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Dolby Laboratories (NYSE:DLB)

Q3 2006 Earnings Conference Call

August 2, 2006 5:00 pm ET

Executives

Kevin Yeaman – CFO

Bill Jasper - President and CEO

Tim Partridge - General Manager, Professional Division

Ramzi Haidamus - General Manager, Consumer Division

Marty Jaffe – EVP Business Affairs

Analysts

Ralph Schackart - William Blair & Co.

Steve Lidberg - Pacific Crest Securities

Steven Frankel - Canaccord Adams

Ben Swinburne - Morgan Stanley

Daniel Ernst - Hudson Square Research

Sam Doctor - JP Morgan

Murray Arenson - Ferris Baker Watts

Scott Kessler - Standard & Poor’s Equity

Mark Anderson - Axial Capital

Presentation

Operator

Welcome to the Dolby Laboratories Conference Call discussing the fiscal third quarter 2006 results. (Operator Instructions) I would now like to turn the conference over to Kevin Yeaman, CFO for Dolby Laboratories. Please go ahead, sir.

Kevin Yeaman

Thank you. Good afternoon, everyone. Welcome to Dolby Laboratories Third Quarter Fiscal 2006 Earnings Conference Call. Joining me today is Bill Jasper, our President and CEO. In addition, Tim Partridge, General Manager of the Professional Division; Ramzi Haidamus, General Manager of the Consumer Division, and Marty Jaffe, Executive Vice President of Business Affairs are here to participate in today's Q&A.

On this conference call we will be making forward-looking statements that include projections of future operating results for our fiscal year ending September 29, 2006, expectations for revenue growth in our fiscal year ending September 28, 2007, market trends for the industries in which we compete, and our expectations concerning how those trends will affect our operating results, our ability to expand our presence in existing markets and to penetrate new markets, the impact of inclusion of our technologies and certain HD and DVD technology standards, DVD player sales and sales of our professional broadcast products, our expectations regarding the success of our digital cinema initiatives, the capabilities and market acceptance of our products and technologies, and our strategic and operational plans.

Important factors could cause actual results to differ materially from those in the forward-looking statements. These factors are detailed under the section captioned Risk Factors in our annual report on Form 10-K and our most recently quarterly report on Form 10-Q available at www.sec.gov.

Dolby disclaims any obligation to update information contained in these forward-looking statements whether as a result of new information, future events, or otherwise.

In this call we may describe certain pro forma financial measures which should be considered in addition to, and not in lieu of, comparable actual financial measures. Please refer to our earnings release for the third quarter of fiscal 2006 results on our website at www.dolby.com under the Investor Relations section for the most directly comparable actual financial measure and related reconciliation.

As for the structure of this call, Bill will begin with an overview of the quarter and I will follow with a rundown of Dolby's financial results. With that I will turn the call over to Bill.

Bill Jasper

Thank you Kevin. Good afternoon everyone. This quarter we made excellent strides in our professional and consumer divisions as we progressed towards our long-term objective of being an essential element and the best entertainment technologies used by professionals and consumers.

In our professional division, we made significant progress working with exhibitors, broadcasters and artists through our digital cinema, broadcast and live sound initiatives. To date, more than 50 digital movies have been screened on more than 160 Dolby Digital Cinema systems deployed worldwide. We continue to work closely with exhibitors and studios to provide innovative technologies that enhance the movie going experience and support the transition to digital cinema.

On Monday, we announced our plans to develop a high quality and practical Dolby Digital Cinema 3D system. With Hollywood's renewed interest in 3D, this will enable exhibitors to provide audiences with stunning 3D images from a flexible system that comes with Dolby's trusted reliability and easy integration while further differentiating the Dolby Digital Cinema system.

In addition, we have been very pleased with out ongoing trials with various exhibitors of our JPEG 2000 digital cinema system. We have also introduced new tools for theatre operators, the Dolby Show Library is an additional component of the Dolby Digital Cinema suite of products that enables exhibitors to move digital content from screen to screen within a networked multiplex. The second generation Dolby media adaptor connects digital cinema and alternative content sources to their existing cinema sound systems more cost effectively.

We made similar strides in professional broadcasting as we introduced several new products at NAB that enabled broadcasters and content producers to create and manage their Dolby bit streams more effectively.

In the live sound market, we launched the new Dolby processor to be used at live concerts for advanced control of complex speaker systems. Eight Day Sound, one of the largest sound reinforcement companies in the US, recently purchased 40 units to enhance the sound on the major concert tours they are supporting this summer.

