UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

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

For the fiscal year ended December 31, 2004

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

For the transition period from to

Commission File Number 000-50335

Digital Theater Systems, Inc.

(Exact name of Registrant as specified in its charter)

Delaware (State or Other Jurisdiction of Incorporation or Organization)	77-0467655 (I.R.S. Employer Identification Number)
5171 Clareton Drive Agoura Hills, California 91301 (Address, including zip code, of Registrant’s principal executive offices)
Registrant’s telephone number, including area code: (818) 706-3525

Securities Registered Pursuant to Section 12(g) of the Act:

Common Stock, par value $.0001 per share

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

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

The aggregate market value of the voting stock held by non-affiliates of the registrant, as of June 30, 2004 was approximately $441,702,809 (based on the closing price for shares of the registrant’s Common Stock as reported by the Nasdaq National Market for that date). Shares of Common Stock held by each officer and director of the outstanding Common Stock have been excluded in that such persons may be deemed affiliates. Exclusion of shares held by any person should not be construed to indicate that such person possesses the power, direct or indirect, to direct or cause the direction of management or policies of the registrant, or that such person is controlled by or under common control with the registrant.

As of March 1, 2005, 17,086,860 shares of common stock were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

The information required by Part III of this Report, to the extent not set forth herein, is incorporated herein by reference to the registrant’s proxy statement relating to the annual meeting of stockholders to be held on May 19, 2005.

DIGITAL THEATER SYSTEMS, INC.
FORM 10-K
For the Fiscal Year Ended December 31, 2004
INDEX

		Page
PART I
Item 1.	Business	3
Item 2.	Properties	20
Item 3.	Legal Proceedings	21
Item 4.	Submission of Matters to a Vote of Security Holders	21
PART II
Item 5.	Market for Registrant’s Common Equity and Related Stockholder Matters	22
Item 6.	Selected Financial Data	23
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	24
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	53
Item 8.	Financial Statements and Supplementary Data	55
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	91
Item 9A.	Controls and Procedures	91
Item 9B.	Other Information	91
PART III
Item 10.	Directors and Executive Officers of the Registrant	92
Item 11.	Executive Compensation	92
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	92
Item 13.	Certain Relationships and Related Transactions	92
Item 14.	Principal Accountant Fees and Services	92
PART IV
Item 15.	Exhibits and Financial Statement Schedules	93
SIGNATURES		96

FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K and the documents incorporated herein by reference contain forward-looking statements based on our current expectations, estimates and projections about our industry, beliefs, and certain assumptions made by us. Words such as “believes,” “anticipates,” “estimates,” “expects,” “projections,” “may,” “potential,” “plan,” “continue” and words of similar import, constitute “forward-looking statements.” The forward-looking statements contained in this report involve known and unknown risks, uncertainties and other factors that may cause our actual results to be materially different from those expressed or implied by these statements. These factors include those listed under the “Risk Factors” section contained in Item 7 and elsewhere in this Form 10-K, and the other documents we file with the Securities and Exchange Commission, or SEC, including our most recent reports on Form 8-K and Form 10-Q. We cannot guarantee future results, levels of activity, performance or achievements. We do not undertake any obligation to revise these forward-looking statements to reflect future events or circumstances.

PART I

Item 1. Business

Company Overview

We are a leading provider of entertainment technology, historically focused on high-quality digital multi-channel audio technology, products, and services for entertainment markets worldwide. Multi-channel audio, commonly referred to as surround sound, allows listeners to hear discrete sounds simultaneously through more than two speakers. Our DTS digital multi-channel audio technology delivers compelling surround sound and is frequently described as the top performing surround sound technology by authoritative sources such as Widescreen Review and AudioRevolution.com in their reviews of products featuring multi-channel audio.

We were founded in 1990 and received a key strategic investment in 1993 from investors, including Universal City Studios, Inc. The first DTS audio soundtrack was created for the release of Steven Spielberg’s Jurassic Park in 1993. From this initial release, we established a technical and marketing platform for the development of entertainment technology solutions for the motion picture, home theater, and other consumer markets.

We provide products and services to film studios, production companies, and movie theaters to produce, release, and play back digital multi-channel film soundtracks, pre-show entertainment content, subtitles, captions and descriptive narration. We currently license our sound technology to all major film distributors in the United States. Most major feature films currently released in the United States include a DTS soundtrack. Our playback systems for DTS- formatted soundtracks have been installed in over 24,000 movie screens worldwide.

In 1996, we launched our consumer business, in which we license our technology to consumer electronics products manufacturers for inclusion in products such as audio/video receivers, DVD players, and home theater systems. The consumer products market has since grown to become the largest segment of our business. To date, we have entered into licensing agreements with substantially all of the major consumer audio electronics manufacturers in the world. We also license our technology to many major consumer semiconductor manufacturers. Our technology, trademarks, and know-how have been incorporated in more than 230 million consumer electronics products worldwide.

Our technology and products have won awards in each of our markets, including:

· a Scientific and Engineering Oscar Award from the Academy of Motion Picture Arts and Sciences for our DTS playback system;

· a Blue Ribbon Award from EQ Magazine voting our Coherent Acoustics algorithm the best product at the 103rd Audio Engineering Society Convention; and

· the Best DVD-Audio Release and Best DVD-Audio Disc Award for Queen: The Game from the Canadian Entertainment Network Awards and the Fifth Annual DVD Awards, respectively, and Best Orchestral Mix for Porcupine Tree: In Absentia from The 3^rd Annual Surround Music Awards.

We develop, market, license, and sell our proprietary technology, products, and services for the following markets:

Consumer Markets:

· Home theater and consumer electronics entertainment devices such as audio/video receivers and DVD players.

· Emerging markets for digital multi-channel audio such as homes, cars, personal computers, video games and consoles, portable electronics devices, and digital satellite and cable broadcast products.

· Professional audio products and services for encoding and decoding digital multi-channel content in our proprietary format.

· Music titles in our digital multi-channel format.

Cinema Markets:

· Audio and video products and services for film producers and distributors to produce movie soundtracks, subtitles, and pre-show or alternative content in our proprietary format.

· Systems for playback of multi-channel audio soundtracks, pre-show and alternative video content, and for subtitling, captioning, and descriptive narration for movie theaters and special venues.

Regardless of the entertainment application that incorporates our technology, we provide high-quality digital delivery technology and branding for product manufacturers, content providers, and movie theaters. As the transition from analog to digital entertainment technology continues, we believe we are well-positioned to grow our licensing and product businesses worldwide. Our goal is to become essential to the ultimate entertainment experience by incorporating our technology into every device that manages, controls or delivers high-quality digital entertainment.

Imaging Markets:

In January 2005, we acquired Lowry Digital Images, Inc., or LDI, and changed the name to DTS Digital Images. Through this subsidiary, we now provide restoration and enhancement services for moving pictures captured on film or in digital form. These services enable current or archived content to be restored for high quality, high definition presentations in digital cinema, high definition optical media or broadcast applications.

Industry Background

Over the past 15 years, two trends have greatly impacted the entertainment industry: the transition from analog to digital entertainment content, and technological advancements in digital coding, transmission, signal processing, and optical storage. These trends helped create a technical foundation for the widespread adoption of digital multi-channel audio for many forms of entertainment.

Adoption and Growth of Digital Multi-Channel Audio in the Motion Picture Industry

Movie soundtracks were originally presented in mono, or one-channel, audio. In the mid-1970s, stereo was introduced. Stereo consists of two channels and presents sound through discrete left and right speakers. Stereo was followed by matrix technology that allowed an inexpensive two-track system to bring surround sound to a large number of movie theaters. However, the audio quality and channel separation were limited.

In the early 1990s, the listening experience of movie audiences was significantly enhanced through the introduction of digital multi-channel surround sound technology. This format, commonly known as 5.1, combined high-quality audio with full separation in five channels: left, center, right, left surround, right surround, and a channel dedicated to low frequency effects known as a subwoofer. Digital discrete surround sound enables movie directors and producers to create a more enveloping and realistic entertainment environment. Many filmmakers recognized the ability of multi-channel audio to enhance the entertainment experience and promoted its widespread adoption.

Digital multi-channel audio is now an industry standard audio format for feature films. Today, all of the major film studios in the United States, and an increasing number of international film studios, release their feature films with digital multi-channel soundtracks. In 2004, over 165 major feature films were released in the United States with a DTS digital multi-channel soundtrack.

Screen Digest Global Media Intelligence, in its December 2004 Cinema Intelligence report estimates that in 2004 there were over 141,000 movie theater screens worldwide, and that in 2004 there were more than 39,000 screens in the United States and Canada. As film studios have increasingly released films with digital multi-channel soundtracks, many movie theaters have purchased and installed digital multi-channel playback systems and cinema processor equipment for both newly constructed and retrofitted movie theaters. A number of other venues also utilize digital multi-channel playback systems and cinema processor equipment to enhance the entertainment experience. These venues include large-screen format theaters, amusement parks, national parks, and museums.

Proliferation of Home Theater Systems

Consumer demand for digital multi-channel capable home theater systems has been fueled by:

· the extensive adoption of digital multi-channel audio in movie theaters;

· declining prices for DVD players, audio/video receivers, and home-theater-in-a-box systems;

· the superior quality and feature sets of DVDs; and

· the widespread availability of DVDs released with digital multi-channel soundtracks.

According to the DVD Entertainment Group website at dvdinformation.com, annual sales of DVDs surpassed annual sales of prerecorded videocassettes for the first time in 2001. Understanding & Solutions, in its Q1 2005 quarterly briefing, estimated that as of December 31, 2004, 64% of U.S. households owned one or more DVD-Video player, a figure that is expected to grow to nearly 90% by the end of 2008.

Home theater systems generally consist of a DVD-Video player, a digital multi-channel audio/video receiver, five speakers, and a subwoofer. Home-theater-in-a-box systems are increasingly offered to consumers as an all-in-one home theater package for ease of use and installation. Understanding & Solutions, in its Q1 2005 quarterly briefing, estimates that by the end of 2004 38% of U.S. households and 28% of Western European households owned at least one home theater system and that by the end of 2007 over 55% of U.S. households and over 50% of Western European households will own at least one.

Development of Robust New Markets for Digital Multi-Channel Sound

Digital multi-channel sound is extending into a growing number of consumer electronics environments, including homes, cars, personal computers, video games and consoles, portable electronics devices, and digital satellite and cable broadcast products.

Manufacturers of home audio products, music labels, and recording artists have recognized that a substantial market opportunity exists for digital multi-channel home audio systems and digital multi-channel music content. Currently, there are multiple formats for CD- and DVD-based digital multi-channel audio content, many of which support our format. Understanding & Solutions, in its Q1 2005 quarterly briefing, estimates that the combined U.S. market for high-resolution digital multi-channel audio content will grow from less than 2 million units in 2002 to approximately 40 million units in 2008.

