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SRS Labs Inc. (NASDAQ:SRSL)

Q1 2006 Earnings Conference Call

May 11, 2006, 5:00pm Eastern

Executives

Thomas Yuen, Chairman and CEO

Ulrich Gottschling, Chief Financial Officer

Analysts

Adam Fischer, UBS

Steve Peak

Jai Kim

Operator

Welcome ladies and gentlemen. All participants are in a listen-only mode. Later we will conduct a question and answer session and instructions will follow at that time. If you should need audio assistance during the conference, please press star then zero on your touchtone telephone. As a reminder this conference is being recorded. I would now like to introduce your host for today’s conference, Mr. Ulrich Gottschling. Sir, you may begin the conference.

Presentation

Ulrich Gottschling, Chief Financial Officer

Thank you. Thank you, good afternoon and welcome to the SRS Labs 2006 Q1 earnings conference call. Before we start this afternoon’s call I would like to go over a couple of items. First, the press release of the results discussed here today has been filed with the SEC on form 8K. if you have not received the press release, it is available on our website at SRS Labs.com in the press section. Also, I would like to remind you this call is being recorded and a replay will be available starting this afternoon at 5pm pacific time, through May 18th, at 866-837-8032. You can hear the replay by dialing this number and entering the ID number 902570 when you hear the prompt. In addition, we are simultaneously web casting this call, and it can also be accessed on our website. I would like to now read our safe harbor statement.

Except for historical information contained in this release, statements in this release, including those of Mr. Yuen and myself, are forward looking statements and projections, which include statements concerning plans and objectives of management for future operations that are based on management beliefs as well as assumptions made by and information currently available to management. While the company believes that its expectations are based upon reasonable assumptions, there can be no assurances that the company’s goals and strategy will be realized. Numerous factors, including risks and uncertainties, may affect the company’s actual results and may cause results to differ materially from those expressed in forward looking statements made by or on behalf of the company. Some of these factors include uncertainties related to the sale of Valence Technology Ltd., and the divestiture of the company’s equity investment in the joint venture. The general market conditions concerning the semi-conductor business, the acceptance of new SRS Labs products and technologies, the impact of competitive products and pricing, the timely development and release of technology by the company, general business and economic conditions, especially in Asia and other factors detailed in the compnay’s form 10K and other periodic reports filed with the SEC. SRS Labs specifically disclaims any obligation to update or revise any forward looking statements, whether as a result of new information, future developments or otherwise.

I will start by giving an overview of the results from our continuing licensing operations.

Our licensing revenues for the first quarter increased to $4.3 million, representing a 32.8% increase for the quarter on a year over year basis. We realized revenue increases in all five product categories, notably in portable media devices which grew by 101% on a year over year basis and advanced displays, which grew by 74% on a year over year basis and in our automotive segment, which grew by 365% on a year over year basis. A breakdown of our licensing revenues for the quarter by category as a percentage of total revenues is as follows:

Home entertainment – 55%

Portable media devices – 20%

Personal computers – 9%

Personal telecommunications – 11%

Automotive – 5%.

On a sequential basis, we noted continued increases in our licensing revenues in Q1 2006 as compared to Q4 2005. Percentage increases were particularly strong in the advanced display segment which grew by 42%, the automotive segment which increased by 30% and the personal telecommunications segment which grew by 25%. We noted decreases in both the portable media devices and personal computer segments in Q1 2006, as compared to Q4 2005. Portable media devices and personal computer licensing revenues decreased by 15% and 10%, respectively. The decrease in portable media device revenues is primarily related to reporting cycles from various customers. The decrease in personal computer licensing revenues relates to the traditional shipment schedules of laptop computers around the holiday season.

Net income from continuing operations for the first quarter was $151,000 or $0.01 per share on 15.8 million weighted average diluted shares, as compared to income from continuing operations of $206,000 or $0.01 per diluted share for the same quarter during the previous year.

Total operating expenses from continuing operations for the first quarter of 2006 were $4.2 million or 95.9% of net sales, compared to $3.0 million or 92.9% of net sales for the first quarter of 2005. Included in the Q1 2006 operating expenses from continuing operations is $343,000 related to stock based compensation expense under FAS123R and $150,000 related to the company’s separation from its former Chief Financial Officer.

