1 ================================================================================ U.S. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q -------------- [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 1998 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ____________ to _____________ Commission File Number 0-21123 SRS LABS, INC. (Exact name of registrant as specified in its charter) -------------- Delaware 33-0714264 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 2909 Daimler Street, Santa Ana, California 92705 (Address of principal executive offices) (Zip Code) (949) 442-1070 (Registrant's telephone number, including area code) Not applicable (Former name, former address and former fiscal year, if changes since last report) -------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- APPLICABLE ONLY TO CORPORATE ISSUERS Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: as of October 31, 1998, 11,646,223 shares of the issuer's common stock, par value $.001 per share, were outstanding. ================================================================================ 2 SRS LABS, INC. FORM 10-Q FOR THE PERIOD ENDED SEPTEMBER 30, 1998 INDEX Page ---- Part I - Financial Information Item 1. Financial Statements. Consolidated Balance Sheets as of September 30, 1998 (Unaudited) and December 31, 1997 3 Consolidated Statements of Operations for the three months and nine months ended September 30, 1998 and 1997 (Unaudited) 4 Consolidated Statements of Cash Flows for the nine months ended September 30, 1998 and 1997 (Unaudited) 5 Notes to the Interim Consolidated Financial Statements (Unaudited) 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. 11 Item 3. Quantitative and Qualitative Disclosures About Market Risk. 18 Part II - Other Information Item 2. Changes in Securities and Use of Proceeds. 19 Item 6. Exhibits and Reports on Form 8-K. 19 Signatures 20 3 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS. SRS LABS, INC. CONSOLIDATED BALANCE SHEETS September 30, December 31, 1998 1997 ------------- ------------ (Unaudited) ASSETS Current Assets Cash and cash equivalents $ 7,856,201 $ 4,446,753 Investments available for sale 1,150,039 2,010,775 Accounts receivable 5,701,729 3,989,927 Inventories 6,939,484 -- Prepaid expenses and other current assets 1,469,444 578,957 Deferred income taxes 505,674 170,674 ----------- ----------- Total current assets 23,622,571 11,197,086 Investments available for sale 12,113,705 19,556,262 Furniture, fixtures & equipment, net 1,283,509 245,779 Intangible assets, net 6,167,535 313,673 Deferred income taxes 229,223 229,223 ----------- ----------- Total Assets $43,416,543 $31,542,023 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities Accounts Payable $ 7,004,059 $ 202,352 Accrued liabilities 1,521,792 826,242 Line of credit 8,000,000 -- Income taxes payable 717,345 1,011,426 Current portion of consideration due on asset purchase -- 81,804 ----------- ----------- Total Current Liabilities 17,243,196 2,121,824 Stockholders' Equity Preferred stock - $.001 par value 2,000,000 shares authorized; no shares issued and outstanding Common stock - $.001 par value 56,000,000 shares authorized; 11,622,423 (at September 30, 1998) and 9,609,867 (at December 31, 1997) shares issued and outstanding 11,623 9,610 Additional paid-in capital 39,013,504 25,022,437 Deferred stock option compensation 306,493 231,087 Unrealized gain on investments available for sale 147,264 163,600 Retained earnings (deficit) (13,305,537) 3,993,465 ----------- ----------- Total Stockholders' Equity 26,173,347 29,420,199 ----------- ----------- Total Liabilities and Stockholders' Equity $43,416,543 $31,542,023 =========== =========== See accompanying notes to financial statements 3 4 SRS LABS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) Three Months Ended Nine Months Ended September 30, September 30, -------------------------- -------------------------- 1998 1997 1998 1997 ----------- ----------- ------------ ---------- Revenues Chip and licensing revenue $ 3,935,479 $ 2,505,656 $ 11,341,907 $6,833,555 Product and component sales 7,382,323 -- 18,658,661 -- ----------- ----------- ------------ ---------- Total revenues 11,317,802 2,505,656 30,000,568 6,833,555 Cost of sales 7,810,345 71,161 19,596,284 186,240 ----------- ----------- ------------ ---------- Gross margin 3,507,457 2,434,495 10,404,284 6,647,315 Sales and marketing 1,176,466 400,284 3,876,993 1,190,178 Research and development 577,816 116,137 1,576,526 414,516 General and administrative 1,536,407 636,739 4,157,535 1,842,272 ----------- ----------- ------------ ---------- Operating income before write-off of acquired in-process research and development 216,768 1,281,335 793,230 3,200,349 Write-off of acquired in-process research and development -- -- 18,510,378 -- ----------- ----------- ------------ ---------- Income (loss) from operations 216,768 1,281,335 (17,717,148) 3,200,349 Other income -- -- 77,438 -- Interest income, net 11,728 276,471 316,688 806,712 ----------- ----------- ------------ ---------- 11,728 276,471 394,126 806,712 Income (loss) before income tax expense (benefit) 228,496 1,557,806 (17,323,022) 4,007,061 Income tax expense (benefit) 36,986 475,131 (24,020) 1,381,356 ----------- ----------- ------------ ---------- Net income (loss) $ 191,510 $ 1,082,675 $(17,299,002) $2,625,705 =========== =========== ============ ========== Net Income (Loss) per Common Share Basic $ 0.02 $ 0.11 $ (1.53) $ 0.28 =========== =========== ============ ========== Diluted $ -- $ 0.11 $ -- $ 0.25 =========== =========== ============ ========== Weighted Average Shares Used in the Calculation of Net Income (Loss) per Common Share Basic 11,619,090 9,580,867 11,339,653 9,542,287 =========== =========== ============ ========== Diluted N/A 10,244,385 N/A 10,620,668 =========== =========== ============ ========== See accompanying notes to financial statements 4 5 SRS LABS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) Nine Months Ended September 30, ------------------------------ 1998 1997 ------------ ----------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss) $(17,299,002) $ 2,625,705 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization 1,300,758 251,604 Deferred income taxes (335,000) -- Write-off of acquired in-process research and development 18,510,378 -- Realized gain on sales of investments available for sale (77,438) -- Amortization of premium on investments available for sale 39,464 81,903 