Digital Theater Systems Inc., Form S-1/A

Approximate date of commencement of proposed sale to the public: As soon as practicable after this Registration Statement becomes effective.

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box. o

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. o

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. o

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. o

If delivery of the prospectus is expected to be made pursuant to Rule 434, check the following box. o

The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to Section 8(a), may determine.

The information in this preliminary prospectus is not complete and may be changed. We and the selling stockholders may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and neither we nor the selling stockholders are soliciting offers to buy these securities in any state where the offer or sale is not permitted.

Our company, Digital Theater Systems, Inc., is selling 1,500,000 shares of common stock. The selling stockholders named in this prospectus are selling 3,000,000 shares of our common stock. The offering is being made on a firm commitment basis.

Our common stock is traded on the Nasdaq National Market under the symbol “DTSI.” On November 3, 2003, the last reported sale price of our common stock on the Nasdaq National Market was $31.38 per share.

Our business and an investment in our common stock involve significant risks. These risks are described under the caption “Risk Factors” beginning on page 6 of this prospectus.

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

The underwriters may also purchase up to 675,000 shares of our common stock from us at the public offering price, less underwriting discounts and commissions, to cover over-allotments, if any. We will not receive any of the proceeds of the sale of shares by the selling stockholders.

SG Cowen


	William Blair & Company


	Thomas Weisel Partners LLC


	U.S. Bancorp Piper Jaffray

You should rely only on the information contained in this prospectus. Neither we nor the selling stockholders have authorized anyone to provide you with information that is different. We and the selling stockholders are offering to sell and seeking offers to buy shares of our common stock only in jurisdictions where offers and sales are permitted. The information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of our common stock.

Until , 2003, all dealers that effect transactions in these securities, whether or not participating in this offering, may be required to deliver a prospectus. This requirement is in addition to the dealers’ obligation to deliver a prospectus when acting as underwriters and with respect to their unsold allotments or subscriptions.

This summary highlights the information contained elsewhere in this prospectus. This summary may not contain all of the information that you should consider before investing in our common stock. You should read the entire prospectus carefully, including “Risk Factors” and the consolidated financial statements and accompanying notes before making an investment decision.

We are a leading provider of 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. In addition, we have received a number of awards for our technology, including a Scientific and Engineering Oscar Award from the Academy of Motion Picture Arts and Sciences for our movie theater playback system.

We were founded in 1990 and received a key strategic investment in 1993 from investors, including Universal City Studios, Inc. The first DTS digital multi-channel audio soundtrack was created for Steven Spielberg’s Jurassic Park in 1993.

We provide products and services to film studios, production companies, and movie theaters to produce and play back digital multi-channel film soundtracks. We license our sound technology to all major film distributors in the United States, including 20th Century Fox, Buena Vista Pictures, Warner Bros. Pictures, and many international distributors. These studios use our technology to create digital multi-channel soundtracks in our DTS format. Our playback systems for DTS-formatted soundtracks have been installed in over 20,000 movie theaters worldwide.

We license our technology to consumer electronics products manufacturers for inclusion in products such as audio/video receivers, DVD players, and home theater systems. This consumer business is now our largest segment. Our technology enables consumers to enjoy movies, video games, and music in our DTS multi-channel format. Our technology, trademarks, and/or know-how have been incorporated in more than 200 million consumer electronics products worldwide. We license our technology to:


	•	substantially all of the major consumer audio electronics products manufacturers in the world, including Pioneer Corporation, Sony Corporation, and Yamaha Corporation; and

	•	major consumer semiconductor manufacturers, including Cirrus Logic Inc., Yamaha Corporation, and Zoran Corporation.

We provide multi-channel audio CDs and DVDs for the consumer retail market. We have released titles by classical composers such as Handel and Tchaikovsky, and titles by artists such as Diana Krall, Herb Alpert, Vince Gill, Lyle Lovett, The Eagles, Queen, Sting, and Bonnie Raitt. We are pursuing relationships with major record labels whereby we re-mix and produce titles from the labels in our multi-channel format and the label distributes these titles. We announced our first such relationship with EMI Music in August 2003.

In the early 1990s, the listening experience of movie audiences was significantly enhanced through the introduction of digital multi-channel surround sound technology. Digital multi-channel sound is now an industry standard audio format for feature films. Today, all of the major film producers and distributors in the United States, and an increasing number of international film producers and distributors, release their feature films with digital multi-channel soundtracks.

The proliferation of digital multi-channel audio in movie theaters has fueled demand for digital multi-channel audio in consumer electronics products, such as home theater systems. Digital multi-channel audio 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. In addition, there is an emerging market for multi-channel music content.

Our proprietary DTS digital audio system provides moviegoers with a high-quality, digital multi-channel audio experience. Our proprietary audio technology for the consumer market brings advanced digital audio entertainment to the home and other consumer electronics environments such as cars and portable electronics devices.

To facilitate the availability of high-quality digital multi-channel audio content, we provide products and services to filmmakers, recording artists, producers, and software developers to make it easy to create content in our proprietary format.

Our goal is to become essential to the ultimate entertainment experience by incorporating our technology into every device that manages or controls high-quality digital audio. Key elements of our strategy include the following:


	•	Drive proliferation of high-quality digital multi-channel audio in new and growing markets through effective licensing strategies. We intend to actively promote the adoption of our technology into markets for home audio components and systems, car audio systems, personal computers, video games and consoles, portable electronics devices, and digital satellite and cable broadcast products.

	•	Expand our global presence. We believe we can broaden and deepen our relationships with customers and accelerate the worldwide adoption of our technology by expanding our global sales, distribution, and support network, and by locating personnel close to our customers.

	•	Leverage our premium brand name to enhance our market position. We plan to capitalize on our brand awareness and strong market position in our theatrical and consumer markets to drive the continued adoption of our technology in existing and emerging consumer electronics markets.

	•	Continue to support the creation and widespread availability of premium digital multi-channel audio content. To aid in the adoption of content, we will continue to sell our hardware-based encoders directly to content providers, license our encoding technology, and produce multi-channel music content directly through our DTS Entertainment label.

	•	Continue to develop and expand our technology, product offerings, and intellectual property portfolio. We intend to work closely with our consumer electronics products and film studio customers to evolve our proprietary technology and product offerings based on our customers’ plans for development and expansion.

Our business was incorporated in California in October 1990 as Digital Theater Systems Corporation. In February 1993, we became the general partner of Digital Theater Systems, L.P., a Delaware limited partnership. In 1996, we formed DTS Technology, LLC, a majority-owned subsidiary, to develop audio technologies for the consumer electronics and other markets. In October 1997, we completed a reorganization and consolidation of the predecessor entities and were re-incorporated in Delaware as Digital Theater Systems, Inc.

Our principal executive offices are located at 5171 Clareton Drive, Agoura Hills, California 91301. Our telephone number is (818) 706-3525. Our website is located at www.dtsonline.com. The information contained on our website is not part of this prospectus.

The number of shares of our common stock to be outstanding immediately after the offering is based on 13,759,449 shares of common stock outstanding as of September 30, 2003. The number of shares of our common stock that will be outstanding immediately after this offering also includes 258,965 and 14,709 shares of common stock issuable upon exercise of options and warrants, respectively, outstanding as of September 30, 2003 with weighted average exercise prices of $1.02 and $4.038 per share, respectively. We expect that these options and warrants will be exercised by certain of our selling stockholders and that the shares purchased through these exercises will be sold in this offering. The number of shares of our common stock that will be outstanding immediately after this offering excludes:


	•	1,279,845 shares issuable upon exercise of outstanding warrants as of September 30, 2003 at an exercise price of $12.114 per share;

	•	35,008 shares issuable upon exercise of outstanding warrants as of September 30, 2003 at an exercise price of $4.038 per share, other than 14,709 shares of common stock subject to warrants that we expect will be exercised by selling stockholders in connection with this offering, which shares are included in our calculation of our shares outstanding after this offering;

	•	1,765,990 shares issuable upon exercise of outstanding options as of September 30, 2003 at a weighted average exercise price of $2.77 per share, other than 258,965 shares of common stock subject to options that we expect will be exercised by selling stockholders in connection with this offering, which shares are included in our calculation of our shares outstanding after this offering;

	•	953,170 shares available for future issuance as of September 30, 2003 under our 2003 Equity Incentive Plan and an additional 500,000 shares available for future issuance under our 2003 Employee Stock Purchase Plans; and

	•	675,000 shares of common stock that may be sold by us if the underwriters exercise their over-allotment option in full.

Except as otherwise noted, all information in this prospectus assumes the underwriters do not exercise their over-allotment option to purchase up to 675,000 shares.

DTS, DTS Digital Surround, DTS Digital Out, Neo:6, Coherent Acoustics, and DTS Digital Sound are trademarks of Digital Theater Systems, Inc. We have trademark rights in these marks in the United States and other countries and have a number of registrations issued and pending in the United States and other countries. This prospectus also refers to brand names, trademarks, service marks, and trade names of other companies and organizations, and these brand names, trademarks, service marks, and trade names are the property of their respective holders.

This prospectus contains market data and industry forecasts that were obtained from industry publications.

The following tables summarize our consolidated financial data for the periods presented. You should read the following financial information together with the information under “Selected Consolidated Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the notes to those consolidated financial statements appearing elsewhere in this prospectus.

