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SRS Labs Inc. (SRSL)

Q2 2006 Earnings Conference Call

August 8, 2006, 5:00 pm ET

Executives

Thomas Yuen - Chairman and CEO

Ulrich Gottschling - Chief Financial Officer

Analysts

Anthony Stoss - Craig-Hallum Capital

Andrew - Barnum

Presentation

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, Ulrich Gottschling. You may begin, sir.

Ulrich Gottschling - Chief Financial Officer

Thank you and good afternoon, and welcome to the SRS Labs 2006 Q2 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 to discuss here today filed with the SEC on form 8-K. If you have not received the press release, it is available on our website at www.srslabs.com in the press section. Also, I would like to remind you that this call is being recorded and a replay will be available through tomorrow evening at 888-211-2648. You can hear the replay by dialing this number and then entering ID number, 943509. In addition, we are simultaneously web casting this call and it can be accessed on our website for the next 60 days.

I would now like to read our Safe Harbor statement. Except for historical information contained in this release, statements in this release, including those of Mr. Yuen and Mr. Gottschling, are forward-looking statements and projections, which include statements concerning plans and beliefs of management for future operations that are based on management’s belief 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 strategies 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, the general market conditions concerning the semiconductor 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 company’s Form 10-K and other periodic reports filed with the SEC. SRS Labs specifically disclaims any obligation to update or revise 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 operations for the three months ended June 30th 2006. Our licensing revenues for Q2 increased to $4.3 million, representing a 20.3% increase for the quarter on a year-over-year basis. We realized strong revenues in all five product categories, notably in advanced display which grew by 101% on a year-over-year basis and in automotive which grew by 111% on a year-over-year basis. Overall, the home entertainment segment grew by 39% on a year-over-year basis, personal computers increased by 35%, and portable media devices and personal telecommunications decreased by 6% and 16% respectively. These fluctuations are representative of the consumer electronics marketplace and validate our strategy leveraging on five distinct segments. Tom Yuen, who will introduce momentarily, will provide a more detailed explanation on market segment fluctuations.

A breakdown of our licensing revenues for the quarter by category and as a percentage of total revenues is as follow: Home entertainment 54%, portable media devices 19%, personal computers 10%, personal telecommunications 11%, and automotive 7%. Net income from continuing operations for the quarter was $406,000 or $0.02 per diluted share on $16.3 million weighted average diluted shares as compared to income from continuing operations of $435,000 or $0.03 per diluted share on $14.9 million weighted average diluted shares for the same quarter during the previous year. Excluding the charges related to stock-based compensation under FAS 123R, net income for the quarter increased by 72% as compared to Q2 of 02005. We are very pleased with the progress we are making. Total operating expenses from continuing operations for Q2 of 2006 were $3.9 million or 91.0% of net sales compared to $3.0 million or 84.8% of net sales for the same quarter of 2005. Included in Q2 of 2006 operating expenses is a total of $344,000 related to stock based compensation expense under FAS123R which we adopted at the beginning of this year.

The major categories of operating expenses were as follows. Sales and marketing expenses were $1.9 million or 43.0% of revenues compare to $1.0 million or 29.0% of revenues in 2005. This increase of $859,000 or 83.7% is primarily attributable to increased sales headcount in overseas markets, increased commissions on higher revenues, and increased marketing expenses including headcount in the United States related to efforts to enhance the company’s brand. Additionally included in sales and marketing expenses for Q2 2006 is $136,000 related to stock based compensation under FAS123R. Research and development expenses were $632,000 or 14.8% of revenue compared to $548,000 or 15.5% of revenue in 2005. This increase of $84,000 or 15-½% is primarily do the company recording $75,000 of expense related to stock based compensation under FAS123R. General and administrative expenses were $1.4 million or 31.9% of sales compared to $1.4 million or 40.3% of sales during 2005. This decrease of approximately $70,000 is primarily attributable to decreased professional fees offset partially by $133,000 of stock based expenses related to 123R.

Our effective tax rate was 29.2% as compared to 27.9% in 2005. The provision for income taxes during Q2 of 2006 is principally comprised of foreign withholding taxes relating to revenues realized from our customers in Korea and Taiwan. Now for very a short summary of discontinued operations, which is comprised of our semiconductor operations based in Hong Kong and our investment in the CHS-SRS, LLT joint venture. Our semiconductor revenues for Q2 of 2006 were $2.2 million representing a 12% decrease for the quarter on a year over year basis. Net income from the semiconductor business was $151,000. The company did not allocate any overhead or administrative cost to any of its discontinued operations during the quarter. On July 14th of this year we announced that we are entered into a definitive sale and purchase agreement to sell are interested in Valence. We expect the transaction to close during this Q3 subject to customary shareholder and regulatory approvals. As we previously announced we also complete the sale our interest in the CHS SRS LLT effective June 30th and recorded a gain on sale of $371,000 during the Q2. I will not provide an overview of the results from continuing operations for the six months ended June 30th.

