UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

For the period ended: December 31, 2003

OR

Commission File Number: 000-26460

SPATIALIZER AUDIO LABORATORIES, INC.

(Exact name of registrant as specified in its charter)

2625 Hampshire Road, Suite 330
Westlake Village, California 91361
(Address of principal executive offices)

1754 Technology Drive, Suite 125
San Jose, California 95110
(Address of principal corporate offices)

Telephone Number: (408) 453-4180
(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:
None

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.01 par value

     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 [X] No [   ]

CAUTIONARY STATEMENT REGARDING FORWARD LOOKING STATEMENTS

     This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended, reflecting management’s current expectations. Examples of such forward-looking statements include our expectations with respect to our strategy. Although we believe that our expectations are based upon reasonable assumptions, there can be no assurances that our financial goals will be realized. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Numerous factors may affect our actual results and may cause results to differ materially from those expressed in forward-looking statements made by or on behalf of our company. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words, “believes,” “anticipates,” “plans,” “expects” and similar expressions are intended to identify forward-looking statements. The important factors discussed under the caption “Factors That May Affect Future Results” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, herein, among others, would cause actual results to differ materially from those indicated by forward-looking statements made herein and represent management’s current expectations and are inherently uncertain. Investors are warned that actual results may differ from management’s expectations. We assume no obligation to update the forward-looking information to reflect actual results or changes in the factors affecting such forward-looking information.

PART I

Item 1. Business

Overview

     Spatializer Audio Laboratories, Inc. (“Spatializer” or “Company”) is a developer, licensor and marketer of next generation technologies for the consumer electronics, personal computing, enterprise computing and entertainment industries. Our position as a developer of next generation technologies is based on our business relationships with brand leaders, such as Toshiba, Samsung, Sanyo and Matsushita. We conduct our audio business through our parent company and our wholly owned subsidiary, Desper Products, Inc. (“DPI”). DPI has developed a full complement of patented and proprietary 3-D or virtual audio signal processing technologies directed to the consumer electronics and multimedia PC markets. We continue to expand our product offerings to take advantage of the growing digital audio marketplace specifically for consumer products like Digital Versatile Disc (“DVD”) players, portable mp3 players, digital televisions and digital home, portable and auto entertainment devices. As of December 31, 2003, more than 45 million licensed units had been shipped covering all of these applications. DPI’s virtual audio signal processing technologies are currently incorporated in products offered by global brand leaders in consumer electronics, including Toshiba, Panasonic, JVC, Samsung, Sanyo, and Sharp. We are focused on broadening recognition of the Spatializer brand name through association with these and other globally recognized consumer electronics and multimedia computer brand leaders, and on broadening our audio technology and software base to position ourselves for continued growth. We believe that with the accelerating growth in the digital audio/video marketplace, the market for virtual audio technologies, and therefore for our products, is entering a new phase of opportunity.

     Our other wholly owned subsidiary, MultiDisc Technologies, Inc., (“MDT”) formed in June 1996 when we acquired development stage optical disc storage and robotics assets and technologies from Home Theater Products International, Inc., a debtor in possession, is now inactive. In September 1998, we announced our plan to refocus our business on the exploitation of our core audio technologies, suspend research and development at MDT and to properly position the MDT assets for sale. Therefore, MDT has been accounted for as a discontinued operation. Since 1998, we have been unsuccessful in identifying a purchaser for the MDT assets or technology. Our repositioning in 1998 recognized that the capital investment required to properly commercialize the MDT technology was beyond our capacity. We believe this strategy provides a better opportunity to further solidify our position as a provider of virtual audio solutions, based on our available capital resources.

     We were incorporated in the State of Delaware in February, 1994 as 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 and research center is located at 1754 Technology Drive, Suite 125, San Jose, California 95110, Telephone (408) 453-4180. We also maintain offices at 2625 Hampshire Road, Suite 330, Westlake Village, California 91361. We have a Website at www.spatializer.com. Copies of this Annual Report, including our financial statements and our quarterly reports on Form 10-Q as well as other corporate information, including press releases, of interest to our

stockholders are available on our website promptly after filing or distribution. As used herein, Spatializer, the “Company,” “we” or “our” means Spatializer Audio Laboratories, Inc. and its wholly-owned subsidiaries.

     Desper Products, Inc. — Virtual Audio Signal Processing Technologies

     DPI has developed a suite of proprietary advanced audio signal processing technologies for the entire spectrum of applications falling under the general category of virtual audio. The objective in each product category is to create or simulate the effect of a multi-speaker sonic environment using two ordinary speakers (or headphones) for playback. The market for virtual audio is segmented into six broad categories of technology as identified in the listing below. Each of these technologies utilizes different underlying scientific principles in accomplishing its design objectives and is targeted to a specific class of consumer electronics or multimedia computer depending on the intended product use and functional capability of the product. DPI currently has other audio signal processing technologies under development which will serve to expand its market scope and partner product capabilities.

Licensed Products

     Our current technology product applications are directed to (1) speaker enhancement, (2) stereo surround sound enhancement, (3) mobile entertainment enhancement and (4) noise reduction.

1.

