10-Q 1 e10-q.txt FORM 10-Q QUARTERLY PERIOD ENDED JUNE 30,2000 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, 2000 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 August 4, 2000, 12,596,935 shares of the issuer's common stock, par value $.001 per share, were outstanding; of that amount, 71,100 shares were held as treasury shares. ================================================================================ 2 SRS LABS, INC. FORM 10-Q FOR THE PERIOD ENDED JUNE 30, 2000 INDEX PAGE ---- PART I - FINANCIAL INFORMATION Item 1. Financial Statements.............................................. 4 Consolidated Balance Sheets as of June 30, 2000 (Unaudited) and December 31, 1999................................................. 4 Consolidated Statements of Operations for the three months and six months ended June 30, 2000 and 1999 (Unaudited)................... 5 Consolidated Statements of Comprehensive Loss for the three month and six months ended June 30, 2000 and 1999 (Unaudited)............... 6 Consolidated Statements of Cash Flows for the six months ended June 30, 2000 and 1999 (Unaudited).................................... 7 Notes to the Interim Consolidated Financial Statements (Unaudited)........................................................... 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations........................................ 11 Item 3. Quantitative and Qualitative Disclosures About Market Risk....... 20 PART II - OTHER INFORMATION Item 2. Changes in Securities and Use of Proceeds........................ 21 Item 4. Submission of Matters to a Vote of Security Holders............. 21 Item 6. Exhibits and Reports on Form 8-K................................. 22 SIGNATURES................................................................... 23 2 3 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 4 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS. SRS LABS, INC. CONSOLIDATED BALANCE SHEETS ASSETS
JUNE 30, DECEMBER 31, 2000 1999 ----------- ------------ (UNAUDITED) CURRENT ASSETS Cash and cash equivalents ............................................ $ 19,185,902 $ 15,969,678 Investments available for sale ....................................... 3,210,100 3,011,250 Accounts receivable, net ............................................. 2,053,165 2,495,157 Inventories, net ..................................................... 3,038,295 2,726,193 Prepaid expenses and other current assets ............................ 888,071 729,881 Deferred income taxes ................................................ 81,467 81,467 ------------ ------------ TOTAL CURRENT ASSETS ............................................ 28,457,000 25,013,626 Investments available for sale ......................................... 4,593,816 6,331,483 Furniture, fixtures & equipment, net ................................... 1,208,311 1,166,757 Intangible assets, net ................................................. 5,675,640 5,425,273 Deferred income taxes .................................................. 740,889 740,889 Other assets ........................................................... 422,493 422,493 ------------ ------------ TOTAL ASSETS .................................................... $ 41,098,149 $ 39,100,521 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES Accounts payable ................................................... $ 2,961,634 $ 2,882,686 Accrued liabilities ................................................ 2,718,039 1,658,964 Line of credit ..................................................... 8,000,000 8,000,000 Income taxes payable ............................................... 1,487,303 1,518,548 ------------ ------------ TOTAL CURRENT LIABILITIES ..................................... 15,166,976 14,060,198 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; 12,596,935 and 11,890,691 shares issued; and 12,525,835 and 11,819,591 shares outstanding at June 30, 2000 (unaudited) and December 31, 1999, respectively ...................................................... 12,597 11,891 Additional paid-in capital ......................................... 49,604,342 40,312,336 Deferred stock option compensation ................................. 321,899 264,557 Cumulative other comprehensive income .............................. 12,535 23,330 Retained deficit ................................................... (23,756,919) (15,308,510) Less treasury stock at cost, 71,100 shares at June 30, 2000 (unaudited) and December 31, 1999 ................ (263,281) (263,281) ------------ ------------ TOTAL STOCKHOLDERS' EQUITY .................................... 25,931,173 25,040,323 ------------ ------------ TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY .................... $ 41,098,149 $ 39,100,521 ============ ============
