Enveric Biosciences, Inc. - Quarter Report: 2006 September (Form 10-Q)

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

þ		Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the period ended: September 30, 2006

o		Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

SPATIALIZER AUDIO LABORATORIES, INC.

(Exact name of registrant as specified in its charter)

Delaware		95-4484725
(State or other jurisdiction of		(IRS Employer
incorporation or organization)		Identification No.)

2025 Gateway Place, Suite 365
San Jose, California 95110

(Address of principal corporate offices)

Telephone Number: (408) 453-4180

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:

Yes þ      No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o       accelerated filer o       non-accelerated filer þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):

Yes o      No þ

As of October 26, 2006, there were 48,763,383 shares of the Registrant’s Common Stock outstanding.

 

 

PART I. FINANCIAL INFORMATION

ITEM I. FINANCIAL STATEMENTS

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

		September 30,				December 31,
		2006				2005
		(unaudited)
ASSETS
Current Assets:
Cash and Cash Equivalents		$	272,985			$	550,633
Accounts Receivable, net			69,572				155,233
Prepaid Expenses and Deposits			46,937				34,104
Total Current Assets			389,494				739,970
Property and Equipment, net			6,205				18,403
Intangible Assets, net			136,833				138,548
Total Assets		$	532,532			$	896,921
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities:
Note Payable			24,176				10,443
Accounts Payable			18,367				14,195
Accrued Wages and Benefits			2,341				48,095
Accrued Professional Fees			22,500				34,000
Accrued Commissions			42,202				31,917
Accrued Expenses			2,998				40,869
Total Current Liabilities			112,584				179,519
Commitments and Contingencies
Shareholders’ Equity:
Common shares, $.01 par value, 65,000,000 shares authorized, 46,975,365 shares issued and outstanding at September 30, 2006 and December 31, 2005			469,772				469,772
Additional Paid-In Capital			46,430,030				46,430,030
Accumulated Deficit			(46,479,854	)			(46,182,400	)
Total Shareholders’ Equity			419,948				717,402
		$	532,532			$	896,921

See notes to consolidated financial statements

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)

		For the Three Month Period Ended								For the Nine Month Period Ended
		September 30,				September 30,				September 30,				September 30,
		2006				2005				2006				2005
Revenues:
Royalty Revenues		$	67,744			$	270,914			$	261,100			$	1,031,777
			67,744				270,914				261,100				1,031,777
Cost of Revenues			6,774				12,752				26,251				89,514
Gross Profit			60,970				258,162				234,849				942,263
Operating Expenses:
General and Administrative			122,210				116,539				371,343				457,463
Research and Development			—				62,068				157,740				244,717
Sales and Marketing			—				45,356				1,241				140,810
			122,210				223,963				530,324				842,990
Operating (Loss)			(61,240	)			34,199				(295,475	)			99,273
Interest and Other Income			1,442				3,376				7,087				9,992
Interest and Other Expense			(2,000	)			(1,030	)			(4,266	)			(5,140	)
			(558	)			2,346				2,821				4,852
Income (Loss) Before Income Taxes			(61,798	)			36,545				(292,654	)			104,125
Income Taxes			—				—				(4,800	)			—
Net Income (Loss)		$	(61,798	)		$	36,545			$	(297,454	)		$	104,125
Basic and Diluted Earnings Per Share		$	(0.00	)		$	0.00			$	(0.01	)		$	0.00
Weighted Average Shares Outstanding			48,763,383				46,975,365				48,763,383				46,975,365

See notes to consolidated financial statements

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(unaudited)

		Nine Months Ended
		September 30,
		2006				2005
Cash Flows from Operating Activities:
Net Income (Loss)		$	(297,454	)		$	104,125
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Depreciation and Amortization			28,926				37,789
Net Change in Assets and Liabilities:
Accounts Receivable and Employee Advances			85,661				138,359
Prepaid Expenses and Deposits			(12,833	)			28,660
Accounts Payable			4,172				(46,170	)
Accrued Wages and Benefits			(45,754	)			(5,506	)
Accrued Professional Fees			(11,500	)			2,500
Accrued Commissions			9,561				2,073
Accrued Expenses			(37,147	)			(31,995	)
Deferred Revenue							(391,395	)
Net Cash Provided By (Used In) Operating Activities			(276,368	)			(161,560	)
Cash Flows from Investing Activities:
Purchase/Disp of Property and Equipment			—				(5,277	)
Increase in Capitalized Patent and Technology Costs			(15,013	)			—
Net Cash Provided By (Used in) Investing Activities			(15,013	)			(5,277	)
Cash flows from Financing Activities:
Issuance (Repayment) of Notes Payable			13,733				(29,891	)
Net Cash Provided by Financing Activities			13,733				(29,891	)
Increase (Decrease) in Cash and Cash Equivalents			(277,648	)			(196,728	)
Cash and Cash Equivalents, Beginning of Period			550,633				871,155
Cash and Cash Equivalents, End of Period		$	272,985			$	674,427
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest		$	4,266			$	5,140
Income Taxes			4,800

See notes to consolidated financial statements

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY
(unaudited)

		Common Shares																Total
		Number of								Additional				Accumulated				Shareholders'
		shares				Par value				paid-in-capital				Deficit				Equity
Balance, December 31, 2005			48,763,383			$	469,772			$	46,430,030			$	(46,182,400	)		$	717,402
Net (Loss)			—				—				—				(172,667	)			(172,667	)
Balance, March 31, 2006			48,763,383			$	469,772			$	46,430,030			$	(46,355,066	)		$	544,735
Net (Loss)															(62,989	)		$	(62,989	)
Balance, June 30, 2006			48,763,383				469,772				46,430,030				(46,418,055	)			481,746
Net (Loss)															(61,798	)		$	(61,798	)
Balance, September 30, 2006			48,763,383				469,772				46,430,030				(46,479,854	)			419,948

See notes to consolidated financial statements

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

Notes to Consolidated Financial Statements

1)

Sale of All or Substantially All of the Assets of Spatializer Audio Laboratories, Inc. and Desper Products, Inc. and Dissolution of Spatializer

     Spatializer has been a developer, licensor and marketer of next generation technologies for the consumer electronics, personal computing, entertainment and cellular telephone markets. Our technology is incorporated into products offered by our licensees and customers on various economic and business terms. We were incorporated in the State of Delaware in February 1994 and are the successor company in a Plan of Arrangement pursuant to which the outstanding shares of Spatializer Audio Laboratories, Inc., a publicly held Yukon, Canada corporation, were exchanged for an equal number of shares of our common stock. Our corporate office is located at 2025 Gateway Place, Suite 365 West Wing, San Jose, California 95110.

The Company’s wholly-owned subsidiary, Desper Products, Inc. (“DPI”), has been in the business of developing proprietary advanced audio signal processing technologies and products for consumer electronics, entertainment, and multimedia computing. All Company revenues are generated from this subsidiary. Desper Products is the owner of certain technology which DTS desires to acquire. Desper Products is a California corporation incorporated in June 1986.

DTS, Inc. is a Delaware corporation and a leading provider of entertainment technology, products and services to the audio and image entertainment markets worldwide. DTS BVI is a British Virgin Island corporation and a wholly owned subsidiary of DTS.

          Background of the Sale of Assets and Dissolution

          Spatializer has been under acute market pressure since 2002. In 2002, a personal computer account began migrating to a totally new operating system, which did not include any audio enhancements. The migration was completed in 2003 and the former licensee chose not to include any audio software enhancements, including those from Spatializer. This account had accounted for approximately 40% of Spatializer’s annual revenues.