During the first quarter, the major categories of operating expenses from continuing operations were as follows:

Sales and marketing expenses were $1.9 million or 43.0% of revenues during 2006, compared to $1.2 million or 36.2% of revenues in 2005. This increase of $683,000 or 57.8% is primarily attributable to increased staffing and related costs, commissions on higher licensing revenues, increased marketing activities related to the enhancement of the company’s brand and $162,000 related to stock-based compensation under FAS123R. Research and development expenses were $654,000 or 15.1% of revenues during 2006, compared to $576,000 or 17.7% of revenues in 2005. This increase of $78,000 is due to the company’s recording of $127,000 of expense related to stock-based compensation under FAS123R, partially offset by a slight decrease in staffing and related costs. General and administrative expenses were $1.6 million or 37.8% of sales during 2006, compared to $1.3 million or 39.0% of sales during 2005. This increase is primarily attributable to increased legal and accounting professional fees, costs associated with the company’s separation from its former CFO and consulting agreements related to human resource management and investor relations activities. Additionally, the company recorded expense of $54,000 related to stock-based compensation under FAS123R.

Our effective tax rate was 51.3% as compared to 36.6% in 2005. The provision for income taxes during the first quarter 2006 is principally comprised of foreign withholding taxes relating to revenues realized from our customers in Korea.

Now for a short summary of discontinued operations, which is comprised of our semiconductor operations based in Hong Kong and our investment in the CHS-SRS, LLC joint venture. Our semiconductor revenues for the first quarter of 2006 increased to $2.1 million, representing an 8% increase for the quarter on a year over year basis. Net income from discontinued operations was $11,000 as compared to $15,000 during the first quarter of 2005. Our semiconductor operations recorded a loss of $83,000 for the first quarter of 2006 and the joint venture recorded net income of $94,000. The company did not allocate any overhead or administrative cost to the discontinued operations during the quarter. Additionally, we did record $56,000 of FAS123R charges related to our Valence Semiconductor operations. Total FAS123R charges for the quarter from both continuing and discontinuing operations is approximately $400,000.

To update our activities regarding the potential sale of either of our discontinued operations, we continue to have discussions with interested parties regarding Valence and/or the joint venture. We believe that these conversations have been productive and that progress is being made. However, we cannot provide any assurance at this time that we will be successful in locating a buyer of either of these operations at a price that we believe will be beneficial to our shareholder.

Turning to financial fundamentals, as of March 31, 2006, our balance sheet remains very strong, with $27.6 million of cash and investments available for sale, an increase of almost $1.8 million compared to December 31, 2005. Operating activities from continuing operations provided $1.5 million of cash flows for the quarter, an increase of over $300,000 as compared to the first quarter of 2005. Additionally, we recorded $915,000 of positive cash flow from the exercise of stock options during the first quarter of this year. Net cash used in discontinuing operations decreased from $1.1 million during the first quarter of ’05 to $190,000 during the first quarter of 2006. We continue to be free from external debt.

This concludes my discussion of the financial results and at this point I would like to turn the call over to Tom Yuen.

Thomas Yuen, Chairman and CEO

Thank you Ulrich for the excellent financial review. Hello and good afternoon everyone. Let me now review with you the performance of our licensing business.

The year over year as well as quarter over quarter sales growth we’ve logged is a strong foundation to begin 2006.

During Q1 2006 our revenue increased by 32.8% to $4.3 million from $3.3 million for the same period in 2005. Q1 licensing revenue represents more than 5 quarters of consistent revenue growth that was built upon the market acceptance of SRS technologies around the world.

Let us review the individual segments. Home entertainment. In Q1 we saw strong growth in advanced displace through the continued adoption of Wow-XT and True Surround XT technologies. Our platform partners for advanced displays continue to expand with our existing partner network including Micronys, TI, Phillips, NJRCST Micro and ADI as well as new relationships for digital TV and HDTV technology chips, which are being developed for the 2nd half of 2006 and 2007.

SRS Labs is fast becoming the standard audio technology supplier for advanced displays. Industry estimates that the advanced displays market unit shipment growth will be in excess of 60% a year. This growth potential bodes well for our presence in this segment.