Car audio, personal computer, and video game console manufacturers are increasingly incorporating digital multi-channel audio capability into their products. Surround sound technology is also incorporated into portable electronics applications, such as palm-top DVD players, which allow listeners to enjoy a simulated surround sound experience using headphones. These markets represent significant growth opportunities as content providers and consumers become familiar with the capability of digital multi-channel audio to enhance the entertainment experience.

The digital satellite and cable broadcast markets may represent significant opportunities for digital multi-channel audio. Understanding & Solutions, in its Q1 2005 quarterly briefing, estimates that digital satellite and/or digital cable was installed in approximately 47% of U.S. households at the end of 2004, projected to grow to 79% by the end of 2008, and in approximately 22% of Western European households at the end of 2004, projected to grow to 44% by the end of 2008. A significant market opportunity may exist in all sectors of this market including broadcast hardware, television set-top boxes, and televisions.

Market Opportunity for Digital Multi-Channel Music Content

Digital multi-channel music can provide an enhanced experience to music listeners, just as home theater products now provide for home video. With the 360-degree sound-field created by digital multi-channel technology, musicians and mixing engineers are able to create a far more compelling and realistic listening experience. With this technology, an artist can create an audio experience that virtually places the listener on stage with the band, in the front rows of the audience, at the conductor’s stand, or in the middle of a concert hall. In addition, digital multi-channel music creates new revenue and profit opportunities for artists and music labels by allowing them to license content to third parties or release new or existing content in a digital multi-channel format. The music industry has faced many well-publicized challenges in recent years. The industry has experienced declining revenues, due in part to piracy, challenges associated with physical distribution, competition from low-priced alternative entertainment such as DVDs, and reliance on blockbuster pop acts. Partly as a result of these business challenges, many music labels are increasingly willing to license their music properties to companies that desire to release digital multi-channel music.

Markets for Other Digital Technologies in the Motion Picture Industry

The motion picture industry faces growing global demand for motion pictures that feature subtitles, captions, or descriptive narration. This demand is a combined result of the expansion of the motion picture business in international markets and increasing political and social pressure to provide access to the motion picture experience for the hearing and visually impaired. Film distributors and theater owners are increasingly seeking a means to address this demand in a cost-effective manner. Traditionally, subtitles or captions were permanently imprinted, etched, or overlayed directly onto the film. These are expensive processes that limit the utility of any individual film print and increases costs as film distributors are required to produce multiple versions of the same movie to support various languages. Movie theaters also

incur additional costs related to managing multiple film prints. We believe a significant market opportunity is developing for digital technologies that provide a flexible, cost-effective solution for subtitling, captioning, and descriptive narration. Advanced solutions can provide for two different delivery methods: closed captioning, in which a single moviegoer uses an assistance device to view the text or hear the narrative audio, and open captioning, which allows everyone in the theater to view the text or hear the narrative audio.

Motion picture exhibitors continue to seek new sources of revenue, independent of feature films. As a result, there is a growing demand for products and services that facilitate the creation, distribution, control, and playback of digital pre-show advertising and alternative content. Pre-show and alternative content presentation can represent sizable revenue opportunity for exhibitors who have historically been financially challenged by the high cost of modern theater construction and the limited revenue sources available from theater operation.

The DTS Solution

Our proprietary DTS digital audio system provides moviegoers with a high-quality, digital multi-channel audio experience. Film studios and production companies use our technology and services to encode the soundtracks of their films using our proprietary digital multi-channel sound format. Theater owners purchase and use our products to play back DTS encoded soundtracks through six or more discrete speakers.

Our competitors imprint their proprietary digital multi-channel audio data directly onto the film. This can result in audio degradation or failure from repetitive use or handling. By contrast, we use a dual-medium system whereby we store audio information on CD-ROM discs, which are synchronized to the motion picture film by the use of our proprietary timecode. The timecode is printed on the film, which enables the correlation of single or multiple events, such as audio, light, or motion, to an individual frame of film. By placing audio data on CD-ROM discs rather than directly on film, we ensure reliable high-quality playback that is not subject to film wear or subsequent audio degradation. Our system enables theater operators to easily change audio tracks or languages by swapping the audio discs rather than changing film prints—a process that can take several hours. The CD-ROM also allows much more data capacity, and consequently higher audio quality, than data-on-film systems.

In addition, we provide products that enable the playback of video-based pre-show advertising and alternative content and systems for the projection and transmission of subtitles, captions, and descriptive narration. Our product suite allows exhibitors to purchase a single system for multiple solutions, thereby combining incremental revenue opportunities with cost efficient use of cinema hardware.

In 1996, we introduced our Coherent Acoustics technology to bring advanced digital audio entertainment to the home. Coherent Acoustics is an audio compression/decompression algorithm, or codec, which enables the encoding and decoding of audio tracks in the DTS digital multi-channel sound format. The design architecture of our technology allows us to scale or adapt, adding features or performance while maintaining backward compatibility with earlier implementations of the technology. The encoding process reduces the storage space or transmission bandwidth required for the audio information, while maximizing the quality of the sound. The audio information can then be stored on a digital medium, such as a DVD, or transmitted over a broadband connection or broadcast signal. The encoded content can be played back on digital audio electronics products equipped with a DTS Coherent Acoustics decoder, such as a DVD-based home theater system.

The performance and flexibility of our Coherent Acoustics technology enables easy implementation in a variety of consumer electronics products. Our core technology has also been incorporated into sound systems used in homes, cars, personal computers, video games and consoles, portable electronics devices, and digital satellite and cable broadcast products.

The adoption of digital multi-channel audio depends on the availability of compelling content, along with the devices required to play it. Accordingly, we provide products and services to filmmakers, recording artists, producers, and software developers to make it easy to create and deliver audio content in our proprietary digital multi-channel format. We have also entered the content-creation market directly through our DTS Entertainment label to further ensure the availability of high-quality digital multi-channel audio content.

We strive to evolve and develop our technology on an ongoing basis. For example, to offer an enhanced experience for existing and new stereo content, we have developed our Neo:6 matrix technology. This technology provides simulated multi-channel playback from stereo content and has been incorporated into home theater, home audio, portable electronics, and our movie theater products. In the future, we expect this technology to be incorporated into car audio systems as well.

Products and Services

We segment our business into consumer markets and cinema markets.

Consumer Markets

In our consumer business segment, we provide technology that enables digital multi-channel surround sound for home theater, home audio, and other emerging segments of the consumer markets. Our Coherent Acoustics technology was designed for the consumer electronics market. This proprietary technology enables delivery of up to 16 channels of discrete digital audio but typically provides from two to seven channels. Coherent Acoustics enables consumers to experience high-quality surround sound in their homes or other listening environments.

We license our Coherent Acoustics technology to consumer electronics products manufacturers through two licensing channels. First, we license our software developer kits to semiconductor manufacturers who embed our decoding software into their digital signal processor chips. In turn, these semiconductor manufacturers sell DTS-enabled chips only to hardware manufacturers who have entered into consumer manufacturer licenses with us. As part of the licensing terms for both semiconductor and hardware manufacturer licensees, we typically receive fees for access to our developer kits and for our certification, prior to sale, of the quality and performance of their products. Our business model provides for us to receive a per-unit royalty for hardware products manufactured containing our technology.

Consumer electronics products manufacturers can also design their products to support the passing of a DTS bitstream to another device, such as an audio/video receiver, that contains a DTS decoder. We refer to this pass-through capability as DTS Digital Out. Only devices equipped with a Coherent Acoustics decoder can play back digital multi-channel audio encoded in our format. Like our hardware licensees, our DTS Digital Out trademark licensees typically pay us fees for access to our developer kits and for our certification, prior to sale, of the quality and performance of their products. Our business model provides that we receive per-unit royalties for products manufactured containing our trademark.

DTS-enabled audio decoders are embedded in popular home theater products including audio/video receivers, DVD players, and home-theater-in-a-box systems. Our technology is also embedded and supported in new and emerging consumer electronics products that use digital multi-channel audio, including home audio systems, car audio devices, personal computers, video games and consoles, portable electronics devices, and digital satellite and cable broadcast products. Through December 31, 2004, our decoders have been embedded in more than 45 million audio/video devices.

We also market products and services for the creation of digital multi-channel audio content and we produce digital multi-channel audio content. We sell professional audio encoding devices to professional audio equipment dealers. We license our encoding technology to professional and professional/consumer

product manufacturers who in turn sell the products to content owners and post-production facilities, enabling them to produce and release audio and audio/video products containing DTS digital multi-channel soundtracks. These content owners include home video producers and distributors, individual music artists, and music labels. We also produce digital multi-channel audio content directly through our DTS Entertainment label by licensing popular titles from successful industry artists and re-mixing and releasing digital multi-channel versions of these music titles.

Home Theater

We have historically derived nearly all of our consumer market revenue from licensing our technology for incorporation into home theater products. These products include:

· Audio and Audio/Video Receivers. Embedded DTS decoders enable these products to decode digital multi-channel audio.

· DVD-Video Players. Incorporation of DTS Digital Out capabilities enables these devices to play DTS encoded DVD-Video and 5.1 Music Discs. In addition, some DVD players contain DTS decoding capability.

· DVD Universal Players. These products offer the same functionality as DVD-Video players but also provide the ability to play DVD-Audio discs.

· Home-Theater-in-a-Box Systems. All-in-one home theater packages typically consist of a DVD player, audio/video receiver, five speakers, and a sub-woofer.

New and Emerging Segments of the Consumer Market

The high quality and flexibility of our Coherent Acoustics algorithm provides for a variety of alternative applications. We are expanding into new and emerging markets for consumer electronics and entertainment products that incorporate high-quality digital multi-channel audio, including:

· Home Audio Systems. Home-based systems that are designed to play digital multi-channel music.

· Car Audio Systems. Currently, most major after-market car audio manufacturers sell, or have products planned for release that include our digital multi-channel audio technology. We expect many automobile manufacturers to introduce factory-installed digital multi-channel audio systems within the next few years. A DTS digital multi-channel sound system is a standard feature on both the 2005 Acura TL and RL models. Lexus, Land Rover, Infinity, Cadillac, Toyota, and Mazda of Japan currently offer a DTS-equipped digital multi-channel sound system as a factory-installed option for certain vehicles. We anticipate that several other automobile manufacturers will soon release vehicles that will incorporate our technology.

