-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, EsJbNLJHECnelRfSiXQSpyt1Z6z2jHL6OccU32QYhqzihB95AAFdSqow7Ev2DMER YhXD9PL7h6SKUNZILdoHsA== 0000892569-99-002248.txt : 19990817 0000892569-99-002248.hdr.sgml : 19990817 ACCESSION NUMBER: 0000892569-99-002248 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19990630 FILED AS OF DATE: 19990816 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SRS LABS INC CENTRAL INDEX KEY: 0001016470 STANDARD INDUSTRIAL CLASSIFICATION: PATENT OWNERS & LESSORS [6794] IRS NUMBER: 330714264 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-21123 FILM NUMBER: 99690290 BUSINESS ADDRESS: STREET 1: 2909 DAIMIER ST CITY: SANTA ANA STATE: CA ZIP: 92705 BUSINESS PHONE: 9494421070 MAIL ADDRESS: STREET 1: 2909 DAIMLER ST CITY: SANTA ANA STATE: CA ZIP: 92705 10-Q 1 FORM 10-Q 1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q -------------- (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 1999 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. [X] Yes [ ] 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 July 30, 1999, 11,701,575 shares of the issuer's common stock, par value $.001 per share, were outstanding, including 12,000 shares of the issuer's common stock designated as treasury stock. ================================================================================ 2 SRS LABS, INC. FORM 10-Q FOR THE PERIOD ENDED JUNE 30, 1999 INDEX
Page ---- PART I - FINANCIAL INFORMATION Item 1. Financial Statements. Consolidated Balance Sheets as of June 30, 1999 (Unaudited) and December 31, 1998 3 Consolidated Statements of Operations for the three months and six months ended June 30, 1999 and 1998 (Unaudited) 4 Consolidated Statements of Comprehensive Income (Loss) for the three months and six months ended June 30, 1999 and 1998 (Unaudited) 5 Consolidated Statements of Cash Flows for the six months ended June 30, 1999 and 1998 (Unaudited) 6 Notes to the Interim Consolidated Financial Statements (Unaudited) 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. 12 Item 3. Quantitative and Qualitative Disclosures About Market Risk. 21 PART II - OTHER INFORMATION Item 1. Legal Proceedings. 22 Item 2. Changes in Securities and Use of Proceeds. 22 Item 4. Submission of Matters to a Vote of Security Holders. 23 Item 6. Exhibits and Reports on Form 8-K. 23 SIGNATURES 24
3 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS. SRS LABS, INC. CONSOLIDATED BALANCE SHEETS
June 30, December 31, 1999 1998 ------------ ------------ (Unaudited) ASSETS CURRENT ASSETS Cash and cash equivalents $ 7,531,747 $ 12,341,242 Investments available for sale 3,020,370 1,519,425 Accounts receivable, net 4,790,235 5,320,686 Inventories, net 4,647,174 4,632,968 Prepaid expenses and other current assets 1,175,158 3,244,233 Deferred income taxes 17,456 17,456 ------------ ------------ TOTAL CURRENT ASSETS 21,182,140 27,076,010 Investments available for sale 8,920,851 10,570,192 Furniture, fixtures & equipment, net 883,183 1,219,433 Intangible assets, net 6,220,284 6,669,671 ------------ ------------ TOTAL ASSETS $ 37,206,458 $ 45,535,306 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES Accounts payable $ 2,903,584 $ 10,632,505 Accrued liabilities 1,378,016 422,843 Line of credit 8,000,000 8,000,000 Income taxes payable 274,012 376,545 ------------ ------------ TOTAL CURRENT LIABILITIES 12,555,612 19,431,893 Deferred income taxes 31,240 31,240 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; 11,699,700 (at June 30, 1999) and 11,688,893 (at December 31, 1998) shares issued and outstanding 11,700 11,689 Additional paid-in capital 39,212,283 39,170,103 Deferred stock option compensation 433,109 313,302 Cumulative other comprehensive income 70,559 141,389 Retained deficit (15,055,545) (13,564,310) Less treasury stock at cost, 12,000 (at June 30, 1999) and zero (at December 31, 1998) shares (52,500) -- ------------ ------------ TOTAL STOCKHOLDERS' EQUITY 24,619,606 26,072,173 ------------ ------------ TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 37,206,458 $ 45,535,306 ============ ============
See accompanying notes to consolidated financial statements 3 4 SRS LABS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