Also, in this segment we saw revenue decrease from set top box segment. We are however seeing a resurgence in interest from quite a few set top box manufacturers for True Surround and its successor, True Surround XT. We are working with a number of set top box designers in Korea and Europe.

Now, to the PC segment. the total amount of revenue remains stable, with continued strong shipments from Toshiba. New customers beginning to ramp production this year were LG and Samsung. Samsung also showcased their new origami line of PCs recently at a trade show, enabled with SRS True-Surround XT features. Also, we worked with our platform partner, Realtech to gain new revenue opportunities among other PC manufacturers.

In the automotive section, circle surround automotive and WOW, with customized features for the challenges of the automobile environment, are two technologies that are being quickly adopted. We continue to see good growth in our Fujitsu parent business, as they expand their product offerings for key suppliers, including Toyota, Honda, Mazda, Daihatsu and Mitsubishi.

While we continue to see growth from after market and dealer installed products with partners including Kenwood, Pioneer and Panasonic. This quarter we’re in the process of confirming design wins for factory line installed automotive head in units such as those that are found in Toyota Avalon line, that should build a strong base for 2007 automotive revenue.

Now turning to portable media devices. The portable media device market is undergoing a transition. As iPod from Apple continues to gain market share, manufacturers are shifting production from Japan and Korea to China, as the price pressure for lower cost MP3 music players continues.

Video is becoming a key component to new portable devices. We have launched SRS Mobile HD, which is a complete solution for audio, video, headphone and surround sound playback.

Thus far, we have not been able to penetrate the Apple opportunity. However, rest assured that our sales force will continue to pursue this account. In the meanwhile, the popularity of the portable media player market has created a sizeable accessory market that makes a variety of items including products such as docking stations and headphones. We have received confirmation of design wins with a growing number of new customers in this accessory market.

Turning the personal telecomm segment. NAC continues to be our strongest partner in the mobile phone market supported by new wins at Samsung and select high end models of Motorola phones. Our strong platform partner relationship with Texas Instruments, a significant mobile phone chip supplier, continues to uncover new licensing opportunities for SRS technologies in the wireless marketplace.

We have also been successful in working with ring tone chip suppliers, such as OGI, to imbed SRS technology in these ring tone platforms that are marketed to mobile phone manufacturers in China and in Europe.

Let’s take a look at our marketing and let me also review with you our new marketing position. While SRS last participated in 5 market segments, the connections between these 5 segments are accelerating due to digital content distribution. We call this collective system the SRS Personal HD experience, where we’re enabling our customers to deliver home theatre style audio, no matter how consumers listen. Its importance is made clear by this year’s winter X Games, hosted by ESPN. For the fourth year in a row, ESPN broadcast the X-Games using our SRS Circle Surround, further reinforcing our traditional value to TV Set makers. What’s new, however, is that these X-Games were – for the first time – also made available over the internet using Apple’s iTunes service to iPods. Without making any changes, suddenly iTunes and the iPod were vehicles to deliver surround to SRS enabled devices. Users could simply download episodes off their iPod to their flat panel televisions with SRS true surround XT and secondly, they were getting the same surround sound experience via their portable media player that was previously only available via broadcast. The best thing about this is that our technologies, including SRS (inaudible) and SRS True Surround enabled this experience from all content formats. Dolby pro-logic, Dolby-digital, Windows Media, AAC MP3 and our own Circle Surround all worked to the advantage of this environment of connected devices with SRS Technologies.

As content distribution methods continue to evolve, we are well-positioned to help our customers, large and small, take advantage of this linked world with our SRS personal HD experience concept.

Let’s take a look at our R&D accomplishments. From the R&D point of view, we are pleased that aside from filing new patents in Q1, we have received a long awaited new and most important patent from the US patent office for our WOW technology. We have also successfully launched our new technology mobile HD for both the mobile phone market and new generations of personal media players. As for Q2 and the rest of the year, business continues to look positive. To make sure that we can deliver on this promising outlook we have three major action items plans. Our first action plan is to drive sales and continue to accelerate our topline growth. We have added new sales staff in Asia-Pacific and we staffed our Europe sales team as part of the actions to accelerate sales. Increasing sales combined with our operating model should enable us to deliver the bottom line benefits of our exceptionally favorably high 98% gross margin business. In the near term, the record growth of the flat panel TVs and our success in this market is expected to be one of the more important key revenue drivers for us.

