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Dolby Laboratories, Inc. (NYSE:DLB)

Credit Suisse 2013 Annual Technology Conference

December 5, 2013 9:00 a.m. ET

Executives

Lewis Chew – Chief Financial Officer, Executive Vice President

Moderator

Good morning everyone. My name is Jack [Mathis]. I work with Phil Winslow. Today we have Lewis Chew, CFO of Dolby Labs presenting for you guys and I think we’ll have a few minutes for Q&A at the end.

Lewis Chew

Thank you. Good morning everybody. It’s always difficult to be the last presenter of the conference. So I just wanted to thank all seven people who showed up, including my wife and two kids and the one guy from T. Rowe who’s only here because his flight got delayed. Yeah, so just for the record for people on the webcast, one guy did laugh at that comment. As a reward for showing up for the last conference -- last presentation of the conference, I will take 45 minutes to read this forward-looking statement boiler plate that we have for these events.

So what I’m going to do today is try to cover three big things about Dolby Labs. I’ll try to give you a quick overview of how the business works, update you on markets and ecosystems which is usually what people want to hear the most about, including things like PC. And then talk a little bit about growth opportunities because obviously it wouldn’t be a tech conference, a growth conference if we didn’t talk about growth, right? So here we go.

At really high level, what does Dolby make, what do we do? What do we sell? We’re primarily an intellectual property company. We’re known for our surround sound. So we have all kinds of technology and solutions that we invent that are aimed primarily at the audio space, although in recent years we’ve also developed some technologies that address the imaging space. The way the broad chain of events occurs is that we want content creators to create stuff in Dolby, encoded in Dolby sound. Then we would like people who are in the distribution chain, whether they be broadcasters or movie houses or even online content OTT providers to distribute that content and broadcast it in Dolby or distribute it on DVDs in Dolby. And then finally you have the point at which you guys would consume it through playback, either by watching it on your TV in the theatre, on a mobile device, DVD player, whatever. So there’s this creation, distribution, playback chain of events that we focus on to try to get Dolby technologies out there in ubiquitous and in many places as possible.

Before I jump right into more about markets and ecosystems, it’s always good to just level set what our numbers look like. So the chart in front of you is the last five years’ worth of revenue and net income. The net income is both GAAP and non-GAAP. You can see that for the last four years one of the things that we’ve been struggling with is the company has not shown any topline growth. And so that’s a big topic of discussion all the time, not only within the company but with investors and potential investors. At the same time I’d like to step back and remind everybody that we have a very rich financial model. We currently are a company that runs our non-GAAP operating margins in the 30s and some companies try forever to get there and we’re there now. We do operate in a lot of different markets that have a lot of opportunities and I’ll talk about that in a second and we do generate quite a bit of cash flow from our operations because we’re not particularly capital intensive.

From the standpoint of our revenue, there’s really almost -- you can almost bifurcate that discussion if I click here for a second. We can see on this revenue chart like I said the last five years not much revenue, but within that we have product and services revenue and then we have licensing revenue. Licensing revenue is the large majority of the company’s revenue today. And you can see that the licensing revenue during that timeframe has grown. Albeit it has not grown significantly or rapidly, it has shown some growth.

So if I click to this next slide, this is a pie chart of the major markets that we play in, the way we classify them for the external world. And I’ve pulled out the slice of the pie for PC because that’s an obvious visible market that a lot of people focus on and ask questions about. You can see that from 2010 through today 2013, by the way our fiscal year ended in September 30 so we’re just recently off our fiscal year end, you can see that the percent of our revenue that is dependent on the PC for licensing has gone from the 30s down to the 20s and in fact for the quarter that we just reported, our fourth quarter, PC revenues represented only about 21% of our licensing revenue.

At the same time, if you scroll back to 2010, the amount of revenue in licensing that we were getting from non-optical display sources was actually less than half of the company’s revenue and for fiscal ’13 that number has moved to over 60% and for the fourth quarter just completed, we just ticked over 70%. So that is really part and parcel of this four year trend that we’ve been on where we’ve been going through a fairly flattish revenue trajectory in the low $900 million range, but at the same time we have been improving the diversity of our revenue base away from optical disk dependence. At the same time, we have ramped up our OpEx, both in R&D and selling and marketing to increase what’s in the pipeline so that we could add some growth on top of that.

So looking forward, I’m not going to talk about every sector that we play in, but there’s four that I think I’ll do, and the four that you see in front of you are the broadcast, the online and mobile, the cinema area and then new products. And I’m going to take a second to talk about each one of these in a second. Now what we have in front of you here is an indication of where we would derive our revenues from in each of these markets. So in the broadcast space, it’s primarily televisions and set-top boxes and the way we derive our revenue is we earn a royalty for units of those devices that are made and shipped. In the online mobile space, very similarly. Mobile devices, mainly smartphones and tablets we earn royalties there. In the cinema arena, it’s more of a traditional product hardware type business. We sell cinema gear that’s at a professional level into the cinema market which is used primarily by either cinema providers or post production houses and we make money on those products. And then we have new products we’ve been coming out with and I’ll spend a second to talk about that near the end of the presentation.