An investment in our common stock involves a high degree of risk. You should carefully consider the risks described below together with all of the other information included in this prospectus before making an investment decision. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties that we are unaware of, or that we may currently deem immaterial, may become important factors that harm our business, financial condition, or results of operations. If any of the following risks actually occurs, our business, financial condition, or results of operations could suffer. In that case, the trading price of our common stock could decline, and you may lose all or part of your investment.

The digital audio, consumer electronics, and entertainment markets are intensely competitive, subject to rapid change, and significantly affected by new product introductions and other market activities of industry participants. Our principal competitor is Dolby Laboratories, Inc., who competes with us in each of our markets. We also compete with other companies offering:


	•	digital audio technology incorporated into consumer electronics products and entertainment mediums, including Fraunhofer Institut Integrierte Schaltungen, Koninklijke Philips Electronics N.V. (Philips), Meridian Audio Limited, Microsoft Corporation, Sony Corporation, and Thomson; and

	•	products for theatrical markets, such as Smart Devices, Inc., Sony Corporation, and Ultra Stereo Labs, Inc.

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


	•	greater name recognition;

	•	a longer operating history;

	•	more developed distribution channels and deeper relationships with semiconductor and consumer electronics products manufacturers;

	•	a more extensive customer base;

	•	digital technologies that offer greater compression and require less storage capacity;

	•	broader product and service offerings;

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

	•	more technicians and engineers.

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

In addition to the competitive advantages described above, Dolby also enjoys other unique competitive strengths relative to us. For example, it introduced multi-channel audio technology before we did. It has a larger base of installed movie theaters for its cinema playback equipment. Its technology has been incorporated in significantly more DVD-Video films than our technology. It has also achieved mandatory standard status in a few product categories, including DVD-Video and DVD Audio Recordable, for its stereo technology and terrestrial digital television broadcasts in the United States. As a result of these factors, Dolby has a competitive advantage in selling its digital multi-channel technology to consumer electronics products manufacturers.

Sony Corporation is both a competitor and a significant customer in all of our markets. If Sony decides to eliminate the use of our technology in its products or to compete with us more aggressively in our markets, the revenues that we derive from Sony would be lower than expected.

Technology standards are important in the audio industry as they help to assure compatibility across a system or series of products. Generally, standards adoption occurs on either a mandatory basis, requiring a particular audio technology to be available in a particular product or medium, or an optional basis, meaning that a particular audio technology may be, but is not required to be, utilized. For example, Dolby’s technology for stereo playback has been selected as a mandatory standard for DVD-Video and DVD Audio Recordable. Both Dolby’s and our digital multi-channel technology have optional status in the DVD-Video standard.

Various national governments have adopted or are in the process of adopting standards for all digital television broadcasts, including cable, satellite, and terrestrial. In the United States, Dolby’s technology has been selected as the sole, mandatory standard for terrestrial digital television broadcasts. As a result, all digital terrestrial television broadcasts in the United States must include Dolby’s technology and must exclude any other format, including ours. We do not know whether this standard will be reopened or amended. If it is not, our technology may never be included. Certain large and developing markets, such as China, have not fully developed their digital television standards. Our technology may or may not ultimately be included in these standards.

Adoption of our technology is not mandatory as part of any governmental or industry accepted standards in any specific entertainment medium or format. As such, there can be no assurance that our technology will continue to be used in current and future applications.

As new technologies and entertainment mediums emerge, including future generations of DVD technology, new standards relating to these technologies or mediums may develop. New standards may also emerge in existing markets that are currently characterized by competing formats, such as the market for personal computers. We may not be successful in our efforts to include our technology in any such standards.

The market for our digital audio technology, products, and services is characterized by:


	•	rapid technological change;

	•	new and improved product introductions;

	•	changing customer demands;

	•	evolving industry standards; and

	•	product obsolescence.

Our future success will depend on our ability to enhance our existing digital audio technology, products, and services and to develop acceptable new technology, products, and services on a timely basis. The development of enhanced and new technology, products, and services is a complex and uncertain process requiring high levels of innovation, highly-skilled engineering and development personnel, and the accurate anticipation of technological and market trends. We may not be able to identify, develop, market, or support new or enhanced technology, products, or services on a timely basis, if at all. Furthermore, our new technology, products, and services may never gain market acceptance, and we may not be able to respond effectively to evolving consumer demands, technological changes, product announcements by competitors, or emerging industry standards. For example, we may not be able to effectively address concerns in the film and music industries relating to piracy in our current or future products. Any failure

Protection of our intellectual property is critical to our success. Patent, trademark, copyright, and trade secret laws and confidentiality and other contractual provisions afford only limited protection and may not adequately protect our rights or permit us to gain or keep any competitive advantage. We face numerous risks in protecting our intellectual property rights, including the following:


	•	our patents may be challenged or invalidated by our competitors;

	•	our pending patent applications may not issue, or, if issued, may not provide meaningful protection for related products or proprietary rights;

	•	we may not be able to prevent the unauthorized disclosure or use of our technical knowledge or other trade secrets by employees, consultants, and advisors;

	•	the laws of foreign countries may not protect our intellectual property rights to the same extent as the laws of the United States, and mechanisms for enforcement of intellectual property rights may be inadequate in foreign countries;

	•	our competitors may produce competitive products or services that do not unlawfully infringe upon our intellectual property rights; and

	•	we may be unable to successfully identify or prosecute unauthorized uses of our technology.

As a result, we cannot assure you that our means of protecting our intellectual property rights and brands will be adequate. Furthermore, despite our efforts, third parties may violate, or attempt to violate, our intellectual property rights. Infringement claims and lawsuits would likely be expensive to resolve and would require management’s time and resources. In addition, we have not sought, and do not intend to seek, patent and other intellectual property protections in all foreign countries. In countries where we do not have such protection, products incorporating our technology may be lawfully produced and sold without a license.

Companies that participate in the digital audio, consumer electronics, and entertainment industries hold a large number of patents, trademarks, and copyrights, and are frequently involved in litigation based on allegations of patent infringement or other violations of intellectual property rights. Intellectual property disputes frequently involve highly complex and costly scientific matters, and each party generally has the right to seek a trial by jury which adds additional costs and uncertainty. Accordingly, intellectual property contests, with or without merit, could be costly and time consuming to litigate or settle, and could divert management’s attention from executing our business plan. In addition, our technology and products may not be able to withstand any third-party claims or rights against their use. If we were unable to obtain any necessary license following a determination of infringement or an adverse determination in litigation or in interference or other administrative proceedings, we may need to redesign some of our products to avoid infringing a third party’s patent and could be required to temporarily or permanently discontinue licensing our products.

We expect to derive a significant percentage of our revenues from the technology, products, and services that we offer to manufacturers of consumer electronics products. To date, the most significant driver for the use of our technology in the home theater market has been the release of major movie titles with DTS audio soundtracks. We also believe that demand for our DTS audio technology in emerging

markets for multi-channel audio, including homes, cars, personal computers, and video games and consoles, will be based on the number, quality, and popularity of the audio DVDs, computer software programs, and video games released with DTS audio soundtracks. Although we have existing relations with many leading providers of movie, music, computer, and video game content, none of our existing contracts require these parties to develop and release content with DTS audio soundtracks. In addition, we may not be successful in maintaining existing relationships or developing relationships with other existing providers or new market entrants that provide content. As a result, we cannot assure you that a significant amount of content in movies, audio DVDs, computer software programs, video games, or other entertainment mediums will be released with DTS audio soundtracks. If the amount, variety, and popularity of entertainment content released with DTS audio soundtracks do not increase, consumer electronics products manufacturers that pay us per-unit licensing fees may discontinue offering DTS playback capabilities in the consumer electronics products that they sell.

Our DTS-CSS system for subtitles, captions, and descriptive narration for films is a key new product of ours. To date, sales and revenues from this system have been immaterial and we have limited experience to indicate whether or not this system will be widely adopted. Nonetheless, we have anticipated significant future sales of this system and our revenue and growth projections contemplate that it will generate significant future revenues. We have also entered into an agreement with a supplier of projection equipment for this system that obligates us to purchase a minimum of approximately $7.9 million in equipment over a two-year period ending in March 2004. Our remaining obligation under this purchase commitment was approximately $5.5 million at September 30, 2003. If we are unsuccessful in selling our DTS-CSS system, our future revenues will be lower than expected and we could be obligated to purchase projection equipment that we may be unable to re-sell at our cost or at all.

Although we have established relations with a number of artists and music labels, we do not have any contractual agreements that require artists or music labels to provide us with music content to re-mix and release in our proprietary DTS audio format. Music companies may in the future be unwilling to license titles from their music catalogs to us. In addition, our audio content competes with other multi-channel formats, including Super Audio CD, which is a format developed jointly by Philips and Sony Corporation. As a result, we may have difficulty in obtaining rights to release a significant amount of audio content, and any content that we do release may not be commercially successful.

The market for consumer electronics products is intensely competitive and price sensitive. Retail prices for consumer electronics products that include our DTS audio technology, such as DVD players and home theater systems, have decreased significantly and we expect prices to continue to decrease for the foreseeable future. Declining prices for consumer electronics products could create downward pressure on the licensing fees we currently charge our customers who integrate our technology into the consumer electronics products that they sell and distribute. Most of the consumer electronics products that include our audio technology also include Dolby’s multi-channel audio. As a result of pricing pressure, consumer electronics products manufacturers could decide to exclude our DTS audio technology from their products altogether.