Spatializer 3D Stereo. Based upon proprietary and patented methods of stereo signal processing, our Spatializer 3—D Stereo technology is designed to create a vivid and expansive three- dimensional surround sound listening experience from any stereo source input using only two ordinary speakers. Along with professional audio quality and coherent stable sonic imaging, the technology includes our unique DDP™ (Double Detect and Protect™) algorithm. DDP continuously monitors the underlying stereo signal and dynamically optimizes spatial processing, avoiding deleterious sonic artifacts common in other systems and provides “set and forget” ease of use for consumers. First introduced in July 1994 by DPI, in the form of a 20 pin analog integrated circuit (IC) from Matsushita Electronics Corporation (“MEC”), the technology is now incorporated into low-cost, standard process ICs by three chip foundries (Matsushita, ESS Technologies, Inc., OnChip Systems and) for easy and inexpensive implementation in any consumer electronics or computer products utilizing stereo audio. The technology is currently available in both analog and digital formats. Matsushita introduced a new Spatializer IC design in 1999, offering the Spatializer 3-D Stereo effect in a simplified, lower cost package. In early 2002, we introduced a new algorithm-based technology which provides a virtual surround sound effect from a two channel input for DSP-based environments. In 2003, we introduced Spatializer ((environ)), especially designed for cellular phones with two, closely spaced speakers to enhance both ring tones and music.

2.

Spatializer N-2-2 Ultra Digital Virtual Surround. In September 1996, DPI introduced Spatializer N-2-2, which we consider a “core”, and “enabling” technology for DVD based home theater products and personal computers. In mid-2001, DPI introduced Spatializer N-2-2 Ultra as the latest generation of this core audio technology. Through outstanding performance and continuous enhancement, Spatializer N-2-2 has emerged as the “de facto standard” for branded virtual surround sound as measured by most brand adoptions, cumulative shipments and market share of such brands in the DVD player market. DVD is considered by many to be the single most important and fastest adopted consumer audio/computer technology ever introduced. The audio standards for DVD (based upon geographic region) are multi-channel audio formats (Dolby Digital® (AC-3) and MPEG-2) which carry six (or more) discrete (independent) channels of audio — the front left and right channels, a center channel (for vocal tracks), two rear surround channels and a Low Frequency Effects (LFE or “sub-woofer”) channel for sound effects. The Spatializer N-2-2 software- based algorithms permit spatially accurate reproduction of this multi-channel audio over any ordinary stereo system using two rather than the five or six speakers normally required in traditional home theater setups. Spatializer N-2-2 runs in real-time on general purpose Digital Signal Processing (“DSP”) hardware platforms like those offered by LSI, Acer Labs, Inc., Motorola, VM Labs and Zoran; may be integrated with host based software-only MPEG-2 or DVD decoders (like WinDVD and PowerDVD, offered by InterVideo and Cyberlink, respectively, for the Intel® Pentium® series of microprocessors); and can be ported to any of the principal audio codecs or media processor/accelerator platforms performing Dolby Digital (AC-3) or MPEG-2 audio decoding. Spatializer N-2-2 has been approved by Dolby Laboratories and qualifies Spatializer licensees to use the newly created Dolby Digital VIRTUAL™ trademark on products incorporating the technology. We believe our Spatializer N-2-2 Ultra process has helped to widen and accelerate the market for DVD acceptance, because it delivers the full cinematic audio experience to ordinary consumers without the additional expense and complication of multi-speaker home theater playback systems.

3.

Spatializer Vi.B.E. In early 1999, DPI introduced Spatializer Vi.B.E., a virtual bass enhancement technology. Spatializer Vi.B.E. produces a dynamic bass response from even the lowest-end speakers or headphones. This is particularly important in enhancing the audio of all forms of portable digital audio devices. Spatializer Vi.B.E. uses proprietary technology to generate the perception of realistic bass frequencies that are unaffected by actual speaker system frequency response capability.

4.

Spatializer VSP-11 First introduced by DPI in early 2002, Spatializer VSP-11 (Virtual Sound Processor 11) is a stand-alone application program for Microsoft Windows 95, 98, ME, 2000 and XP platforms that utilizes Spatializer proprietary psychoacoustic techniques to allow consumers to enjoy the benefits of the renowned Spatializer audio enhancement technologies on all leading media players, soft DVD players and file sharing programs. This means that Spatializer VSP-11 is a universal audio enhancement software package that will enhance output from the Microsoft® Media Player, Real

Player®, Real Jukebox®, WinAmp®, WinDVD®, PowerDVD®, among others, without any special modification. It will run in conjunction with any sound card, as well as with USB audio.

5.

Spatializer Natural Headphone Spatializer Natural Headphone, introduced by DPI in March 2001, renders spatially accurate multiple speaker positions simulating the typical home theater or stereo arrangement through a headphone. The headphone algorithm delivers a high performance simulated surround sound experience, using a reasonable amount of processing power at a reasonable cost. Thus, this solution is equally practical and effective for both low-power portable devices and home theater applications. Unlike typical virtual surround sound headphone solutions, which rely heavily on reverberation which can sound unnatural, Spatializer Natural Headphone utilizes a combination of techniques to provide an expanded, yet natural sound field.

6.

