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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
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(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2001
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)
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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)
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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, 2001,
12,760,894 of the issuer's common stock, par value $.001 per share, were
outstanding. In addition, as of October 31, 2001, 124,400 shares of the issuer's
common stock were held as treasury shares.
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SRS LABS, INC.
Form 10-Q
For the Quarterly Period Ended September 30, 2001
Index
Page
----
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements........................................................... 4
Condensed Consolidated Balance Sheets as of September 30, 2001 (Unaudited) and
December 31, 2000................................................................... 4
Condensed Consolidated Statements of Operations for the three months
and nine months ended September 30, 2001 and 2000 (Unaudited)....................... 5
Condensed Consolidated Statements of Comprehensive Loss for the three
months and nine months ended September 30, 2001 and 2000 (Unaudited)................ 5
Condensed Consolidated Statements of Cash Flows for the nine months ended
September 30, 2001 and 2000 (Unaudited)............................................. 6
Notes to the Condensed 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..................... 21
PART II - OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K............................................... 22
SIGNATURES................................................................................ 23
2
FORWARD-LOOKING INFORMATION
This Quarterly Report on Form 10-Q contains forward-looking statements within
the meaning of Section 21E of the Securities Exchange Act of 1934, as amended,
and Section 27A of the Securities Act of 1933, as amended, reflecting
management's current expectations. Examples of such forward-looking statements
include the expectations of the Company with respect to its strategy. Although
the Company believes that its expectations are based upon reasonable
assumptions, there can be no assurances that the Company's financial goals will
be realized. Such forward-looking statements involve known and unknown risks,
uncertainties and other factors that may cause the actual results, performance
or achievements of the Company, or industry results, to be materially different
from any future results, performance or achievements expressed or implied by
such forward-looking statements. Numerous factors may affect the Company's
actual results and may cause results to differ materially from those expressed
in forward-looking statements made by or on behalf of the Company. For this
purpose, any statements contained herein that are not statements of historical
fact may be deemed to be forward-looking statements. Without limiting the
foregoing, the words, "believes," "anticipates," "plans," "expects" and similar
expressions are intended to identify forward-looking statements. The important
factors discussed in Part I, Item 2, Management's Discussion and Analysis of
Financial Condition and Results of Operations - Factors That May Affect Future
Results", herein, among others, could cause actual results to differ materially
from those indicated by forward-looking statements made herein and presented
elsewhere by management. Such forward-looking statements represent management's
current expectations and are inherently uncertain. Investors are warned that
actual results may differ from management's expectations. The Company assumes no
obligation to update the forward-looking information to reflect actual results
or changes in the factors affecting such forward-looking information.
3
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
SRS LABS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
September 30, December 31,
2001 2000
------------ ------------
(unaudited)
CURRENT ASSETS
Cash and cash equivalents ................................ $ 16,655,746 $ 24,128,480
Investments available for sale ........................... 3,073,754 5,713,881
Accounts receivable, net ................................. 1,446,926 787,908
Inventories, net ......................................... 1,945,694 3,068,478
Prepaid expenses and other current assets ................ 774,528 847,953
Deferred income taxes .................................... 38,116 38,116
------------ ------------
TOTAL CURRENT ASSETS ................................ 23,934,764 34,584,816
Investments available for sale ............................. -- 582,849
Furniture, fixtures & equipment, net ....................... 1,673,559 1,808,624
Intangible assets, net ..................................... 2,655,222 3,692,218
Deferred income taxes ...................................... 900,839 900,839
------------ ------------
TOTAL ASSETS ........................................ $ 29,164,384 $ 41,569,346
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Accounts payable ......................................... $ 1,024,387 $ 1,603,401
Accrued liabilities ...................................... 1,660,281 1,974,357
Line of credit ........................................... -- 8,000,000
Income taxes payable ..................................... 1,093,099 1,093,107
------------ ------------
TOTAL CURRENT LIABILITIES ........................... 3,777,767 12,670,865
MINORITY INTEREST ............................................ 439,308 595,428
COMMITMENTS AND CONTINGENCIES
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; 12,760,894 and
12,652,844 shares issued; and 12,636,494 and
12,581,744 shares outstanding at September 30, 2001 and
December 31, 2000, respectively ......................... 12,761 12,653
Additional paid-in capital ............................... 55,172,334 55,060,403
Deferred stock option compensation ....................... 448,986 376,052
Cumulative other comprehensive loss ...................... (70,544) (64,950)
Accumulated deficit ...................................... (30,165,545) (26,817,824)
Less treasury stock at cost, 124,400 shares at
September 30, 2001 and 71,100 shares
at December 31, 2000 ................................... (450,683) (263,281)
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TOTAL STOCKHOLDERS' EQUITY .......................... 24,947,309 28,303,053
------------ ------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY .......... $ 29,164,384 $ 41,569,346
============ ============
See accompanying notes to the condensed interim consolidated financial
statements
4
SRS LABS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------------- ----------------------------
2001 2000 2001 2000
------------ ------------ ------------ ------------
REVENUES
Chip and licensing revenue ....................... $ 2,878,251 $ 3,871,803 $ 8,252,052 $ 9,611,135
Product and component sales ...................... 670,878 4,136,104 4,472,333 12,180,530
------------ ------------ ------------ ------------
TOTAL REVENUES ................................ 3,549,129 8,007,907 12,724,385 21,791,665
COST OF SALES .................................... 1,274,288 4,616,384 5,910,643 13,732,550
------------ ------------ ------------ ------------
GROSS MARGIN ..................................... 2,274,841 3,391,523 6,813,742 8,059,115
EXPENSES
Sales and marketing .............................. 935,189 1,913,199 3,480,605 4,620,676
Research and development ......................... 872,998 1,087,849 2,647,976 3,011,946
General and administrative ....................... 1,418,192 1,722,389 4,549,058 7,336,349
Non-cash stock issuance cost ..................... -- -- -- 3,111,859
------------ ------------ ------------ ------------
TOTAL EXPENSES ................................ 3,226,379 4,723,437 10,677,639 18,080,830
------------ ------------ ------------ ------------
LOSS FROM OPERATIONS .......................... (951,538) (1,331,914) (3,863,897) (10,021,715)
OTHER INCOME, NET ................................ 186,300 332,152 665,350 850,128
MINORITY INTEREST ................................ 39,241 -- 156,879 --
------------ ------------ ------------ ------------
LOSS BEFORE INCOME TAX EXPENSE .................. (725,997) (999,762) (3,041,668) (9,171,587)
INCOME TAX EXPENSE ............................... 76,302 222,189 306,053 498,773
------------ ------------ ------------ ------------
NET LOSS ......................................... $ (802,299) $ (1,221,951) $ (3,347,721) $ (9,670,360)
============ ============ ============ ============