We are dependent on our customers and licensees — including consumer electronics products manufacturers, semiconductor manufacturers, movie theaters, and producers and distributors of content for music, films, videos, and games — to incorporate our digital audio technology in their products, purchase our products and services, and release their content in our proprietary DTS audio format. Although we have license agreements with many of these companies, these license agreements do not require any minimum purchase commitments and are on a non-exclusive basis. Our customers and other licensees might not continue to utilize our technology in the future.

Although all nine major film producers and distributors are customers of ours, we generally do not have contractual arrangements that require them to use our DTS audio technology. Our theatrical business depends on our having good relations with these film studios. A deterioration in our relationship with any of these film studios could cause these customers to stop using our DTS audio technology. Any significant decline in the release of motion pictures with DTS audio soundtracks would decrease the demand for and revenues from the playback products and services that we offer to movie theaters. In addition, other film studios throughout the world generally adopt the technologies used by the major U.S. film studios. Therefore, if the major U.S. film studios stop using our technology, we would not only lose the per-movie licensing fee we receive from these customers, but may also lose per-movie licensing fees from other film studios throughout the world.

The movie theater industry may transition from film-based media to electronic-based, or digital, media. If this transition occurs, we may be unable to meaningfully respond with competitive product offerings. In addition, if the film industry broadly adopts digital cinema, our technology and current product offerings could be rendered obsolete. In such an event, demand by movie theaters for our playback systems, cinema processors, and systems for subtitling, captioning, and descriptive narration would decline.

Our theatrical business depends in part on the construction of new screens and the renovation of existing theaters that install our DTS playback systems and cinema processors. In recent years, aggressive building of megaplexes by companies that operate movie theaters has generated significant competition and 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, to an inability by many major film exhibitors to satisfy their financial obligations. Several major movie theater operators have reorganized through bankruptcy proceedings, and many movie theaters have closed. As a result, our playback systems and cinema processors that we previously sold to movie theaters that have reorganized and closed have been relocated to other theaters or have been available for resale in the secondary market to movie theaters that might otherwise have purchased these products directly from us. If movie theater operators decide to close a significant number of screens in the future or cut their capital spending, demand for our playback systems and cinema processors will decline.

Our success depends, in part, upon the continued availability and contributions of our management team, particularly Jon Kirchner, our President and Chief Executive Officer, and W. Paul Smith, our Senior Vice President, Research and Development. We also rely on the skills and talents of our engineering and technical personnel because of the complexity of our products and services. Several of our key engineers have been instrumental in the development of our technology. Important factors that could cause the loss of key personnel include:


	•	our existing employment agreements with the members of our management team allow such persons to terminate their employment with us at any time;

	•	we do not have employment agreements with a majority of our key engineering and technical personnel;

	•	we do not maintain key-man life insurance on any of our employees;

	•	significant portions of the stock options held by the members of our management team are vested; and

	•	many of the stock options held by our executive officers provide for accelerated vesting in the event of a sale or change of control of our company.

The loss of key personnel or an inability to attract qualified personnel in a timely manner could slow our technology and product development and harm our ability to execute our business plan.

Although the first movie with a DTS audio soundtrack was released in 1993, we did not enter the home theater market until 1996, and our technology has only recently been incorporated into other consumer electronics markets, such as car audio, personal computers, video games and consoles, portable electronics devices, and digital satellite and cable broadcast products. As a result, the demand for our technology, products, and services and the income potential of these businesses are unproven. In addition, because the market for digital audio technology is relatively new and rapidly evolving, we have limited insight into trends that may emerge and affect our business. We may make errors in predicting and reacting to relevant business trends, which could harm our business. Before investing in our common stock, you should consider the risks, uncertainties, and difficulties frequently encountered by companies in new and rapidly evolving markets such as ours. We may not be able to successfully address any or all of these risks.

Our technology or products could contain errors that could cause our products or technology to operate improperly and could cause unintended consequences. If our products or technology contain errors we could be required to replace them, and if any such errors cause unintended consequences we could face claims for product liability. Although we generally attempt to contractually limit our exposure to incidental and consequential damages, if these contract provisions are not enforced or are unenforceable for any reason, or if liabilities arise that are not effectively limited, we could incur substantial costs in defending and/or settling product liability claims.

Although we have been in business since 1990, we have only achieved profits from our business operations in the last nine fiscal quarters. We expect our operating expenses to increase, as we, among other things:


	•	expand our domestic and international sales and marketing activities;

	•	increase our research and development efforts to advance our existing technology, products, and services and develop new technology, products, and services;

	•	hire additional personnel, including engineers and other technical staff;

	•	upgrade our operational and financial systems, procedures, and controls; and

	•	continue to assume the responsibilities of being a public company.

As a result, we will need to grow our revenues in order to maintain and increase our profitability. In addition, we may fail to accurately estimate and assess our increased operating expenses as we grow.

We market and sell our products and services outside the United States, and currently have employees located in China, England, Japan, Mexico, Northern Ireland, and Spain. Many of our customers and licensees are located outside the United States. As a key component of our business strategy, we intend to expand our international sales. We face numerous risks in doing business outside the United States, including:


	•	unusual or burdensome foreign laws or regulatory requirements or unexpected changes to those laws or requirements;

	•	tariffs, trade protection measures, import or export licensing requirements, trade embargos, and other trade barriers;

	•	difficulties in staffing and managing foreign operations;

	•	dependence on foreign distributors and their sales channels;

	•	longer accounts receivable collection cycles and difficulties in collecting accounts receivable;

	•	less effective and less predictable protection of intellectual property;

	•	changes in the political or economic condition of a specific country or region, particularly in emerging markets;

	•	fluctuations in the value of foreign currency versus the U.S. dollar and the cost of currency exchange; and

	•	potentially adverse tax consequences.

Our business practices in international markets are also subject to the requirements of the Foreign Corrupt Practices Act. If any of our employees is found to have violated these requirements, we could be subject to significant fines and other penalties.

Our international revenue is mostly denominated in U.S. dollars. As a result, fluctuations in the value of the U.S. dollar and foreign currencies may make our technology, products, and services more expensive for international customers, which could cause them to decrease their purchases from us. We do not currently engage in currency hedging activities to limit the risk of exchange rate fluctuations.

One of our key strategies is to expand our business operations in China. However, we may be unsuccessful in implementing this strategy as planned or at all. Factors that could inhibit our successful expansion into China include its historically poor recognition of intellectual property rights and poor performance in stopping counterfeiting and piracy activity. If we are unable to successfully stop unauthorized use of our intellectual property and assure compliance by our Chinese licensees, we could experience increased operational and enforcement costs both inside and outside China.

Even if we are successful in expanding into China, we may be greatly impacted by the political, economic, and military conditions in China, Taiwan, North Korea, and South Korea. These countries have recently conducted military exercises in or near the other’s territorial waters and airspace. Such disputes may continue or escalate, resulting in economic embargos, disruptions in shipping, or even military hostilities. This could severely harm our business by interrupting or delaying production or shipment of our products.

We purchase a small number of parts from sole-source suppliers. In addition, our professional audio encoding devices and movie theater playback systems are manufactured according to our specifications by single third-party manufacturers. Because we have no direct control over these third-party suppliers and manufacturers, interruptions or delays in the products and services provided by these third parties may be difficult to remedy in a timely fashion. In addition, if such suppliers or manufacturers are incapable of or unwilling to deliver the necessary parts or products, we may be unable to redesign our technology to work without such parts or find alternative suppliers or manufacturers. In such events, we could experience interruptions, delays, increased costs, or quality control problems.

In addition, we have entered into agreements with two companies to serve as our sole distributors for our DTS Entertainment products in the United States and Canada and in Europe, respectively. We have no direct control over these distributors and any problems with their performance may take time to identify and/or remedy, and any remedial measures that we take may be unsuccessful. In addition, if either or both of these distributors were to go out of business, as our last distributor did, or otherwise becomes incapable of continuing as our distributor, we could experience delays in distributing our DTS Entertainment products to the retail market, loss of inventory, and loss of revenue.

A significant percentage of our revenues are generated from our consumer electronics products manufacturer customers who license and incorporate our technology in their consumer electronics products. Under our existing arrangements, these customers pay us a per-unit licensing fee based on the number of consumer electronics products manufactured that incorporate our technology. We rely on our customers to accurately report the number of units manufactured in collecting our license fees, preparing our financial reports, projections, budgets, and directing our sales and product development efforts. Most of our license agreements permit us to audit our customers, but audits are generally expensive and time consuming and could harm our customer relationships. If any of our customer reports understate the number of products they manufacture, we may not collect and recognize revenues to which we are entitled.

Negative trends in the general economy, including trends resulting from actual or threatened military action by the United States and threats of terrorist attacks on the United States and abroad, could cause a decrease in consumer spending on entertainment in general. Any reduction in consumer confidence or

disposable income in general may affect the demand for consumer electronics products that incorporate our digital audio technology, audio DVDs that we produce and distribute through our DTS Entertainment label, and demand by film studios and movie theaters for our theatrical products and services.

