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DTSI > SEC Filings for DTSI > Form 10-Q on 14-Aug-2013All Recent SEC Filings

Show all filings for DTS, INC.

Form 10-Q for DTS, INC.


14-Aug-2013

Quarterly Report


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

Forward-Looking Statements May Prove Inaccurate

This quarterly report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended. Words such as "believes," "anticipates," "estimates," "expects," "intends," "projections," "may," "can," "will," "should," "potential," "plan," "continue" and similar expressions are intended to identify those assertions as forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this report. All statements, other than statements of historical fact, are statements that could be deemed forward-looking statements, including, but not limited to, statements regarding our future financial performance or position, future economic conditions, our business strategy, plans or expectations, and our objectives for future operations, including relating to our products and services. Although forward-looking statements in this report reflect our good faith judgment, such statements are based on facts and factors currently known by us. We caution readers that forward-looking statements are not guarantees of future performance and our actual results and outcomes may be materially different from those expressed or implied by the forward-looking statements. Important factors that could cause or contribute to such differences in results and outcomes include, without limitation, those discussed under "Risk Factors" contained in Part II, Item 1A in this quarterly report on Form 10-Q and in other documents we file with the Securities and Exchange Commission ("SEC"). Readers are urged not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. We undertake no obligation to revise or update these forward-looking statements to reflect future events or circumstances.

In Management's Discussion and Analysis of Financial Condition and Results of Operations, "we," "us" and "our" refer to DTS, Inc. and its consolidated subsidiaries, including, except as otherwise stated, SRS and its subsidiaries, which we acquired on July 20, 2012. References to "Notes" are Notes included in our Notes to Consolidated Financial Statements. The financial results include SRS and Phorus from their respective dates of acquisition.

You should read the following discussion and analysis of our financial condition and results of operations in conjunction with the consolidated financial statements and the notes to those statements included elsewhere in this Form 10-Q.

Overview

We are a premier audio solutions provider for high-definition entertainment experiences-anytime, anywhere, on any device. Our audio solutions enable delivery and playback of clear, compelling high-definition audio which is incorporated by hundreds of licensee customers around the world into billions of consumer electronic devices, including audio/video receivers, soundbars, Blu-ray Disc players, DVD based products, PCs, automotive audio products, video game consoles, TVs, digital media players ("DMPs"), set-top-boxes ("STBs"), mobile phones, tablets and home theater systems.

We derive revenues from licensing our audio technologies, copyrights, 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 actively engage in intellectual property compliance and enforcement activities focused on identifying third parties who have either incorporated our technologies, copyrights, trademarks or know-how without a license or who have under-reported the amount of royalties owed under license agreements with us. We continue to invest in our compliance and enforcement infrastructure to support the value of our intellectual property to us and our licensees and to improve the long-term realization of revenues from our intellectual property. As a result of these activities, from time to time, we


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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. While we consider such revenues to be a part of our normal operations, we cannot predict such recoveries or the amount or timing of such revenues.

Our cost of revenues consists primarily of amortization of acquired intangibles, and also includes costs for products and materials, salaries and related benefits and expenses for operations personnel, and payments to third parties for copyrighted material.

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

Our research and development costs consist primarily of salaries and related benefits and expenses 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.

Acquisition of SRS Labs, Inc.

On July 20, 2012, we acquired SRS pursuant to the Agreement and Plan of Merger and Reorganization, dated as of April 16, 2012 (the "Merger Agreement"), by and among us, DTS Merger Sub, Inc., and our wholly owned subsidiary ("Merger Sub"), DTS LLC, a single member limited liability company and our wholly owned subsidiary ("DTS LLC"), and SRS. Pursuant to the Merger Agreement, Merger Sub was merged with and into SRS, with SRS surviving the merger as our wholly owned subsidiary (the "Merger"). Immediately following the Merger, SRS was merged with and into DTS LLC, with DTS LLC continuing as the surviving entity and our wholly owned subsidiary. As used herein, "SRS" refers to SRS prior to the closing of the Merger and after the closing of the Merger, as the context requires.

