SRSL Srs Labs, Inc. (MM)

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x       QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2010

OR

o          TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period          to         

Commission File Number 0-21123

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 has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  o  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 July 30, 2010, 14,684,289 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 Six Months Ended June 30, 2010

Index

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FORWARD-LOOKING INFORMATION

As used herein, the “Company,” “SRS Labs,” “SRS,” “we,” “us,” or “our” means SRS Labs, Inc., the parent company, and its wholly-owned subsidiaries, SRSWOWcast.com, Inc., Shenzhen Representative Office of SRS Labs, Inc. (a Chinese company), Shanghai Representative Office of SRS Labs, Inc. (a Chinese company) and SRS Labs Japan, KK (a Japanese company).

This Quarterly Report on Form 10-Q contains forward-looking statements regarding our assumptions, projections, expectations, targets, intentions or beliefs about future events. All statements other than statements of historical facts included in this Quarterly Report, including, but not limited to,  those relating to our future operating results, profitability, growth and capital requirements, our investment and expansion plans, changes in our competitive position, the outcome of certain disputes, changes in economic conditions or capital markets and changes in customer usage patterns and preferences, are forward-looking statements. In some cases, you can identify forward-looking statements by terms such as may, will, should, could, expect, plan, intend, forecast, anticipate, believe, estimate, predict, potential, likely or similar expressions or variations of these terms. 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 Part II, Item 1A, “Risk Factors” of this Quarterly Report, including, but not limited to, the loss of any significant customer; the acceptance of new SRS Labs products and technologies; our ability to increase our brand awareness and enter into new or expanded license arrangements; the impact of competitive products and pricing; general economic and business conditions that may adversely impact sales of consumer products incorporating our technologies or that otherwise may impact our operating results and future performance; the timely development and release of technologies by the Company; and other factors identified from time to time in our filings with the Securities and Exchange Commission (“SEC”).

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 SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

See accompanying notes to the condensed consolidated financial statements

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SRS LABS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 See accompanying notes to the condensed consolidated financial statements

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SRS LABS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(Unaudited)

See accompanying notes to the condensed consolidated financial statements

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SRS LABS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

See accompanying notes to the condensed consolidated financial statements

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SRS LABS, INC. AND SUBSIDIARIES

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., the parent company, and its wholly-owned subsidiaries, SRSWOWcast.com, Inc., Shenzhen Representative Office of SRS Labs, Inc. (a Chinese company), Shanghai Representative Office of SRS Labs, Inc. (a Chinese company) and SRS Labs Japan, KK (a Japanese company).  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 (“GAAP”) for interim financial information and the rules and regulations of the SEC for interim reporting. In the opinion of management, all adjustments (which include 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 GAAP have been condensed or omitted pursuant to SEC rules and regulations for presentation of interim financial information. Therefore, the unaudited 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, 2009. 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.  Amounts related to disclosure of December 31, 2009 balances within these condensed consolidated financial statements were derived from the audited consolidated financial statements for the year ended December 31, 2009.

Estimates

The preparation of financial statements in accordance with GAAP 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, 2009 for an additional discussion of the significant accounting policies and estimates used in the preparation of our financial statements.

Cash and Cash Equivalents

Cash and cash equivalents include 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 when purchased.  The Company places its cash in banks and its cash and cash equivalents 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 losses on its cash equivalents.

Short-term and Long-term Investments

Short-term investments consist of certificates of deposit with original maturities ranging from six to twelve months.  Long-term investments consist of certificates of deposit with maturities ranging from eighteen to twenty-four months.  All of the certificates of deposit are fully FDIC insured. The Company has not experienced any losses on its short and long-term investments.

Revenue Recognition

Our revenues consist primarily of royalties generated from the license of SRS Labs’ audio and voice technologies.  Our license agreements typically have multi-year or automatic renewal terms, and either require: (a) per-unit royalty payments for all products implementing our technologies and/or solutions; (b) fixed annual or quarterly royalty payments; or (c) a minimum fixed annual or quarterly royalty payment, which allow the licensee to ship up to a pre-determined number of units during the specified time period, with additional per-unit royalty payments thereafter.  The majority of our license agreements are per-unit royalty arrangements, which are generally reported by the licensee in the quarter following shipment of the consumer electronics devices and are therefore typically recognized by us following shipment of the devices by the original equipment manufacturer (“OEM”). 

