I have a Sondigo Inferno, which is based on the same C-Media Oxygen HD chipset as the auzentech x-meridian. You will take a SMALL hit in games, but you have several DTS and Dolby IIx encoding methods, but yes, I am pretty sure it will encode digital output on the fly.
I have logitech z5300 speakers, and when used with a C-Media based card, the first thing people say when they watch a movie on my comp (some DIVX compressed file), is "damn this sounds really nice." I am perplexed as to how they managed to hit the 5.1 channel upscaling so well too. You will have to tweak the EQ SLIGHTLY to get it to sound great, but thats it.
On another note, for gaming, it only goes up to EAX2.0. So, it the X-Fi will be better for that, if you care about exact positioning.
If it was up to me, I'd buy another sondigo inferno over an X-fi anyday.