10-Q

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)
ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2005
OR
o	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 incorporation or organization)	(I.R.S. Employer 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 changed 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 ý No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes o   No ý

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o   No ý

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, 2005, 14,901,124 of the issuer’s common stock, par value $.001 per share, were outstanding; of that amount, 674,098 shares were held as treasury shares.

SRS LABS, INC.

Form 10-Q

For the Period Ended September 30, 2005

Index

PART I - FINANCIAL INFORMATION
Item 1.	Financial Statements
	Condensed Consolidated Balance Sheets as of September 30, 2005 (Unaudited) and December 31, 2004
	Condensed Consolidated Statements of Operations for the three months and nine months ended September 30, 2005 and 2004 (Unaudited)
	Condensed Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the nine months ended September 30, 2005 (Unaudited)
	Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2005 and 2004 (Unaudited)
	Notes to the Condensed Consolidated Financial Statements (Unaudited)
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures About Market Risk
Item 4.	Controls and Procedures
PART II - OTHER INFORMATION
Item 6.	Exhibits
SIGNATURES

2

FORWARD-LOOKING INFORMATION

This Quarterly Report on Form 10-Q contains forward-looking statements 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.

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PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

SRS LABS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

	September 30, 2005			December 31, 2004
	(unaudited)
ASSETS
Current Assets
Cash and cash equivalents	$	7,820,333		$	7,011,912
Accounts receivable, net	1,740,935			1,318,665
Inventories, net	624,440			571,280
Prepaid expenses and other current assets	1,366,480			1,337,506
Deferred income taxes	23,406			23,406
Total Current Assets	11,575,594			10,262,769
Investments available for sale	17,068,070			17,261,267
Investment in LLC	—			2,596,090
Furniture, fixtures and equipment, net	1,592,861			1,995,579
Capitalized production costs, net	3,023,775			—
Intangible assets, net	2,546,886			2,660,955
Goodwill	533,031			533,031
Deferred income taxes	325,827			192,750
Total Assets	$	36,666,044		$	35,502,441
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities
Accounts payable	$	1,121,332		$	984,805
Accrued liabilities	1,813,976			1,640,714
Deferred revenue	350,072			436,910
Income taxes payable	27,043			8,628
Total Current Liabilities	3,312,423			3,071,057
Commitments and contingencies (Note 8)
Stockholders’ Equity
Preferred stock—$.001 par value; 2,000,000 shares authorized; no shares issued or outstanding	—			—
Common stock—$.001 par value; 56,000,000 shares authorized;14,880,317 and 14,671,416 shares issued; and 14,206,219 and 14,229,541 shares outstanding at September 30, 2005 and December 31, 2004, respectively	14,881			14,672
Additional paid-in capital	63,260,412			62,523,292
Accumulated other comprehensive loss	(504,612		)	(309,722		)
Accumulated deficit	(26,413,615		)	(27,853,003		)
Treasury stock at cost, 674,098 and 441,875 shares at September 30, 2005 and December 31, 2004, respectively	(3,003,445		)	(1,943,855		)
Total Stockholders’ Equity	33,353,621			32,431,384
Total Liabilities and Stockholders’ Equity	$	36,666,044		$	35,502,441

See accompanying notes to the condensed consolidated financial statements

4

SRS LABS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2005		2004		2005		2004
Revenues:
Semiconductor	$	1,929,605	$	3,644,298	$	6,435,342	$	8,992,511
Licensing	3,722,662		2,727,861		10,526,734		8,140,592
Total revenues	5,652,267		6,372,159		16,962,076		17,133,103
Cost of sales:
Semiconductor	753,730		1,320,855		2,481,136		3,269,622
Licensing	100,241		100,342		251,424		146,886
Total cost of sales	853,971		1,421,197		2,732,560		3,416,508
Gross Margin	4,798,296		4,950,962		14,229,516		13,716,595
Operating expenses:
Sales and marketing	1,521,788		1,305,349		4,892,666		4,260,784
Research and development	1,220,889		1,266,606		3,610,829		3,620,219
General and administrative	1,445,733		1,452,236		4,492,991		4,490,732
Total operating expenses	4,188,410		4,024,191		12,996,486		12,371,735
Income from operations	609,886		926,771		1,233,030		1,344,860
Equity in income of investee	—		—		91,096		—
Other income, net	174,195		118,908		488,421		455,132
Income before income tax expense	784,081		1,045,679		1,812,547		1,799,992
Income tax expense	79,887		241,721		373,159		790,863
Net income	$	704,194	$	803,958	$	1,439,388	$	1,009,129
Net income per common share:
Basic	$	0.05	$	0.06	$	0.10	$	0.07
Diluted	$	0.05	$	0.05	$	0.10	$	0.06
Weighted average shares used in the calculation of net income per common share:
Basic	14,094,690		14,278,589		14,076,833		14,045,162
Diluted	15,300,803		15,395,792		15,070,362		15,991,331

See accompanying notes to the condensed consolidated financial statements

5

SRS LABS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND
COMPREHENSIVE INCOME (LOSS) (Unaudited)

	Common Stock				Additional Paid-In		Accumulated Other Comprehensive			Accumulated			Treasury						Comprehensive Income (Loss) for the Period
	Shares		Amount		Capital		Loss			Deficit			Stock			Total			Ended
BALANCE, Dec. 31, 2004	14,229,541		$	14,672	$	62,523,292	$	(309,722	)	$	(27,853,003	)	$	(1,943,855	)	$	32,431,384
Proceeds from exercise of stock options	17,612		18		66,269		—			—			—			66,287
Deferred stock option compensation	—		—		14,831		—			—			—			14,831
Unrealized loss on investments available for sale, net of tax	—		—		—		(259,460		)	—			—			(259,460		)	(259,460		)
Net income	—		—		—		—			221,460			—			221,460			221,460
BALANCE, March 31, 2005	14,247,153		$	14,690	$	62,604,392	$	(569,182	)	$	(27,631,543	)	$	(1,943,855	)	$	32,474,502		$	(38,000	)
Proceeds from exercise of stock options	110,110		110		355,742		—			—			—			355,852
Deferred stock option compensation	—		—		9,739		—			—			—			9,739
Purchase of treasury stock	(232,223	)	—		—		—			—			(1,059,590		)	(1,059,590		)
Unrealized gain on investments available for sale, net of tax	—		—		—		218,348			—			—			218,348			218,348
Net income	—		—		—		—			513,734			—			513,734			513,734
BALANCE, June 30, 2005	14,125,040		$	14,800	$	62,969,873	$	(350,834	)	$	(27,117,809	)	$	(3,003,445	)	$	32,512,585		$	694,082
Proceeds from exercise of stock options	81,179		81		282,490		—			—			—			282,571
Deferred stock option compensation	—		—		8,049		—			—			—			8,049
Unrealized loss on investments available for sale, net of tax	—		—		—		(153,778		)	—			—			(153,778		)	(153,778		)
Net income	—		—		—		—			704,194			—			704,194			704,194
BALANCE, Sept. 30, 2005	14,206,219		$	14,881	$	63,260,412	$	(504,612	)	$	(26,413,615	)	$	(3,003,445	)	$	33,353,621		$	1,244,498