Three Months Ended Six Months Ended June 30, June 30, -------------------------------- --------------------------------- 1999 1998 1999 1998 ------------ ------------ ------------ ------------ REVENUES Chip and licensing revenue 3,989,938 $ 4,524,467 $ 8,094,005 $ 7,406,428 Product and component sales 4,214,009 7,100,903 7,826,783 11,276,338 ------------ ------------ ------------ ------------ TOTAL REVENUES 8,203,947 11,625,370 15,920,788 18,682,766 COST OF SALES 4,902,778 7,387,523 10,178,420 11,785,939 ------------ ------------ ------------ ------------ GROSS MARGIN 3,301,169 4,237,847 5,742,368 6,896,827 Sales and marketing 1,101,937 1,511,633 2,673,936 2,700,527 Research and development 789,343 599,631 1,429,361 998,710 General and administrative 1,409,831 1,368,305 3,549,376 2,621,128 Acquired in-process research and development -- -- -- 18,510,378 ------------ ------------ ------------ ------------ INCOME (LOSS) FROM OPERATIONS 58 758,278 (1,910,305) (17,933,916) OTHER INCOME, NET 102,056 184,906 205,403 382,398 INCOME (LOSS) BEFORE INCOME TAX BENEFIT 102,114 943,184 (1,704,902) (17,551,518) INCOME TAX EXPENSE (BENEFIT) 96,239 222,762 (213,667) (61,006) ------------ ------------ ------------ ------------ NET INCOME (LOSS) $ 5,875 $ 720,422 $ (1,491,235) $(17,490,512) ============ ============ ============ ============ NET INCOME (LOSS) PER COMMON SHARE Basic $ 0.00 $ 0.06 $ (0.13) $ (1.56) ============ ============ ============ ============ Diluted $ 0.00 $ 0.06 $ (0.13) $ (1.56) ============ ============ ============ ============ WEIGHTED AVERAGE SHARES USED IN THE CALCULATION OF NET INCOME (LOSS) PER COMMON SHARE Basic 11,686,237 11,545,318 11,686,090 11,199,935 ============ ============ ============ ============ Diluted 12,022,691 12,572,615 11,686,090 11,199,935 ============ ============ ============ ============
See accompanying notes to consolidated financial statements 4 5 SRS LABS, INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (UNAUDITED)
Three Months Ended Six Months Ended June 30, June 30, --------------------------------- --------------------------------- 1999 1998 1999 1998 ------------ ------------ ------------ ------------ Net income (loss) $ 5,875 $ 720,422 $ (1,491,235) $(17,490,512) Other comprehensive loss Unrealized loss on investments available for sale, net of tax (62,914) (17,343) (70,830) (57,759) ------------ ------------ ------------ ------------ Comprehensive income (loss) $ (57,039) $ 703,079 $ (1,562,065) $(17,548,271) ============ ============ ============ ============
See accompanying notes to consolidated financial statements 5 6 SRS LABS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Six Months Ended June 30, --------------------------------- 1999 1998 ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net loss $ (1,491,235) $(17,490,512) Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Depreciation and amortization 1,011,670 805,683 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 -- (76,277) Amortization of premium on investments available for sale 28,344 32,521 Accretion of consideration due on asset purchase -- 8,196 Increase in deferred stock option compensation 119,807 51,754 Changes in operating assets and liabilities, net of the effect of acquisitions: Accounts receivable 230,451 1,213,908 Inventories (14,206) (988) Prepaid expenses and other current assets 2,239,670 (1,595,057) Accounts payable (7,728,921) (836,693) Accrued liabilities 1,012,523 692,735 Income taxes payable (53,312) (477,042) ------------ ------------ Net cash provided by (used in) operations (4,645,209) 503,606 CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of furniture, fixtures and equipment (105,756) (95,292) Proceeds from sales of investments available for sale -- 7,467,572 Cash paid for acquisitions, less cash acquired -- (6,911,216) Expenditures related to patents (48,221) (534,985) ------------ ------------ Net cash used in investing activities (153,977) (73,921) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from line of credit -- 7,000,000 Payments on subsidiary debt -- (6,846,737) Payment of consideration due on asset purchase -- (91,707) Repurchase of stock (52,500) -- Exercise of stock options 42,191 166,971 ------------ ------------ Net cash provided by (used in) financing activities (10,309) 228,527 ------------ ------------ NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (4,809,495) 658,212 CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 12,341,242 4,446,753 ------------ ------------ CASH AND CASH EQUIVALENTS, END OF PERIOD $ 7,531,747 $ 5,104,965 ============ ============ SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the period for: Interest $ 234,378 $ 109,896 Income taxes $ -- $ 640,000
See accompanying notes to consolidated financial statements 6 7 SRS LABS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:
Six Months Ended June 30, --------------------------------- 1999 1998 ------------ ------------ Additional consideration accrued for asset purchase $ -- $ 8,196 Unrealized gain (loss) on investments, net $ (70,830) $ 57,759
The Company acquired the stock of Valence Technology Inc. ("Valence") during March 1998 (Note 2) and issued 1,680,611 shares of common stock in payment of $12,105,778 of the acquisition price. 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, including acquisition costs (21,879,033) ------------ Liabilities assumed $ 15,579,314 ============