Turning to our consumer division, we continue to position ourselves to benefit from growth in the many markets in which we license. Technology progress in HD broadcast, flat panel displays, bandwidth and next generation DVD is complementing consumer appetite for a more immersive entertainment experience and greater portability.

We are focused on these trends and through Dolby's industry relationships, technology portfolio and global brand, we are diversifying into newer markets and delivering premium technologies that further enhance the consumer entertainment experience.

In our consumer electronics market, we continue to demonstrate our technologies and work with manufacturers as they release their next generation DVD players. In both the United States and Japan, we demonstrated Dolby True HD Technology for next generation DVD formats, which provides Dolby opportunity to deliver richer surround sound experience matching the quality of the high definition picture and offering consumers a more immersive entertainment experience.

In concert with this effort, our professional division introduced the Dolby Media Producer, which will enable the encoding of movie titles in Dolby Digital Plus and true HD by studios and content creators. Some studios are beginning to release movie titles in HD DVD and Blu-Ray formats. Recently, Warner Studios released 10 titles in HD DVD, four of which were encoded in Dolby True HD.

We are seeing initial shipments of Toshiba's HD DVD player, Samsung's Blu-Ray player. With our technology and data standards in both formats, we are positioned to benefit from their growth when it occurs.

In the PC market, we are beginning to see some new media-centric PCs by certain manufacturers that include next generation DVD playback capabilities and enhanced Dolby technologies. While media-centric PCs are still a very small part of the overall PC market, we are seeing initial offerings by manufacturers.

For instance, Sony recently introduced it's VAIO AR series of notebooks and RC series of desktop PCs, both aimed at entertainment and containing Blu-Ray technology. Toshiba is shipping Qosmio notebook PC with HD DVD playback and Dolby Home Theater technology, which includes Dolby Pro Logic II, Dolby Headphone and Dolby Virtual Speaker technologies. Its keyboard even has a Dolby button.

In addition, several new PC products were announced featuring Dolby Digital Live technology, including motherboards for AMD processors from Foxconn and Universal ADID, an Acer notebook PC and the Ceraco wireless audio bridge, which is the first wireless PC solution with Dolby Digital Live.

In the broadcast market, demand for digital television has been growing with the increasing supply of HD content, declining prices of flat panel displays and the approaching FCC mandated switch over to digital television. The recent FIFA World Cup was a strong catalyst for many stations, particularly in Europe to prepare for HD broadcast. In Europe, 96 stations are broadcasting in Dolby Digital 5.0 and over 20 stations showed the World Cup in Dolby Digital 5.1. In Asia, the China Central TV HD Channel broadcast the World Cup in Dolby Digital 5.1 and HD.

HD TV prices continue to decline, with the average selling price of 32-inch LCD display declining 24% in the first 18 weeks of the year according to third-party research. Many HDTVs shipped with the ATSE tuner, which includes our mandated Dolby Digital Decoder, so we benefit as they become more affordable to the consumers.

Furthermore the FCC has mandated as of March of 2007, any television that contains a tuner must contain the ATSE tuner. As a result, Dolby should be included in a growing percentage of digital televisions.

In the gaming market, our technologies are included in all major existing platforms, including the Xbox 360 in over 600 titles. Like all of you, we are anticipating the release of Sony's PS3 in November and expect our technologies to be includes in the PS3 platform's Blu-Ray drive.

In the automotive market, we benefit from the addition of rear seat entertainment from our Pro Logic II technology. Last month, Land Rover demonstrated its 2007 LR2 model automobile, which offers Dolby Pro Logic II technology as does the recently released Aston Martin VH Vantage.

In summary, there are many new market opportunities and with our strong industry relationships, rich technology portfolio and global brand, we are well positioned [Break in audio]

Kevin Yeaman

Production services revenue. One customer accounted for 10% of our third quarter revenue.

In the technology licensing segment, revenue was approximately $69 million, an increase of 14% year-over-year, driven primarily by strength in our PC and consumer broadcasting markets. The CE portion of our licensing business returned to the levels we expected following the second quarter's exceptional performance from strong holiday sell-through. We saw a general sequential decline for all consumer electronics in the CE portion of our business, but continue to expect CE revenue to be flat to slightly up for the full fiscal year on strong first half demand.

CE composed just over 50% of our consumer division's revenue in fiscal 2005 and as we stated coming into this year, we see it making up less than 50% in fiscal 2006 as we diversify our revenue stream and the standard DVD market matures.

In our PC market, year-over-year growth was robust on strong laptop and desktop shipments by brand name OEMs and was roughly flat sequentially. In our other markets, we saw strong growth from broadcast as a result of the continuing shift towards HD-broadcast related products and modest year-over-year growth from gaming, although down sequentially.