See accompanying notes to the condensed consolidated financial statements

6

SRS LABS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	Nine Months Ended September 30,
	2005			2004
Cash Flows From Operating Activities:
Net income	$	1,439,388		$	1,009,129
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	1,020,639			966,692
Provision for doubtful accounts	47,355			153,859
Benefit for obsolete inventory	(13,449		)	(44,600		)
Deferred taxes	(133,077		)	(20,513		)
(Accretion) amortization of (discount) premium on investments available for sale	(1,693		)	5,981
Deferred stock option compensation	32,619			66,393
Loss on disposition of furniture, fixtures and equipment	1,417			6,791
Impairment on intangible assets	—			12,163
Equity in income of investee	(91,096		)	—
Changes in operating assets and liabilities, net of consolidation of CHS/SRS LLC:
Accounts receivable	(360,554		)	(182,417		)
Inventories	(25,188		)	30,612
Prepaid expenses and other current assets	183,192			192,765
Accounts payable	132,885			(22,402		)
Accrued liabilities	105,828			243,498
Deferred revenue	(86,838		)	369,125
Income taxes payable	18,415			107,802
Net cash provided by operating activities	2,269,843			2,894,878
Cash Flows From Investing Activities:
Purchase of furniture, fixtures and equipment	(165,736		)	(874,737		)
Proceeds from sales of furniture and equipment	2,300			550
Proceeds from sale of investments available for sale	—			241,876
Investment in LLC	—			(2,025,626		)
Capitalized production costs.	(601,273		)	—
Expenditures related to patents and intangible assets	(341,833		)	(417,742		)
Net cash used in investing activities	(1,106,542		)	(3,075,679		)
Cash Flows From Financing Activities:
Proceeds from exercise of stock options	704,710			3,569,927
Purchase of Treasury Stock	(1,059,590		)	(164,461		)
Net cash (used in) provided by financing activities	(354,880		)	3,405,466
Net Increase in Cash and Cash Equivalents	808,421			3,224,665
Cash and Cash Equivalents, Beginning of Period	7,011,912			12,795,620
Cash and Cash Equivalents, End of Period	$	7,820,333		$	16,020,285
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Income taxes	$	546,847		$	456,600
Supplemental Disclosure of Non-Cash Investing Activities:
Unrealized (loss) gain on investments, net	$	(194,890	)	$	38,823
Fair market value of assets consolidated, inclusive of cash of $10,733	$	3,047,154		$	—
Fair market value of liabilities assumed in the consolidation	$	71,076		$	—

See accompanying notes to the condensed consolidated financial statements

7

SRS LABS, INC.

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

1.Basis of Presentation and Summary of Significant Accounting Policies and Estimates

As used herein, the “Company,” “SRS Labs,” “we,” “us,” or “our” means SRS Labs, Inc. and its wholly-owned subsidiaries, Valence Tech Limited (including its wholly-owned subsidiaries) and SRSWOWcast.com, Inc. (“SRSWOWcast.com) and CHS/SRS, LLC, a joint venture between the Company and Coming Home Studios LLC (“CHS”) to complete and distribute the concert DVDs (the “Joint Venture”).  The accompanying unaudited condensed consolidated financial statements have been prepared by the Company in conformity with accounting principles generally accepted in the United States of America (“generally accepted accounting principles”) for interim financial information and the rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”) for interim reporting. In the opinion of management, all adjustments (which include only normal recurring adjustments) considered necessary for a fair presentation of our financial position and results of operations have been included. Certain amounts included in the accompanying prior periods’ consolidated financial statements have been reclassified to conform to the current period presentation.

In September 2004, the Company entered into a strategic alliance with CHS to produce and sell concert DVDs by Duran Duran, Boz Scaggs, Godsmack and All Access featuring our Circle Surround technology.   In connection with the strategic alliance, the Company and CHS established the Joint Venture.  In July 2005, the Company replaced CHS as the manager of the Joint Venture.  As a result of becoming the manager of the Joint Venture, the Company has control over the Joint Venture’s business strategy and decisions.  Accordingly, the Company is required under applicable accounting rules to consolidate the financial statements of the Joint Venture into our financial statements commencing with the third quarter of fiscal 2005.  Previously, we accounted for our interest (50% of the equity ownership) in the Joint Venture as an investment using the equity method.  In the consolidated financial statements, all inter-company accounts and transactions between the Company and the Joint Venture have been eliminated.

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, 2004. Current and future financial statements may not be directly comparable to the Company’s historical financial statements. The results of operations for the interim period is not necessarily indicative of the results to be expected for any other interim period or for the full year.

Estimates

The preparation of financial statements in accordance with generally accepted accounting principles requires management to make use of certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported periods. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ materially from those estimates. See the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2004 for an additional discussion of the significant accounting policies and estimates used in the preparation of our financial statements.

2.Stock-Based Compensation

The Company accounts for stock-based awards to employees under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. The Company provides additional pro forma disclosures as required under Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation” and SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure — an Amendment of SFAS No. 123.” Accordingly, no stock-based employee compensation cost is reflected in net income, as all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. Had compensation expense been recorded under the

8

provisions of SFAS No. 123, the Company’s net income (loss) and earnings per share would have been the pro forma amounts indicated below:

	For the three months ended						For the nine months ended
	September 30,						September 30,
	2005			2004			2005			2004
Net income (attributable to common shareholder) — as reported	$	704,194		$	803,958		$	1,439,388		$	1,009,129
Add: stock-based employee compensation expense included in reported net income, net of tax effect	4,829			15,715			19,571			39,590
Less fair value of stock-based employee compensation expense, net of tax effect	(273,860		)	(380,894		)	(854,137		)	(1,215,778		)
Net income (loss) (attributable to common shareholder) — pro forma	$	435,163		$	438,779		$	604,822		$	(167,059	)
Net income (loss) per share:
Basic, as reported	$	0.05		$	0.06		$	0.10		$	0.07
Basic, pro forma	$	0.03		$	0.03		$	0.04		$	(0.01	)
Diluted, as reported	$	0.05		$	0.05		$	0.10		$	0.06
Diluted, pro forma	$	0.03		$	0.03		$	0.04		$	(0.01	)

The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants during the three and nine months ended September 30, 2005:

	Three months ended Sept 30, 2005		Nine months ended Sept. 30, 2005
Risk-free interest rate	4.2	%	4.0	%
Expected life	6.25 years		6.25 years
Expected volatility	55	%	60	%

3.Capitalized Production Costs

Production costs consist of capitalized costs to film and produce concert DVDs for domestic and international distribution and include the costs of film and tape conversion to the optical disc format, menu and packaging design, authoring, compression and mastering.  The Company amortizes the production costs as units are sold.  Capitalized production costs as of September 30, 2005 is as follows:

	September 30, 2005
Capitalized production costs	$	3,046,196
Accumulated amortization	(22,421		)
Capitalized production costs, net	$	3,023,775

4.Capitalization of Software Development Costs

Costs incurred in the research, design and development of software for sale to others as a separate product or embedded in a product and sold as part of the product as a whole are charged to expense until technological feasibility is established. Under SFAS No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed,” the Company capitalizes software purchased from third parties if the related software product under development has reached technological feasibility or if there are alternative future uses for the purchased software, provided that capitalized amounts will be realized over a period not exceeding five years. Costs incurred prior to the establishment of technological feasibility are charged to research and development expense.

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Capitalized software as of September 30, 2005 and December 31, 2004 is as follows:

	September 30, 2005			December 31, 2004
Capitalized software	$	563,568		$	464,568
Accumulated amortization	(278,684		)	(193,003		)
Capitalized software, net	$	284,884		$	271,565

As of September 30, 2005, the weighted average useful life of the Company’s capitalized software is approximately 2.0 years. The following table shows the estimated amortization expense for those assets for the remaining three months of the current fiscal year end and each of the four succeeding fiscal years.

Year ending December 31,	Estimated Expense
2005	$	32,914
2006	$	130,964
2007	$	78,690
2008	$	38,158
2009	$	4,158

5.Goodwill and Intangible Assets

On January 1, 2002, the Company adopted 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.