Net loss per common share
Basic and diluted ............................. $ (0.06) $ (0.10) $ (0.27) $ (0.79)
============ ============ ============ ============
Weighted average shares used in the
calculation of net loss per common share
Basic and diluted ............................. 12,672,707 12,540,336 12,627,393 12,313,491
============ ============ ============ ============
SRS LABS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(Unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------------- ----------------------------
2001 2000 2001 2000
------------ ------------ ------------ ------------
Net loss ......................................... $ (802,299) $ (1,221,951) $ (3,347,721) $ (9,670,360)
Other comprehensive income (loss)
Foreign currency translation ................. -- (82,489) -- (81,219)
Unrealized loss on investments
available for sale, net of tax ............. (8,277) (52) (5,594) (12,116)
------------ ------------ ------------ ------------
Comprehensive loss ............................... $ (810,576) $ (1,304,492) $ (3,353,315) $ (9,763,695)
============ ============ ============ ============
See accompanying notes to the condensed interim consolidated financial
statements
5
SRS LABS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Nine Months Ended
September 30,
----------------------------
2001 2000
------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss ....................................................... $ (3,347,721) $ (9,670,360)
Adjustments to reconcile net loss to net cash used
in operating activities:
Non-cash stock issuance cost .............................. -- 3,111,859
Depreciation and amortization ............................. 1,605,050 1,875,715
Minority interest ......................................... (156,879) --
Other ..................................................... 7,186 (20,512)
Amortization of premium on investments available for sale.. 13,494 --
Increase in deferred stock option compensation ............ 72,934 88,059
Changes in operating assets and liabilities:
Accounts receivable ................................... (677,946) 552,613
Inventories ........................................... 1,140,342 27,734
Prepaid expenses and other current assets ............. 73,425 349,694
Accounts payable ...................................... (579,014) (508,675)
Accrued liabilities ................................... (314,076) 369,230
Income taxes payable .................................. 3,879 146,250
------------ ------------
Net cash used in operating activities ..................... (2,159,326) (3,678,393)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of furniture, fixtures and equipment .................. (359,039) (488,338)
Proceeds from sale of investments available for sale ........... 3,200,000 3,000,000
Expenditures related to patents and intangible assets .......... (73,949) (1,320,000)
------------ ------------
Net cash provided by (used in) investing activities ....... 2,767,012 1,191,662
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from sale of Common Stock ............................. -- 5,000,291
Purchase of treasury stock ..................................... (187,402) --
Obligation to issue Preferred Stock in Subsidiary .............. 5,000,000
Principal payment on line of credit ............................ (8,000,000) --
Proceeds from exercise of stock options ........................ 106,982 1,408,063
------------ ------------
Net cash (used in) provided by financing activities ....... (8,080,420) 11,408,354
------------ ------------
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS ........... (7,472,734) 8,921,623
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD ................. 24,128,480 15,969,678
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CASH AND CASH EQUIVALENTS, END OF PERIOD ....................... $ 16,655,746 $ 24,891,301
============ ============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the period for:
Interest .................................................. $ 151,667 $ 435,056
Income taxes .............................................. $ 300,575 $ 177,191
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND
FINANCING ACTIVITIES:
Unrealized gain (loss) on investments, net ................. $ (5,594) $ (12,116)
See accompanying notes to the condensed interim consolidated financial
statements
6
SRS LABS, INC.
NOTES TO THE CONDENSED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. General/Basis of Presentation
SRS Labs, Inc. ("SRS Labs") is a developer and provider of technology
solutions for the consumer electronics, home theater, computer, game, broadcast,
Internet and telecommunications markets. SRS Labs' principal business activities
in these markets include:
. Developing and licensing audio and voice technologies to original
equipment manufacturers ("OEMs") and semiconductor manufacturers around
the world;
. Through its majority-owned subsidiary, SRSWOWcast.com, Inc., now
conducting business under the name SRSWOWcast Technologies
("SRSWOWcast"), developing and licensing software and hardware audio
enhancement technology solutions dedicated to the broadcast and
Internet markets; and
. Through its wholly-owned subsidiary, ValenceTech Limited and its
foreign subsidiaries (collectively "Valence"), designing and selling
technology solutions through custom application specific integrated
circuits ("ASICs") to OEMs; and designing, distributing and
manufacturing components, sub-assemblies and electronics products for
the OEM and retail communities within the Company's targeted markets.
SRS Labs and its majority-owned and wholly-owned subsidiaries together are
hereby collectively referred to as the "Company".
The Company has prepared the accompanying condensed interim consolidated
financial statements without audit in conformity with accounting principles
generally accepted in the United States of America "(generally accepted
accounting principles)" for interim financial information and with the rules and
regulations of the U.S. Securities and Exchange Commission ("SEC"). In the
opinion of management, all adjustments (which include only normal recurring
adjustments) considered necessary for a fair presentation have been included.
Certain accounts as previously reported have been reclassified to conform to the
current period presentation.
Certain information and footnote disclosures normally included in financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted pursuant to SEC rules and regulations for
presentation of interim financial information. Therefore, the condensed interim
consolidated financial statements should be read in conjunction with the
Company's Annual Report on Form 10-K for the fiscal year ended December 31,
2000. 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. Investments Available for Sale
The Company has classified its investments as available-for-sale in
accordance with Statement of Financial Accounting Standards ("SFAS") No. 115
"Accounting for Certain Investments in Debt and Equity Securities". As of
September 30, 2001, the Company's available-for-sale investments had a cost of
$3,047,481 and an estimated fair value of $3,073,754, based on quoted market
prices. The unrealized gains on these investments of $26,273 net of income taxes
of $10,772 are reported as a separate component of stockholders' equity.
3. Inventories
Inventories, which consist of finished goods, are stated at the lower of cost
or net realizable value. Cost is calculated using the weighted average method
and is comprised of material costs and, where applicable, subcontracting and
overhead costs that have been incurred in bringing the inventories to their
present location and condition. Net realizable value represents the estimated
selling price less estimated costs to completion and costs to be incurred in
selling and distribution.
7
SRS LABS, INC.
NOTES TO THE CONDENSED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
4. Minority Interest in Consolidated Subsidiary
Minority interest in consolidated subsidiary represents the minority
stockholders' proportionate share of the equity of SRSWOWcast. At September 30,
2001, the Company owned approximately 87% of the outstanding capital stock of
SRSWOWcast.
5. Net Loss Per Common Share
The Company computes earnings per share ("EPS") in accordance with SFAS No.
128, "Earnings per Share". SFAS No. 128 requires the Company to disclose basic
and diluted earnings per share. The Company's basic EPS is computed by dividing
net loss for the period by the weighted average number of outstanding common
shares for that period. Diluted EPS amounts are the same as basic EPS for all
periods presented as the effect of including common share equivalents have not
been included as their inclusion would have been anti-dilutive.
