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Executives

Alex Hughes

Lewis Chew - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Kevin J. Yeaman - CEO and President

Analysts

Steven B. Frankel - Dougherty & Company LLC, Research Division

Perry Huang - Goldman Sachs Group Inc., Research Division

James C. Goss - Barrington Research Associates, Inc., Research Division

John F. Bright - Avondale Partners, LLC, Research Division

Dolby Laboratories (DLB) Q2 2013 Earnings Call April 25, 2013 5:00 PM ET

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Dolby Laboratories' conference call discussing fiscal second quarter results. [Operator Instructions] As a reminder, this call is being recorded, Thursday, April 25, 2013.

I would now like to turn the conference call over to Alex Hughes, Senior Director of Investor Relations for Dolby Laboratories. Please go ahead, Mr. Hughes.

Alex Hughes

Thank you. Good afternoon. Welcome to Dolby Laboratories' Second Quarter Fiscal 2013 Earnings Conference Call. Joining today are Kevin Yeaman, Dolby Laboratories President and CEO; and Lewis Chew, Executive Vice President and Chief Financial Officer.

On this conference call, we will be making forward-looking statements that include projections of future operating results for our fiscal year ending September 27, 2013; market trends and developments for the industries in which we compete and in the PC, online and portable industries in particular, and our expectations and beliefs concerning how those trends and developments will affect our operating results; the capabilities and market acceptance of our products and technologies; expectations relating to licensing arrangements; and our strategic and operational plans and objectives.

These statements are based on management's current expectations and assumptions that are subject to risks and uncertainties. Actual results may differ materially from those set forth in such statements. Important factors, such as general economic, PC, broadcast, consumer electronic or cinema market conditions could cause actual results to differ materially from those in forward-looking statements. These factors are addressed in the earnings press release that we issued today under the section captioned Risk Factors and elsewhere at our most recent quarterly report on Form 10-Q available at www.sec.gov or on our website at dolby.com, under the Investor Relations section. Dolby disclaims any obligation to update information contained in these forward-looking statements, whether as a result of new information, future events or otherwise.

During this call, we will discuss GAAP and non-GAAP financial measures. A reconciliation between the 2 is available in our earnings release and in the Dolby Laboratories Investor Relations Data Sheet on our IR website.

As for the structure of the call, Lewis will begin with a recap of Dolby's financial results and provide our fiscal 2013 outlook. Kevin will finish with a discussion of the business. So with that introduction behind us, I will now turn the call over to Lewis.

Lewis Chew

Thanks, Alex, and good afternoon, everyone. I'll focus my comments on 3 main topics today before turning the call over to Kevin. First, I will discuss revenue in the second quarter along with details about the end markets that we serve. Then I'll take you through gross margins, operating results and net results. And then I'll finish with an outlook for the third quarter and for the full fiscal year.

So let's cover the revenue trend. Total revenue in the second quarter was $249.3 million, of which licensing comprised $226.5 million, while product and services comprised $22.8 million. Our Q2 licensing revenue was up sequentially over Q1 by $21.6 million or about 10% and down $1.4 million, about 1% from Q2 of last year.

In general, our second fiscal quarter benefits from seasonally higher sales activity. And this year, the sequential increase we achieved in Q2 was driven primarily by broadcast, gaming and mobile, offset partially by declines in consumer electronics and PC.

So here's a breakdown of our Q2 licensing revenues by end market. Broadcast represented about 38% of total licensing in the second quarter. Revenues in this category were up about 27% sequentially and about 8% over last year's second quarter. We benefited from higher amounts collected for back payments, which helped both the sequential and the year-over-year revenue comparisons. And the sequential increase was also helped by seasonally higher unit volume of TVs, as well as higher attach rates in set-top boxes.

PC revenues comprised about 26% of total licensing in Q2. They were down about 2% sequentially, and about 4% compared to last year's second quarter. Although a number of different factors affect our trends in PC both plus and minus, the primary factor behind our lower revenues in this area was the decreasing unit trend in the overall PC market.

Consumer electronic revenues in Q2 made up about 15% of total licensing. They decreased about 5% sequentially and about 25% compared to Q2 last year. The sequential decline was due to lower amounts collected for back payments and lower Blu-ray unit sales. The year-over-year decline was due to similar reasons as those I just mentioned, as well as lower unit volume in DVD and home theater in a box.

