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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

SRS LABS, INC.

(Exact name of registrant as specified in its charter)

2909 Daimler Street, Santa Ana, California 92705

(Address of principal executive offices) (Zip Code)

(949) 442-1070

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  x  No  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

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

As of October 30, 2008, 15,782,577 shares of the issuer’s common stock, par value $.001 per share, were outstanding.

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SRS LABS, INC.

Quarterly Report on Form 10-Q

For the Three and Nine Months Ended September 30, 2008

Index

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FORWARD-LOOKING INFORMATION

As used herein, the “Company,” “SRS Labs,” “SRS,” “we,” “us,” or “our” means SRS Labs, Inc. and its wholly-owned subsidiary SRSWOWcast.com, Inc.

Some of the statements in this Quarterly Report on Form 10-Q contain forward-looking statements regarding our assumptions, projections, expectations, targets, intentions or beliefs about future events, which involve risks and uncertainties. All statements other than statements of historical facts included in this Quarterly Report relating to expectation of future financial performance, continued growth, changes in economic conditions or capital markets and changes in customer usage patterns and preferences, and our potential stock repurchases are forward-looking statements. In some cases, you can identify forward-looking statements by terms such as may, will, should, expect, plan, intend, forecast, anticipate, believe, estimate, predict, potential, continue or the negative of these terms or other comparable terminology. The forward-looking statements contained in this Quarterly Report involve known and unknown risks, uncertainties and situations that may cause our or our industry’s actual results, level of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these statements. Factors that might cause actual events or results to differ materially from those indicated by these forward-looking statements may include the matters listed in our most recently filed Annual Report on Form 10-K and elsewhere in this Quarterly Report on Form 10-Q, including, but not limited to, general business and economic conditions; our high dependence on the consumer electronics market, which is characterized by short product life cycles, fluctuations in demand and seasonality; the loss of any one significant customer; the acceptance of new SRS Labs products and technologies; the import of competitive products and pricing; the timely development and release of technologies by the Company; product and customer concentration in our business; our dependence on growth in emerging markets; the length and unpredictable nature of our sales cycle; our ability to protect our products through patents and other intellectual property rights; our dependence on key personnel; the volatility of the price of our common stock; provisions that could discourage transactions resulting in a change in control contained in our certificate of incorporation and bylaws as well as Delaware law; competition we face from companies with greater brand recognition and resources; pricing pressures on the consumer electronics product manufacturers; and other factors identified from time to time in our filings with the Securities and Exchange Commission.

Any forward-looking statement speaks only as of the date on which such statement is made, and, except as required by law, we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time, and it is not possible for management to predict all such factors.

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PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

SRS LABS, INC. AND SUBSIDIARY

CONDENSED CONSOLIDATED BALANCE SHEETS

See accompanying notes to the condensed consolidated financial statements

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SRS LABS, INC. AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

See accompanying notes to the condensed consolidated financial statements

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SRS LABS, INC. AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND

COMPREHENSIVE INCOME (Unaudited)

For The Nine Months Ended September 30, 2008

See accompanying notes to the condensed consolidated financial statements

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SRS LABS, INC. AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

See accompanying notes to the condensed consolidated financial statements

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SRS LABS, INC. AND SUBSIDIARY

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,” “SRS,” “we,” “us,” or “our” means SRS Labs, Inc. and its wholly-owned subsidiary SRSWOWcast.com, Inc.  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” or “GAAP”) for interim financial information and the rules and regulations of the U.S. Securities and Exchange Commission (“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 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 year ended December 31, 2007. 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 are not necessarily indicative of the results to be expected for any other interim period or for the full year.  The condensed consolidated balance sheet as of December 31, 2007 and related disclosure amounts within these condensed consolidated financial statements were derived from the audited 2007 consolidated financial statements.

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.  By their nature, estimates are subject to an inherent degree of uncertainty.  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, 2007 for an additional discussion of the significant accounting policies and estimates used in the preparation of our financial statements.