Our licensing revenues for the six months increased to $8.6 million representing a 26.3% increase for the period on a year over year basis. We realized strong revenue in all product categories notably in advanced displays, which grew by over 93% on a year over year basis and in automotive, which increased by 177% on a year over year basis. Overall the home entertainment segment increased by 25%, portable media devices increase by 30%, personal telecommunications increased by 11%, and personal computers increased by 13%. We are very pleased that we realized revenue increases in all five of our market segments. Our breakdown of the licensing revenues for the period by category and as a percentage of total revenues is as follows. Home entertainment 54%, portable media devices 20%, personal computers 9%, personal telecommunications 11%, and automotive 6%. Net income from continuing operations for the first six months of 2006 was $557,000 for $0.3 per share on $16.2 weighted average diluted shares, as compared to $642,000 or $0.4 per diluted share on $15.0 million weighted average diluted shares for the same period during the previous year.

Excluding the charges related to stock-based compensation, net income increased over 93% for the six moth period as compared to 2005. Total operating expenses from continuing operations for the first half of 2006 were $8 million or 93.4% of net sales compared to $6 million or 88.7% of net sales in the first half of 2005. Included in the 2006 operating expenses is $867,000 related to stock based compensation under FAS123R which was adopted at the beginning of this year. During the period the major categories of consolidated operating expenses were as follows. Sales and marketing expenses were $3.8 million or 43.6% of revenues compared to $2.2 million or 32.5% of revenues in 2005. This increase of $1.5 million or approximately 70% is primarily attributable to increased sales headcount, increase commissions on higher revenues and increased marketing expenses related to efforts to enhance the company’s brand. Additionally included in sales and marketing expense for 2006 is $299,000 related to stock-based compensation. Research and development expenses were $1.3 million or 15.0% of revenues compared to $1.1 million or 16.5% of revenues in 2005. This increase of $162,000 or 14.4% is due to the company recording $202,000 of expense related to stock-based compensation under FAS123R.

General and administrative expenses were $3.0 million or 34.8% of sales compared to $2.7 million or 39.7% of sales during 2005. This increase is primarily attributable to increased professional fees and $187,000 related to stock-based compensation under FAS123R. Our effective tax rate was 37.0% as compared to 30.9% in 2005. The provision for income taxes during the first half of 2006 is primarily comprised of foreign withholding taxes relating to revenues realized from our customers in Korea and Taiwan. Turning to financial fundamentals, as of June 30th 2006 our balance sheet remains very strong with $29.1 million in cash and investments available for sale, an increase of almost $3.3 million as compared to December 31, 2005. Operating activities from continuing operations provided $1.9 million of cash flows for the six months ended June 30th. An additional $1.9 million of cash flows was realized from the exercise of employee stock options during this first six months of 2006. Net cash provided by discontinued operations was approximately $7,000 and we continued 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 Yeun.

Thomas Yuen - Chairman and CEO

Thank you Ulrich for the financial review. Hello everyone and good afternoon. Let me review with you our Q2 performance. As Ulrich has noted we had an excellent Q2. During Q2 of 2006 revenue increase by 20% to $4.3 million from $3.6 million for the same period in 2005. The result represents a new Q2 sales record for SRS. Our strategy enables us to continue to gain OEM and consumer acceptance of our work class audio enhancement technologies which contributes to our strong results. Even with the new required non-cash stock option charges, our operating income came in at a respectable $406,000. Let me review with you the exciting progress we have made with our five segments. First, let’s take a look at the home entertainment segment. In Q2 flat panel displays on a worldwide basis continues to experience exclusive growth. Licensing revenue from this segment benefited directly by this favorable trend. Our popular technology such as Wow and True Surround XT are being adopted by increasing numbers of manufacturers. Many models are being introduce by existing OEM such as Samsung, Sony, LG and Toshiba. We also welcome products from new OEM such as Sharp and Panasonic. More excitingly our additional coverage of sales executive in the European region has quickly bring to bear final contract discussions with major volume TV manufactures in Europe.