In connection with the Merger, we issued 2.3 million shares of our common stock and paid $66.9 million in cash to former SRS stockholders and paid $13.3 million in cash to former SRS equity award holders. Aggregate consideration for this acquisition was valued at $124.8 million, based on a $19.32 per share closing price of our common stock on July 20, 2012.

SRS is an industry leader in audio signal processing for consumer electronics across the four screens: TVs, PCs, mobile phones and automotive entertainment systems. SRS holds approximately 150 worldwide registered and pending patents and is recognized by the industry as an authority in research and application of audio post processing technologies based on the human auditory principles. Through partnerships with leading global consumer electronics companies, semiconductor manufacturers, software developers, and content aggregators, SRS is recognized as a leader in audio enhancement, surround sound, volume leveling, audio streaming and voice processing technologies. We plan to leverage SRS' relationships, technologies and accomplishments to accelerate the growth of our business.

Acquisition of Phorus' Assets

On July 5, 2012, we acquired substantially all of the assets of Phorus pursuant to an Asset Purchase Agreement dated the same day (the "Asset Purchase Agreement"). Pursuant to the terms of the Asset Purchase Agreement, we paid initial cash consideration of $3.0 million upon the closing of the acquisition, and we may be required to pay up to an additional $10.0 million in consideration


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subject to the achievement of certain milestones. The Phorus business is dedicated to wireless audio solutions for connected devices with expertise in such areas as acoustic design, digital signal processing and wireless networking.

All discussions and amounts in Management's Discussion and Analysis include SRS and Phorus from their respective dates of acquisition.

Executive Summary

Financial Highlights


Revenues increased $5.4 million for the three months ended June 30, 2013, compared to the same prior year period. Revenues increased $11.3 million for the six months ended June 30, 2013, compared to the same prior year period.


Royalty recoveries from intellectual property compliance and enforcement activities decreased $0.1 million for the three months ended June 30, 2013, compared to the same prior year period. Royalty recoveries decreased $2.4 million for the six months ended June 30, 2013, compared to the same prior year period.


Royalties from network-connected markets increased 100% and 158% for the three and six months ended June 30, 2013, respectively, compared to the same prior year periods.

Trends, Opportunities, and Challenges

Historically, our revenue has been primarily dependent upon the DVD and Blu-ray Disc based home theater markets. Because we are a mandatory technology in the Blu-ray Disc standard, our revenue stream from this market is closely tracking the sales trend of Blu-ray equipped players, game consoles and PCs. However, the market for optical disc based media players, in general, has slowed in favor of a growing trend toward network-based delivery of entertainment content to network-connected devices-what we call the network-connected markets. In response to this shift in entertainment delivery and consumption over the past several years, we have transitioned our primary focus to providing end-to-end audio solutions to the network-connected markets, and we believe that our mandatory position in the Blu-ray Disc standard has given us the ability to extend the reach of our audio into the growing network-connected markets.

We have signed agreements with a number of network-connected digital TV, DMP, mobile phone, and tablet manufacturers to incorporate DTS audio solutions into their products. In 2012, we joined forces with Deluxe Digital Distribution to expand our presence in cloud-based content. In the second quarter of 2013, we announced that Rovi-enabled digital video entertainment storefronts, beginning with Best Buy's CinemaNow, are pairing their movie and TV show libraries with powerful DTS-HD surround sound. Recently, in July 2013, our DTS-HD codec was selected by Paramount Pictures as a surround sound format for the release of its content in the UltraVioletTM Common File Format, which will further expand our presence in cloud-based content. To date, our premium audio technologies have been integrated into thousands of titles, and we are actively pursuing other partnerships to expand the integration of our premium audio technologies into streaming content.