Cash and Cash Equivalents and Short-term Investments

Cash and cash equivalents are short-term, highly liquid investments that are readily convertible to cash and are so near maturity that they present insignificant risk of changes in value because of interest rates. Cash and cash equivalents generally consist of cash, money market funds and instruments with original maturities of three months or less when purchased.  Short-term investments consist of certificates of deposits with original maturities of twelve months or less when purchased.  The Company places its cash in banks and its cash and cash equivalents in commercial paper and money market funds at certain financial institutions in excess of amounts insured by federal agencies.  The Company does not believe that it is subject to any unusual financial risk beyond the normal risk associated with commercial banking relationships.  The Company performs periodic evaluations of the relative credit standing of these financial institutions.  The Company has not experienced any significant losses on its cash equivalents or investments.

Customer Concentrations

Our revenue is primarily derived from licensing.  For the three months ended September 30, 2008, Samsung accounted for approximately 40% of the licensing revenue.  For the same period in the prior year, Samsung, LG and New Japan Radio accounted for approximately 26%, 14% and 11%, respectively, of the licensing revenue.  For the nine months ended September 30, 2008, Samsung accounted for approximately 40% of the licensing revenue.  For the same period in the prior year, Samsung accounted for approximately 25% of the licensing revenue.

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Income Taxes

The Company has net operating loss carryforwards to offset income taxes. Consequently, no provision is reflected in the accompanying interim financial statements.  Refer to our Annual Report on Form 10-K for additional disclosure.

2.                                       Intangible Assets

Intangible assets consist of the following:

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

As of September 30, 2008, the weighted average useful life of the Company’s patents and intangible assets was approximately 6.62 years. The following table shows the estimated amortization expense for those assets for the remaining months of the current fiscal year and each of the four succeeding fiscal years and thereafter:

3.                                       Net Income Per Common Share

The Company applies Statement of Financial Accounting Standards (“SFAS”) No. 128, Earnings per Share (“SFAS No. 128”), 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 during 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.

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Basic and diluted net income per share computed in accordance with SFAS No. 128 for the three and nine months ended September 30, 2008 and 2007 are as follows:

There were outstanding options to purchase an aggregate of 2,943,708 and 2,164,455 shares of the Company’s common stock for the three months and nine months ended September 30, 2008, respectively, that were not included in the table above because they would be anti-dilutive. There were outstanding options to purchase an aggregate of 557,439 and 542,660 shares of the Company’s common stock for the three and nine months ended September 30, 2007, respectively, that were not included in the table above because they would be anti-dilutive.

4.                                       Commitments and Contingencies

On June 8, 2007, we sent a letter to Sony Corporation (“Sony”) relating to the possible infringement of several SRS patents by Sony’s S-Force technology. Sony responded to the letter by filing a Complaint for Declaratory Relief in the U.S. District Court in the Southern District of New York on July 6, 2007. In November 2007, Sony and SRS entered into a standstill agreement for the purpose of conducting discussions towards an amicable resolution of the dispute, and the Complaint for Declaratory Relief was dismissed.  While the standstill agreement has expired, the parties continue to negotiate regarding this matter.  In October 2008, the outside patent counsel hired to evaluate the Sony S-Force technology informed us that they had completed their evaluation based on the information provided by Sony.  Based on their study, they confirmed SRS’ position that the S-Force technology infringes our patents.  The basis for this infringement position has been provided to Sony for their review.  SRS cannot assure that it will prevail in this matter and is unable to determine at this time the impact that this matter may have, if any, on its consolidated financial position, results of operations or cash flows.  From time to time, we may be involved in other litigation matters and disputes arising in the normal course of business. Any such matters and disputes could be costly and time consuming, subject us to damages or equitable remedies, and divert our management and key personnel from our business operations.

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5.                                       Segment Information

The Company operates in one reportable segment as disclosed in our Annual Report on Form 10-K.  The following schedule presents the Company’s revenue by geographic area. Revenue is summarized based on the location of the licensee’s corporate headquarters. The Americas region includes North, Central and South Americas.

6.                                       Recent Accounting Pronouncements

In May 2008, the Financial Accounting Standards Board (“FASB”) issued SFAS  No. 162, Hierarchy of Generally Accepted Accounting Principles (“SFAS No. 162”). This statement is intended to improve financial reporting by identifying a consistent framework, or hierarchy, for selecting accounting principles to be used in preparing financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles. This statement will be effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendment to AU Section 411, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles . The Company does not expect that the adoption of SFAS No. 162 will have a material impact on its consolidated financial position or results of operations.

