Digital Theater Systems makes move to consumer electronics.

A decade ago, Hollywood heavyweights such as Steven Spielberg and Joel Silver helped Digital Theater Systems Inc. challenge audio pioneer Dolby Labs as the sound system of choice in the multiplex.

Now the Agoura Hills-based audio systems outfit is going head to head with Dolby to become the de facto audio standard in consumer electronics.

"We want to be the primary audio product in the home. Once a moviegoer hears a film on one of our systems, they'll want the same audio experience in their own homes," said Chief Executive Jon Kirchner, a former Price Waterhouse turnaround consultant and one of the company's first employees.

Founded in 1990, DTS invented a digital audio system in which a film's sound and voice tracks are recorded and played back on two separate compact disks instead of directly on the celluloid print, as Dolby and other traditional sound systems do.

It got early endorsements from Spielberg, the DreamWorks SKG cofounder, who used the system for "Jurassic Park," and from the studio that released it, Universal Studios--about to be part of General Electric Co. Universal bought and installed the system for 1,000 movie screens. Silver, the producer of the "Lethal Weapon" and "Matrix" franchises, convinced Warner Bros. to use the DTS system for "Demolition Man," which starred Sylvester Stallone.

Today, the system is installed in some 23,000 theater screens, second behind San Francisco-based Dolby's 40,000, according to US Bancorp Piper Jaffrey analyst Gene Munster.

Ascendant consumer business

The movie portion of the business, which also includes the licensing and sale of equipment to studios and editing labs, still provides 31 percent of Digital Theater Systems' revenues. But consumer electronics is now a larger part of the business and is driving the company's revenue growth.

Instead of manufacturing stereo systems, DTS supplies a collection of codes that dictate the quality of audio recording and playback. DTS licenses the codes to electronics makers that include Japan's Pioneer Corp. and Panasonic manufacturer Matsushita Electric Industrial Co. for a royalty of at least $2 per piece of equipment.

In recent months, deals have been signed with Honda Motor Co., which will use the DTS code as part of the eight-speaker sound system in its Acura TL, and computer sound card manufacturer Creative Technology Ltd. Such deals have led to a 68 percent increase in revenues in the consumer division, which now accounts for 69 percent of DTS' revenues.

For the third quarter ended Sept. 30, DTS reported net income of $2.7 million, compared with $857,000 for the like period a year earlier. Revenues rose 41 percent, to $13.3 million.

From here, the company is rolling out new sound codes for the consumer market. At the Consumer Electronics Show in Las Vegas last week, it introduced the Neo: 6 code that converts traditional stereo signals into surround sound. The feature will be included on new receivers made by Pioneer and Denon Ltd.

Broadcasting and videogames are other segments DTS is targeting. Videogame maker Take-Two Interactive used DTS to improve the sound for the latest version of its "Grand Theft Auto" series.

Facing Goliath

But the biggest challenge remains privately held Dolby, the industry pioneer that invented surround sound. Much larger, with revenues of $200 million a year, Dolby is already the standard for most audio systems. To maintain its lead, Dolby rolled out its own stereo-to-surround sound converter last month.

To overcome the competition, DTS is betting that manufacturers and buyers will view its system less as an upscale add-on than as standard equipment. In its deal with Honda, the surround sound package will be a standard feature.

"We believe the market can support two players and two standards," said Kirchner. "But we admit that Dolby is the incumbent."

So far Wall Street likes what it sees. DTS made a splash during its initial public offering last July, when its shares, offered at $17 each, reached a high of $24.92 during the first day of trading. At a closing price of $25 on Jan. 7, the shares were trading at a 47 percent premium to the offering price.

Digital Theater Systems Inc.


[GRAPHICS OMITTED]

YEAR (Dec. 31)

                                 2002      2001

Revenue (millions)              $41.1     $28.7
Total Expenses (millions)        30.8      27
Operating Income (millions)      10.3       1.8
Net Income (millions)             6.3       3.9
Earnings Per Share               $0.50     $0.31

SUMMARY

Business: Audio systems
Headquarters: Agoura Hills
CEO: Jon Kirchner
Market Cap: $344 million
Total Liabilities: $11.6 million
Long-Term Debt: $0
Dividend Yield: N/A *
P/E Ratio: 33

* Company does not pay a dividend.