Krell Showcase --> Evolution S1200U upgrade nightmare

Have you gone into the setup menus for the newer unit and made sure the speaker settings are correct?  Is the a room processing feature that isn’t being correctly implemented?

I'm not aware that it has any. One of the reasons I love these Krell processors is that they pre-date the whole room setup thing that takes the sound configuration away from you and forces you to accept what the computer comes up with. This unit is exactly like my older Showcase - same menu options - same structure - it just has 4 HDMI v1.3 connections on the back and it up-converts all video inputs to a single HDMI output and upscales the resolution and handles 1080p. It has an equalizer which I do use and would affect the sound. My sources are all HDMI v1.3 also.
I'm going to hook it back up today with no HDMI connections and see what happens. I'll hunt through the menu and see if there is anything in there I may have missed. 

The S1200 has a known issue where the digital DSP board fails.  This is common on the earlier versions of the board.  The "waiting for audio" message and static/poor sound were definitely symptoms of this.  So, yes, I completely agree that the unit is defective.  If you want to raise an issue with the seller and ask for return/refund, you are definitely justified.
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To fix this, Krell has developed a "Version 2" DSP board with newer chips (the old DSP chips were discontinued).  You would need to submit a "Service Request Form" on their website to obtain a RMA number for shipping back.  I don't know what the cost would be.  My S1200 had the failed board from the get go (new in box) and Krell covered it as part of the warrantee.  I imagine that It would probably at least be a couple thousand dollars.
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If you are wanting to keep this S1200 and try to work with it, I would test the 7.1 analog inputs first to make sure there was nothing wrong with the audio boards.  If this is successful, you know is a DSP board issue. 

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As far as the volume is concerned, I think that Krell made changes in the firmware and/or resistor ladder volume circuit with the new S1200.  I had an HTS 7.1 processor (same generation as your Showcase) and I would typically have the volume anywhere between 17 and 24 (really damn loud).  With the S1200U, I have the volume somewhere between 65 and 76.  At 76-80 it gets pretty damn loud.

I bought this unit from a very reputable seller on Audiogon and he kept insisting the unit works - he tested it thoroughly. I tend to believe him/her. I cannot give up on this. I thought about it and came up with some theories: 

• even when I went back to optical audio / component video connections I still had an HDMI cable connecting the Krell to my TV. It wouldn't surprise me if some piece decided to reject the connection and somehow lost sound but not picture
• the unit seems to freeze up and stop responding to even the buttons on the front of the unit. It can only be restored by me turning it off using the power switch on the back of the unit. When it powers back up it is responding again. Cable TV equipment tends to generate lots of noise that can be problematic for sensitive equipment. When I first bought the Krell Showcase years ago I went thru a similar exercise where I reduced the noise coming into the unit from the cable equipment via my TiVo. My Showcase still freezes up maybe once a month. Could that be a source of problems for this newer unit?
• I have not used the HDMI connections in my devices ever. Years later - how much dust built up in them? Did I clean them .. ???
• do all these cables I have not used since Noah's Ark actually work?

I got a can of compressed air and cleaned out all ports all devices. I stripped down to no connections. I tested every cable connecting them from my TiVo to my TV. One component video and one HDMI cable failed the test. 
I connected nothing but component video and optical audio to all devices including to my TV and powered up. It worked. Sounded fine. Yes the volume needed to go up to 50 or 60 but it works - all channels have sound. The picture for the TiVo is terrible - very noisy. Hmm.
Next I connected nothing but HDMI across all devices. This time the unit worked for my BluRay but froze up when selecting the TiVo. I did get a picture but no sound. 
In my earlier tests of HDMI cables I noted that the best I get is 1080i and DD 5.1 from my TiVo even when connected via HDMI (yes I enabled 1080p on the TiVo). Why do I need HDMI for this source? So - I connected an optical audio cable from the TiVo to the Krell and switched the Digital Audio input to that leaving video on HDMI. Now I get sound and picture rather quickly and it does not freeze up. The picture is great. The sound is great. I'm getting 1080i and DD 5.1
My BluRay works fine - 1080p DTS HD MA. 
In conclusion I believe all 4 bullet points I listed above contributed to my problems. With patience and trial and error we got it working. Thanks!