In accordance with SFAS No. 142, all of our intangible assets that have definite lives are being amortized on a straight-line basis over their estimated useful lives and goodwill is evaluated at least annually to determine if fair value of the asset has decreased below its carrying value. We performed our annual assessment of goodwill as of December 31, 2004, and determined that no adjustment to impair goodwill was necessary.

Goodwill and intangible assets consist of the following:

	September 30, 2005			December 31, 2004
Goodwill	$	533,031		$	533,031
Patents	$	2,281,414		$	2,038,582
Accumulated amortization	(1,046,394		)	(891,178		)
Patents, net	1,235,020			1,147,404
Other Intangibles:
Assets acquired in the purchase of our subsidiary Valence Technology in 1998: Covenant not to compete, Developed Technology, ASP brand name, Cell Library, and Customer List	4,910,400			4,910,400
License agreements acquired in purchase of our subsidiary SRSWOWcast in February 2003	640,071			640,071
Poly Planar purchased technology for speaker products	120,000			120,000
Capitalized software and hardware for several technologies	493,841			394,840
Total of Other Intangibles	6,164,312			6,065,311
Accumulated amortization, other intangibles	(4,852,446		)	(4,551,760		)
Other intangibles, net	1,311,866			1,513,551
Intangible assets, net	$	2,546,886		$	2,660,955

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Amortization periods range from three to eleven years depending on the estimated useful life of the asset. Amortization expense consists of the following:

	Three months ended September 30,				Nine Months ended September 30,
	2005		2004		2005		2004
Patents	$	53,834	$	46,331	$	155,216	$	113,307
Other intangibles:
Covenant not to compete, Developed Technology, ASP brand name, Cell Library and Customer List	51,477		51,477		154,432		154,431
License agreements acquired in purchase of our subsidiary SRSWOWcast in February 2003	16,002		16,002		48,005		48,005
Poly Planar purchased technology	—		6,000		4,000		18,000
Capitalized software and hardware	32,746		29,713		94,249		60,358
Total intangible amortization expense	$	154,059	$	149,523	$	455,902	$	394,101

As of September 30, 2005, the weighted average useful life of the Company’s patents and intangible assets is approximately 3.0 years. The following table shows the estimated amortization expense for those assets for the remaining three months of the current fiscal year and each of the four succeeding fiscal years:

Year ending December 31,	Estimated expense
2005	$	161,618
2006	$	643,112
2007	$	560,148
2008	$	340,215
2009	$	184,882
Thereafter	$	656,911

6.Investments Available for Sale

The Company has classified its investments as available for sale in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” The following table summarizes the Company’s investment securities available for sale:

	September 30, 2005			December 31, 2004
Cost	$	17,489,688		$	17,489,688
Accretion of discount	1,693			—
Unrealized loss	(423,311		)	(228,421		)
Estimated fair value	$	17,068,070		$	17,261,267

The contractual maturities of investments are shown below. Actual maturities may differ from contractual maturities.

	September 30, 2005				December 31, 2004
	Cost		Estimated Fair Value		Cost		Estimated Fair Value
U.S. Government securities available for sale:
Due in one to five years	$	17,489,688	$	17,068,070	$	17,489,688	$	17,261,267

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The following table summarizes sales of available for sale securities for three months and nine months ended September 30, 2005 and 2004. Specific identification was used to determine costs in computing realized gains or losses.

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2005		2004		2005		2004
Proceeds from sale	$	—	$	—	$	—	$	5,235,626
Realized gains	—		—		—		139,375

7.Net Income Per Common Share

The Company applies SFAS No. 128, “Earnings per Share,” which requires the disclosure of basic and diluted net income or loss per share for all current and prior periods. Basic net income or loss per common share is computed by dividing net income or loss available to common stockholders by the weighted average number of common shares outstanding during each year. Diluted net income or loss per common share reflects the maximum dilution, based on the average price of the Company’s common stock each period, and is computed similar to basic income or loss per share except that the denominator is increased to include the number of additional shares that would have been outstanding if potentially dilutive stock options and warrants had been exercised.

Basic and diluted net income per share computed in accordance with SFAS 128 for the three months and nine months ended September 30, are as follows:

	For the three months				For the nine months
	ended September 30,				ended September 30,
	2005		2004		2005		2004
BASIC EPS
Net income	$	704,194	$	803,958	$	1,439,388	$	1,009,129
Denominator: weighted average common shares outstanding	14,094,690		14,278,589		14,076,833		14,045,162
Net income per share—basic	$	0.05	$	0.06	$	0.10	$	0.07
DILUTED EPS
Net income	$	704,194	$	803,958	$	1,439,388	$	1,009,129
Denominator: weighted average common shares outstanding	14,094,690		14,278,589		14,076,833		14,045,162
Common equivalent shares outstanding:
Options	1,206,113		1,117,203		993,529		1,946,169
Total diluted shares	15,300,803		15,395,792		15,070,362		15,991,331
Net income per share—diluted	$	0.05	$	0.05	$	0.10	$	0.06

There were 898,811 and 1,308,500 potentially dilutive options outstanding for the quarters ending September 30, 2005 and 2004, respectively and there were 1,349,811 and 164,000 potentially dilutive options outstanding for the nine months ending September 30, 2005 and 2004, respectively, that were not included in the table above because they would be anti-dilutive.

8.Commitments and 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.

9.Stockholders’ Equity

On June 30, 2004, the Company’s Board of Directors authorized the repurchase of up to $3,000,000 of its outstanding common stock for a period from July 1, 2004 to December 31, 2004 (the “2004 Repurchase Program”).  The Company repurchased 216,575 shares at a cost of $1,225,254 under the 2004 Repurchase Program.

On March 24, 2005, the Company’s Board of Directors authorized the repurchase of up to $3,000,000 of the outstanding shares of the Company’s common stock for a period from January 1, 2005 to December 31, 2005 (the “2005 Repurchase Program”). As of September 30, 2005, 232,223 shares had been repurchased under the 2005 Repurchase Program. Purchases may be made from time to time in the open market, block purchases or privately negotiated transactions,

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depending on market conditions, share price and other factors.  All repurchased shares are reflected as treasury stock in the accompanying consolidated balance sheets. The following table shows activity under the 2005 Repurchase Program for the nine months ending September 30, 2005:

	September 30,
	2005
Shares repurchased	232,223
Average price per share	$	4.56
Total repurchase authorized	$	3,000,000
Repurchases under the plan	$	(1,059,590	)
Authorized repurchase remaining	$	1,940,410

10.Segment Information

The Company operates two business segments — semiconductors and licensing.  The Company does not allocate corporate operating expenses or specific assets to these segments. Therefore, the segment information that follows includes only net revenues, cost of sales and gross margins of the identified segments:

	Valence Semiconductor		SRS Labs Licensing		Total
Three Months Ended September 30, 2005
Total revenues	$	1,929,605	$	3,722,662	$	5,652,267
Cost of sales	753,730		100,241		853,971
Gross margin	$	1,175,875	$	3,622,421	$	4,798,296
Three Months Ended September 30, 2004
Total revenues	$	3,644,298	$	2,727,861	$	6,372,159
Cost of sales	1,320,855		100,342		1,421,197
Gross margin	$	2,323,443	$	2,627,519	$	4,950,962

	Valence Semiconductor		SRS Labs Licensing		Total
Nine Months Ended September 30, 2005
Total revenues	$	6,435,342	$	10,526,734	$	16,962,076
Cost of sales	2,481,136		251,424		2,732,560
Gross margin	$	3,954,206	$	10,275,310	$	14,229,516
Nine Months Ended September 30, 2004
Total revenues	$	8,992,511	$	8,140,592	$	17,133,103
Cost of sales	3,269,622		146,886		3,416,508
Gross margin	$	5,722,889	$	7,993,706	$	13,716,595

For the three months ending September 30, 2005, one customer accounted for approximately 10% of consolidated revenues, or $568,149, in the semiconductor segment. For the same period in the prior year, one customer accounted for approximately 12% of consolidated revenues, or $757,886, in the semiconductor segment. There was no significant customer in the licensing segment for the three months ending September 30, 2005 and September 30, 2004.