Spatializer PCE Spatializer PCE, introduced in October 2001, makes high frequencies clearer, crisper and more brilliant while low frequencies are more dramatic, tighter and have more impact. Spatializer® PCE gives the manufacturer an inexpensive way to dramatically improve the sound of low-end loudspeakers, such as the kind found in televisions, boom boxes and computers. Spatializer PCE is also ideal for improving the quality of Internet audio, which can sound rather lackluster and dull due to compression or low bit rates. It can be applied prior to encoding audio streams, and can just as easily enhance the playback of the decompressed audio. It can improve the clarity, intelligibility and impact of both dialog and music. Spatializer PCE works by both modifying and smoothing non-linear phase response and by creating psycho-acoustic cues. Typical equalization techniques cause phase distortion (non-zero group delay) due to non-linear phase response. Spatializer PCE has a nearly-linear phase response, which results in a near-zero group delay. This improves the “naturalness”, or transparency of the dialog or music by not adding to phase distortion already present in many playback systems.. Spatializer PCE can be custom tailored for two or an array of speaker configurations. The technology, without a surround sound effect, can enhance single speaker applications as well.

7.

Spatializer enCompass AV Spatializer enCompass AV, launched in late 2002, is designed to offer high quality, multi-channel audio, even from mono or stereo sources. This technology allows owners of home theater systems with five or more speakers to hear a surround sound effect, utilizing all of their speakers to deliver full system utility from CDs, cassettes or VHS tape or records.

8.

Spatializer VirtuaLFE processes the sub-woofer channel with proprietary psycho-acoustic techniques to virtualize, reinforce and enhance the effect for accurate reproduction through two speaker home audio or on-board television speakers. The result is an emotive low frequency effect that brings DVDs alive as if an actual sub-woofer speaker were employed. The efficient algorithm architecture makes implementation feasible on a wide array of home entertainment products.

9.

Spatializer Audio Alchemy dynamically removes noise from up to six input channel simultaneously. Utilizing state of the art noise removal and reduction techniques, Spatializer Audio Alchemy dynamically adjusts to changing noise levels and environments. Tailored for the human voice, Spatializer Audio Alchemy removes background noise such as fans, motor hum, and tape hiss. Spatializer Audio Alchemy features an advanced equalization processor to compensate for frequency response limitations in the audio recording hardware and transducers. In addition, Spatializer Audio Alchemy also performs spatial reconstruction to simulate the original acoustic environment, and normalizes the dynamic range of the digital audio source to a level compatible with home theater environments

In addition, we offer three whole product solutions with multiple Spatializer technologies that comprehensively address the unique audio delivery challenges inherent in each targeted platform. The Spatializer HD Class is comprised of three new products specifically targeted at home audio, cellular telephones and other mobile applications and personal computers. The Spatializer technologies in each package operate in a complementary fashion, such that the concurrent technologies deliver a more powerful and effective audio experience than that possible from a single solution. Further, each technology has been optimized and customized for the targeted application and is designed to overcome the audio challenges presented by small form factor, transducer limitations and even cost constraints.

Spatializer UltraMobile HD™ delivers higher definition digital audio to mobile audio systems through the multiple and complementary use of Spatializer Natural Headphone, Spatializer Vi.B.E. and Spatializer PCE. UltraMobile HD improves the performance of low cost headphones or ear buds, as well as from compressed audio by opening up the sound field while improving bass performance. In cellular telephone applications, Spatializer ((environ)) delivers maximum performance from micro-speakers that are mounted closely together and helps compensate for the more limited dynamic range as compared with standard size speakers.

When applied to stereophonic ring tones, Spatializer ((environ)) creates a startling and expressive sound field when such speakers are utilized in cellular handsets.

Spatializer UltraTV HD™ delivers higher definition digital audio performance to digital televisions, DVD players and DVD Recorders. HDTV signals can realistically be retrieved only in limited ways, leading to customer disappointment. The Spatializer UltraTV HD processor is designed to compensate for these shortcomings in digital home entertainment for the millions of households without home theater systems. Realistic surround sound, near-sub-woofer effects and crisp dialog is made possible through two speakers, rather than through expensive arrays of external speakers. Another unique aspect of this product is that it is designed specifically for playback through television speakers and can be custom tailored to the frequency aspects of a manufacturer’s speaker set.

Spatializer UltraPC HD™ helps ease the transition of the personal computer from business tool to a comprehensive component of the digital home entertainment experience. Spatializer UltraPC HD includes Spatializer N-2-2 Ultra that delivers surround sound through only two speakers, Spatializer Natural Headphone for personal surround sound, Spatializer VirtuaLFE™ that processes the sub-woofer channel for a low frequency effect through ordinary speakers and Spatializer PCE for dialog clarity. Each of these technologies has been optimized for small speaker or headphone playback and can be custom tuned to a manufacturer’s specific speaker set.

Licensing Activities

     Until 2000, we licensed our technologies primarily through semiconductor manufacturing and distribution licenses (“Foundry Licenses”) with semiconductor foundries. In turn, the foundries manufacture and distribute integrated circuits ICs (integrated circuits) or DSPs (digital signal processors) incorporating Spatializer technology to consumer electronics and multimedia computer OEMs (original equipment manufacturers).

     In 2000, we began offering foundries the option of entering into a non-royalty bearing distribution agreement with us. Under this business model, the foundry offers Spatializer technology as an optional feature, promotes our technology in their sales materials and cooperates with the Spatializer sales force in closing license agreements for Spatializer technology with the OEM customer. This business model provides the foundry with an additional selling feature at no additional cost to the foundry. The OEM can obtain use of the technology directly from Spatializer without any additional mark-up from the foundry.