· Personal Computers. We have licensed our technology for incorporation into both hardware and software products for the personal computer. In the hardware market, we have licensed our decoding technology to a number of hardware peripherals manufacturers who incorporate our technology into sound cards and speaker systems. In the software market, we have licensed our decoding technology to two of the leading software-based DVD player providers, Cyberlink Corporation and Intervideo Inc., who have incorporated our technology into some of their products.

· Video Games and Consoles. We believe that the addition of interactive digital multi-channel audio to video games will enable a level of realism not provided by conventional audio systems and represents a significant enhancement to the quality of the gaming experience. We intend to license our technology for inclusion into gaming hardware and software applications. In the video game hardware market, Sony Corporation’s PlayStation 2 supports our interactive digital multi-channel

sound technology when connected to a DTS-capable audio/video receiver. In the game software market, we have entered into licensing relationships with several major game publishers, including Activision, Inc., Atari, Inc., and Electronic Arts, Inc., to incorporate our digital multi-channel encoding technology into their PlayStation 2 games.

· Portable Electronics Devices. Our technology is incorporated into some portable electronics devices, such as portable DVD players. We intend to aggressively pursue incorporation of our technology into other portable electronics devices such as camcorders, portable disc players, and music archival devices for stereo and simulated multi-channel playback via headphones.

· Digital Satellite and Cable Broadcast Products. Our technology has been adopted by the European Broadcasting Union’s Digital Video Broadcast Project as one of several formats for digital multi-channel audio delivery. This standards group sets digital cable, satellite, and terrestrial broadcast standards for international markets including Europe. We are actively working with other relevant standards organizations for the inclusion of our technology. Such inclusion would enable us to pursue the incorporation of our technology into broadcast hardware, set-top-boxes, and televisions. To date, we have licensed our trademarks and decoding technology for incorporation into television set-top boxes.

New Technologies for Existing and Emerging Consumer Markets

We continue to evolve and develop our technology for the consumer market. Our Neo:6 matrix technology provides simulated multi-channel play back from stereo, or two-channel, content. This technology increasingly is being incorporated into home theater systems, home audio systems, and portable electronics devices. We expect this technology to be incorporated into car audio systems and broadcast products in the future. This technology provides us with new revenue opportunities from existing and new customers.

We continue to develop the synergies between the various market segments in which we operate, such as the incorporation of our Coherent Acoustics technology into our cinema products to provide higher quality audio delivery for alternative content presentation in the cinema market.

Audio Content

To support the adoption of our technology, we sell, license, and provide professional audio products and services for encoding and decoding digital multi-channel content in our format. We also produce, market, and sell music titles in our digital multi-channel format under our DTS Entertainment label.

Professional Audio Products and Services. We sell, license, and provide a variety of professional audio products and services for content creators. The ultimate customers for these products are recording artists, music labels, and post-production facilities. The following table lists the professional audio products and services that we currently provide:

Product or Service		Description
DTS Pro Series Surround Encoder		Software based encoder for Apple or PC digital audio workstations.
DTS Pro Series Network Encoder		Software based multi-user network encoder operating on Apple’s Xserve platform through either a Mac or PC.
DTS Encoding Service		Content providers create a digital multi-channel master audio mix and provide it to us for encoding.

DTS Entertainment Label. We re-mix and produce digital multi-channel music content to support technology options, branding and to capitalize on the emerging market for multi-channel music. We license this content and pay a royalty based on the number of discs sold. We have released over 150 titles from artists in different genres of music including classical, jazz, country, pop, rock, and others. These releases include works from classical composers such as Handel and Tchaikovsky, and titles by artists such as Diana Krall, The Crystal Method, Vince Gill, Lyle Lovett, The Eagles, Queen, Sting, and The Blue Man Group.

Under our DTS Entertainment label, we sell the following products:

· 5.1 Music Discs. Our 5.1 Music Discs play in DVD players that are connected to a DTS-capable 5.1 playback system. Due to our patent coverage, we are the only company able to produce 5.1 Music Discs, although we have licensed, and may continue to license, the right to produce 5.1 Music Discs in the future. We have released over 115 titles in this format.

· DVD-Audio Discs. DVD-Audio is a relatively new and growing format for music presentation. Our DVD-Audio discs are fully compatible with both DVD-Audio players and DVD-Video players. We have released 38 DVD-Audio discs.

· OEM/Commercial Bundling. We provide major consumer electronics products manufacturers targeted digital multi-channel content, which they bundle with their product offerings to highlight a particular feature or capability and to enhance the perceived value of their product.

Relationships with Record Labels. We are pursuing relationships with major record labels whereby we re-mix and produce titles from the label in our multi-channel format and the label distributes these titles. We announced our first such relationship with EMI Music in August 2003. We produce multi-channel recordings from various EMI titles, these products carry the DTS logo, and we receive a per-unit royalty for each unit sold.

Cinema Markets

In our cinema business segment, which we have previously described as our theatrical business segment, we license technology and sell products and services to producers and distributors of feature length films and to movie theaters and special venues.

Products and Services for Film Producers and Distributors

For film producers and distributors, we license technology to encode a movie’s audio master into our digital multi-channel format and provide audio CD-ROMs for distribution with film prints to movie theaters. To facilitate synchronization to the film print, we provide the studios with equipment and the right to produce a timecode track which is printed on the film. The discs and the film print have corresponding electronic serial numbers to ensure playback of the correct soundtrack.

Products for Movie Theaters and Special Venues

Digital Audio Playback Systems. In order for a movie theater to play a DTS-encoded soundtrack, the theater must use one of our audio playback systems. These systems are rack-mounted products installed in movie theater projection booths. These playback systems are sold in several configurations that support analog and digital audio play back, and other audio management and theater automation functions.

We sell similar products and services to special venues such as large-format theaters, amusement parks, national parks, and museums. We believe we are a leading supplier in this market due to our high quality and reliability and because we have the only commercially available technology that supports all film sizes and speeds from 8 millimeter to 70 millimeter.

Systems for Subtitling, Captioning, and Descriptive Narration. We also sell our DTS-CSS system to movie theaters. This system delivers feature-film subtitles, captions, and descriptive narration for foreign language and hearing and visually impaired audiences. We believe this proprietary digital system is a cost-effective method to provide subtitles, captions, and descriptive narration for a film because it eliminates the need to permanently imprint, etch, or overlay the subtitles or captions directly onto the film. The DTS-CSS system enables the delivery of open or closed captioning, depending on the output device utilized. For open captions, the DTS-CSS system uses a separate video projector to render subtitles or captions; for closed captions, the system is utilized in conjunction with a rear-wall display device. This product is designed to address the increasing political and social pressure to provide access to the motion picture experience for the hearing and visually impaired.

This same family of products is also being used for alternative content presentations and for pre-show advertising. These products enable a theater owner to extend its range of revenue opportunities, but also help to maximize the utility of equipment in theater projection rooms, saving expense and space. In the pre-show advertising area, both the CSS system and the DTS XD10 Cinema Media player can be used when coupled with a color projector. The DTS XD10 has an extensive feature set, which includes networking capability to facilitate its integration into a content distribution system.

The chart below lists the products that we sell to movie theaters and special venues:

Product or Service		Description
DTS XD10 Cinema Media Player		The DTS XD10 is a DVD and hard-drive based multi-function playback device for movie theaters. DTS XD10 supports up to ten channels of audio, digital video playback capability, and can be upgraded to support DTS-CSS applications and/or pre-show advertising and alternative content.
DTS XD10 Cinema Audio Processor		The recently introduced DTS XD10P is a standalone digital and analog cinema audio processor. The XD10P provides up to eight channels of audio output and interfaces with the XD10 Cinema Media Player and other digital sources as well as theater automation systems.
DTS-6D Digital Playback System		A digital multi-channel audio playback unit for movie theaters.
DTS-6AD Cinema Processor		An integrated DTS-6D playback unit with a cinema processor, providing audio playback management and control as well as theater automation functions.
DTS-ES Extended Surround Decoder		A decoding device which derives a center surround channel from extended surround tracks, providing 6.1 audio for theaters.
DTS-6SV Special Venue		A modified DTS-6D playback unit for special venue customers, providing six full bandwidth audio channels and a time code reader for use with non-standard film sizes.
DTS-ECP Expandable Cinema Processor		An entry-level analog cinema processor and booth monitor that can be upgraded for DTS digital play back.
DTS Digital Playback Package		A digital playback upgrade kit for the DTS-ECP, providing the functionality of our DTS-6AD Cinema Processor.
DTS-CSS System		A digital subtitling, captioning, and descriptive narration system consisting of a processing unit, time code reader, and a digital projector.

Image Restoration and Enhancement Services

In January 2005, we acquired Lowry Digital Images, Inc. and changed the name to DTS Digital Images. Through this subsidiary, we now provide restoration and enhancement services for moving pictures captured on film or in digital form. These services enable current or archived content to be restored for high quality, high definition presentations in digital cinema, high definition optical media or broadcast applications.

DTS Technology Platform

Our core audio technology platform is designed to capture, store, and reproduce audio signals. There are several technical considerations involved in this process, including the frequency of data sampling, the word length, and the bit rate. These factors can control the quality of audio presentation and are commonly managed through compression techniques.

A fundamental challenge with digital audio distribution is that capturing analog signal representations in digital form requires a tremendous amount of data. Therefore, the storage and subsequent transmission of that data presents physical space, efficiency, and economic challenges. We address this challenge by developing coding technology and products that reduce the amount of data required to store and transmit an audio signal and to subsequently reproduce the data.

The design, architecture, and implementation of this coding solution are complex. Signal coding requires a thorough and combined understanding of the disciplines of electrical engineering, computer science, and psychoacoustics, coupled with significant practical experience. One of our key technical strengths has been our ability to develop a system that enables the transparent reproduction of an original audio signal, meaning that the reproduction sounds indistinguishable from its source.

Emerging applications for digital multi-channel audio, such as video games, the Internet, and recordable media, have limited bandwidth. Our technology architecture is flexible enough to accommodate these needs and optimize quality within the constraints of the application.

The following chart compares our audio technology against the two other predominant technologies used on DVD-Video—Dolby AC-3, and MPEG-2, Layer 2.

Comparison of Technologies Used in DVD-Video	DTS	Dolby AC-3	MPEG-2, Layer 2
Range of Operation (Bit Rates)	32-9,216 kbps	32-640 kbps	32-920 kbps
Range of Sample Rates	8-192 kHz	32-48 kHz	8-148 kHz
Number of Channels	16 +	5.1	7
Scalability:
Sampling frequency	Yes	No	Yes
Channels	Yes	No	Partly
Bit Rate	Yes	Partly	No

We have designed the following attributes into the basic architecture of our technology:

· scalable, meaning that parameters such as data rate can be set over a very wide range, as applications require;

· extensible, meaning that the structure itself accommodates additional data for enhancements both anticipated and unknown; and

· backward compatible, meaning that extensions and enhancements do not preclude the ability of earlier decoders to play the core signal.