          In 2003, Spatializer experienced declining revenue from three major customers, primarily from the curtailment or cessation of use of its products by these customers. Two of these cases were in the DVD player market, where Spatializer historically had been strong. During 2003, the DVD player market became largely commoditized, resulting in intense pricing pressure and a steep decline in price and margins. Manufacturers were forced to strip out features, such as those offered by Spatializer, in order to compete. One of Spatializer’s accounts switched to outside sourcing and Spatializer was able to expand its relationship with their supplier to recapture most of that revenue. However, a major new design win Spatializer was projecting for the DVD market was cancelled due to these cost constraints.

          In 2004, the revenue mix by licensee platform was significantly different compared to the prior year. The decrease in revenue on the DVD and personal computer accounts

previously discussed generated approximately 56% of total fiscal 2003 revenue, which was lost in 2004. These losses were partially offset by three new revenue sources in cellular phones, mobile audio semiconductors and personal computers and the expansion of an existing license relating to recordable DVD. Cellular phone, mobile audio and the personal computer markets had been targeted by Spatializer for replacing the losses in the DVD player category. Nevertheless, market pressures mounted and Spatializer was forced to substantially reduce overhead in order to remain liquid.

     In response to increased market competitiveness and Spatializer’s difficulty competing in this environment, in November 2002, the board of directors created a Special Committee to review certain strategic opportunities as they arise and to obtain additional information regarding such opportunities for consideration and evaluation by the board of directors. Through December 19, 2005, the Special Committee consisted of Messrs. Mandell, Pace and Segel. Spatializer hired an entity in late 2002 to provide investment banking services, paying such entity a $75,000 retainer fee. Over one hundred companies were contacted on Spatializer’s behalf but, after examining the potential opportunities that resulted therefrom, Spatializer decided that no such opportunities were viable. Spatializer ended its relationship with such investment banking entity in the second half of 2003 as a result of the unsuccessful effort, with no future financial obligation to such entity.

     In August 2005, Spatializer and Strategic Equity Group, Inc. (collectively, with its broker/dealer subsidiary, “SEG”) entered into a confidentiality agreement in connection with a possible investment banking services relationship.

     In October 2005, Spatializer and SEG entered into an agreement for investment banking services. Under the terms of that agreement, Spatializer engaged SEG for a one year period, on an exclusive basis, to provide Spatializer with services, including the identification of possible strategic, financial and foreign partners or purchasers. Per the terms of such agreement, SEG received an upfront payment of a non-refundable retainer in the amount of $25,000 and is entitled to payment of a “success fee” payable upon consummation of a sale transaction in an amount equal to the greater of (a) $250,000 or (b) the sum of 5% of the first $2,000,000 of consideration, 4% of the second $2,000,000, 3% of the third $2,000,000 and 2% of any amount in excess of $6,000,000. SEG is also entitled to reimbursement for reasonable actual out-of-pocket expenses for travel and other incidentals in an amount not to exceed $25,000. Spatializer is required to indemnify SEG for liabilities that SEG may suffer which arise from any breach of any representations or warranties in the investment banking services agreement, the breach of any covenant of Spatializer in that agreement or any instrument contemplated by that agreement, any misrepresentations in any statement or certificate furnished by Spatializer pursuant to that agreement or in connection with any sale transaction contemplated by that agreement, any claims against, or liabilities or obligations of, Spatializer and any good faith acts of SEG undertaken in good faith and in furtherance of SEG’s performance under the agreement.

     On December 19, 2005, at a regularly scheduled board of directors meeting, the board of directors of Spatializer discussed Spatializer’s current financial outlook. Management indicated to the board of directors that two customers, the revenues from which accounted for approximately 70% of Spatializer’s income during 2005, would not be sustainable in 2006. Based on management’s estimates, without new licensing revenue sources, management believed Spatializer would exhaust its available cash by the fourth quarter of 2006. The board of directors also discussed various strategic options for Spatializer, including potential

suitors and the distribution by SEG of interest books to approximately 55 potential purchasers, competition in its niche, and other business matters. Following the presentation, Gilbert Segel and James Pace, two of the three independent directors of Spatializer, decided to resign from the board of directors in order to allow for other individuals more qualified and experienced in matters relating to the sale of Spatializer and other strategic alternatives for Spatializer, including liquidation, to fill the vacancies created. The board was reduced from four members to three authorized directors leaving one vacancy thereon, which has not been filled to date. Henry R. Mandell then indicated his desire to resign as an officer of Spatializer, for personal reasons, effective January 6, 2006, which vacancy would result in a significant reduction in payroll expense, but would stay as a director and Chairman of the Board and Secretary of Spatializer. Mr. Mandell offered to become a consultant to Spatializer on terms to be negotiated with Carlo Civelli, the remaining member of the Board. The board of directors then discussed plans for the future of Spatializer and measures for scaling back operations, while continuing to pursue a potential buyer through SEG, with a view to maximizing stockholder value.

     On January 6, 2006, Henry R. Mandell’s resignation as the Chief Executive Officer and Chief Financial Officer became effective. Effective as of that date, Spatializer and Mr. Mandell entered into an agreement to continue his employment with Spatializer as Chairman and Secretary. In that agreement, Mr. Mandell agreed to continue to provide certain specified services to Spatializer, including supervising the preparation of Spatializer’s financial statements and records, reviewing and authorizing day to day disbursements, supervising all of Spatializer’s licensing and business activities, handling stockholder communications and serving as the contact person with SEG. He was permitted to accept other employment during the term of that agreement. As an incentive for Mr. Mandell to continue in Spatializer’s employ during the term of that agreement, and in consideration for the foregoing of certain severance pay to which he otherwise may have been entitled, Spatializer paid him a lump sum payment of $35,733.33, which amount was paid concurrently with the execution of that agreement. That agreement also provided for a monthly salary of $5,000, a bonus of $10,000 for Mr. Mandell’s assistance in the preparation of Spatializer’s Form 10-K for the fiscal year ended December 31, 2005 and a separate bonus of $5,000 each for his assistance on each Form 10-Q upon which he assists for any quarterly period ending after December 31, 2005 and each proxy. Additionally, if Spatializer is sold or enters into certain specified extraordinary transactions during the term of that agreement, Mr. Mandell may be entitled to an additional bonus in an amount equal to 3.5% of the total consideration, not to exceed $150,000. During the term of that agreement, he is entitled to employee benefits and reimbursement of reasonable, actual and necessary business expenses. That agreement contains certain non-competition, non-solicitation and confidentiality provisions. That agreement terminated certain provisions of Mr. Mandell’s then existing employment agreement (including without limitation the compensation and severance pay obligations thereunder) but continued certain other provisions thereof (such as the proprietary information, confidentiality and other similar provisions thereunder). While that agreement was to expire on the earlier of (a) the consummation of certain extraordinary transactions, (b) the expiration, termination or non-renewal of the directors’ and officers’ insurance policy of Spatializer under which Mr. Mandell is covered as a director and officer of Spatializer and (c) June 30, 2006, that agreement was extended for a period ending on the earlier of June 30, 2007 or the date of dissolution of Spatializer. Spatializer may terminate Mr. Mandell’s employment at any time during the term and Mr. Mandell may voluntarily resign his employment at any time during such term.