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). In February 1998, the Company issued 25,000 shares of common stock and warrants to purchase 100,000 shares of common stock in conjunction with the acquisition of Voice Intelligibility Processor ("VIP"). The shares and warrants have an ascribed fair value of $176,575 and $341,957, respectively (Note 2). In May 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). In January 1999, the Company received certain computer equipment and a fully paid-up license for MPEG-1 Technology Core from DVS Inc. in payment for $300,000 of license fees due to the Company for the use of its technologies. See accompanying notes to consolidated financial statements 7 8 SRS LABS, INC. NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. GENERAL/BASIS OF PRESENTATION SRS Labs, Inc. is a developer and provider of technology solutions for the consumer electronics, computer, game and telecommunications markets. The Company's principal business activities in these markets include: - - Developing and licensing audio and voice technologies to consumer electronic manufacturers and semiconductor manufacturers around the world; and - - Through its subsidiary, Valence Technology Inc. and its foreign subsidiaries, designing and selling technology solutions through custom application specific integrated circuits ("ASICs") to consumer electronic manufacturers; and designing, distributing and manufacturing components, sub-assemblies and electronics products for manufacturers and retailers within the Company's targeted markets. The accompanying interim consolidated financial statements have been prepared by the Company without audit (except for the balance sheet information as of December 31, 1998) 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. In the opinion of management, all adjustments (which include only normal recurring adjustments) considered necessary for a fair presentation have been included. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. Therefore, the interim financial statements should be read in conjunction with the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 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 the following business activities: (i) the development and marketing of technology in the form of integrated circuits (ASICs) to consumer electronic manufacturers and (ii) the sale of consumer electronic and telecommunications products and components. 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 with a fair value of $12,105,778. The Company's consolidated statement of operations for the six months ended June 30, 1998 includes a charge of $17.5 million for the write-off of acquired in-process research and development expense associated with the Valence acquisition. 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 the aggregate to such three shareholders. 8 9 SRS LABS, INC. NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) The following summarizes the consideration granted for the acquisition of Valence and the 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 acquired $23,382,068 =========== Allocation to: In-process research and development $17,471,668 Intangible assets 5,910,400 ----------- $23,382,068 ===========
The resulting intangible assets are being amortized on a straight-line basis over periods ranging from three to eleven years. 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 Statement of Financial Accounting Standards ("SFAS") No. 115. As of June 30, 1999, the Company's available-for-sale investments had a cost of $11,821,629 and an estimated fair value of $11,941,221, based on quoted market prices. The unrealized gains on these investments of $119,592, net of income taxes of $49,033, are reported as a separate component of stockholders' equity. 4. 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. 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. 9 10 SRS LABS, INC. NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 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 the fiscal year ended December 31, 1998 ("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. As of June 30, 1999, 12,000 shares had been repurchased at a cost of $52,500. Such repurchased shares are reflected as treasury stock in the accompanying consolidated balance sheets. 8. SEGMENT INFORMATION The Company operates in two business segments: (i) the development and marketing of technology either in the form of integrated circuits through Valence (ASICs) or the licensing of technologies developed by the Company to consumer electronic manufacturers and semiconductor manufacturers and (ii) the sale of consumer electronic products and components. The Company does not allocate operating expenses or specific assets to these segments. Therefore, segment information includes only net revenues, cost of sales and gross margin. Prior to the acquisition of Valence, the Company operated in the single business segment of licensing audio technologies.