Accretion of consideration due on asset purchase 8,196 17,882 Increase in deferred compensation 75,406 60,909 Increase (decrease) in cash resulting from changes in operating accounts, net of acquisitions: Accounts receivable 1,560,735 (2,067,923) Inventories (307,698) -- Prepaid expenses and other current assets (437,722) (125,077) Accounts payable (1,750,143) (152,936) Other accrued liabilities 695,550 (215,572) Income taxes payable (467,447) 881,124 ------------ ----------- Net cash provided by operations 1,516,037 1,357,619 CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of furniture, fixtures and equipment (166,042) (35,080) Proceeds from sales of investments available for sale 8,317,572 Purchases of investments available for sale (580,256) Cash paid for acquisitions, less cash acquired (6,911,216) -- Expenditures related to patents (576,830) (51,439) ------------ ----------- Net cash provided (used) in investing activities 663,484 (666,775) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from line of credit 8,000,000 -- Payments on subsidiary debt (6,846,737) -- Payment of consideration due on asset purchase (91,707) (140,394) Exercise of stock options 168,371 140,543 ------------ ----------- Net cash provided by financing activities 1,229,927 149 ------------ ----------- NET INCREASE IN CASH AND CASH EQUIVALENTS 3,409,448 690,993 CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 4,446,753 3,455,997 ------------ ----------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 7,856,201 $ 4,146,990 ============ =========== SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the period for: Interest $ 239,716 $ 0 Income taxes $ 640,000 $ 0 SUPPLEMENTAL DISCLOSURES ON NON-CASH TRANSACTIONS: Additional consideration accrued for asset purchase $ 8,196 $ 41,794 Unrealized gain (loss) on investments, net $ (16,336) $ 55,742 See accompanying notes to financial statements 5 6 SRS LABS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING ACTIVITY: During the nine months ended September 30, 1998, the Company issued 1,680,611 shares of common stock in payment of $12,105,778 of the acquisition price of Valence Technology, Inc. (Note 2) During the nine months ended September 30, 1998, the Company issued 125,000 shares of common stock in consideration for certain non-competition agreements with the key employees of Valence. The shares have an ascribed fair value of $900,400. (Note 2) During the nine months ended September 30, 1998, the Company issued 25,000 shares of common stock in conjunction with the acquisition of VIP. The shares have an ascribed fair value of $176,575. (Note 2) During the nine months ended September 30, 1998, the Company issued warrants to purchase 100,000 shares of common stock in conjunction with the acquisition of VIP. The warrants have an ascribed value of $341,957. (Note 2) The Company acquired the stock of Valence Technology, Inc. during the nine months ended September 30, 1998. (Note 2) In conjunction with the acquisition, certain liabilities were assumed as follows: Fair value of assets acquired $ 14,076,279 Acquired in-process research and development costs 17,471,668 Acquired intangible assets 5,910,400 ------------ Total consideration (21,879,033) ------------ Liabilities assumed $ 15,579,314 ============ During the nine months ended September 30, 1998, the Company issued 35,294 shares of common stock in conjunction with the acquisition of certain rights associated with the Circle Surround technology. The shares have an ascribed fair value of $300,000. (Note 2) See accompanying notes to financial statements 6 7 SRS LABS, INC. NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. GENERAL/BASIS OF PRESENTATION SRS Labs, Inc. (the "Company") is known as a leading provider of audio and voice enhancement technology solutions. The Company's business consists of licensing audio and voice enhancement technologies to manufacturers of consumer electronics, computer, gaming and telecommunications equipment; the design of custom ASICs (application-specific integrated circuits) for consumer electronics, game, telecommunications and personal computer manufacturers; the distribution of components, chips and assembly systems for the China and Hong Kong markets; and the manufacturing and marketing of home theater and game products for the Asian consumer marketplace. The accompanying interim consolidated financial statements have been prepared by the Company without audit (except for the balance sheet information as of December 31, 1997) in conformity with generally accepted accounting principles for interim financial information and with the rules and regulations of the U.S. Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such regulations. In the opinion of management, all adjustments (which include only normal recurring adjustments) considered necessary for a fair presentation have been included. The interim financial statements should be read in conjunction with the Company's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1997, the Current Report on Form 8-K dated March 12, 1998 and the Current Report on Form 8-K/A dated May 18, 1998. Current and future financial statements may not be directly comparable to the Company's historical financial statements. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year. 2. ACQUISITIONS On March 2, 1998, the Company acquired (the "Acquisition") all of the outstanding shares of capital stock of Valence Technology Inc., a British Virgin Islands holding company with its principal business operations in Hong Kong and China ("Valence"). Valence, which conducts its business through its subsidiaries based in Hong Kong and China, is engaged in three primary areas of business, namely, the design and sale of application-specific integrated circuits (ASICs) and other semiconductor products; the design, manufacture and sale of consumer electronics products; and the distribution of components and products within mainland China and throughout Asia. The aggregate purchase price of $19,500,000 consisted of approximately $7,400,000 in cash and 1,680,611 shares of the Company's common stock. The acquisition was accounted for as a purchase having an effective date of February 1, 1998. In connection with such acquisition, three of the four management shareholders and their respective sole shareholders, each of whom was a key employee of Valence or one of its subsidiaries, entered into non-competition agreements with the Company. In consideration for