6. Contingencies
The Company is subject to legal proceedings and claims that arise in the
normal course of business. While the outcome of these proceedings and claims
cannot be predicted with certainty, management does not believe that the outcome
of any of these matters will have a material adverse effect on the Company's
consolidated financial position or results of operations.
7. Stockholders' Equity
During Fiscal 1998, the Company's Board of Directors authorized the
repurchase of up to 500,000 of the outstanding shares of the Company's common
stock for a period from December 23, 1998 to December 31, 1999 (the "1998
Repurchase Program"). Under the 1998 Repurchase Program, 71,100 shares had been
repurchased at a cost of $263,281. On September 17, 2001, the Company's Board of
Directors authorized the repurchase of up to 250,000 of the outstanding shares
of the Company's common stock for a period from September 17, 2001 to March 17,
2002 (the "2001 Repurchase Program"). As of September 30, 2001, 53,300 shares
had been repurchased at a cost of $187,402 under the 2001 Repurchase Program.
All repurchased shares under both the 1998 Repurchase Program and the 2001
Repurchase Program are reflected as treasury stock in the accompanying
consolidated balance sheets.
In March 2000, the Company entered into a technology and marketing alliance
with Microsoft Corporation ("Microsoft"). In conjunction with this transaction,
Microsoft purchased 290,529 shares of the Company's common stock for $17.21 per
share or approximately $5,000,000 in the aggregate. The difference between the
purchase price received and the fair value of the common stock on the date of
purchase, totaling approximately $555,000, was recorded as non-cash stock
issuance cost by the Company during the quarter ended March 31, 2000. Also in
connection with this transaction, Microsoft has a three year warrant to purchase
100,000 shares of common stock of the Company and a three year warrant to
purchase up to 2,500,000 shares of common stock of the Company's majority-owned
subsidiary, SRSWOWcast. The fair value of these warrants, aggregating
approximately $2,555,000, was recorded as non-cash stock issuance cost by the
Company during the quarter ended March 31, 2000.
During the fiscal year ended December 31, 2000, the Company's majority-owned
subsidiary SRSWOWcast and certain investors, which included shareholders,
directors and an executive officer of the Company, entered into a Series A
Preferred Stock and Warrant Purchase Agreement (the "Private Placement
Agreement") relating to the purchase and sale of 3,000,000 shares of SRSWOWcast
Series A Convertible Preferred Stock ("Preferred Stock") for a purchase price of
$2.00 per share or $6,000,000 in the aggregate (the "Private Placement").
Pursuant to the Private Placement Agreement, investors received an immediately
exercisable, three year warrant evidencing a right to purchase one-tenth of a
share of SRSWOWcast's common stock for each share of Preferred Stock purchased
by such investor, exercisable at $2.50 per whole share. The fair value of the
warrants was zero at the date of issuance. In accordance with Staff Accounting
Bulletin ("SAB") No. 51 issued by the SEC, "Accounting for Sales of Stock by
8
SRS LABS, INC.
NOTES TO THE CONDENSED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
a Subsidiary" the Company recorded approximately $5,155,000 of additional
paid-in capital associated with the Private Placement.
8. Segment Information
The Company operates in three business segments: (i) the development and
marketing of technology either in the form of ASICs through Valence or the
licensing of technologies developed by the Company to original equipment
manufacturers and semiconductor manufacturers; (ii) the sale of consumer
electronic products and components; and (iii) the SRSWOWcast broadcast and
Internet-based business. The Company does not allocate corporate operating
expenses or specific assets to these segments. Therefore, segment information
includes only net revenues, cost of sales and gross margin for those segments.
The Company's broadcast and Internet-based business generated insignificant
revenues and incurred net losses of $300,849 and $1,180,466 for the three month
and nine month periods ended September 30, 2001. These losses were composed
primarily of sales and marketing expenses and general and administrative
expenses associated with the development and training of a direct sales force
and the introduction of the Company's technology solutions to new markets.
Three Months Ended September 30, 2001
------------------------------------------------
Chips and Product and
Licensing Component Sales Total
-------------- ----------------- ------------
Net revenues.......... $2,878,251 $ 670,878 $3,549,129
Cost of sales......... 561,155 713,133 1,274,288
---------- ---------- ----------
Gross margin.......... $2,317,096 $ (42,255) $2,274,841
========== ========== ==========
Three Months Ended September 30, 2000
------------------------------------------------
Chips and Product and
Licensing Component Sales Total
-------------- ----------------- ------------
Net revenues.......... $3,871,803 $4,136,104 $8,007,907
Cost of sales......... 1,178,066 3,438,318 4,616,384
---------- ---------- ----------
Gross margin.......... $2,693,737 $ 697,786 $3,391,523
========== ========== ==========
Nine Months Ended September 30, 2001
------------------------------------------------
Chips and Product and
Licensing Component Sales Total
-------------- ----------------- ------------
Net revenues.......... $8,252,052 $4,472,333 $12,724,385
Cost of sales......... 1,563,953 4,346,690 5,910,643
---------- ---------- -----------
Gross margin.......... $6,688,099 $ 125,643 $ 6,813,742
========== ========== ==========
Nine Months Ended September 30, 2000
------------------------------------------------
Chips and Product and
Licensing Component Sales Total
-------------- ----------------- ------------
Net revenues.......... $9,611,135 $12,180,530 $ 21,791,665
Cost of sales......... 2,961,730 10,770,820 13,732,550
---------- ----------- ------------
Gross margin.......... $6,649,405 $ 1,409,710 $ 8,059,115
========== =========== ============
9. Recent Accounting Pronouncements
On January 1, 2001, the Company adopted SFAS No. 133, "Accounting for
Derivative Instruments and Hedging Activities" as amended by SFAS No. 138,
"Accounting for Certain Derivative Instruments and Certain Hedging Activities -
an amendment of FASB Statement No. 133" which requires derivatives to be
reported as assets or liabilities in the balance sheet at fair value. The
amendment included expanding the normal purchase and sale exemption for supply
contracts, permitting the offsetting of certain intercompany foreign currency
derivatives and thus reducing the number of third party derivatives, permitting
hedge accounting for foreign-currency denominated assets and liabilities and
redefining interest rate risk to reduce sources of ineffectiveness. The adoption
of SFAS No. 133, as amended by SFAS No. 138, did not have a material impact on
the Company's consolidated results of operations, financial position or cash
flows.
9
SRS LABS, INC.
NOTES TO THE CONDENSED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
In December 1999, the SEC staff issued SAB No. 101, "Revenue Recognition in
Financial Statements". SAB No. 101 summarizes the SEC staff's views in applying
generally accepted accounting principles to revenue recognition in financial
statements. The implementation of SAB No. 101 in the fourth quarter of 2000 did
not have a material effect on the Company's consolidated results of operations,
financial position or cash flows.