We continued to work with our market share leading platform partners such as Micronys, TI, Phillips, NJRCST Micro and ADI. We are also working with a host of new relationships with the digital TV and high definition TV technology chip makers who are beginning to market these new ICs in the near future. By working with our platform partners we are well positioned to accelerate our sales by codetailing the powerful growth phenomena of the flat panel TV. This clearly sets the stage to solidify the leadership of our technologies in this market segment. To further our lead in this segment, already our sales force has been previewing newer technologies to our partners and OEMs to support their new audio feature needs. We are also introducing new offerings, the reach of our IT coverage through the variety of size and price ranges of these segment. We are aiming to increase our market share and make SRS Lab Technology a standard feature for advanced display HDTVs and standard CRT based TVs. Industry estimates that the advanced display market unit segment growth will be in excess of 60% per year. This is an excellent market to leverage upon and to grow our business.

Now for a look at our PC segment. During the quarter our revenue grew 35% with continued strong shipments from Toshiba. New customers beginning to ramp production this quarter, were LG and Samsung. The industry is anticipating the New Vista operating system from Microsoft and by working with our OEM’s our platforms, such as RealTel, SigmaTel, ADI and of course with Microsoft. We are preparing to welcome this new system, new compatible technologies end of this year. Now on to the portable media device segment, as noticed during our last call, portable media device market is undergoing a change, 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 continue. Yet, we yet have to win Apple’s iPod business. We saw some decline in revenue during the quarter, especially from Samsung, as they’re revising their mp3 MPMP strategy. However, we are pleased that we are secured many design wins with OEM platform partners in Q2, that should result in an improved revenue from this market segment in the near future quarter. Furthermore, we are able to leverage on the accessory after market created by the iPod and other mp3 players. Many companies are already commanding very good volume businesses selling audio accessory products such as iPod docking speakers, headphones, etc. We are making strong inroads in this accessory business and increasing our licensing, such as Memorex and GPI, just to name a few.

Now on to the personal telecom segment, our revenue in this segment declined as one of our major licensee is encountering some market share loss. Nevertheless we are seeing a ramp up of cell phone segment business by other accounts such as Franteck in China. We are also excited that our WOW technology is being included in a very popular US based mobile phone that was launched late in Q2, which we begin to yield revenue in Q3 and Q4. We look forward to making an announcement with this customer in this quarter.

Now for the automotive segment. During the quarter sales have grown 111%, the automobile audio market generally has a long designing cycle which we have diligently pursued and invested in this market for years. By sowing the seeds in earlier years we are starting to harvest our work. The automotive and WOW are two technologies that are driving sales growth. Our licensee for (inaudible) is a major provider of audio end units for the car manufacturers, especially in Japan. They have expended their products offerings with our IP to key OEM’s, such as Toyota, Honda, Mazda, Daihatsu, and Mitsubishi etc. Aftermarket and dealer installed products are served by partners including Kenwood, Pioneer and Panasonic. With our new presence in Europe, we are also able to address several new automobile market opportunities there. Likewise, we are seeing opportunity developing in our Korea region where we have received confirmation of several new design wins this quarter that will result in further increases in revenue from the automotive segment starting next year. These wins are factory installations of major global automotive companies. The future revenue potential looks very encouraging and I believe that we are just beginning to see what may be the tip of the iceberg.

So in conclusion as you can see that we have great achievements and good potentials in nearly all five segments of our business. We’ve also achieved the best first six month’s sales record in licensing. In all the six, the first six months results were both rewarding and reassuring. During the six months we generated positive EPS, positive cash flow which continues to increase our cash, and we are remaining debt free. Our business outlook for the balance of the year continues to look great. The team spirit is high. We have just recently concluded a week long global sales and marketing meeting where our regional team leaders have reported that the demand for our branded technology continues to grow in all our sales regions and accelerating. The addition of our sales coverage in Europe has further identified significant near-term volume TV, and car automobile audio sounds business go up. The sales addition in Taiwan has also strengthened our support of manufacturers in the advanced display, cell phone, PC, and portable devices area. Based on the business deals in the pipeline, expanding number of new IC platforms and products sent in for certification, our second-half business remains strong and growing.

We have good sales activities and new technology plans for all five segments. And furthermore, early licensing revenue report from OEMs supports our optimism, especially reports of exceptional growth in the advanced display segment. And also as the shopping season is fast approaching, aside from revenue growth, we also expect to see an opportunity to realize increased retail brand presence as we anticipate many stores that will feature flat panel TVs with SRS logo displayed in front of it. Additionally, we are working with a major high end specialty retail and catalog, Merchandizing Company that will feature many premium consumer products, featuring SRS technology in the coming season. A planned promotion of these products will provide tremendous retail and in print visibility for our brand. This will undoubtedly strengthen the value of the SRS logo for years to come. With the corporate refocus and licensing being our principal business, we have defined and communicated our plans for our team to achieve a set of laser-focused business objectives.