For the nine months ending September 30, 2005, one customer accounted for approximately 11% of consolidated revenues, or $1,799,659, in the semiconductor segment. For the same period in the prior year no single customer accounted for more than 10% of revenues in the either segment.

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The following schedule presents the Company’s revenue by geographic area. For product sales, revenue is allocated based on the country to which the product was shipped. For licensing-related revenue, the allocation is based on the location of the licensee’s corporate headquarters. The Americas region includes North, Central and South America.

	Three Months Ended September 30,						Nine Months Ended September 30,
	2005		%	2004		%	2005		%	2004		%
Geographic Area Revenue:
Hong Kong	$	1,809,186	32	$	3,283,202	52	$	5,864,536	35	$	8,264,269	54
Japan	1,253,986		22	1,098,643		17	4,221,028		25	3,756,473		19
Other Asia Pacific	1,256,014		22	502,769		7	3,268,729		19	1,103,930		9
Americas	590,251		11	512,699		8	1,770,102		10	1,824,668		3
China	662,681		12	797,074		13	1,625,284		10	1,590,754		9
Europe	80,149		1	177,772		3	212,397		1	593,009		6
Total	$	5,652,267	100	$	6,372,159	100	$	16,962,076	100	$	17,133,103	100

11.Recent Accounting Pronouncements

 In December 2004, the Financial Accounting Standards Board (“FASB”) issued a revised Statement 123, which as amended is effective for the Company’s first quarter of 2006. Statement 123(R) requires companies to expense in their consolidated statement of operations the estimated fair value of employee stock options and similar awards. SFAS 123(R) will be effective for quarterly periods beginning after December 31, 2005.  The Company will adopt the provisions of Statement 123(R) using a modified prospective application. Under the modified prospective application, Statement 123(R), which provides certain changes to the method for valuing stock-based compensation among other changes, will apply to new awards and to awards that are outstanding on the effective date and are subsequently modified or cancelled. Compensation expense for outstanding awards for which the requisite service had not been rendered as of the effective date will be recognized over the remaining period using the compensation cost calculated for pro forma disclosure purposes under Statement 123. Depending on the model used to calculate stock-based compensation expense in the future, the implementation of certain other requirements of Statement 123(R) and additional option grants expected to be made in the future, the pro forma disclosure may not be indicative of the stock-based compensation expense that will be recognized in the Company’s future financial statements. The Company is in the process of determining how the new method of valuing stock-based compensation as prescribed in Statement 123(R) will be applied to valuing stock-based awards granted after the effective date and the impact the recognition of compensation expense related to such awards will have on its financial statements.

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

This information should be read in conjunction with 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, 2004 (the “Form 10-K”), the audited consolidated financial statements and the notes thereto included in the Form 10-K and the unaudited condensed interim consolidated financial statements and notes thereto included in this Quarterly Report.

Overview

SRS Labs is a leading developer and provider of application-specific integrated circuits, or (“ASIC”), standard integrated circuits, or ICs, and audio and voice technology solutions for the home entertainment, portable media device, personal telecommunications, personal computer, automotive and broadcast markets. We operate in the following two business segments:

Semiconductors: Through SRS Labs, Inc.’s wholly-owned subsidiary, Valence Tech Limited, and ValenceTech Limited’s wholly-owned subsidiaries (collectively “Valence”), we operate a fabless semiconductor business which develops, designs and markets standard and custom analog ICs, digital signal processors, or DSPs, and mixed signal integrated circuits primarily to original equipment manufacturers, or OEMs, and original design manufacturers, or ODMs, in the Asia Pacific region.

Licensing: Through SRS Labs, the parent company, and its wholly-owned subsidiary, SRSWOWcast.com, Inc., doing business as SRSWOWcast Technologies (“SRSWOWcast”), the licensing segment develops and licenses audio, voice and surround sound technology solutions to many of the world’s leading OEMs/ODMs, software providers and semiconductor companies, and licenses and markets hardware and software products for the Internet and professional audio markets.

As used herein, the “Company,” “SRS Labs,” “we,” “us,” or “our” means SRS Labs, Inc. and its wholly owned subsidiaries and CHS/SRS, LLC, a joint venture (the “Joint Venture”) that we entered into with Coming Home Studios LLC (“CHS”).

In September 2004, we entered into a strategic alliance with CHS to produce and sell concert DVDs by Duran Duran, Boz Scaggs, Godsmack and All Access featuring our Circle Surround technology.   In connection with the strategic alliance, the Company and CHS established the Joint Venture to complete and distribute the concert DVDs.  In July 2005, we replaced CHS as the manager of the Joint Venture.  As a result of becoming the manager of the Joint Venture, we have control over the Joint Venture’s business strategy and decisions; accordingly, we are required under applicable accounting rules to consolidate the financial statements of the Joint Venture into our financial statements commencing with the third quarter of fiscal 2005.  Previously, we accounted for our interest (50% of the equity ownership) in the Joint Venture as an investment using the equity method.  In the consolidated financial statements, all inter-company accounts and transactions between the Company and the Joint Venture have been eliminated.

Results of Operations

Three Months Ended September 30, 2005 Compared to Three Months Ended September 30, 2004

Revenues

Semiconductor revenues consists of (a) design fees relating to, and sales of, ASIC for third parties by Valence to original equipment manufacturers (“OEMs”); and  (b) sales of general purpose integrated circuits (“ICs”) designed by Valence under the brand name ASP.  Licensing revenues consist primarily of royalties generated from the license of SRS Labs’ audio and voice technologies.  License and royalty agreements generally provide for the license of technologies for a fee based on the number of units distributed by the licensee.  However, we have in the past and may again in the future, enter into a license agreement for a one-time fee. Also included in licensing revenue are revenues generated from the sale of hardware and software applications into the broadcast audio markets and the sale of concert DVDs.

Total revenues for the three months ended September 30, 2005 were $5,652,267 compared to $6,372,159 for the three months ended September 30, 2004, a decrease of $719,892 or 11.3%. Semiconductor revenues were $1,929,605 for the three months ended September 30, 2005 compared to $3,644,298 for the three months ended September 30, 2004, a decrease of $1,714,693 or 47.1%. Within semiconductor revenue, ASIC accounted for $1,086,207 or 56.3% for the three months

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ended September 30, 2005 compared to $2,526,417 or 69.3% for the same period last year, a decrease of $1,440,210 or 57.0%. ASP chips accounted for $843,398 or 43.7% for the three months ended September 30, 2005 compared to $1,117,881 or 30.7% for the same period last year, a decrease of $274,483 or 24.6%. Within ASP revenues, SRS chips accounted for 37.3% for the three months ended September 30, 2005 compared to 49.5% for the same period last year. The decrease in semiconductor sales can be attributed to the change in backlog movement, which built up in Q2 2004 and shipped in Q3 2004 resulting in a non-recurring spike in revenue in Q3 2004.  The decrease is also due to competitive pressure in the market and a decline in certain customer sales due to a shift in market trends from CD combo and Boombox to MP3.