Three Months Ended June 30, 1999 -------------------------------------------------- Chips and Product and Licensing Component Sales Total ------------ --------------- ------------ Net revenues $ 3,989,938 $ 4,214,009 $ 8,203,947 Cost of sales 889,689 4,013,089 4,902,778 ------------ ------------ ------------ Gross margin $ 3,100,249 $ 200,920 $ 3,301,169 ============ ============ ============
Three Months Ended June 30, 1998 -------------------------------------------------- Chips and Product and Licensing Component Sales Total ------------ --------------- ------------ Net revenues $ 4,524,467 $ 7,100,903 $ 11,625,370 Cost of sales 1,181,846 6,205,677 7,387,523 ------------ ------------ ------------ Gross margin $ 3,342,621 $ 895,226 $ 4,237,847 ============ ============ ============
Six Months Ended June 30, 1999 -------------------------------------------------- Chips and Product and Licensing Component Sales Total ------------ --------------- ------------ Net revenues $ 8,094,005 $ 7,826,783 $ 15,920,788 Cost of sales 2,627,267 7,551,153 10,178,420 ------------ ------------ ------------ Gross margin $ 5,466,738 $ 275,630 $ 5,742,368 ============ ============ ============
10 11 SRS LABS, INC. NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Six Months Ended June 30, 1998 -------------------------------------------------- Chips and Product and Licensing Component Sales Total ------------ --------------- ------------ Net revenues $ 7,406,428 $ 11,276,338 $ 18,682,766 Cost of sales 1,853,778 9,932,161 11,785,939 ------------ ------------ ------------ Gross margin $ 5,552,650 $ 1,344,177 $ 6,896,827 ============ ============ ============
11 12 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW SRS Labs, Inc. is a developer and provider of technology solutions for the consumer electronics, computer, game and telecommunications markets. The Company's principal business activities in these markets include: - - Developing and licensing audio and voice technologies to consumer electronic manufacturers and semiconductor manufacturers around the world; and - - Through its subsidiary, Valence Technology Inc. and its foreign subsidiaries, designing and selling technology solutions through custom application specific integrated circuits ("ASICs") to consumer electronic manufacturers; and designing, distributing and manufacturing components, sub-assemblies and electronics products for manufacturers and retailers within the Company's targeted markets. From the Company's inception in 1993 until February 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 had a material impact on the Company's financial statements for the fiscal year ended December 31, 1998 ("Fiscal 1998") and will continue to have a material impact for the reporting periods thereafter; accordingly, current and future financial statements may not be directly comparable to the Company's historical financial statements. SRS currently operates in two business segments: (a) the development and marketing of technology in the forms of integrated circuits designed and distributed through Valence and the licensing of technologies developed by the Company to consumer electronic manufacturers and semiconductor manufacturers and (b) the sale of consumer electronic products and components. A summary of the Company's operations and activities by business segment is included in the notes to the interim consolidated financial statements. RESULTS OF OPERATIONS THREE MONTHS ENDED JUNE 30, 1999 COMPARED TO THREE MONTHS ENDED JUNE 30, 1998 Revenues Chip and licensing revenue consists of design fees and sales of custom application specific integrated circuits (ASICs) by Valence to consumer electronic manufacturers and sales of general purpose ASICs designed by the Company under the brand name ASP Microelectronics. Licensing revenues are royalties and technology transfer fees that are currently generated primarily from the license of the Company's audio 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 the distribution of semiconductor products, manufacturing components and sub-assemblies to consumer electronic manufacturers for the Hong Kong and China markets. Certain sub-assemblies sold by the Company are incorporated in electronic home entertainment products under the Valence brand name. Total revenues for the three months ended June 30, 1999 were $8,203,947 compared to $11,625,370 for the three months ended June 30, 1998. Excluding chip design revenue, licensing revenue decreased 22.6% from the same period last year due to the following factors: (a) the shift in the PC market to lower cost models which cannot bear the cost of performance enhancement technologies such as those offered by SRS Labs; (b) the Asian financial crisis which reduced demand for consumer electronics products in the region and negatively impacted the sales of semiconductor ICs that include the Company's audio technologies; and (c) the trend by consumer electronic manufacturers to initially adopt the Company's new technologies into their higher end models with limited volume potential for the short term. Revenue from custom ASIC chip design and chip sales related to Valence's activities 12 13 decreased 7.5% from the same prior year period due to a high volume ASIC project undertaken in the second quarter of 1998. Revenue from product and component sales decreased to $4,214,009 for the quarter ended June 30, 1999 from $7,100,903 for the same prior year quarter primarily due to the Company's decision to focus on higher margin revenue and deemphasize certain lower margin distribution activities. Gross Margin Cost of sales consists primarily of fabrication costs, assembly and test costs, and the cost of materials and overhead from operations. Gross margin as a percentage of total revenue for the three months ended June 30, 1999 increased to 40.2% from 36.5% for the same period in 1998. The increase resulted from the shift in the Company's revenue base towards higher margin chip and licensing sales and away from lower margin sales from the distribution of components. The Company is continuing efforts to focus on higher margin activities, but expects that gross margins in future quarters will continue to be heavily impacted by the cost of procuring and manufacturing products for sale. Sales and Marketing Sales and marketing expenses consist primarily of employee salaries and sales consultants' fees and related expenses, sales commissions and product promotion. Sales and marketing expenses were $1,101,937 for the three months ended June 30, 1999 compared to $1,511,633 for the same prior year period, a decrease of 27.1%. The decrease was primarily due to a reduction in promotional activities, including cooperative advertising funding, for the Company's products and technologies and tighter control on travel expenses for sales and marketing personnel. As a percentage of total revenues, sales and marketing expenses increased slightly to 13.4% for the quarter ended June 30, 1999 from 13.0% for the same prior year quarter. 