We expect to consider opportunities to acquire or make investments in other technologies, products, and businesses that could enhance our technical capabilities, complement our current products and services, or expand the breadth of our markets. We have not made any acquisitions or strategic investments to date, and therefore our ability as an organization to make acquisitions or strategic investments is unproven. Acquisitions and strategic investments involve numerous risks, including:


	•	problems assimilating the purchased technologies, products, or business operations;

	•	problems maintaining uniform standards, procedures, controls, and policies;

	•	unanticipated costs associated with the acquisition, including accounting charges and transaction expenses;

	•	diversion of management’s attention from our core business;

	•	adverse effects on existing business relationships with suppliers and customers;

	•	risks associated with entering markets in which we have no or limited prior experience; and

	•	potential loss of key employees of acquired organizations.

If we fail to properly evaluate and execute acquisitions and strategic investments, our management team may be distracted from our day-to-day operations, our business may be disrupted, and our operating results may suffer. In addition, if we finance acquisitions by issuing equity or convertible debt securities, our existing stockholders would be diluted.

We expect to continue to experience growth in the scope of our operations and the number of our employees. If this growth continues, it will place a significant strain on our management team and on our operational and financial systems, procedures, and controls. Our future success will depend in part on the ability of our management team to manage any growth effectively. This will require our management to:


	•	hire and train additional personnel in the United States and internationally;

	•	implement and improve our operational and financial systems, procedures, and controls;

	•	maintain our cost structure at an appropriate level based on the revenues we generate;

	•	manage multiple, concurrent development projects; and

	•	manage operations in multiple time zones with different cultures and languages.

Any failure to successfully manage our growth could distract management’s attention, and result in our failure to execute our business plan. For instance, the establishment of our operations in Guangzhou, China has required significant time and attention from our management team. Any future growth could cause similar management challenges or create distractions.

We have historically experienced moderate seasonality in our business due to our business mix and the nature of our products. In our consumer business, consumer electronics manufacturing activities are generally lowest in the first calendar quarter of each year, and increase progressively throughout the remainder of the year. Manufacturing output is generally strongest in the third and fourth quarters as our technology licensees increase manufacturing to prepare for the holiday buying season. Since recognition of

revenues in our consumer business generally lags manufacturing activity by one quarter, our revenues and earnings from the consumer business are generally lowest in the second quarter. Film licensing revenues are generally strongest in the second and fourth quarters due to the abundance of movies typically released during the summer and year-end holiday seasons. The introduction of new products and inclusion of our technologies in new and rapidly growing markets can distort the moderate seasonality described above. Our revenues may continue to be subject to seasonal fluctuations in the future. Unanticipated fluctuations in seasonality could cause us to miss our earnings projections which could cause our stock price to decline.

In addition, 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 underreported to us the amount of royalties owed under license agreements with us. 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 recur in future reporting periods. Such fluctuations in our revenues and operating results may cause declines in our stock price.

The market price of our common stock is likely to be highly volatile and may fluctuate substantially due to many factors, including:


	•	actual or anticipated fluctuations in our results of operations;

	•	announcements of technological innovations or technology standards;

	•	announcements of significant contracts by us or our competitors;

	•	changes in our pricing policies or the pricing policies of our competitors;

	•	developments with respect to intellectual property rights;

	•	the introduction of new products or product enhancements by us or our competitors;

	•	the commencement of or our involvement in litigation;

	•	our sale of common stock or other securities in the future;

	•	conditions and trends in technology industries;

	•	changes in market valuation or earnings of our competitors;

	•	the trading volume of our common stock;

	•	changes in the estimation of the future size and growth rate of our markets; and

	•	general economic conditions.

In addition, the stock market in general, and the Nasdaq National Market and the market for technology companies in particular, has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. Further, the market prices of securities of technology companies have been particularly volatile. These broad market and industry factors may materially harm the market price of our common stock, regardless of our operating performance. In the past, following periods of volatility in the market price of a company’s securities, securities class-action litigation has often been instituted against that company. Such litigation, if instituted against us, could result in substantial costs and a diversion of management’s attention and resources.

Upon completion of this offering, our executive officers, directors, and stockholders holding more than 5% of our outstanding capital stock and their affiliates will, in the aggregate, beneficially own approximately 39.55% of our outstanding common stock, or 33.92% if the underwriters’ over-allotment option is exercised in full. As a result, these persons, acting together, will have the ability to significantly affect the outcome of all matters submitted to our stockholders for approval, including the election and removal of directors and any merger, consolidation, or sale of all or substantially all of our assets. In addition, these persons, acting together, will have the ability to substantially control the management and affairs of our company. This concentration of ownership may harm the market price of our common stock by, among other things:


	•	delaying, deferring, or preventing a change in control of our company;

	•	impeding a merger, consolidation, takeover, or other business combination involving our company;

	•	causing us to enter into transactions or agreements that are not in the best interests of all stockholders; or

	•	discouraging a potential acquirer from making a tender offer or otherwise attempting to obtain control of our company.

Presently, anticipated uses of the proceeds of this offering and our existing cash balances include:


	•	domestic and international selling and marketing;

	•	research and development;

	•	development of new business and potential acquisitions; and

	•	other general corporate purposes.

We cannot specify with certainty how we will use the net proceeds of this offering or our existing cash balance. Accordingly, our management will have considerable discretion in the application of the net proceeds, and you will not have the opportunity to assess whether the proceeds are being used appropriately. The net proceeds may be used for corporate purposes that do not increase our operating results or market value. Until the net proceeds are used, they may be placed in investments that do not produce income or that lose value.

As of September 30, 2003, we have 13,759,449 shares of common stock outstanding, and will have 15,533,123 shares of common stock outstanding after this offering, assuming the underwriters do not exercise their over-allotment option. As a result of our relatively small public float, our common shares may be less liquid than the common shares of companies with broader public ownership. Among other things, trading of a relatively small volume of our common shares may have a greater impact on the trading price for our shares than would be the case if our public float were larger.

Based on the shares outstanding as of September 30, 2003, and assuming 4,500,000 shares are sold in this offering, upon completion of the offering, we will have 15,533,123 shares of common stock outstanding, or 16,208,123 shares if the underwriters’ over-allotment is exercised in full. Of these shares, approximately 9,141,353 or 9,816,353 shares, respectively, will be freely tradeable without restriction or further registration under federal securities laws, except for any shares that are held by our affiliates. An

additional 100,353 shares of common stock issuable upon exercise of stock options are eligible for sale in the public market pursuant to a temporary release by SG Cowen Securities Corporation of such shares from lock-up agreements; however, if any of these shares are not sold during the approximate two-week period beginning on the first trading day following the closing of this offering, they will again be subject to lock-up agreements with SG Cowen Securities Corporation which expire on January 5, 2004, after which time such unsold shares may be sold in the open market. The remaining 6,391,770 shares of common stock outstanding after this offering will be available for sale in the public market as follows:

The above table assumes the effectiveness of the lock-up agreements under which some of our stockholders have agreed not to sell or otherwise dispose of their shares of common stock prior to the dates set forth in the table above. SG Cowen Securities Corporation may, in its sole discretion and at any time without notice, release all or any portion of the securities subject to lock-up agreements. The table excludes warrants to purchase up to 1,314,853 shares of our common stock. As of the date of this prospectus, all of the holders of such warrants have entered into lock-up agreements with SG Cowen Securities Corporation and, as a result, may not sell or otherwise dispose of their shares of common stock issuable upon exercise of the warrants for 90 days after the date of this prospectus.

If our common stockholders sell substantial amounts of common stock in the public market, or if the market perceives that these sales may occur, the market price of our common stock may decline. After this offering, the holders of approximately 5,750,285 shares of common stock will have rights, subject to some conditions, to require us to file registration statements covering their shares or to include their shares in registration statements that we may file for ourselves or other stockholders. These registration rights of our stockholders could impair our ability to raise capital by depressing the price at which we could sell our common stock.

In addition, we have registered the shares of common stock issuable upon exercise of outstanding options under our stock plans and the 1,453,170 shares of common stock reserved for future issuance under our equity incentive and employee stock purchase plans. Accordingly, these shares will be available for sale in the open market, subject to vesting restrictions with us, the contractual lock-up agreements described above, as well as the contractual lock-up agreements and market stand-off provisions that prohibit the sale or other disposition of the shares of common stock underlying the options prior to January 6, 2004.

The offering price of our common stock in this offering is considerably more than the net tangible book value per share of our outstanding common stock. Accordingly, investors purchasing shares of common stock in this offering will pay a price per share that substantially exceeds the value of our assets after subtracting liabilities and will incur substantial dilution in pro forma net tangible book value per share of $24.51 at an assumed offering price of $31.38 per share. To the extent outstanding stock options or warrants are exercised, there will be further dilution to new investors.


	•	acceptance of, and demand for, our products and technology;

	•	the costs of developing new products or technology;

	•	the extent to which we invest in new technology and research and development projects;

	•	the number and timing of acquisitions and other strategic transactions; and

	•	the costs associated with our expansion, if any.