In the Product and Services segment, revenue for the third quarter was up 30% year-over-year on increased cinema product orders from several customers in anticipation of an announced price increase and strong demand by broadcasters in preparation for their HD programming.

Turning to the details of the P&L for the quarter, licensing gross margin was 91%, which was flat sequentially. Products gross margin was 46%, which was negatively impacted by approximately $1 million due to a few unrelated issues, including a writedown of our inventory, the market value of certain early digital cinema installations related to the Disney roll out that were in inventory and the impact of meeting the lead-free deadline in Europe.

Services gross margins was 52%, down 8 points sequentially, as we have lower third quarter revenue from what is often a slow quarter for motion picture services in the United States and increased costs associated with depreciation of some of our cinema services equipment.

SG&A expense was slightly down sequentially in dollars, but was 41% of revenue, up 4 points sequentially as a result of lower third quarter revenue. R&D expense was 10% of revenue for the third quarter, up 2 points sequentially due to lower revenue and increased spending of $700,000.

Dolby's effective tax rate for the quarter was 38%. Net income for the quarter was $19.1 million, or $0.17 per diluted share, compared to $14.8 million, or $0.13 per diluted share for the third quarter of fiscal 2005. Per share calculations are based on 112 million diluted shares in the third quarter of fiscal 2006. Net income also includes stock-based compensation charges of $4.7 million for the third quarter of 2006 compared to $3.2 million for the third quarter a year ago.

Turning to the balance sheet, Dolby finished the quarter with approximately $470 million in cash, cash equivalents and marketable securities. In the third quarter, we diversified a portion of cash into a portfolio of municipal and government agency securities, having an average duration of significantly less than a year and with a policy of no instrument having a maturity greater than three years.

From operations, we added $16.5 million in cash during the third quarter and capital expenditures were $1.8 million.

Before I cover the guidance section of my presentation, an aspect of our business model that we want to continue to stress is the lack of a predictable quarterly pattern in our results. Our revenues are lumpy, different quarters are higher in different years.

Secondly, we license our technologies to consumer electronics manufacturers and software developers who use them in products. Our licensees are required to report to us between 30 and 60 days after the end of the quarter in which they ship their products. Since the licensing royalties comprise roughly three-quarters of our revenue, our overall revenue can fluctuate quarter-to-quarter as a result of the timing of our receipt of those royalty reports.

In addition, it is not uncommon for royalty reports to include corrected or retroactive royalties that cover extended periods of time. This could cause our results to vary from forecasts. As of June 30, 2006, we estimate that there is approximately $10 million due from two existing licensees, relating to new products that have been shipped by these licensees over the past nine quarters. We do not expect to recognize revenue with respect to these shipments until certain contractual matters have been resolved. We cannot estimate when this will occur. To be clear this royalty amount is not included in our guidance.

Turning to guidance, coming into the third quarter we were cognizant of the effect particularly a strong holiday season for our licensees in the first half of the year and therefore expected single-digit year-over-year revenue growth in the second half of the year.

As anticipated, third quarter revenue growth slowed significantly from the second quarter but still registered 18% year-over-year growth. In light of this we now expect revenues to be in the range of $370 million and $375 million for fiscal 2006.

Additionally we expect fiscal net income to be in the range of $74 million and $77 million. We expect diluted earnings per share to be in the range of $0.66 to $0.69. While under FAS 123, stock-based compensation expense may vary based on factors such as stock price or volatility. We continue to expect stock-based compensation expense for the full year to be between $19 million and $21 million.

Coming into the year expect fiscal 2006 revenue growth of single-digits. While we are pleased with our stronger than expected performance to date and our growth opportunities going forward, we are still working through our 2007 numbers.

In addition to growth factors, we will be considering the anticipated slow adoption of next generation DVD given the competing formats and high initial price points. Also we are cautious of the fact that in the PC market, OEMs and ISVs are under pricing pressure which may cause them to evaluate whether or not to bundle DVD playback software into base models. This could have some effect on the growth rate from our PC market.

We will offer formal fiscal 2007 guidance next quarter, but believe that on a preliminary basis that is appropriate to expect mid to high single-digit revenue growth, which is similar to what we had expected coming in to fiscal 2006.

With that I would like to turn the call over to the operator for the Q&A portion of our call.

Question-and-Answer Section

Operator

(Operator Instructions) Our first question will come from Ralph Schackart - William Blair & Co.

Ralph Schackart - William Blair & Co.