In April 2008, the FASB issued FASB Staff Position (“FSP”) SFAS No. 142-3, Determination of the Useful Life of Intangible Assets (“FSP No. 142-3”).  This FSP amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS 142”). The intent of FSP No. 142-3 is to improve the consistency between the useful life of a recognized intangible asset under SFAS No. 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS No. 141R, and other GAAP. This FSP is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Early adoption is prohibited. The Company is currently evaluating the impact of FSP No. 142-3, but does not expect the adoption of this pronouncement will have a material impact on its consolidated financial position, results of operations or cash flows.

In December 2007, FASB issued SFAS No. 141 (revised 2007), Business Combinations (“SFAS No. 141(R)”), which replaces SFAS No. 141. SFAS No. 141(R) retains the purchase method of accounting for acquisitions, but requires a number of changes, including changes in the way assets and liabilities are recognized in the purchase accounting. It also changes the recognition of assets acquired and liabilities assumed arising from contingencies, requires the capitalization of in-process research and development at fair value, and requires the expensing of acquisition-related costs as incurred. SFAS No. 141(R) is effective for us beginning January 1, 2009 and will apply prospectively to business combinations completed on or after that date. We do not expect the adoption of SFAS No. 141 (R) will have a material effect on our consolidated financial position or results of operations.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS No. 157”). The purpose of SFAS No. 157 is to define fair value, establish a framework for measuring fair value and enhance disclosures about fair value measurements. The measurement and disclosure requirements became effective for us beginning January 1, 2008.  The adoption of SFAS No. 157 did not have a material effect on our consolidated financial position or results of operations.

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7.                                       Share Repurchase Program

On May 19, 2008, the Company’s Board of Directors approved a stock repurchase program.  Under the stock repurchase program, the Company was seeking to acquire up to $10.0 million of the Company’s outstanding common stock for a period from May 20, 2008 to November 19, 2008.   In total, the Company repurchased a total of 14,200 shares of the Company’s outstanding common stock under the program all in the second fiscal quarter.  On August 29, 2008, the Company suspended this repurchase program and announced it would conduct a Dutch auction tender offer, pursuant to which the Company could purchase up to $10.0 million of shares of its common stock (the “Dutch Auction”). On September 30, 2008, the Dutch Auction was terminated and withdrawn as a result of the Company’s receipt of an unsolicited inbound offer to purchase all of the Company’s common stock for consideration with a stated value per share in excess of the repurchase price set forth in the Offer to Purchase for the Dutch Auction.  As a result, SRS did not repurchase any shares under the Dutch Auction. After consultation with its financial and legal advisors, the Company’s Board of Directors believes that proceeding with the inbound offer as submitted, was not in the best interest of the Company and its stockholders.

On November 3, 2008, the Company’s Board of Director’s approved a stock repurchase program, pursuant to which the Company is seeking to acquire up to $15.0 million of the Company’s outstanding common stock.  This repurchase program will not be conducted using a Dutch auction and and will commence on November 7, 2008 and will remain open for a period of up to six months.

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 our Annual Report on Form 10-K for the year ended December 31, 2007, and the unaudited condensed interim consolidated financial statements and notes thereto included in this Quarterly Report.

Overview

We are a leading developer and provider of audio and voice technology solutions for the home entertainment, portable media device, personal telecommunications, personal computer, automotive, and broadcast markets.  Our operations are conducted through SRS Labs, Inc., the parent company, and its wholly-owned subsidiary, SRSWOWcast.com, Inc. Our business is focused on developing and licensing audio, voice and surround sound technology solutions to many of the world’s leading original equipment manufacturers, or OEMs, software providers and semiconductor companies, and licensing and marketing hardware and software products for the PC and broadcast audio markets.

Critical Accounting Policies

Our discussion and analysis of our results of operations and liquidity and capital resources are based on our consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States of America.