See accompanying notes to the interim consolidated financial statements 4 5 SRS LABS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30 JUNE 30 --------------------------------- --------------------------------- 2000 1999 2000 1999 ------------ ------------ ------------ ------------ REVENUES Chip and licensing revenue .............. $ 2,860,253 $ 3,978,390 $ 5,739,332 $ 7,559,548 Product and component sales ............. 3,732,953 4,214,009 8,044,426 8,287,421 ------------ ------------ ------------ ------------ TOTAL REVENUES ....................... 6,593,206 8,192,399 13,783,758 15,846,969 COST OF SALES ........................... 4,267,465 4,953,156 9,116,166 10,046,941 ------------ ------------ ------------ ------------ GROSS MARGIN ............................ 2,325,741 3,239,243 4,667,592 5,800,028 EXPENSES Sales and marketing ..................... 1,422,744 865,154 2,707,477 2,149,486 Research and development ................ 984,908 981,018 1,924,097 2,070,924 General and administrative .............. 4,195,373 1,392,262 5,613,960 3,513,821 Non-cash stock issuance cost ............ -- -- 3,111,859 -- ------------ ------------ ------------ ------------ INCOME (LOSS) FROM OPERATIONS ........... (4,277,284) 809 (8,689,801) (1,934,203) OTHER INCOME, NET ....................... 308,413 138,608 517,976 266,586 ------------ ------------ ------------ ------------ INCOME (LOSS) BEFORE INCOME TAX (EXPENSE) (3,968,871) 139,417 (8,171,825) (1,667,617) BENEFIT .............................. INCOME TAX (EXPENSE) BENEFIT ............ (138,491) (133,542) (276,584) 176,382 ------------ ------------ ------------ ------------ NET INCOME (LOSS) ....................... $ (4,107,362) $ 5,875 $ (8,448,409) $ (1,491,235) ============ ============ ============ ============ NET INCOME (LOSS) PER COMMON SHARE Basic ................................ $ (0.33) $ 0.00 $ (0.69) $ (0.13) ============ ============ ============ ============ Diluted .............................. $ (0.33) $ 0.00 $ (0.69) $ (0.13) ============ ============ ============ ============ WEIGHTED AVERAGE SHARES USED IN THE CALCULATION OF NET INCOME (LOSS) PER COMMON SHARE Basic ................................ 12,492,205 11,686,237 12,198,822 11,686,090 ============ ============ ============ ============ Diluted .............................. 12,492,205 12,022,691 12,198,822 11,686,090 ============ ============ ============ ============
See accompanying notes to the interim consolidated financial statements 5 6 SRS LABS, INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS (UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30 JUNE 30, -------------------------- -------------------------------- 2000 1999 2000 1999 ------------ -------- ----------- ------------ Net income (loss) .......................... $(4,107,362) $ 5,875 $(8,448,409) $(1,491,235) Other comprehensive income (loss) Foreign currency translation ........... (1,544) -- 1,269 -- Unrealized loss on investments available for sale, net of tax ................. (920) (62,914) (12,064) (70,830) ----------- -------- ----------- ----------- Comprehensive loss ......................... $(4,109,826) $(57,039) $(8,459,204) $(1,562,065) =========== ======== =========== ===========
See accompanying notes to the interim consolidated financial statements 6 7 SRS LABS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
SIX MONTHS ENDED JUNE 30, ---------------------------------- 2000 1999 ------------ ------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net loss ...................................................... $ (8,448,409) $ (1,491,235) Adjustments to reconcile net loss to net cash used in operating activities: Non-cash stock issuance cost ............................. 3,111,859 -- Depreciation and amortization ............................ 1,387,323 1,011,670 Other .................................................... 18,497 28,344 Increase in deferred stock option compensation ........... 57,342 119,807 Changes in operating assets and liabilities: Accounts receivable .................................. 515,191 230,451 Inventories .......................................... (378,578) (14,206) Prepaid expenses and other current assets ............ (158,190) 2,239,670 Accounts payable ..................................... 78,948 (7,728,921) Accrued liabilities .................................. 1,059,075 1,012,523 Income taxes payable ................................. (22,862) (53,312) ------------ ------------ Net cash used in operating activities .................... (2,779,804) (4,645,209) CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of furniture, fixtures and equipment ................. (338,800) (105,756) Proceeds from sale of investments available for sale .......... 1,500,000 -- Expenditures related to patents and intangible assets ......... (1,346,025) (48,221) ------------ ------------ Net cash used in investing activities .................... (184,825) (153,977) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from sale of Common Stock ............................ 5,000,291 -- Purchase of treasury stock .................................... -- (52,500) Proceeds from exercise of stock options ....................... 1,180,562 42,191 ------------ ------------ Net cash provided by (used in) financing activities ...... 6,180,853 (10,309) ------------ ------------ NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS .......... 3,216,224 (4,809,495) CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD ................ 15,969,678 12,341,242 ------------ ------------ CASH AND CASH EQUIVALENTS, END OF PERIOD ...................... $ 19,185,902 $ 7,531,747 ============ ============ SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the period for: Interest ................................................. $ 284,264 $ 234,378 Income taxes ............................................. $ 177,191 $ -- SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES: Unrealized loss on investments, net ....................... $ (12,064) $ (70,830)