Good afternoon. Two questions for you. First and foremost can you talk about your Chinese enforcement activities and the progress that you are making there? Additionally too, is you looked out over the horizon into fiscal '07. Did you factor the consumer into that type of guidance? Were you taking a conservative stance there and can you give us an update on any implications the slowdown with the consumers affecting on the business? Thank you.

Marty Jaffe

I'll take the compliance side of this and I'll pass off the consumer side. Compliance program continues to remain a very top, high priority for us and over the last several quarters we have augmented our compliance team. As we move forward, we will continue to increase our attention, efforts and resources in that area. This includes moving more licenses account managers to China and other parts of the world to be closer to our licensees and the IT manufacturers.

We'll continue to improve our on our tracking of technologies by focusing on the information rights under our license agreements and by better analyzing the information that's available to us and increasing our enforcement activities.

So that's including everything from licensing audits to being tough with known offenders to working with local authorities and other parties to identify unlicensed manufacturers. So as I said, it's a high priority, we'll continue to work on this and we'll take some time and continue to improve over time.

I'll turn it over to Kevin on the compliance.

Kevin Yeaman

In terms of the second part of your question, Ralph. So again we're pretty pleased with year-to-date where we've come in growth wise in '06. But as we said, we think it's appropriate to model at mid to single-high digits going into '07. Part of that is the factors we referred to and part of that is, yes, we are aware of general reports or speculation about what might happen with consumer spending.

We're really in the stage of working through the '07 numbers at this juncture. So other than the few factors I highlighted in the script, I don't think we have a lot else to say in that regard.

Ralph Schackart - William Blair & Co.

Just to clarify, is that mid to single high digit for the consolidated business? Or one specific revenue line item, such as licensing?

Kevin Yeaman

That’s for the consolidated business.

Ralph Schackart - William Blair & Co.

Okay. Thank you.

Operator

And our next question will come from Steve Lidberg - Pacific Crest Securities.

Steve Lidberg - Pacific Crest Securities

Good afternoon, guys. With regards to the outlook for the September quarter, or the yearly guidance provided, it would seem to imply an uptick in expenses and I was curious as to kind of what was the driver behind that?

Kevin Yeaman

I don't know if I'd point to any one thing. I think that we do, as we do going into most quarters, have some additional headcount built in there. This is also the final quarter in our run up to 404 compliance, so there are normal fees that are associated with that, other than that I wouldn't point to any other factors that stand out.

Steve Lidberg - Pacific Crest Securities

And then on the royalty, I guess the $10 million outstanding royalties, you highlighted there were some issues that needed to be addressed. I guess are those on your side or the customer or a combination of both? What are the prospects for that?

Kevin Yeaman

I don't think we want to get into the details of the issues. It's something that we're mutually working through. While we can't predict which quarter it will come in, I guess I can point out that since it's two licensees, it may come in two chunks over two different quarters or it may come in all at once during one quarter.

While we're not in a position to predict which quarter, we do think that we can resolve it sometime by the end of the first half of 2007.

Steve Lidberg - Pacific Crest Securities

Was there any reason to spell out these two licensees versus your ongoing normal activity in royalty enforcement?

Kevin Yeaman

Well just that I think you've all asked this on occasion, what a normal portion is to us and what we've always said is that it's routine part of our business. But if there's anything that we think is large enough that we think you need to understand that we'll point it out. This falls in that category. So we're just giving you a heads up that we see this on the horizon.

Steve Lidberg - Pacific Crest Securities

Great, thank you.

Operator

Our next question will come from Steven Frankel - Canaccord Adams.

Steven Frankel - Canaccord Adams

Good afternoon. You mentioned the total of 96 stations in Europe that are broadcasting in 5 1, could you just scale that for me, in terms of what the reasonable opportunity is in the next couple of years? Are you a third of the way through that penetration? Just give us some hints there.

Bill Jasper

So, Steve, are you talking about at the broadcaster level? Or at the consumer level?

Steven Frankel - Canaccord Adams

No, at the broadcaster level.

Bill Jasper

I’ll let Tim add a little bit to this, but in Europe, the 96 stations, we have all the premier channels there. You have to remember that the broadcasting equipment is not huge percentage of our total product sales, which is only 25% in total. So it's not a huge factor, but we've already made great penetration there. But we do know that there are additional premium channels coming onboard. We continue to get some all the time, but we've had great penetration already.

I think without going into the actual total number of stations, some will never go 5.1, but we think that we've got a very, very good percentage of the premium channels that there are, but there's still some room for growth.

Tim Partridge

In terms of the overall opportunity, Steven, while we're doing really well in Europe with all of those channels, the opportunity remains beyond Europe, as well. So we're working hard within Asia and other countries that have not yet adopted HD in the same way that Europe and the U.S. is beginning to.