The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and disclosure of contingent assets and liabilities. We base our estimates on historical and anticipated results and trends and on various other assumptions that we believe are reasonable under the circumstances, including assumptions as to future events. These estimates form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. By their nature, estimates are subject to an inherent degree of uncertainty. Actual results may materially differ from our estimates.

Refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2007 for a discussion of critical accounting policies which include revenue recognition, valuation of accounts receivable, valuation of intangible assets and capitalization of software, recognition and measurement of current and deferred income tax assets and liabilities, and stock-based compensation.  During the nine months ended September 30, 2008, there were no material changes to these policies.

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Results of Operations

Three Months Ended September 30, 2008 Compared to Three Months Ended September 30, 2007

Revenues

Licensing revenues consist primarily of royalties generated from the license of our 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 or on an annual flat fee arrangement.  Certain of our licenses include minimum annual royalties. Also included in licensing revenue are revenues generated from the sale of hardware and software applications into the PC and broadcast audio markets.

The following table presents our licensing revenues mix by market :

Our revenues were $ 4,319,433 for the three months ended September 30, 2008, compared to $4,769,271 for the three months ended September 30, 2007, a decrease of $449,838 or 9%.  Revenues in our Home Entertainment market decreased by $373,339 or 11% primarily due to decreased revenues associated with the previously disclosed loss of one major customer, offset by increased revenues from our largest licensee. Additionally, in the prior fiscal year, we changed the fee arrangement with one licensee, from a per unit royalty to a flat fee royalty arrangement, which resulted in a one-time increase in revenues of approximately $443,000 for the three months ended September 30, 2007.  Revenues in the portable media devices market decreased by $97,372 or 19% primarily due to decreased revenues from headphones and MP3 docking stations. Revenues in the automotive market increased $63,638 or 19% due to increased revenues from several customers in Japan who provide line install, dealer option and after market automotive audio systems to many of the significant Japanese automobile manufacturers.  Revenues in the PC market decreased by $56,694 or 20% due to fewer software downloads.

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 $2,451,026 for the three months ended September 30, 2008, compared to $1,460,185 for the same prior year period, an increase of $990,841 or 68%.  This increase was primarily attributable to one-time recruitment and severance costs, totaling approximately $500,000, in the third quarter of 2008 related to the Company’s ongoing investment in strengthening its sales and marketing departments.  In addition to increasing the marketing and sales personnel by three additional persons during the three months ended September 30, 2008, the Company has also increased its branding efforts.  Included in sales and marketing expenses is stock-based compensation expense of $111,751 and $112,162 for the three months ended September 30, 2008 and 2007, respectively.  We expect that sales and marketing expenses will continue to increase as we hire additional sales personnel to penetrate target markets and key regions and as we continue to increase our marketing efforts to cultivate and elevate the SRS brand globally.  As a percentage of total revenues, sales and marketing expenses increased from 31% for the three months ended September 30, 2007 to 57% 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 and costs for engineering materials and supplies. Research and development expenses were $948,305 for the three months ended September 30, 2008, compared to $689,901 for the same prior year period, an increase of $258,404 or 37%.  This increase is attributable to employing six additional engineers in the three months ended  September 30, 2008 as compared to the same period in the prior year, and increased travel to support our global licensees.  Included in research and development expenses is stock-based compensation expense of $85,734 and $108,987 for the three months ended September 30, 2008 and 2007, respectively.  We expect that research and development expenses will continue to increase as we seek to accelerate the implementation of our technology with a greater number of customers and devices.  As a percentage of total revenues, research and development expenses increased from 14% for the three months ended September 30, 2007 to 22% for the same period this year.

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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 $1,524,529 for the three months ended September 30, 2008, compared to $1,436,184 for the same prior year period, an increase of $88,345 or 6%. The increase is primarily attributable to an increase in other professional fees of approximately $166,000 associated with the Company’s Dutch Auction repurchase program in the three months ended September 30, 2008.  Included in general and administrative expenses is stock-based compensation expense of $227,706 and $216,901 for the three months ended September 30, 2008 and 2007, respectively.  As a percentage of total revenues, G&A expenses increased from 30% for the quarter ended September 30, 2007 to 35% for the same period this year.