Mobile device revenues represented about 10% of licensing in the second quarter. They were up about 10% sequentially and about 32% over last year. The increasing trends were driven by a combination of ongoing adoption of our technology into more smartphones and tablets, along with growth in the overall mobile device market.

Revenues in other markets, which includes gaming and automotive, represented approximately 11% of total licensing in Q2. They were up about 20% sequentially, but roughly flat compared to last year. And the sequential increase was due primarily to higher seasonal sales of gaming consoles.

Product and services revenue were $22.8 million in Q2, which was down $8.8 million sequentially and $12 million year-over-year. The declines were attributable to lower unit volume and ASPs from cinema products as the current cycle of digital equipment conversion in the cinema market continues to mature. In addition, the year-over-year comparison reflects approximately $5 million of revenue recorded in last year's Q2 for digital cinema product that had reached DCI compliance, and there is no similar occurrence in this year's Q2.

So now I'd like to discuss margins and the rest of the income statement. Total gross margin in the second quarter was 90.7% on a GAAP basis and 91.7% on a non-GAAP basis. Product gross margin on a GAAP basis was 25.5% in the second quarter compared to 27.5% in Q1 and 35.2% in last year's second quarter. On a non-GAAP basis, product gross margin was 33% in the second quarter, which was the same as it was in Q1, but down from 37.6% in last year's Q2. The year-over-year decline was due to lower ASPs and mix, offset partially by improvements in net manufacturing costs.

Operating expenses in the second quarter on a GAAP basis were $141.9 million compared to $144 million in the first quarter. And on a non-GAAP basis, operating expenses for Q2 were $124.1 million compared to $125.7 million in Q1, and compared to an estimate of $127 million when we gave guidance at the beginning of the second quarter. And although the differences are not particularly big, much of it was due to timing on R&D and marketing programs.

Operating income in the second quarter was $84.2 million on a GAAP basis or 33.8% of revenue, and $104.6 million on a non-GAAP basis or 42% of revenue. The effective tax rate for the quarter was 26.7% on a GAAP basis and 27.2% on a non-GAAP basis. Net income in the second quarter was $61.9 million on a GAAP basis or 24.8% of revenue, and was $76.4 million on a non-GAAP basis or 30.6% of revenue.

Diluted earnings per share in Q2 were $0.60 on a GAAP basis, which was $0.10 higher than Q1 and down $0.21 from last year's Q2. On a non-GAAP basis, Q2 diluted EPS were $0.74, which was, again, $0.10 higher than Q1 but $0.17 lower than last year's Q2.

During the second quarter, we generated $56 million of cash flow from operations. And as of the end of Q2, we had about $780 million in total cash reserves, which would include cash and cash equivalents, as well as both short- and long-term marketable securities.

During the second quarter, we repurchased about 380,000 shares of our common stock for $11.5 million and we ended the quarter with about $133 million remaining available under our approved stock repurchase program.

Looking forward, here's our outlook for Q3 and for the year as a whole. In the third quarter, we estimate that total revenue will range from $205 million to $215 million. Within that, we anticipate that licensing will range from $180 million to $185 million with product and services ranging from $25 million to $30 million. The sequential decline in total revenue that we are projecting is heavily affected by seasonality. In addition, we have lowered our expectations for PC revenues based on recent market data.

Gross margin in the third quarter is projected to be about 89% on a GAAP basis and around 90% on a non-GAAP basis. And we estimate that operating expenses in the third quarter will be around $145 million on a GAAP basis and about $125 million on a non-GAAP basis, plus or minus. Other income in the third quarter is expected to be approximately $1 million and our effective tax rate for the third quarter is estimated to range from 27% to 28% on both the GAAP and non-GAAP basis.

Based on a combination of the factors I just went over, diluted earnings per share in the third quarter are projected to range from $0.26 to $0.32 on a GAAP basis, and from $0.42 to $0.49 on a non-GAAP basis. For the full fiscal year 2013, we are now estimating that revenue will range from $910 million to $940 million. This compares to our prior estimate of $910 million to $950 million.

Within the new range, we anticipate that licensing will range from $795 million to $820 million, and products and services together range from $115 million to $120 million. We have lowered the high end of our range for product revenues, as the current Digital Cinema conversion cycle is nearing its end, while the new cycle for adoption of our leading-edge technology like Atmos, is still early. We have also reduced our full year estimate for PC revenue based on market data.