Okay, so in the broadcast arena, this actually represents the largest portion of the company’s licensing revenue today in the most recent period presented. Over 35% of our licensing revenue is derived from the broadcast market. It’s a bifurcated view of the world in places like the U.S and Europe. We are substantially penetrated in those markets. So for all intents and purposes, if you buy a TV or have a set-top box in the U.S it’s going to have Dolby on it. The same is true for Europe. But in areas like India or China or Latin America, the reverse is true. Much of those areas of the world have not switched yet completely to digital television broadcasts and certainly not to high definition. And the reason I bring up high definition is because we found there’s a tight correlation between high definition video broadcast and the desire to have Dolby Audio because this Dolby Audio typically is viewed as a higher quality audio and a very efficient use of bandwidth.

So during fiscal ’13, one of the things that we noted was that in China where there’s still a low percentage of total digital adoption in high definition broadcast, Dolby has roughly half or 50% penetration in that situation. And then you can see on here and also in other comments we’ve made that we’ve made progress in other countries sprinkled around the world. So we step back and look out there across the globe. Our global penetration number in the broadcast arena is probably in the 60s, but that’s because it’s very heavily weighted towards U.S and Europe as I said. The rest of the world we view as being a significant opportunity. And so we spend a significant amount of time in those markets working with local broadcasters, working with standards bodies, also working with hardware electronics OEMs to get people to understand the value that we present and to adopt Dolby as a broadcast standard which then leads to more TVs and set-top boxes and other devices being enabled in Dolby.

The online and mobile space is relatively new to us. If you step back a few years ago and in fact on the pie chart that I threw up at the beginning, four years ago we didn’t even have enough mobile revenue to even consider it per se. this is the first year we’ve broken it out separately, but we gave you three years look back. We just ticked over the double digit where 12% of our revenues in fiscal ’13 were from mobile devices and that’s from relatively zero four or five years ago. The bulk of our presence today is in higher end devices and maybe there’s a tight correlation again between a higher end device and the desire to have at least the capability to do high end audio. We’re present in a number of different devices across the Amazon/Android platform. We’re also featured on Windows 8 phones. And then most notably we get a lot of questions because now we’re not currently in any of the Apple mobile devices which would include their iPhones and their tablets.

If you wanted to understand better what the value proposition might be, probably the most stellar representation today of good audio in a mobile device would be in the Amazon tablet which they’re now in the second generation of, the so called HDX. It really does sound amazing and especially if you’re enjoying a movie on a plane, no, it does not have to be without headphones. With headphones we do believe it does sound significantly better. And on top of that, Amazon has fully adopted the Dolby audio approach. So they’re also streaming content in Dolby, so just to make that clear, for the whole thing to work. We already know there’s lot of content out there in Dolby, but whoever is providing that content to the online streaming needs to stream a version in Dolby and then the device that you’re using needs to have Dolby capability.

So here is -- for those of you who probably obsess about this a lot more than the seven people in the audience, but recently there was a whole slew of probably pre-Christmas reviews of electronic devices and this is a comment that I cherry picked out of a review that the Wall Street Journal did just several weeks ago. And they were talking about the Amazon Kindle and I’ll read it out loud. What makes the Amazon 7 inch Kindle Fire HDX our top pick is superlative sound. It’s the easiest way to view movies with Dolby Digital 5.1 which boosts the clarity of dialogue and adds a virtual surround sound effect that is especially convincing over headphones. There’s a whole variety of different things out there that you can point to that reaffirm our belief that the audio quality is quite high. Whether or not it matters to the end consumer is something that we can’t control and that would be something we’ll deal with over time.

Okay, in the cinema arena, cinema is the area where Dolby has played for the longest, given the fact that we essentially created surround sound, but that was many, many years ago. So surround sound has been around for a long time, has crept its way into the home. Many, many people today have receivers in their home. They can do 5.1 sound. It’s almost become a given. So last year we released our newest technology aimed at the cinema referred to as Dolby Atmos. It’s more encompassing. It’s like the next step beyond surround sound. It has vertical height. It allows content creators to put the sound where they want to. I didn’t even bother putting up the quotes on that because you can go out there and Google it and there’s some amazing stuff out there from people extoling the virtues of Dolby Atmos.