Licensing revenues were $3,722,662 for the three months ended September 30, 2005, compared to $2,727,861 for the three months ended September 30, 2004, an increase of $994,801 or 36.5%. The sales growth in licensing was attributable to our continued diversification strategy, which yielded new accounts as well as the expanded use of our technologies in existing accounts in portable devices, PC, mobile phone and automotive markets.  The following table presents the Company’s licensing revenues mix by market segment:

	Three Months Ended September 30,
	2005		2004
Home Entertainment (TV, Set Top Box, A/V Receiver, DVD)	48	%	69	%
Portable Media Devices (Digital Media Player, Headphone)	29	%	13	%
PC (Software, Hardware)	9	%	8	%
Personal Telecommunications (Mobile Phone, PDA)	11	%	7	%
Automotive	3	%	3	%

Gross Margin

Cost of sales consists primarily of fabrication costs, assembly and test costs, and the cost of materials and overhead from operations. Gross margins are dependent on the mix of products sold, services provided and royalties earned. The decline in semiconductor gross margins can be attributable to the amortization of masking charges, competitive pressure in the ASIC market and an aggressive pricing strategy on ASP chips to increase market penetration. The following table presents the Company’s gross margin percentages for the three months ended September 30:

	Three Months Ended September 30,
	2005		2004
Semiconductor
ASIC revenue as a percentage of total semiconductor revenue	56.3	%	69.3	%
ASIC gross margin	64.8	%	63.0	%
ASP revenue as a percentage of total semiconductor revenue	43.7	%	30.7	%
ASP gross margin	55.9	%	65.5	%
Total semiconductor revenue as a percentage of total revenue	34.1	%	57.2	%
Total semiconductor gross margin	60.9	%	63.8	%
Licensing
Licensing revenue as a percentage of total revenue	65.9	%	42.8	%
Licensing gross margin	97.3	%	96.3	%
Total Gross Margin	84.9	%	77.7	%

Sales and Marketing

Sales and marketing expenses consist primarily of employee salaries, sales consultants’ fees and related expenses, sales commissions and product promotion costs. Sales and marketing expenses were $1,521,788 for the three months ended September 30, 2005 compared to $1,305,349 for the same prior year period, an increase of $216,439 or 16.6%.  The increase is attributable to an increase in sales and marketing headcount in our semiconductor and licensing segments. As a percentage of total revenues, sales and marketing expenses increased from 20.5% for the quarter ended September 30, 2004 to 26.9% for the same period this year.

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Research and Development

Research and development expenses consist of salaries and related costs of employees engaged in ongoing research, design and development activities. Research and development expenses were $1,220,889 for the three months ended September 30, 2005 compared to $1,266,606 for the same prior year period, a decrease of $45,717 or 3.6 %.  As a percentage of total revenues, research and development expenses increased from 19.9% for the quarter ended September 30, 2004 to 21.6% for the same period this year.

General and Administrative

General and administrative (“G&A”) expenses consist primarily of employee-related expenses, legal costs associated with the administration of intellectual property and other professional fees. G&A expenses were $1,445,733 for the three months ended September 30, 2005 compared to $1,452,236 for the same prior year period, a decrease of $6,503. As a percentage of total revenues, G&A expenses increased from 22.8% for the quarter ended September 30, 2004, to 25.6% for the same period this year.

Other Income, Net

Other income, net, consists primarily of interest income, gain on sale of securities and foreign currency transaction gains and losses. Other income, net, was $174,195 for the three months ended September 30, 2005, compared to $118,908 for the same prior year period, an increase of $55,287 or 46.5%. The increase is primarily attributable to improved interest rates on investments.

Provision for Income Taxes

The income tax expense for the three months ended September 30, 2005 was $79,887, compared to tax expense of $241,721 for the same prior year period, a decrease of $161,834 or 67.0%. The provision consists primarily of taxes paid on licensing revenues sourced from countries requiring foreign tax withholdings and taxes paid on profits in Hong Kong at the rate of 17.5%.  The lower tax expense for the three months ended September 30, 2005 resulted from decreased taxable income in our foreign subsidiary.

Nine Months Ended September 30, 2005 Compared to Nine Months Ended September 30, 2004

Total revenues for the nine months ended September 30, 2005 were $16,962,076 compared to $17,133,103 for the period ended September 30, 2004, a decrease of $171,027 or 1.0%. Semiconductor revenues were $6,435,342 for the nine months ended September 30, 2005 compared to $8,992,511 for the period ended September 30, 2004, a decrease of $2,557,169 or 28.4%. Within semiconductor revenue, ASIC accounted for $4,300,283 or 66.8% for the nine months ended September 30, 2005 compared to $6,188,486 or 68.8% for the same period last year, a decrease of $1,888,203 or 30.5%. ASP chips accounted for $2,135,059 or 33.2% for the nine months ended September 30, 2005 compared to $2,804,025 or 31.2% for the same period last year, a decrease of $668,966 or 23.9%. Within ASP revenues, SRS chips accounted for 40.2% for the nine months ended September 30, 2005 compared to 40.6% for the same period last year.  The decrease in semiconductor sales can be attributed to competitive pressure and the decline in certain customer sales due to a shift in market trends from CD Combo and Boombox products to MP3.

Licensing revenues were $10,526,734 for the nine months ended September 30, 2005, compared to $8,140,592 for the nine months ended September 30, 2004, an increase of $2,386,142 or 29.3%. The sales growth in licensing was attributable to our continued diversification strategy, which yielded new customers and expanded the use of our technologies in portable devices, PC, mobile phone and automotive markets. The following table presents the Company’s licensing revenues mix by market segment:

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	Nine Months Ended September 30,
	2005		2004
Home Entertainment (TV, Set Top Box, A/V Receiver, DVD)	51	%	68	%
Portable Media Devices (Digital Media Player, Headphone)	23	%	10	%
PC (Software, Hardware)	11	%	11	%
Personal Telecommunications (Mobile Phone, PDA)	12	%	10	%
Automotive	3	%	1	%

Gross Margin

Cost of sales consists primarily of fabrication costs, assembly and test costs, and the cost of materials and overhead from operations. Gross margins are dependent on the mix of products sold, services provided and royalties earned. The decline in semiconductor gross margins can be attributable to the amortization of masking charges and an aggressive pricing strategy on ASP chips to increase market penetration. The following table presents the Company’s gross margin percentages for the nine months ended September 30:

	Nine Months Ended September 30,
	2005		2004
Semiconductor
ASIC revenue as a percentage of total semiconductor revenue	66.8	%	68.8	%
ASIC gross margin	64.8	%	65.4	%
ASP revenue as a percentage of total semiconductor revenue	33.2	%	31.2	%
ASP gross margin	54.6	%	59.8	%
Total semiconductor revenue as a percentage of total revenue	37.9	%	52.5	%
Total semiconductor gross margin	61.4	%	63.6	%
Licensing
Licensing revenue as a percentage of total revenue	62.1	%	47.5	%
Licensing gross margin	97.6	%	98.2	%
Total Gross Margin	83.9	%	80.1	%

Sales and Marketing

Sales and marketing expenses consist primarily of employee salaries, sales consultants’ fees and related expenses, sales commissions and product promotion costs. Sales and marketing expenses were $4,892,666 for the nine months ended September 30, 2005 compared to $4,260,784 for the same prior year period, an increase of $631,882 or 14.8%. The increase is primarily attributable to headcount and recruiting expenses related to increased sales and marketing personnel in our semiconductor and licensing segments.  As a percentage of total revenues, sales and marketing expenses increased from 24.9% for the nine months ended September 30, 2004 to 28.8% for the same period this year.

Research and Development

Research and development expenses consist of salaries and related costs of employees engaged in ongoing research, design and development activities. Research and development expenses were $3,610,829 for the nine months ended September 30, 2005 compared to $3,620,219 for the same prior year period, a decrease of $9,390.  As a percentage of total revenues, research and development expenses were 21.1% for the nine months ended September 30, 2004, and 21.3% for the same period this year.