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Revenues associated with fixed royalty payments are recognized ratably over the term of the license agreement.  We also sell some of our products and solutions via the Internet.  Revenues associated with those sales are recognized upon shipment and were not material in the three months ended June 30, 2010 or 2009. The Company may offer customer support or license support programs in the form of assisting the licensee with implementing the Company’s technology into the manufactured products of the licensee to ensure that the licensee receives the maximum benefit from the Company’s technology.  Such customer support is not contractually mandated and is generally provided on a discretionary basis to assist the customer and to improve customer relations.  Such customer support generally does not extend past the time in which the licensed technology is placed in service or implemented in any given device by the licensee.  In this regard, any support services occur during a finite period prior to the sale or revenue recognition.

Customer Concentrations

For the three months ended June 30, 2010 and 2009, one customer, Samsung, accounted for approximately 42% and 44%, respectively, of our revenues.  For the six months ended June 30, 2010 and 2009, one customer, Samsung, accounted for approximately 40% and 42%, respectively, of our revenue.  The revenue from Samsung is derived from multiple technology license agreements with various divisions of Samsung.

Reclassifications

Certain amounts in the financial statements have been reclassified to conform to the current presentation.

Income Taxes

The Company currently has net operating loss carryforwards to offset income taxes. Consequently, no significant provision is reflected in the accompanying interim consolidated financial statements.  Due to our licensees being located in foreign countries, they may be obligated to withhold foreign taxes based upon local and country requirements of the taxing authority.  Refer to our Annual Report on Form 10-K for the year ended December 31, 2009 for additional disclosure in this regard.

2.             Intangible Assets

Intangible assets consist of the following:

Amortization expense associated with our intangibles was $164,218 and $123,219 in the three months ended June 30, 2010 and 2009, respectively, and $302,164 and $239,177 in the six months ended June 30, 2010 and 2009, respectively.  Amortization expense is included in general and administrative expenses in the accompanying condensed consolidated statements of operations.

3.              Net Income Per Common Share

Basic net income 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 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 are as follows:

There were outstanding options to purchase an aggregate of 1,207,680 and 3,459,086 shares of the Company’s common stock for the three months ended June 30, 2010 and 2009, respectively, that were not included in the table above because they would be anti-dilutive.  There were outstanding options to purchase an aggregate of 1,253,993 and 2,705,647 shares of the Company’s common stock for the six months ended June 30, 2010 and 2009, 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 2009, an independent third party 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.  Sony has not agreed with the position of the independent third party.  SRS continues to evaluate its alternatives in this matter and cannot assure you that it will prevail in this dispute.  While SRS is currently in settlement negotiations with Sony, no assurance can be given that such settlement will be entered into on favorable terms, or at all.  As a result, SRS 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.

5.             Segment Information

The Company operates in one reportable segment as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2009.  The following schedule presents the Company’s revenue by geographic area.  Licensing-related revenue is summarized based on the location of the licensee’s corporate headquarters.  For product and online sales, revenue is allocated to the United States.  The China region includes all licensees with their corporate headquarters located in mainland China.  The Asia Pacific region includes all licensees with their corporate headquarters located in Taiwan and Hong Kong. Substantially all of the Company’s revenues during the three and six months ended June 30, 2010 and 2009 were denominated in U.S. Dollars.

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6.             Fair Value Measurements

The Company measures the fair value of applicable financial and non-financial assets based on the following levels of inputs.

·                   Level 1 inputs: Level 1 inputs are quoted market prices in active markets for identical assets or liabilities that are accessible at the measurement date.

·                   Level 2 inputs: Level 2 inputs are from other than quoted market prices included in Level 1 that are observable for the asset or liability, either directly or indirectly.

·                   Level 3 inputs: Level 3 inputs are unobservable and should be used to measure fair value to the extent that observable inputs are not available.

The hierarchy noted above requires us to minimize the use of unobservable inputs and to use observable market data, if available, when determining fair value. There were no transfers between Level 1 and Level 2 and/or Level 3 during the three months ended June 30, 2010.  Financial assets carried at fair value as of June 30, 2010 are classified below:

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, 2009, and the unaudited condensed interim consolidated financial statements and notes thereto included in this Quarterly Report.

Overview

We are the recognized global leader in the practical application of psychoacoustics , the science behind how the human ear operates, and in the post processing segment of the market for audio delivery.  Our award-winning audio enhancement technologies and solutions dramatically restore audio and voice to its natural state, the way it was originally recorded, in both dimension and clarity, thus providing a superior consumer experience for a wide variety of consumer electronic devices such as televisions, personal computers and mobile phones.