We released the product for commercial availability in April of 2013. So it wasn’t that long ago. And at this point what we have is a little over 400 theatres worldwide either installed or committed to Dolby Atmos and that number is growing. At the time -- at the end of the year that number was probably closer to 300. Over 80 titles announced, which includes pretty much a broad, if not nearly complete selection of all the big name movies during the year, including most recently the Hunger Games, Elysium, Iron Man 3, Gravity, all those kinds of things. So I think we have pretty strong affirmation that the people who are creating movies see the value in encoding it in Dolby Atmos sound. And our challenge is to get more and more theatres enabled in Dolby Atmos sound so that more people can go out and enjoy these movies in Dolby Atmos and have that create its own momentum similar to what we did many, many years ago with Dolby Surround Sound when that first came out. And right now the main focus in this arena is to help the exhibitors install more and more Dolby Atmos in their theatres.

Okay, in the area of new offerings, I’ll step back and talk about something in our financial numbers that something that people have paid attention to the last several years. During that same time that our revenues flattened out, we had a substantial increase in our operating expenses. A large majority of that was in R&D and selling and marketing. Yes, there were some increases in G&A, but that was primarily for some infrastructure type reasons, but in terms of additional investments, it has been a heavy push in R&D and F&M. and in the R&D area, I would characterize that as being expanding the breadth of the products that we offer. And here are just a couple of those samplings. One of the things that I know about Dolby is that historically the vast majority, if not all of our revenue has essentially been derived from consumer entertainment. Even though some of our products are sold to professional theatres, at the end of the day it’s driven by consumers enjoying things like movies.

But just recently we released a product called Dolby Voice which is actually an audio product which builds on our heritage, but aimed at the enterprise market. And our first partner in this area is BT Global and in the middle of October BT Global announced and released their MeetMe solution which is aimed at the audio conferencing market. That product that they offer basically is driven by Dolby Voice which is an audio solution that helps make conference call sound a lot clear, allows for some special separation and really improves we believe the quality of your audio conference calls at a very competitive price. The business model that we have there is there are some licensing fees upfront, but then we share in the revenue stream with BT Global as they sell their minutes to their end customers.

Ultimately the end customers are actually people like you and me, our firms, our companies. My guess would be the most large and small companies use some outsource provider to give them their audio conferencing service. These numbers that you and your colleagues can call into to have a brief conference call, that’s provided by a service provider. And so that’s the market that BT is going after gaining. It’s our understanding that that market today is probably $3 billion to $5 billion worth of money already being spent. So this is a very attractive area for us, not only because it leverages our heritage in audio, it takes something that already is sucky today and makes it a lot better and we’re dealing with a pretty prominent player here in BT Global in terms of going to market.

Switching to the other end of the spectrum, several years ago another area we started investing in is more the imaging area. At that point we had pretty much been 100% audio technologies. So we started investing in imaging technologies. We eventually came out with some things along the way, but currently our newest offering is an imaging technology that allows for TV at home doing 3D without wearing glasses and at high enough quality that where you’d find that acceptable. It’s our understanding that at least one major TV manufacturer will be releasing a TV in calendar ’14 that embeds this technology and we’ve also of course had chances to show this technology to independent people. We’ve gotten good feedback. And earlier this year, James Cameron and his Cameron Pace Group endorsed this technology as being the leading technology that they believe is appropriate for the home environment.

All right. So and the last thing I should say is the increase in R&D that we’ve had over the last several years is not limited to these items, but I brought these up because these are all items that essentially have come out or have been announced within this last year. At Dolby I would say our typical development timeline might be anywhere from one and a half to three years. So I think it’s pretty logical to me that if we started ramping up expenses a few years back we’d start to see some things coming out now, but I’d say going forward we fully expect the company to continue to release new technologies and solutions that build off of the items that I just talked about.

All right, so just to wrap up on maybe what might be my punch line about the company. We’ve always been known for having really, really good technologies. I think we do have a very strong business model, but of course the PC market, I didn’t wait for a lot of the audience this time talking in advance about PC, but you’re welcome to ask any questions, but we do have PC headwinds that we’re working through and right now the primary focus we have is getting that topline return to growth because it’s been stuck in this low $900 million range for too long.

So let me stop there and we’ll throw it open to Q&A. we have another five, six minutes to go.

Question-and-Answer Session

Moderator

Any questions from the audience? If not I can go ahead and --

Unidentified Analyst

I just want to clarify some of your comments when you were talking about the tablet opportunity, how people need to encode the streaming content and then have a capable device. And you mentioned -- made a comment whether the users appreciated it or not you’ll get to that. So can you clarify that please? Thank you.

Lewis Chew

Yeah. I think when I say we’ll get to that, it’s not something that I know but I’m not sharing with you. I think we’re still early days on people doing what we just described. We’re not early days with things like television and HD. It’s pretty broadly spread, but even I personally for example only rented my first movie in iTunes a few weeks back and watched it on my iPad. Now, maybe I’m a [inaudible]. I don’t think so. So what I’m thinking is it’s still early days on how many people are out there actually consuming things like movies on a mobile device and how many of those people have heard something in good audio and say that matters. So I think sometimes we run into that as an obstacle. We can’t do a lot to solve that other than to keep making these technologies and convincing companies like Amazon that it does matter. And they do believe that it matters, but then there might be other companies who feel like it matters less and might adopt it less rapidly.