Our second action item relates to harnessing further values from our intellectual properties. We have close to 200 issued and pending patents. As our rich and comprehensive patent portfolio continues to grow, we intend to study other potential avenues of business opportunities by leveraging on our intellectual properties. The recently issued WOW patent and several other key patents in our portfolio are the centerpieces for new IP initiatives. These initiatives could include IP producing, IP enforcement, sub-licensing and cross-licensing, which – when implemented – can help generate additional revenue for us.

Our third agenda is to redefine our mobile phone strategy. To date, our efforts in the mobile phone area have yielded modest success. As the growth of mobile phone continues, it is imperative that we need to better strategize our plan to address this huge market potential. The recent introductions of technology such as mobile HD, X-bass, have made our offerings more comprehensive and compelling solutions to the mobile phone OEMs. Our goal is to have a better strategy and focus to capture more of this market with the advantage of our technologies and mobile IT platforms that have SRS technologies already imbedded in them.

So, in closing, I’m very pleased with another consecutive record-breaking quarter. With both the Valence and Segus issues soon behind us, our management team can now be able to better focus on our core business, accelerate the positive momentum of the licensing business, increase sales, increase profits, and thus increase our shareholder value.

I look forward to another exciting update next quarter and thank you for your support.

Ulrich Gottschling, Chief Financial Officer

Operator, we would like to turn this call over for questions and answers.

Question-and-Answer Session

Operator

If you have a question at this time, please press the one key on your touchtone telephone. If your question has been answered or you wish to remove yourself from the cue, please press the pound key. Again, if you have a question, please press the one key.

Our first question comes from Steve Peak. Your question please?

Steve Peak.

Hello. I have a couple of questions. Firstly, could you run through the cost structure in Q1? How much of the costs, if any, are still related to Valence? And is that at all separated…is that entirely separated from the results you just reported? And second, how much of the costs may be one time and how much of the costs are investment, future investment for the business that you’re not really deriving revenue from but you would expect to be able to leverage those costs as you go forward and grow?

Ulrich Gottschling, Chief Financial Officer

Steve, thank you .a couple of very good questions. We’ll start with the Valence question. We have completely separated all of the expenses between Valence into discontinued operations. So what you see in continuing operations relates only to the licensing business. So there’s no mix there between the two at all. We do not allocate any of our overhead expenses here to Valence as a discontinued operation. So this is all of the costs associated with the licensing business. Regarding your second question as to what are one time charges, what are ongoing charges and those types of things, we’ve been very consistent in stating that Q1 happens to be one of our larger expense quarter our of the year. In fact, its typically the largest due to a couple of reasons. On the sales and marketing side, the largest trade show of the year –CES - is in Q1 and we expense that currently as part of our Q1 expenses. Secondly on the admin side, the annual report, the annual audit, those kinds of activities are principally all in Q1, a little bit into Q2 as we get ready for our shareholder meeting. But for the most part there’s a large legal and accounting expense that’s recorded in Q1 to audit the financial statements in both this company as well as Valence.

In terms of what, in this quarter, were one time charges that may or may not recur in the future. As you’re aware, our former CFO was still involved with the company during Q1, so there were costs of essentially having both myself and the former CFO in the company in Q1, as well as the transition agreement that we had entered into with her. So my expectation is that there’s probably somewhere in the neighborhood of on a fully loaded basis, $225,000 in Q1 that we would not expect to have going forward as it relates to G&A. the rest of eh charges as G&A is concerned appear to be recurring charges, again with the exception of costs associated with the annual audit and annual report. It is our goal to really look very diligently at all of or costs in G&A and continue to try to maximize what we can from those and eliminate those that really aren’t necessary.

Steve Peak.

Okay and then one last part is, how much of the costs were hiring staff in the Asia and Europe expansion plans, which maybe you’re not really seeing any revenue from but you made those costs strategically and in anticipation of growth ahead.