these agreements and for a nominal cash payment equal to the par value of the shares, the Company issued 125,000 additional shares of its common stock in aggregate to such three shareholders. The following summarizes the consideration granted for the acquisition of Valence and non-compete agreements, the allocation of the purchase price and other purchase accounting adjustments: Cash $ 7,394,222 Common stock 13,006,178 ----------- Total purchase price 20,400,400 Deficiency in net assets acquired 1,503,035 Acquisition costs 1,478,633 ----------- Excess of purchase price over net assets $23,382,068 =========== Allocation to: In-process research and development $17,471,668 Intangible assets 5,910,400 ----------- $23,382,068 =========== 7 8 SRS LABS, INC. NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) The resulting intangible assets are being amortized on a straight-line basis over periods ranging from three to eleven years. Unaudited proforma combined results of operations for the nine months ended September 30, 1998 would have been as follows had the Acquisition occurred on January 1, 1998: Revenues $32,338,561 Proforma Net Loss $ (328,554) Proforma Net Loss Per Share $ (0.03) Weighted Average Shares Outstanding 11,819,713 On February 28, 1998, the Company acquired certain rights to a proprietary technology, Voice Intelligibility Processor, ("VIP") from a third party. The aggregate consideration, including acquisition costs, was $1,138,710 and was comprised of $620,178 in cash, 25,000 shares of the Company's common stock with a fair value of $176,575 and warrants to purchase 100,000 shares of the Company's common stock at $9.47 per share with a fair value of $341,957. The purchase price allocated to in-process research and development was charged to the Company's operations, resulting in a charge of $1,038,710. The remainder of the purchase price was allocated to an intangible asset and is being amortized over eight years. On May 21, 1998, the Company acquired certain rights to a proprietary technology, Circle Surround, from a third party. The aggregate consideration, including acquisition costs, was $834,985 and was comprised of $534,985 in cash and 35,294 shares of the Company's common stock with a fair value of $300,000. The purchase price was allocated to an intangible asset and is being amortized over ten years. 3. INVESTMENTS AVAILABLE FOR SALE The Company has classified its investments as available-for-sale in accordance with SFAS No. 115. As of September 30, 1998, the Company's available-for-sale investments had a cost of $13,014,145 and an estimated fair value of $13,263,744, based on quoted market prices. The unrealized gains on these investments of $249,600, net of income taxes of $102,336, have been reported in the Company's Consolidated Balance Sheet as an increase in stockholders' equity. 8 9 SRS LABS, INC. NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 4. CHANGE IN ACCOUNTING PRINCIPLES Effective January 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (FAS 130). FAS 130 requires that all items recognized under accounting standards as components of comprehensive earnings be reported in an annual financial statement that is displayed with the same prominence as other annual financial statements. It also requires that an entity classify items of other comprehensive earnings by their nature in an annual financial statement. For example, other comprehensive earnings may include foreign currency translation adjustments and unrealized gains and losses on marketable securities classified as available-for-sale. Annual financial statements for prior periods will be reclassified, as required. The Company's total comprehensive income (loss) is as follows: For Three Months Ended For Nine Months Ended September 30, September 30, ---------------------- ------------------------- 1998 1997 1998 1997 --------- ---------- ------------ ---------- Net income (loss) $191,510 $1,082,675 $(17,299,002) $2,625,705 Unrealized gain (loss) on investments available for sale, net of tax 41,423 60,331 (16,336) 55,742 -------- ---------- ------------ ---------- Total comprehensive income (loss) $232,933 $1,143,006 $(17,315,338) $2,681,447 ======== ========== ============ ========== 5. NET INCOME (LOSS) PER COMMON SHARE In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128, "Earnings per Share" (FAS 128) which is effective for financial statements for both interim and annual periods ending after December 15, 1997. FAS 128 requires the Company to disclose a basic and diluted earnings per share (EPS). The Company adopted the provisions of FAS 128 in the fiscal year ended December 31, 1997. The following is an illustration of the reconciliation of the numerators and the denominators of the basic and diluted net income (loss) per common share computations: For Three Months For Three Months Ended September 30, 1998 Ended September 30, 1997 ----------------------------------- ------------------------------------ Income Shares Per Share Income Shares Per Share (Numerator) (Denominator) Amount (Numerator) (Denominator) Amount ----------- ------------- --------- ----------- ------------- --------- BASIC: Income available to common stockholders $ 191,510 11,619,090 $ 0.02 $ 1,082,675 9,580,867 $ 0.11 DILUTED: Effect of Dilutive Securities: Stock options 663,518 0.00 ---------- ---------- ------ ----------- ---------- ------ Income available to common stockholders N/A N/A N/A $ 1,082,675 10,244,385 $ 0.11 ========== ========== ====== =========== ========== ====== 9 10 SRS LABS, INC. NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) For Nine Months For Nine Months Ended September 30, 1998 Ended September 30, 1997 ------------------------------------ ------------------------------------ Income Shares Per Share Income Shares Per Share (Numerator) (Denominator) Amount (Numerator) (Denominator) Amount ------------ ------------- --------- ----------- ------------- --------- BASIC: Income (loss) available to common stockholders $(17,299,002) 11,339,653 $ (1.53) $ 2,625,705 9,542,287 $ 0.28 DILUTED: Effect of Dilutive Securities: Stock options 1,078,381 (0.03) ------------ ---------- ------- ----------- ---------- ------ Income available to common stockholders N/A N/A N/A $ 2,625,705 10,620,668 $ 0.25 ============ ========== ======= =========== ========== ====== 10 11 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW SRS Labs, Inc. (the "Company") is known as a leading provider of audio and voice enhancement