     On January 10, 2006, Spatializer issued a press release regarding a potential auction, open to pre-qualified buyers, of the assets of Spatializer or the sale of an unlimited number of perpetual licenses of certain technology of Spatializer, all of which transactions would be subject to stockholder approval. Under the contemplated open auction process, potential buyers were invited to bid for the assets of Spatializer at a minimum bid of $2,000,000, such assets to be sold on an “as-is/where is” basis. Simultaneously, Spatializer offered all interested parties the opportunity to acquire non-exclusive, royalty-free, irrevocable, perpetual licenses for a one-time fee of $750,000 each, which licenses would be absent of any representations, warranties, or ongoing support by Spatializer. Bids were due by 11:59 P.M. Pacific Standard Time on February 15, 2006.

     During a period commencing on or about January 12, 2006 through February 15, 2006, SEG sent out to more than 160 potential buyers materials relating to the announced auction. SEG followed up, or attempted to follow up, with such potential buyers through the close of the auction period.

     At a meeting held on February 16, 2006, the board of directors of Spatializer discussed a proposed term sheet for the acquisition of Spatializer’s assets that had been delivered by DTS and feedback that SEG had received from certain of the potential buyers that had been contacted during the auction period. As DTS’s offer did not specify a precise purchase price, such offer was deemed non-conforming to the guidelines established for the initial auction. Certain of the potential buyers had requested an extension of the auction period to perform additional due diligence. The board of directors again discussed what alternatives were available to Spatializer. The board of directors elected to extend the auction period until 11:59 P.M., Pacific Standard Time, on March 15, 2006 to provide bidders and other interested parties additional time to clarify their offers and perform further due diligence, as well as to permit Spatializer time to solicit additional offers. The board of directors, based on feedback received in the auction process, determined to simplify the auction process and eliminated the minimum bid requirements but reserved the right to reject any offers or bids in their discretion.

     During the period from February 15, 2006 through March 15, 2006, SEG continued to follow up, or attempted to follow up, with the potential buyers to whom auction materials had been provided.

     At the close of the extended auction period, Spatializer received a bid from DTS for the purchase of substantially all of the assets of Spatializer and Desper Products and bids from three other parties interested in buying a perpetual license. Management of Spatializer determined that the bids for the perpetual licenses were not sufficient in amount and decided that the bid for the assets of Spatializer received from DTS was the most attractive offer to pursue.

     From March 16, 2006 through approximately April 10, 2006, Spatializer and DTS negotiated the terms of a non-binding letter of intent. Although Spatializer, in the course of such negotiations, requested that the transaction be structured as a stock sale or merger transaction, DTS was not willing to so structure the transaction. The letter of intent, requiring the transaction to be structured as an asset sale, was executed on April 10, 2006. In connection with the execution of the letter of intent and as required by the terms thereof, DTS deposited $250,000 towards the purchase price of the assets, which deposit amount is being held in a trust account and will be disbursed to Spatializer contingent upon, among other things, approval of the transaction by the stockholders of Spatializer and satisfaction of the conditions to closing.

          From January 25, 2006 through May 5, 2006, DTS performed various due diligence examinations relating to Spatializer. Preliminary discussions were held over the phone between DTS and SEG on January 25, 2006 and February 6, 2006. A technology demonstration was held at SEG’s office on February 10, 2006. A due diligence conference call including Spatializer was held on February 13, 2006. Counsel to DTS spent February 23, 2006, at SEG’s office analyzing contracts and various other due diligence items. Four due diligence conference calls were held in March 2006, three additional conference calls in April 2006, and one in May 2006.

During the period from May 1, 2006 through mid-September 2006, legal counsel for DTS and for Spatializer prepared, and representatives of DTS and Spatializer negotiated, the Asset Purchase Agreement.

     In July 2006, the board of directors of Spatializer was presented with and carefully considered a draft of the Asset Purchase Agreement. After due consideration of such draft, the board of directors of Spatializer approved, by unanimous written consent dated July 10, 2006, a form of the Asset Purchase Agreement. However, subsequent to that date, numerous changes and refinements were made to that draft based on the negotiations of the parties.

     In July 2006, the board of directors of Desper Products was presented with and carefully considered a draft of the Asset Purchase Agreement. After due consideration of such draft, the board of directors of Desper Products approved, by a written consent of sole director dated July 10, 2006, a form of the Asset Purchase Agreement. However, subsequent to that date, numerous changes and refinements were made to that draft based on the negotiations of the parties.

     In August 2006, the board of directors of Spatializer was presented with and carefully considered a draft of the Asset Purchase Agreement. After due consideration of all of the foregoing, the board of directors of Spatializer, by a unanimous written consent of directors dated August 28, 2006, authorized the execution and delivery on behalf of Spatializer of the Asset Purchase Agreement providing for the sale to DTS and DTS BVI of all or substantially all of the assets of each of Spatializer and Desper Products, deemed the sale of all or substantially all of the assets of Spatializer and Desper Products for $1,000,000 in aggregate cash consideration to be expedient and for the best interests of Spatializer, and deemed the sale of all or substantially all of the assets of Spatializer and Desper Products to be advisable and in the best interests of Spatializer. Furthermore, the board of directors of Spatializer deemed it advisable that, following the sale of the assets, Spatializer be dissolved. The board of directors also recommended that the stockholders of Spatializer vote in favor of both the sale of assets transaction and the dissolution of Spatializer. The board of directors called a meeting of the stockholders of Spatializer to consider the proposed sale of assets pursuant to the Asset Purchase Agreement and to take action upon the resolution of the board of directors to dissolve Spatializer. The board of directors also recommended that the stockholders of Spatializer vote in favor of both the sale of assets transaction and the dissolution of Spatializer.

     Effective August 28, 2006, Spatializer, as the sole shareholder of Desper Products, executed a written consent of sole shareholder approving the principal terms of the sale of the assets of Desper Products.

     On September 18, 2006, the parties executed and delivered the Asset Purchase Agreement. It is anticipated that a meeting of Stockholders will be held in January, 2007 to vote on the approval of this Agreement.

     The foregoing interim financial information is unaudited and has been prepared from the books and records of the Company. The financial information reflects all adjustments necessary for a fair presentation of the financial condition, results of operations and cash flows of the Company in conformity with generally accepted accounting principles. All such adjustments were of a normal recurring nature for interim financial reporting. Operating results for the three months ended September 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006. Accordingly, your attention is directed to footnote disclosures found in the December 31, 2005 Annual Report and particularly to Note 1, which includes a summary of significant accounting policies.

(2) Significant Accounting Policies

     Basis of Consolidation — The consolidated financial statements include the accounts of Spatializer Audio Laboratories, Inc. and its wholly-owned subsidiary, DPI. All significant intercompany balances and transactions have been eliminated in consolidation. Corporate administration expenses are not allocated to subsidiaries.

     Revenue Recognition — The Company recognizes royalty revenue upon reporting of such royalties by licensees. License revenues are recognized when earned, in accordance with the contractual provisions, typically upon our delivery of contracted services or delivery and contractual availability of licensed product. Royalty revenues are recognized upon shipment of products incorporating the related technology by the original equipment manufacturers (OEMs) and foundries, as reported by quarterly royalty statements. The Company recognizes revenue in accordance with SEC Staff Accounting Bulletin (SAB) 104.

     Deferred Revenue - The Company receives royalty fee advances from certain customers in accordance with contract terms. The Company does not require advances from all customers. Advances are negotiated on a per contract basis. Cash received in advance of revenue earned from a contract is recorded as deferred revenue until the related contract revenue is earned under the Company’s revenue recognition policy.

     Concentration of Credit Risk — Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of cash, cash equivalents and trade accounts receivable. The Company places its temporary cash investments in certificates of deposit in excess of FDIC insurance limits, principally at CitiBank FSB. At September 30, 2006 substantially all cash and cash equivalents were on deposit at two financial institutions.