Ulrich Gottschling, Chief Financial Officer

Okay. Good question Steve. We did not incur any recruitment charges that I can think of in Q1 related to those individuals. This individual in Europe came on board in April, the individual in Taiwan came on real late in March or the beginning of April. So there really aren’t any costs associated in Q1 with those individuals. So, we have no recruiting expense and principally no costs associated with those individuals in Q1 at all.

Steve Peak.

Okay and with the options cost, how come it was broken down into three separate sub-categories? And what can y9ou do to control that going forward?

Ulrich Gottschling, Chief Financial Officer

There’s a couple of things that are going on. One is under the accounting pronouncement 123R, there is a requirement to allocate the cost of the stock options to the exact cost centers that those individuals are related to. So for some companies that actually have inventory and cost of goods sold, it would be included in those items in addition to their costs that they may have as it relates to G&A or R&D or sales and marketing. We have undertaken an initiative here, in fact this goes back already for a couple of years, whereby the company through its comp committee which is extremely active in this area in managing our stock options, is really taking a hard look at making sure that our stock option grants are in line with industry statistics, in line with what’s going on in the market place and we have seen a dramatic decrease in the amount of stock options that we’re granting to employees. We expect that trend to continue. You’ll also note and one of the things that’s included in our proxy for this year, is that we’re actually terminating the 1996 stock option plan, which has a little bit over 2 million shares still available to be granted under, and we’re replacing it with a 2006 stock option plan, whereby we’ve affirmatively stated that we’re actually going to reduce down to a maximum of 1.5 million shares, the amount of options that we would issue over time through that plan. So not only are we affirmatively reducing the amount that we’re issuing on an annual basis to our employees and to new employees, but we’re also attempting to initiative a new plan which will further reduce the potential dilutive nature of those options.

Steve Peak.

Okay. And one more new thing I heard. The idea behind utilizing the intellectual property in the patent portfolio. Could you elaborate a little bit on how that would work? I presume these would be for products which don’t really have a competitive overlap with the existing suite of products that you’re offering. But, maybe the technology is applicable? Could you just elaborate on how that might work and what type of customers may have demand for the intellectual property or the patent portfolio?

Ulrich Gottschling, Chief Financial Officer

One of the things that we’re initiating to undertake here is a compliance program of sorts, as it relates to reporting of royalties from our customers, as it relates to the technology that we believe that we have protected and have rights to and making sure that other people do not encroach upon those rights. But also, we want to take a look at the tremendous amount of technology that the company’s developed over the last 13 years and see if there aren’t any applications outside of what we currently use that technology for, and see if there aren’t other individuals who might license that from us and distribute that technology through completely different kinds of distribution systems to different kinds of products that we really have no knowledge in and no interest to pursue on our own. So it’s a matter of taking those assets and trying to fully monetize the value that’s in those assets, rather than just allowing them to sit there without realizing anything for our shareholders.

Steve Peak.

Okay, so that would be beyond consumer electronic even?

Ulrich Gottschling, Chief Financial Officer

It may very well be.

Steve Peak.

Okay great, thanks. I’ll free up the call for other people.

Operator:

Again if you have a question, please press the one key.

Our next question comes from Adam Fischer. Your question please?

Adam Fischer.

Hey guys, how’s it going? Tom, you mentioned, I think when you were talking about the cell phone opportunity, a hand Motorola phone, which is not a client that you guys had disclosed previously. Did I hear you correctly?

Thomas Yuen.

Yes, Motorola has publicized actually that they have used our technology in one of their new offerings. It’s not a high volume line, but nonetheless, it’s a high-end. I think it could lead into future access to the Motorola opportunity.

Adam Fischer.

And that phone is shipping now?

Thomas Yuen.

Yes, I believe so.

Adam Fischer.

In the states or overseas?

Thomas Yuen.

It’s in the US.

Adam Fischer.

Great. That’s a great opportunity. I just wanted to make sure I heard you correctly. When you talk about the auto opportunity, you obviously sound like it’s expanded a lot recently. Do you foresee that being … I think you said you really see that as an ’07 event. Should we start seeing revenues later on this year or will the bulk of that be in ’07?