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 the interim 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: o Developing and licensing audio and voice technologies to original equipment manufacturers ("OEMs") and semiconductor manufacturers around the world and through its subsidiary, SRSWOWcast.com, Inc., an internet based business organized in 1999, developing website content employing SRS Labs, Inc. technologies designed to attract website viewers and advertisers; and o Through its 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. The accompanying interim consolidated financial statements have been prepared by the Company without audit (except for the balance sheet information as of December 31, 1999) in conformity with accounting principles generally accepted in the United States 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 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. 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, 1999. 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 No. 115 "Accounting for Certain Investments in Debt and Equity Securities". As of June 30, 2000, the Company's available-for-sale investments had a cost of $7,776,640 and an estimated fair value of $7,803,916, based on quoted market prices. The unrealized gains on these investments of $27,276 net of income taxes of $11,183, are reported as a separate component of stockholders' equity. 3. INTANGIBLE ASSETS During the six months ended June 30, 2000, the Company purchased software and related intellectual property rights for an aggregate purchase price of approximately $1,320,000. The purchases are included in intangible assets in the accompanying financial statements and are being amortized over estimated useful lives of 5 years. 4. NET LOSS PER COMMON SHARE The Company computes earnings per share (EPS) in accordance with Statement of Financial Accounting Standards No. 128, "Earnings per Share" (FAS 128). FAS 128 requires the Company to disclose basic and diluted earnings per share. 8 9 SRS LABS, INC. NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 5. 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. 6. 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. As of June 30, 2000, 71,100 shares had been repurchased at a cost of $263,281. Such repurchased shares 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 $5,000,000 in the aggregate. The difference between the purchase price 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. The Company also granted Microsoft warrants to purchase up to 200,000 shares of common stock of the Company and the Company's wholly-owned subsidiary, SRSWOWcast.com, Inc., granted a warrant to purchase up to 1,250,000 shares of its common stock. 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. 7. SEGMENT INFORMATION The Company operates in three business segments: (a) 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 original equipment manufacturers and semiconductor manufacturers; (b) the sale of consumer electronic products and components; and (c) the SRSWOWcast.com, Inc. internet based business. The Company does not allocate operating expenses or specific assets to the segments described in clauses (a) and (b) above. Therefore, segment information includes only net revenues, cost of sales and gross margin for those segments. The Company's internet-based business generated no significant revenues and incurred operating losses of $837,605 and $1,259,605 for the three month 9 10 SRS LABS, INC. NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) and six month periods ended June 30, 2000. These losses were composed primarily of sales and marketing expenses and general and administrative expenses associated with the development of web content, and the promotion and launch of the Company's website. THREE MONTHS ENDED JUNE 30, 2000 ---------------------------------------------- CHIPS AND PRODUCT AND LICENSING COMPONENT SALES TOTAL ---------- --------------- ---------- Net revenues ...... $2,860,253 $3,732,953 $6,593,206 Cost of sales ..... 900,663 3,366,802 4,267,465 ---------- ---------- ---------- Gross margin ...... $1,959,590 $ 366,151 $2,325,741 ========== ========== ========== THREE MONTHS ENDED JUNE 30,1999 ---------------------------------------------- CHIPS AND PRODUCT AND LICENSING COMPONENT SALES TOTAL ---------- --------------- ---------- Net revenues ...... $3,978,390 $4,214,009 $8,192,399 Cost of sales ..... 940,067 4,013,089 4,953,156 ---------- ---------- ---------- Gross margin ...... $3,038,323 $ 200,920 $3,239,243 ========== ========== ========== SIX MONTHS ENDED JUNE 30, 2000 ----------------------------------------------- CHIPS AND PRODUCT AND LICENSING COMPONENT SALES TOTAL ---------- --------------- ----------- Net revenues ...... $5,739,332 $8,044,426 $13,783,758 Cost of sales ..... 1,783,663 7,332,503 9,116,166 ---------- ---------- ----------- Gross margin ...... $3,955,669 $ 711,923 $ 4,667,592 ========== ========== =========== SIX MONTHS ENDED JUNE 30,1999 ----------------------------------------------- CHIPS AND PRODUCT AND LICENSING COMPONENT SALES TOTAL ---------- --------------- ----------- Net revenues ...... $7,559,548 $8,287,421 $15,846,969 Cost of sales ..... 2,004,783 8,042,158 10,046,941 ---------- ---------- ----------- Gross margin ...... $5,554,765 $ 245,263 $ 5,800,028 ========== ========== =========== 10 11 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: o Developing and licensing audio and voice technologies to original equipment manufacturers ("OEMs") and semiconductor manufacturers around the world and through its subsidiary, SRSWOWcast.com, Inc., an internet based business organized in 1999, developing website content employing SRS Labs, Inc. technologies designed to attract website viewers and advertisers; and o Through its 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 the OEM and retail communities within the Company's targeted markets. 