General and Administrative

General and administrative (“G&A”) expenses consist primarily of employee-related expenses, legal costs associated with the administration of intellectual property and other professional fees. G&A expenses were $4,492,991 for the nine months ended September 30, 2005 compared to $4,490,732 for the same prior year period, an increase of $2,259. As a percentage of total revenues, G&A expenses were 26.2% for the nine-months ended September 30, 2004 and 26.5% for the same period this year.

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Equity in Income of Investee

Equity in income of investee of $91,096 for the nine months ended September 30, 2005 represents the Company’s proportionate share of profit from the Joint Venture prior to the consolidation of the Joint Venture’s financial statement with our condensed consolidated financial statements.

Other Income, Net

Other income, net, consists primarily of interest income, gain on sale of securities and foreign currency transaction gains and losses. Other income, net, was $488,421 for the nine months ended September 30, 2005, compared to $455,132 for the same prior year period, an increase of $33,289 or 7.3%. The increase is primarily attributable to improved interest rates on investments.

Provision for Income Taxes

The income tax expense for the nine months ended September 30, 2005 was $373,159, compared to tax expense of $790,863 for the same prior year period, a decrease of $417,704 or 52.8%. The provision consists primarily of taxes paid on licensing revenues sourced from countries requiring foreign tax withholdings and taxes paid on profits in Hong Kong at the rate of 17.5%.  The lower tax expense in fiscal 2005 resulted from decreased taxable income in our foreign subsidiary.  In addition, we benefited from the U.S. Japan tax treaty, which eliminated source-country withholdings on royalties. That treaty became effective on July 1, 2004.

Liquidity and Capital Resources

The Company’s principal source of liquidity to fund ongoing operations at September 30, 2005 consisted of cash, cash equivalents and long-term investments of $24,888,403.  At September 30, 2005, the Company had cash and cash equivalents of $7,820,333 and long-term investments of $17,068,070. Cash and cash equivalents generally consist of cash, money market funds and other money market instruments with original maturities of three months or less. Investments consist of U.S. government securities rated AAA.

We generated $2,269,843 of cash and cash equivalents in our operating activities during the first nine months of fiscal year 2005, primarily due to net income, further adjusted for depreciation and amortization and a decrease in prepaid expenses, increases in accounts payable and accrued liabilities offset by an increase in accounts receivable.  In the comparable period of fiscal year 2004, we generated $2,894,878 of cash and cash equivalents in our operating activities primarily due to net income, further adjusted for depreciation and amortization and a decrease in prepaid expenses, increases in accrued liabilities and deferred revenue offset by an increase in accounts receivable.

During the first nine months of fiscal year 2005, we used $1,106,542 in investing activities primarily related to the investment in production costs associated with our strategic alliance with Coming Home Studios LLC, referenced above under the caption “Overview” and expenditures relating to capital equipment, patents and intangibles.  In the comparable period of fiscal year 2004, we used $3,075,679 in investing activities primarily related to the investment in the strategic alliance with Coming Home Studios LLC and expenditures relating to capital equipment, patents and intangibles.

 During the nine months ended September 30, 2005, we used $354,880 in financing activities due to the purchase of treasury stock offset by proceeds received from the issuance of common stock in connection with option exercises.  In the comparable period of fiscal year 2004, we generated $3,405,466 from financing activities primarily due to the issuance of common stock in connection with option exercises.

On September 23, 2004, we entered into a strategic alliance with Coming Home Studios LLC (“CHS”) to produce and sell concert DVDs which incorporate our Circle Surround technology. In connection with that strategic alliance, we entered into a joint venture, CHS/SRS, LLC, formed to complete and distribute concert videos featuring Duran Duran, Boz Scaggs, Godsmack and All Access.

As noted above, in September 2004 we entered into a strategic alliance with CHS to produce and sell concert DVDs using our Circle Surround technology.  In connection with this strategic alliance, we formed the Joint Venture with CHS to complete and distribute the concert DVDs.  Profits from the distribution of the concert DVDs and related assets pursuant to the Joint Venture will be allocated and distributed in the following manner and order: (a) 100% to the Company until such

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time as we have received 130% of the cumulative additional advances that we provided to the Joint Venture; (b) equally until we and CHS have each received 1.75 times our respective original defined capital contributions; and thereafter (c) 90% to CHS and 10% to the Company.  As of September 30, 2005, our aggregate capital contribution was $3.2 million, consisting of $1.8 million in original capital contributions, $1.1 million in additional advances and $.3 million in capitalized costs associated with the formation of the joint venture.  As of September 30, 2005, CHS’ capital contribution was valued at $1.8 million and consisted of the artist agreements with Duran Duran, Boz Scaggs, Godsmack and All Access pursuant to which the concert videos are filmed, produced and distributed, and is recorded at $0 in the accompanying financial statements.

Based on current plans and business conditions, the Company expects that its cash, cash equivalents and investments together with any amounts generated from operations will be sufficient to meet the Company’s cash requirements for the foreseeable future. However, there can be no assurance that the Company will not be required to seek other financing sooner or that such financing, if required, will be available on terms satisfactory to the Company.

Factors That May Affect Future Results

The concert DVDs for our joint venture with Coming Home Studios may not be completed.

We have invested a total of $3.2 million in CHS/SRS, LLC, our joint venture with CHS to produce a total of six concert DVDs by Duran Duran, Godsmack, Boz Scaggs and All Access featuring our Circle Surround technology.  Although three of the concert DVDs have been completed and are in distribution, the remaining three concert DVDs have been delayed past the originally scheduled completion date.  We depend on the services of other parties beyond our control to produce, complete and distribute the concert DVDs, including, without limitation, the services of CHS pursuant to a production services agreement between CHS and the Joint Venture.  In the event additional funds are required to complete the purpose of the Joint Venture, we may need to make additional cash contributions to the Joint Venture.

The production, completion and distribution of the concert DVDs is subject to a number of uncertainties, including delays and increased expenditures due to creative problems, technical difficulties, talent availability, accidents, natural disasters and other events beyond our control.  Because of these uncertainties, the projected cost of the concert DVDs may increase, the completion dates may be substantially delayed or the projects may be abandoned due to the exigencies of production.  Delays in production may also result in concert DVDs not being ready for release at the intended time and being postponed to a less favorable time, which could result in lower revenues.  In extreme cases, a concert DVD may be abandoned.  We cannot predict the success of any of the concert DVDs even if they are completed because their economic success will depend on their acceptance by the public, which cannot be accurately predicted.  The economic success of a concert DVD may also depend on the public’s acceptance of competing shows, the availability of alternative forms of entertainment and leisure time activities, general economic conditions, and other tangible and intangible factors, all of which can change and cannot be predicted with certainty.  There can be no assurance that the concert DVDs can be completed, or if completed and distributed, that the concert DVDs will achieve economic success.  If the concert DVDs are further delayed, not completed or generate insufficient returns once completed, there is a risk that our investment in CHS/SRS, LLC will be impaired or lost.

We are exposed to risks in our licensing business related to product and customer concentration

Currently, our licensing revenue is concentrated in the home theater market with the majority of revenue generated from the inclusion of SRS technology inside televisions, DVD players and set-top boxes. We expect that the consumer home entertainment market will continue to account for a significant portion of our licensing revenues for the foreseeable future. While consumer spending in general on consumer electronic products has increased, retail prices for certain consumer electronics products that include our audio technology, such as DVD players, have decreased significantly. Indications are that this trend will continue for the foreseeable future. From time to time, certain of our original equipment manufacturer and semiconductor manufacturer customers may account for a significant portion of revenue from a particular product application, such as DVD players, set-top boxes or televisions. Consumer electronics products manufacturers could decide to exclude our audio enhancement technology from their home theater products altogether in an effort to reduce cost. The loss of any such customer could have a material adverse affect on our financial condition and results of operations.