In July 2001, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 141 "Business Combinations", which, among other things, will require that
the purchase method of accounting be used for all business combinations
initiated after June 30, 2001, will no longer permit the use of the
pooling-of-interests method of accounting for business combinations and broadens
the criteria for recording intangible assets separate from goodwill. The
adoption of SFAS No. 141 during the third quarter of 2001 did not have a
material impact on the Company's consolidated results of operations, financial
position or cash flows.
In July 2001, FASB issued SFAS No. 142 "Goodwill and Other Intangible
Assets", which, among other things, establishes new standards for goodwill
acquired in a business combination, eliminates the amortization of goodwill and
requires the carrying value of goodwill and identifiable intangibles to be
evaluated for impairment on an annual basis. Identifiable intangible assets with
a determinable useful life will continue to be amortized over that period. SFAS
No. 142 is effective for fiscal years beginning after December 15, 2001.
Management does not believe the adoption of SFAS No. 142 will have a material
impact on the Company's consolidated results of operations, financial position
or cash flows.
10
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
This information should be read in conjunction with the unaudited condensed
interim consolidated financial statements and the notes thereto included in this
Quarterly Report, and the audited consolidated financial statements and notes
thereto and Management's Discussion and Analysis of Financial Condition and
Results of Operations contained in the Company's Annual Report on Form 10-K for
the year ended December 31, 2000.
Overview
SRS Labs, Inc. ("SRS Labs") is a developer and provider of audio and voice
technology solutions for the consumer electronics, home theater, computer, game,
broadcast, Internet and telecommunications markets. SRS Labs' principal business
activities in these markets include:
. Developing and licensing audio and voice technologies to original equipment
manufacturers ("OEMs") and semiconductor manufacturers around the world;
. Through its majority-owned subsidiary, SRSWOWcast.com, Inc., now conducting
business under the name SRSWOWcast Technologies ("SRSWOWcast"), developing
and licensing software and hardware audio enhancement technology solutions
dedicated to the broadcast and Internet markets; and
. Through its wholly-owned subsidiary, ValenceTech Limited and its foreign
subsidiaries (collectively "Valence"), designing and selling technology
solutions through custom application specific integrated circuits ("ASICs")
to OEMs; and designing, distributing and manufacturing components,
sub-assemblies and finished goods for targeted markets within selected OEM
and retail communities.
SRS Labs and its majority-owned and wholly-owned subsidiaries together are
hereby collectively referred to as the "Company".
The Company was formed in 1993 by purchasing all rights and assets of various
audio and speaker technologies from the Hughes Aircraft Company. The Company
successfully completed its initial public offering in August 1996, raising
approximately $22 million. From the Company's inception in 1993 until February
1998, the Company derived substantially all of its revenues from audio
technology licensing activities for the consumer electronics, computer and game
markets. The primary technologies that contributed to revenue were SRS(R) (Sound
Retrieval System(R)) ("SRS"), which produces a 3D sound-enhanced stereo image
from any mono or stereo source, and TruSurround(TM), a "virtual" audio
technology which processes multi-channel surround sound through any standard
pair of stereo speakers.
On March 2, 1998, the Company acquired 100% of the outstanding stock of
Valence Technology Inc., a British Virgin Islands holding company with its
principal business operations in Hong Kong and the Peoples Republic of China
(the "PRC"). This acquisition significantly expanded the Company's business
activities from the original licensing model to include the design, manufacture
and marketing of chips, components and products.
In addition to the acquisition of Valence Technology, Inc. during the fiscal
year ended December 31, 1998 ("Fiscal 1998"), the Company acquired two
additional technologies. In the first quarter of Fiscal 1998, the Company
acquired certain rights to Voice Intelligibility Processor ("VIP"), a patented
voice processing technology that improves the intelligibility of the spoken
voice, especially in high ambient noise environments and, in the following
quarter, acquired certain rights to Circle Surround, 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 to be decoded into
a multi-channel surround format.
During the fiscal year ended December 31, 1999 ("Fiscal 1999"), the Company
re-engineered its business model and operational structure. Valence Technology,
Inc., while continuing to expand its ASICs business, exited certain of the lower
margin distribution product lines and directed more of its resources to develop
and market solutions that integrate the SRS technologies. With respect to its
licensing business, the Company expanded its focus from entering into technology
licenses with PC chip manufacturers to developing a new business model which
included developing consumer products incorporating SRS Labs' patented
technology portfolio as well as applications relating to the Internet. This new
focus resulted in the Company launching the WOWThing product family and
11
establishing a new wholly-owned subsidiary, SRSWOWcast, to be the platform to
launch this business. In March 2000, Microsoft Corporation ("Microsoft") and the
Company entered into a strategic alliance whereby Microsoft and the Company
entered into a License Agreement relating to the Company's WOW Technology. The
License Agreement has facilitated the incorporation of the WOW Technology into
the Windows 2000 Media Player and a click-through hyper-link on the interface of
the Windows Media Player to the SRSWOWcast website. In addition, Microsoft made
an equity investment into the Company and was granted a warrant to purchase
additional shares of the Company's common stock as well as a warrant to purchase
shares of common stock in SRSWOWcast.
During the fiscal year ended December 31, 2000, SRSWOWcast and certain
investors, which included shareholders, directors and an executive officer of
the Company, entered into a Series A Preferred Stock and Warrant Purchase
Agreement (the "Private Placement Agreement") relating to the purchase and sale
of 3,000,000 shares of SRSWOWcast Series A Convertible Preferred Stock
("Preferred Stock") for a purchase price of $2.00 per share or $6,000,000 in the
aggregate (the "Private Placement"). Pursuant to the Private Placement
Agreement, investors received an immediately exercisable, three year warrant
evidencing a right to purchase one-tenth of a share of SRSWOWcast's common stock
for each share of Preferred Stock purchased by such investor, exercisable at
$2.50 per whole share. The fair value of the warrants was zero at the date of
issuance. In accordance with Staff Accounting Bulletin ("SAB") No. 51 issued by
the U.S. Securities and Exchange Commission ("SEC"), "Accounting for Sales of
Stock by a Subsidiary" the Company recorded $5,154,995 of additional paid-in
capital associated with the Private Placement.
Recently, the Company refined its Internet strategy to focus on the sale and
licensing of hardware and software products incorporating the Company's audio
and voice enhancement technology solutions to the broadcast and Internet
markets. Applications for these technology solutions include Internet streaming
media, Internet radio, encoded material on demand, live event broadcasts as well
as traditional television and cable broadcasting. To implement this strategy,
the Company has established a direct sales force to market the technology
solutions to web portals, entertainment companies, encoding companies, service
providers and broadcasting companies. Consistent with the corporate licensing
trademark policy, the Company will actively promote the use of its trademarks
and logos and will direct its customers to display the appropriate SRS
technology logo.
