-----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, J+PA7HpIcynP3mQNxuoLFHXzW8OV6xAvcsq+2rKZhQJJarboFZ3zSDhvZamAy7+f 0ufWnbbgeWqgEfF3M7oyqA== 0000898430-01-503325.txt : 20020410 0000898430-01-503325.hdr.sgml : 20020410 ACCESSION NUMBER: 0000898430-01-503325 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 20010930 FILED AS OF DATE: 20011109 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: 1934 Act SEC FILE NUMBER: 000-21123 FILM NUMBER: 1780585 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 d10q.txt FORM 10-Q DATED SEPTEMBER 30, 2001 ================================================================================ 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 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) ---------------- Delaware 33-0714264 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 2909 Daimler Street, Santa Ana, California 92705 (Address of principal executive offices) (Zip Code) (949) 442-1070 (Registrant's telephone number, including area code) Not Applicable (Former name, former address and former fiscal year, if changes since last report) ---------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] APPLICABLE ONLY TO CORPORATE ISSUERS Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: as of October 31, 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. ================================================================================ 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) ------------ ------------ 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 ------------ ------------ 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 19 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. 20 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. 21 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. 22 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) 23 -----END PRIVACY-ENHANCED MESSAGE-----