Our operations are conducted through SRS Labs, Inc., the parent company, and its wholly-owned subsidiaries, SRSWOWcast.com, Inc., Shenzhen Representative Office of SRS Labs, Inc., Shanghai Representative Office of SRS Labs, Inc. and SRS Labs Japan, KK. Our business is focused on developing and licensing audio, voice and surround sound technology solutions to many of the world’s leading OEMs, software providers and semiconductor companies, and limited sales and marketing of standalone software and hardware products through the Internet.

During the three months ended June 30, 2010 and 2009, licensing revenues from the home entertainment market represented 58% and 69%, respectively, of our total revenues in such periods.  In the home entertainment market, our technologies have achieved broad market acceptance in the television sector.  We plan to continue to leverage our success in the television sector to expand our audio technologies into a variety of other consumer electronics devices, including PCs, mobile phones, portable media devices and

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automotive audio systems, but our technologies to date have only been incorporated in products representing only a small portion of the total market opportunity.  The consumer electronics market in general is characterized by rapid technological changes, short product life cycles, seasonality, significant price erosion and competition, any of which may impede our ability to gain broad market acceptance for our technologies in other consumer electronics devices.  Nonetheless, we plan to continue to seek other opportunities where we can continue to leverage our core technologies and expertise.  If we are able to successfully gain broad market share for our technologies in any other market, it could significantly improve our revenues and brand name recognition.

Critical Accounting Policies

Our critical accounting policies have been disclosed in our Form 10-K for the year ended December 31, 2009. Our discussion and analysis of our results of operations and liquidity and capital resources are based on our unaudited consolidated financial statements for the three and six months ended June 30, 2010 and 2009, which have been prepared in accordance with GAAP.

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.

Results of Operations

Three Months Ended June 30, 2010 Compared to Three Months Ended June 30, 2009

Revenues

Our revenues consist primarily of royalties generated from the license of SRS Labs’ audio and voice technologies.  Our license agreements typically have multi-year or automatic renewal terms, and either require: (a) per-unit royalty payments for all products implementing our technologies and/or solutions; (b) fixed annual or quarterly royalty payments; or (c) a minimum fixed annual or quarterly royalty payment, which allow the licensee to ship up to a pre-determined number of units during the specified time period, with additional per-unit royalty payments thereafter.  The majority of our license agreements are per-unit royalty arrangements, which are generally reported by the licensee in the quarter following shipment of the consumer electronics devices and are therefore typically recognized by us following shipment of the devices by the OEM.  Revenues associated with fixed royalty payments are recognized ratably over the term of the license agreement.  We also sell some of our products and solutions via the Internet.  Revenues associated with those sales are recognized upon shipment and were not material in the three months ended June 30, 2010 or 2009. We may offer customer support or license support programs in the form of assisting the licensee with implementing our technology into the manufactured products of the licensee to ensure that the licensee receives the maximum benefit from our technology.  Such customer support is not contractually mandated and generally provided on a discretionary basis to assist the customer and improve customer relations.  Such customer support generally does not extend past the time in which the licensed technology is placed in service or implemented in any given device by the licensee.   In this regard, any support services are not contractual and occur during a finite period prior to the sale or revenue recognition.

Our revenues were $7,161,030 for the three months ended June 30, 2010, compared to $5,055,528 for the three months ended June 30, 2009, an increase of $2,105,502 or 42%.  In the personal computer market, our total revenues increased by $751,469 in the current quarter, primarily due to revenues generated from new licensees, such as Elitegroup Computer Systems, and increased revenues due to increased volume from our existing customers, including Dell and AsusTek.  Revenues from the home entertainment market increased by $699,301 in the current quarter.  Within this market, revenues from televisions increased by $560,404 mainly due to increased royalties due to volume increases from existing licensees such as Samsung, due to increased demand for flat panel televisions.  We have not experienced a material change in our per unit license rates in the current periods other than volume pricing discounts provided pursuant to existing contractual obligations.  In the automotive market, revenues increased by $477,470 in the current quarter primarily due to higher revenues from our Japanese customers who provide line install, dealer option and aftermarket automotive audio systems to many of the significant Japanese automotive manufacturers.  Additionally, through our royalty compliance program, we were able to identify and collect approximately $175,490 of previously under reported royalties from a customer in the automotive  market segment. Revenues recovered pursuant to our royalty compliance program vary considerably from period to period.  Revenues in the personal telecommunications market increased by $159,954 in the current quarter primarily due to new licensees.