Interest Income

Interest income was $310,219 for the three months ended September 30, 2008, compared to $508,825 for the same prior year period, a decrease of $198,606 or 39%. This decrease was primarily attributable to lower interest rates earned on cash balances invested.

Provision for Income Taxes

The income tax expense for the three months ended September 30, 2008 was $0, compared to a tax benefit of $18,800 for the same prior year period.  The prior year income tax benefit reflects a tax refund due from the state of California.  We reduced our current quarter tax provision and our valuation allowance on our deferred tax assets by $385,290 and $450,290 for the three months ended September 30, 2008 and 2007, respectively, based on our assessment of the future estimated realization of such assets.

Nine Months Ended September 30, 2008 Compared to Nine Months Ended September 30, 2007

Revenues

The following table presents our licensing revenues mix by market:

Licensing revenues were $13,438,565 for the nine months ended September 30, 2008, compared to $14,536,526 for the nine months ended September 30, 2007, a decrease of $1,097,961 or 8%.  The decrease in licensing revenues was primarily attributable to a decrease in PC revenue of $626,045 or 47% due to the loss of our major customer in this market. This customer contributed $580,247 in revenue during the first nine months of 2007.  There were no significant amounts of revenue derived from this customer after the second fiscal quarter of 2007.   Revenue from the Home Entertainment market decreased $429,447 or 4% primarily due to the previously disclosed loss of one major customer in this market, and another significant customer changing in fiscal 2007 from a per unit royalty arrangement to a flat fee agreement.  These decreases were offset in part by increased revenues from our largest licensee.

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 $7,078,563 for the nine months ended September 30, 2008, compared to $5,104,195 for the same prior year period, an increase of $1,974,368 or 39%.  This

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increase was primarily attributable to higher payroll and related costs, including recruitment costs of $449,000, associated with hiring an additional twelve sales and marketing personnel in the first nine months of 2008 including our Vice President of Sales and our Vice President of Marketing.  In addition to increasing the marketing and sales personnel, the Company has also increased its branding efforts.  Included in sales and marketing expenses is stock-based compensation expense of $381,607 and $382,655 for the nine months ended September 30, 2008 and 2007, respectively.  As a percentage of total revenues, sales and marketing expenses increased from 35% for the nine months ended September 30, 2007 to 53% 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 and costs for engineering materials and supplies. Research and development expenses were $2,727,838 for the nine months ended September 30, 2008, compared to $2,366,121 for the same prior year period, an increase of $361,717 or 15%.  This increase was attributable to higher payroll related costs associated with hiring six additional engineers in fiscal 2008. Included in research and development expenses is stock-based compensation expense of $294,684 and $325,173 for the nine months ended September 30, 2008 and 2007, respectively.  As a percentage of total revenues, research and development expenses increased from 16% for the nine months ended September 30, 2007 to 20% for the same period this year.

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 $4,490,484 for the nine months ended September 30, 2008, compared to $4,105,792 for the same prior year period, an increase of $384,692 or 9%. The increase was primarily attributable to an increase in professional fees and expenses of $166,000, associated with the Company’s Dutch Auction repurchase program, which was terminated in September 2008.  The Company also incurred increased professional and legal fees associated with corporate matters, and an increase in stock-based compensation expense.  Included in general and administrative expenses is stock-based compensation expense of $666,142 and $581,232 for the nine months ended September 30, 2008 and 2007, respectively.  As a percentage of total revenues, G&A expenses increased from 28% for the nine months ended September 30, 2007 to 33% for the same period this year.

Interest Income

Interest income was $1,093,543 for the nine months ended September 30, 2008, compared to $1,511,585 for the same prior year period, a decrease of $418,042 or 28%. This decrease was primarily attributable to lower interest rates earned on cash balances invested.

Provision for Income Taxes

The income tax expense for the nine months ended September 30, 2008 was $13,232, compared to tax benefit of $18,800 for the same prior year period.  We reduced our current period tax provision and our valuation allowance on our deferred tax assets by $1,210,219 and $1,022,205 for the nine months ended September 30, 2008 and 2007, respectively, based on our assessment of the future estimated realization of such assets.