Thomas Yuen.

There is the automotive segment, it continues to grow. I think that some of the revenue, the new opportunities could start as early as late 2006. but really, the volume I think we expect is in 2007.

Ulrich Gottschling, Chief Financial Officer

Adam, let me follow up on that a little bit. Q1 ’06 to Q1 ’05 was a 365% increase in automotive revenues. Now as we’ve talked about in the past, the number so far has been relatively small so…it isn’t overly difficult to get to a high percentage increase because the number is small. But nonetheless we are starting to see some good traction in that area and as we’ve publicly stated in the past, we feel that this is a growing opportunity for us, we’re hopeful that we’ll be able to capitalize on it as we move not only more into high end models, but also start looking at getting into more of the volume models as well.

Adam Fischer.

Great. And then Tom, one last thing. You mentioned redefining our phone strategy. But I was just looking for some more detail to that. What parts of the strategy do you feel didn’t work the first go-round? What do you think you need to do to win new customers going forward?

Thomas Yuen.

I think that a recent executive that we have recruited, namely our VP of Marketing, has a tremendous amount of success in his former company in terms of the strategy for addressing mobile phone segment. so we think that we have laid a lot of the foundation pieces, but with a seasoned expert in successful licensing of technology to cell phones, I think David is essentially chartered to look at what we have done right and what we have done wrong and also the recent introductions that he lead of the mobile HD, is part of his contribution come up with a more definitive and more aggressive approach to crack this market again.

Adam Fischer.

Was he a part of the Motorola win or was that a win that came before he… I know he’s relatively new.

Thomas Yuen.

Motorola is a long time exercise for us. The mobile phone market remains a fairly patient market because of the volume and because of the competition. Generally, it takes quite a long time, sometimes in excess of a couple of years to close a deal. So the Motorola situation is a relationship that we have courted for almost 3 ½ years.

Adam Fischer.

Great thanks. Good quarter. Thank you.

Operator.

Our next question comes from Jai Kim. Your question please?

Jai Kim.

I’m just curious here. It seems to me that the first call numbers that are out there for your guys. They seem a little bit stale. But that being said, am I doing the calculation right if you back out or add back in the stock-based comp and the CFO termination expenses that you get reasonably close to the $0.04 that’s printed anyway?

Ulrich Gottschling, Chief Financial Officer

I’m not sure what the $0.04 is, but clearly the cost between the stock-based compensation which we on a consolidated basis –meaning for both continued and discontinued operations – was about $400,000. Again, as we said, the total cost of having essentially two CFOs during the first quarter was about another $225,000. It would be reasonable to add, again if you took all that out, you would add that to our net income and you would certainly be in a scenario where it would be much, much higher. As to whether that’s $0.04, $0.05, it’s something that we need to stay away from in terms of making those kinds of statements. But again, those are costs that we incurred this quarter that are different than what the expectation was.

Jai Kim.

And, you guys generated it looks like $2 million in cash this quarter. Do you see the pace of cash flow actually, relative to your net income, to stay fairly consistently ahead or will there be variations in the quarters coming up?

Ulrich Gottschling, Chief Financial Officer

In terms of positive cash flows?

Jai Kim.

Yes.

Ulrich Gottschling, Chief Financial Officer

Well, as we’ve said, one of the things that was significant in Q1 was the exercise of a significant number of stock options which generated around $914,000 of cash for us this last quarter. We’re still continuing to see stock option exercises because the stock price has gone up quite a bit in the last couple of years and also we have a number of former employees that are on the clock to exercise those options that are in the money before they expire after their termination date with the company. We are pleased in the fact that we did generate almost $1.5 million of operating cash flows this last quarter, from continuing operations. I don’t think that we feel that there’s anything right now that would cause us to believe that our cash flow situation would be any different than what we’ve been experiencing. We generally don’t have to issue or deal with a lot of accounts receivable, because most of our licensees pay us concurrent with their reporting. We don’t have a significant and won’t have a significant investment in additional fixed assets. So we’d like to think we’ll continue on generating good, positive cash flows.

Jai Kim.