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The following table presents our licensing revenues mix by market:

Sales and Marketing

Sales and marketing expenses consist primarily of employee salaries and benefits, sales consultants’ fees and related expenses, sales commissions, tradeshow costs and costs associated with branding activities. Sales and marketing expenses were $3,221,144 for the three months ended June 30, 2010, compared to $2,711,351 for the same prior year period, an increase of $509,793 or 19%.  This increase was primarily related to payroll and related costs associated with the addition of seven sales and marketing personnel since June 30, 2009 and also due to increased commission and bonuses largely related to increased revenue and higher net income in the current quarter.  Additionally, the Company increased its participation in global tradeshows in the current period.  Included in sales and marketing expenses is share-based compensation expense of $168,594 and $131,101 for the three months ended June 30, 2010 and 2009, respectively.  We expect that sales and marketing expenses will continue to increase as we hire additional sales and marketing personnel to penetrate target markets and key regions in order to gain broad market share for our technologies 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 decreased from 54% for the quarter ended June 30, 2009 to 45% 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 $1,826,118 for the three months ended June 30, 2010, compared to $1,189,517 for the same prior year period, an increase of $636,601 or 54%.  This increase was primarily attributable to an increase in payroll and related costs associated with hiring seventeen additional engineers since June 30, 2009.  Included in research and development expenses is share-based compensation expense of $135,238 and $111,096 for the three months ended June 30, 2010 and 2009, respectively.  We expect that research and development expenses will continue to increase in 2010 as we plan to continue to add to our research and development team in order to support our global licensees and continue to develop new leading audio technologies. As a percentage of total revenues, research and development expenses increased from 24% for the quarter ended June 30, 2009 to 26% for the same period this year.

General and Administrative

General and administrative (“G&A”) expenses consist primarily of employee-related expenses, attorneys’ fees, accounting fees, depreciation of the Company’s assets, patent amortization, and other professional fees. G&A expenses were $1,431,833 for the three months ended June 30, 2010, compared to $1,373,757 for the same prior year period, an increase of $58,076 or 4%.  This increase was primarily related to higher legal and other professional fees in the current period. Included in G&A expenses was share-based compensation expense of $241,927 and $238,766 for the three months ended June 30, 2010 and 2009, respectively.  As a percentage of total revenues, G&A expenses decreased from 27% for the quarter ended June 30, 2009 to 20% for the same period this year.

Other Income, Net

Other income, net consists primarily of interest income. Other income, net was $71,863 for the three months ended June 30, 2010, compared to $92,185 for the same prior year period, a decrease of $20,322 or 22%.  Our investment focus continues to be on asset protection of our cash, and as such we have invested our cash in low-risk, high liquidity investments such as fully insured certificates of deposits and assets backed by the United States Treasury.  We continue to monitor our cash assets to maximize our interest income while maintaining an acceptable level of risk.  The Company did not realize any losses on its investments in the current or prior year periods.

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Income Taxes

Income tax expense for the three months ended June 30, 2010 was $23,095, compared to an income tax expense of $9,139 for the same prior year period.  The income tax provision consisted primarily of taxes paid on licensing revenues in the current quarter that were sourced from countries requiring foreign tax withholdings, principally Korea.  We reduced our tax provision and our valuation allowance on our deferred tax assets by $725,711 and $501,513 for the three months ended June 30, 2010 and 2009, respectively, based on our assessment of the future estimated realization of such assets.

Six Months Ended June 30, 2010 Compared to Six Months Ended June 30, 2009

Revenues

Our revenues were $15,546,422 for the six months ended June 30, 2010, compared to $10,759,538 for the six months ended June 30, 2009, an increase of $4,786,884 or 44%.  In our home entertainment market, our total revenues increased by $2,455,951 in the six months ended June 30, 2010.  Within this market, flat panel revenue increased by $2,291,000 mainly due to increased revenue from Samsung due to increased volume shipments.  Our revenues from the personal computer market increased by $1,604,372, primarily due to revenue generated from new licensees and increased revenues due to increased volume from our existing customers.  In the automotive market, revenues increased by $523,196 primarily due to higher revenues from increased volume from our Japanese customers who provide line install, dealer option and aftermarket automotive audio systems to many of the significant Japanese automotive manufacturers.  Additionally, we were able to recover $180,653 in this market segment through our royalty compliance program in the six months ended June 30, 2010 compared to $51,360 in the six months ended June 30, 2009.  Our revenues in the personal telecommunications market increased by $217,787 in the current period due to increased revenues from new licensees such as Texas Instruments.