The proceeds from this offering together with our existing sources of cash and cash flows may not be sufficient to fund our activities. As a result, we may need to raise additional funds, and such funds may not be available on favorable terms, or at all. Furthermore, if we issue equity or debt securities to raise additional funds, our existing stockholders may experience dilution, and the new equity or debt securities may have rights, preferences, and privileges senior to those of our existing stockholders. If we cannot raise funds on acceptable terms, we may not be able to develop or enhance our products and services, execute our business plan, take advantage of future opportunities, or respond to competitive pressures or unanticipated customer requirements. This may materially harm our business, results of operations, and financial condition.

Our Restated Certificate of Incorporation and Restated Bylaws contain provisions that could delay or prevent a change of control of our company or changes in our Board of Directors that our stockholders might consider favorable. Some of these provisions:


	•	authorize the issuance of preferred stock which can be created and issued by the board of directors without prior stockholder approval, with rights senior to those of the common stock;

	•	provide for a classified Board of Directors, with each director serving a staggered three-year term;

	•	prohibit stockholders from filling board vacancies, calling special stockholder meetings, or taking action by written consent; and

	•	require advance written notice of stockholder proposals and director nominations.

In addition, we are governed by the provisions of Section 203 of the Delaware General Corporate Law, which may prohibit certain business combinations with stockholders owning 15% or more of our outstanding voting stock. These and other provisions in our Restated Certificate of Incorporation, Restated Bylaws and Delaware law could make it more difficult for stockholders or potential acquirors to obtain control of our Board or initiate actions that are opposed by the then-current Board, including delay or impede a merger, tender offer, or proxy contest involving our company. Any delay or prevention of a change of control transaction or changes in our Board could cause the market price of our common stock to decline.

This prospectus contains forward-looking statements. When used in this prospectus, the words “anticipate,” “believe,” “estimate,” “will,” “plan,” “intend,” and “expect” and similar expressions identify forward-looking statements. Although we believe that our plans, intentions, and expectations reflected in any forward-looking statements are reasonable, these plans, intentions, or expectations may not be achieved. Our actual results, performance, or achievements could differ materially from those contemplated, expressed, or implied, by the forward-looking statements contained in this prospectus. Important factors that could cause actual results to differ materially from our forward-looking statements are set forth in this prospectus, including under the heading “Risk Factors.” All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements set forth in this prospectus. Except as required by federal securities laws, we are under no obligation to update any forward-looking statement, whether as a result of new information, future events, or otherwise.

You should rely only on the information contained in this prospectus. Neither we, the selling stockholders, nor the underwriters have authorized anyone to provide you with information different from that contained in this prospectus. We and the selling stockholders are offering to sell and seeking offers to buy shares of our common stock only in jurisdictions where offers and sales are permitted. The information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or any sale of our common stock.

The net proceeds from the sale of the 1,500,000 shares of common stock that we are selling in this offering (including approximately $324,000 of proceeds that we expect to receive in connection with the exercise of options and warrants by the selling stockholders in connection with this offering) will be approximately $44.6 million (or approximately $64.7 million if the over-allotment option is exercised in full), after deducting underwriting discounts and commissions and our estimated offering expenses. We will not receive any proceeds from the sale of common stock by the selling stockholders.

We intend to use the net proceeds to us from this offering for general corporate purposes, including working capital, research and development, geographic and market expansion, and sales and marketing efforts. We may also use the net proceeds of this offering to acquire or invest in complementary businesses, joint ventures, strategic alliances, products, or technologies, relating to audio, video, or other entertainment or media or to obtain the right to use such complementary technologies. We have no material commitments with respect to any acquisition or investment.

The amounts and timing of our actual expenditures will depend on numerous factors, including the status of our product development efforts, sales and marketing activities, technological advances, amount of cash generated or used by our operations, and competition. We will retain broad discretion in the allocation and use of the net proceeds. Pending the uses described above, we intend to invest the net proceeds in short-term, interest-bearing, investment-grade securities. We believe that our available cash, together with the net proceeds of this offering, will be sufficient to meet our capital requirements for at least the next twelve months.

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.

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:

On November 3, 2003, the last reported sale price of our common stock on the Nasdaq National Market was $31.38 per share. As of September 30, 2003, there were approximately 250 stockholders of record of our common stock.


	•	on an actual basis; and


	•	on a pro forma basis to give effect to the sale by us of 1,500,000 shares of common stock at an assumed public offering price of $31.38 per share, after deducting underwriting discounts and commissions and our estimated offering expenses, and to give effect to the assumed issuance of 258,965 and 14,709 shares of common stock upon the exercise for cash of outstanding options and warrants, respectively, for weighted-average exercise prices per share of $1.02 and $4.038, respectively, which are expected to be sold by the selling stockholders in connection with this offering.

You should read the following table in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Description of Securities,” and our consolidated financial statements and related notes appearing elsewhere in this prospectus.

The number of shares of common stock to be outstanding after this offering is based on 13,759,449 shares outstanding as of September 30, 2003, and excludes:


	•	1,279,845 shares issuable upon exercise of outstanding warrants at an exercise price of $12.114 per share;

	•	35,008 shares issuable upon exercise of outstanding warrants at an exercise price of $4.038, other than 14,709 shares of common stock subject to warrants that we expect will be exercised by selling stockholders in connection with this offering;

	•	1,765,990 shares issuable upon exercise of outstanding options at a weighted average exercise price of $2.77 per share, other than 258,965 shares of common stock subject to options that we expect will be exercised by selling stockholders in connection with this offering; and


	•	953,170 shares available for future issuance as of September 30, 2003 under our equity incentive plan and an additional 500,000 shares available for future issuance under our employee stock purchase plans.

Our net tangible book value as of September 30, 2003 was approximately $62.1 million, or approximately $4.52 per share of our common stock. Net tangible book value per share is equal to the amount of our total tangible assets less the amount of our total liabilities, divided by the number of shares of common stock outstanding at September 30, 2003. Dilution in net tangible book value per share represents the difference between the amount per share paid by purchasers of our common stock in this offering and the pro forma net tangible book value per share of our common stock immediately after the offering.

After giving effect to our sale of the 1,500,000 shares offered in this offering by us at an assumed public offering price of $31.38 per share, and after deducting underwriting discounts and commissions and our estimated offering expenses, and giving effect to the assumed issuance of 258,965 and 14,709 shares of common stock upon the exercise for cash of outstanding options and warrants, respectively, for weighted-average exercise prices per share of $1.02 and $4.038, respectively, which are expected to be sold by the selling stockholders in connection with this offering, our pro forma net tangible book value as of September 30, 2003 would have been approximately $106.7 million, or approximately $6.87 per share. This represents an immediate increase in net tangible book value of $2.35 per share to our existing stockholders, and an immediate dilution in net tangible book value of $24.51 per share to new investors. The following table illustrates this per share dilution:

If the underwriters exercise their over-allotment option in full, the pro forma net tangible book value per share would increase to $7.82 per share, and the pro forma dilution per share to new investors would be $23.56.

The preceding discussion assumes no exercise of the following options and warrants outstanding as of September 30, 2003:


	•	1,279,845 shares issuable upon exercise of outstanding warrants at an exercise price of $12.114 per share;

	•	35,008 shares issuable upon exercise of outstanding warrants at an exercise price of $4.038, other than 14,709 shares of common stock subject to warrants that we expect will be exercised by selling stockholders in connection with this offering;

	•	1,765,990 shares issuable upon exercise of outstanding options at a weighted average exercise price of $2.77 per share, other than 258,965 shares of common stock subject to options that we expect will be exercised by selling stockholders in connection with this offering.

Because the exercise prices of the vast majority of outstanding options and warrants are significantly below the assumed offering price, investors purchasing common stock in this offering will suffer additional dilution when and if these options and warrants are exercised.

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, 1998 and 1999 and the consolidated balance sheet data as of December 31, 1998, 1999, and 2000 are derived from our audited consolidated financial statements for such periods and dates, which are not included in this prospectus. The consolidated statement of operations data for the years ended December 31, 2000, 2001, and 2002 and the consolidated balance sheet data as of December 31, 2001 and 2002 are derived from, and qualified by reference to, our audited consolidated financial statements for such periods and dates, which appear elsewhere in this prospectus. The consolidated statement of operations data for the nine months ended September 30, 2002 and 2003 and the consolidated balance sheet data as of September 30, 2003 are derived from, and qualified by reference to, our unaudited consolidated financial statements for such periods and dates, which are included elsewhere in this prospectus. The unaudited consolidated financial statements for such periods and dates have been prepared on a basis consistent with our audited consolidated financial statements and include all adjustments, consisting only of normal recurring adjustments, which, in the opinion of management, are necessary for the fair presentation of the information presented in those consolidated financial statements. 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 prospectus. Our historical results are not necessarily indicative of the operating results that may be expected in the future.

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.

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 prospectus. 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 prospectus.

We are a leading provider of 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 theatrical business and our consumer business. Historically, we have derived a majority of our revenues from the theatrical business. Beginning in our year ended December 31, 2001, however, we have derived a majority of our revenues from our consumer business.

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 music titles in our digital multi-channel format.

In our theatrical business, we derive revenues from sales of our playback equipment and cinema processors to movie theaters and special venues. In addition, we 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 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 theatrical 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 theatrical 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 theatrical 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 theatrical 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. 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. We also employ consultants to coordinate sales to independent retailers. We are in the process of establishing distribution channels in other international territories. We expect that distribution in Asia will be handled through established distributors located in these 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 theatrical 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, China, and Eastern Europe.