And way back when, there was some seasonality to the business, a couple of years back. It seems like its getting less seasonal and when you look at some of the line items that you have, the home theatre kind of growing and the auto as a new category coming up, do you think and I’m not asking for guidance but just a characterization if you will of the scope of the curve throughout the year… do you think that the positives and negatives will kind of wash our and we’ll see fairly consistent growth in the licensing for the remainder of the year? Or should we expect some sort of variances?

Thomas Yuen

I think that last year we saw for the first time that the seasonality phenomenon sorty of changed and we had a more steady quarter after quarter type of performance. I think a lot of that has to do with the segments. The diversification I think, in essence, that those segments tried to balance each other out. Additionally, in general, when we have 5 segments, from the micro vs. the macro, we still have a lot of percentage to grow in each segment. so consequently, we expect in the near term…I think the growth of these segments may mask our the seasonality that we saw previously. As we in Q1 are looking at the pipeline and looking at the situation, we feel pretty comfortable that we may be developing a new trend where seasonality is not a significant swing.

Jai Kim.

Perfect, I’ll jump back in the cue. Thanks.

Operator:

Next we have a follow up question from Steve Peak. Your question please?

Steve Peak.

I just wanted to follow up with the tax rate. You had mentioned some items in Korea. The tax rate has been quite volatile. What should we anticipate as something which would be a normal tax rate?

Ulrich Gottschling, Chief Financial Officer

As we stated in the 10K that we filed at March 23, we continue to have for the US purposes a significant net operating loss carried forward for both Federal and state of California purposes. So our expectation is that our taxes in the US will continue to be very nominal. There are also tax treaties in place with some of our other geographic areas, which contribute heavy revenues to us. For example, Japan. One area in which there is no tax treaty between the US and the foreign entity is Korea. And we are currently operating under a scenario whereby we have a statutory foreign withholding rate that is applied to all of our sales; I believe that rate is 16.5%. to the extent that we have good sales from our customers in Korea, for example LG and Samsung, all amounts that are remitted to us – there’s a 16.5% withholding on that. We’re looking at ways to hopefully minimize that exposure and minimize that tax event to us. But right now, that’s the scenario that we have going forward. So to the extent that Korea continues to generate significant revenues for us, we will continue to have that 16.5% withholding tax on those revenues.

Steve Peak.

So in the 10K did you have an expectation of what a normalized tax rate would be?

Ulrich Gottschling, Chief Financial Officer

Again, depending on what percentage of revenue that Korea would be as a total percentage of our revenues, that’s what’s going to drive the tax rate. So if Korea represents half of our taxes, we would have a tax rate of around 8.25%, if it was 25% of our revenues, it would be down to 4%, and so on. Right now, statutorially, there isn’t much that we can do unless we create a different kind of entity structure there, which we’re taking a look at.

Steve Peak.

Okay, but wasn’t the rate much higher than that this past quarter?

Ulrich Gottschling, Chief Financial Officer

It was only higher because of the fact that we only had approximately $200,000 pre-tax income and because of our tax due to the revenues from Korea, it created a (inaudible) rate. Okay?

Steve Peak.

Got it. And in terms of…do you have a timeframe on when you hope to spin off Valence? And, even if that’s somewhat unclear, what would be a good expectation for the use of the proceeds from the sale? Because there’s already a lot of cash on the balance sheet. What are your thoughts on where the proceeds will go?

Ulrich Gottschling, Chief Financial Officer

Let’s address the timetable first, Steve. We are in discussions with a number of individuals and we’ve been straightforward with that. Kaufman Brothers, who is the party that’s helping us with that transaction, we’re working on trying to narrow down the specific bidders. We’re trying to get to where we feel like we have a good agreement that’s beneficial to both our stock holders as well as the folks that would acquire Valence, so that they can make a real go of it and make it be a successful organization. That timetable is moving forward. My expectation is that we should be able to announce something within the next couple of months relative to that. And, we’re hopeful that we’re going to be able to reach a conclusion on that. The second part of your question, Steve, if you could repeat that?

Steve Peak.

The use of the proceeds.