     At September 30, 2006, two customers, not presented in the order of importance, Sharp and Funai, accounted for 57% and 14% respectively of our. accounts receivable. At September 30, 2005, three customers, not presented in the order of importance, Matsushita, Sharp and Funai, accounted for 42%, 21% and 20% respectively of our. accounts receivable.

     The Company performs ongoing credit evaluations of its customers and normally does not require collateral to support accounts receivable. Due to the contractual nature of sales agreements and historical trends, no allowance for doubtful accounts has been provided.

     The Company does not apply interest charges to past due accounts receivable.

     Cash and Cash Equivalents — Cash equivalents consist of highly liquid investments with original maturities of three months or less.

     Customers Outside of the U.S. — Sales to foreign customers were 100% and 100% of total sales in the year to date periods ended September 30, 2006 and 2005, respectively. Approximately 95% and 5% of sales were generated in Japan and Korea, respectively, in the nine months ended September 30, 2006.

     Major Customers — During the quarter ended September 30, 2006, two customers, Sharp and Funai, not presented in order of importance, accounted for 57% and 14% of the Company’s revenue. In the nine months ended September 30, 2006, two customers, Funai, Sharp, not presented in order of importance, accounted for 41% and 25% of the Company’s revenue.

     Research and Development Costs — The Company expenses research and development costs as incurred, which is presented as a separate line on the statement of operations.

     Property and Equipment — Property and equipment are stated at cost. Major renewals and improvements are charged to the asset accounts while replacements, maintenance and repairs, which do not improve or extend the lives of the respective assets, are expensed. At the time property and equipment are retired or otherwise disposed of, the asset and related accumulated depreciation accounts are relieved of the applicable amounts. Gains or losses from retirements or sales are credited or charged to income. Property and equipment are depreciated over the useful lives of the asset ranging from 3 years to 5 years under the straight line method.

     Intangible Assets — Intangible assets consist of patent costs and trademarks which are amortized on a straight-line basis over the estimated useful lives of the patents which range from five to twenty years. The weighted average useful life of patents was approximately 11 years. All of our Intangible Assets have finite lives as defined by Statement of Financial Accounting Standard (SFAS) 142.

     Earnings Per Share — Basic earnings (loss) per share is computed by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. The following table presents contingently issuable shares, options and warrants to purchase shares of common stock that were outstanding during the three month and nine month periods ended September 30, 2006 and 2005 which were not included in the computation of diluted loss per share because the impact would have been antidilutive or less than $0.01 per share:

		2006				2005
Options			1,750,000				2,960,000
Warrants			0				0
			1,750,000				2,960,000

     Stock Option Plan — On January 1, 2006 the Company adopted SFAS 123R “Share Based Payments. No options were granted in the quarter ended September 30, 2006. Options to purchase 250,000 common shares expired in the quarter ended September 30, 2006/

     Impairment of Long-Lived Assets and Assets to be Disposed of - The Company adopted the provisions of SFAS No. 144, Accounting for the Impairment of Long-Lived Assets, on January 1, 2002. This Statement requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying amounts of the assets exceed the fair value of the assets.

     Segment Reporting - The Company adopted SFAS 131, Disclosures about Segments of an Enterprise and Related Information (“SFAS No. 131”), in December 1997. MDT has been considered a discontinued operation since September 1998. The Company has only one operating segment, DPI, the Company’s audio enhancement licensing business.

     Income Taxes - Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

     Recent Accounting Pronouncements -

     In May 2005 the FASB issued SFAS 154 “Accounting Changes and Error Corrections”. This Statement replaces APB Opinion No. 20, “Accounting Changes”, and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements”, and changes the requirements for the accounting for and reporting of a change in accounting principle and also corrections of error in previously issued financial statements. This Statement harmonizes US accounting standards with existing international accounting standards by requiring companies to report voluntary changes in accounting principles via a retrospective application, unless impracticable. Also, the reporting of an error correction involves adjustments to previously issued financial statements similar to those generally applicable to reporting an accounting change retrospectively. The Company adopted this Statement as required on January 1, 2006.

     The Company believes the adoption of this pronouncement will not have a material effect on the Company’s financial position, results from operations or cash flows.

     Use of Estimates - Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these financial statements in conformity with generally accepted accounting principles. Actual results could differ from those estimates.

Fair Value of Financial Instruments - The fair and carrying values of cash equivalents, accounts receivable, accounts payable, short-term debt to a related party and accrued liabilities and those potentially subject to valuation risk at December 31, 2005 and September 30, 2006 approximated fair value due to their short maturity or nature.

(3) Property and Equipment

     Property and equipment, as of December 31, 2005 and September 30, 2006, consists of the following in accordance with application of SFAS 144:

		September 30,				December 31,
		2006				2005
Office Computers, Software, Equipment and Furniture		$	337,144			$	337,145
Test Equipment			73,300				73,300
Tooling Equipment			45,539				45,539
Trade Show Booth and Demonstration Equipment			174,548				174,548
Automobiles			0				7,000
Total Property and Equipment			630,531				637,531
Less Accumulated Depreciation and Amortization			624,326				619,128
Property and Equipment, Net		$	6,205			$	18,403

(4) Intangible Assets

     Intangible assets, as of December 31, 2005 and September 30, 2006 consist of the following:

		September				December 31,
		30, 2006				2005
Capitalized Patent, Trademarks and Technology Costs		$	540,709			$	525,695
Less Accumulated Amortization			403,876				387,147
Intangible Assets, Net		$	136,833			$	138,548

     Estimated amortization is as follows:

2006		$	8,351
2007		$	134,059
2008		$	0
2009		$	0
Thereafter		$	0

     It is anticipated that the intangible assets will be written off upon completion of the sale of assets, subject to stockholder approval, in January, 2007.

(5) Notes Payable

     The Company is indebted to the Premium Finance, Inc., an unrelated insurance premium finance company. This note finances the Company’s annual Directors’ and Officers’ Liability Insurance. This amount bears interest at a fixed rate of 13% annually, is paid in monthly installments of $4,835 that commenced on June 1, 2006 and continues for eight months until the entire balance of principal and interest is paid in full.

(6) Shareholders’ Equity

          During the quarter ended September 30, 2006, shares were issued, cancelled or converted as follows:

Options to purchase 250,000 shares of common stock previously granted to one employee, at an exercise price of $0.05 were cancelled after the resignation of the employee per terms of the option agreement.

Capitalization

     Series B-1 Redeemable Convertible Preferred Stock: On November 6, 2002 the Board of Directors Designated a Series B-1 Preferred Stock. The series had a par value of $0.01 and a stated value of $10.00 per share US and was designated as a liquidation preference. The stock ranked prior to the Company’s common stock. No dividends were to be paid on the Series B-1 Preferred Stock. Conversion rights vested on January 1, 2003 to convert the Series B-1 Preferred Stock to common at a certain formula based on an average closing share price, subject to a floor of $0.56 and a ceiling of $1.12. The Series B-1 Preferred Stock has no voting power. Certain restrictions on trading existed based on date sensitive events based on the Company’s Insider Trading Policy. In December 2002, 87,967 shares of Series B-1 Preferred Stock were issued in exchange for the Series B Preferred Stock and 14,795 shares were issued in lieu of the adjusted accrued dividends on the Series B Preferred Stock. In 2004, the Company reflected the issuance of 15,384 shares of Series B-1 Convertible Preferred Stock that was originally recorded in Additional Paid in Capital. This resulted in a reclassification of $154 to Convertible Preferred Stock from APIC. In December 2005, the Company, as stipulated by the related Subscription Agreement, forced the conversion of all outstanding Series B-1 Preferred Stock into Restricted Common Stock at the minimum conversion price of $.56 per share. This resulted in the issuance of 1,788,018 Common Stock shares.