Our team spirit is reinvigorated by a recent record setting results and still accelerating global brand visibility, and the team is eager to execute our plan to grow both the top line and bottom line. The second half is shaping up to be a very promising period for us. So I look forward to another substantial update next quarter and thank you very much.

Thomas Yuen

I would like to have the operator if available, open up the floor for questions. I guess we’ve maybe lost our operator so we’d like to open the floor directly for anyone that has any questions.

Question-and-Answer-Session

Anthony Stoss - Craig-Hallum

Ulrich, can you hear me?

Ulrich Gottschling

We can

Anthony Stoss - Craig-Hallum

I’ll jump in, this is Anthony Stoss from Craig-Hallum.

Ulrich Gottschling

Hi, Anthony, how are you?

Anthony Stoss - Craig-Hallum

How are you?

Ulrich Gottschling

I’m good, thank you.

Anthony Stoss - Craig-Hallum

Can you give a little update on if anything changed the -- for pricing per se in your industry, I guess that’s the first question?

Ulrich Gottschling

You kind of broke up a little bit there I guess, was your question for Tom and myself, whether we are seeing any changes in pricing in our industry?

Anthony Stoss - Craig-Hallum

That’s correct.

Ulrich Gottschling

Up until now we haven’t noticed anything, Tony, we continue to try to be as optimistic as we can and hold to our price points where it’s -- to do so. Obviously, we shared with you and with others in the past that to the extent we want to move into a lower price higher volume type products that we would need to be conscientious of the price points related to that, but up until now we haven’t noticed any kind of deterioration in any respect.

Anthony Stoss - Craig-Hallum

Okay. Second, you know a follow up on the Opex lines for Q3, anything we should be aware of as this you know -- previous number to Q2 numbers?

Ulrich Gottschling

There isn’t any thing that I can -- you know we are kind of stay away from doing projections and forecast on those type of things for financial but right now I’m not aware of any thing that would cause us to believe that we should be expecting any kind of a material change.

Anthony Stoss - Craig-Hallum

Okay what’s your headcount now and do have any plans to expand that dramatically?

Ulrich Gottschling

The headcount here in the US is approximately 45 or so and then with the international sales consultants we’ll probably have another 20, 25 folks. We continue to be opportunistic, we are indeed looking for a couple of more R&D individuals, we have some very specific needs as we’ve shared with you and others, those needs relate not necessarily to pure R&D development, but more to the implementation of our technologies you know things such as technical writers, field engineers and those kinds of activities. We are continuing to look to expand our sales force in China and we will look to do so in other areas as well whether here in the US, in Europe or Taiwan for that matter.

Anthony Stoss - Craig-Hallum

Okay great, thank you.

Ulrich Gottschling

Any other questions this afternoon?

Andrew - Barnum

Ulrich can you hear me?

Ulrich Gottschling

Yes.

Andrew - Barnum

Hi this is Andrew (inaudible) from Barnum.

Ulrich Gottschling

Hi Andrew, how are you?

Andrew - Barnum

Good. I want to just follow up a couple of questions, I guess first in the advanced display side. I wasn’t quite sure if I heard Tom correctly with respect to the European market. I think he implied that we had some new design wins there, is that correct?

Thomas Yuen

Yes, hi this is Tom. Yeah and my message I’m reporting that because of our EBITDA sales coverage in Europe we had been making very quick progress with a couple of significant, volume TV manufacturers in Europe and we are negotiating contracts and luckily we should be in a good position to report the revenue production soon.

Andrew - Barnum

Okay so you would expect to revenue production from those new design wins in the second half of the year.

Thomas Yuen

We will look at the lead time necessary and probably be -- we’ll be very -- late this year or early next year.

Ulrich Gottschling

Remember that we trail our revenues by one quarter so to the extents of those TV manufacturers are shipping in Q4 that would become Q1 revenue in ‘07 for us.

Andrew - Barnum

I guess what I’m more concern is that we have those designs in place for the holiday selling fees and if you recognize that Q4 or Q1 next year less concern.

Ulrich Gottschling

We are looking for to make that happen. We are working to go as quickly as we can on that.

Andrew - Barnum

And is that, I mean you know obviously work have presence currently in most of the major OEM is the designs we are talking about potentially designs with existing OEM customers for European markets or its with new European OEMs.

Thomas Yuen

These are new OEMs however, there are also customers of our platforms, in other -- mentioned that the beauty of our strategy is that we enable a lot of ICs. So that you know the -- getting the design in, may indeed result in product shipment much sooner because they are already using platforms that we have been enabled.