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 $789,343 for the three months ended June 30, 1999 compared to $599,631 for the same prior year period, an increase of 31.6%. The increase is primarily attributable to headcount added to develop, enhance and implement new audio and voice technologies and to develop software and Internet applications for the Company's technologies. As a percentage of total revenues, research and development expenses increased to 9.6% for the quarter ended June 30, 1999 from 5.2% for the same prior year quarter. Management believes research and development expenses will increase in the future to support the Company's product development efforts. General and Administrative General and administrative expenses consist primarily of employee-related expenses, legal costs associated with the administration of intellectual property and other professional fees. General and administrative expenses were $1,409,831 for the three months ended June 30, 1999 compared to $1,368,305 for the same prior year period, an increase of 3.0%. The increase was primarily attributable to increased headcount added to subsidiary operations to manage the acquired operations and to support new business development. The increase was partially offset by corporate headcount reductions and management's efforts to better manage outside professional fees. As a percentage of total revenues, general and administrative expenses increased to 17.2% for the quarter ended June 30, 1999 from 11.8% for the same prior year quarter. As part of the Valence acquisition, the Company allocated a portion of the purchase price to various intangible assets totaling approximately $5,910,400. This amount was capitalized and is being amortized on a straight line basis over periods ranging from three to eleven years with the related amortization expense of $332,796 and $326,497 for the quarters ended June 30, 1999 and June 30, 1998, respectively, included in general and administrative expenses. See Note 2 of the notes to the interim consolidated financial statements for more information concerning the purchase price allocation associated with the Valence acquisition. 13 14 Other Income, Net Net other income consists primarily of interest income, interest expense, realized gains and losses on the sale of investments and foreign currency transaction gains and losses. Net other income was $102,056 for the three months ended June 30, 1999 compared to $184,906 for the same prior year period, a decrease of 44.8%. The decrease is primarily attributable to lower average cash and investment balances during the current year quarter as compared to the prior year quarter due to the cash paid in conjunction with the acquisitions of Valence and VIP and interest expense on the outstanding borrowings under the Company's line of credit obtained during the first quarter of Fiscal 1998. Provision for Income Taxes The income tax provision for the three months ended June 30, 1999 was $96,239 compared to $222,762 for the same prior year period. During the second quarter of 1999, the Company recognized no additional tax benefit in connection with taxable losses related to domestic operations and recorded a tax provision at statutory tax rates in the Asian countries where Valence has its principal business operations. SIX MONTHS ENDED JUNE 30, 1999 COMPARED TO SIX MONTHS ENDED JUNE 30, 1998 Impact of Valence acquisition The Company's consolidated financial results for the six month period ended June 30, 1998 include the results of the Valence operations beginning as of February 1, 1998. Accordingly, results for the six months ended June 30, 1999 may not be directly comparable to the results for the six months ended June 30, 1998. Revenues Total revenues for the six months ended June 30, 1999 were $15,920,788 compared to $18,682,766 for the six months ended June 30, 1998. Excluding chip design revenue, licensing revenue decreased 37.1% from the same period last year due to the following factors: (a) the shift in the PC market to lower cost models which cannot bear the cost of performance enhancement technologies such as those offered by SRS Labs; (b) the Asian financial crisis which reduced demand for consumer electronics products in the region and negatively impacted the sales of semiconductor ICs that include the Company's audio technologies; and (c) the trend by consumer electronic manufacturers to initially adopt the Company's new technologies into their higher end models with limited volume potential for the short term. The licensing revenue decrease was offset by an increase of 36.6% in the custom ASIC chip design and chip sales related to Valence's activities. Revenue from product and component sales decreased to $7,826,783 for the six months ended June 30, 1999 from $11,276,338 for the same prior year period primarily due to the Company's decision to focus on higher margin revenue and deemphasize certain lower margin distribution activities. Gross Margin Gross margin as a percentage of total revenue for the six months ended June 30, 1999 decreased to 36.1% from 36.9% for the same period in 1998. The decrease resulted from the shift in the Company's revenue base towards ASIC and general purpose IC chip sales, which have significantly lower margins than the Company's historic licensing revenue base. The Company expects that gross margins in future quarters will continue to be impacted by the cost of procuring and manufacturing products for sale. Sales and Marketing Sales and marketing expenses were $2,673,936 for the six months ended June 30, 1999 compared to $2,700,527 for the same prior year period, a decrease of 1.0% or relatively unchanged. During the six-month period ended June 30, 1999, sales and marketing expenses included the cost for