(7) Stock Options

In 1995, the Company adopted a stock option plan (the “Plan”) pursuant to which the Company’s Board of Directors may grant stock options to directors, officers and employees. The Plan which was approved by the stockholders authorizes grants of options to purchase authorized but unissued common stock up to 10% of total common shares outstanding at each calendar quarter, 4,876,339 as of September 30, 2006. Stock options were granted under the Plan with an exercise price equal to the stock’s fair market value at the date of grant. Outstanding stock options under the Plan have five-year terms and vest and become fully exercisable up to three years from the date of grant. The Plan expired in February 2005. To date, the Company has not adopted a new stock option plan.

						WEIGHTED-AVERAGE
		Exercisable				Number				Exercise Price
Options outstanding at December 31, 2003			2,540,000				3,035,000			$	0.18
Options granted							200,000			$	0.09
Options exercised							—				—
Options forfeited							(600,000	)		$	0.43
Options outstanding at December 31, 2004			2,381,666				2,635,000			$	0.11
Options granted							500,000			$	0.10
Options exercised							(0	)		$	—
Options forfeited/expired							(325,000	)		$	0.31
Options outstanding at December 31, 2005			2,726,666				2,810,000			$	0.10
Options granted							(0	)		$	0.10
Options exercised							(0	)		$	—
Options forfeited/expired			(976,666	)			(1,060,000	)		$	0.10
Options outstanding at September 30, 2006			1,750,000				1,750,000			$	0.09

     The per share weighted-average fair value of stock options granted during 2005 was $0.04, on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions: expected dividend yield 0%, risk-free interest rate of 4.5%, expected volatility of 100% and an expected life of 5 years.

     At September 30, 2006, the number of options exercisable was 1,750,000 and the weighted-average exercise price of those options was $0.09.

     There were no warrants outstanding at December 31, 2005 or September 30, 2006.

(8) Commitments and Contingencies

     We also anticipate that, from time to time, we may be named as a party to legal proceedings that may arise in the ordinary course of our business.

Operating Lease Commitments

     The Company is obligated under several non-cancelable operating leases. Future minimum rental payments at September 30, 2006 for all operating leases were approximately $7,000 through December 2006. There is no continuing lease obligation after that date. Rent expense amounted to approximately $9,000 and $8,000 for the quarters ended September 30, 2006 and 2005, respectively.

(9) Profit Sharing Plan

     The Company has a 401(k) profit sharing plan covering substantially all employees, subject to certain participation and vesting requirements. The Company may elect to make discretionary contributions to the Plan, but has never done so over the life of the Plan.

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

     This information should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, the audited consolidated financial statements and the notes thereto included in the Form 10-K and the unaudited interim consolidated financial statements and notes thereto included in this report.

     This report contains forward-looking statements, within the meaning of the Private Securities Reform Act of 1995, which are subject to a variety of risks and uncertainties. Our actual results, performance, or achievements may differ significantly from the results, performance, or achievements expressed or implied in such forward-looking statements.

Executive Overview

     Revenues decreased to $68,000 for the quarter ended September 30, 2006 compared to $271,000 for the quarter ended September 30, 2005, a decrease of 75%. Revenues were comprised of royalties pertaining to the licensing of Spatializer^® audio signal processing algorithms and circuit designs. A key issue discussed is our ability to obtain and maintain revenue traction when traditional revenue sources are eroding, while being replaced by new revenue sources.

     Net Loss was $62,000 for the quarter ended September 30, 2006; $0.00 basic and diluted per share, compared to net income of $37,000, ($0.00) per share basic, for the quarter ended September 30, 2005. The increased net loss for the current period is primarily the result of lower revenue, partially offset by lower overhead. A key issue discussed is management’s unsuccessful efforts to increase revenues while managing overhead and maintaining competitiveness during revenue source transition to new markets for the Company.

     At September 30, 2006, we had $273,000 in cash and cash equivalents as compared to $551,000 at December 31, 2005. The decrease in cash resulted primarily from the net loss. We had working capital of $277,000 at September 30, 2006 as compared with working capital of $560,000 at December 31, 2005.

     A key issue is the Company’s ability to generate positive cash flow, or if needed, raise additional capital to fund its business. We do not believe this is attainable.

     The business environment in which we operate is very difficult and the industry, we believe, is unattractive from a competitive strategy perspective. We face substantial risk as a result. These risks should be studied and understood, as outlined in Risk Factors later in this document.

Approach to MD&A

     An important demonstration of our commitment to our stockholders is a clear explanation of the Company’s operating results, risks and opportunities. The purpose of MD&A is to

provide our shareholders and other interested parties with information necessary to gain an understanding of our financial condition, changes in financial condition and results of operations. As such, we seek to satisfy three principal objectives:

	•		to provide a narrative explanation of a company’s financial statements “in plain English” that enables the average investor to see the company through the eyes of management;
	•		to enhance the overall financial disclosure and provide the context within which financial information should be analyzed; and
	•		to provide information about the quality of, and potential variability of, a company’s earnings and cash flow, so that investors can ascertain the likelihood and relationship of past performance being indicative of future performance.

     We believe the best way to achieve this is to give the reader:

	•		An understanding of our operating environment and its risks
	•		An outline of critical accounting policies
	•		A review of our corporate governance structure
	•		A review of the key components of the financial statements and our cash position and capital resources
	•		A review of the important trends in the financial statements and our cash flow
	•		Disclosure on our internal controls and procedures

Operating Environment

     We operate in a very difficult business environment. This environment impacts us in various ways, some of which are discussed below which such items are further discussed in greater detail in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005.

	•		Our Board of Directors has Determined it is in the Company’s and it’s Stockholders’ Interests to Sell the Company’s Assets
	•		We Face Significant Pricing Pressure and Competition that has Resulted in Our Technology Being Designed Out Within a Short Time Frame, and Impeded Efforts to Secure New Design Wins
	•		New Customer Product Development Has been Delayed. This Resulted in Delays In Revenues. Further, Where our Products are Delayed, Competitive Products May Reach The Market Before, or Replace Our Products.
	•		We Rely on the Schedules and Cooperation of Chip Makers or Other Third Parties to

Deliver Our Technology in Consumer Products. These Third parties Have Their Own Priorities and Alliances that Delayed or Could Thwart our Sales Efforts to Potential Customers.

In December 2005 our revenues were stagnant, with those from certain of our major customers winding down. Revenues from certain of our other customers appear not to be sustainable in the future. In December 2005, two of our three independent directors resigned and the Chairman of the Board, Chief Executive Officer, Chief Financial Officer and Secretary resigned from all positions held with the Company other than as a director, Chairman and Secretary. For these and other reasons, and after exploring other exit strategies and opportunities, our Board of Directors concluded in December 2005 to attempt to sell the Company either through a sale of assets or a sale of multiple, non-exclusive perpetual licenses with a subsequent sale of the residual assets and engaged Strategic Equity Group to assist us in this endeavor. Following such transaction, it is anticipated that the Company would be wound up and dissolved. The consummation of any such transaction and the determination to wind up and dissolve is subject to stockholder approval. There is no assurance that the Company will be able to negotiate an agreement for the sale of assets. There is no assurance that, if such an agreement is successfully negotiated, that such transaction will be approved by stockholders or consummated. Further, even if such transaction is consummated, there is no assurance that there will be any funds available for distribution to stockholders. If such sale and subsequent wind up and dissolution is not approved, the Board of Directors will be required to explore other alternatives for the Company and its business.