Liquidity and Capital Resources

Our principal source of liquidity to fund ongoing operations at September 30, 2008 consisted of cash, cash equivalents and short-term investments of $46,717,491.  At September 30, 2008, we had cash and cash equivalents of $41,733,491 and short-term investments of $4,984,000. Cash and cash equivalents are short-term highly liquid investments that are readily convertible to known amounts of cash and are so near maturity that they present insignificant risk of changes in value because of interest rates.  Cash and cash equivalents generally consist of cash, money market funds and instruments with original maturities of three months or less. The money market funds are primarily invested in U.S. government obligations. Short-term investments consist of certificates of deposit with original maturities of six months.

Net cash provided by operating activities was $2,333,848 and $3,922,769 during the nine months ended September 30, 2008 and September 30, 2007, respectively.  The $1,588,921 decrease in net cash provided by operating activities for the nine months ended September 30, 2008, compared to the same period in the prior year, was primarily a

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result of a decrease in net income from $4,374,891 during the nine months ended September 30, 2007 to $133,565 for the nine months ended September 30, 2008.  Offsetting the decrease in net income, accounts receivable decreased by $561,452 during the nine months ended September 30, 2008 compared to an increase of $846,007 during the same period in the prior year, due to lower revenues and increased cash collections.  Additionally, accounts payable and accrued liabilities increased $17,849 and $270,440, respectively, during the nine months ended September 30, 2008 as compared to decreasing $249,444 and $489,159, respectively, in the same period in the prior year.  The changes in liability accounts generally related to the timing of payments to vendors and changes in accrued commissions and amounts due to employees under our Profit Sharing and Bonus Plan.  Additionally, deferred revenue increased $646,163 for the nine months ended September 30, 2008 compared to $57,441 during the nine months ended September 30, 2007.   The increase in deferred revenue during the nine months ended September 30, 2008 was primarily due to the Company entering into a multi-year license agreement with LG Electronics in October 2007 for the use of our existing technology for television and monitors through December 2010.  We received the final lump sum payment under this agreement in the nine months ended September 30, 2008.

Our net cash used in investing activities was $163,267 and $701,606 during the nine months ended September 30, 2008 and 2007, respectively.  The net cash used in investing activities was attributable primarily to the Company’s purchase of short-term investments during the nine months ended September 30, 2008 totaling $4,984,000.  Offsetting this decrease, the Company received $5,500,000 from the sale of investments during the nine months ended September 30, 2008.

Our net cash used in financing activities was $ 52,381 during the nine months ended September 30, 2008, and net cash provided by financing activities was $1,842,964 during the nine months ended September 30, 2007. The decrease in net cash provided by financing activities was primarily attributable to a decrease in stock option exercises during the current period. The Company expects to continue to use a portion of its cash to conduct market repurchases under the stock repurchase program approved by the Board of Directors on November 3, 2008.  Under the new stock repurchase program, the Company is seeking to acquire up to $15.0 million of the Company’s outstanding common stock.  This repurchase program will not be conducted using a Dutch auction and will commence on November 7, 2008 and will remain open for a period of up to six months.

Based on current plans and business conditions, we expect that our cash, cash equivalents and investments together with any amounts generated from operations will be sufficient to meet our cash requirements for the next twelve months. However, we cannot guarantee that we will not be required to seek other financing sooner or that such financing, if required, will be available on terms satisfactory to us.

Our operations and financial results are subject to various risks and uncertainties that could adversely affect our business, financial condition, results of operations and trading price of our common stock. Please refer to Item 1A, “Risk Factors” in this report for information concerning these and other uncertainties that could negatively impact us.

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, 2007.

Item 4.  Controls and Procedures

Evaluation of Disclosure Controls and Procedures. Our Chief Executive Officer and President and our Chief Financial Officer have evaluated the effectiveness 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) as of the end of the period covered by this Quarterly Report on Form 10-Q and, based on this evaluation, have concluded that our disclosure controls and procedures are effective.

Changes in Internal Controls. There have been no changes in our internal controls over financial reporting that occurred during our third quarter ended September 30, 2008 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

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PART II: OTHER INFORMATION

Item 1A. Risk Factors

You should carefully consider the risk factors described below, as well as the other information included in this Report, prior to making a decision to invest in our securities. The risks and uncertainties described below are not the only ones facing our company. Additional risks and uncertainties not presently known or that we currently believe to be less significant may also adversely affect us.