     The terms of all of our licenses are negotiated on an individual basis requiring the payment of a per unit running royalty according to sliding scales based upon cumulative volume. Some of our licenses call for the payment of an up-front license issuance fee either in lieu of, or in addition to the running royalty. Other agreements require the OEM customer, rather than the foundry, to pay the royalty. Per unit royalties are generally reportable and payable 45 days after the end of the quarter following shipment from the foundry to the OEM or, in the case of a distribution agreement, by the OEM to its accounts.

     OEMs who desire to incorporate these DSPs or ICs into their products are required to enter into a license (“OEM Licenses”) with us before they may purchase the ICs in quantity. Foundry Licenses generally have limited the sale of DSPs or ICs with Spatializer technology to OEMs who have entered into an OEM License with us. OEM licenses generally provide for the payment of a further per unit royalty by the OEM for OEM products incorporating a Spatializer IC (“Licensed Products”) payable in the quarter following shipment by the OEM of its Licensed Products.

     In early 2001, we reached an agreement with C-Cube Semiconductor II (now LSI Logic Corporation) to unbundle the royalty on their DSPs in order to facilitate the licensing of multiple technologies to OEM manufacturers and to help ensure that their products remained highly competitive in the market. As such, effective April 1, 2001, C-Cube’s customers using Spatializer technology have entered into direct licenses with us.

     We are currently negotiating new IC/DSP Foundry Licenses and OEM Licenses with potential customers for Spatializer N-2-2 Ultra, Spatializer Vi.B.E., Spatializer Natural Headphone , Spatializer PCE and combinations and optimizations of these technologies under the Spatializer Ultra HD series. Currently, all new licenses are negotiated by our Chief Executive Officer.

     IC/DSP Foundry Licenses

     In 2000 and early 2001, VM Labs, Inc., MIPS Technologies, New Japan Radio Corporation (“NJRC”), Tvia, Inc. and Link Up Systems entered into Foundry License or Distribution Agreements for Spatializer N-2-2. All but the NJRC agreements were non-royalty bearing distribution agreements, with per unit royalties to be paid by the OEM customer.

     In 2001, we entered into license or distribution agreements with Texas Instruments, Cirrus Logic, Sanyo, Sharp and Kenwood, among others.

     In 2002, we entered into distribution agreements with MediaTek, Amlogic, LSI Logic and Samsung Semiconductor for the porting and distribution of our technologies to OEM manufacturers. These Distribution agreements grant the right to port and or distribute our technology only to licensed customers of Spatializer, who then pay a royalty for the use of such technologies.

     As of December 31, 2003, we have entered into non-exclusive Foundry Licenses for our Virtual Audio Signal Processing technologies with Matsushita Electronics Corporation (“MEC”), ESS Technology, Inc. (“ESS”), OnChip Systems, Inc. (“OnChip”), LSI Logic, Inc. (“LSI”), Acer Labs, Inc. (“Ali”), MIPS Technologies, NJRC, Tvia, Inc., Texas Instruments, Cirrus Logic and Link Up Systems. Foundry Licenses generally require the payment of per unit running royalties based upon a sliding scale computed on the number of Spatializer ICs or DSPs sold.

     As of December 31, 2003, more than 45 million ICs and DSPs incorporating Spatializer audio signal processing technology had been manufactured and sold.

OEM Licensees and Customers

     As of December 31, 2003, our technology has been incorporated in products offered by more than 100 separate OEM Licensees and customers on various economic and business terms. Some of these OEM Licenses required a license issuance fee and/or a separate per unit royalty, while others were licensed under the Logo Usage Agreement (“LUA”) or were authorized customers under bundled royalty licenses with the IC foundries. The OEM Licensees and customers offer a wide range of products, which include DVD players, car stereo systems, direct view TVs, wide screen and projection TVs, cellular phones, powered speakers, portable audio systems (“Boomboxes”), HiFi stereo systems and components, computer sound cards and graphics accelerator cards, multimedia desktop personal computers, notebook computers, LCD projectors, multimedia computer monitors, and arcade pinball and video games.

     In 2003, four major customers, not presented in order of importance, each accounted for 10% or more of our total revenues: Apple Computer, Orion, JVC and Samsung, each of whom accounted for greater than 10% of our total 2003 revenues. One OEM accounted for 34%, two accounted for 20% each and one accounted for 10% of our royalty revenues during 2003. Two other accounts comprised more than 5%, but less than 10% of revenues, each. All other OEM’s accounted for less than 5% of royalty revenues individually. During 2003 we anticipated a significant reduction in revenues from Apple as it completes its migration to its newest operating system and from Toshiba due to sourcing reallocation on some products.

     The following table is a partial list of the OEM Licensees and authorized customers as of December 31, 2003:

     We have extensive relationships with OEM licensees and customers outside the United States. Japanese and Korean based entities accounted for 71% and 20% of our total revenues, respectively in 2003, 50% and 17% of our total revenues, respectively in 2002, and 31% and 15% of our total revenues, respectively in 2001. The products incorporating our technology are, in turn, sold throughout the world, in market segments and amounts that are consistent with the overall general world markets for consumer electronics and software.