The consolidated statement of operations data for the three months ended September 30, 2002 and 2003, the consolidated balance sheet data as of September 30, 2003, and other financial data as of September 30, 2003 and for the nine months ended September 30, 2002 and 2003 are unaudited.

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

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

Total revenues for the nine months ended September 30, 2003 increased 35% to $36.8 million from $27.3 million for the nine months ended September 30, 2002 due primarily to the increase in technology and film licensing revenues. Technology and film licensing revenues totaled $30.3 million for the first nine months of 2003, compared to $20.5 million in the first nine months of 2002, an increase of 48%. Technology licensing revenues posted growth of 59% for the period, driven primarily by payments received as a result of intellectual property compliance and enforcement activities and 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, foreign language dubbed versions of major U.S. films, and foreign original-version films released with a DTS soundtrack. Product sales and other revenues declined 5% during the first nine months of 2003, due primarily to softness experienced during the quarter ended March 31, 2003.

In the consumer business, revenues for the nine months ended September 30, 2003 were $25.3 million, a 58% increase over the $16.0 million recorded in the first nine months of 2002 due to the intellectual property compliance and enforcement activities and the strength of the consumer electronics licensing activities as discussed above. Theatrical revenues were $11.5 million for the nine months ended

Consolidated gross profit improved to 78% of related revenues for the nine months ended September 30, 2003, from 69% for the same period in 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 nine months ended September 30, 2003, up from 75% 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 nine months ended September 30, 2003 from 86% in the prior year period. Gross profit associated with product sales and other revenues improved to 24% of related revenues for the three months ended September 30, 2003 from 19% in the prior year period. This increase is primarily due to accruals in the three months ended September 30, 2002 totaling $600,000 related to payments required under a vendor supply agreement.

Gross profit for our consumer business improved to 93% of related revenues for the nine months ended September 30, 2003, from 89% in the prior year period. The increase is due to the rapid growth of higher margin technology licensing revenues. Theatrical business gross profit increased slightly to 44% of related revenues for the nine months ended September 30, 2003 from 42% in the prior year period due to the accruals mentioned above.

Selling, general, and administrative expenses increased 26% to $14.9 million for the nine months ended September 30, 2003, from $11.8 million for the same period in the prior year. The increase is primarily due to advertising and promotion related to new product introductions, costs associated with intellectual property compliance and enforcement activities, insurance costs, professional services, and other costs required to operate as a public company. In addition to these growth factors, the 2003 amount includes $497,000 in expenses related to stock-based compensation for options and warrants to purchase common stock.

Research and development expenses for the nine months ended September 30, 2003 increased to $3.6 million compared to $2.7 million for the same period in the prior year. 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.

We expect quarterly research and development expenses in 2003 to increase in absolute dollars relative to the prior year quarters.

Interest and other (income) expense, net, for the nine months ended September 30, 2003 decreased to $3,000 from $100,000 in the prior year period. The decrease was primarily due to increased investment income subsequent to the initial public offering.

Income tax expense totaled $3.5 million for the nine months ended September 30, 2003, representing an effective tax rate of 35%, down from 37% for nine months ended September 30, 2002. Our effective tax rate reflects the full federal and state statutory rates on U.S. taxable income net of available tax credits, combined with taxes expected to be paid by our wholly owned subsidiaries in lower tax jurisdictions such as the United Kingdom, China, and the British Virgin Islands. The reduction in our effective tax rate in

Total revenues for the year ended December 31, 2002 increased 43% to $41.1 million from $28.7 million in the prior year. The increase in revenues in 2002 primarily resulted from a 63% increase in technology and film licensing revenues to $31.9 million for the year ended December 31, 2002 from $19.6 million for the prior year. The increase in revenues from technology and film licensing was attributable to an 83% growth in revenues from consumer electronics licensing, driven by a rapid 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. Our film licensing revenues grew 21% from 2001 to 2002 due primarily to revenues generated from an increase in both the number of foreign language dubbed versions of films released by major studios and the number of foreign original-version films produced with a DTS soundtrack. Product sales and other revenues remained relatively constant at $9.1 million and $9.2 million for each of the years ended December 31, 2001 and 2002, respectively, as increased sales of our core cinema processor and audio playback equipment were substantially offset by a $500,000 decline in revenues from our digital multi-channel music discs. Theatrical hardware sales grew by approximately 27% from 2001 to 2002, representing the first growth in our theatrical hardware sales since 1998, as many major North American movie theater chains began to emerge from bankruptcies in 2000 and 2001 and sales of our products outside of North America improved. We believe the decline in music disc revenues to $800,000 in 2002 from $1.3 million in 2001 was caused primarily by the bankruptcy of our previous music distributor.

Revenues from our consumer business totaled $25.7 million for the year ended December 31, 2002, an increase of 68% from $15.2 million in the prior year. The increase in revenues was driven by the growth in consumer electronics technology licensing as described above. Theatrical revenues were $15.4 million for the year ended December 31, 2002, up 14% from $13.5 million in the prior year. Growth in theatrical revenues was due to a combination of the growth in audio hardware and film licensing revenues described above, which were partially offset by declines in service, repair, and other miscellaneous theatrical business revenues, which decreased 27% for the year ended December 31, 2002 to $1.7 million.

Gross profit improved to 74% of related revenues for the year ended December 31, 2002, from 65% in the prior year. The increase is due to changes in the mix of licensing and product revenues, as higher-margin technology and film licensing comprised 78% of related revenues for the year ended December 31, 2002, up from 68% of revenues for the prior year.

Gross profit associated with technology and film licensing revenues improved to 88% of related revenues for the year ended December 31, 2002 from 85% in the prior year. The margin improvement resulted from a favorable change in the mix of higher margin technology licensing revenues and film licensing revenues. Gross profit associated with product sales and other revenues improved slightly to 24% of related revenues for the year ended December 31, 2002 from 23% in the prior year. The increase is primarily due to a less than 1% increase in overall product sales and other revenues, which allowed fixed overhead costs to be spread over the larger revenue base.

Gross profit for our consumer business improved to 93% of related revenues for the year ended December 31, 2002, from 80% in the prior year. The increase is due to the rapid growth of higher margin technology licensing revenues. Theatrical business gross profit declined to 42% of related revenues for the year ended December 31, 2002 from 48% in the prior year due primarily to a shift in the mix of revenues between higher-margin film licensing and hardware sales. Hardware sales comprised 33% of theatrical revenues in 2002, up from 29% in 2001.

Selling, general, and administrative expenses increased 23% to $16.4 million for the year ended December 31, 2002, compared to $13.3 million in the prior year. The increase is primarily due to increased headcount, occupancy costs, and costs associated with compliance, protection, and enforcement activities relating to our intellectual property. Selling, general, and administrative headcount increased by 25%, or 18 people in 2002, including four in the United States, seven in the United Kingdom, and seven in China and other territories. As a percentage of total revenues, selling, general, and administrative expenses were 40% for the year ended December 31, 2002, down from 46% for the prior year. The decline as a percentage of revenues was caused primarily by our rapid revenue growth, which outpaced our expected growth in selling, general, and administrative expenses. We expect selling, general, and administrative expenses to continue to increase in absolute dollars in the future as a result of continued expansion of our global sales, marketing, and administrative infrastructure in support of a broader technology and product portfolio, and continued intellectual property compliance, protection, and enforcement activities.

Research and development expenses increased to $3.8 million for the year ended December 31, 2002, compared to $3.6 million for the prior year. The increase is primarily due to increased labor costs caused by ordinary-course salary increases and increased headcount associated with new product initiatives and the optimization of our Coherent Acoustics technology for new consumer electronics applications. Research and development headcount increased from 28 at December 31, 2001 to 32 at December 31, 2002. As a percentage of total revenues, research and development expenses were 9% in the year ended December 31, 2002, down from 13% in the prior year. The decline as a percentage of revenues was caused primarily by our rapid revenue growth, which outpaced our expected growth in research and development spending. We expect research and development expenses to increase in absolute dollars in the future as we continue to develop and expand our technology, product offerings, and intellectual property portfolio.

Interest and other expense, net, decreased $231,000 or 40% to $349,000 for the year ended December 31, 2002. The decrease is primarily due to repayments of bank borrowings, which resulted in reduced interest expense.

Management continually evaluates our deferred tax assets to determine whether it is “more likely than not” that the deferred tax assets will be realized. In the evaluation of the potential realization of deferred tax assets, management considers projections of future taxable income and the reversal of temporary differences. In the year ended December 31, 2001, based on this review process, we recorded an income tax benefit of $2.7 million, as it was determined that it was “more likely than not” that certain of our deferred tax assets would be realized, which necessitated a reduction in the related valuation allowance. In the year ended December 31, 2002, income taxes totaled $3.7 million, representing an effective tax rate of 37%. Our effective tax rate reflects the full federal and state statutory rates on U.S. taxable income net of available tax credits, combined with taxes expected to be paid by our wholly owned subsidiary in the United Kingdom. In addition, our evaluation of foreign deferred tax assets at December 31, 2002 resulted in a reduction in the valuation allowance for such assets, thereby reducing income tax expense by $120,000.