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 TruSurroundTM, 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 China. 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 changed its focus from entering into technology licenses with PC chip manufacturers to developing a new business model which focuses on Internet radio. This new focus resulted in the Company launching the WOWThing product family and establishing a new wholly-owned subsidiary, SRSWOWcast.com, Inc., 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.com 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.com, Inc. The Company's technologies also were implemented in new consumer products in Fiscal 1999. Among the most notable implementations included the Kenwood receiver (CircleSurround), the Sony Walkman (SRS Headphones), Philips (TruSurround) and Sony (SRS Headphone) DVD players, as well as Hitachi TVs (Focus). In addition to these new implementations, the Company entered into new licenses with key industry manufacturers including 11 12 Loewe, ST Microelectronics and TCE in Europe; Yamaha and Marantz in Japan; Konka and TCL in China; Samsung and LG in Korea and Cirrus Logic, Lucent and Peavey in the United States. SRS currently operates in three 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 OEMs and semiconductor manufacturers, (b) the sale of consumer electronic products and components, and (c) the SRSWOWcast.com, Inc. internet based business. A summary of the Company's operations and activities by business segment is included in the accompanying notes to the interim consolidated financial statements. RESULTS OF OPERATIONS THREE MONTHS ENDED JUNE 30, 2000 COMPARED TO THREE MONTHS ENDED JUNE 30, 1999 Revenues Chip and licensing revenue consists of design fees and sales of custom application specific integrated circuits (ASICs) by Valence to OEM manufacturers and sales of general purpose integrated circuits ("IC"s) designed by the Company under the brand name ASP Microelectronics. Licensing revenues are royalties 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 (a) the manufacture and sale of Valence's own branded product line of VCD players, amplifiers, and game products and (b) the distribution of semiconductor products, manufacturing components and sub-assemblies to OEMs for the Hong Kong and China markets. Total revenues for the three months ended June 30, 2000, were $6,593,206, compared to $8,192,399 for the same period in the prior year, a decrease of $1,599,193, or 20%. The decrease was due primarily to lower demand during the quarter for the Company's ASIC design services and products, which are order specific and custom in nature, and subject to variability based on timing of customer orders, and to a comparative decrease in licensing revenue during the quarter resulting from the Company's recording of a large one-time technology transfer fee in the second quarter of 1999, and to a decline in licensing fees generated by computer manufacturer related activity in the second quarter of 2000. Revenues generated by the Company's internet based business were not significant during the quarter ended June 30, 2000. Product and component revenues decreased $481,056, or 11%. This decrease is consistent with the Company's strategy to exit certain of its low margin distribution product lines in order to focus resources on expansion of its ASIC business and integration of SRS technologies into its products. 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 June 30, 2000, the gross margin percentage decreased to 35%, compared to 40% for the same period in the prior year. The decrease in margin percentage is attributable to lower licensing revenue and lower ASIC sales, the two most profitable components of the Company's revenues. In addition, the Company experienced higher ASIC fabrication costs during the second quarter of 2000, as a result of higher worldwide demand for semiconductors and limited fabrication capacity. The Company expects that gross margins in future quarters will continue to be negatively impacted by higher fabrication costs. 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. Sales and marketing expenses were $1,422,744 for the three months ended June 30, 2000 compared to $865,154 for the same prior year period, an increase of $557,590, or 64%. The increase is due primarily to spending associated with the development and promotion of the SRSWOWcast.com website, and creation of program content for such website. The website was launched July 18, 12 13 2000 and it is the Company's expectation that sales and marketing expenses will continue to increase as a result of the expansion and growth of SRSWOWcast.com business operations. 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 $984,908 for the three months ended June 30, 2000 compared to $981,018 for the same prior year period. 