     Customers, Revenues and Expenses

     We generate revenues in our audio business from royalties pursuant to our Foundry, OEM, and other licenses, and from non-recurring engineering fees to port our technologies to specific licensees’ applications. Our revenues, which totaled $1,269,000 in 2003, were derived almost entirely from Foundry and OEM license fees and royalties.

     We seek to maximize return on our intellectual property base by concentrating our efforts in higher margin licensing and software products and eliminated our hardware product operations. Licensing operations have been managed internally by our personnel and through use of an international sales rep force.

     In 2003, four major customers, not presented in order of importance, each accounted for 10% or more of our total revenues: Apple Computer, Inc., JVC, Samsung and Orion Corporation, each of whom accounted for greater than 10% of our total 2002 revenues. One OEM accounted for 34%, another accounted for 20%, another accounted for 20% and one accounted for 10% of our royalty revenues during 2003. Two other accounts comprised more than 5%, but less than 10% of revenues, each. All other OEM’s accounted for less than 5% of royalty revenues individually.

     We achieved improved operating results in 2002 as a result of overhead reductions combined with the strong growth of DVD-related revenues. In 2001, we began expanding our headcount, primarily in the engineering area in anticipation of continued growth. At midyear, in light of a weakening in market conditions and lower than anticipated royalties from a key Asian account, expenditures were once again curtailed in order to bring overhead levels more in line with current revenues. In 2003, declining revenues were experienced from three major customers resulting primarily from the cessation of use of our products by these customers. In most of these cases, the DVD player market, where we had a high concentration of accounts, became commoditized and resulted in a steep decline in price and margins. Manufacturers were forced to strip out features, such as those from our company, in order to compete. Another PC account migrated completely in 2003 to a new operating system and chose not to include any audio software enhancements.

Competition

     We compete with a number of entities that produce various audio enhancement processes, technologies and products, some utilizing traditional two-speaker playback, others utilizing multiple speakers, and others restricted to headphone listening. These include the consumer versions of multiple speakers, matrix and discrete digital technologies developed for theatrical motion picture exhibition (like Dolby Digital®, Dolby ProLogic®, and DTS®), as well as other technologies designed to create an enhanced stereo image from two or more speakers.

     Our principal competitors in the field of virtual audio are SRS Labs, Inc. and Qsound Labs, Inc. In addition, some DSP foundries and OEMs have proprietary virtual audio technologies that they regularly offer to OEMs at no cost. These companies have, or may have, substantially greater resources than us to devote to further technologies and new product developments.

     Pressure on OEMs to reduce their costs, particularly in the DVD market is intense. The marketplace is also susceptible to undisciplined competitors who, from time to time, may offer below market prices to generate short term revenue and larger market penetrations even if it does not provide for viable margins. In the future, our products and technologies also may compete with audio technologies and product applications developed by other companies including entities that have business relationships with us. Factors that affect our ability to compete include product quality, performance and features, conformance to existing and new standards, price, customer support and marketing and distribution strategies.

     We believe that we will favorably compete in this market because we offer a single source, complete suite of patented and proprietary 3D Stereo, interactive positional, virtual surround sound, headphone and speaker virtualization technologies. By virtue of our specialized engineering and OEM support, we can offer a “turn-key” audio solution to OEMs who do not possess this expertise internally. We also have developed new products that address our customer’s need for a low cost solution. In addition, the strength of our IC Foundry and OEM relationships and the Spatializer brand name recognition in the industry are other key differentiators between both our branded and unbranded competition. Lastly, we continue to explore new and alternative business models that we believe serve the interests of both our customers and our stockholders.

Research and Development

     Our research and development expenditures in 2003, 2002 and 2001 were approximately 28%, 25% and 35% of total operating expenses respectively. These expenses consist of salaries and related costs of employees and consultants engaged in ongoing research, design and development activities and costs for engineering materials and supplies

     As of December 31, 2003, we had five employees and consultants in our R&D group representing 56% of our total human resources. Our software, hardware and application engineers focus on developing intellectual property, technology solutions and consumer products.

Intellectual Property and Proprietary Information

     We rely on a variety of intellectual property protections for our products and services, including patent, copyright, trademark and trade secret laws, and contractual obligations. Our core signal processing technology is covered by U.S. patents 5,412,731, 5,896,456 and 6,307,941. On March 20, 1998, we filed a patent application on our enCompass V 2.0 technology with the United States Patent & Trademark Office (“USPTO”) covering our enCompass 2.0 positional audio gaming technology. In June 2000, we filed an additional patent application for our reduced cost/higher performance 3-D Stereo circuit design. In late 2002, we filed a patent application covering our Spatializer PCE technology. In 2003, we filed a patent application for Spatializer Audio Alchemy. Much of our intellectual property consists of trade secrets. In 2002, patent 6,307,941 was issued by the USPTO covering our Spatializer N-2-2 technology. We possess copyright protection for its principal software applications and has U.S. and foreign trademark protection for its key product names and logo marks.

     There can be no assurance that these measures will be successful, or that competitors will not be able to produce a non-infringing competitive product or service. In addition, the laws of certain countries in which our products are or may be developed, manufactured or sold, including various countries in Asia, may not protect our products and intellectual property rights to the same extent as the laws of the United States, or at all. There can be no assurance that third parties will not assert infringement claims against us, or that if required to obtain any third party licenses as a result of an infringement dispute, we will be able to obtain such licenses.