The Company currently operates in three business segments: (a) the
development and marketing of technology in the form of integrated circuits,
distributed through Valence and the licensing of technologies developed by the
Company to OEMs and semiconductor manufacturers, (b) the sale of consumer
electronic products and components and (c) the SRSWOWcast broadcast and
Internet-based business. A summary of the Company's operations and activities by
business segment is included in the accompanying notes to the condensed interim
consolidated financial statements.
Results of Operations
Three Months Ended September 30, 2001 Compared To Three Months Ended September
30, 2000
Revenues
Chip and licensing revenue consists of design fees and sales of custom ASICs
by Valence to OEMs, sales of general purpose integrated circuits ("IC"s)
designed by the Company under the brand name ASP Microelectronics as well as
license royalties generated primarily from the license of the Company's audio
and voice technologies. License and royalty agreements generally provide for the
license of technologies for a specified period of time for either a single fee
or a fee based on the number of units distributed by the licensee. Product and
component sales primarily represent (a) the manufacture and sale of Valence's
own branded product line of amplifiers, and game products, (b) the manufacture
and sale of SRS Labs' products incorporating one or more of the Companies
licensed audio technologies and (c) the distribution of semiconductor products,
manufacturing components and sub-assemblies to OEMs for the Hong Kong and the
PRC markets.
Total revenues for the three months ended September 30, 2001 were $3,549,129
consisting of chip and licensing revenue of $2,878,251 and product and component
revenue of $670,878. This contrasts with the three months ended September 30,
2000, where total revenues were $8,007,907 consisting of chip and licensing
revenue of $3,871,803 and product and component revenues of $4,136,104. Total
revenues decreased by $4,458,778 or 55.7% for the three
12
months ended September 30, 2001 compared to the same period in 2000. Chip and
licensing revenue decreased by $993,552 or 25.7% for the three months ended
September 30, 2001 compared to the same period in 2000, with revenue from custom
ASIC chip design and chip sales related to Valence's activities decreasing by
48.3% which was partially offset by an increase in licensing revenue of 58.2%.
The decrease in ASIC chip design and chip sales was primarily due to recent
global weakness in the semiconductor industry. The increase in licensing
revenues during the quarter was the result of new licensing contracts signed
since the first half of 2000. Product and component revenues decreased by
$3,465,226 or 83.8% from the same prior year period which was due both to recent
global weakness in the semiconductor industry and the Company's decision to
focus on higher margin chip and licensing revenues and de-emphasize certain
lower margin distribution activities. Revenues generated by the Company's
broadcast and Internet-based business were not significant during the three
months ended September 30, 2001.
Gross Margin
Cost of sales consists primarily of fabrication costs, assembly and test
costs, and the cost of materials and overhead from operations. For the three
months ended September 30, 2001, the gross margin percentage increased to 64.1%,
compared to 42.4% for the same period in the prior year. The increase in margin
percentage is attributable to a significant reduction in lower margin product
and component revenues and an increase in licensing revenue, the most profitable
component of the Company's revenues.
Sales and Marketing
Sales and marketing expenses consist primarily of employee salaries and sales
consultants' fees and related expenses, sales commissions, advertising, and
product promotion costs. Sales and marketing expenses were $935,189 for the
three months ended September 30, 2001 compared to $1,913,199 for the same prior
year period, a decrease of $978,010, or 51.1%. The decrease is due primarily to
reductions in spending at Valence associated with revenue declines related to
the recent global weakness in the semiconductor industry and spending and
headcount reductions at SRSWOWcast related to the change in Internet strategy
from a content development model to focus on licensing of audio and voice
technology solutions.
Research and Development
Research and development expenses consist of salaries and related costs of
employees engaged in ongoing research, design and development activities and
costs for engineering materials and supplies. Research and development expenses
were $872,998 for the three months ended September 30, 2001 compared to
$1,087,849 for the same prior year period, a decrease of $214,851, or 19.8%.
Research and development costs as a percentage of total revenues increased from
13.6% of revenues for the quarter ended September 30, 2000 to 24.6% of revenues
for the same period this year. Research and development expenses may increase in
the future as a result of ongoing product development efforts.
General and Administrative
General and administrative expenses consist primarily of employee-related
expenses, professional fees and patent and intangible asset amortization costs.
General and administrative expenses were $1,418,192 for the quarter ended
September 30, 2001 compared to $1,722,389 for the same prior year period, for a
decrease of $304,197 or 17.7%. The decrease is due primarily to salary and
headcount reductions across all business segments plus a general reduction in
overall general and administrative expenses due to the recent global weakness in
the semiconductor industry and the reduced infrastructure at SRSWOWcast related
to the change in business strategy. General and administrative expenses as a
percentage of total revenues increased from 21.5% of revenues for the quarter
ended September 30, 2000, to 40.0% for the same period this year.
Other Income, Net
Other income, net consists primarily of interest income, interest expense and
foreign currency translation gains and losses. Other income, net was $186,300
for the three months ended September 30, 2001 compared to $332,152
13
for the same prior year period, a decrease of 43.9%. The decrease is primarily
due to lower interest income, net of interest expense that is attributable to
lower average cash and investment balances being invested at lower average
interest rates during the current year quarter. Other income, net may decline in
the future as interest rates continue to decrease and cash and investment
balances decline as they are used to fund operations or used in financing
activities.
Minority Interest
Minority interest represents the minority shareholders' proportionate share
of losses in SRSWOWcast. Losses in SRSWOWcast are expected to continue as a
result of expenditures exceeding revenues in an effort to support the expansion
and growth of SRSWOWcast business operations. Should losses continue in
SRSWOWcast, the minority interest adjustment in the consolidated statement of
operations will continue to reduce the Company's net losses by the minority
shareholders' proportionate share of SRSWOWcast's net losses to the extent of
their investment.
Provision for Income Taxes
The income tax expense for the three months ended September 30, 2001 was
$76,302 compared to $222,189 for the same prior year period. The decrease is
primarily due to a significant reduction in taxable income at Valence for the
three months ended September 30, 2001 compared to the same period in the prior
year.
Nine Months Ended September 30, 2001 Compared to Nine Months Ended September 30,
2000
Revenues
Total revenues for the nine months ended September 30, 2001 were $12,724,385
consisting of chip and licensing revenue of $8,252,052 and product and component
revenue of $4,472,333. This contrasts with the nine months ended September 30,
2000, where total revenues were $21,791,665 consisting of chip and licensing
revenue of $9,611,135 and product and component revenues of $12,180,530. Total
revenues decreased by $9,067,280, or 41.6% for the nine months ended September
30, 2001 compared to the same period in 2000. Chip and licensing revenue
decreased by $1,359,083 or 14.1% for the nine months ended September 30, 2001,
with revenue from custom ASIC chip design and chip sales related to Valence's
activities decreasing by 46.4% which was partially offset by an increase in
licensing revenue of 120.4% compared to the same period in 2000. The decrease in
ASIC chip design and chip sales was primarily due to recent global weakness in
the semiconductor industry. The increase in licensing revenues during the nine
months ended September 30, 2001 was the result of new licensing contracts signed
since the first half of 2000. Product and component revenues decreased by
$7,708,197 or 63.3% from the same prior year period which was due both to recent
global weakness in the semiconductor industry and the Company's decision to
focus on higher margin chip and licensing revenues and de-emphasize certain
lower margin distribution activities. Revenues generated by the Company's
broadcast and Internet-based business were not significant during the nine
months ended September 30, 2001.