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, legal costs and patent and intangible asset amortization costs. General and administrative expenses were $4,195,373 for the three months ended June 30, 2000 compared to $1,392,262 for the same prior year period, for an increase of $2,803,111 or 201%. The increase is due primarily to compensation costs incurred as a result of the resignation of an employee of Valence ($735,000), accelerated amortization of intellectual property incorporating outdated technologies ($300,000), additional legal and employee related expenses associated with the launch of SRSWOWcast.com, Inc. ($190,000), postponed IPO-related expenses ($1,142,000-discussed below) plus higher salaries and benefits, legal, and other administrative expenses in the Company's core licensing business. As part of the acquisition of Valence, 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 $332,796 for the quarters ended June 30, 2000 and June 30, 1999, respectively, and is included in general and administrative expenses. 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 was targeted for completion in the second quarter of 2000. However, due to negative market conditions affecting equity markets worldwide, including the GEM, the Company elected to postpone the offering indefinitely. 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. Other Income, Net Net other income consists primarily of interest income, interest expense and foreign currency transaction gains and losses. Net other income was $308,413 for the three months ended June 30, 2000 compared to $138,608 for the same prior year period, an increase of 123%. The increase is primarily due to higher interest income which is attributable to higher average cash and investment balances during the current year quarter and favorable foreign currency transaction gains. Provision for Income Taxes The income tax expense for the three months ended June 30, 2000 was $138,491 compared to $133,542 for the same prior year period. Commencing in the fiscal year ending December 31, 2000, the Company recorded a tax provision at statutory tax rates in the Asian countries where Valence has its principal business operations. In Fiscal 1999, the Company recognized tax benefits related to domestic operations in connection with federal refundable taxes which could be recovered through a net operating loss carryback. 13 14 SIX MONTHS ENDED JUNE 30, 2000 COMPARED TO SIX MONTHS ENDED JUNE 30, 1999 Revenues Total revenues for the six months ended June 30, 2000, were $13,783,758, compared to $15,846,969 for the same period in the prior year, a decrease of $2,063,211, or 13%. The decrease was due primarily to lower demand during the period for the Company's ASIC design services and products, which are order specific and custom in nature, and subject to variability based on timing of customer orders, and to a comparative decrease in licensing revenue during the period resulting from the Company's recording of a large one-time technology transfer fee in the second quarter of 1999, and to a decline in licensing fees generated by computer manufacturer related activity for the period. Revenues generated by the Company's internet based business were not significant during the six months ended June 30, 2000. Product and component revenues decreased $242,995, or 3%. This decrease is consistent with the Company's strategy to exit certain of its low margin distribution product lines in order to focus resources on expansion of its ASIC business and integration of SRS technologies into its products. Gross Margin For the six months ended June 30, 2000, the gross margin percentage decreased to 34%, compared to 37% for the same period in the prior year. The decrease in margin percentage is attributable to lower licensing revenue and lower ASIC sales, historically the most profitable components of the Company's revenues. In addition, the Company experienced higher ASIC fabrication costs during the six months ended June 30, 2000, as a result of higher worldwide demand for semiconductors, and limited fabrication capacity. The Company expects that gross margins will continue to be negatively impacted by higher fabrication costs. Sales and Marketing Sales and marketing expenses were $2,707,477 for the six months ended June 30, 2000, compared to $2,149,486 for the same period in the prior year, an increase of $557,991 or 26%. The increase is due primarily to spending during the second quarter of 2000, associated with the development and promotion of the SRSWOWcast.com website (website), and creation of program content for the website. The website was launched July 18, 2000, and it is the Company's expectation that sales and marketing expenses will continue to increase as a result of the expansion and growth of SRSWOWcast.com business operations. Research and Development Research and development costs were $1,924,097 for the six months ended June 30, 2000, compared to $2,070,924 for the same period in the prior year, a decrease of $146,827, or 7%. The decrease is due primarily to lower staffing levels at Valence. 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 $5,613,960 for the six months ended June 30, 2000, compared to $3,513,821 for the same period in the prior year, an increase of $2,100,139, or 60%. First quarter 2000 general and administrative expenses were $1,418,587 compared to first quarter 1999 expenses of $2,121,559, a decrease of approximately $703,000. The decrease in first quarter 2000 general and administrative expenses was offset in the second quarter of 2000 by compensation costs incurred as a result of the resignation of an employee of Valence ($735,000), accelerated amortization of intellectual property incorporating outdated technologies ($300,000), higher legal and employee related expenses associated with the launch of SRSWOWcast.com, Inc. ($190,000), postponed IPO related expenses ($1,142,000), plus higher salaries and benefits, legal, and other administrative expenses in the Company's core licensing business. Amortization expense related to intangible assets associated with the Valence acquisition was $665,592 for both the six month periods ended June, 30, 2000 and 1999, and is included in general and administrative expenses. 