Steven Frankel - Canaccord Adams

Great. A Digital Cinema question, you announced this 3-D initiative, is this complementary to real 3-D? Or competitive to what was used for Chicken Little?

Tim Partridge

This would be a competitive system, Steven, and we've seen that 3-D has attracted a lot of interest in the industry, both in Hollywood and the exhibition community. We've seen that the consumers are willing to pay more to go see movies in 3-D, so there's clearly a demand there.

As you know, the theatre showing Chicken Little, and recently Monster House, out-grossed the 2-D theatres by, some say, 3:1. So at the same time, exhibitors are looking for a way to offer something new and to generate additional revenue streams, and we always saw 3-D as a great opportunity for that.

If you remember, we've always said that we've felt that Digital Cinema was a great opportunity for Dolby to provide new technologies going-forward to the exhibition community, and we felt 3-D was one of those.

In terms of the opportunity, obviously we've got a large footprint on the audio side, a very large market share for digital surround sound, and now we can come to exhibitors as they transition into Digital Cinema and offer them yet another innovation that could potentially generate additional revenue.

In terms of the system itself, we've looked long and hard at all the drawbacks of the offering of the last few decades, as well as current ones, and while the current ones offer great quality, there are a couple of drawbacks. We hope to offer a system that will be more flexible and affordable than the alternatives.

Bill Jasper

So the big difference being, Steve, that we don't require a silver screen for our system, whereas the systems out there today do, and we've found that the exhibition community does not like having to change their screens out.

Steven Frankel - Canaccord Adams

Thanks very much.

Operator

Our next question will come from Ben Swinburne - Morgan Stanley.

Ben Swinburne - Morgan Stanley

First I wanted to go back to the PC business and just make sure I hear you, Kevin, you said PC was flat sequentially?

Kevin Yeaman

That's correct.

Ben Swinburne - Morgan Stanley

Okay. Just curious, because the global PC sales, I think, were down about 12% in the March quarter from December, the implication being that the growth in revenue per PC, or the growth in Dolby technology per PC is increasing. I'm just trying to connect the dots with your expectations going-forward on PC, that you might get some kind of push back on additional technologies. It seems like things are going very well in that segment.

Maybe on this, then for me, you could add a little bit more color there, that would be helpful.

Kevin Yeaman

On the dots you're trying to connect, I'll make one comment, and then I may pass it over to Ramzi for some color on the PC market. But there is probably not a direct correlation between the PC sales numbers as we are getting paid at the time the OEM or the ISE makes the sale, so there might not always be a direct correlation. So that might be part of the issue there.

Bill Jasper

The quarter lag.

Kevin Yeaman

And it's on a quarter lag, as Bill points out.

Ben Swinburne - Morgan Stanley

Yes, I know. That was the March quarter versus December.

Kevin Yeaman

Yes. But in terms of color on what is going on in that market, I would turn it over to Ramzi.

Ramzi Haidamus

We feel pretty good about the PC market. One trend in the PC market, of course, is to add additional multimedia experiences and to add a lot of PC entertainment elements that we've seen, and we've introduced ourselves to the market place. To balance that, we also have seen a trend towards more customization on the side of the customer, meaning should somebody log online and try to purchase a system, they do have now the opportunity to either take out or leave in a DVD entertainment system, which could effect the revenues for us.

We also have seen another trend in the operating system choice of operating system companies releasing several SKUs, some of which do not include entertainment technologies, which also could affect our revenues to the extent that those operating systems might be geared towards the corporate environment.

So on balance, we're optimistic, however, we do see some choice in the long-term that some corporate entities might leave entertainment experience out of these choices.

Ben Swinburne - Morgan Stanley

That's very helpful. So I guess looking forward, your mid to high single-digit growth, I realize it is a consolidated number, but it sounds like your baking in maybe some kind of decrease in the percentage of PCs sold with DVD software players, going into next year. Is that accurate?

Kevin Yeaman

Yes, as I've said, of course, it's preliminary, so this is early thinking. But in our mid to high single-digits, we are factoring in that all of these factors that Ramzi has mentioned could net out in a lower growth rate in PC than what we've been experiencing of late.

Ramzi Haidamus

I should also add that part of this experience, when a customer does try to either leave out or leave in these technologies, we do look at this as an upside or an opportunity for us to add our attached premium technologies. So, again, we see an opportunity to sell our premium technology, as opposed to our standardized technologies.