Gross Margin
For the nine months ended September 30, 2001, the gross margin percentage
increased to 53.6%, compared to 37.0% for the same period in the prior year. The
increase in margin percentage is attributable to a shift in the revenue mix
during the period from lower margin product and component revenues to a higher
percentage of revenues in the higher margin chip and licensing category from the
same prior year period.
Sales and Marketing
Sales and marketing expenses were $3,480,605 for the nine months ended
September 30, 2001, compared to $4,620,676 for the same period in the prior
year, a decrease of $1,140,071 or 24.7%. The decrease is due primarily to
reductions in spending during the second and third quarters of 2001, both at
Valence which resulted from the recent global weakness in the semiconductor
industry and at SRSWOWcast where significant early stage development and
promotion costs were incurred during the second and third quarters of 2000 for
the creation of the SRSWOWcast website and creation of program content for the
website.
14
Research and Development
Research and development costs were $2,647,976 for the nine months ended
September 30, 2001, compared to $3,011,946 for the same period in the prior
year, a decrease of $363,970, or 12.1%. Research and development costs as a
percentage of total revenues increased from 13.8% of revenues for the nine
months ended September 30, 2000 to 20.8% of revenues for the same period this
year. Research and development costs may increase in the future as a result of
ongoing product development efforts.
General and Administrative
General and administrative costs were $4,549,058 for the nine months ended
September 30, 2001, compared to $7,336,349 for the same period in the prior
year, a decrease of $2,787,291, or 38.0%. The decrease is due primarily to a
reduction in significant one time costs being incurred in the nine months ended
September 30, 2000 (totaling approximately $2,177,000) including costs
associated with the resignation of an employee of Valence, the accelerated
amortization of intangible assets deemed to relate to outdated technologies and
costs associated with a postponed IPO involving Valence (see discussion below
under IPO Related Expenses) plus a general reduction in overall general and
administrative expenses due to headcount reductions. As a percentage of total
revenues, general and administrative expenses increased from 33.7% of revenues
for the nine month period ended September 30, 2000, to 35.8% of revenues for the
same period this year.
IPO Related Expenses
On March 3, 2000, the Company filed an application to list the common shares
of Valence on the Growth Enterprise Market of the Hong Kong Stock Exchange (the
"GEM"), in order to sell a minority interest in Valence to the public. The
initial public offering (the "GEM Offering") was targeted for completion in the
second quarter of 2000. However, the Company decided not to proceed with the GEM
Offering based upon the weaker than expected response by institutional investors
and market conditions in Hong Kong. GEM Offering costs incurred by the Company,
comprised primarily of legal, accounting and underwriting fees, totaled
$1,142,175 as of June 30, 2000. These costs are included in general and
administrative expense in the accompanying financial statements.
Non-cash Stock Issuance Costs
In March 2000, the Company entered into a technology and marketing alliance
with Microsoft Corporation. In conjunction with this transaction, Microsoft
purchased shares of common stock of the Company and was granted a warrant to
purchase additional shares of common stock of the Company and a warrant to
purchase shares of common stock of SRSWOWcast. As a result of the transaction,
the Company recognized one-time, non-cash charges totaling $3,111,859 (see Note
7 of the Notes to the Condensed Interim Consolidated Financial Statements for
more information concerning the Microsoft transaction).
Other Income, Net
Other income, net was $665,350 for the nine months ended September 30, 2001,
compared to $850,128 for the same period in the prior year, a decrease of
$184,778 or 21.7%. The decrease is due primarily to lower interest income, net
of interest expense that is attributable to lower average cash and investment
balances being invested at lower average interest rates during the current year
period. Other income, net may decline in the future as interest rates continue
to decrease and cash and investment balances decline as they are used to fund
operations or used in financing activities.
Minority Interest
Minority interest represents the minority shareholders' proportionate share
of losses in SRSWOWcast. Losses in SRSWOWcast are expected to continue as a
result of expenditures exceeding revenues in an effort to support the expansion
and growth of SRSWOWcast business operations. Should losses continue in
SRSWOWcast, the minority interest adjustment in the consolidated statement of
operations will continue to reduce the Company's net losses by the minority
shareholders' proportionate share of SRSWOWcast's net losses to the extent of
their investment.
15
Provision for Income Taxes
The income tax expense for the nine months ended September 30, 2001 was
$306,053 compared to $498,773 for the same period in the prior year. The
decrease is primarily attributable to lower results in the nine months ended
September 30, 2001 at Valence resulting in reduced tax expense for the quarter
when compared to the same prior year period.
New Accounting Pronouncements
On January 1, 2001, the Company adopted Statement of Financial Accounting
Standard ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging
Activities" as amended by SFAS No. 138, "Accounting for Certain Derivative
Instruments and Certain Hedging Activities - an amendment of FASB Statement No.
133" which requires derivatives to be reported as assets or liabilities in the
balance sheet at fair value. The amendment included expanding the normal
purchase and sale exemption for supply contracts, permitting the offsetting of
certain intercompany foreign currency derivatives and thus reducing the number
of third party derivatives, permitting hedge accounting for foreign-currency
denominated assets and liabilities and redefining interest rate risk to reduce
sources of ineffectiveness. The adoption of SFAS No. 133, as amended by SFAS No.
138, did not have a material impact on the Company's consolidated results of
operations, financial position or cash flows.
In December 1999, the SEC staff issued SAB No. 101, "Revenue Recognition in
Financial Statements". SAB No. 101 summarizes the SEC staff's views in applying
generally accepted accounting principles to revenue recognition in financial
statements. The implementation of SAB No. 101 in the fourth quarter of 2000 did
not have a material effect on the Company's consolidated results of operations,
financial position or cash flows.
In July 2001, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 141 "Business Combinations", which, among other things, will require that
the purchase method of accounting be used for all business combinations
initiated after June 30, 2001, will no longer permit the use of the
pooling-of-interests method of accounting for business combinations and broadens
the criteria for recording intangible assets separate from goodwill. The
adoption of SFAS No. 141 during the third quarter of 2001 did not have a
material impact on the Company's consolidated results of operations, financial
position or cash flows.
In July 2001, FASB issued SFAS No. 142 "Goodwill and Other Intangible
Assets", which, among other things, establishes new standards for goodwill
acquired in a business combination, eliminates the amortization of goodwill and
requires the carrying value of goodwill and identifiable intangibles to be
evaluated for impairment on an annual basis. Identifiable intangible assets with
a determinable useful life will continue to be amortized over that period. SFAS
No. 142 is effective for fiscal years beginning after December 15, 2001.