Full year operating expenses are estimated to be around $572 million on a GAAP basis, plus or minus, and $500 million or slightly less on a non-GAAP basis. We estimate that full year gross margins will be around 90% or 91%. Other income is estimated to range from $4 million to $6 million and the effective tax rate is projected to range for the full year from 27% to 28%.

So with that, I'd like to turn the call over to Kevin Yeaman. Kevin?

Kevin J. Yeaman

Thank you, Lewis. Good afternoon, everyone. With 2 quarters behind us, the year is playing out about as we expected with weak PC and consumer electronics markets, being offset by strength coming from broadcast and mobile. Overall, we continue to diversify our revenue base by extending our presence in broadcast and mobile, and we made progress bringing new technologies to market, such as Dolby Voice, Dolby Atmos and consumer 3D without glasses. Let me turn to discussing each of these areas.

In broadcast, we are building on our position as the mandated standard in North American digital television and the adopted standard for high-definition content throughout much of Europe. The team's focus is now on extending our technologies to the emerging markets. In China, the country's second largest content aggregator for the cable TV industry, SiTV, recently launched 4 high-definition channels in Dolby. We estimate that Dolby technologies are deployed in over half of the high-definition channels on air in China, and our technologies are included as an option in the country's digital TV standard.

In the EMEA region, our technologies were mandated in the digital TV standards of Austria, Greece, Ghana and Turkey, while also going on air with Abu Dhabi Media. We also continue to grow the use of our technologies and over-the-top services around the world. Dolby technologies are already deployed in leading services such as iTunes, Netflix, Amazon, HBO Go, VUDU and CinemaNow.

In the second quarter, we continue to bring new OTT services into the fold. In Europe, the leading electronics retailer, Dixons Retail, and the video-on-demand service, Acetrax, both deployed Dolby technologies. And in Asia, we added 2 large over-the-top service providers in China and another in Korea.

Turning to mobile. We continue to achieve new wins as the industry looks to enable a superior audio experience from smartphones and tablets. Smartphone and tablet shipments are expected to be nearly 900 million units this fiscal year, according to industry research, and we continue to se this as a significant growth opportunity. With the increased adoption of our technology across many portable devices, I said last quarter that we would increasingly focus on working with content providers to deploy Dolby-enabled content to these devices. In the second quarter, we saw progress in this area across major mobile ecosystems.

In the Windows ecosystem, our technologies are embedded in the Windows 8 operating system for tablets and PCs, and Netflix is now sending Dolby-enabled content to select Win 8 devices. In Android, our technologies are now on roughly 1/4 of smartphones and tablets, and we are seeing service providers such as LaTV, PPTV Live and SK Planet, send Dolby-enabled content to Android devices. In the Amazon ecosystem, you can now receive content through the Amazon prime service to your Kindle Fire HD in full Dolby sound.

Furthermore, we're also laying the ground work in the IC and developer communities. Qualcomm has began shipping the Snapdragon 800 chipset with our technologies, making it easier for OEMs to support our format in their handsets. In addition, we recently launched the Windows 8 developer program to help developers build applications supporting Dolby premium audio. With that, let me move on to discussing the progress we are making in bringing new technologies to market such as Dolby Voice, Dolby consumer 3D and Dolby Atmos.

As I discussed last quarter, we recently entered into a partnership with BT for Dolby Voice. Since then, Dolby and BT unveiled Dolby Voice to industry analysts and IT buyers at the trade show, Enterprise Connect, where it received overwhelmingly positive feedback. BT has successfully completed its internal trial of Dolby Voice and is planning for general availability in the calendar third -- the calendar year third quarter.

Another technology that we're bringing to market is Dolby consumer 3D, which delivers a full resolution 3D experience without the need for glasses. We are demonstrating the technology to various content creators and OEMs. Recently, the Cameron Pace Group, which is led by James Cameron and Vince Pace, said it believes that Dolby 3D delivers the best possible 3D experience to consumers and announced that it would integrate the format into its 3D video production workflow.

Finally, we are making great progress with Dolby Atmos as it becomes the next-generation audio solution embraced by studios and exhibitors. Within 1 year of the launch, nearly 40 titles have been announced or released across 8 studios, including Paramount, Warner Bros., Disney, Universal, Fox and DreamWorks. Dolby Atmos is also being supported internationally, with local titles produced in China, India, Singapore, Spain and Germany. In support of this demand, over 20 global postproduction facilities now have Dolby Atmos installed. In the exhibitor community, over 50 exhibitors around the world have deployed Dolby Atmos systems, including the 3 major U.S. chains, AMC, Regal and Cinemark.