Ben Swinburne - Morgan Stanley

Great. I just have one last follow-up on the product sales. You had your best year-on-year growth in this quarter in years, and I know there was some early buying from the anticipation of price increase. Can you give us any kind of quantification what the growth rate might have been if you had ex'ed that out, so we get a normalized view of that segment?

Kevin Yeaman

I don't know that we have any scientific way of knowing how many of the orders were associated with the price increase. Part of the growth was also due to broadcast, which is a continuation of broadcasters gearing up for HD programming.

Bill Jasper

World Cup.

Kevin Yeaman

And the World Cup, as Bill points out.

Tim Partridge

We know that a couple of customers who came into the end of their fiscal year were doing that pre-buy before the price announcement so it remains to be seen how long that will effect us going forward.

Ben Swinburne - Morgan Stanley

Great, thanks Tim.

Operator

Our next question will come from Daniel Ernst - Hudson Square Research.

Daniel Ernst - Hudson Square Research

Yes, good evening. Thanks for taking my call. Two questions, just working again at the prior question on your exceptional growth rate, on the professional products side. Maybe it would be helpful if you could give us some breakout between broadcast, feeder, and production services, or production products for Hollywood? Then maybe talk about what the concert audio contribution was that may have not have been a contribution last year?

Second, on the consumer side, you know you talk about the deceleration on the DVD. Can you give us an update about where DVD as a percentage of the consumer is, and what that year-over-year, or sequential growth in DVD was? Thanks.

Bill Jasper

Daniel, we don't break the products and services out. Our Q has products and services in there in total. We haven't gotten down to the granularity of breaking out, basically the three elements in the product sales, which are regular traditional film, digital film, and broadcast. Of course services is a fourth element of that. I'll let Kevin address the others.

Kevin Yeaman

Yes, well I would just say, as we said in our script there was good growth in both cinema products, the traditional audio cinema products as well as broadcast. It was a good quarter for both.

Tim Partridge

Yes, I would just say that the largest growth was definitely the broadcast sector. But of course, that is also possibly the smallest dollar volume. It didn't have as big an impact as the growth we had in cinema which was slightly less, but still very strong. But of course, that is our major product line.

As far as the Lake products, that is something that we've been waiting to get out there into the market. This is the first product we've launched since that acquisition. And it is performing very well in the marketplace with the concert guys.

Daniel Ernst - Hudson Square Research

Excellent. Just to drill down a little bit further. Is the broadcast side a material portion, at least, of the product side, or maybe the smallest with recent material?

Kevin Yeaman

Well the largest is the, are the cinema products, and I think, you know, the next largest after that would be the broadcast.

Daniel Ernst - Hudson Square Research

The second question was on the consumer side where DVD was as a percentage of consumer?

Kevin Yeaman

Yes, so, traditional DVD players as opposed to PC playback or DVDs in automobiles makes up much of our consumer electronics market that we break out. And as we said, it was just over 50% in 2005 but we continue to have good growth in the other markets. So we do see that making up less than half of our licensing business. So we continue to see that.

We've also said that while we expected it to be flat to slightly down, coming into the year, we now see it flat to slightly up and that was really on a strong holiday season. So it came back down to where we expect it this quarter.

In terms of what we're seeing, in terms of DVD or next generation DVD, I'd turn that over to Ramzi.

Ramzi Haidamus

We do see several dynamics happening in the DVD market. On the traditional DVD side, obviously we all realize that the traditional DVD video red laser is reaching maturity. However, to balance that, we are looking forward to both formats, the Blu-Ray and the High Definition taking over the market.

Now had there not, what is interesting here, is that if you take a look at the broadcast side, which is exposing a lot of consumers to high definition experiences. That is acting as a sort of pull into the HD DVD world. If we did not have high definition broadcast experiences, the uptake of HD DVD might be slower, but the exposure to high definition broadcast could act as a catalyst to accelerate either the Blue Ray or the HD.

To balance that, clearly two competing formats do not help the market place, as you know we are in both formats and we are looking forward to seeing how that market pans out.

Operator

(Operator Instructions) And our next question will come from Sam Doctor - JP Morgan.

Sam Doctor - JP Morgan

A couple of questions for you. First, can you give us any sense of the catch up royalties in the current quarter and how do they compare, in terms of magnitude relative to the $10 million that you were talking about earlier?

Kevin Yeaman

We do not break out catch up royalties in any given quarter, it is a normal part of our business. To the extent that there is anything that is significant enough that we think it is important to understand the trends, historically or going forward, then we will point it out. That is why we did point out that we did see $10 million in royalties accumulated that we are looking to try and resolve sometime by the end of the first half of 2007. Other than that, we do not break it out.