Management does not believe the adoption of SFAS No. 142 will have a material
impact on the Company's consolidated results of operations, financial position
or cash flows.
Liquidity and Capital Resources
The Company's principal source of liquidity at September 30, 2001 consisted
of cash, cash equivalents and investments aggregating $19,729,500. At December
31, 2000, the Company had cash, cash equivalents and investments of $30,425,210.
During the nine months ended September 30, 2001 the Company used $8,000,000 to
repay its line of credit. Since April 2, 2001 the Company no longer has any
external bank debt outstanding. In March 2000, the Company sold shares of its
common stock to Microsoft Corporation, for aggregate cash proceeds of $5,000,000
(see Note 7 to the Condensed Interim Consolidated Financial Statements). In
November 2000, the Company's wholly-owned subsidiary, SRSWOWcast sold to
investors 3,000,000 shares of its Series A Convertible Preferred Stock for an
aggregate amount of $6,000,000 and granted warrants to purchase shares of
SRSWOWcast common stock to such investors at an exercise price of $2.50 per
share (the "SRSWOWcast Investment"). All remaining proceeds from the SRSWOWcast
Investment will be used exclusively by SRSWOWcast (see Note 7 to the Condensed
Interim Consolidated Financial Statements).
The Company's operating activities utilized $2,159,326 in cash for the nine
months ended September 30, 2001, and $3,678,393 for the nine months ended
September 30, 2000. The use of cash in operations was primarily due to the
Company's loss from operations for the period, after adjustment for non-cash
charges related to depreciation and
16
amortization. The net decrease in cash and cash equivalents of $7,472,734 for
the period is primarily attributable to the repayment of the line of credit
during the period.
In March 1998, the Company obtained a revolving line of credit (and letter of
credit facility) with a bank which was secured by certain of the Company's cash,
cash equivalents and investments. This line of credit expired on April 1, 2001
and was fully repaid on April 2, 2001. The total availability under the line of
credit was the lesser of $10,000,000 or a percentage of the fair market value of
the collateral. Interest on the line of credit was at the bank's prime rate or
LIBOR plus 0.75%. On April 1, 2001, the Company entered into a new revolving
line of credit with the same bank on substantially the same terms and conditions
as the previous revolving line of credit except the total availability under the
new line of credit was reduced to the lesser of $5,000,000 or a percentage of
the fair market value of the collateral. The collateral requirements under the
above-referenced credit facility may have the effect of restricting the amounts
of cash available to pay dividends. At September 30, 2001, the Company had no
borrowings outstanding under the new revolving line of credit and on October 11,
2001 the Company terminated the new revolving line of credit (and letter of
credit facility) with the bank.
In November 1999, Valence obtained a credit facility with a bank that
provided for borrowings aggregating approximately $5,000,000. In January 2001,
the credit facility was renegotiated to reduce the amount available to borrow
under the new credit facility and to provide for a variety of import/export
trade instruments up to $2,000,000 at interest rates ranging from 1% over the
Hong Kong Dollar prime rate to 1.75% over LIBOR. The new facility is
collateralized by certain of Valence's assets on deposit with the bank. At
September 30, 2001, Valence had no borrowings outstanding and no letters of
credit outstanding under this credit facility. The new facility expired on
October 31, 2001 and is currently being renegotiated.
The Company anticipates that its primary uses of working capital in future
periods will be to acquire new technologies and to fund increased costs for
additional sales and engineering headcount and marketing activities associated
with the introduction of new technologies and products into the market. The
Company also expects to fund increased costs associated with the ongoing
expansion and promotion of its SRSWOWcast operations.
Based on current plans and business conditions, the Company expects that its
cash, cash equivalents and/or investments, together with any amounts generated
from operations, will be sufficient to meet the Company's cash requirements for
the next 12 months. However, there can be no assurance that the Company will not
be required to seek other financing sooner or that such financing, if required,
will be available on terms satisfactory to the Company.
Factors That May Affect Future Results
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 the Company's technologies into their products; the timing of orders
from and the shipments to major customers; the timing of new product
introductions by the Company; the gain or loss of significant customers;
competitive pressures on selling prices; the market acceptance of new or
enhanced versions of the Company's technologies; the rate that the Company's
semiconductor licensees manufacture and distribute chips to product
manufacturers; results of operations of SRSWOWcast; and fluctuations in general
economic 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 that market has impacted the Company's
revenues and net income. In particular, the Company believes that there is
seasonality relating to the Christmas season, generally, and the Chinese New
Year within the Asia region, which fall into the fourth and first quarters,
respectively. As a result, the Company believes that period-to-period
comparisons of its results of operations are not necessarily meaningful and
should not be relied upon as indications of future performance.
Valence's Business
The Company derives a significant amount of its revenue from Valence's ASIC
and component distribution business. Valence's engineering team focuses on the
design of custom ASICs to meet specific customers'
17
requirements and outsources the production of the design to mask houses,
foundries and packaging houses located primarily in Asia. The operations of
Valence could be affected by a variety of factors, including global demand
within the semiconductor market, 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.
Valence's ASIC business is concentrated in a limited number of customers in
the areas of consumer electronics, communications products, computers and
computer peripherals. As such, the loss of any such customers or any bad debt
arising from them may have a material adverse impact on the Company's financial
condition and results of operation. Beginning in Fiscal 1999, Valence began to
exit from certain lower margin product offerings in the distribution side of the
business and has begun developing and distributing products that are related to
or incorporate the Company's proprietary technologies. As a result, the
immediate loss in revenue of the low margin distribution business will not be
entirely offset by the new proprietary technology based products, which will
take time to develop and be introduced into the marketplace. There can be no
assurance that the Company will be able to quickly introduce new products to
offset the loss in revenue or that the new products developed will receive a
favorable market acceptance.
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 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.
Internet Business
In Fiscal 1999, the Company launched its Internet business with the formation
of SRSWOWcast. In Fiscal 2000, SRSWOWcast commenced operations with a business
plan which focused on developing and acquiring audio based content to attract
visitor traffic to its website in order to sell advertising and e-commerce
products. In 2001, the Company changed its Internet strategy to focus on the
sale and licensing of hardware and software products incorporating the Company's
audio and voice enhancement technology solutions to the broadcast and Internet
markets. There can be no assurance that this new business model will develop a
sufficient customer base to be able to generate meaningful revenue.
Product Business
In Fiscal 1999, the Company developed and marketed on its e-commerce site,
www.wowthing.com, its first consumer audio product, the WOWThing Processor Box.
The WOWThing Processor Box enhances the sound quality of music downloaded over
the Internet as well as audio performance of computer and home entertainment
products and speakers. This was the Company's first entry into the consumer
market in the United States which is both competitive and demands products with
short life cycles.