One of the largest challenges that we face is the growing consumer trend toward open platform, on-line entertainment consumption and the need to constantly and rapidly evolve our technologies to address the emerging markets. We believe that although the trend has begun, any transition to such open platform, on-line entertainment will take many years. Further, we believe that this trend demands that playback devices be capable of processing content originating in any form, whether optical disc-based or streaming, which creates a substantial opportunity for our technologies to extend into network-connected products that may not have an optical disc drive. During the transition period, we expect that both optical disc based media and on-line entertainment formats will continue to thrive.


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Further, we currently face challenges regarding the impact of the ongoing global economic downturn on consumer buying patterns. While we do not have visibility into the timing or extent of an economic recovery, we continue to remain optimistic that our revenues will continue to grow.

Critical Accounting Policies and Estimates

Management's Discussion and Analysis of Financial Condition and Results of Operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP"), and pursuant to the rules and regulations of the SEC. The preparation of our consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosures of contingent assets and liabilities. On an ongoing basis, estimates and judgments are evaluated, including those related to business combinations; revenue recognition; allowance for doubtful accounts; valuations of goodwill, other intangible assets and long-lived assets; fair value of contingent consideration; stock-based compensation; and income taxes. These estimates and judgments are based on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, which form the basis for our judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. By their nature, estimates are subject to an inherent degree of uncertainty. Actual results may differ materially from these estimates. There has been no material change to our critical accounting policies and estimates from the information provided in our Annual Report on Form 10-K filed with the SEC on March 18, 2013.

Results of Operations

     Revenues

                                                                    Change
                                            2013       2012        $        %
                                                    ($ in thousands)
            Three months ended June 30,   $ 27,188   $ 21,754   $  5,434     25 %
            Six months ended June 30,     $ 59,916   $ 48,639   $ 11,277     23 %

Revenues for the three months ended June 30, 2013, compared to the same prior year period, included a decrease of $0.1 million in royalties recovered through intellectual property compliance and enforcement activities, which we characterize as "royalty recoveries." Revenues for the six months ended June 30, 2013, compared to the same prior year period, included a decrease of $2.4 million in royalty recoveries. Royalty recoveries may cause revenues to be higher than expected during a particular period and may not occur in subsequent periods. Therefore, unless otherwise noted, the impact of royalty recoveries has been excluded from our revenue discussions in order to provide a more meaningful and comparable analysis.

We have started integrating the licensing agreements acquired with SRS with the Company's agreements, and as a result, total revenue from licensing agreements acquired with SRS is no longer identifiable.

Excluding royalty recoveries, the increase in revenues for the three months ended June 30, 2013, compared to the same prior year period, was largely attributable to continued growth in royalties from network-connected markets. In dollar terms, these royalties were up 100% for the three months ended June 30, 2013, compared to the same prior year period. Also, these royalties comprised over 45% and 30% of revenues for the three months ended June 30, 2013 and 2012, respectively. The growth in network-connected markets was primarily driven by increased royalties from connected TVs. Partially offsetting the increase in network-connected markets was a decline in DVD related royalties and Blu-ray markets. DVD related royalties continued to decline as Blu-ray and network-connected devices


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become more mainstream. DVD related royalties comprised over 10% and 20% of revenues for the three months ended June 30, 2013 and 2012, respectively. In dollar terms, these royalties were down 19% for the three months ended June 30, 2013, compared to the same prior year period. The decline in royalties from the Blu-ray market was largely the result of softness in consumer demand. Blu-ray related royalties comprised over 15% and 25% of revenues for the three months ended June 30, 2013 and 2012, respectively. In dollar terms, these royalties were down 10% for the three months ended June 30, 2013, compared to the same prior year period. We remain cautious regarding the outlook for the consumer electronics industry as a whole, and the revenues we derive from that industry, in light of ongoing global economic challenges. However, we expect to see continued growth from the network-connected markets, as we expand our footprint in terms of both products and geographies served.