14 15 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 issued warrants to purchase additional shares of the Company and its subsidiary. As a result of the transaction, the Company recognized one-time, non-cash charges totaling $3,111,859. See Note 6 of the Notes to the Interim Consolidated Financial Statements for more information concerning the Microsoft transaction. Other income, Net Net other income was $517,976 for the six months ended June 30, 2000, compared to $266,586 for the same period in the prior year, an increase of $251,390 or 94%. The increase is due primarily to higher interest income associated with higher cash and investment balances, and favorable foreign currency transaction gains. Income Taxes The income tax expense for the six months ended June 30, 2000 was $276,584 compared to a tax benefit of $176,382 for the same period in the prior year. Commencing in the fiscal year ended December 31, 2000, the Company recorded a tax provision at statutory tax rates in the Asian countries where Valence has its principal business operations. In Fiscal 1999, the Company recognized tax benefits related to domestic operations in connection with federal refundable taxes which could be recovered through a net operating loss carry back. New Accounting Pronouncements On December 3, 1999, the Securities and Exchange Commission released Staff Accounting Bulletin #101 (SAB 101) "Revenue Recognition in Financial Statements." Management of the Company has determined that the application of SAB 101 will not have any material impact on the Company's consolidated financial statements. LIQUIDITY AND CAPITAL RESOURCES The Company's principal source of liquidity at June 30, 2000 consisted of cash, cash equivalents and investments aggregating $26,989,818, as well as borrowings available under its credit facilities. At December 31, 1999, the Company had cash, cash equivalents and long-term investments of $25,312,411. In March 2000, the Company sold shares of its common stock to Microsoft Corporation, for aggregate cash proceeds of $5,000,000. See Note 6 to the Interim Consolidated Financial Statements. The Company's operating activities utilized $2,779,804 in cash for the six months ended June 30, 2000, and $4,645,209 for the six months ended June 30, 1999. 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 the Microsoft transaction and depreciation and amortization. The net increase in cash and cash equivalents of $3,216,224 for the period is attributable primarily to proceeds from sale of long-term investments, proceeds from stock option exercises and proceeds from the sale of common stock to Microsoft. In March 1998, the Company obtained a revolving line of credit (and letter of credit facility) with a bank which expires on April 1, 2001 and is secured by certain of the Company's cash, cash equivalents and investments. As of June 30, 2000, approximately $6,479,000 million in cash and cash equivalents and $7,804,000 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%. As of June 30, 2000, the Company had $8.0 million outstanding under the line of credit and was contingently liable for $1.0 million under an irrevocable letter of credit which expires July 31, 2000. The collateral requirements under the above referenced credit facility may have the effect of restricting the amounts of cash available to pay dividends. In November 1999, Valence obtained a credit facility with a bank that provides for borrowings aggregating approximately $5,000,000. The facility has no fixed expiration date and is collateralized by certain of Valence's 15 16 assets on deposit with the bank. The facility provides for a variety of import/export trade instruments which bear interest rates ranging from 1% over the Hong Kong Dollar prime rate to 1.75% over LIBOR. The facility also provides for a revolving line of credit of up to $3,500,000 which bears interest at 1.25% over the related collateral deposit interest rate. At June 30, 2000, there were no obligations outstanding under this credit facility. 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.com operations. Based on current plans and business conditions, the Company expects that its cash, cash equivalents, investments and/or available borrowings under its credit facilities, 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. On March 3, 2000, ValenceTech Limited (the successor entity to Valence Technology Inc. for purposes of listing common shares on the Growth Enterprise Market of the Hong Kong Stock Exchange (the "GEM)) filed an application to list its common shares on the GEM in connection with an initial public offering. Approximately one-third of the net proceeds of the offering were earmarked to be repatriated to the Company. In June 2000, the Company decided to postpone the offering indefinitely based upon the weaker than expected response by institutional investors and market conditions in Hong Kong. Irrespective of the decision to postpone the offering, the Company has sufficient financial resources to meet its cash requirements for the next 12 months, and will continue to expand Valences' core business utilizing available working capital. Neither the Company nor Valence anticipates a significant adverse financial impact from the decision to postpone the offering. The Company will continue to evaluate its future financing options in both domestic and foreign capital markets. 