     In June 1996, we acquired certain developmental stage technologies and assets from Home Theatre Products (“HTP”), for approximately $1,062,000 in June 1996 and formed a subsidiary, MultiDisc Technologies, Inc. (“MDT”). The MDT transaction brought a combination of proprietary electromechanical designs, robotics, operating software, firmware, intellectual property, and engineering know-how and five patent applications acquired in the asset acquisition. MDT added an additional forty-seven patent applications filed with the USPTO to bring the total to fifty-two patent applications filed. On September 25, 1998, we announced our plan to refocus our business on the exploitation of our core audio technologies and to properly position the MDT assets for sale. The repositioning strategy recognized that the capital investment required to properly commercialize the MDT technology was beyond our capacity. As a result, all operations, including research and development activities, were suspended and we have accounted for MDT as a discontinued operation. We have explored the sale of the business or the patent portfolio with interested parties, but to date, no transaction has been consummated.

Seasonality

     Due to our dependence on the consumer electronics market, we experience seasonal fluctuation is sales and earnings. In particular, we believe that there is seasonality relating to the Christmas season in the third and fourth quarters, as well as the first quarter, which is generally the weakest. We are moving toward diversifying our key market segments in the consumer electronics industry in an effort to even out our seasonal fluctuation. Overall, seasonality does not have a material effect on our business.

Employees

     We began 2003 with five full-time and nine part-time employees and sales representatives and decreased our staff to four full time and five part-time employees, consultants and sales representatives by December 31, 2003. At year-end, there were two full-time employees and three consultants engaged in research and development. We employ the services of outside professional consultants, particularly in the audio engineering area, due to the costly and tight labor market for such professionals in Silicon Valley as well as the need for specialized expertise in the course of our business. None of our employees are represented by a labor union or are subject to a collective bargaining agreement. We consider our relations with our employees and consultants to be satisfactory.

Item 2. Properties

     Our corporate office and research center in San Jose, California, is the primary location for our audio technology division, (“DPI”). We occupy approximately 1,200 square feet with an annual rent on a full service basis of approximately $22,000. The lease expires on December 30, 2004 and is renewable at market rates thereafter.

     Our executive office is located in Westlake Village, California, where we occupy approximately 100 square feet with an annual rent of approximately $5,000. The lease term on this space expires on September 30, 2004 and is renewable on a month to month basis thereafter. This space in the Los Angeles area is used to facilitate business and contacts with the entertainment community as well as with our accountants, lawyers and directors.

     We lease an apartment in San Jose, California for use by the chief executive officer when away from the executive office. The annual rent on this apartment is approximately $18,000. The lease is on a month-to-month basis.

     We lease our space at rental rates and on terms which management believes are consistent with those available for similar space in the applicable local area. Our properties are well maintained and we believe they are adequate to support our current requirements.

Item 3. 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 the date of this Annual Report on Form 10-K, 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, 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 the above legal proceedings could change in the future.

Item 4. Submission of Matters to a Vote of Security Holders

     There were no matters submitted to a vote of our security holders either through solicitation of proxies or otherwise in the fourth quarter of the fiscal year ended December 31, 2003.

Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters

     Our Common Stock was listed and commenced trading on the NASDAQ SmallCap market on August 21, 1995 under the symbol “SPAZ”. In January 1999, the Common Stock was delisted by the NASDAQ SmallCap Market due to our inability to maintain listing requirements. Our Common Stock immediately commenced trading on the OTC Bulletin Board under the same symbol. The following table sets forth the high and low bid price of our Common Stock as reported on the OTC Bulletin Board for fiscal years 2001 and 2002. The quotations listed below reflect interim dealer prices without retail mark-up, mark-down or commission and may not represent actual transactions.

     On February 25, 2004, the closing price reported by the OTC Bulletin Board was U.S. $0.17. Stockholders are urged to obtain current market prices for our Common Stock. Computershare Investor Services, LLC is our transfer agent and registrar.

     There were no sales of unregistered securities by the Company during the year ended December 31, 2003.

     To our knowledge there were approximately 200 holders of record of the stock of the Company as of March 5, 2003. Our transfer agent has indicated that beneficial ownership is in excess of 4,000 stockholders.

     We have not paid any cash dividends on its Common Stock and have no present intention of paying any dividends. Our current policy is to retain earnings, if any, for use in operations and in the development of its business. Our future dividend policy will be determined from time to time by the Board of Directors.

Item 6. Selected Consolidated Financial Data

     The following selected consolidated financial data should be read in conjunction with our Consolidated Financial Statements and related Notes and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, included in Item 7. The selected financial data for the years ended December 31, 2003, 2002, 2001, 2000 and 1999 are derived from our consolidated financial statements that have been audited by Farber & Hass LLP, independent certified public accountants. The consolidated statements of operation and cash flows for the year ended December 31, 2003 and the report thereon are included elsewhere in this Report.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Approach to MD&A

     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 that enables investors 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 that past performance is indicative of future performance.