additional headcount needed to promote the Company's new technologies and increased promotional activities related to product sales in China. These increases were offset by reductions in cooperative advertising activities related to the Company's technologies and in travel expenses for sales and marketing personnel. As a percentage of sales, sales and marketing expenses 14 15 increased to 16.8% for the six-month period ended June 30, 1999 from 14.5% for the same prior year period, primarily due to the lower revenue base. Research and Development Research and development expenses were $1,429,361 for the six months ended June 30, 1999 compared to $998,710 for the same prior year period, an increase of 43.1%. The increase is primarily attributable to headcount added to support the increased ASIC design activity, to develop, enhance and implement new audio and voice technologies and to develop software and Internet applications for the Company's technologies. As a percentage of total revenues, research and development expenses increased to 9.0% for the six-month period ended June 30, 1999 from 5.3% for the same prior year period. General and Administrative General and administrative expenses were $3,549,376 for the six months ended June 30, 1999 compared to $2,621,128 for the same prior year period, an increase of 35.4%. The increase was primarily attributable to increased headcount added to corporate and subsidiary operations to manage the acquired operations and to support new business development, costs incurred for due diligence activities related to potential acquisitions that did not occur and higher costs associated with year end reporting activities required of a public company due to the expanded scope of the Company's operations. As a percentage of total revenues, general and administrative expenses increased to 22.3% for the six month period ended June 30, 1999 from 14.0% for the same prior year period. Amortization expense related to intangible assets associated with the Valence acquisition was $665,592 and $527,495 for the six-month periods ended June 30, 1999 and 1998, respectively, and is included in general and administrative expenses. See Note 2 of the notes to the interim consolidated financial statements for more information concerning the purchase price allocation associated with the Valence acquisition. Acquired In-Process Research and Development The Company's Consolidated Statement of Operations for the six months ended June 30, 1998 includes the one-time charge of $18,510,378 for the write-off of acquired in-process research and development expenses associated with the Valence acquisition and the acquisition of certain assets associated with the VIP technology. The in-process research and development expenses arose from new product projects that were under development at the date of the acquisition and expected to eventually lead to new products but had not yet established technological feasibility and for which no future alternative use was identified. The valuation of the in-process research and development projects was based upon the discounted expected future net cash flows of the products over the products' expected lives, reflecting the estimated stages of completion of the projects and the estimated costs to complete the projects. New product development projects underway at Valence at the time of the Valence acquisition included, among others, (a) ASICs for consumer electronics, computing and voice and audio applications, (b) home entertainment systems, (c) digital multimedia players and (d) digital power amplifiers. The Company estimated that these projects were approximately 63% complete at the date of acquisition and estimated that the cost to complete these projects will aggregate approximately $7 million and will be incurred over a three-year period. New product development projects utilizing the VIP technology at the time of the VIP acquisition included, among others, digital and analog sound reinforcement, wireless and non-wireless telecommunications applications, hearing aid applications, headphone and microphone applications. The Company estimated that these projects were approximately 62% complete at the date of acquisition and estimated that the cost to complete these projects will aggregate approximately $525,000 and will be incurred over a two-year period. 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 15 16 that the acquired in-process research and development projects will be pursued or successfully completed and commercially introduced. Other Income, Net Net other income consists primarily of interest income, interest expense, realized gains and losses on the sale of investments and foreign currency transaction gains and losses. Net other income was $205,403 for the six months ended June 30, 1999 compared to $382,398 for the same prior year period, a decrease of 46.3%. The decrease is primarily attributable to lower average cash and investment balances during the current fiscal year to date as compared to the prior year due to the cash paid in conjunction with the acquisitions of Valence and VIP and interest expense on the outstanding borrowings under the Company's line of credit obtained during the first quarter of Fiscal 1998. Provision for Income Taxes The income tax benefit for the six months ended June 30, 1999 was $213,667 compared to $61,006 for the same prior year period. Related to domestic operations, the Company recognized tax benefits in connection with federal refundable taxes which could be recovered through a net operating loss carryback. In addition, the Company recorded a tax provision at statutory tax rates in the Asian countries where Valence has its principal business operations. LIQUIDITY AND CAPITAL RESOURCES The Company's principal source of liquidity at June 30, 1999 consisted of cash, cash equivalents and investments aggregating $19.5 million, as well as borrowings available under its credit facility. At December 31, 1998, the Company had cash, cash equivalents and long term investments of approximately $24.4 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 utilized $4,645,209 in cash for the six months ended June 30, 1999 and provided $503,606 for the six months ended June 30, 1998. The use of cash in operations for the six-month period ended June 30, 1999 was primarily due to the reduction in accounts payable related to major suppliers of the Company's component distribution business, as well as the Company's loss from operations. Partially offsetting this decrease was an increase in cash due to a reduction in accounts receivable and other current assets that resulted from the collection of certain large balances due from SRS and Valence customers that were outstanding at December 31, 1998. As described above, the Company acquired Valence and additional technologies during the first quarter 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 cash, cash equivalents and investments. As of June 30, 1999, approximately $435,000 in cash and cash equivalents and $10.9 million in investments were pledged as collateral for the line of credit. 