We have experienced a loss from operations in four of the last five years. We experienced losses in the last two years. While our objective and full effort has been on managing a profitable business, due to the market conditions and factors outlined in this Quarterly Report on Form 10-Q and their impact on fluctuations in operating expenses and revenues, we no longer believe that we will be able to generate a positive profit position in any given future period, nor do we believe that is feasible. We cannot guarantee that we will increase sales of our products and technologies, or that we will successfully develop and market any additional products, or achieve or sustain future profitability. We cannot, because of market and business conditions, rely on the sale of shares or on debt financings in the future. Further, we do not believe that debt or equity financing will be available as required and as such, have decided to try to sell the assets of the Company.

The PC and consumer electronics markets are under intense pressure, primarily from retailers, to reduce selling prices, with resultant pressure to reduce costs. In addition, certain of our competitors appear to be pursuing a business plan that disregards commercially reasonable pricing to achieve a larger market penetration even if the penetration will not provide for viable margins or returns. Cost reductions are driven by lower cost sourcing, often in China, design simplification and reduction in or substitution of features. Therefore, we have been seeking commercial acceptance of our products in highly competitive markets. We responded by offering additional products targeted to each price and quality segment of the market, more aggressively priced and feature enriched our products and entered new segments, such as cell phones, with different competitive pressure. Our value proposition that stressed the cost reducing capabilities of our audio solutions through improved performance from lower cost components as well as product differentiation that Spatializer technology can deliver, failed to resonate with our targeted customers in this highly competitive environment. The result was the elimination of features, including ours, to

reduce cost. There is no assurance that our present or contemplated future products or a repositioned value proposition will achieve or maintain sufficient commercial acceptance, or if they do, that functionally equivalent products will not be developed by current or future competitors or customers who had access to significantly greater resources or which are willing to “give away” their products.

Spatializer does not develop or market semiconductors. That is why we carry no inventory or have order backlogs that typically are good indicators of near term performance. Rather, we develop audio algorithms that are embedded on third party processors or semiconductors used by our customers. While our algorithms are implemented on a wide array of processors, often times a customer uses a processor where there is no such implementation, or where a competing solution has been implemented. In this case, our customers request that our algorithm be implemented. While these requests are typically honored, processor manufacturers must schedule such implementation as their resources or corporate strategies allow. Therefore, the supply-chain is often quite long and complicated, which potentially can result in delays or deadlines that may not always coincide with our customer’s requirements and which are beyond the control of our company. In addition, standards may be adopted by cell phone system operators or manufacturers that may impede or prevent the penetration of non-standard technology onto their platforms. Lastly, customer implementation delays have put off expected cash flow into the future, beyond the time frame of operations based on our available cash resources.

Therefore, when reviewing the operating results or drawing conclusions with regard to future performance, these competitive forces and uncertainties must be taken into consideration. Though there is no absolute long-term visibility, it is likely that our operations would fail if we attempted to continue long-term in this environment. Hence, the Company’s Board of Directors has decided to recommend to and seek the approval of stockholders for the sale of the assets of the Company and liquidate the business.

Critical Accounting Policies

     Our discussion and analysis of our financial condition and results of operations are based upon our consolidated statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses based on historical experience and various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. In consultation with our Board of Directors and Audit Committee, we have identified three accounting policies that we believe are critical to an understanding of our financial statements. These are important accounting policies that require management’s most difficult, subjective judgments.

     The first critical accounting policy relates to revenue recognition. Royalty revenues are recognized upon shipment of products incorporating the related technology by the original equipment manufacturers (OEMs) and foundries. These revenues are reported to us by our Licensees in formal, written royalty reports, which serve as the basis for our quarterly revenue accruals. Infrequently, certain written reports are received after our required reporting deadlines, sometimes due to contractual requirements. In such cases, management tries to obtain verbal reports or informal reports from the Licensee. In the absence of such information, management may utilize conservative estimates based on information received

or historical trends. In such isolated cases, management strives to under-estimate such revenues to err on the side of caution. In the event such estimates are used, the revenue for the following quarter is adjusted based on receipt of the written report. In addition, any error in Licensee reporting, which is very infrequent, is adjusted in the subsequent quarter when agreed by both parties as correct.

     The second critical accounting policy relates to research and development expenses. We expense all research and development expenses as incurred. Costs incurred to establish the technological feasibility of our algorithms (which is the primary component of our licensing) is expensed as incurred and included in Research and Development expenses. Such algorithms are refined based on customer requirements and licensed for inclusion in the customer’s specific product. There are no production costs to capitalize as defined in Statement on Financial Accounting Standards No. 86.

The third critical accounting policy relates to our long-lived assets. The Company continually reviews the recoverability of the carrying value of long-lived assets using the methodology prescribed in Statement of Financial Accounting Standards (SFAS) 144, “Accounting for the Impairment and Disposal of Long-Lived Assets.” The Company also reviews long-lived assets and the related intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Upon such an occurrence, recoverability of these assets is determined by comparing the forecasted undiscounted net cash flows to which the assets relate, to the carrying amount. If the asset is determined to be unable to recover its carrying value, then intangible assets, if any, are written down first, followed by the other long-lived assets to fair value. Fair value is determined based on discounted cash flows, appraised values or management’s estimates, depending on the nature of the assets. Our intangible assets consist primarily of patents. We capitalize all costs directly attributable to patents and trademarks, consisting primarily of legal and filing fees, and amortize such costs over the remaining life of the asset (which range from 3 to 20 years) using the straight-line method. In accordance with SFAS 142, “Goodwill and Other Intangible Assets”, only intangible assets with definite lives are amortized. Non-amortized intangible assets are instead subject to annual impairment testing. Management believes based on the preliminary results of its auction bids that the net carrying value of its assets exceeds the current carrying value.

Corporate Governance

     Audit Committee

     This committee is directed to review the scope, cost and results of the independent audit of our books and records, the results of the annual audit with management and the internal auditors and the adequacy of our accounting, financial, and operating controls; to recommend annually to the Board of Directors the selection of the independent auditors; to approve proposals made by our independent auditors for consulting work; and to report to the Board of Directors, when so requested, on any accounting of financial matters. Gilbert Segel was the only independent director on this committee. Mr. Segel resigned from our Board of Directors in December 2005. Mr. Mandell, Chairman of the Board and Secretary of the Company, served as ex-officio member of the Audit Committee during fiscal year 2005. Mr. Mandell resigned as CEO with Company effective January 6, 2006, though he remained as Chairman to assist in the search and closing of a sale transaction. There were no members of the committee upon the resignation of Mr. Segel.

     Compensation and Stock Committee

     Our Compensation and Stock Option Committee (the “Compensation Committee”) consisted of Messrs. Pace and Segel, each of whom was a non-employee director of the Company and a “disinterested person” with respect to the plans administered by such committee, as such term is defined in Rule 16b-3 adopted under the Securities Exchange Act of 1934, as amended, and the rules and regulations thereunder (collectively, the “Exchange Act”). The Compensation Committee reviews and approves annual salaries, bonuses and other forms and items of compensation for our senior officers and employees. Except for plans that are, in accordance with their terms or as required by law, administered by the Board of Directors or another particularly designated group, the Compensation Committee also administers and implements all of our stock option and other stock-based and equity-based benefit plans (including performance-based plans), recommends changes or additions to those plans or awards under the plans. Messrs. Pace and Segel resigned as directors in December 2005.

Our Audit Committee and Compensation and Stock Committee charters are available in print to any stockholder upon request in writing to our principal corporate office at 2025 Gateway place, Suite 365, San Jose, California 95110.