technology solutions. The Company's business consists of licensing audio and voice enhancement technologies to manufacturers of consumer electronics, computer, gaming and telecommunications equipment; the design of custom ASICs (application-specific integrated circuits) for consumer electronics, game, telecommunications and personal computer manufacturers; the distribution of components, chips and assembly systems for the China and Hong Kong markets; and the manufacturing and marketing of home theater and game products for the Asian consumer marketplace. From the Company's inception in 1993 through February of 1998, the Company derived substantially all of its revenue from royalties received from technology licenses. On March 2, 1998, the Company acquired all of the outstanding capital stock of Valence Technology, Inc., a British Virgin Islands holding company with its principal business operations in Hong Kong and China ("Valence") for an aggregate purchase price, excluding non-compete agreements and acquisition costs, of $19,500,000 consisting of approximately $7,400,000 in cash and approximately 1,680,611 shares of the Company's common stock, $.001 par value per share (the "Common Stock"). The acquisition was accounted for as a purchase with an effective date of February 1, 1998. The acquisition of Valence has had, and will continue to have, a material impact on the Company's financial statements for the reporting period ending September 30, 1998 and for the reporting periods thereafter; accordingly, current and future financial statements may not be directly comparable to the Company's historical financial statements. During the first quarter of the fiscal year ending December 31, 1998 ("Fiscal 1998"), the Company acquired certain rights to Voice Intelligibility Processor ("VIP"), which is a patented voice processing technology that improves the intelligibility of the spoken voice, especially in high ambient noise environments. Aggregate consideration, including acquisition costs, was $1,138,710 and was comprised of $620,178 in cash, 25,000 shares of Common Stock and warrants to purchase 100,000 shares of Common Stock at $9.47 per share. During the second quarter of Fiscal 1998, the Company acquired certain rights to Circle Surround, which is a patented audio delivery system that allows multi-channel surround sound to be encoded into a two-channel stereo format and allows an encoded two-channel audio source or a traditional stereo audio source to be decoded into a multi-channel surround format. The aggregate purchase price, including acquisition costs, was $834,985 and was comprised of $534,985 in cash and 35,294 shares of Common Stock. RESULTS OF OPERATIONS THREE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 1997 Revenues Total revenues for the three months ended September 30, 1998 were $11,317,802 including revenues generated by Valence. This contrasts with the third quarter of 1997 when the revenues of $2,505,656 were generated entirely from the Company's licensing activities. Chip and licensing revenue of $3,935,479 increased 57.1% compared to the same period last year. Licensing revenue decreased from the same period last year primarily as a result of declining per unit royalty due to aggressive pricing from certain of the Company's competitors, the weakness in the semiconductor industry as experienced by our chip partners, the erosion of revenue in the PC market, where certain royalties paid to the company are a percentage of average selling price and the absence of technology transfer fees due to overall economic conditions. Should these conditions continue, they may result in declining licensing revenue in the future. The decrease was offset by the custom ASIC chip design and chip sales related to Valence's activities. Revenue generated from product and component sales is primarily attributable to Valence; and therefore, is not comparable to last year. 11 12 Gross Margin Gross margin for the three month period ended September 30, 1998 decreased to 31.0% from 97.2% for the same period in 1997. This decline in margin percentage results from the decrease in licensing revenues for the current quarter and the shift in the Company's revenue base towards product and electronic component sales which have significantly lower margins as compared with the Company's historic technology licensing revenue base. The decline in margin percentage is also due to competitive price reductions of the Company's electronic products, specifically VideoCD players sold primarily in China. The Company's gross margins in the future will depend on the revenue mix between product and electronic component sales and revenues from licensing and chip activities, as well as competitive pricing pressure on existing products. Sales and Marketing Sales and marketing expenses for the third quarter were $1,176,466 compared to $400,284 for the same quarter last year, an increase of 193.9% which is primarily due to sales and marketing activities attributed to Valence. Sales and marketing expenses as a percentage of total revenue for the three months ended September 30, 1998 decreased to 10.4% from 16.0% for the three months ended September 30, 1997 due to the leveraging of these expenses over a larger revenue base. Research and Development Research and development expenses for the third quarter were $577,816 compared to $116,137 for the same quarter last year, an increase of 397.5% which is primarily due to research and development activities attributed to Valence. For the three months ended September 30, 1998, Valence incurred research and development expenses aggregating $421,677. Research and development expenses as a percentage of total revenue for the three months ended September 30, 1998 increased slightly to 5.1% from 4.6% for the three months ended September 30, 1997. General and Administrative General and administrative expenses for the third quarter were $1,536,407 compared to $636,739 for the same quarter last year, an increase of 141.3% which is attributable to Valence's operations and the amortization of certain intangible assets associated with the Valence acquisition. Amortization of these intangibles total $326,497 for the three months ended September 30, 1998. General and administrative expenses as a percentage of total revenue for the three months ended September 30, 1998 decreased to 13.6% from 25.4% for the three months ended September 30, 1997, as general and administrative expenses are leveraged over a