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

•		An understanding of our operating environment
•		An outline of critical accounting policies
•		A review of the key components of the financial statements and our cash position and capital resources
•		Disclosure on our internal controls and procedures

Operating Environment

     We operate in a very competitive business environment. This environment impacts us in the following ways, further discussed in greater detail under Risk Factors:

•		We Face Significant Pricing Pressure and Competition that can Result in Our Technology Being Designed Out Within a Short Time Frame, or Impeding Efforts to Secure New Design Wins
•		New Customer Product Development Can be Delayed. This Results 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 May Delay or Thwart our Sales Efforts to Potential Customers.

		The PC and consumer electronics markets are under intense pressure, primarily from retailers, to reduce selling prices, with resultant pressure to reduce costs. Cost reductions are driven by lower cost sourcing, often in China, design simplification and reduction in features. While we present a value proposition that stresses 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, all such features are closely scrutinized by potential customers' product marketing and engineering. This makes it more challenging to secure new design wins, particularly in product categories that have become commoditized, such as the case with DVD players. It also may result in the elimination of features, including ours, if cost is of paramount importance. When this occurs, we receive very short notice and revenues from such an account will typically begin a steep decline in the subsequent quarter, resulting in period-to-period fluctuation. Our response has been to strengthen our value proposition, more aggressively price and feature enrich our products and enter new segments, such as cell phones, with different competitive pressure.

		Manufacturer’s design-in cycles for our technology range from four to twelve months, from the decision to adopt our technology to actual cashflow. These schedules are also prone to delays at the manufacturer level and in some cases, manufacturer’s new products may be cancelled due to market testing or resource allocation. Since these events are beyond our control, it is difficult to absolutely project when new deals will begin generating revenues or if signed deals will generate financial results. For this reason, we do not typically announce new deals until the target product is being introduced.
		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.

		Therefore, when reviewing the operating results or drawing conclusions with regard to future performance, these competitive forces and uncertainties must be taken into consideration. Without absolute long-term visibility, it is difficult to draw such conclusions in absolute terms. Further, the dynamic nature of the business environment creates the potential for both positive and negative fluctuations in near and long term operating performance. While management strives to mitigate these risks, as outlined in Risk Factors, it is not possible to be fully immune from such dynamics.

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. We recognize revenue from product sales upon shipment to the customer. License revenues are recognized when earned, in accordance with the contractual provisions. Royalty revenues are

recognized upon shipment of products incorporating the related technology by the original equipment manufacturers (OEMs) and foundries.

     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 intangible assets. Our intangible assets consist primarily of patents. We capitalize all costs directly attributable to patents, consisting primarily of legal and filing fees, and amortize such costs over the remaining life of the patent (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.

     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.

     Compensation and Stock Committee

     Our Compensation and Stock Option Committee (the “Compensation Committee”) currently consists of Messrs. Pace and Segel, each of whom is 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.

Results of Operations

     The following discussion and analysis relates to our financial condition and results of operations for the year ended December 31, 2003 compared to the year ended December 31, 2002, and the year ended December 31, 2002 compared to the year ended December 31, 2001. The following discussion of the financial condition and results of operations should be read in conjunction with the Consolidated Financial Statements and Notes thereto included elsewhere in this report.

For the Year Ended December 31, 2003, Compared to the Year Ended December 31, 2002

     Revenues

     Revenues decreased to $1,269,000 for the year ended December 31, 2003 compared to $1,856,000 for the year ended December 31, 2002, a decrease of 32%. Revenues are almost entirely comprised royalties pertaining to the licensing of Spatializer® audio signal processing algorithms.

     The decrease in revenues is attributed primarily to the loss or reduction at two key accounts which generated in excess of 20% of total revenue each, partially offset by revenue from a new account. The first lost account was in the PC market, which completed its migration to a new operating system in which it chose not to include any software audio enhancements. The second account was in the DVD player market, where it selected a lower cost solution for its low cost, high volume DVD players.

     Gross Profit

     Gross profit decreased to $1,147,000 for the year ended December 31, 2003 compared to $1,725,000 in the comparable period last year, a decrease of 34%. Gross margin decreased to 90% of revenue in the year ended December 31, 2003 compared with 93% of revenue for the comparable period last year. The decrease in gross profit results from lower revenues in the current year and from lower gross margin. The decrease in the gross margin percentage reflects a change in mix to commissionable foreign royalty revenue compared to non-commissionable U.S. sourced revenue. We maintain a high margin since revenues are from licensing and royalty activities, which have little or no associated direct manufacturing or selling costs other than commissions paid to our independent representatives that solicit and oversee the particular accounts.

     Operating Expenses

     Operating expenses for the year ended December 31, 2003 decreased to $1,631,000 (128% of sales) from $1,711,000 (92% of sales) for the year ended December 31, 2002, a decrease of 5%. The decrease in operating expenses results primarily from reductions in sales and marketing due to the elimination of a marketing and business development executive position and related travel. These responsibilities were transferred to another executive and to a new representative firm in Japan.

     In the fourth quarter of fiscal 2003, we implemented a cost reduction program that included the elimination of an executive position, relocation of the corporate offices to smaller and lower cost facilities, replacement of a stipended representative with a commissioned representative and other overhead related cost savings. The annualized reduction to be provided by these initiatives are expected to result in an overall overhead reduction of at least 20%.