Our business is highly dependent on the consumer electronics market, which is characterized by short product life cycles, fluctuations in demand and seasonality, and subject to risks related to product transitions and supply of other components

The consumer electronics market is characterized by intense competition, rapidly evolving technology, and ever-changing consumer preferences. These factors result in the frequent introduction of new products, short product life cycles and significant price competition. The dynamic nature of this market limits our, as well as our customers’, ability to

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accurately forecast quarterly and annual sales. If we, or our customers, are unable to manage product transitions, our business and results of operations could be negatively affected.

Pricing pressures on the consumer electronics product manufacturers who incorporate our technologies into their products could limit the licensing fees we charge for our technologies, which could adversely affect our revenues

The markets for the consumer electronics products in which our technologies are incorporated are intensely competitive and price sensitive. Retail prices for consumer electronics products that include our technologies, such as DVD players and home theater systems, have decreased significantly, and we expect prices to continue to decrease for the foreseeable future. In response, manufacturers have sought to reduce their product costs, which can result in downward pressure on the licensing fees we charge our customers who incorporate our technologies. A decline in the licensing fees we charge could materially and adversely affect our operating results.

Our business and prospects depend on the strength of our brand, and if we do not maintain and strengthen our brand, our business will be materially harmed

Maintaining and strengthening the “SRS” brand is critical to maintaining and expanding both our products and services business and our technology licensing business, as well as to our ability to enter new markets for our audio and other technologies. Our continued success is due, in part, to our reputation for providing high quality products, services and technologies across multiple consumer electronics product segments. If we fail to effectively promote and maintain the SRS brand, our business and prospects will suffer.

Our quarterly results may fluctuate

Our 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 our licensees incorporate our technologies into their products; the timing of orders from, and the shipments to, major customers; the timing of new product introductions; the gain or loss of significant customers; competitive pressures on selling prices; the market acceptance of new or enhanced versions of our technologies; the rate that our semiconductor licensees manufacture and distribute chips to product manufacturers; and fluctuations in general economic conditions, particularly those affecting the consumer electronics market. Due to our dependence on the consumer electronics market, the substantial seasonality of sales in the market could impact our revenues and net income. In particular, we believe 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, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied on as indications of future performance.

We are subject to the highly cyclical nature of the semiconductor industry

The semiconductor industry is highly cyclical. The industry has experienced significant downturns, often in connection with, or in anticipation of, maturing product cycles (of both semiconductor companies’ and their customers’ products) and declines in general economic conditions. These downturns have been characterized by production overcapacity, high inventory levels and accelerated erosion of average selling prices. Any future downturns could significantly harm our sales or reduce our profitability for a prolonged period of time. From time to time, the semiconductor industry also has experienced periods of increased demand and production capacity constraints. We may experience substantial changes in future operating results due to general semiconductor industry conditions, general economic conditions and other factors.

We rely on revenue contribution from our ASIC and standard IC business

We derive a significant amount of our revenue from Valence’s ASIC business. Valence’s engineering team focuses on the design of custom ASICs to meet specific customers’ requirements and out sources 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 a new industry standard, product obsolescence and changes in pricing policies by us, our competitors or our suppliers.

Business revenue from ASICs is concentrated in a limited number of customers in the areas of consumer electronics, communications products, computers and computer peripherals. The business generated from any one customer may be for a fixed length or quantity. As such, it is customary in our ASIC business to have a certain amount of customer turnover as new ASIC projects are obtained for different customers. However, it is possible that the loss of any particular customer or any bad debt arising from such customer may have a materially adverse impact on our financial condition and results of operation.

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Valence adds significant diversity to our overall business structure and opportunities. We recognize that in the presence of such corporate diversity, and in particular with regard to the semiconductor industry, there will always exist a potential for conflict among sales channels between us and our technology licensees. Although the operations of our 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, we may or may not be able to mitigate the effect of such perceived conflicts, which, if not resolved, may impact the results of operations.

Potential channel conflict with existing semiconductor partners could cause us to lose future business

As we bring out more and more Valence semiconductors with SRS audio technologies embedded in them, our current semiconductor partners may perceive those new devices as threats to their own products. The semiconductor partners may respond by reducing or eliminating the volumes of business they presently do with us, which would have an adverse effect on our licensing revenue.

We are exposed to risks in our Valence business related to product fabrication outsourcing to third parties

Valence is a “fabless” semiconductor company meaning that Valence designs, develops and markets our selection of custom and standard integrated circuits but we rely on third-party contractors to manufacture, assemble and test our products. From time to time there can be foundry capacity issues due to global demands that affect the semiconductor industry. Although we believe our relationships are generally good, we do not have long-term supply agreements with our third-party

vendors and they are not obligated to perform services or supply products to us for any particular period or in any particular quantities, except as provided in each separate purchase order accepted by them. The increased demand for our products coupled with the demand for foundry services, is, and will continue to be for the foreseeable future, a challenge for us. In times of high demand, there are significant risks associated with our reliance on third-party vendors including: reallocation of capacity to other foundry customers, potential price increases, delays and interruptions in order deliveries, reduced control over product quality and increased risk of misappropriation of intellectual property.

We conduct operations in a number of countries and are subject to risks of international operations, particularly in the People’s Republic of China (“PRC”) and other parts of Asia

We have significant operations in the PRC and other parts of Asia that require refinement to adapt to the changing market conditions in those regions. Our operations in Asia, and international operations in general, are subject to risks of unexpected changes in, or impositions of, legislative or regulatory requirements.

Our customers geographically located in the Asia Pacific markets accounted for approximately 86%, 93% and 90% of total Company sales in 2004, 2003 and 2002, respectively and are expected to continue to account for a substantial percentage of sales in the future.

The PRC economy has experienced significant growth in the past decade; but such growth has been uneven across geographic and economic sectors. There can be no assurance that such growth will continue or that any potential currency devaluation in the region will not have a negative effect on our 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 our 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.” We can give no assurance that Hong Kong will continue to enjoy autonomy from the PRC.

The Hong Kong dollar has remained relatively 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. We 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 declining consumer spending in Hong Kong, deflation or the discontinuation of the currency peg could adversely affect our business.

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We are exposed to currency fluctuations and instability in the Asian markets

We expect that international sales will continue to represent a significant portion of our total revenues. To date, all of our licensing revenues have been denominated in U.S. dollars and most costs have been incurred in U.S. dollars. It is our expectation that licensing revenues will continue to be denominated in U.S. dollars for the foreseeable future. Because Valence’s business is primarily focused in Asia and because of our anticipated expansion of business in the PRC and other parts of Asia, our consolidated results of operations and financial position 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, our 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. We intend to actively monitor ourforeign exchange exposure and to implement strategies to reduce our foreign exchange risk at such time that we determine the benefits of such strategies outweigh the associated costs. However, there is no guarantee that we will take steps to insure against such risks, and should such risks occur, there is no guarantee that we will not be significantly impacted.

If the sale of consumer electronics products incorporating our technologies does not grow in emerging markets, our ability to increase our licensing revenue may be limited

We also expect that growth in our licensing revenue will depend, in part, upon the growth of sales of consumer electronics products incorporating our technologies in other countries, including China and India, as consumers in these markets have more disposable income and are increasingly purchasing entertainment products with surround sound capabilities. However, if our licensing revenue from the use of our technologies in these new markets or geographic areas does not expand, our prospects could be adversely affected.