Ulrich Gottschling, Chief Financial Officer

Right now, one of the things that we’ve been straightforward about is the fact that we want to focus in on the licensing business. We believe that this is probably the best use of our time and energy right now – to focus on that and to get away from all of the other distractions. Ideally, having a lot of cash in relatively low risk, low interest rate type investments, isn’t necessarily the best use of cash, but for the time being, we think that it’s the best place for us to be so that we don’t go back and get distracted from what it is that we should be doing, which is generating licensing revenues with 98-99% gross margins.

Steve Peak.

If the cash balances…you have positive cash flows from operations and you may get a one time cash infusion, would you consider maybe ramping up the share repurchase?

Ulrich Gottschling, Chief Financial Officer

It’s certainly something that we would consider doing, absolutely. We’ve been, as I understand it over the last several years, we’ve done that when we though it was advantageous to do that. And if the board and management feel that it was the right thing to do, we would certainly initiate that. It’s certainly an option.

Steve Peak.

Okay and last question. In the past you’ve given a breakdown of the home theatre revenues by TV, DVD and set top box. Do you have that?

Ulrich Gottschling, Chief Financial Officer

I’m not sure that we’ve ever given a significant breakdown on that and I apologize, I could be wrong on that.

Steve Peak.

Usually percentages.

Ulrich Gottschling, Chief Financial Officer

I can give you some trends if you will. Clearly the advanced displays, as we talked about, is growing quite nicely, it’s growing very rapidly. Where we’re seeing come deterioration is on the CRTs, which is what we would expect. Although, we’re working on trying to come up with an initiative where we feel like we can continue to play real well in that arena. For the most part, set top boxes, DVDs and AV receivers, collectively it’s just not a significant number anymore as it relates to that. The same with the home theatre in a box. By far, the biggest driver in the home entertainment market is now the flat panel advanced display audio.

Steve Peak.

Okay, great. Thank you.

Operator:

Next we have a follow up question from Jai Kim. You question please?

Jai Kim.

Hey guys. Just two questions. And Tom, I apologize, I know I have a tendency of asking fairly esoteric questions. But, when you take a look at your licensees. On average, do you know what the number of SKUs are? The average number of products that a licensee takes? For example, circles at around plus x, y and z and is there an opportunity for you to keep stacking, if you will, more and more? And what do you think that ARPU could get to, if you will?

Thomas Yuen.

I think, unfortunately, we have really based on previous conversations, we tried to start to really tally up the SKUs. Unfortunately, the person that was in charge has left the company and we have just finally recruited another royalty administrative accountant. And so we are trying to resume that. And so, I apologize. It was a very interesting suggestion and we did try to follow up with that. So I hope that by the next conference call or before that, we’ll be able to give some idea in terms of the number of SKUs in the segments.

Jai Kim.

Okay. And, the other question that I had was related to your sales force. have you guys ever disclosed how many people you have on the sale force and your plans on what that number could grow to and what the quotas are like and trending toward?

Thomas Yuen.

We have never gotten to that detail. But I think that we are very careful in addition of headcount. So, the recent additions are really … one was to re-staff Europe, which we used to have, and also the increasing and pending opportunities in China and Taiwan that prompted us to add the extra sales person. We are also studying new areas that we may have representatives that are basically on a pay for performance basis. At this moment, I think we have roughly about a little bit more than a dozen sales people. And that’s pretty adequate for what we need to grow the business.

Jai Kim.

And that would suggest a ballpark million dollar number per sales person, per year?

Thomas Yuen.

Well, the business is really scaleable. And so, I think it takes as much manpower to sell, to license someone for 100,000 units or 1 million units. So, we are more increasingly looking at prioritizing our target licensees so that we can really maximize our revenue earnings potential per license event. So, it is not like selling goods, where generally you can quota a salesperson by units, per se.

Jai Kim.

Fair enough. I’ll back off now, thanks.

Operator:

Thank you. At this time I show no further questions.

Ulrich Gottschling, Chief Financial Officer

In closing, we’d like to thank everyone for your participation today and once again, if you would like a copy of the news release or would like to listen to the audio replay, please visit our website, SRSLABS.com and we look forward to speaking with you again at our next conference call. Thank you very much.

Operator:

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program. You may now disconnect.

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Source: SRS Labs Inc. Q1 2006 Earnings Conference Call Transcript (SRSL)
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