Sam Doctor - JP Morgan

Okay. Could you give us a bit of an update on the Digital Cinema and what kind of risk do you see for ASPs, to the extent that there is an un bundling of hardware and software and there is a potential for open standards, what does that do to your ASPs?

Does it even open you up at some point to competition from someone like Yamaha or someone like that, where you are going away from, on the traditional film stage, whether it is you, JDS or DTS and with Digital Cinema do you open yourselves up to a lot of other potential competition?

Tim Partridge

Yes, this is Tim. The competitive landscape in Digital Cinema is already quite different that which we have experienced before in traditional cinema. Right now, I think at the last count at the trade show, there was something between 10 and 15 different people competing in this market for the product that we are currently building. Very few of those have ever been in the cinema industry before, so there are many and various competitors in there right now.

Obviously that is leading to pressure on pricing, but the market is still very nascent. As you know, there are few hundred screens out there, very few people actually deploying those screens and a lot of decisions to be made right now.

Hopefully you may have seen one announcement referring to us in the last quarter which was a cinema chain in Belgium, called Kinepolis and they are moving forward with Technicolor who are one of the major deployment agencies. They announced that they intend to deploy Dolby Digital Cinema systems.

So we are still in the very early stages, and yes there is price pressure, but we believe we have designed the right system for the market and we believe with our brand name and our reputation for reliability and service that we will be able to be successful in the marketplace.

Bill Jasper

Sam, we think we have a designed a product which builds upon our 30 plus years of experience in the film industry. We think we have a very good working relationship both with the studios and the exhibitors. We think we have a decent understanding, an excellent understanding if you will, of what is needed in order to make Digital Cinema a success and we think that in the long run, it is going to pay off.

Sam Doctor - JP Morgan

So you aren't seeing a lot of pressure in terms of unbundling of hardware and going with Dell or HP servers? Then going into the software separately? Are you seeing that as competitive threat?

Ramzi Haidamus

Absolutely. That is what many people in the Street felt would happen as Digital Cinema was first being discussed a number of years ago. And indeed, we looked to see if we could do that. Obviously to save costs and to take advantage of larger businesses by taking an off-the-shelf computer.

But when we seriously looked at those pieces of equipment, we just didn't feel that they met the needs of the marketplace in terms of reliability, to perform day in, day out, in a projection room in Beijing as well as well as Mumbai, as well as Hollywood. That's a very harsh environment and we didn't think the off-the-shelf equipment would be able to be reliable in that environment and then there's the issue of content security. We didn't think the off-the-shelf equipment would provide the kind of security of the content that the studios are looking for in Digital Cinema.

Finally, there's the issue of ease of use. As we know, these cinemas are being operated by not particularly technical people. The film industry's projectionists have a lot on their plate in terms of running the whole cinema. So the Digital Cinema system has to be pretty easy to operate and typically off-the-shelf computers or broadcast servers are not designed for that kind of user.

So that's what led us to believe we need to design something specifically for the industry, both in terms of reliability, security and ease of use. While some people may indeed try to deploy the off-the-shelf computers that you talk about, we just don't think that they will meet the needs of the industry/

Operator

And we'll go next to Murray Arenson - Ferris Baker Watts.

Murray Arenson - Ferris Baker Watts

Thanks. Good afternoon. The $10 million is not included in the preliminary '07's guidance? Is that correct?

Kevin Yeaman

That is correct. That is correct.

Murray Arenson - Ferris Baker Watts

Even though you do believe you'll be able to clean that up by the first half? Or halfway through the year roughly?

Kevin Yeaman

We do. But since we don't know when it might be cleaned up between now and then, we haven't included in either our '06 guidance or our preliminary '07 outlook.

Murray Arenson - Ferris Baker Watts

HD DVD and Blu-Ray, I've been hearing a little bit recently about the EU looking at some of the licensing strategies. Are you involved in that? Is that something we need to be looking at?

Bill Jasper

Dolby at this point is not involved in that.

Murray Arenson - Ferris Baker Watts

Okay. And last one, just on a housekeeping note. Can you tell how to be looking at taxes going into fourth quarter of next year?

Kevin Yeaman

Our effective rate for the third quarter was 38%. That's probably about the appropriate rate for '06. We haven't really given any guidance for '07 yet.

Murray Arenson - Ferris Baker Watts

Okay. Great. Thank you.

Operator

Our next question will come from Scott Kessler - Standard & Poor's Equity.