Excluding royalty recoveries, the increase in revenues for the six months ended June 30, 2013, compared to the same prior year period, was largely attributable to continued growth in royalties from network-connected markets. In dollar terms, these royalties were up 158% for the six months ended June 30, 2013, compared to the same prior year period. Also, these royalties comprised over 45% and 20% of revenues for the six months ended June 30, 2013 and 2012, respectively. The growth in network-connected markets was primarily driven by increased royalties from connected TVs. Partially offsetting the increase in network-connected markets was a decline in the Blu-ray markets and DVD related royalties. The decline in royalties from the Blu-ray market was largely the result of softness in consumer demand. Blu-ray related royalties comprised over 20% and 30% of revenues for the six months ended June 30, 2013 and 2012, respectively. In dollar terms, these royalties were down 21% for the six months ended June 30, 2013, compared to the same prior year period. DVD related royalties continued to decline as Blu-ray and network-connected devices become more mainstream. DVD related royalties comprised over 10% and 20% of revenues for the six months ended June 30, 2013 and 2012, respectively. In dollar terms, these royalties were down 17% for the six months ended June 30, 2013, compared to the same prior year period.

     Gross Profit

                                                                    Percentage point change
                                 2013      %       2012      %      in gross profit margin
                                       ($ in thousands)
 Three months ended June 30,   $ 24,776     91 % $ 21,560     99 %                        (8 )%
 Six months ended June 30,     $ 55,182     92 % $ 48,251     99 %                        (7 )%

Our gross profit percentage for both periods decreased primarily due to the additional amortization of intangibles from our SRS and Phorus acquisitions.

Selling, General and Administrative ("SG&A")

                                                                    Change
                                            2013       2012        $       %
                                                    ($ in thousands)
            Three months ended June 30,   $ 18,749   $ 16,706   $ 2,043     12 %
            % of Revenue                        69 %       77 %
            Six months ended June 30,     $ 40,439   $ 31,989   $ 8,450     26 %
            % of Revenue                        67 %       66 %

The dollar increase in SG&A for both periods was primarily due to employee related costs, including our recent acquisitions of SRS and Phorus, and advertising and related activities for brand marketing and tradeshows. These increases were partially offset by decreased professional services costs due to the winding down of costs associated with our acquisition of SRS.


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We expect dollars spent on SG&A expenses to continue to increase, primarily to support activities such as new technology initiatives, international expansion and intellectual property enforcement.

     Research and Development ("R&D")

                                                                    Change
                                             2013      2012        $       %
                                                    ($ in thousands)
             Three months ended June 30,   $  7,842   $ 4,780   $ 3,062     64 %
             % of Revenue                        29 %      22 %
             Six months ended June 30,     $ 15,521   $ 9,290   $ 6,231     67 %
             % of Revenue                        26 %      19 %

The dollar increase in R&D for both periods was primarily due to employee related costs, including our recent acquisitions of SRS and Phorus, and consultant related expenses to support our growth and our investments in new technologies.

We intend to continue to invest in R&D to support the activities mentioned above, and thus expect to see growth in dollars spent through the remainder of the year.

Interest and Other Income (Expense), Net

Change
2013 2012 $ %
($ in thousands)

Three months ended June 30, $ (174 ) $ 2 $ (176 ) (8800 )% Six months ended June 30, $ (419 ) $ (86 ) $ (333 ) (387 )%

Interest and other income (expense), net, decreased for both periods primarily due to interest expense associated with our debt incurred to partially fund our acquisition of SRS and the effects of translation for certain foreign subsidiaries to the U.S. dollar or functional currency.