larger revenue base. Other Income/Interest Income, net Net interest and other income for the third quarter was $11,728 compared to $276,471 for the same quarter of 1997. Other income and interest income, net reflects interest earned on average cash and investment balances less interest paid on the outstanding borrowings under the Company's line of credit. The decrease is primarily due to lower average cash and investment balances as compared to the prior year and current interest expense charged on the outstanding borrowings under the Company's line of credit. Income Tax Expense Income tax expense for the third quarter was $36,986 compared to $475,131 for the same quarter last year, a decrease of 92.2%. The effective tax rate for the three months ended September 30, 1998, which is based on current estimates of the annual effective income tax rate, was 16.2% compared to 30.5% for the three months ended September 30, 1997. Lower statutory tax rates in the Asian countries where Valence has its principal business operations, and where substantially all of the earnings for the quarter arose, resulted in a lower consolidated tax rate for the Company. 12 13 NINE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 1997 Revenues Total revenues for the nine months ended September 30, 1998 were $30,000,568 including revenues generated by Valence since February 1, 1998. This contrasts with the nine month period ended September 30, 1997 when the revenues of $6,833,555 were all generated from the Company's licensing activities. Chip and licensing revenue of $11,341,907 increased 66.0% compared to the same period last year. Licensing revenue decreased from the same period last year, but the decrease was offset by the custom ASIC chip design and chip sales related to Valence's activities. Revenue from licensing has decreased over the past year due to declining per unit royalty due to aggressive pricing from certain of the Company's competitors, the weakness in the semiconductor industry as experienced by our chip partners, the erosion of revenue in the PC market, where certain royalties paid to the company are a percentage of average selling price and the absence of technology transfer fees due to overall economic conditions. Should these conditions continue, they may result in declining licensing revenue in the future. Revenue generated from product and component sales is primarily attributable to Valence; and therefore, is not comparable to last year. Gross Margin Gross margin for the nine month period ended September 30, 1998 decreased to 34.7% from 97.3% for the same period in 1997. This decrease results from the shift in the Company's revenue base towards product and electronic component sales that have significantly lower margins compared with the Company's historic technology licensing revenue base. The Company's gross margins in the future will depend on the revenue mix between product and electronic component sales and revenues from licensing and chip activities. However, the Company expects product and electronic component sales to contribute a significant portion of revenues in the near term, resulting in lower anticipated margins compared to its historical margins. Sales and Marketing Sales and marketing expenses for the first nine months of 1998 were $3,876,993 compared to $1,190,178 for the same prior year period, an increase of 225.8% which is primarily due to sales and marketing activities attributed to Valence. Sales and marketing expenses as a percentage of total revenue for the nine months ended September 30, 1998 decreased to 12.9% from 17.4% for the nine months ended September 30, 1997 due to the leveraging of these expenses over a larger revenue base. Research and Development Research and development expenses for the nine months ended September 30, 1998 were $1,576,526 compared to $414,516 for the same period last year, an increase of 280.3% which is primarily due to research and development activities attributed to Valence. For the nine months ended September 30, 1998, Valence incurred research and development expenses aggregating $1,160,903. Research and development expenses as a percentage of total revenue for the nine months ended September 30, 1998 decreased to 5.3% from 6.1% for the nine months ended September 30, 1997. General and Administrative General and administrative expenses for the first nine months of 1998 were $4,157,535 compared to $1,842,272 for the comparable prior year period, an increase of 125.7% which is attributable to Valence's operations and the amortization of certain intangible assets associated with the Valence acquisition. Amortization of these intangibles total $853,992 for the nine months ended September 30, 1998. General and administrative expenses as a percentage of total revenue for the nine months ended September 30, 1998 decreased to 13.9% from 27.0% for the nine months ended September 30, 1997, as general and administrative expenses are leveraged over a larger revenue base. 13 14 Acquired In-Process Research and Development Acquired in-process research and development costs of $18,510,378 during the nine month period ended September 30, 1998 represented an allocation of a portion of the purchase price for certain assets associated with the VIP technology and for the acquisition of the outstanding shares of Valence Technology, Inc. to in-process research and development costs, which, based on management assumptions, had no future alternative use. (See Note 2 to the Interim Consolidated Financial Statements.) Other Income/Interest Income, net Net interest and other income for the first nine months of 1998 was $394,126, a decrease from the net interest income amount of $806,712 for the same prior year period. The decrease is primarily due to lower average cash and investment balances during the fiscal year to date as compared to the prior year due to cash paid in conjunction with the acquisition of Valence and for the acquisition of new technologies. Income Tax Expense (Benefit) The income tax benefit for the nine months ended September 30, 1998 was $24,020 compared to an expense of $1,381,356 for the same period last year. Lower statutory tax rates in the Asian countries where Valence has its principal business operations contributed to a lower consolidated tax rate. LIQUIDITY AND CAPITAL RESOURCES The Company's principal source of liquidity at September 30, 1998 consisted of cash, cash equivalents and investments aggregating $21.1 million, as well as borrowings