Key Components of the Financial Statements and Important Trends

     The financial statements, including the Consolidated Balance Sheets, the Consolidated Statements of Operations, the Consolidated Statements of Cash Flows and the Consolidated Statements of Stockholders’ Equity, should be read in conjunction with the Consolidated Financial Statements and Notes thereto included elsewhere in this report. MD&A explains the key components of each of these financial statements, key trends and reasons for reporting period-to-period fluctuations.

     The Consolidated Balance Sheet provides a snapshot view of our financial condition at the end of our fiscal year. A balance sheet helps management and our stockholders understand the financial strength and capabilities of our business. Balance sheets can help identify and analyze trends, particularly in the area of receivables and payables. A review of cash compared to the comparable year and in relation to ongoing profit or loss can show the ability of the Company to withstand business variations. The relationship between Current Assets and Current Liabilities Working capital (current assets less current liabilities) measures how much in liquid assets a company has available to build its business. The presence of Deferred Revenue indicates cash received on revenue to be earned over the next twelve months. Receivables that are substantially higher than revenue for the quarter may indicate a slowdown of collections, with an impact on future cash position. This is addressed further in MD&A under Liquidity and Capital Resources.

          The Consolidated Statement of Operations tells the reader whether the Company had a profit or loss. It shows key sources of revenue and major expense categories. It is important to note period-to-period comparisons of each line item of this statement, reasons for any fluctuation and how costs are managed in relation to the overall revenue trend of the business. These statements are prepared using accrual accounting under generally accepted accounting standards in the United States. This is addressed further in MD&A under Revenues and Expenses.

          The Consolidated Statement of Cash Flows explains the actual sources and uses of cash. Some expenses of the Company, such as depreciation and amortization do not result in a cash outflow in the current period, since the underlying patent expenditure or asset purchase was made years earlier. New capital expenditures, on the other hand, result in a disbursement of cash, but will be expensed in the Consolidated Statement of Operations over its useful life. Fluctuations in receivables and payables also explain why the net change in cash is not equal to the loss reported on the Statement of Operations. Therefore, it is possible that the impact of a net loss on cash is less or more than the actual amount of the loss. This is discussed further in MD&A under Liquidity and Capital Resources.

          The Consolidated Statement of Changes in Stockholders’ Equity shows the impact of the operating results on the Company’s equity. In addition, this statement shows new equity brought into the Company through stock sales or stock option exercise. This is discussed further in MD&A under Liquidity and Capital Resources.

Results of Operations

Revenues

     Revenues decreased to $68,000 for the quarter ended September 30, 2006 compared to $271,000 for the quarter ended September 30, 2005, a decrease of 75%. Revenues were comprised of royalties pertaining to the licensing of Spatializer audio signal processing algorithms and circuit designs. Revenues in the nine months ended September 30, 2006 were $261,000, compared to revenues of $1,032,000 in the comparable period last year, a decrease of 75%. Revenues in the three and nine months ended September 30, 2006 decreased due to end of life of a mobile telephone license and the recognition, earlier in 2005, of deferred revenue on a royalty prepayment received in the third quarter of 2004.

Gross Profit

     Gross profit for the three months ended September 30, 2006 was $61,000 (90% of revenue) compared to gross profit of $258,000 (95% of revenue) in the comparable period last year, a decrease of 76%. Gross profit for the nine months ended September 30, 2006 were $235,000 (90% of revenue) compared to $942,000 (91% of revenue) in the comparable period last year. Gross profit in the three and nine-month periods decreased due to decreased revenue.

Operating Expenses

     Operating expenses in the three months ended September 30, 2006 were $122,000 (180% of revenue) compared to operating expenses of 224,000 (83% of revenue) in the comparable period last year, a decrease of 46%. Operating expenses in the nine months ended September 30, 2006 were $530,000 (203% of revenue) compared to $843,000 (82% of revenue) in the comparable nine-month period last year. The decrease in operating expenses for the three and nine months ended September 30, 2006 resulted primarily from personnel and operating reductions resulting from the suspension of day-to-day operations during the asset auction process, with the goal of conserving cash.

General and Administrative

     General and administrative expenses in the three months ended September 30, 2006 were $122,000 (180% of revenue) compared to general and administrative expenses of $117,000 (43% of revenue) in the comparable period last year, an increase of 4%. General and administrative expenses in the nine months ended September 30, 2006 were $371,000 (142% of revenue) compared to $457,000 (44% of revenue) in the comparable nine month period last year. The increase in general and administrative expense for the three month period results primarily from higher legal expenses arising from the proposed sale of assets. The decrease in general and administrative expense for the nine month period resulted primarily from the elimination of the CEO position and related corporate travel expenses.

Research and Development

     Research and Development expenses in the three months ended September 30, 2006 were $0 (0% of revenue) compared to research and development expenses of $62,000 (23% of revenue) in the comparable period last year, a decrease of 100%. Research and Development expenses for the nine months ended September 30, 2006 were $158,000 (61% of revenue) compared to $245,000 (25% of revenue) in the comparable nine month period last year. There were no engineering activities in the third quarter. The decrease in the nine month research and development expenses resulted from the elimination of an in-house applications engineering position and the resignation of the principal engineer in May 2006.

Sales and Marketing

     Sales and Marketing expenses in the three months ended September 30, 2006 were $0 (0% of revenue) compared to sales and marketing expenses of $45,000 (17% of revenue) in the comparable period last year, an decrease of 100%. Sales and Marketing expenses for the nine months ended September 30, 2006 were $1,000 (1% of revenue) compared to $141,000 (14% of revenue) in the comparable nine month period last year. The decrease in sales and marketing expense in the three and nine month periods resulted from the suspension of all travel and selling activities, with the resignation of the CEO who performed this function as among his duties.

Net Income (Loss)

     Net Loss was ($62,000) for the quarter ended September 30, 2006, $0.00 basic per share, compared to net income of $37,000, $0.00 basic and diluted per share, for the quarter ended September 30, 2005. Net loss in the nine months ended September 30, 2006 was ($297,000), ($0.01) basic per share, compared with net income of $104,000, $0.00 basic and diluted per share in the comparable period last year. The net loss in the three month and nine month periods resulted from decreased revenues and a general wind down of operations.

     At September 30, 2006, we had $273,000 in cash and cash equivalents as compared to $551,000 at December 31, 2005. The decrease in cash resulted primarily from the net loss. We had working capital of $277,000 at September 30, 2006 as compared with working capital of $560,000 at December 31, 2005.

     In December 2005, the Company, as stipulated by the related Subscription Agreement, forced the conversion of all outstanding Series B-1 Preferred Stock, into Restricted Common Stock at the minimum conversion price of $.56 per share. This resulted in the issuance of 1,788,018 Common Stock shares, worth approximately $100,000 at market value at issuance. This issuance diluted existing common stockholders by approximately 4%, but eliminated $1.1 million in liquidation preference shares.

     Future payments due under operating lease obligations as of September 30, 2006 are described below:

		Payment due by period
						Less than												More than
Contractual obligations		Total				1 year				1-3 years				3-5 years				5 years
Operating Lease Obligations		$	7,000			$	7,000
Total		$	7,000			$	7,000

     In the event the Company is to be wound up and dissolved the Company would attempt to settle these amounts, negotiate early termination, or pay the remaining obligation if cash resources permitted.

     Our future cash flow will come primarily from the audio signal processing licensing and OEM royalties until or if our efforts to sell the assets of the company, with stockholders approval, is consummated and in that case from any net proceeds from the sale of assets or perpetual licenses. The Board of Directors will, with the approval of the stockholders, decide on the dispensation of such proceeds.