     Income Taxes

                                                 2013        2012
                                                 ($ in thousands)
                 Three months ended June 30,    $     38    $   831
                 Effective tax rate                   (2 )%    1093 %
                 Six months ended June 30,      $  2,362    $ 3,596
                 Effective tax rate                 (197 )%      52 %

Our effective quarterly tax rates are based in part upon projections of our annual pre-tax results. These rates differed from the U.S. statutory rate of 35% primarily due to non-creditable foreign withholding taxes and reserves for U.S. federal and state tax audits, partially offset by state research and development tax credits. Our effective tax rate for the six months ended June 30, 2013 was also high due to the change in the valuation allowance for federal deferred taxes, as realization of the deferred tax asset is deemed uncertain. Absent any tax planning strategies or until we establish a pattern of continuing profitability in the U.S., we expect our overall effective tax rate to be subject to significant variability for the foreseeable future as any tax benefit related to future U.S. losses will be offset by the valuation allowance. Our effective tax rate for the six months ended June 30, 2012 was also higher than the U.S. statutory rate due to certain non-deductible transaction costs associated with the acquisition of SRS.


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Liquidity and Capital Resources

At June 30, 2013, we had cash, cash equivalents and short-term investments of $71.7 million, compared to $72.0 million at December 31, 2012. At June 30, 2013, $44.6 million of cash, cash equivalents, and short-term investments was held by our foreign subsidiaries. If these funds are needed for our operations in the U.S., they would be subject to U.S. federal and state income taxes, less applicable foreign tax credits. However, except for China, our intent is to permanently reinvest funds outside of the U.S. and our current plans do not demonstrate a need to repatriate them to fund our U.S. operations.

Net cash provided by operating activities was $3.6 million and $10.6 million for the six months ended June 30, 2013 and 2012, respectively. Cash flows from operating activities consisted of net income (loss) adjusted for certain non-cash items, including stock-based compensation, depreciation and amortization and the effect of changes in working capital and other operating activities. The operating cash flows during the six months ended June 30, 2013 and 2012 were largely impacted by income (loss) from operations, partially offset by certain non-cash items. The operating cash flows during the six months ended June 30, 2013 were also impacted by the timing of payments for certain liabilities. Further, under existing service arrangements, we may be obligated to pay up to $8.1 million over the next three years if certain milestones are achieved.

The cash used in investing activities is typically used to purchase office equipment, fixtures, computer hardware and software and engineering and certification equipment, for securing patent and trademark protection for our proprietary technologies and brand name and to purchase investments such as bank certificates of deposit and municipal bonds. Net cash provided by investing activities totaled $8.6 million for the six months ended June 30, 2013. These cash flows resulted primarily from investment maturities, partially offset by investment purchases. Net cash used in investing activities totaled $10.7 million for the six months ended June 30, 2012. These cash flows resulted primarily from investment purchases, partially offset by investment maturities.

Net cash used in financing activities totaled $2.2 million for the six months ended June 30, 2013. These cash flows were primarily the result of treasury stock purchases and amounts used to satisfy statutory withholding requirements upon the vesting of restricted stock. Net cash provided by financing activities totaled $1.7 million for the six months ended June 30, 2012, which resulted primarily from the proceeds from the issuance of common stock under stock-based compensation plans, including the related tax benefits, partially offset by purchases of treasury stock.

Credit Facility

In connection with the consummation of the Merger, we entered into a Loan Agreement, dated as of July 18, 2012 (the "Loan Agreement"), between us and Union Bank, N.A., together with the other lenders thereunder from time to time. The Loan Agreement provides us with a $30.0 million revolving line of credit (the "Revolver"), with a five million sublimit for the issuance of standby and commercial letters of credit, to use to finance permitted acquisitions and for working capital and general corporate purposes. We may increase the Revolver by up to $20.0 million subject to certain conditions. Proceeds from the Revolver were used to finance the cash portion of the Merger consideration as mentioned above. As of June 30, 2013, $30.0 million was outstanding under the Revolver. All advances under the Revolver will become due and payable on July 18, 2015, or earlier in the event of a default. As of and for the three months ended June 30, . . .

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