The following table presents our licensing revenues mix by market:

Sales and Marketing

Sales and marketing expenses were $6,641,687 for the six months ended June 30, 2010, compared to $5,450,491 in the same prior year period, an increase of $1,191,196 or 22%.  This increase was primarily attributable to an increase in payroll and commissions and related costs, such as payroll taxes, benefits and recruitment associated with the addition of sales and marketing personnel since June 30, 2009.  We also increased participation and promotion at several trade shows, which resulted in an increase in such expenses of approximately $341,000 in the six months ended June 30, 2010.  Included in sales and marketing expenses is share-based compensation expense of $345,788 and $246,917 for the six months ended June 30, 2010 and 2009, respectively.  As a percentage of total revenues, sales and marketing expenses decreased from 51% for the six months ended June 30, 2009 to 43% for the same period this year.

Research and Development

Research and development expenses were $3,716,112 for the six months ended June 30, 2010, compared to $2,364,183 for the same prior year period, an increase of $1,351,929 or 57%.  This increase was primarily attributable to an increase in payroll and related costs associated with hiring seventeen additional engineers since June 30, 2009.  Included in research and development expenses is share-based compensation expense of $284,746 and $218,819 for the six months ended June 30, 2010 and 2009, respectively.  As a percentage of total revenues, research and development expenses increased from 22% for the six months ended June 30, 2009 to 24% for the same period this year.

General and Administrative

G&A expenses were $2,997,131 for the six months ended June 30, 2010, compared to $2,805,884 for the same prior year period, an increase of $191,247 or 7%. The increase was primarily attributable to an increase in accounting, legal and other professional fees. Included in G&A expenses is share-based compensation expense of $496,386 and $481,627 for the six months ended June 30, 2010 and 2009, respectively.  As a percentage of total revenues, G&A expenses decreased from 26% for the six months ended June 30, 2009 to 19% for the same period this year.

Other Income, Net

Other income, net was $101,502 for the six months ended June 30, 2010, compared to $196,818 for the same prior year period, a decrease of $95,316 or 94%. This decrease was primarily attributable to lower interest rates on the Company’s investments in the current period.

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Income Taxes

Income tax expense was $31,463 and $14,075 for the six months ended June 30, 2010 and 2009, respectively. The income tax provision consisted primarily of taxes paid on licensing revenues in the current quarter that were sourced from countries requiring foreign tax withholdings, principally Korea.  We reduced our tax provision and our valuation allowance on our deferred tax assets by $1,484,711 and $1,018,331 for the six months ended June 30, 2010 and 2009, 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 June 30, 2010 consisted of cash, cash equivalents and short-and long-term investments of $42,324,996.  At June 30, 2010, we had cash and cash equivalents of $15,680,996, short-term investments of $12,383,000 and long-term investments of $14,261,000.  Cash and cash equivalents generally consist of cash, money market funds and treasury bills 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 ranging from 6 to 12 months.  Long-term investments consist of certificates of deposit with maturities ranging from 18 to 24 months.  The cash and certificates of deposit are FDIC insured.  The Company has not experienced any losses on its cash and cash equivalents or its short and long-term investments in the current period.

Net cash provided by operating activities was $1,072,953 and $213,133 for the six months ended June 30, 2010 and 2009, respectively.  The increase in our cash flows from operating activities was primarily the result of net income of $2,097,176 during the six months ended June 30, 2010, compared to net income of $187,550 during the six months ended June 30, 2009.  This was offset by changes in our operating assets and liabilities specifically, an increase in our accounts receivable of $678,165 during the six months ended June 30, 2010 compared to an increase of $75,766 during the six months ended June 30, 2009.  The increase in accounts receivable during the six months ended June 30, 2010 was primarily due to increased revenues in the current quarter from new and existing licensees.

Net cash used in investing activities was $13,943,575 and $5,104,415 during the three months ended June 30, 2010 and 2009, respectively.  The increase in cash used by investing activities during the six months ended June 30, 2010 was attributable primarily to the purchase of long-term investments in the current period.  The Company expects to continue to invest in certificates of deposit with maturities ranging from 18 to 24 months.