General economic or market conditions may reduce our revenues and harm our business.

Our business is particularly exposed to adverse changes in general economic and market conditions, because products that incorporate our technologies are entertainment oriented and often luxury goods. A slowdown or decline in U.S. or foreign economic growth may adversely affect consumer confidence, disposable income or retail spending in general. As a result, sales by our licensees of consumer electronics and other products incorporating our technologies may not grow as rapidly as in prior periods or may even decrease if the current economic downturn continues or worsens, which could adversely affect our licensing revenue.

Our business is highly dependent on the consumer electronics market, which is characterized by short product life cycles, fluctuations in demand and seasonality, and is 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. As a result, we may need to develop new products or technologies to integrate with the new products and technologies developed by our customers. If we are unable to develop the necessary technologies to meet the changing needs of our customers or provide such technologies at competitive prices, our customers may reduce their use of our technologies and our revenues may decline. In addition, the dynamic nature of this market limits our, as well as our customers,’ ability to accurately forecast quarterly and annual sales. If we, or our customers, are unable to adequately manage product transitions, our business and results of operations could be negatively affected.

Our business and future prospects depend on the strength of our brand and our continued recognition as an industry standard in our existing or future markets.  If we do not maintain and strengthen our brand, our business will be materially harmed.

Maintaining and strengthening the “SRS” brand and our position as an industry standard is critical to maintaining and expanding our licensing revenues and licensing relationships, as well as to our ability to enter into new markets for our technologies.  Our continued success depends, in part, on our reputation for providing high quality technologies across a wide range of consumer products, including home electronics, personal computing devices, automotive entertainment systems, cell phones, PDAs and PCs.  If we fail to promote, maintain and expand the SRS brand successfully, our business and future prospects will suffer.  Maintaining and strengthening our brand will depend heavily on our ability to continue to develop innovative technologies for the entertainment industry and to continue to provide high quality technologies, which we may not do successfully. Moreover, we believe that the likelihood that our technologies will be adopted as industry standards in other markets and for various applications depends, in large part, upon the strength of our brand, because professional organizations and industry participants are more likely to accept, as an industry standard, technologies developed by a well-respected and well-known brand.  If our technologies are not recognized as industry standards in existing or future markets, our ability to enter into new licensing arrangements or expand our revenues will be adversely affected.

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

Currently, we generate a majority of our revenue in the home theater market, principally through the inclusion of SRS technology inside LCD and Plasma televisions, 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 have decreased significantly. We expect that this trend will continue for the foreseeable

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future. In addition, from time to time, certain of our OEM and semiconductor manufacturer customers may account for a significant portion of our revenues. For example, for the year ended December 31, 2007, Samsung accounted for approximately 28% of our consolidated revenues. These manufacturers could develop their own technologies or decide to exclude our audio rendering technology from their products altogether in an effort to reduce costs. The loss of any key customer could have a material adverse affect on our financial condition and results of operations.

We depend on the sale by our licensees of products that incorporate our technologies, and a reduction in those sales would adversely affect our licensing revenue.

We derive most of our revenue from the licensing of our technologies to manufacturers of consumer electronics products. We do not manufacture consumer electronics products ourselves and our licensing revenue is dependent on sales by our licensees of products that incorporate our technologies and the ability of such licensees to achieve broad market acceptance for such products. We cannot control these manufacturers’ product development or commercialization efforts or predict their success. In addition, our license agreements, which typically require manufacturers of consumer electronics products to pay us a specified royalty for products shipped that incorporate our technologies, do not require these manufacturers to include our technologies in any specific number or percentage of units. Accordingly, if our licensees sell fewer products incorporating our technologies, decline to market products incorporating our technologies, or otherwise face significant economic difficulties, our revenue will decline. Lower sales of products incorporating our technologies could occur for a number of reasons including, but not limited to, new product introductions and technological advancements, the existence of competing products, changes in consumer tastes or trends, or changes in industry standards, as well as increased market saturation for the products incorporating our technologies or alternate consumer entertainment options, any of which could adversely impact our business.