     The fluid, competitive and dynamic nature of the market continues a high degree of uncertainty to our operations. The operations of our business, and those of our competitors, are also impacted by the continued trend in the semiconductor industry to offer free, but minimal audio solutions to certain product classes to maintain and attract market share. In addition, the commoditization of many consumer electronics segments, our lack of resources and the departure of key employee and directors has made it unfeasible to continue to compete.

     Based on current and projected operating levels, we no longer believe that we can maintain our liquidity position at a consistent level both on a short-term and long-term basis. As such, we do not believe our current cash reserves and cash generated from our existing operations and customer base are sufficient for us to meet our operating obligations and the anticipated additional research and development for our audio technology business for at least the next 12 months.

     On January 10, 2006, the Company announced that it would hold an open auction for the

sale of substantially all of its assets. The Board of Directors of the Company decided that it is in the best interests of the stockholders to hold an open auction for the acquisition of the assets of the Company or the granting of an unlimited amount of non-exclusive perpetual licenses for a one-time fee and a subsequent auction of the residual assets. The consummation of any of such transactions will be subject to approval by the stockholders of the Company. The Company received non-conforming bids for such assets on the February 15, 2006 deadline. The Board of Directors of the company, in consultation with their financial and legal advisors, extended the auction period to March 15, 2006, to provide bidders and other interested parties additional time to clarify their offers and perform due diligence, as well as to solicit additional offers.

     In August 2006, the board of directors of Spatializer was presented with and carefully considered a draft of the Asset Purchase Agreement. After due consideration of all of the foregoing, the board of directors of Spatializer, by a unanimous written consent of directors dated August 28, 2006, authorized the execution and delivery on behalf of Spatializer of the Asset Purchase Agreement providing for the sale to DTS and DTS BVI of all or substantially all of the assets of each of Spatializer and Desper Products, deemed the sale of all or substantially all of the assets of Spatializer and Desper Products for $1,000,000 in aggregate cash consideration to be expedient and for the best interests of Spatializer, and deemed the sale of all or substantially all of the assets of Spatializer and Desper Products to be advisable and in the best interests of Spatializer. Furthermore, the board of directors of Spatializer deemed it advisable that, following the sale of the assets, Spatializer be dissolved. The board of directors also recommended that the stockholders of Spatializer vote in favor of both the sale of assets transaction and the dissolution of Spatializer. The board of directors called a meeting of the stockholders of Spatializer to consider the proposed sale of assets pursuant to the Asset Purchase Agreement and to take action upon the resolution of the board of directors to dissolve Spatializer. The board of directors also recommended that the stockholders of Spatializer vote in favor of both the sale of assets transaction and the dissolution of Spatializer.

     Effective August 28, 2006, Spatializer, as the sole shareholder of Desper Products, executed a written consent of sole shareholder approving the principal terms of the sale of the assets of Desper Products.

     On September 18, 2006, the parties executed and delivered the Asset Purchase Agreement. It is anticipated that a meeting of Stockholders will be held in January, 2007 to vote on the approval of this Agreement.

Net Operating Loss Carry forwards

     At December 31, 2005, we had net operating loss carry forwards for Federal income tax purposes of approximately $26,500,000 which are available to offset future Federal taxable income, if any, through 2013. Approximately $21,700,000 of these net operating loss carry forwards are subject to an annual limitation of approximately $1,000,000. Based on the suspension of operations and the pending sale of assets, these net operating loss carry forwards will not be utilized.

Recently Issued Accounting Pronouncements

     In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R, “Share Based Payment”. This Statement is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation”. This Statement supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” and its related implementation guidance. This Statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. The Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. This Statement does not change the accounting guidance for share-based payment transactions with parties other than employees provided in Statement 123 as originally issued and EITF Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.” This Statement does not address the accounting for employee share ownership plans, which are subject to AICPA Statement of Position 93-6, “Employers’ Accounting for Employee Stock Ownership Plans”. The Securities and Exchange Commission has delayed the adoption requirement of SFAS No. 123R until the first annual reporting period beginning after December 15, 2005. We adopted SFAS No. 123R as of January 1, 2006 as required.

In May 2005 the FASB issued SFAS 154 “Accounting Changes and Error Corrections”. This Statement replaces APB Opinion No. 20, “Accounting Changes”, and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements”, and changes the requirements for the accounting for and reporting of a change in accounting principle and also corrections of error in previously issued financial statements. This Statement harmonizes US accounting standards with existing international accounting standards by requiring companies to report voluntary changes in accounting principles via a retrospective application, unless impracticable. Also, the reporting of an error correction involves adjustments to previously issued financial statements similar to those generally applicable to reporting an accounting change retrospectively. This pronouncement is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005

Item 3. Quantitative and Qualitative Disclosures About Market Risk

     We have not been exposed to material future earnings or cash flow fluctuations from changes in interest rates on our short-term investments at September 30, 2006. A hypothetical decrease of 100 basis points in interest rate (ten percent of our overall earnings rate) would not result in a material fluctuation in future earnings or cash flow. We have not entered into any derivative financial instruments to manage interest rate risk or for speculative purposes and we are not currently evaluating the future use of such financial instruments.

Item 4. Controls and Procedures

     The Company carried out an evaluation of the effectiveness of the Company’s disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities and Exchange Act of 1934. Based on that evaluation, the Chairman of the Board, in performing the functions of the principal executive and principal financial officers of the Company, concluded that the Company’s disclosure controls and procedures as of September 30, 2006 were effective to ensure that information required to be disclosed by the Company in reports

which it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to management as appropriate to allow timely decisions regarding required disclosure . There were no changes in the Company’s internal control over financial reporting that occurred during the quarter ended September 30, 2006 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

     From time to time we may be involved in various disputes and litigation matters arising in the normal course of business. As of October 29, 2006 we are not involved in any legal proceedings that are expected to have a material adverse effect on our consolidated financial position, results of operations or cash flows. However, litigation is subject to inherent uncertainties. Were an unfavorable ruling to occur, given the size of our company, there exists the possibility of a material adverse impact on our results of operations of the period in which the ruling occurs. Our estimate of the potential impact on our financial position or overall results of operations for new legal proceedings could change in the future.

ITEM 1A. RISK FACTORS

     In addition to the other information set forth in this Quarterly Report, stockholders should carefully consider the factors discussed in Item 1A, Risk Factors, of our Annual Report on Form 10-K for the year ended December 31, 2005, which could materially affect our business, financial condition or future results. The risks described in our Annual Report on Form 10-K are not the only risks facing the Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

     There were no unregistered sales of equity securities or repurchases during the period covered by this report.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None

ITEM 5. OTHER INFORMATION

None

ITEM 6. EXHIBITS

10.9

Asset Purchase Agreement, dated as of September 18, 2006, by and among DTS, Inc., a Delaware corporation (“Purchaser”), DTS BVI Limited, a corporation organized under the laws of the British Virgin Islands and a subsidiary of Purchaser (“Purchaser Subsidiary”), Spatializer Audio Laboratories, Inc., a Delaware corporation (“Seller”), and Desper Products, Inc., a California corporation which is a wholly

		owned subsidiary of Seller (“Seller Subsidiary”).
31		Rule 13a-14(a)/15d-14(a) Certification
32*		Section 1350 Certification

*

Certification will not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Dated: November 14, 2006

		SPATIALIZER AUDIO LABORATORIES, INC.
		(Registrant)
		/s/ Henry R. Mandell
		Henry R. Mandell
		Chairman of the Board and Secretary
		(Principal Executive, Financial and Accounting Officer)