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.com, Inc.; 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 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. 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 ASIC to meet specific customers' 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 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. 16 17 The ASIC business' revenue 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 public offering of common shares of ValenceTech Limited in Hong Kong was intended to bring new capital to grow Valence's core business while, at the same time, adding significant value to the Company's shareholders. Postponement of the offering is not expected to adversely affect Valence's core business operations, and the Company will continue to evaluate its financing options domestically and in foreign capital markets. There is no assurance however, that the Company will be successful in a future initial public offering or in securing alternate sources of capital. 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 The Company launched its Internet business with the formation of SRSWOWcast.com, Inc. SRSWOWcast.com plans to develop and acquire engaging and audio based content to generate and retain visitor traffic to its web site. The revenue of SRSWOWcast.com will, in turn, depend on fees charged to third party businesses for advertising on the site as well as e-commerce products sold to visitors to the site. The Company has planned for other Internet subsidiaries in different geographical regions to be launched at a later date by duplicating the business model of SRSWOWcast.com and with content that is adapted for local culture and taste. However, there can be no assurance that SRSWOWcast.com and other planned subsidiaries or business ventures will be able to develop or acquire the content necessary to attract significant Internet traffic or able to generate substantial revenue from advertising and e-commerce. 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 the year 2000 and beyond. 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. And as the business increases, it is anticipated that significant capital will be required to finance product inventory and account receivables. 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 17 18 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. Economic Risks Associated with Doing Business in Asia, Particularly in Hong Kong and the PRC The Company's significant operations in China 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 is also experiencing deflation 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 US 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 China and other parts of Asia, the Company's consolidated operations and financial results could be significantly affected by risks associated with international activities, including economic and labor conditions, political instability, tax laws (including U.S. taxes on foreign subsidiaries) and changes in the value of the U.S. dollar versus the local currency in which the products are sold. In addition, the Company's valuation of assets recorded as a result of the Valence acquisition may also be adversely impacted by the currency fluctuations relative to the U.S. dollar. The Company intends to actively monitor its foreign exchange exposure and to implement strategies to reduce its foreign exchange risk at such time that the Company determines the benefits of such strategies outweigh the associated costs. However, there is no guarantee that the Company will take steps to insure against such risks, and should such risks occur, there is no guarantee that the Company will not be significantly impacted. Countries in the Asia Pacific region have 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 18 19 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 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. 19 20 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. 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 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 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 six months ended June 30, 2000, 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 credit facilities bear interest based on the lending bank's prime rate or LIBOR plus 0.75%. The interest rate on the balance of $8.0 million outstanding at June 30, 2000 was 7.3125%. If interest rates were to increase by 10%, the impact on the Company's consolidated financial statements would be additional interest expense of approximately $14,600 per quarter. 20 21 PART II - OTHER INFORMATION ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS. USE OF PROCEEDS The effective date of the Company's initial public offering of its Common Stock was August 8, 1996 (SEC Registration No. 333-4974-LA). During the second quarter of Fiscal 2000, the Company utilized $2,528,404 of the $22,052,955 net offering proceeds for working capital. The table below sets forth at June 30, 2000, the amount of the net offering proceeds used for the purposes noted in the table.