In summary, we continue to grow our presence in mobile devices and emerging market broadcast, which is further diversifying our revenue base. In addition, we see an opportunity to apply our expertise to render a superior customer experience in new areas and applications. Our newest technologies such as Dolby Voice, Dolby consumer 3D and Dolby Atmos, are being well received and give us confidence that we are positioning ourselves well for long-term growth.

And with that, I'll turn it over to Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question today is from Steven Frankel, Dougherty.

Steven B. Frankel - Dougherty & Company LLC, Research Division

Kevin, let's talk about Atmos for a minute. You do seem to have some pretty impressive traction. What's that business model going to be -- look like? Is this is a product sale or is this some kind of royalty business?

Kevin J. Yeaman

So, yes, we do have great traction with Dolby Atmos. Demand throughout both the film titles, as well as in screen from exhibitors. That product, Steve, I think as you know, just went generally available this quarter, so it will begin contributing to revenue in the second half of this year. The primary model will be the product sales model, although we do continue to work with exhibitors and explore models that might be things that meet their needs. But I would plan on it primarily being a product sales model for now.

Steven B. Frankel - Dougherty & Company LLC, Research Division

Okay. And what kind of unit shrinkage assumption are you making for the PC business for the year?

Lewis Chew

Steve, this is Lewis Chew. That seems to be a moving target. We came into the quarter at -- on last quarter's call, we were using market data that said units will be down somewhere in the 4% range for the year, and now that number is pushing up closer to 10%. I think there's a varying degree of estimates out there, so we've tried to bake in that more pessimistic outlook into our numbers. So we are now baking in a unit decline for the year closer to 10% than to the 4% we had last quarter.

Operator

[Operator Instructions] Up next is Perry Huang, Goldman Sachs.

Perry Huang - Goldman Sachs Group Inc., Research Division

I also wanted to ask a question about the PC segment. I think, Lewis, you mentioned the year-over-year decline for revenue was down 4%, which outperformed the 8% decline in PC units for December. Are there any key drivers that are causing this out-performance, which is actually wide in the past couple of quarters?

Lewis Chew

Well, the first thing I'd say, Perry, is that there always are a number of different factors that affect our PC numbers like everyone else, right? You've mix of product and things like that, ASPs. But the other thing, too, is that the tolerances you're dealing with are pretty tight. I think, in general, we are affected by the unit trends versus the market. If anything, the one thing we did see this quarter was an encouraging sign about the mix of our revenue that still has the higher pricing because of optical disc attachment, if you will. But otherwise, I would say, we're driven by the market there. There's no real big obvious things I can point out. We're a little bit lagged, so it's not always a perfect timing. I know that you can say, well, December should show up in your March numbers, yes, in general they do. But overall, I think we anticipate that the unit trends will affect us, but that we are seeing slightly positive numbers in terms of the mix of optical versus non-optical.

Perry Huang - Goldman Sachs Group Inc., Research Division

Got you. That's very helpful. And then just a quick follow-up on the full year revenue guidance. I think Lewis had provided a high-level look at sort of the puts and takes at the changing guidance. I guess, gnawing in on the license range, in the midpoint, it looks like it's a bit higher than the previous range that you've provided. Is there any additional color that you could provide there for the puts and takes? For example, with the decline in contribution from PCs, is that largely offset by mobile or broadcast or both?

Lewis Chew

Yes, both. I think what you're seeing is, if you think about it, the first 2 quarters of this year, Perry, were very much on track, which is why, in Kevin's opening comment, the year so far is playing out very similar to what we thought, right? We gave guidance in Q1, we gave guidance in Q2. And in both quarters, we've met our expectation on licensing. For the full year, as I mentioned in my comments, at a high level, we are softening our outlook on product, mainly because it's hard to predict for a number that isn't that big to begin with. And two, we have to factor in that there's going to be some softening in the PC. But so far this year, we're actually running a little ahead in broadcast. And mobile continues to be a growth area for us. So yes, there's a lot of different things going on there, so -- I don't know if that addresses your question or not.

Perry Huang - Goldman Sachs Group Inc., Research Division

No, it does.