Revenues increased 15% to $28.7 million for the year ended December 31, 2001, compared to $25.0 million for the prior year. The growth in revenues resulted from a 34% increase in technology and film licensing revenues, driven primarily by a substantial increase in sales of home theater systems, audio/

video receivers, and other DVD-based systems containing DTS technology. Partially offsetting the increase in licensing revenues was a 13% decline in product sales and service revenues caused by ongoing weakness in the U.S. and international theatrical exhibition markets, as many of the major exhibitors underwent financial restructurings throughout 2000 and 2001, which resulted in reduced theatrical hardware sales.

Revenues for our consumer business increased 53% for the year ended December 31, 2001 to $15.2 million, compared to $10.0 million for the prior year. The increase in revenues was driven by the growth in consumer electronics technology licensing. Theatrical revenues decreased 10% for the year ended December 31, 2001 to $13.5 million, compared to $15.1 million in the prior year. The decline in theatrical revenues was due primarily to a substantial reduction in audio hardware sales caused by the financial difficulties of North American movie theaters. Partially offsetting the decline in hardware sales was a 34% increase in film licensing, service, repair, and other theatrical revenues.

Gross profit associated with technology and film licensing revenues improved to 85% of related revenues for the year ended December 31, 2001 from 80% in the prior year. The margin improvement resulted from a favorable change in the mix of higher-margin technology licensing revenues and film licensing revenues. Gross profit associated with product sales and other revenues declined to 23% of related revenues for the year ended December 31, 2001 from 43% in the prior year. The decrease is primarily due to a 13% decrease in overall product sales and other revenues, which caused fixed overhead costs to comprise a larger percentage of the related revenue base.

Gross profit for our consumer business declined to 80% of related revenues for the year ended December 31, 2001 from 85% for the prior year. The decline was primarily due to amortization of production costs related to our digital multi-channel music discs and costs associated with the release and shipment of encoding equipment to content creators, such as music studios, to encourage creation of DTS-encoded content. Theatrical business gross profit declined to 48% of related revenues for the year ended December 31, 2001 from 51% for the prior year. This decline was primarily due to a decline in hardware sales, which resulted in a higher percentage of fixed costs which could not be eliminated ratably with the decline in shipments.

Despite the declines in margins in both the consumer and theatrical businesses, the overall gross profit remained constant at 65% because revenues for our higher-margin consumer business increased to 53% of total revenues for the year ended December 31, 2001 from 40% in the prior year.

Selling, general, and administrative expenses increased to $13.3 million, or 46% of revenues, for the year ended December 31, 2001 from $12.8 million, or 51% of revenues, in the prior year. The increase in absolute dollars was primarily attributable to increased personnel costs and promotional expenses to support our expansion in the home theater market and into new markets such as car audio, broadcast, and video games.

Research and development expenses were $3.6 million for the year ended December 31, 2001 compared to $3.0 million in the prior year. As a percentage of total revenues, research and development expenses were 13% for the year ended December 31, 2001 and 12% for the year ended December 31, 2000. The increase in absolute dollars and as a percentage of total revenues was due primarily to increased personnel associated with new product initiatives and the optimization of our Coherent Acoustics technology for new consumer electronics applications.

Interest and other expense, net, increased to $580,000 for the year ended December 31, 2001 from $469,000 in the prior year. The increase was primarily due to increased financing costs incurred in 2001.

For the year ended December 31, 2001, we recorded an income tax benefit of $2.7 million. For the year ended December 31, 2000, we did not recognize any tax benefits from our deferred tax assets based on our evaluation of potential realization at December 31, 2000.

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, deferred taxes, impairment of long-lived assets, product warranty, 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. Revenues from the sale of audio playback systems 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.


	Revenues from licensing audio technology, trademarks, and know-how is 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. Our allowances for doubtful accounts at December 31, 2001 and 2002 and September 30, 2003 amounted to $550,000, $437,000 and $429,000, 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. Our inventory reserves at December 31, 2001 and 2002 and September 30, 2003 amounted to $242,000, $351,000, and $354,000, respectively.

	•	Deferred Taxes. A valuation allowance is recorded to reduce deferred tax assets to the amount that is more likely than not to be realized. As of December 31, 2002 and September 30, 2003, we have evaluated our deferred tax assets and liabilities and we have determined that no valuation allowance is necessary. Should we determine that we would not be able to realize all or part of the net deferred tax asset in the future, an adjustment to the deferred tax asset would reduce income in the period such determination was made.

	•	Impairment of Long-Lived Assets. We periodically assess potential impairments of our long-lived assets in accordance with the provisions of Statement of Financial Accounting Standards (“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 one year after sale and provide for estimated future warranty costs at the time revenues are recognized. Our warranty obligation is affected by 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, 2001 and 2002 and September 30, 2003 amounted to $36,000, $52,000, and $62,000, respectively.

	•	Commitments and Contingencies. 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.

At September 30, 2003, we had cash, cash equivalents, and short-term investments of $51.0 million, compared to $4.1 million at December 31, 2002.

Since our inception, we have financed our operations through sales of redeemable preferred stock, borrowings under bank line of credit arrangements, internally generated cash flows and proceeds from our initial public offering. At September 30, 2003, we had no outstanding borrowings under our bank facility, which expires on June 30, 2004. Availability under this facility is variable up to $10.0 million and was $10.0 million at September 30, 2003 pursuant to an availability formula that is based on cash, cash equivalents, short-term investments, 80% of eligible accounts receivable, and 20% of inventory balances (up to a maximum of $1.0 million). The facility requires us to comply with the following restrictive financial covenants:


	•	capital expenditures cannot exceed $2.0 million per fiscal year;

	•	we must maintain a consolidated current ratio in excess of 1.2:1.0;

	•	consolidated tangible net worth must equal or exceed the sum of $6.5 million plus 75% of net income accumulated from April 10, 2002;

	•	consolidated debt (excluding mandatorily redeemable preferred stock) to consolidated tangible net worth ratio may not exceed 1.9:1.0;

	•	the sum of cash, cash equivalents, and marketable securities must exceed $2.0 million at each quarter-end; and

	•	consolidated net income for any consecutive six-month period must be greater than zero.

The facility is collateralized by substantially all of our assets. Interest rates under this facility range from the bank’s prime rate less 0.5% to prime rate plus 1% (3.75% to 5.25% at December 31, 2002 and 3.5% to 5.0% at September 30, 2003). We are currently in the process of renegotiating the terms of the bank facility.

Through September 30, 2003, we have raised $14.7 million in cash through the sale of mandatorily redeemable preferred stock and net proceeds of $63.0 million from our initial public offering. The preferred stock was redeemable at the original issuance price of $2.019 per share plus dividends accumulating at 8% per annum through October 24, 2002 and 10% per annum from October 25, 2002 through the redemption date of May 24, 2004. We used approximately $21.3 million from the proceeds of our initial public offering to redeem all shares of the preferred stock and to pay all accrued but unpaid dividends on such shares through the date of redemption.

Net cash used in operating activities was $732,000 for the year ended December 31, 2000, and net cash provided by operating activities was $3.7 million and $4.6 million, respectively, for the years ended December 31, 2001 and 2002. For the nine months ended September 30, 2002 and 2003, net cash provided by operating activities was $3.8 million and $7.0 million, respectively. The improvement in cash flows from operations was primarily a result of increases in net income in 2001, 2002, and the nine months ended September 30, 2003. Accounts receivable decreased $1.4 million for the nine months ended September 30, 2003, due to a reduction in accruals related to consumer license fees and an increase in collections. Inventory increased $1.7 million as a result of inventory purchases for the nine months ended September 30, 2003 related to our new product offerings.

We use cash in investing activities primarily to purchase office equipment, fixtures, computer hardware and software, engineering and manufacturing test and certification equipment, for securing patent and trademark protection for our proprietary technology and brand name, and to purchase short-term investments such as bank certificates of deposit and municipal bonds. Cash used in investing activities totaled $982,000, $939,000, and $3.2 million, respectively, in the years ended December 31, 2000, 2001, and 2002. In 2002, $2.1 million was used for the purchase of short-term investments. For the nine months ended September 30, 2002 and 2003, net cash used in investing activities was $641,000 and $2.5 million, respectively. The increase in cash used in investing activities during the nine months ended September 30, 2003 is the result of purchases of short-term investments, funded primarily by proceeds from our initial public offering. In addition, we continue to invest in property and equipment, including office equipment and fixtures, engineering and manufacturing test equipment, and computer hardware and software.

Net cash flows provided by financing activities totaled $3.7 million for the year ended December 31, 2000 and cash used in financing activities totaled $100,000 and $6.3 million for the years ended December 31, 2001 and 2002, respectively. For the nine months ended September 30, 2002, net cash used in financing activities of $3.0 million was used to repay the bank line of credit. For the nine months ended September 30, 2003, cash provided by financing activities was $40.5 million representing proceeds of $63.0 million received from the issuance of common stock in conjunction with our initial public offering, partially offset by cash dividends paid to our preferred stockholders totaling $6.8 million. In addition, $15.8 million was used to redeem the principal value of our mandatorily redeemable preferred stock. At December 31, 2002, we had no material commitments other than purchase commitments in the ordinary course of business and obligations under our non-cancellable lease agreements and redeemable preferred stock agreements. At September 30, 2003, only ordinary course purchase commitments were outstanding.