available under its credit facility. The Company's cash, cash equivalents and investments serve as collateral for borrowings under the Company's credit facility. At September 30, 1997, the Company had cash, cash equivalents and long term investments of approximately $25.7 million. The Company has primarily financed its operations through the cash provided by its operations and proceeds from its initial public offering of Common Stock in August 1996. The Company's operating activities provided $1,516,037 in cash for the nine months ended September 30, 1998 and $1,357,619 for the nine months ended September 30, 1997. The $158,418 increase in cash provided by operations was primarily due to the decrease in accounts receivable. As described above, the Company acquired Valence and additional technologies during the first nine months of Fiscal 1998. (See Note 2 to the Interim Consolidated Financial Statements.) On March 4, 1998, the Company obtained a revolving line of credit with a bank which expires on June 1, 2000 and is secured by certain of the Company's investments. The total availability under the line of credit is the lesser of $10 million or a percentage of the fair market value of the collateral. The line of credit bears interest at the bank's prime rate or LIBOR plus 0.75%. The Company had $8.0 million outstanding under the line of credit as of September 30, 1998. As a result of the acquisition of Valence, the Company provided Valence $8.0 million to pay off its short-term debt and other obligations. These funds were provided by borrowings on the above-referenced line of credit. The Company anticipates that its primary uses of working capital in future periods will be to acquire new technologies, to provide Valence with additional working capital and to fund increased costs for additional sales headcount and marketing activities associated with the introduction of new technologies and products into the market. The Company also anticipates making additional capital expenditures for the improvement of its operating system infrastructure and management reporting systems in the United States and Hong Kong. Management currently estimates these capital expenditures could aggregate $1,000,000 through 1999. Based on current plans and business conditions, the Company believes that its cash, cash equivalents, investments and/or available borrowings under its line of credit, together with any amounts generated from operations, will be sufficient to meet the Company's operating and capital requirements for the foreseeable 14 15 future. However, there can be no assurance that the Company will not be required to seek other financing sooner or that such financing, if required, will be available on terms satisfactory to the Company. Year 2000 Readiness Disclosure The Company is currently in the process of addressing a problem that is facing all users of automated information systems. The"Year 2000 issue" arises out of the fact that many of the world's computer systems currently record years in a two-digit format. Such computer systems will be unable to properly interpret dates beyond the year 1999, which could lead to business disruptions in the U.S. and internationally. The Company and its subsidiaries have identified the following areas, which could be impacted by the Year 2000 issue. They are: Company products; internally used systems and software; products or services provided by key third parties; and the inability of chip partners or licensees to process business transactions relating to licensing revenue. During Fiscal 1998, the Company and its subsidiaries began a review of its internal systems including those which support manufacturing process control and financial and general business operations. The review consisted of an evaluation of significant internal hardware systems and major software application programs for their ability to accurately recognize and process dates properly in the Year 2000 and beyond. As a result of this evaluation, the Company has identified certain systems which require upgrades to be Year 2000 ready, including certain business software applications. The Company is in the process of replacing, converting or eliminating systems which it has determined are not Year 2000 compliant. The Company anticipates that it will complete its review of its internal systems and expects that all necessary upgrades to ensure Year 2000 compliance will be completed by the second quarter of 1999. In addition, the Company and its subsidiaries are in the process of assessing the compliance of their major customers, suppliers and vendors. Management believes that third-party relationships upon which the Company relies represent the greatest risk with respect to the Year 2000 issue, because the Company cannot guarantee that third parties will be able to adequately assess and address their Year 2000 compliance issues in a timely manner. As a consequence, the Company can give no assurances that issues related to Year 2000 would not have a material adverse effect on future results of operations or financial condition. Total costs relating to the Company's compliance efforts, based on management's best estimates, could range as high as $1,000,000. The Company is expensing as incurred, all costs related to the assessment of Year 2000 compliance issues. Equipment purchases required for Year 2000 compliance will be capitalized and charged to expense over the useful lives of those assets in accordance with the Company's existing policy. These cost estimates are based on currently available information and may be subject to change. While the Company continues to focus on solutions for Year 2000 issues and expects its internal operations to be Year 2000 compliant in a timely manner, the difficulty in determining whether third-parties have resolved their Year 2000 issues necessitates the need for the development of a contingency plan. Such a plan will set forth the Company's responses should the Company or third parties which are materially significant to the Company fail to achieve Year 2000 compliance in a timely manner. The Company expects to finalize its contingency plan by mid-year 1999. The information set forth above under this caption "Year 2000 Readiness Disclosure" relates to the Company's efforts to address the Year 2000 concerns regarding the Company's (a) operations; (b) products and technologies licensed or sold to third parties and (c) major suppliers and customers. Such statements are intended as