Operator

[Operator Instructions] Next we'll hear from James Goss, Barrington Research.

James C. Goss - Barrington Research Associates, Inc., Research Division

I have a couple of questions. First, regarding Atmos. One of the concerns that seems to be voiced is that even if Atmos is as terrific as it might be, that the ROI from the cinema chain partner might not be very evident because it would be tough to add to the ticket price for the sound quality and -- which might push it into maybe a replacement cycle or an upgrade cycle. Now I'm just wondering how you are looking at that in this stage of roll out, and if there's anything that could be done -- you say there are options you have considered, what sort of options might this be?

Kevin J. Yeaman

Well, the stage we're at right now is really focused on the top tier screens. And that's about, specifically, in less than a year we're now included in 5 out of top 10 grossing screens. In just under a year, 1/3 of the top grossing U.S. films have been released in Dolby Atmos. And so really good traction. And I think that there's a real focus in the industry, as you know, on making sure that attendance is strong and that top quality experience is a very important part of that. So we're seeing that demand in the high-end screen, so that's where the focus is. And I believe that the demand we have shows that they do see the payback in that. We do have examples of some exhibitors that have been charging additional price, many have not, and are focused more on attendance. I think as you start looking forward, whenever something has as fast of a roll out into the high end, as we've seen with Dolby Atmos, people start looking beyond that. And we're already working with exhibitors to look at how, over time, the total cost of ownership is affected as you continue to move this broader into the industry, which really is the case with any new technology that we've introduced in the past, and we're working with the industry to do that. And we think that it ultimately has very broad applications throughout the industry.

James C. Goss - Barrington Research Associates, Inc., Research Division

So right now it's in the largest -- premium large-format hedge screens, the specialty ones, non-IMAX. And that over the next couple of years, you might feel the presence and that it might become more meaningful, that's basically how we should look at it?

Kevin J. Yeaman

Yes. I don't want to overly generalize, but most of the installations so far are in the premium format screens, the largest screens in the house. But we absolutely do see demand beyond that, and we look at this as a broad application to the industry.

James C. Goss - Barrington Research Associates, Inc., Research Division

All right. And the other area I was wondering about was your 3D effort. That sounds like a pretty good breakthrough. I'm wondering what are the requirements. Where do you fit in? Is that the encoding side or is that the projection side or a little of both? And what are the requirements in your stage of involvement and how will you be paid on that particular project?

Kevin J. Yeaman

So this is our Dolby consumer 3D format, and it is a delivery format, so it's the encoding, the decoding. It would be incremented on the silicon in partnership with OEMs.

James C. Goss - Barrington Research Associates, Inc., Research Division

Okay. And it will be on a royalty fee, that sort of business model?

Kevin J. Yeaman

I would see that being a model that's consistent with our traditional business model, yes.

Operator

And next from Avondale Partners is John Bright.

John F. Bright - Avondale Partners, LLC, Research Division

Kevin, same question on Dolby Voice regarding the business model.

Kevin J. Yeaman

One of the things that's exciting about Dolby Voice is that it is a very new market for us. It's gotten a very strong reception, we have a great partnership with BT, we're very excited about it. And together, we're in sales cycles now introducing this technology, which will become generally available in the summer. That is an application that is integrated into their infrastructure for providing the service, it's also integrated into the client. And that's going to be a usage-based model, based on the scale of the deployment and based on the minutes usage of the Dolby Voice service.

John F. Bright - Avondale Partners, LLC, Research Division

And this is in HD Voice, or -- how would you characterize the service?

Kevin J. Yeaman

Well, it's really -- having a conference call on a Dolby Voice-enabled service is like being in the conference room of the people that you're having the experience with. It's a very natural experience, it spatializes the experience, it makes it easier to understand, easier to participate and overall, just a much more productive experience.

John F. Bright - Avondale Partners, LLC, Research Division

Final question. The percentage of total revenues, Lewis, did that come from optical today?

Lewis Chew

Yes. So this quarter, that's roughly 35-65 split. 35 optical, 65 non-optical.

Operator

[Operator Instructions] And there appear to be no further questions today. I'd like to turn the conference back to our speakers for any additional or closing remarks.

Kevin J. Yeaman

Okay. Thank you for joining us today. We look forward to continue to keep you updated on our progress. Thank you.

Operator

And ladies and gentlemen, that does conclude today's conference. We would like to thank you all for your participation today.

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