Intellectual Property

We have a substantial base of intellectual property assets covering patents, trademarks, copyrights, and trade secrets. We have 21 individual patent families resulting in more than 123 individual patents and more than 55 patent applications throughout the world. We have more than 70 trademarks and more than 45 trademark applications pending worldwide with additional marks in the pre-application phase. We also have a number of federally registered copyrights and maintain a sizeable library of copyrighted software

and other technical materials as well as numerous trade secrets. We have targeted our intellectual property coverage to provide protection in the major manufacturing and commercial centers of the world.

We pursue a general practice of filing patent applications for our technology in the United States and various foreign countries where our customers manufacture, distribute, or sell licensed products. We actively pursue new applications to expand our patent portfolio to address new technological innovations. Most of the patents in our patent portfolio have an average life of 20 years from their date of filing with some beginning to expire between 2005 and 2009. However, many of our more substantive patents are relatively young and have expiration dates ranging from 2015 to 2018. We have multiple patents covering unique aspects and improvements for many of our technologies. Accordingly, we do not believe that the expiration of any single patent is likely to significantly affect our intellectual property position or our ability to generate licensing revenues.

The following table lists our key patents and patent applications and the inventions they cover:

Key Patent Titles		Coverage
Consumer Markets
Multi-Channel Predictive Subband Audio Coder Using Psychoacoustic Adaptive Bit Allocation in Frequency, Time and over Multiple Channels		Coherent Acoustics Algorithm—Encoder & Decoder
Improving Sound Quality of Established Low Bit-Rate Audio Coding Systems Without Loss of Decoder Compatibility		Core + Extension Architecture, 96 kHz/24 Bit Structure
Method of Decoding Two-Channel Matrix Encoded Audio to Reconstruct Multi-Channel Audio		Neo:6 (stereo to multi-channel) and DTS-ES (6.1 channel)
Digitally Encoded Machine Readable Storage Media Using Adaptive Bit Allocation in Frequency, Time and over Multiple Channels		Coherent Acoustics Algorithm—Article of Manufacture
Method and Apparatus for Multiplexed Encoding of Digital Audio Information onto a Digital Storage Medium		Multi-Channel CD—5.1 Music Disc (applicable to cinema discs)
Cinema Markets
Motion Picture Digital Sound System and Method with Primary Sound Storage Edit Capability		Cinema Synchronization and Play Back
Motion Picture Digital Sound System & Method		DTS Time Code on Film
Motion Picture Subtitling System and Method Using an Electro-Optical Dowser		Subtitling System Using an Optical Dowser

We generally license our technology on standard terms through a two-tiered structure: first to integrated circuit semiconductor manufacturers and then to consumer electronics product manufacturers. We generally license on a non-exclusive, perpetual, worldwide basis. Our business model provides for hardware manufacturers to pay us for each unit they produce that contains our technology or trademarks. We require that all licensees have their integrated circuits or hardware devices certified by us prior to distribution. We reserve the right to audit their records and quality standards. Licensees are required to use the appropriate DTS trademark on the products they manufacture.

In the consumer products market, we have 52 patents issued and 39 patents pending worldwide spanning the entire spectrum of our technology including the encoding and decoding process, the structure of the DTS audio stream, and media containing DTS encoded material. In addition, we have a number of patents and applications covering extensions of our core technology architecture as well as unique implementation approaches for various product applications.

In the cinema market, we have 47 patents issued and seven patents pending worldwide covering our cinema system, the DTS time code, and our subtitling method. These patents cover the technology that is utilized in our various cinema products as well as our film license rights.

We also have 24 patents and nine patent applications that span across both the consumer products and cinema sectors of our business. These rights primarily cover the process of producing media containing DTS and digital multi-channel audio as well as the individual finished product.

We have licensed from Audio Processing Technology Limited the rights to the apt-X algorithm on a perpetual, worldwide, non-exclusive basis. The apt-X algorithm is the audio algorithm used by our cinema products to encode and play back our audio tracks.

Our trademarks consist of over 20 individual word marks, logos, and slogans filed throughout the world. The marks cover our various products, technology, improvements, and features as well as the services that we provide. Our trademarks are an integral part of our licensing program and are required to be used on licensed products to identify the existence of the technology and to provide greater consumer awareness. Our trademarks include the following:

We have a significant amount of copyright protected materials including software, textual materials, and master audio materials used to produce our DTS Entertainment products. A number of these products have been federally registered.

Customers

Consumer Markets

Consumer Electronics Products Manufacturers. We have licensed our Coherent Acoustics technology to over 250 consumer electronics products manufacturers for use in hundreds of consumer audio products. Collectively, these manufacturers have sold over 45 million products with DTS digital sound decoding technology. The following list sets forth some of the consumer electronics products manufacturers that have licensed our technology.

Audio & Audio/Video Receivers

DVD Players

Koninklijke Philips Electronics

LG Electronics, Inc.
Pioneer Corporation

Samsung Electronics Co., Ltd.

Sony Corporation
Yamaha Corporation

Funai Electric Co., Ltd.

Orion Electric Co., Ltd.

Samsung Electronics Co., Ltd.

Sanyo Technosound Co. Ltd.

Sony Corporation
Thomson

Car Audio Systems
Fujitsu Ten Co., Ltd.		Hyundai Autonet		Kenwood Corporation		Matsushita Electric Industrial Co., Ltd.

Semiconductor Manufacturers. We have licensed to over 40 semiconductor manufacturers the right to incorporate our technology in their semiconductors and to sell semiconductors with DTS technology to our hardware manufacturer licensees. Our major semiconductor-manufacturing customers include the following:

Cirrus Logic, Inc.		LSI Logic Corporation		Yamaha Corporation
Fujitsu Limited		Matsushita Electrical Industrial Co., Ltd.

Content Providers. We have also provided our Coherent Acoustics technology to many of the leading home video and music content providers including DreamWorks Home Entertainment, New Line Home Entertainment, Inc., and Warner Bros. Records, Inc. To date, over 5,000 DVD titles, over 155 CD titles, and over 38 DVD-Audio titles have been produced with DTS digital multi-channel audio tracks.

DTS Entertainment. Major retail customers who sell DTS Entertainment labeled music content to consumers include Amazon.com, Best Buy, Musicland, and Tower Records.

Cinema Markets

The nine major film studios in the United States are all customers of ours. According to Exhibitor Relations, these film studios accounted for approximately 84% of admission revenues and 83 of the 100 highest grossing films in the United States in 2004. These studios, which released most of their major feature films in the DTS format in 2004, are listed below.

20th Century Fox	DreamWorks SKG	Paramount Pictures
Buena Vista Pictures	MGM Pictures	Universal Pictures
Columbia Pictures	New Line Cinema Corp.	Warner Bros. Pictures

In addition, we sell our playback equipment to movie theaters, including the following:

Jack Loeks		Rave Theatres		Wallace Theatres
Odeon Cinemas		Regal Entertainment

Sales, Marketing, and Support

Consumer Products

We have a licensing team that markets our technology directly to large consumer electronics products manufacturers and semiconductor manufacturers. This team includes employees located in the United States, China, England, Japan, and Northern Ireland. We believe that by locating staff near the leading consumer electronics and semiconductor manufacturers we can enhance our sales and business development efforts.

We market our digital sound encoding equipment directly to the content providers and audio professionals serving the consumer electronics market. We believe that allowing easy access to encoders will result in more DTS content, which we believe will drive consumer demand for DTS-enabled electronics products.

Film Producers and Distributors

Our post-production department, senior management, and liaison offices market our products and services directly to individual film producers and distributors worldwide.

Movie Theaters

We sell our cinema playback systems to movie theaters through a direct sales force and a network of independent dealers. To date, most of our sales and marketing efforts have been focused in the United States, Western Europe, and in targeted markets in Asia and Latin America. We have also begun to focus our efforts on pursuing theater companies that have a large concentration of movie theaters in selected foreign countries such as India, China, and Eastern Europe.

DTS Entertainment

We sell music content released under our DTS Entertainment label through distributors. In the United States, Navarre Corporation is our exclusive distributor of DTS Entertainment label products to major national retail accounts. In addition to our in-house staff, we also employ consultants to coordinate sales to independent retailers. We are in the process of establishing distribution channels internationally. Cadiz Music Limited serves as our exclusive distributor of DTS Entertainment label products in Europe and Disc Union serves as our exclusive distributor in Japan. We intend to engage one or more additional distributors with an established presence in Asia to handle distribution in other Asian territories. We also sell this music directly to consumers through an online store and other web-based retailers. We intend to expand the number of retail outlets that carry our products and broaden our distribution network worldwide.

Research and Development

We have a group of 46 engineers and scientists, including seven PhDs, focused on research and development. This group oversees our product development efforts and is responsible for implementing our technology into our existing and emerging products. We carry out research and development activities at our corporate headquarters in Agoura Hills, California and at our facility in Bangor, Northern Ireland.

Our research and development expenses totaled approximately $3.8 million during 2002, $5.0 million during 2003, and $6.1 million during 2004. We expect that we will continue to commit significant resources to applications engineering efforts, particularly in support of the new high definition disc standards, and to research and development in the future.

In December of 2003 we entered into a collaborative research agreement with Sonic Arts Research Centre, or SARC, located at Queen’s University in Belfast, Northern Ireland. The research is focused on the development of new multi-channel audio technologies and is jointly funded by DTS and Invest NI, a development agency in Northern Ireland.

Governmental and Industry Standards

There are a variety of governmental and industry-related organizations that are responsible for adopting system and product standards. Standards are important in many technology-focused industries as they help to assure compatibility across a system or series of products. Generally, standards adoption occurs on either a mandatory basis, requiring the existence of a particular technology or feature, or an optional basis, meaning that a particular technology or feature may be, but is not required to be, utilized.

We actively participate in a variety of standards organizations worldwide, including the DVD Forum, Blu-ray Disc Association, Digital Video Broadcast Project, International Engineering Consortium, High-Definition Multimedia Interface Standard, Media Oriented Systems Transport Bus, Audio Engineering

Society, and Society for Motion Picture and Television Engineers. We anticipate being involved in a number of other standards organizations as appropriate to facilitate the implementation of our technology.

We believe the market for audio and audio/video products is very standards driven and our active participation with standards organizations is important as we work to include our technology in standards or change our status from optional to mandatory where possible. We believe our standards involvement also provides us early visibility into future opportunities.