We believe our existing cash, cash equivalents, and short and long-term investment balances together with cash generated from operating activities, will be sufficient to meet our anticipated cash needs for at least the next twelve months.  Our future capital requirements will depend on many factors, including our level of revenues, the timing and extent of spending to support product development efforts, the impact of existing adverse economic conditions, the expansion of sales and marketing activities, the timing of introductions of new products, continuing market acceptance of our products, and potential acquisitions of businesses or technologies.

Item 3.  Quantitative and Qualitative Disclosures about Market Risk

Except as follows, 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, 2009. As of June 30, 2010, the Company had $26.7 million in short and long-term investments held in certificates of deposit (“CDs”), all of which are federally insured.  The CDs has stated interest rates when purchased, and we plan to hold the CDs to maturity.  As of June 30, 2010, the Company has $15.7 million in cash and cash equivalents, primarily held in money market funds, which are invested in US government obligations, such as U.S. treasuries.  We have not realized any losses on any of our investments. We believe that we have limited our exposure to interest rate risk as a result of investing in only federally insured CDs and U.S. government obligations.  Because of the conservative nature of these investments, interest rate fluctuations and exposure to interest rate risk has been minimum and immaterial.

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 second quarter ended June 30, 2010 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 1.  Legal Proceedings

The information set forth under Note 4 of Notes to Unaudited Condensed Consolidated Financial Statements, included in Part I, Item 1 of this report, is incorporated herein by reference.  For an additional discussion of certain risks associated with legal proceedings, see Part II, Item 1A. “Risk Factors.”

Item 1A. Risk Factors

You should carefully consider the risk factors described below, as well as the other information included in this Quarterly Report on Form 10-Q, and in our other filings with the SEC, 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.

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 entertainment market, principally through the inclusion of SRS technology inside flat panel LCD and plasma televisions. We expect that the consumer home entertainment market will continue to account for a significant portion of our licensing revenues for the foreseeable future. Consumer spending on home entertainment products is subject to significant fluctuations, and there is significant price competition for such products. Retail prices for certain consumer electronics products that include our audio technology have decreased significantly, and we expect that this trend will continue for the foreseeable 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 the six months ended June 30, 2010 and 2009, Samsung accounted for approximately 40% and 42%, respectively, of our consolidated revenues. Our technology license agreements with Samsung and most of our other manufacturers do not obligate them to incorporate our technologies into any of their products or to continue to do business with us.  As a result, Samsung or the other manufacturers could develop their own technologies, use a competitor’s technologies or decide to exclude our audio rendering technology from their products altogether in an effort to reduce cost, either of which could adversely impact our revenues and profitability.  For example, during 2007, we were informed by Sony that they were no longer using our technology in the majority of their televisions.  The loss of any key customer in the future could have a material adverse affect on our financial condition and results of operations.

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

Our business is exposed to adverse changes in general economic conditions because products that incorporate our technologies are entertainment-oriented and generally discretionary goods. The current slowdown or decline in U.S. and foreign economic growth has adversely affected consumer confidence, disposable income and spending. 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, 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, seasonality and declining retail prices and is subject to risks related to product transitions.

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 ability and the ability of our customers 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.

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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 consumer electronics product manufacturers. 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. 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 and media software vendors to pay us a specified royalty for every electronics product shipped that incorporates our technologies, do not require these manufacturers to include our technologies in any specific number or percentage of units, and only a few of these agreements guarantee us a minimum aggregate licensing fee. Accordingly, if our licensees sell fewer products incorporating our technologies, decline to actively market products incorporating our technologies or otherwise face significant economic difficulties, our revenue will decline. Changes in consumer tastes or trends, changes in industry standards or adverse changes in business and economic conditions may also adversely affect our licensing revenue.

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

Certain of our current and potential competitors enjoy notable 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.

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.

Inaccurate licensee royalty reporting and unauthorized use of our intellectual property could materially adversely affect our operating results.