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 reduce 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, 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 into their products. Alternatively, our customers may seek to eliminate our technologies in their products in favor of internally developed technologies. A decline in the licensing fees we charge could materially and adversely affect our operating results.

We face intense competition from companies with greater brand recognition and resources.

The digital audio, consumer electronics and entertainment markets are intensely competitive, subject to rapid change, and significantly affected by new product introductions and other market activities of industry participants

Many of our current and potential competitors enjoy substantial competitive advantages, including:

·                   greater name recognition;

·                   a longer operating history;

·                   more developed distribution channels and deeper relationships with consumer electronics products designers and manufacturers;

·                   a more extensive customer base;

·                   broader product and service offerings;

·                   greater resources for competitive activities, such as research and development, strategic acquisitions, alliances, joint ventures, sales and marketing, and lobbying industry and government standards; and

·                   more technicians and engineers.

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As a result, these current and potential competitors may be able to respond more quickly and effectively than we can to new or changing opportunities, technologies, standards, or customer requirements.

We are subject to risks associated with substantial international operations.

We conduct sales and customer support operations in a number of countries throughout the world that require refinement to adapt to the changing market conditions on a regional basis. In addition, many of our significant customers are headquartered in the Asia Pacific region, particularly Japan and Korea. Approximately 90%, 91% and 84% of our revenues were derived from customers with headquarters located in the Asia Pacific markets during the years ended December 31, 2007, 2006 and 2005, respectively. We expect to continue to derive a significant portion of our revenues from sales to customers in these markets for the foreseeable future. Also, a substantial number of products incorporating our technologies are manufactured, assembled and tested by third parties in Asia. As a result, we are subject to a number of risks of conducting business outside of the United States, any of which could have a material adverse impact on our business and results of operations, including:

·                   political, social and economic instability, and the risk of war, terrorist activities or other international incidents in Asia and elsewhere abroad;

·                   difficulties and costs of staffing and managing foreign operations;

·                   unexpected changes in, or impositions of, government requirements;

·                   adverse changes in tariffs and other protectionist laws and business practices that favor local competitors;

·                   potentially longer payment cycles and greater difficulty in collecting receivables from foreign entities;

·                   the burdens of complying with a variety of non-U.S. laws and reduced protection of our intellectual property in some countries;

·                   potentially adverse tax consequences and the complexities of foreign value added tax systems; and

·                   other factors beyond our control, including natural disasters and major health concerns.

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. These countries have rapidly expanding and growing economies that are less mature than economies of other regions in which we derive significant portions of our revenue. Because of this, changes to employment patterns, currency fluctuations and political uncertainties could impact our ability to grow our licensing revenue in these regions

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 of our technologies to potential new customers 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, purchases of our products are usually made in connection with new design starts by our customers, 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, or in which the consumer electronic product ultimately does not sell in large quantities, thereby foregoing other higher revenue opportunities.

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If our patents and other intellectual property rights do not adequately protect our products, we may lose market share to our competitors and be unable to operate our business profitably.

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. We cannot guarantee 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. Litigation in the consumer electronics markets is common. It is possible that third parties may 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. Claims and litigation brought against us or initiated by us could be costly and time consuming and could divert our management from our business. The outcome of any such pending or future litigation is uncertain, and could require us to pay significant damages or could prevent us from licensing some or all of our technologies, of which could significantly harm our business and results of operations.

If we lose the services of our key personnel, or if we are unable to attract and retain other key personnel, we may not be able to manage our operations or meet our growth objectives.

Our future success depends to a large extent upon the continued service of key personnel, including engineering, sales and administrative 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 it is possible that we may not be able to recruit and retain necessary personnel to operate our business and support future growth.

The market price of our common stock is volatile and your investment in our common stock could suffer a decline in value.

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 Global 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. Because of the relatively low trading volume of our stock, our stockholders may have difficulty selling our common stock.

Our certificate of incorporation and bylaws 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, our bylaws and Delaware law contain provisions that might enable our management to discourage, delay or prevent a 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.

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Item 6. Exhibits

The exhibits listed below are hereby filed with the SEC as part of this Report.

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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.

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EXHIBIT INDEX