The Company intends to expand its offerings of high-end audio enhancement
products in 2001 and in future years. There can be no assurance that the Company
will be able to develop an effective distribution channel and build brand
recognition as a product manufacturer. As the business increases, it is
anticipated that significant capital will be required to finance product
inventory and accounts receivable. As a result, the Company is subject to risks
of product obsolescence, bad debt and insufficient financial resources to grow
the business.
The Company also recognizes that as new consumer audio products are developed
and marketed by the Company, there will always exist a potential for a conflict
and competition between the Company and certain of the Company's technology
licensees. Although the intended products of the Company and those of its
licenses do not generally overlap, there can be no assurance that the Company's
products will not compete with those of their licensees. If such conflicts do
materialize, it is uncertain whether the Company will be able to mitigate the
effect of such conflicts, which if not resolved, may impact the results of
operations.
18
Economic Risks Associated with Doing Business in Asia, Particularly in Hong
Kong and the PRC
The Company's significant operations in the PRC and Asia have required, and
will continue to require, refinement to adapt to the changing market conditions
in the region. The Company's operations in Asia, and internationally in general,
are subject to risks of unexpected changes in, or impositions of legislative or
regulatory requirements.
The PRC economy has experienced significant growth in the past decade, but
such growth has been uneven across geographic and economic sectors and has
recently been slowing. There can be no assurance that such growth will not
continue to decrease or that any slow down will not have a negative effect on
the Company's business, including Valence. The PRC economy has also experienced
deflation in the past which may continue in the future. The current economic
situation may adversely affect the Company's profitability over time as
expenditures for consumer electronics products and information technology may
decrease due to the results of slowing domestic demand and deflation.
Hong Kong is a Special Administrative Region of the PRC with its own
government and legislature. Hong Kong enjoys a high degree of autonomy from the
PRC under the principle of "one country, two systems". The Company can give no
assurance that Hong Kong will continue to enjoy autonomy from the PRC.
The Hong Kong dollar has remained relative constant due to the U.S. dollar
peg and currency board system that has been in effect in Hong Kong since 1983.
Since mid-1997, interest rates in Hong Kong have fluctuated significantly and
real estate and retail sales have declined. The Company can give no assurance
that the Hong Kong economy will not worsen or that the historical currency peg
of the Hong Kong dollar to the U.S. dollar will be maintained. Continued
recession in Hong Kong, deflation or the discontinuation of the currency peg
could adversely affect the Company's business.
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 licensing
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. Because
Valence and its subsidiaries' business is primarily focused in Asia and because
of the Company's anticipated expansion of its business in the PRC 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 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. The Company's present or future competitors may be able to develop
products and technologies comparable or superior to those offered by the
Company, and to adapt more quickly than the Company to new technologies or
evolving market needs. The Company believes that the competitive factors
affecting the market for the Company's products and technologies include product
performance, price and quality; product functionality and features; the ease of
integration; and implementation of the products and technologies with other
hardware and
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software components in the OEM's products. 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. Accordingly, there can be no assurance that the Company will be
able to continue to compete effectively in its respective markets, that
competition will not intensify or that future competition will not have a
material adverse effect on the Company's business, operating results, cash flows
and financial condition.
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 continued growth of the Company and its subsidiaries 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 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, strategic alliances between the
Company and third parties, general market fluctuations and other events and
factors. Changes in earnings estimates made by brokerage firms and industry
analysts relating to the markets in which 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.
Acquisitions
From time to time, the Company expects to make acquisitions of businesses or
technologies that are complementary to its business strategy. Such future
acquisitions would expose the Company to risks commonly encountered in
acquisitions of businesses. Such risks include, among others, difficulty of
assimilating the operations, information systems and personnel of the acquired
businesses, the potential disruption of the Company's ongoing business; and the
inability of management to maximize the financial and strategic position of the
Company through successful incorporation of the acquired technologies, employees
and customers. There can be no assurance that any potential acquisition will be
consummated or, if consummated, that it will not have a material adverse effect
on the Company's business, financial condition and results of operations.
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Acquired In-Process Research and Development
Uncertainties that could impede the progress of converting a development
project to a developed technology include the availability of financial
resources to complete the project, failure of the technology to function
properly, continued economic feasibility of developed technologies, customer
acceptance, customer demand and customer qualification of such new technology
and general competitive conditions in the industry. There can be no assurance
that the acquired in-process research and development projects associated with
the acquisitions of Valence and VIP will be successfully completed and
commercially introduced.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The Company is exposed to a variety of risks, including foreign currency
fluctuations and changes in interest rates affecting investment returns and the
cost of its debt.
Foreign Currency
The Company has subsidiary operations in Hong Kong and accordingly, the
Company is exposed to translation gains and losses that could result from
changes in foreign currency exchange rates. The Company uses the local currency
(Hong Kong dollars) as the functional currency for its Asian subsidiaries.
Translation adjustments resulting from the process of translating foreign
currency financial statements into U.S. dollars were not significant in Fiscal
1999 and for the nine months ended September 30, 2001, due to the fact that the
value of the Hong Kong dollar is currently pegged to the U.S. dollar, and the
exchange rate remained constant throughout such periods. Under the current
circumstances, the Company believes that the foreign currency market risk is not
material. The Company actively monitors its foreign exchange exposure and,
should circumstances change, intends to implement strategies to reduce its risk
at such time that it determines that the benefits of such strategies outweigh
the associated costs. There can be no assurance that management's efforts to
reduce foreign exchange exposure will be successful.
Interest Rates
The Company's exposure to market risk for changes in interest rates, relates
primarily to our invested balances of cash, cash equivalents and investments.
The Company's investment policy specifies excess funds are to be invested in a
manner that preserves capital, provides liquidity and generates the highest
available after-tax return. To limit exposure to market risk, the Company places
its cash in banks, cash equivalents in high quality, short-term commercial paper
and investments consist of short-term municipal bonds. The Company does not
invest in any derivative instruments. The fair value of the Company's cash, cash
equivalents and investments or related income would not be significantly
impacted by either a 100 basis point increase or decrease in interest rates as
most investments are at fixed rates and are relatively short term. All cash,
cash equivalents and investments are carried at market value, which approximates
cost.
Valence's credit facilities bore interest at rates ranging from 1% over the
Hong Kong Dollar prime rate to 1.75% over LIBOR.
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PART II - OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits. None.
(b) Reports on Form 8-K. No reports on Form 8-K were filed with the
Commission during the quarter for which this report is filed.
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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.
SRS LABS, INC.,
a Delaware corporation
Date: November 9, 2001 By: /s/ DARRELL E. BAKER
---------------------------------------
Darrell E. Baker
Vice President - Finance,
Secretary and acting Treasurer,
(Authorized Signatory,
Principal Financial Officer and
Principal Accounting Officer)
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