In the consumer products area, we are members of the DVD Forum and Blu-ray Disc Association. In both organizations we are specifically involved in several working groups and expert groups. For DVD-Video, we have obtained optional status for our core Coherent Acoustics technology. Through our participation, we have expanded the supported specification of our codec, increasing the quality and number of channels. Our technology has been selected as mandatory in the future high definition optical disc standards. Our technology has been accepted as an optional format in the DVD-Audio Recordable specification and we are currently involved in the working groups for Interactive DVD and DVD recording specifications for both audio and high definition video.

In the digital broadcast area, we participate in the Digital Video Broadcast Project, or DVB, and the Advanced Television Systems Committee, or ATSC. In late 2002 our technology was accepted as an optional audio format in the DVB Specification.

We actively participate in the major industry associations that publish research and establish standards. These include the Society of Motion Picture and Television Engineers and, in particular, the committees relating to digital cinema, and the Audio Engineering Society.

We have six employees and consultants focused on standards activities, including one in Europe, one in Japan, and four in the United States. We also employ additional resources as necessary to assist with specific standards-related tasks.

Competition

We face intense competition in each of our markets and expect competition to intensify in the future. Our primary competitor is Dolby Laboratories, who develops and markets digital multi-channel audio products and services. Except for image restoration and enhancement, we compete with Dolby in nearly all of our markets and product categories.

Dolby was founded more than 35 years ago and for many years was the only significant provider of audio technologies. Dolby’s long-standing market position, brand, business relationships, and inclusion in various industry standards provide it with a strong competitive position.

In addition to Dolby Laboratories, we also compete in specific product markets with Coding Technologies, Fraunhofer Institut Integrierte Schaltungen, Koninklijke Philips Electronics N.V., Microsoft Corporation, Smart Devices, Inc., Sony Corporation, Thomson, Ultra Stereo Labs, Inc., and various consumer electronics products manufacturers. Many of these competitors have longer operating histories and significantly greater resources or greater name recognition than we do.

We believe that the principal competitive factors in each of our markets include some or all of the following:

· technology performance, flexibility, and range of application;

· quality and reliability of products and services;

· brand recognition and reputation;

· inclusion in industry standards;

· price;

· relationships with film producers and distributors and with semiconductor and consumer electronics manufacturers;

· availability of compatible high-quality audio content; and

· timeliness and relevance of new product introductions.

We have been successful in penetrating the consumer and cinema markets and building and maintaining significant market share. Most major feature-film releases in the United States are encoded in our format, many top selling and premier edition DVDs contain digital multi-channel soundtracks in our format, and a substantial majority of consumer electronics products with digital multi-channel capability incorporate our technology, trademarks, or know-how. Our success has been due in large part to our ability to position our brand as a premium offering that contains superior proprietary technology, the quality of our customer service, our inclusion in industry standards, and our industry relationships.

We believe there are significant barriers to entry in our key markets. In the cinema market, there are three well-established formats—DTS, Dolby, and Sony—and we believe it would be very difficult for a new entrant to penetrate the market. Key barriers to entry include physical limitations on the film, intellectual property coverage, and the reluctance of the film studios to pay additional license fees and theater operators to purchase additional playback equipment. In the consumer electronics products market, the standards relating to DVD-Video are well established and support a limited number of technologies including DTS Coherent Acoustics.

Employees

As of December 31, 2004, we had 174 employees, which includes 46 employees in engineering, technical services, and research and development, 12 employees in production and operations, 69 employees in sales, marketing, service, and support, 22 employees in accounting and information technology, and 25 employees in senior management and administration. Of the 174 total employees, 121 work in the United States and 53 work in our various international locations, including 38 in the United Kingdom. None of our employees is subject to a collective bargaining agreement, and we have never experienced a work stoppage. We believe our relations with our employees are good. Our future success depends on our ability to attract, motivate, and retain highly-qualified technical and management personnel. From time to time, we also employ independent contractors to support our product development, sales, marketing, business development, and administration organizations.

Website Access to SEC Filings

We maintain an Internet website at www.dtsonline.com. We make available free of charge through our Internet website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.

Item 2. Properties

Our corporate headquarters and principal offices are located in Agoura Hills, California, where we lease approximately 42,000 square feet. This space is leased under two leases which expire in May 2007 and October 2007. We also lease smaller facilities in other locations including the United States of America, England, Northern Ireland, Japan, Canada, China, and Hong Kong. We believe that our existing space is adequate for our current operations. We believe that suitable replacement and additional space will be available in the future on commercially reasonable terms.

Item 3. Legal Proceedings

In the ordinary course of our business, we actively pursue legal remedies to enforce our intellectual property rights and to stop unauthorized use of our technology and trademarks.

In connection with such activities against Sunplus Technology Co., Ltd., or Sunplus, we terminated Sunplus’ license agreement with us. In response, Sunplus filed suit against us alleging breach of contract arising from our termination of their license agreement. We have prevailed on several preliminary motions by Sunplus seeking to enjoin us from terminating the license agreement. We have filed a cross-complaint seeking a judicial declaration that we properly terminated the license agreement and to recover damages arising from Sunplus’ breach of the agreement. We believe Sunplus’ claim is without merit and we intend to vigorously defend the case.

We are not a party to any other material legal proceedings. We may, however, become subject to lawsuits from time to time in the course of our business.

Item 4. Submission of Matters to a Vote of Security Holders

We did not submit any matters to a vote of security holders during the fourth quarter of the year ended December 31, 2004.

PART II

Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters

PRICE RANGE OF COMMON STOCK

Our common stock has been traded on the Nasdaq National Market under the symbol “DTSI” since our initial public offering on July 10, 2003. The following table sets forth, for the periods indicated, the high and low sales prices for our common stock as reported by the Nasdaq National Market:

	High		Low
2003:
Third Quarter (from July 10, 2003)	$	31.31	$	19.50
Fourth Quarter	$	34.28	$	24.05
2004:
First Quarter	$	27.15	$	20.08
Second Quarter	$	28.00	$	19.87
Third Quarter	$	26.27	$	12.56
Fourth Quarter	$	21.30	$	15.14

As of March 1, 2005 there were approximately 1,700 stockholders of record of our common stock. We believe that the number of beneficial owners is substantially greater than the number of record holders because a large portion of our common stock is held of record through brokerage firms in “street name.”

DIVIDEND POLICY

We have never declared or paid any cash dividends on our common stock. We currently intend to retain all available funds to support our operations and to finance the growth and development of our business. We do not anticipate paying any cash dividends in the foreseeable future. Any future determination relating to dividend policy will be made at the discretion of our board of directors and will depend on a number of factors, including our future earnings, capital requirements, financial condition, future prospects, and other factors as the board of directors may deem relevant.

USE OF INITIAL PUBLIC OFFERING PROCEEDS

On July 15, 2003, we completed our initial public offering for the sale of 4,091,410 shares of common stock at a price to the public of $17.00 per share, which resulted in net proceeds of approximately $63.0 million after payment of the underwriters’ commissions and deductions of offering expenses. All of the shares of Common Stock sold in the offering were registered under the 1933 Act on a Registration Statement on Form S-1 (Reg. No. 333-104761) that was declared effective by the SEC on July 9, 2003 and a Registration Statement filed pursuant to Rule 462(b) under the Securities Act that was filed on July 10, 2003 (Reg. No. 333-106920). Subsequent to the offering, we used approximately $22.5 million of our net proceeds to redeem all outstanding shares of redeemable preferred stock and to pay all accrued but unpaid dividends on such shares through the date of redemption. The remaining proceeds to us have conformed with our intended use outlined in the prospectus related to the offering. As of December 31, 2004, we have approximately $40.5 million remaining from the proceeds of the offering.

Item 6. Selected Financial Data

SELECTED CONSOLIDATED FINANCIAL DATA

In the table below, we provide you with historical selected consolidated financial data of Digital Theater Systems, Inc. The consolidated statement of operations data for the years ended December 31, 2000 and 2001 and the consolidated balance sheet data as of December 31, 2000, 2001, and 2002 are derived from our audited consolidated financial statements for such periods and dates, which are not included in this Form 10-K. The consolidated statement of operations data for the years ended December 31, 2002, 2003, and 2004 and the consolidated balance sheet data as of December 31, 2003 and 2004 are derived from, and qualified by reference to, our audited consolidated financial statements for such periods and dates, which appear elsewhere in this Form 10-K. It is important that you read the selected consolidated financial data set forth below in conjunction with our consolidated financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Form 10-K. Our historical results are not necessarily indicative of the operating results that may be expected in the future.

	Years Ended December 31,
	2000			2001			2002			2003			2004
	(In thousands, except share and per share data)
Consolidated Statement of Operations Data
Revenues:
Technology and film licensing	$	14,605		$	19,615		$	31,906		$	42,229		$	49,920
Product sales and other revenues	10,457			9,133			9,150			9,473			11,511
Total revenues	25,062			28,748			41,056			51,702			61,431
Cost of goods sold:
Technology and film licensing	2,901			3,007			3,687			4,281			4,451
Product sales and other revenues	5,988			7,045			6,949			6,751			11,711
Total cost of goods sold	8,889			10,052			10,636			11,032			16,162
Gross profit	16,173			18,696			30,420			40,670			45,269
Operating expenses:
Selling, general and administrative	12,819			13,336			16,379			20,473			27,644
Research and development	2,984			3,603			3,754			4,987			6,131
Total operating expenses	15,803			16,939			20,133			25,460			33,775
Income (loss) from operations	370			1,757			10,287			15,210			11,494
Interest income (expense), net	(338		)	(278		)	(94		)	271			1,447
Other expense, net	(131		)	(302		)	(255		)	(214		)	(31		)
Income from legal settlement	—			—			—			—			2,601
Income (loss) before provision (benefit) for income taxes	(99		)	1,177			9,938			15,267			15,511
Provision (benefit) for income taxes	—			(2,731		)	3,688			5,368			5,535
Net income (loss)	(99		)	3,908			6,250			9,899			9,976
Accretion and accrued dividends on preferred stock	(1,783		)	(1,813		)	(1,848		)	(1,234		)	—
Net income (loss) attributable to common stockholders	$	(1,882	)	$	2,095		$	4,402		$	8,665		$	9,976
Net income (loss) attributable to common stockholders per common share:
Basic	$	(0.44	)	$	0.49		$	0.99		$	0.95		$	0.59
Diluted	$	(0.44	)	$	0.23		$	0.47		$	0.80		$	0.55
Weighted average shares used to compute net income (loss) attributable to common stockholders per common share:
Basic	4,294,378			4,295,419			4,432,408			9,166,389			16,865,805
Diluted	4,294,378			9,054,843			9,329,278			10,764,867			18,143,114

See our consolidated financial statements and related notes for a description of the calculation of the historical net income (loss) attributable to common stockholders per common share and the weighted average number of shares used in computing the historical per common share data.