Andrew - Barnum

So, not to put words in your mouth but for example Phillips is a OEM customer in the auto segment I believe, but not currently in the TV segment. Would that be an example of what you are talking about? Without significant --

Thomas Yuen

There are many manufacturers in Europe that have a pretty good size and certainly Phillip would be one of the potential target and you are right they do make TVs too.

Andrew - Barnum

Okay, with respect to the announced wins you know Sharp and Panasonic specifically being new. Do you have any estimate of what are market share is today in advanced displays versus perhaps when it was a year ago?

Thomas Yuen

I think that last year we -- measurement indicated that we were in the 20 some % range and that unfortunately the growth of flat panel market is quite rapid and so it’s very hard to gauge what percentage we have. We have a feeling that we have at least maintained the 25% if not increased from that point on as we continue to see extremely positive growth and adoption of our technology by many new brands.

Andrew - Barnum

Okay, I wanted to move on to some questions about the cell phone design we have in the US. I realized you don’t want disclose the customer -- not in position to disclose the specific customer yet, but are talking about a tier 1 OEM or tier 2?

Thomas Yuen

You want to field that one, Ulrich?

Ulrich Gottschling

May be is a tier 1 OEM.

Andrew - Barnum

And can you give us a sense of the retail price point of the phone?

Thomas Yuen

I think that – that will be -- too much and -- but it’s a good volume product.

Andrew - Barnum

Okay, and then may be you can elaborate from the strategy or how you go about it with that customer. What we’re doing, obviously you’re saying it’s a good volume product, sounds like it’s relatively a mainstream product line. What we’re doing to try to get on other platforms within that customer?

Thomas Yuen

Yeah, that’s a good point, its an important strategy to try to break in to any account and try to then drill deeper into those accounts. So I think that our sales team is quite experienced and I think we have made inroads with a significant account, we obviously have many ideas and methods that we have deployed to drill in to his opportunity and the cell phone market continues to have a lot of multimedia type of feature needs and being a major player in the MP3 market and being a respected audio authority basically whether it is to make the ringtone sound louder or make the MP3 sound more lively and now looking at also the videophone’s movie-watching feature and by introducing different technologies we hope to leverage on the contact points we have now and to really make our way into the other groups of these cell phone companies, especially this tier 1 phone company.

Andrew - Barnum

I mean, I what you doing now I mean you know from their prospective I mean how would they -- what measures are you looking at -- though I haven’t noticed a material marketing around our presence in this line. Is they are a marketing campaign related to this --?

Thomas Yuen

Yes, I think that you know we are really clearly looking at the multimedia aspects of the cell phone and we are looking at our advantage and you know treating these sounds that are generally less than optimum after going through the infrastructure and also looking at producing the best sound through the miniature speakers. So there are at least two or three advantage points that we are trying to address this market. We have a complete suite of audio and voice technology to provide a single stop that for these major cell phone companies that are looking at a variety of sound related technology to enhance their phones and the speaker is also another angle that is (inaudible) for cell phones companies. We have a unique technology that can make tiny speakers to sound much better and a fuller range. Also, by working with Microsoft the software -- the mobile edition we also one of the very few companies that have been able to provide enhancements through the Microsoft mobile phone operating system. So indeed there is many new technologies including the game playing Xspace that we introduced, and in the most recent CTIA exhibit, we also introduced a brand new technology called the Mobile HD which offers a surround headphone technology to enhance video program watching over the telephone. So, we are definitely you know, looking at those high-end audio and entertainment features at our launch -- I mean our contact points to launch our activity into the cell phone market.

Andrew - Barnum

Is this design -- given the timing, I guess the design activity and do -- will this be the only material new design win in the cell phone space this year or do we feel like there is still time to get design in for the holiday season to additional cell phones?

Thomas Yuen

I think this would be a very significant win for this year and that with -- constantly work with several other opportunities and when we are ready we’ll certainly -- announcement just about any features -- in the cell phone market.

Andrew - Barnum

Okay, you said that we’ll begin to recognize revenue for this product since it’s ready for shipping in Q3 and Q4, is it significant enough such that it will materially improve the rates of growth in this segment category?

Thomas Yuen

It’s very difficult to forecast and we certainly will try to do that as soon as we have information. And, so far we believe this phone is very well received, and hopefully we’ll bring you know, a material impact to our bottom line.

Ulrich Gottschling - Ulrich Gottschling - Chief Financial Officer

Are there any questions this afternoon? All right, then I would like to thank everyone for your participation today. And once again if you would like a copy of news release or would like to listen to the audio replay, please visit our website, www.srslabs.com. And we look forward to speaking with you again on our next conference call. Thank you.

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