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 June 30, 1999. 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. In August 1999, the Company entered into a new line of credit agreement with another bank that expires on April 1, 2001. The terms of the new agreement are substantially the same as the previous agreement which was replaced. 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 and engineering headcount and marketing activities associated with the introduction of new technologies and products into the market. 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 future. 16 17 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: Company products; internally used systems and software; products or services provided by key third parties; and the ability of chip partners, licensees or customers to process business transactions relating to chip design and licensing revenue and product and component sales. During Fiscal 1998, the Company and its subsidiaries reviewed 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 identified certain systems which require upgrades to be Year 2000 ready, including certain business software applications. The Company is in the process of installing a new computer system in its overseas operation and has been assured by the software and hardware providers that these systems will be fully compliant with the Year 2000. The Company believes that installation will be complete by the end of the third quarter of 1999. The Company's products do not have any material Year 2000 problems. In addition, the Company and its subsidiaries are in the process of assessing and documenting 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, are estimated to be approximately $350,000. Should the Company not be completely successful in mitigating internal and external Year 2000 risks, the likely worst case scenario could be a system failure causing disruptions of operations, including, among other things, a temporary inability to process transactions, manufacture products, send invoices or engage in similar normal business activities at the Company or its vendors and suppliers. The Company currently is developing a contingency plan with respect to potential Year 2000 failures of its suppliers or customers. However, if such failures would occur, depending upon their duration and severity, there is no guarantee that the contingency plan would mitigate the effects of these failures, and they could have a material adverse effect on the Company's business, results of operations and financial condition. 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." FORWARD-LOOKING INFORMATION AND CERTAIN FACTORS Included in this Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations are certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, reflecting management's current expectations. Examples of such forward-looking statements include the expectations of the Company with respect to its strategy and the shift in revenue mix which is expected to be weighted more toward chip and electronic component sales and less to licensing. Although the Company believes 17 18 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. Such factors include, among others, those set forth below. 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. 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 consumer electronic manufacturers, and fluctuations in general economic conditions, particularly those affecting the consumer electronics market. In addition, due to the Company's dependence on the consumer electronics market, the substantial seasonality of sales in the 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. Changes to the Business Model/Integration of Valence/Refinement of Asian Strategy From the Company's inception in 1993 through 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 components and 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 integration of certain operations following the Valence acquisition has required, and will continue to require, the dedication of management and other personnel resources which may temporarily distract them from the day-to-day business of the combined company. The geographic separation of these operations places 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 and to identify and focus on those segments that contribute the highest margins. 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, 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. 18 19 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. 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 continues to actively monitor its foreign exchange exposure and to evaluate strategies to reduce its foreign exchange risk. At such time that the Company determines the benefits of such strategies outweigh the associated costs, the Company intends to implement appropriate strategies. 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 continue to experience 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; and the ease of integration and implementation of the products and technologies with other hardware and software components in the manufacturer'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. 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 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 19 20 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 IC 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 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. 