Year 2000 Statements and Year 2000 Readiness Disclosures and are subject to the Year 2000 Information Readiness Act." 15 16 FORWARD-LOOKING STATEMENTS AND FACTORS WHICH MAY AFFECT FUTURE RESULTS Included in this Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations are a number of forward-looking statements that are subject to certain risks and uncertainties that could cause the Company's actual results and financial position to be affected negatively as events unfold in the markets for the Company's products. These events include, but are not limited to, the risks involved in the expansion of the Company's business through acquisitions of new companies like Valence or new technologies like VIP and Circle Surround, as well as the risks discussed below. The Company assumes no obligation to update the forward-looking information in this Report or the factors listed below to reflect actual results or changes in the factors affecting such forward-looking information. Quarterly Fluctuations The Company's operating results may fluctuate from those in prior quarters and will continue to be subject to quarterly and other fluctuations due to a variety of factors, including the extent to which the Company's licensees incorporate SRS or the Company's other technologies into their products, the gain or loss of significant customers, competitive pressures on selling prices, the acceptance of new or enhanced versions of the Company's technologies, the rate that the Company's semiconductor licensees manufacture and distribute chips to original equipment manufacturers ("OEMs"), the ability of the Company to secure one-time license fees for its technologies from new and existing licensees and general business conditions, particularly those affecting the consumer electronics market. Due to the Company's dependence on the consumer electronics market, the substantial seasonality of sales in the market could impact the Company's revenues and net income. In particular, the Company believes that there is seasonality relating to the Christmas season as well as the Chinese New Year within the Asia-Pacific region which fall into the fourth and first quarters, respectively. Changes to the Business Model/Integration of Valence/Refinement of Asian Strategy From the Company's inception in 1993 to 1997, the Company derived substantially all of its revenues from licensing activities. As a result of the acquisition of Valence, the Company has added business operations engaged in the design and sale of ASICs and other semiconductor products; the design, manufacture and sale of consumer electronics products; and the distribution of components and products within mainland China and throughout Asia. These operations differ substantially from the Company's previous business model, and future operating results could be affected by a variety of factors, including the timing of customer orders, the timing of development revenue, changes in the mix of products distributed and the mix of distribution channels employed, the emergence of new industry standards, product obsolescence and changes in pricing policies by the Company, its competitors or its suppliers. The Company's future success will depend in large part on its ability to successfully create business synergies upon integrating the operations of Valence with those of the Company. The degree to which the Company can successfully derive synergistic value will depend on a number of factors, including the Company's ability to expand the scope of its operations beyond technology licensing into the new business of manufacturing electronic and semiconductor products and the Company's ability to increase its market penetration in China. The integration of certain operations following the acquisition has required and will continue to require the dedication of management and other personnel resources which may temporarily distract from the day-to-day business of the combined company. The geographic separation of these operations is likely to place additional strain on the Company's resources. In addition, the Company's significant operations in China and Asia have required refinement to adapt to the changing market conditions in that region. This refinement may impact certain of the Company's current business directions, including Valence, as the Company attempts to position itself to maximize penetration of selected growth segments in that region. The Company's operations in Asia, and internationally in general, also are subject to risks of unexpected changes in, or impositions of, legislative or regulatory requirements. The acquisition of Valence has added significant diversity to the Company's overall business structure and the Company's opportunities. The Company recognizes that in the presence of such corporate diversity, and in particular with regard to the semiconductor industry, there will always exist a potential for a conflict among sales channels between the Company and certain of the Company's technology licensees. Although the operations of the Company's licensing business and those of Valence are generally complementary, there can be no assurances 16 17 that sales channel conflicts will not arise. If such potential conflicts do materialize, the Company may or may not be able to mitigate the effect of such perceived conflicts which, if not resolved, may impact the results of operations. Currency Risk/Stability of Asian Markets The Company expects that international sales will continue to represent a significant portion of total revenues. To date, all of the Company's revenues have been denominated in U.S. dollars and most costs have been incurred in U.S. dollars. It is the Company's expectation that licensing revenues will continue to be denominated in U.S. dollars for the foreseeable future. With its acquisition of Valence and the Company's anticipated expansion of its business in China and other parts of Asia, the Company's consolidated operations and financial results could be significantly affected by risks associated with international activities, including economic and labor conditions, political instability, tax laws (including U.S. taxes on foreign subsidiaries) and changes in the value of the U.S. dollar versus the local currency in which the products are sold. In addition, the Company's valuation of assets recorded as a result of the Valence acquisition may also be adversely impacted by the currency fluctuations relative to the U.S. dollar. The Company intends to actively