	As of December 31,
	2000			2001			2002			2003		2004
	(In thousands)
Consolidated Balance Sheet Data
Cash, cash equivalents, and short-term investments	$	4,152		$	6,858		$	4,051		$	99,389	$	114,311
Working capital	7,815			9,452			9,381			110,810		125,573
Total assets	15,176			21,707			25,779			127,495		144,689
Long-term obligations, less current portion	6,403			6,303			—			—		—
Mandatorily redeemable preferred stock	17,641			19,454			21,302			—		—
Total stockholders’ equity (deficit)	(12,950		)	(10,855		)	(6,315		)	118,871		134,766

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Annual Report on Form 10-K and the documents incorporated herein by reference contain forward-looking statements based on our current expectations, estimates and projections about our industry, beliefs, and certain assumptions made by us. Words such as “believes,” “anticipates,” “estimates,” “expects,” “projections,” “may,” “potential,” “plan,” “continue” and words of similar import, constitute “forward-looking statements.” The forward-looking statements contained in this report involve known and unknown risks, uncertainties and other factors that may cause our actual results to be materially different from those expressed or implied by these statements. These factors include those listed under the “Risk Factors” section contained below and elsewhere in this Form 10-K, and the other documents we file with the Securities and Exchange Commission, or SEC, including our most recent reports on Form 8-K and Form 10-Q. We cannot guarantee future results, levels of activity, performance or achievements. We do not undertake any obligation to revise these forward-looking statements to reflect future events or circumstances.

You should read the following discussion of our financial condition and results of operations in conjunction with the consolidated financial statements and the notes to those statements included elsewhere in this Form 10-K. This discussion may contain forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, such as those set forth under “Risk Factors” and elsewhere in this Form 10-K.

Overview

We are a leading provider of entertainment technology, historically focused on high-quality digital multi-channel audio technology, products, and services for entertainment markets worldwide. Multi-channel audio, commonly referred to as surround sound, provides more than two-channels of audio, allowing the listener to simultaneously hear discrete sounds from multiple speakers. Our DTS digital multi-channel audio technology delivers compelling surround sound for the motion picture and consumer electronics markets.

We manage our business through two reportable segments—our consumer business and our cinema business, which we have previously described as our theatrical business. Historically, we have derived a majority of our revenues from the cinema business. Beginning in 2001, however, we have derived a majority of our revenues from our consumer business. In connection with our acquisition of Lowry Digital Images, Inc., or LDI, we will have a third reportable segment in the first quarter of 2005.

In our consumer business, we derive revenues from licensing our audio technology, trademarks, and know-how under agreements with substantially all of the major consumer audio electronics manufacturers. Our business model provides for these manufacturers to pay us a per-unit amount for DTS-enabled products that they manufacture. We also derive revenues from licensing our technology to consumer semiconductor manufacturers. Through our DTS Entertainment label, we derive revenues from the sale of multi-channel music titles in our digital multi-channel format.

In our cinema business, we derive revenues from sales of our playback equipment and cinema processors to movie theaters and special venues. In addition, we license technology and sell encoding and duplication services to film producers and distributors for the creation of digital multi-channel motion picture soundtracks. We also derive revenues from the sale of systems and encoding services for pre-show advertising, alternative content, subtitling, captioning, and descriptive narration.

We present revenues in our consolidated financial statements and in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” as derived from (1) technology and film licensing and (2) product sales and other revenues. Our technology and film licensing revenues are derived from each of our consumer and cinema business segments. Revenues from technology licensing in connection with our consumer business segment include revenues derived from licensing our audio technology, trademarks, and know-how to consumer electronics, personal computer, video game and console, digital satellite and cable broadcast, and professional audio companies as well as to semiconductor manufacturers. Revenues from technology and film licensing in connection with our cinema business segment include revenues derived from film licensing and services that we provide to film studios for the production of soundtracks in our digital multi-channel format. Our product sales and other revenues also are derived from each of our consumer and cinema business segments. Revenues from product sales and other revenues in connection with our consumer business segment include revenues derived from sales of music titles that we produce in our digital multi-channel format and sales of our professional audio products and services. Revenues from product sales and other revenues in connection with our cinema business segment include revenues derived from sales of our digital playback systems, cinema processor equipment, and systems for subtitling, captioning, and descriptive narration to movie theaters and special venues.

We actively engage in intellectual property compliance and enforcement activities focused on identifying third parties who have either incorporated our technology, trademarks, or know-how without a license or who have under-reported to us the amount of royalties owed under license agreements with us. We continue to invest in our compliance and enforcement infrastructure to support the value of our intellectual property to us and our licensees and to improve the long-term realization of our intellectual property. As a result of these activities, from time to time, we recognize royalty revenues that relate to consumer electronics manufacturing activities from prior periods. These royalty recoveries may cause revenues to be higher than expected during a particular reporting period and may not occur in subsequent periods. We cannot predict the amount or timing of such revenues.

Our cost of goods sold consists primarily of amounts paid for products and materials, salaries and related benefits for production personnel, depreciation of production equipment, and payments to third parties for licensing technology and copyrighted material.

Our selling, general, and administrative expenses consist primarily of salaries, commissions, and related benefits for personnel engaged in sales, corporate administration, finance, human resources, information systems, legal, and operations, and costs associated with promotional and other selling activities. Selling, general, and administrative expenses also include professional fees, facility-related expenses, and other general corporate expenses.

Our research and development costs consist primarily of salaries and related benefits for research and development personnel, engineering consulting expenses associated with new product and technology

development, and quality assurance and testing costs. Research and development costs are expensed as incurred.

In our consumer business, we have a licensing team that markets our technology directly to large consumer electronics products manufacturers and semiconductor manufacturers. This team includes employees located in the United States, China, England, Japan, and Northern Ireland. We sell music content released under our DTS Entertainment label through distributors. In the United States and Canada, Navarre Corporation is our exclusive distributor of DTS Entertainment label products to major national retail accounts and in Europe, Cadiz Music Limited is our exclusive distributor of DTS Entertainment label products. Disc Union serves as our exclusive distributor in Japan. We also employ consultants to coordinate sales to independent retailers. We are in the process of establishing distribution channels in other international territories. We intend to engage one or more additional distributors with an established presence in Asia to handle distribution other Asian territories. We also sell this music directly to consumers through an online store and other web-based retailers. We intend to expand the number of retail outlets that carry our products and broaden our distribution network worldwide.

In our cinema business, our post-production department, senior management, and liaison offices market our products and services directly to individual film producers and distributors worldwide. We sell our digital multi-channel playback systems to movie theaters through a direct sales force and a network of independent dealers. To date, most of our sales and marketing efforts have been focused in the United States and Canada, Western Europe, and in targeted markets in Asia and Latin America. We have also begun to focus our efforts on pursuing theater companies that have a large concentration of movie theaters in selected foreign countries such as India and China, and in Eastern Europe.

With our recent acquisition of LDI, we now provide restoration and enhancement services for moving pictures captured on film or in digital form. These services enable current or archived content to be restored for high quality, high definition presentations in digital cinema, high definition optical media or broadcast applications.

Management Discussion Regarding Trends, Opportunities, and Challenges

Consumer Segment

Revenue from our consumer segment constitutes the majority of our total revenue, representing 62%, 68%, and 68% of total revenues in fiscal years ended December 31, 2002, 2003, and 2004, respectively. Our consumer revenue is primarily dependent upon the home theater and DVD player markets, which have experienced rapid growth over the past several years. The success of DVD-Video-based systems and products has fueled a demand for ever-higher quality entertainment in the home, and this demand is extending to the car and PC markets as well. We expect the recent acceleration of the market for high definition televisions to drive demand for high definition optical disc players beginning in late 2005. Because we expect to be a mandatory technology for the next generation players, our consumer revenue growth should more closely track the growth rate of these players over the next several years. We expect that the market for high definition players will yield new growth that provides an offset to the expected decline in the overall growth in DVD player shipments. Further, we believe that expected mandatory inclusion in next generation optical disc standards will help to improve the adoption rate of our technologies in other consumer products such as next generation video game consoles, personal audio and video players, personal computers and in-car entertainment systems. Failure to attain mandatory status in next generation high definition optical disc standards could cause revenue growth in our consumer business to be significantly lower than expected and could have a material adverse effect on our business.

In July 2004, we acquired QDesign Corporation, or QDesign, a company focused on lower-bit rate audio delivery technology. The market for higher quality entertainment is expanding into portable devices that require the use of low-bit rate audio coding systems including portable audio players, PDAs and

wireless handset applications. Concurrent with this trend, there is a growing need for a good link between home and portable devices that preserves as much quality as possible and allows consumers a seamless technology solution for the storage and playback of their content. In October 2004, leveraging our existing research and development efforts and the intellectual property acquired in the QDesign acquisition, we launched DTS-HD, a scalable coding system. This technology allows content to be played in home and portable devices. We believe that the broad and robust nature of this offering improves the probability of inclusion of our technologies in next generation products.

Cinema Segment

Revenue from our cinema segment represented 38%, 32%, and 32% of total revenues for the years ended December 31 2002, 2003, and 2004, respectively. In our cinema business, 2004 was a solid year for sales of our playback hardware, marking a return to growth for cinema product sales. We expect growth in our cinema audio hardware to continue at a modest pace in 2005. We also believe that the cinema exhibition community has recognized that pre-show entertainment represents a significant revenue growth opportunity that will lead to investment in pre-show solutions over the next several years. Because our XD-10 Cinema Media Player can be configured to perform audio playback along with pre-show or subtitling presentation, we believe that we are well-positioned to participate in the growth in this market.

In January 2005 we acquired Lowry Digital Images, Inc., or LDI, a company focused in high quality image restoration and enhancement. We believe that the growing market for televisions capable of playing high resolution or high definition content will create a substantial demand for such content. We believe that LDI has a technological advantage over many of its competitors based on the sophistication of its processes and level of automation used to restore or enhance the image quality of entertainment content. To date, LDI has restored and/or enhanced over 100 feature films, including such recent major DVD releases as Star Wars and Indiana Jones. Major motion picture and television studios possess libraries containing thousands of titles, which we believe represents a sizable market opportunity for LDI’s service.