20 21 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 the cost of its debt. Foreign Currency The Company has subsidiary operations in Hong Kong and China, and accordingly, the Company is exposed to transaction 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 subsidiaries. Translation adjustments resulting from the process of translating foreign currency financial statements into U.S. dollars were nil in Fiscal 1998 and in the six month period ended June 30, 1999 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 the period. Under the current circumstances, the Company believes that the foreign currency market risk is not material to its consolidated results of operations. The Company continues to actively monitor its foreign exchange exposure and to evaluate possible strategies to reduce its risk. At such time that the benefits of such strategies outweigh the associated costs, the Company intends to implement appropriate strategies. 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. Interest Rates The Company's line of credit bears interest based on the lending bank's prime rate or LIBOR. The interest rate on the balance of $8 million outstanding at June 30, 1999 was 5.71%. The Company believes that if interest rates were to increase by as much as 10%, the short term impact on the Company's consolidated financial statements would not be material. If circumstances in the market change materially, the Company intends to evaluate possible strategies to reduce its risk related to changes in interest rates. 21 22 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS On April 23, 1999, Dolby Laboratories, Inc. filed a civil lawsuit in the United States District Court for the Central District of California against the Company and Smart Devices, Inc. ("Smart Devices"). Smart Devices is a licensee of the Company under the SRS(R) and CIRCLE SURROUND(R) technologies. The complaint seeks both preliminary and permanent injunctions, monetary damages in an unspecified amount and further equitable relief, based upon allegations of false advertising, unfair competition, trademark infringement and false labeling relating to the CIRCLE SURROUND EX trademark. On May 17, 1999, the Company filed an answer to such complaint generally denying the allegations made by the plaintiff under each claim for relief and denying that the plaintiff is entitled to any relief under each stated claim for relief. In addition, the Company also responded by alleging affirmative defenses to each claim for relief. The Company is not providing a defense for Smart Devices. Although the Company cannot predict the likely outcome of the lawsuit at this time, it intends to vigorously defend the case and believes that the final outcome will not have a material adverse effect on the Company's consolidated financial condition. 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). During the second quarter of 1999, the Company utilized approximately $1,717,512 of the $22,052,955 net offering proceeds for working capital purposes as follows:
Direct or indirect payments to directors, officers, general partners of the issuer or their associates to persons owning ten percent or more of any class of equity securities of the issuer, Direct or indirect and to affiliates of the issuer payments to others -------------------------------- ------------------ Construction of plant, building and facilities -- -- Purchase and installation of machinery and equipment -- -- Purchase of real estate -- -- Acquisition of other business(es)/assets -- $ 8,394,222(1) Repayment of indebtedness -- -- Working capital -- $ 1,717,512 Temporary investment (cash and municipal bonds) $11,941,221
- --------- (1) During the second quarter of Fiscal 1998, the Company utilized $500,000 of the net offering proceeds as part of the consideration to acquire assets related to the Circle Surround technology. During the first quarter of Fiscal 1998, the Company utilized an aggregate of $7,894,222 in connection with two other acquisitions (see Note 2 to the Interim Consolidated Financial Statements). 22 23 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Annual Meeting of Stockholders of SRS Labs, Inc. was held on June 10, 1999 for the purpose of (a) electing two Class III Directors to the Board of Directors and (b) voting on a proposal to approve an amendment and restatement of the SRS Labs, Inc. 1996 Nonemployee Directors' Plan (the "Nonemployee Directors' Plan"). Stephen V. Sedmak and Thomas C.K. Yuen were elected to serve as Class III Directors of the Company for three year terms expiring at the 2002 Annual Meeting of Stockholders. Robert Pfannkuch, Jeffrey I. Scheinrock and Thomas W.T. Wan continued in office as Class I Directors, and John AuYeung and John Tu continued in office as Class II Directors. The tabulation of the votes cast for the election of Mr. Sedmak and Mr. Yuen was as follows:
Votes Votes For Withheld ---------- -------- Mr. Sedmak 10,509,010 309,578 Mr. Yuen 10,509,010 309,578
The proposal to amend and restate the Nonemployee Directors' Plan was approved. The tabulation of the votes was as follows:
Votes Votes Broker For Against Abstentions Non-Votes ---------- ------- ----------- --------- 10,338,799 461,210 18,579 0
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. (a) Exhibits. The exhibit listed below is hereby filed with the U.S. Securities and Exchange Commission (the "Commission") as part of this Report.
Exhibit No. Description ------- ----------- 27 Financial Data Schedule.
(b) Reports on Form 8-K No reports on Form 8-K were filed with the Commission during the six month period ended June 30, 1999. 23 24 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: August 14, 1999 By: /s/ JOHN AUYEUNG ------------------------------------ John AuYueng Executive Vice President, Chief Operating Officer, Secretary, Acting Chief Financial Officer and Acting Treasurer (Principal Financial and Accounting Officer) 24 25 EXHIBIT INDEX
Exhibit No. Description ------- ----------- 27 Financial Data Schedule.
EX-27 2 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM BALANCE SHEET AND STATEMENT OF OPERATIONS AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FORM 10Q FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1999. 6-MOS DEC-31-1999 JAN-01-1999 JUN-30-1999 7,531,747 11,941,221 4,790,235 0 4,647,174 21,182,140 883,183 0 37,206,458 12,555,612 0 11,700 0 0 24,607,906 37,206,458 7,826,783 15,920,788 10,178,420 7,652,673 (11,200) 0 (194,203) (1,704,902) (213,667) (1,491,235) 0 0 0 (1,491,235) (0.13) (0.13)
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