Our licensing revenue is generated primarily from consumer electronics product manufacturers who license our technologies and incorporate them in their products. Under a significant percentage of our existing arrangements, these licensees typically pay us a specified royalty for every product they ship that incorporates our technologies. We rely on our licensees to accurately report the number of units shipped that incorporate our technologies. We calculate our license fees, prepare our financial reports, projections and budgets, and direct our sales and product development efforts based on these reports we receive from our licensees. However, it can be

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difficult for us to independently determine whether or not our licensees are reporting shipments accurately. This is especially true with respect to software incorporating our technologies because software can be copied relatively easily and we often do not have easy ways to determine how many copies have been made. Most of our license agreements permit us to audit our licensees’ records, but audits are generally expensive and time consuming and initiating audits could harm our customer relationships. We expect that we will continue to be subject to understatement and non-reporting of royalty bearing revenues by licensees, which could adversely affect our operating results. Conversely, to the extent that our licensees overstate the number of products incorporating our technologies, negative corrections could result in reductions of royalty revenue in subsequent periods. Some of our licensees may begin to more closely scrutinize their past licensing statements which may result in an increased receipt of negative corrective statements.

We also may experience problems with non-licensee consumer electronics product manufacturers and media software vendors, particularly in emerging economies, incorporating our technologies or incorporating our technologies and trademarks into their products without our authorization and without paying us any licensing fees. This unauthorized use of our intellectual property could adversely affect our operating results.

Our business and future prospects depend upon the strength of our brand. Awareness of our brand depends to a significant extent upon decisions by our customers to display our trademarks on their products, and if our customers do not display our trademarks on their products, our ability to increase our brand awareness may be harmed.

Because we engage in relatively little direct brand advertising, the promotion of our brand depends upon consumer electronics industry participants displaying our trademarks on their products that incorporate our technologies.  Although we do generally require our customers to place our brand on their products, some are not required to do so. Maintaining the SRS brand and our position as an industry standard is critical to maintaining and expanding our licensing revenues and entering into new or broadening existing licensing relationships.  If our customers choose for any reason not to display our trademarks on their products, our ability to maintain or increase our brand awareness may be harmed, which would have an adverse effect on our business and prospects. In addition, if we fail to maintain high quality standards for our products, or the products that incorporate our technologies through the quality control evaluation process that we require of our licensees, the strength of our brand could be adversely affected.

Licensee products that incorporate our technologies, from time to time, experience quality problems that could damage our brand, decrease revenues and increase operating expenses.

Licensee products that incorporate our technologies often are complex and sometimes contain undetected software or hardware errors, particularly when first introduced or when new versions are released. In addition, those products are often combined with, or incorporated into, products from other companies, sometimes making it difficult to identify the source of a problem. Any negative publicity or negative impact relating to these product problems (even if unrelated to our technologies) could adversely affect the perception of our brand. In addition, these errors could result in loss of, or delay in, market acceptance of those products or our technologies, or cause delays in delivering them and meeting customer demands, any of which could reduce our revenue and raise significant customer relations issues. Although we generally attempt to contractually limit our liability for our licensees’ defective products, we may elect to help reengineer those products, which could increase our expenses and adversely affect our operating results.

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 Asia, particularly Korea and Japan. Approximately 72%, 88% and 90% of our revenues during the years ended December 31, 2009, 2008, and 2007, respectively, were derived from customers with headquarters located in Asia. We expect to continue to derive a significant portion of our revenues from sales to customers in these regions 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:

·                   global economic downturn;

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

·       currency fluctuations;

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·                   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.

Our technologies 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 and another six to nine months to begin generating revenues. 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.

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 we will obtain any additional patents in the future, 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. 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. Litigation in the technology industry is common.  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 litigation is uncertain and could require us to pay significant damages or could prevent us from licensing some or all of our technologies, 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

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stock. Even though our stock is listed 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. In addition, the stock market in general, and The NASDAQ Global Market and the market for technology and small market cap companies in particular, has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. Further, the market prices of securities of technology companies have been particularly volatile. These broad market and industry factors may materially harm the market price of our common stock, regardless of our operating performance.

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.

Item 5. Other Information

One of our directors, Sam Yau, previously entered into a sales plan pursuant to Rule 10b5-1 (the “ 10b5-1 Plan ”) promulgated under the Securities Exchange Act of 1934, as amended, pursuant to which sales are expected to commence in August 2010.  The 10b5-1 Plan covers the sale over the next eight months of up to an aggregate of 30,000 shares of the Company’s common stock issuable upon exercise of two stock options held by Mr. Yau, which expire in November 2010 and January 2011, respectively.  The shares covered by the 10b5-1 Plan will be sold if the price per share of our common stock reaches the amounts designated in the 10b5-1 Plan.

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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

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