Future payments due under lease obligations and redeemable preferred stock agreements as of December 31, 2002 are described below (in thousands):

In addition to the above noted commitments, we are party to a supply agreement that expires in March 2004, pursuant to which we had future purchase obligations of $6.1 million at December 31, 2002 and $5.5 million at September 30, 2003. We believe that we will utilize the committed amount in the normal course of business. We have no other material off-balance-sheet obligations.

We believe that our cash and short-term investments, funds available under our existing bank line of credit facility, and cash flows from operations will be sufficient to satisfy our working capital and capital expenditure requirements for at least the next twelve months. We used a portion of the proceeds from our initial public offering to redeem all outstanding shares of our redeemable preferred stock. Beyond the next twelve months, additional financing may be required to fund working capital and capital expenditures. Changes in our operating plans, lower than anticipated revenues, increased expenses or other events, including those described in “Risk Factors,” may cause us to seek additional debt or equity financing on an accelerated basis. Financing may not be available on acceptable terms, or at all, and our failure to raise capital when needed could negatively impact our growth plans and our financial condition and results of operations. Additional equity financing may be dilutive to the holders of our common stock and debt financing, if available, may involve significant cash payment obligations and covenants and/or financial ratios that restrict our ability to operate our business.

The following table sets forth the unaudited quarterly results of operations for each of the eleven quarters ended September 30, 2003, as well as the same data expressed as a percentage of our total revenues for the periods indicated. This information includes all adjustments management considers necessary for the fair presentation of such data. The information for each quarter is unaudited and we have prepared it on the same basis as the audited consolidated financial statements appearing elsewhere in this prospectus. In the opinion of management, all necessary adjustments, consisting only of normal recurring

Generally, consumer electronics manufacturing activities are lowest in the first calendar quarter of each year, and increase progressively throughout the remainder of the year. The third and fourth quarters are typically the strongest in terms manufacturing output as our technology licensees increase their manufacturing output to prepare for the holiday buying season. Since recognition of revenues in our consumer business generally lags manufacturing activity by one quarter, our revenues and earnings are generally lowest in the second quarter. Film licensing revenues are typically strongest in the second and fourth quarters due to the abundance of movies typically released during the summer and year-end holiday seasons. In general, the introduction of new products and inclusion of DTS technologies in new and rapidly growing markets can have a material effect on quarterly revenues and profits, and can distort the moderate seasonality described above.


Delaware	3651, 6794, 7819	77-0467655
(State or Other Jurisdiction of Incorporation or Organization)	(Primary Standard Industrial Classification Code Number)	(I.R.S. Employer Identification Number)


	Per
	Share	Total

Public offering price	$	$
Underwriting discount and commissions	$	$
Proceeds, before expenses, to us	$	$
Proceeds, before expenses, to the selling stockholders	$	$


PROSPECTUS SUMMARY
RISK FACTORS
FORWARD-LOOKING INFORMATION
USE OF PROCEEDS
DIVIDEND POLICY
PRICE RANGE OF COMMON STOCK
CAPITALIZATION
DILUTION
SELECTED CONSOLIDATED FINANCIAL DATA
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
BUSINESS
MANAGEMENT
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
PRINCIPAL AND SELLING STOCKHOLDERS
DESCRIPTION OF SECURITIES
SHARES ELIGIBLE FOR FUTURE SALE
MATERIAL UNITED STATES FEDERAL INCOME TAX CONSIDERATIONS FOR NON-U.S. HOLDERS OF OUR COMMON STOCK
UNDERWRITING
LEGAL MATTERS
EXPERTS
WHERE YOU CAN FIND MORE INFORMATION
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
SIGNATURES
EXHIBIT INDEX
EXHIBIT 1.1
EXHIBIT 5.1
EXHIBIT 23.1


Common stock we are offering		1,500,000 shares

Common stock offered by selling stockholders		3,000,000 shares

Common stock to be outstanding after the offering		15,533,123 shares

Use of proceeds		We intend to use the net proceeds to us from this offering for general corporate purposes, including working capital, research and development, geographic and market expansion, and sales and marketing efforts. In addition, we may use a portion of the net proceeds to acquire or invest in complementary businesses, joint ventures, strategic alliances, products, or technologies relating to audio, video, or other entertainment or media or to obtain the right to use such complementary technologies. We have no material commitments with respect to any acquisition or investment. We will not receive any proceeds from the sale of shares by the selling stockholders. See “Use of Proceeds.”

Nasdaq National Market symbol		DTSI

Dividend policy		We do not intend to pay dividends on our common stock in the foreseeable future. See “Dividend Policy.”



									Nine Months Ended
		Years Ended December 31,							September 30,

		2000			2001		2002		2002		2003


									(Unaudited)
Consolidated Statement of Operations Data
Revenues		$	25,062		$	28,748	$	41,056	$	27,260	$	36,791
Gross profit			16,173			18,696		30,420		18,929		28,699
Income from operations			370			1,757		10,287		4,355		10,103
Net income (loss)			(99	)		3,908		6,250		2,670		6,566
Net income (loss) attributable to common stockholders		$	(1,882	)	$	2,095	$	4,402	$	1,284	$	5,332
Net income (loss) attributable to common stockholders per common share:
	Basic	$	(0.44	)	$	0.49	$	0.99	$	0.30	$	0.74
	Diluted	$	(0.44	)	$	0.23	$	0.47	$	0.14	$	0.59
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		4,295,419		7,227,480
	Diluted		4,294,378			9,054,843		9,329,278		9,072,086		9,058,898


Craig S. Andrews, Esq. Heller Ehrman White & McAuliffe LLP 4350 La Jolla Village Drive, 7th Floor San Diego, California 92122-1246 (858) 450-8400		Thomas J. Ivey, Esq. Skadden, Arps, Slate, Meagher & Flom LLP 525 University Avenue, Suite 1100 Palo Alto, California 94301 (650) 470-4500


	Page
Prospectus Summary		1
Risk Factors		6
Forward-Looking Information		19
Use of Proceeds		20
Dividend Policy		20
Price Range of Common Stock		20
Capitalization		21
Dilution		22
Selected Consolidated Financial Data		23
Management’s Discussion and Analysis of Financial Condition and Results of Operations		25
Business		42
Management		60
Certain Relationships and Related Transactions		76
Principal and Selling Stockholders		81
Description of Securities		85
Shares Eligible for Future Sale		89
Material United States Federal Income Tax Considerations for Non-U.S. Holders of our Common Stock		91
Underwriting		94
Legal Matters		96
Experts		96
Where You Can Find More Information		96
Index to Consolidated Financial Statements		F-1



		As of September 30, 2003

		Actual		Pro Forma(1)


		(Unaudited)
Consolidated Balance Sheet Data
	Cash, cash equivalents, and short-term investments	$	50,996	$	95,556
	Working capital		57,147		101,707
	Total assets		74,158		118,718
	Total stockholders’ equity		62,556		107,116


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


	*Current and future governmental and industry standards may significantly limit our business opportunities.*


	*We may not be able to evolve our technology, products, and services or develop new technology, products, and services that are acceptable to our customers or the changing market.*


	*If we fail to protect our intellectual property rights, our ability to compete could be harmed.*


	*We may be sued by third parties for alleged infringement of their proprietary rights.*


	If we are unable to maintain and increase the amount of entertainment content released with DTS audio soundtracks, demand for the technology, products, and services that we offer to consumer electronics products manufacturers may significantly decline.


	*If our DTS-CSS system for subtitles, captions, and descriptive narration for films is not adopted widely, our business may be harmed.*


	*We have limited experience in licensing, re-mixing, marketing, and directly selling multi-channel audio content.*


	*Declining retail prices for consumer electronics products could force us to lower the license fees we charge our customers.*


	*We have limited control over our customers’ and licensees’ decision to include our digital audio technology in their product offerings.*


	Our revenues from film producers and distributors and from the products and services that we offer to movie theaters would decline if the major U.S. film producers and distributors decrease the number of films they release with DTS audio soundtracks.


	*If the movie industry adopts new digital cinema technology in place of current film technology, demand for our theatrical products and services could decline.*


	The movie theater industry has suffered and may continue to suffer from an oversupply of screens, which has affected and may continue to affect demand for the products and services we offer to movie theaters.


	*We are dependent on our management team and key technical employees, and the loss of any of them could harm our business.*


	*We have a limited operating history in many of our key markets.*


	*Our technology and products are complex and may contain errors that could cause us to lose customers, damage our reputation, or incur substantial costs.*


	*Because we expect our operating expenses to increase in the future, we may not be able to sustain or increase our profitability.*


	*We are subject to additional risks associated with our international operations.*


	*We face risks in expanding our business operations in China.*


	*We depend on single suppliers, manufacturers, and distributors for some of our products, and the loss of any of these suppliers, manufacturers, or distributors could harm our business.*


	We rely on the accuracy of our customers’ manufacturing reports for reporting and collecting our revenues, and if these reports are untimely or incorrect, our revenues could be delayed or inaccurately reported.


	*A prolonged economic downturn could materially harm our business.*


	*We may not successfully address problems encountered in connection with any future acquisitions.*


	*We may have difficulty managing any growth that we might experience.*


	*We may experience fluctuations in our operating results.*


	*We expect that the price of our common stock will fluctuate substantially.*


	*Because of their significant stock ownership, some of our existing stockholders will be able to exert substantial control over us and our significant corporate decisions.*