Scott Kessler - Standard & Poor’s Equity

Hi. Thanks a lot. I'm relatively new to your story. Please indulge me. Consumer Electronics market has been relatively soft. PC segment, it's been in decline. The video game area has been plagued by an upcoming major transition, the new consoles. The box office, with a few exceptions, it really hasn't generated a lot of new excitement.

Now I know you guys have been talking about this in response to questions, but I guess what I'm trying to get at is, notwithstanding all those things I just said, you guys generated 18% revenue growth in the quarter, which is well above analysts' expectations. So I'm wondering if you guys could kind of point to maybe the one or two or three contributors to that upside? Thanks.

Kevin Yeaman

Well first of all, the 18% year-over-year growth is coming off of what was a pretty rough Q3 for us last year. Secondly, for the reasons we've discussed, we had good growth in products, both in the cinema side and due to people preparing for broadcast.

In the PC segment, while it was flat sequentially, we do have very good year-over-year growth in that segment. CE has been flat to slightly up. Gaming has been a good year as well, I mean we did have a strong holiday season and the release of the Xbox. So those are some of the things that have contributed to the strong year-to-date over year-to-date growth.

I don't know if you would have anything to add on some of those comments, Ramzi?

Ramzi Haidamus

We are fairly diversified across most of the market. While you might see some high level trends as you might point out, I would say that we have a fairly significant diversification strategy, we're not only diverse within market, but we're fairly diversified within most of the active geographies in this field, which I think is leading to some positive contributions in most of these markets.

As Kevin said, our PC market has been very solid. We have been fairly pleased in the CE market, even with the high def story that we've been hearing and with the uptick of broadcast and this March 2007 deadline coming up for folks to switch over their manufacturing habits we are really looking forward to a strong broadcast market.

Bill Jasper

I think you have to remember, Kevin pointed out that our third quarter last year was almost the lowest of the year, the third and fourth quarters last year were our two lowest quarters. And even though we are up sequentially over June of last year, we are also down from the March '06 quarter by around 10%. So that 18% you can't just apply to the whole big picture and say, hey, everything is fantastic.

Kevin Yeaman

We reiterate that lumpiness point that we made that no one quarter is as high as any one year. So it's hard to predict those.

Tim Partridge

At the big picture level, Scott, I would also add that in any environment, but particularly in the environment that you just described, people have got to compete really hard and therefore to do so, they are offering premium technologies that provide premium experiences.

So on the product side, we're seeing high-definition broadcast take off. Their competitor is DVD and DVD looked great. So therefore they've got to provide an experience that competes with the DVD experience, which is great pictures, . high definition and of course surround sound. In the cinema, despite the – or maybe even because of the environment that you described -- they've got to provide a premium experience. That means today, 5.1 surround sound. And therefore, the Dolby Digital has become a standard for any new cinema opening.

Scott Kessler - Standard & Poor’s Equity

That's great. Thanks a lot.

Tim Partridge

Operator

Our next question will come from Mark Anderson - Axial Capital.

Mark Anderson - Axial Capital

Yes, I was wondering if you could comment on any traction you're getting in the Smartphone market, given that your technology's been embedded in PCs and other different devices. I wonder if you could comment on your ability to embed it in smart phones?

Ramzi Haidamus

Our first play in these types of phones, whether they be Smartphones or just the multimedia phones have been, as you know, RAAC technology, which is licensed via licensing subsidiary. We have had several design wins and the AAC being the codec of playback choice. Whether it be some of Nokia phones or other similar type phones.

Clearly moving forward, Dolby sees this market as a strategic one, an important one. We see opportunities for technologies such as Dolby headphones where you can see some form of surround experience even just with a pair of headphones. We're considering of course, increasing our efforts in this marketplace from the Dolby side. But so far it has been mostly the AAC design wins that, that we are trying to leverage into different areas.

Mark Anderson - Axial Capital

Are those just design wins that have yet to be implemented in a broader market? Or are they actually out there in the marketplace now?

Ramzi Haidamus

They are in the market right now and they are increasing with each new generation of these Smartphones being introduced.

Mark Anderson - Axial Capital

Great, thank you.

Operator

That does conclude today's question-and-answer session. I'd like to turn the conference back over to Bill Jasper for any additional or closing remarks.

Bill Jasper

Thank you very much. Well, we appreciate everybody attending today's conference. We've had, we think, a reasonable year-to-date. We anticipate talking to you in three months time to report on our full year results. At that point in time as Kevin pointed out, we will be giving you guidance for 2007. Thank you for participating, and take care.

Operator

Ladies and gentlemen that does conclude today's conference. We thank you for participating and have a great day.

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Source: Dolby Laboratories Q3 2006 Earnings Conference Call Transcript (DLB)
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