     General and Administrative

     General and administrative costs increased to $811,000 for the year ended December 31, 2003 from $766,000 for the year ended December 31, 2002, an increase of 6%. The increase is primarily due to increased legal expenses related to public filings, in part in response to the additional requirements imposed on public companies by the Sarbanes-Oxley Act, and increased travel by the CEO. General operating costs include rent, telephone, legal, public filing, office supplies and stationery, postage, depreciation and similar costs.

     Research and Development

     Research and Development costs increased to $459,000 for the year ended December 31, 2003, compared to $433,000 for the year ended December 31, 2002, an increase of 6%. The increase in research and development expense was due strategic use of outside specialist consultants, wage increases and increased health insurance premiums for such personnel.

     We continued efforts to identify, validate, and develop new product ideas at DPI. Specific engineering efforts were directed toward the launch of Spatializer Audio Alchemy, refinement of Spatializer Natural Headphone, development of the HD Series of whole product solutions and applications engineering to port our technology to leading processor platforms.

     Sales and Marketing

     Sales and Marketing costs decreased to $361,000 for the year ended December 31, 2003, compared to $513,000 for the year ended December 31, 2002, a decrease of 30%. The reduction in such expenses resulted from the elimination of a sales consultant position, the elimination of a sales executive position in the third quarter of 2003 and fewer trade show participations.

     Net Income (Loss)

     Net loss was $495,000 for the year ended December 31, 2003, ($0.01) basic per share, compared to net income of $18,000, ($0.00) per share basic and diluted, for the year ended December 31, 2002. Net loss for the current period is primarily the result of lower gross margin, partially offset by lower overhead.

For the Year Ended December 31, 2002, Compared to the Year Ended December 31, 2001

     Revenues

     Revenues increased to $1,856,000 for the year ended December 31, 2002 compared to $1,604,000 for the year ended December 31, 2001, an increase of 16%. Revenues are almost entirely comprised royalties pertaining to the licensing of Spatializer® audio signal processing algorithms.

     The increase in revenues is attributed primarily to the addition of two new accounts which generated in excess of 10% of total revenue each, partially offset by declining royalties on declining analog chip sales from another account.

     Gross Profit

     Gross profit increased to $1,725,000 for the year ended December 31, 2002 compared to $1,507,000 in the comparable period last year, an increase of 14%. Gross margin decreased to 93% of revenue in the year ended December 31, 2002 compared with 94% of revenue for the comparable period last year. The increase in gross profit results from higher revenues in the current year, partially offset by slightly lower gross margin. This decrease in the gross margin percentage reflects a slight change in mix to commissionable foreign royalty revenue compared to non-commissionable U.S. sourced revenue. We maintain a high margin since revenues are from licensing and royalty activities, which have little or no associated direct manufacturing or selling costs other than commissions paid to our independent representatives that solicit and oversee the particular accounts.

     Operating Expenses

     Operating expenses for the year ended December 31, 2002 decreased to $1,711,000 (92% of sales) from $1,823,000 (114% of sales) for the year ended December 31, 2001, a decrease of 6%. The decrease in operating expenses results primarily from completion of various outside engineering consulting projects in 2001 for which we paid outside engineering fees. In 2002, a much greater level of applications engineering projects were either done in house or by our licensed distributors and the fees incurred for such work was significantly reduced over the prior year. However, levels of pure R&D were unchanged between the two years, as reflected by the level of new product introductions.

     General and Administrative

     General and administrative costs increased to $766,000 for the year ended December 31, 2002 from $707,000 for the year ended December 31, 2001, an increase of 9%. The increase is primarily due to increased legal expenses related to public filings and increased travel by the CEO. General operating costs include rent, telephone, legal, public filing, office supplies and stationery, postage, depreciation and similar costs.

     Research and Development

     Research and Development costs decreased to $433,000 for the year ended December 31, 2002, compared to $639,000 for the year ended December 31, 2001, a decrease of 32%. The decrease in research and development expense was due completion of various outside engineering consulting projects in 2001 for which we paid outside engineering fees. In 2002, a much greater level of applications engineering projects were either done in house or by our licensed distributors and as such, the fees incurred for such work were significantly reduced over the prior year. However, levels of pure R&D were unchanged between the two years, as reflected by the level of new product introductions.

     We continued efforts to identify, validate, and develop new product ideas at DPI. Specific engineering efforts were directed toward the launch of encompass AV™ , development of Spatializer Audio Alchemy™, refinement of Spatializer Natural Headphone™ and applications engineering to port our technology to leading processor platforms.

     Sales and Marketing

     Sales and Marketing costs increased to $513,000 for the year ended December 31, 2002, compared to $476,000 for the year ended December 31, 2001, an increase of 8%. Spending was increase in the area of foreign travel, where the Asian customer visitation frequency was doubled in the second half of 2002.

     Net Income (Loss)

     Net Income was $18,000 for the year ended December 31, 2002, compared to net loss of $240,000 for the year ended December 31, 2001. Net Income for the current period is primarily the result of higher revenues and improved overhead management.

Liquidity and Capital Resources

     At December 31, 2003, we had $590,000 in cash and cash equivalents as compared to $859,000 at December 31, 2002. The decrease in cash and cash equivalents is attributed to the operating loss. We had working capital of $793,000 at December 31, 2003 as compared with working capital of $1,125,000 at December 31, 2002.

     Net cash used in operating activities was $253,965 for the year ended December 31, 2003, as compared to net cash provided by opera