treatment.

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SIGNATURES

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

	DTS, INC.
	by:	/s/ JON E. KIRCHNER
		Jon E. Kirchner
		President and Chief Executive Officer
		(Duly Authorized Officer)
Date: November 9, 2006
	by:	/s/ MELVIN L. FLANIGAN
		Melvin L. Flanigan
		Executive Vice President, Finance and
		Chief Financial Officer
		(Principal Financial and Accounting Officer)
Date: November 9, 2006

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