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, AND TO DIRECT OR INDIRECT 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 ............................. -- 9,640,247(1)(2) Repayment of indebtedness ............ -- -- Working capital ...................... -- $8,372,475 Temporary investment (cash and municipal bonds) ................... -- $4,040,233
------------ (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. (2) During the six month period ended June 30, 2000, the Company utilized approximately $1,250,000 of the net offering proceeds as consideration for the purchase of software and related intellectual property rights. The Company expects to pay an additional $100,000 as final payment for the software in the third quarter of 2000. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. The Annual Meeting of Stockholders of SRS Labs, Inc. was held on June 15, 2000 for the purpose of (a) electing three Class I Directors to the Board of Directors and (b) voting on a proposal to approve an amendment to the SRS Labs, Inc. Amended and Restated 1996 Long-Term Incentive Plan (the "Incentive Plan") to increase the number of shares of Common Stock available for issuance thereunder by 2,500,000. Robert B. Pfannkuch, Jeffrey I. Scheinrock and Thomas W.T. Wan were elected to serve as Class I Directors of the Company for three-year terms expiring at the 2003 Annual Meeting of Stockholders. John AuYeung and John Tu continued in office as Class II Directors and Stephen V. Sedmark and Thomas C.K. Yuen continued in office as Class III Directors. The tabulation of the votes cast for the election of Messrs. Pfannkuch, Scheinrock and Wan was as follows: VOTES FOR VOTES WITHHELD --------- -------------- Mr. Pfannkuch 11,491,955 255,475 Mr. Scheinrock 11,492,395 255,035 Mr. Wan 11,494,765 252,665 The proposal to amend the Incentive Plan was approved. The tabulation of votes was as follows: VOTES FOR VOTES AGAINST ABSTENTIONS BROKER NON-VOTES --------- ------------- ----------- ---------------- 7,191,100 1,039,859 13,681 3,502,790 21 22 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. (a) Exhibits. The exhibits listed below are hereby filed with the U.S. Securities and Exchange Commission (the "Commission") as part of this Report. EXHIBIT NUMBER DESCRIPTION ------- ----------- 10.1 SRS Labs, Inc. Amended and Restated 1996 Long-Term Incentive Plan, as amended, previously filed with the Commission as Appendix A to the Company's Definitive Proxy Statement dated and filed with the Commission on April 26, 2000, which is incorporated herein by reference. 27 Financial Data Schedule. (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 23 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 11, 2000 By: /s/ JOHN AUYEUNG ----------------------------------------------- John AuYeung Executive Vice President, Chief Operating Officer, Chief Financial Officer, Treasurer and Secretary (Authorized Signatory and Principal Financial Officer) 23 24 EXHIBIT INDEX EXHIBIT NUMBER DESCRIPTION ------ ----------- 10.1 SRS Labs, Inc. Amended and Restated 1996 Long-Term Incentive Plan, as amended, previously filed with the Commission as Appendix A to the Company's Definitive Proxy Statement dated and filed with the Commission on April 26, 2000, which is incorporated herein by reference. 27 Financial Data Schedule.