Another trend that we believe will affect our cinema business segment is the the long-term trend toward digital media. We believe this trend will involve the near term adoption of digital pre-show and/or electronic cinema solutions, followed by longer term adoption of higher quality digital cinema. Digital media offers the motion picture industry a means to achieve substantial cost savings, including the printing and distribution of movies, help in combating piracy, and will enable movies to be played repeatedly without degradation. It also provides additional revenue opportunities for cinema operators, as digital content such as advertisements, concerts and sporting events could be shown in or broadcast to digitally equipped theaters. We believe the widespread adoption of digital cinema will be longer term because of the significant capital investment that will be required by cinema operators to purchase new equipment and solutions. We believe this represents an opportunity for us as we seek to provide products and services in support of the transition from film-based content towards digital cinema. However, we do not currently offer digital cinema products and may not be succesful in developing or selling competitive product offerings. We believe that our recent acquisition of LDI, coupled with the pre-show and alternative content capabilities of our XD10 Cinema Media Player, will enable us to play a role in the industry transition to high definition sound and images for digital cinema.

Sales of cinema products and film licensing tend to fluctuate based on the underlying trends in the motion picture industry. For instance, in the late 1990s various cinema operators aggressively built megaplexes, which resulted in an oversupply of screens in some domestic and international markets. The resulting oversupply of screens led to significant declines in revenues per screen, and eventually, many theaters were closed. As the theater industry has regained health in the last several years, sales of our DTS playback systems and cinema processors have improved. Our film licensing revenues are also subject to fluctuations based on industry trends, most significantly, the number of films being made by studios and independent filmmakers.

Critical Accounting Policies and Estimates

Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of our financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, estimates are evaluated, including those related to revenue recognition, allowance for doubtful accounts, inventories, goodwill and intangible assets, impairment of long-lived assets, product warranty, taxes, and contingencies and litigation. These estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.

We apply the following critical accounting policies in the preparation of our consolidated financial statements:

· Revenue Recognition. We recognize revenues in accordance with the guidelines of the SEC Staff Accounting Bulletin, or SAB, No. 101 as amended by SAB No. 104 “Revenue recognition in Financial Statements.” Revenues from the sale of cinema hardware products are recorded upon shipment, assuming title and risk of loss has transferred to the customer, we have no significant obligations remaining, prices are fixed or determinable, and collection of the related receivable is reasonably assured. The licensing, encoding and duplication of motion picture soundtracks for use in our playback systems is undertaken under arrangements with major film studios. Revenues arising from the licensing and duplication of soundtracks are recognized upon completion, assuming prices are fixed or determinable, we have no significant obligations remaining, and collection of the related receivable is reasonably assured. Direct costs associated with deferred revenue are deferred and included in other assets. Included in the balance sheet are $519,000 and $296,000 of deferred revenue and costs, respectively, at December 31, 2004.

· Revenues from licensing audio technology, trademarks, and know-how are generated from licensing agreements with consumer electronics products manufacturers that generally pay a per-unit license fee for products manufactured under those license agreements. Licensees generally report manufacturing information within 30 to 60 days after the end of the quarter in which such activity takes place. Consequently, we recognize revenue from these licensing agreements on a three-month lag basis, generally in the quarter following the quarter of manufacture, provided amounts are fixed or determinable and collection is reasonably assured. Use of this lag method allows for the receipt of licensee royalty reports prior to the recognition of revenue. Revenues from the sale of digital multi-channel audio and video content are recorded upon shipment to retail accounts or end customers, assuming title and risk of loss has transferred, prices are fixed or determinable, we have no significant obligations remaining, and collection of the related receivable is reasonably assured. We provide for returns on product sales based on historical experience and adjust such reserves as considered necessary. To date, there have been no significant sales returns.

· Allowance for Doubtful Accounts. An allowance for doubtful accounts is maintained for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. In determining the reserve, we evaluate the collectibility of our accounts receivable based upon a variety of factors. In cases where we become aware of circumstances that may impair a specific customer’s ability to meet its financial obligations, we record a specific allowance against amounts due. For all other customers, we recognize allowances for doubtful accounts based on its historical write-off experience in conjunction with the

length of time the receivables are past due, customer creditworthiness, geographic risk and the current business environment. Our allowances for doubtful accounts at December 31, 2003 and 2004 amounted to $429,000 and $402,000, respectively.

· Inventories. Inventory levels are based on projections of future demand and market conditions. Any sudden decline in demand and/or rapid product improvements and technological changes can result in excess and/or obsolete inventories. On an ongoing basis, inventories are reviewed and written down for estimated obsolescence or unmarketable inventories equal to the difference between the costs of inventories and the estimated net realizable value based upon forecasts for future demand and market conditions. If actual market conditions are less favorable than our forecasts, additional inventory reserves may be required. Estimates could be influenced by sudden declines in demand due to economic downturns, rapid product improvements, and technological changes. During the fourth quarter of 2004, we recorded a write-down of approximately $3.9 million related to our monochrome projector inventory as a result of our revised outlook based on declines in future demand and technological obsolescence.

· Goodwill and Intangible Assets. We account for goodwill in accordance with Statement of Financial Accounting Standards, or SFAS, No. 142, “Goodwill and Other Intangible Assets,” or SFAS 142, which, among other things, establishes new standards for goodwill acquired in a business combination, eliminates the amortization of goodwill and requires the carrying value of goodwill and certain non-amortizing intangibles to be evaluated for impairment on an annual basis. As required by SFAS 142, we perform an impairment test on recorded goodwill by comparing the estimated fair value of each of our reporting units to the carrying value of the assets and liabilities of each unit, including goodwill. We determine fair value of the reporting units principally based upon our management’s determination of the value of DTS as a whole. This value is determined by considering a number of factors, including our historical and projected financial results, valuation analyses, risks facing us and the liquidity of our common stock. If the carrying value of the assets and liabilities of the reporting units, including goodwill, were to exceed our estimation of the fair value of the reporting units, we would record an impairment charge in an amount equal to the excess of the carrying value of goodwill over the implied fair value of the goodwill. We did not have any goodwill at December 31, 2004. We expect to record goodwill in connection with our acquisition of LDI, which occurred in January 2005.

We account for intangible assets in accordance with SFAS 144. This standard requires that intangible assets with definite lives be amortized over their estimated useful lives and reviewed for impairment whenever events or changes in circumstances indicate an asset’s carrying value many not be recoverable. Recoverability of an asset is measured by comparison of its carrying amount to the expected future undiscounted cash flows that the asset is expected to generate. If it is determined that an asset is not recoverable, an impairment loss is recorded in the amount by which the carrying amount of the asset exceeds its fair value. Our intangible assets principally consist of acquired technology, which is being amortized over eight years. No intangible or long-lived assets were impaired as of December 31, 2004. We expect to record intangible assets in connection with our acquisition of LDI.

· Impairment of Long-Lived Assets. We periodically assess potential impairments of our long-lived assets in accordance with the provisions of SFAS, No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets.” An impairment review is performed whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors considered by us include, but are not limited to, significant underperformance relative to expected historical or projected future operating results; significant changes in the manner of use of the acquired assets or the strategy for our overall business; and significant negative industry or economic trends. When we determine that the carrying value of a long-lived asset may not be recoverable based upon the

existence of one or more of the above indicators of impairment, we estimate the future undiscounted cash flows expected to result from the use of the asset and its eventual disposition. If the sum of the expected future undiscounted cash flows and eventual disposition is less than the carrying amount of the asset, we recognize an impairment loss. An impairment loss is reflected as the amount by which the carrying amount of the asset exceeds the fair value of the asset, based on the fair market value if available, or discounted cash flows, if not. To date, we have not had an impairment of long-lived assets.

· Product Warranty. We generally warrant our products against defects in materials and workmanship for either a one or three year term after sale and provide for estimated future warranty costs at the time revenues are recognized. Our warranty obligation is affected by the length of product warranties, product failure rates, material usage, and service delivery costs incurred in correcting product failures. Should actual product failure rates, material usage, or service delivery costs differ from our estimates, revisions to the estimated warranty liability would be required. Our warranty reserves at December 31, 2003 and 2004 amounted to $81,000, and $162,000, respectively.

· Stock-based Compensation. We account for employee stock option and purchase plans in accordance with the provisions of Accounting Principals Board, or APB, Opinion No. 25, “Accounting for Stock Issued to Employees” and the related interpretations of the Financial Accounting Standards Board, or FASB, “Accounting for Certain Transactions Involving Stock Compensation.” Accordingly, compensation expense related to employee stock options is recorded, if on the date of the grant, the fair value of the underlying stock exceeds the exercise price. Upon adoption of SFAS 123R in the third quarter of 2005, mentioned in Recently Issued Accounting Standards included elsewhere in this document, we expect to incur significant charges to the statement of operations.

· Taxes. We must make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of certain tax assets and liabilities, which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes.

We must assess the likelihood that we will be able to recover our deferred tax assets. If recovery is not likely, we must increase our provision for taxes by recording a valuation allowance against the deferred tax assets that we estimate will not ultimately be recoverable. As of December 31, 2004, we believe that all of the deferred tax assets recorded on our balance sheet would ultimately be recovered. However, should there be a change in our ability to recover our deferred tax assets, our tax provision would increase in the period in which we determine that the recovery is not probable.

In March 2005, in connection with the U.S. Internal Revenue Service’s, or IRS, regular examination of our tax return for the year ended December 31, 2002, the IRS proposed adjustments related to certain items included in our return. We do not agree with the proposed adjustments and intend to appeal these adjustments. If the IRS prevails in its position, our federal income tax due for 2002 would increase by approximately $1.9 million, plus interest. The IRS could make similar claims for years subsequent to 2002 in future audits.

Although the final resolution of the adjustments is uncertain, based on currently available information, we believe that the ultimate outcome will not have a material adverse effect on our financial position, cash flows or overall trends in the results of operations. There is the possibility of a material adverse impact on the results of operations in the period in which the matter is ultimately resolved, if it is resolved unfavorably, or in the period in which an unfavorable outcome becomes probable and reasonably estimable.

· Contingencies and Litigation. We evaluate contingent liabilities including threatened or pending litigation in accordance with SFAS No. 5, “Accounting for Contingencies,” and record accruals when the outcome of these matters is deemed probable and the liability is reasonably estimable. We make these assessments based on the facts and circumstances and in some instances based in part on the advice of outside legal counsel.