We are subject to competitive pressures

Our 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. Present or future competitors may be able to develop products and technologies comparable or superior to ours, and to adapt more quickly than us to new technologies or evolving market needs. We believe that the competitive factors affecting the market for our 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 we compete 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 we 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 our business, operating results, cash flows and financial condition.

We have a long and unpredictable sales cycle, which can result in uncertainty and delays in generating additional revenues

Historically, because of the complexity of our technologies, it can take a significant amount of time and effort to explain the benefits and to negotiate a sale. For example, it typically takes six to nine months after our first contact with a prospective customer before we start licensing our technology to that customer. In addition, purchase of our products is usually made in connection with new design starts, the timing of which is outside of our control. Accordingly, we may be unable to predict accurately the timing of any significant future sales of our products. We may also spend substantial time and management attention on potential license agreements that are not consummated, thereby foregoing other opportunities.

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We strongly rely on our intellectual property

Our ability to compete may be affected by our ability to protect our proprietary information. We have filed numerous U.S. and foreign patent applications and to date have a number of issued U.S. and foreign patents covering various aspects of our technologies. There can be no assurance that the steps taken by us to protect our intellectual property will be adequate to prevent misappropriation of our technology or that our competitors will not independently develop technologies that are substantially equivalent or superior to our technology. In addition, the laws of certain foreign countries may not protect our 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. We are not currently a party to any claims of this nature. There can be no assurances that third parties will not assert claims or initiate litigation against us or our customers with respect to existing or future products. In addition, we may initiate claims or litigation against third parties for infringement of our proprietary rights or to determine the scope and validity of our proprietary rights.

We depend on our key personnel

Our future success depends to a large extent upon the continued service of key personnel, including engineering, sales and marketing staff, and highly skilled semiconductor design staff. We anticipate that any future growth will require us to recruit and hire a number of new personnel in engineering, operations, finance, sales and marketing. Competition for such personnel can be intense, and there can be no assurance that we can recruit and retain necessary personnel to operate our business and support future growth.

The market price of our common stock is volatile

The trading price of our common stock has been, and will likely continue to be, subject to wide fluctuations in response to quarterly variations in our operating results, announcements of new products or technological innovations by us or our competitors, strategic alliances between us 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 we do business, or relating to us 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. Even though our stock is quoted on the Nasdaq Stock Market, our stock has had and may continue to have low trading volume and high volatility. The historically low trading volume of our stock makes it more likely that a severe fluctuation in volume, either up or down, will significantly impact the stock price. Since our shares are thinly traded, our shareholders may have difficulty selling our common stock.

Our certificate of incorporation, bylaws, change in control agreements with officers and key employees,  as well as Delaware law contain provisions that could discourage transactions resulting in a change in control, which may negatively affect the market price of our common stock

Our certificate of incorporation, bylaws, change in control agreements with officers and key employees and Delaware law contain provisions that might enable our management to discourage, delay or prevent change in control. In addition, these provisions could limit the price that investors would be willing to pay in the future for shares of our common stock.

Item 3.  Quantitative and Qualitative Disclosures about Market Risk

There have been no material changes to the information called for by this Item 3 from the disclosures set forth in Part II, Item 7A in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

Item 4.  Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this Quarterly Report. The controls evaluation was done under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer. Based on their evaluation as of the end of the period covered by this Quarterly Report, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective.

Changes in Internal Controls

There have been no changes in the Company’s internal controls over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the third quarter ended September 30, 2005, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II — OTHER INFORMATION

Item 6.  Exhibits

The exhibits listed below are hereby filed with the U.S. Securities and Exchange Commission as part of this Report.

Exhibit Number	Description
3.1	Certificate of Incorporation of the Company, previously filed with the Commission as Exhibit 3.1 to the Company’s Registration Statement on Form SB-2, specifically included in Amendment No. 1 to such Registration Statement filed with the Commission on July 3, 1996 (File No. 333-4974-LA), which is incorporated herein by reference.
3.2	Bylaws of the Company, previously filed with the Commission as Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 1999, filed with the Commission on November 12, 1999, which is incorporated herein by reference.
10.1	Employment Letter Agreement dated June 24, 2005, between the Company and Michael Franzi, previously filed with the Commission as Exhibit 10.1 to the Form 8-K, filed with the Commission on August 16, 2005, which is incorporated herein by reference.
10.2	Separation Agreement dated September 30, 2005, between the Company and Philip Wong, previously filed with the Commission as Exhibit 10.1 to the Form 8-K, filed with the Commission on September 30, 2005, which is incorporated herein by reference.
31.1	Certification of Chief Executive Officer of SRS Labs, Inc., pursuant to Rule 13a-14 of the Securities Exchange Act.
31.2	Certification of Chief Financial Officer of SRS Labs, Inc., pursuant to Rule 13a-14 of the Securities Exchange Act.
32.1	Certification of Chief Executive Officer of SRS Labs, Inc., pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification of Chief Financial Officer of SRS Labs, Inc., pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	SRS LABS, INC., a Delaware corporation
Date:  November 10, 2005	By:	/s/ THOMAS C.K. YUEN
		Thomas C.K. Yuen
		Chairman of the Board and Chief Executive Officer
		(Principal Executive Officer)
Date:  November 10, 2005	By:	/s/ JANET M. BISKI
		Janet M. Biski
		Chief Financial Officer
		(Principal Financial and Accounting Officer)

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EX-31.1

Exhibit 31.1

CERTIFICATION OF CHIEF EXECUTIVE OFFICER
PURSUANT TO SECTION 302
OF THE SARBANES-OXLEY ACT OF 2002

I, Thomas C.K. Yuen, certify that:

1.I have reviewed this quarterly report on Form 10-Q of SRS Labs, Inc.;

2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a)Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;

c)Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d)Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s third fiscal quarter ended September 30, 2005 that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5.The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

a)All significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information;

b)Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls over financial reporting.

Dated: November 10, 2005
	/s/ Thomas C.K. Yuen
	Thomas C.K. Yuen
	Chief Executive Officer

EX-31.2

EXHIBIT 31.2

CERTIFICATION OF CHIEF FINANCIAL OFFICER

PURSUANT TO SECTION 302

OF THE SARBANES-OXLEY ACT OF 2002

I, Janet M. Biski, certify that:

1.I have reviewed this quarterly report on Form 10-Q of SRS Labs, Inc.;

2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a)Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;

c)Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d)Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s third fiscal quarter ended September 30, 2005 that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5.The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

a)All significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information;

b)Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls over financial reporting.

Dated: November 10, 2005
	/s/ Janet M. Biski
	Janet M. Biski
	Chief Financial Officer

EX-32.1

Exhibit 32.1

CERTIFICATION OF THE CHIEF EXECUTIVE OFFICER PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of SRS Labs, Inc. (the “Company”) on Form 10-Q for the quarter ending September 30, 2005 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Thomas C.K. Yuen, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. 1350, as adopted pursuant to 906 of the Sarbanes-Oxley Act of 2002, that to the best of my knowledge:

1.The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

2.The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company.

Date: November 10, 2005
	By:	/s/ Thomas C.K. Yuen
		Thomas C.K. Yuen
		Chief Executive Officer

EX-32.2

Exhibit 32.2

CERTIFICATION OF THE CHIEF FINANCIAL OFFICER PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of SRS Labs, Inc. (the “Company”) on Form 10-Q for the quarter ending September 30, 2005 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Janet M. Biski, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. 1350, as adopted pursuant to 906 of the Sarbanes-Oxley Act of 2002, that to the best of my knowledge:

3.The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

4.The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company.

Date: November 10, 2005
	By:	/s/ Janet M. Biski
		Janet M. Biski
		Chief Financial Officer