monitor its foreign exchange exposure and to implement strategies to reduce its foreign exchange risk at such time that the Company determines the benefits of such strategies outweigh the associated costs. However, there is no guarantee that the Company will take steps to insure against such risks, and should such risks occur, there is no guarantee that the Company will not be significantly impacted. Countries in the Asia Pacific region have recently experienced weakness in their currency, banking and equity markets. These weaknesses could adversely affect consumer demand for Valence's products, the U.S. dollar value of the Company's and its subsidiaries' foreign currency denominated sales, the availability and supply of product components to Valence and ultimately, the Company's consolidated results of operations. Competitive Pressures The Company's existing and potential competitors include both large and emerging domestic and international companies that have substantially greater financial, manufacturing, technical, marketing, distribution and other resources. Competitors of the Company may also include a number of smaller companies that may have greater flexibility to address specific market needs. In addition, the markets in which the Company competes are intensely competitive and are characterized by rapid technological changes, declining average sales prices and rapid product obsolescence. Importance of Intellectual Property The Company's ability to compete may be affected by its ability to protect its proprietary information. The Company has filed several U.S. and foreign patent applications and to date has a number of issued U.S. and foreign patents covering various aspects of its technologies. There can be no assurance that the steps taken by the Company to protect its intellectual property will be adequate to prevent misappropriation of its technology or that the Company's competitors will not independently develop technologies that are substantially equivalent or superior to the Company's technology. In addition, the laws of certain foreign countries may not protect the Company's intellectual property rights to the same extent as do the laws of the U.S. The semiconductor industry is characterized by frequent claims and litigation regarding patent and other property rights. The Company is not currently a party to any claims of this nature. There can be no assurances that third parties will not assert additional claims or initiate litigation against the Company or its customers with respect to existing or future products. In addition, the Company may initiate claims or litigation against third parties for infringement of the Company's proprietary rights or to determine the scope and validity of the proprietary rights of the Company or others. Management of Growth; Dependence on Key Personnel The Company has recently experienced rapid growth and expansion with the acquisition of Valence. This acquisition has placed, and will continue to place, a significant strain on its administrative, operational and financial resources, and has increased, and will continue to increase, the level of responsibility for both existing and new management personnel. The Company's future success depends in part on the continued service of its 17 18 key engineering, sales, marketing and executive personnel, including highly skilled semiconductor design personnel. The Company anticipates that any future growth will require it to recruit and hire a number of new personnel in engineering, operations, finance, sales and marketing. Competition for such personnel is intense, and there can be no assurance that the Company can retain and recruit necessary personnel to operate its business and support future growth. The Company's ability to manage its growth successfully also will require the Company to continue to expand and improve its administrative, operational, management and financial systems and controls. Volatility of Stock Price The trading price of the Common Stock has been, and will likely continue to be, subject to wide fluctuations in response to quarterly variations in the Company's operating results, announcements of new products or technological innovations by the Company or its competitors, general market fluctuations and other events and factors. Changes in earnings estimates made by brokerage firms and industry analysts relating to the markets in which the Company does business, or relating to the Company specifically, have in the past resulted in, and could in the future result in, an immediate and adverse effect on the market price of the Common Stock. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Not Applicable. 18 19 PART II - OTHER INFORMATION ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS USE OF PROCEEDS The effective date of the Company's initial public offering of its Common Stock was August 8, 1996 (SEC Registration No. 333-4974-LA). Since the Company's last periodic report filed pursuant to Section 13(a) of the Securities Exchange Act of 1934, as amended (i.e., its Quarterly Report on Form 10-Q for the Quarterly Period Ended June 30, 1998), there has been no change in the Company's use of its aggregate net offering proceeds of $22,052,955. As noted in such prior Report, the Company utilized an aggregate of $8,394,222 in connection with three acquisitions (see Note 2 to the Interim Consolidated Financial Statements herein) with the remaining funds being temporarily invested in cash and municipal bonds pending application. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. (a) Exhibits. The exhibits listed below are hereby filed with the U.S. Securities and Exchange Commission (the "Commission") as part of this Report. Exhibit No. Description ------- ----------- 10.1 Employment Agreement, dated July 1, 1998 by and between the Company and John AuYeung. 27 Financial Data Schedule. (b) Reports on Form 8-K No reports on Form 8-K were filed with the Commission during the three month period ended September 30, 1998. 19 20 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SRS LABS, INC., a Delaware Corporation Date: November 13, 1998 By: /s/ JANET M. BISKI --------------------------------------- Janet M. Biski Vice President, Chief Financial Officer and Secretary (Principal Financial and Accounting Officer) 20 21 EXHIBIT INDEX Exhibit No. Description ------- ----------- 10.1 Employment Agreement dated July 1, 1998 by and between the Company and John AuYeung 27 Financial Data Schedule