Segment and Geographic Information

Our reportable segment and geographic information is as follows (in thousands):

	Revenues by Segment
	For the Years Ended December 31,
	2002		2003		2004
Cinema business	$	15,399	$	16,328	$	19,545
Consumer business	25,657		35,374		41,886
Total revenues	$	41,056	$	51,702	$	61,431

	Gross Profit by Segment
	For the Years Ended December 31,
	2002		2003		2004
Cinema business	$	6,517	$	7,190	$	5,448
Consumer business	23,903		33,480		39,821
Total gross profit	$	30,420	$	40,670	$	45,269

	Income (Loss) From Operations by Segment
	For the Years Ended December 31,
	2002			2003			2004
Cinema business	$	(2,425	)	$	(3,504	)	$	(8,475	)
Consumer business	12,712			18,714			19,969
Total income from operations	$	10,287		$	15,210		$	11,494

	Revenues by Geographic Region
	For the Years Ended December 31,
	2002		2003		2004
United States	$	10,224	$	15,837	$	17,830
International	30,832		35,865		43,601
Total revenues	$	41,056	$	51,702	$	61,431

The following table sets forth, for the periods indicated, long-lived assets by geographic region in which we hold assets (in thousands):

	Long-Lived Assets
	As of December 31,
	2002		2003		2004
United States	$	3,244	$	3,150	$	3,099
International	297		366		2,219
Total long-lived assets	$	3,541	$	3,516	$	5,318

Results of Operations

The following table sets forth our results of operations expressed as a percentage of total revenues:

	For the Years Ended December 31,
	2002		2003		2004
Revenues:
Technology and film licensing	77.7	%	81.7	%	81.3	%
Product sales and other revenues	22.3		18.3		18.7
Total revenues	100.0		100.0		100.0
Cost of goods sold:
Technology and film licensing	9.0		8.3		7.2
Product sales and other revenues	16.9		13.0		19.1
Total cost of goods sold	25.9		21.3		26.3
Gross profit	74.1		78.7		73.7
Operating expenses:
Selling, general and administrative	39.9		39.7		45.0
Research and development	9.1		9.6		10.0
Total operating expenses	49.0		49.3		55.0
Income from operations	25.1		29.4		18.7
Interest income, net	(0.2	)	0.5		2.4
Other expense, net	(0.7	)	(0.4	)	(0.1	)
Income from legal settlement	—		—		4.2
Income before provision for income taxes	24.2		29.5		25.2
Provision for income taxes	9.0		10.4		9.0
Net income	15.2	%	19.1	%	16.2	%

Comparison of Years Ended December 31, 2004 and 2003

Revenues

Technology and Film Licensing. Technology and film licensing revenues for the year ended December 31, 2004 increased 18% to $49.9 million from $42.2 million for the year ended December 31, 2003. The increase in revenues from technology and film licensing was primarily attributable to continued growth in consumer electronics licensing, driven by an increase in the number of DVD-based home entertainment systems that incorporate DTS technology, such as audio/video receivers, DVD players, and home-theater-in-a-box systems. The increase also related to revenues recognized as a result of intellectual property compliance and enforcement activities. These activities, which included audits of shipments by certain of our licensees of products containing our technology, trademarks and/or know-how and legal actions taken against licensees and parties who are not our licensees, resulted in recoveries of royalty payments relating to prior periods. We expect such royalty recoveries to continue and that this activity will continue to improve revenue realization in our licensing business going forward. Overall, we expect technology licensing revenues to continue to grow in 2005, based primarily on the expected continuation of growth in the home theater and DVD player markets. In addition, our film licensing revenues increased moderately due to revenues generated from increases in the number of U.S. films released, foreign language dubbed versions of major films, and foreign original-version films released with a DTS soundtrack. Film licensing is expected to grow modestly again in 2005.

Product Sales and Other. Product sales and other revenues increased 22% to $11.5 million for the year ended December 31, 2004 from $9.5 million for the year ended December 31, 2003. This increase was primarily attributable to increased purchases by theater operators of our cinema processors and playback

equipment by theater operators as a result of the film exhibition industry’s return to growth as well as solid interest in our XD10 Cinema Media Player. The adoption of our newer technologies for pre-show, subtitling and multi-channel music continues to be slower than expected. Product sales and other revenue is expected to grow at a modest rate, as we expect the market for pre-show entertainment to develop at a measured pace in 2005.

Segment Sales. Revenues from our consumer business totaled $41.9 million for the year ended December 31, 2004, an increase of 18% from $35.4 million for the year ended December 31, 2003. The increase in revenues was driven by the growth in consumer electronics technology licensing as mentioned above. Cinema revenues were $19.5 million for the year ended December 31, 2004, up 20% from the same period last year due primarily to growth in the sales of our cinema audio products, driven by the film exhibition industry return to growth, as mentioned above.

Gross Profit

Consolidated gross profit decreased to 74% of revenues for the year ended December 31, 2004, from 79% for the year ended December 31, 2003. The decrease is primarily due to the write-down of our monochrome projector inventory of approximately $3.9 million that was a result of our revised outlook based on declines in future demand and technological obsolescence. We expect consolidated gross margins in the 70% to 75% range in 2005, as we incorporate the activities of LDI into our consolidated results.

Technology and Film Licensing. Gross profit associated with technology and film licensing revenues increased slightly to 91% from 90% of related revenues for the year ended December 31, 2004 and 2003, respectively and we expect this rate to increase slightly during 2005 due to a higher mix of technology licensing relative to film licensing.

Product Sales and Other. Gross profit associated with product sales and other revenues decreased to (2)% of related revenues for the year ended December 31, 2004 from 29% in the prior year period due to the write-down discussed above and we expect this rate to recover to its historical levels and range from the low to mid thirties in 2005.

Segment Gross Profit. Gross profit for our consumer business remained consistent between years at 95% and we expect this trend to continue into 2005. Our cinema business gross profit decreased to 28% of related revenues for the quarter ended December 31, 2004 from 44% in the prior year period primarily due to the write-down of the monochrome projector inventory discussed above. The impact of this write-down on gross profit was partially offset by the increase in revenue for our cinema business year-over-year relative to fixed costs. We expect the gross profit from the cinema business to recover to its historical levels

Selling, General and Administrative

Selling, general and administrative expenses increased 35% to $27.7 million for the year ended December 31, 2004, compared to $20.5 million in the prior year period. The increase is primarily due to increases in professional services of $2.5 million, which includes costs associated with our increased intellectual property compliance and enforcement activities, Sarbanes-Oxley related costs and other costs associated with operating as a public company. Also contributing to the increase is an increase of $2.2 million in salaries and related costs as we increased headcount to support our growth. The increase also includes increases in advertising and promotion costs related to new product introductions, and insurance costs. Salaries and related costs include stock-based compensation, which decreased to $273,000 for the year ended December 31, 2004 from $497,000 in the prior year period. Stock-based compensation for the prior period primarily consists of a charge related to the issuance of a warrant. Included in professional services for the year ended December 31, 2004 is approximately $300,000 in legal costs related to our settlement with Mintek that was reached in May 2004.

Costs of compliance with the Sarbanes-Oxley Act were approximately $899,000 for the year ended December 31, 2004. We expect Sarbanes-Oxley Act costs to decrease in 2005 to approximately $500,000.

We expect selling, general and administrative expenses to increase as a whole to support our growth initiatives including acquisitions, international expansion and enforcement activities.

Research and Development

For the year ended December 31, 2004, research and development expenses were $6.1 million, compared to $5.0 million for the year ended December 31, 2003. The increase is primarily due to increased labor costs associated with new product initiatives and the optimization of our Coherent Acoustics technology for new consumer electronics applications and development of tools associated with next generation optical disc standards.

We expect to continue to increase our investment in applications engineering and research and development activities overall and will accelerate those initiatives in future quarters to support the roll out of next generation optical disc standards and the continued optimization of our Coherent Acoustics technology.

Interest (Income) Expense, Net

Interest income, net, for the year ended December 31, 2004 increased significantly over the previous year due to increased investment income relating to proceeds from our initial and follow-on public offerings in July and November of 2003.

Income From Legal Settlement

In May 2004, we reached a settlement with Mintek for $3.5 million for Trademark Infringement, False Designation of Origin, Trademark Dilution, and Unfair Competition relating to Mintek’s distribution of DVD players bearing our registered trademarks without obtaining a license from us. In the year ended December 31, 2004, we recognized $899,000 in revenue under the settlement agreement for royalties due on known units that could be identified as using our trademark and accounted for the remaining $2.6 million as other income. Selling, general and administrative expenses for the year ended December 31, 2004 included approximately $300,000 in legal fees related to the Mintek case. Legal fees related to Mintek were approximately $200,000 for 2003.

Income Taxes

For the year ended December 31, 2004, we recorded an income tax provision of $5.5 million on pre-tax income of $15.6 million. This resulted in an annualized effective tax rate of 36%. For the year ended December 31, 2003, we recorded an income tax provision of $5.4 million on pre-tax income of $15.3 million. This resulted in an annualized effective tax rate of 35%. These rates differed from the statutory rates primarily due to state income taxes offset by benefits associated with the foreign rate differentials and research and development credits. We expect the effective tax rate for 2005 will be approximately 36%.

Comparison of Years Ended December 31, 2003 and 2002

Revenues

Total revenues for the year ended December 31, 2003 increased 26% to $51.7 million from $41.1 million for the year ended December 31, 2002, due primarily to the increase in technology and film licensing revenues. Technology and film licensing revenues totaled $42.2 million for 2003, compared to $31.9 million in 2002, an increase of 32%. Technology licensing revenues posted growth of 36% for the period, driven primarily by the rapid increase in sales by our licensees of DVD-based home entertainment

systems that incorporate DTS technology, such as audio/video receivers, DVD players, and home-theater-in-a-box systems. Film and other content licensing grew by 21% due primarily to revenues generated from increases in the number of U.S. films released in the DTS format, foreign language dubbed versions of major U.S. films, and foreign original-version films released with a DTS soundtrack. Product sales and other revenues totaled $9.5 million for 2003, compared to $9.2 million in 2002.

In the consumer business, revenues for the year ended December 31, 2003 were $35.4 million, a 38% increase over the $25.7 million recorded in the year ended December 31, 2002, due to the strength of the consumer electronics licensing activities discussed above. Cinema revenues were $16.3 million for the year ended December 31, 2003, a 6% increase over 2002, as growth in film licensing revenues more than offset a decline in product-related revenues.

Gross Profit

Consolidated gross profit improved to 79% of revenues for the year ended December 31, 2003, from 74% for 2002. The increase is due to changes in the mix of licensing and product revenues, as higher-margin technology and film licensing comprised 82% of revenues in the year ended December 31, 2003, up from 78% of revenues in the prior year period.

Gross profit associated with technology and film licensing revenues improved slightly to 90% of related revenues for the year ended December 31, 2003 from 88% in the prior year period. This increase is primarily due to a favorable mix of technology licensing, which carries very little cost, relative to film licensing, which typically carries cost of 25% to 30%.

Gross profit for our consumer business improved to 95% of related revenues for the year ended December 31, 2003, from 93% in the prior year. The increase is due to the rapid growth of higher margin technology licensing revenues. Cinema business gross profit increased slightly to 44% of related revenues for the year ended December 31, 2003 from 42% in the prior year due to the higher revenues achieved in 2003, which allowed certain fixed overhead costs to be spread over a larger revenue base.