The Direct Monitor must be set to Main, not S/PDIF, to make it work!!!!
The manual explains this, as does an FAQ on the E-MU site...but neither seems to do it particularly well, because the question keeps reappearing here.
The Direct Monitor setting defines where the input signals will be sent, not which input signal will be monitored.....and because MikeB wants the unit to take a digital input and produce an analog output, the Direct Monitor must be set to Main so the analog output stage is activated. Setting the DM to S/PDIF would be used only if you wanted to route the digital conversion of analog input to the mic pre section out to another DAC, or when using the device as simply a transport between a PC and another DAC.
Next, the Direct Monitor level encoder to the left of the output selector button must be cranked to the right. It's an encoder, not a pot, so there are no stops. It's a digital volume control, and cranking it to the right ensures that the full output of any digital input is sent forward to the main analog output stage and the internal headamp.
EDIT: I wrote the following italicized portion based on experience from last year, before a couple of firmware updates....and now I'm unsure if this advice works for units with the latest update. YMMV....
The easiest way to get the box to sync as an external DAC is to make sure that the digital source is powered up first, then select the coax or optical S/PDIF input on the 0404 USB, and lastly connect the digital cable to the appropriate digital input on the 0404 USB. The Sync Status indicator should flip over to "Ext" at that point and remain solidly lit. If it blinks, or the indication stays in "Int", turn off the 0404 USB for about 10 seconds, then turn it back on. Some of us have found that power cycling is the only method to get it to sync at times.
I haven't used it in that mode extensively, but it does seem as if there is no need to use the E-MU Control Panel applet to select the sample rate that you plan to feed it from the external source before disconnecting it from the PC......though some have suggested that is necessary. To me, it seems to automatically sync to whatever data rate is present on the digital input.
One other issue that has arisen is that some devices apparently don't provide enough peak-to-peak voltage on their coax outputs to properly drive the 0404 USB coax input, though that seems rare. E-MU tech support indicated that it has been an issue, but never followed up with me when I asked for a spec on the 0404 USB digital input, so users here could determine if their digital source was the issue rather than a simple cable or configuration problem.