So the question is, we potentially do end user advertising. At the current time we don’t have any plans to. It’s a pretty big market. One of the challenges we face of course is we’re not a particularly large company. So I don’t think we have tons of budget to go out there and sway the minds of whatever, 2 billion people. So we’re hopeful that as there is more adoption that will create its own momentum. But that doesn’t mean we’re doing nothing in marketing, but I don’t think we’ll be buying any Super Bowl ads right now, not to mention they already sold out. Okay, other questions? Okay, there’s one right up here.

Unidentified Analyst

Thanks. On the PC side, putting aside the headwinds that the markets had there, aren’t you guys also going through a payment or collection change from Microsoft to the OEMs and I guess when does that normalize?

Lewis Chew

Sure. Yeah. I wouldn’t necessarily characterize it as a payment change. It’s probably more significant than that. what you’re probably referring to is prior to Windows 8, there were instances where our total revenue collected per PC was much higher than it can be now, but it didn’t really have anything to do with those payments terms due to the flow of who put the software on the machine and who pays us what. Today the Windows 8 structure is fairly straightforward. All Windows 8 PCs pay us a base royalty. If they want the PC to operate with this capability, it’s a little bit higher royalty and that’s universal.

The point of that is to make sure that all Windows 8 PCs can consume online content in Dolby. And with respect to the transition, the Q4 that we just reported is pretty much a quarter that now doesn’t have any more of that old revenue from that old structure. So going forward now, we will have a couple more quarters in FY14 that have tough year-over-year comparisons because last year because we were in a lag basis we still did have -- our first couple of quarters had some ripple through of revenues we were getting from the old Windows 7 type arrangement.

Unidentified Analyst

And on the pricing excluding the disk capability, is there much of a change in ASP for mobile versus desktop or what is roughly the --

Lewis Chew

I would say that the mobile pricing probably has just a wider range because mobile pricing there’s no standard price. With PC it’s set with Microsoft as a number, but with mobile pricing it depends on who is the guy and how many phones they’re making and how broad the implementation is and how many models they put it in. So the mobile space is a lot more complex I think than the PC space. In general I think you should say yeah, when you have higher volume markets there’s probably a little bit more pricing pressure, but then there’s more total revenue opportunities.

Unidentified Analyst

So that term is -- you still think that is much larger for you even offsetting any [inaudible]

Lewis Chew

Time will tell long term. It goes back maybe to the question about tablets and how that evolves. I think right now it seems like it’s a stronger argument for media content on a tablet versus the phones, but yet we do see a lot of Dolby being put onto phones as well.

Okay. We have a question right in the back, sir and then we have one over here. Wow, all seven people have now asked a question, including my wife and two kids. All right, go ahead.

Unidentified Analyst

I have a question on the return to growth which you mentioned there. You already showed revenue was quite flattish over the last few years. Can you --

Lewis Chew

Thank you for reminding me by the way.

Unidentified Analyst

Can you give any guidance there?

Lewis Chew

We don’t have a specific number right now, but I would say that we don’t view -- we’re not trying to be cute and say that 1% growth is growth. I think there are established norms about what a healthy growth number might be. But I think it would be disingenuous for me to stand up here and say oh, we can grow 15%. That’s a bunch of bologna until we can do it, right? So I think we want to move from shrinking to growing and progress from there. But I think we’re well beyond the vaporware stage on that discussion. We have a number of new products coming out, products like Voice which are very cordial to what we do well that have a great revenue profile and are tucking in existing market. But I don’t have a specific number for you right now. I look forward to the day when I can give you guys a number or a model and have that have credibility. But right now I’d like to just see us return to some measurable amount of growth.

Unidentified Analyst

Can you give some color on margins?

Lewis Chew

We’re a high margin company and I think we like to leave it at that. I think incrementally it’s hard to find a lot of extra revenue on gross margins of 98%, but that’s off the charts good. But I think we -- even our low margin stuff can be in the 50s and 60s. I think that’s fine if that can generate growth.

We’ll take one more here. I guess there’s no one after me anyway since I’m last, right? So I guess there’s actually a couple more people whose flights were delayed and showed up for my --

Unidentified Analyst

So my question is on the broadcast side. If a program or a channel is being broadcast in Dolby Digital Plus, I’m just trying to understand, is there backward compatibility with the TVs and set-top boxes that are out there currently that just have Dolby Digital?

Lewis Chew

Yes.

Unidentified Analyst

So all those TVs will simply [inaudible]

Lewis Chew

Yes. Generally speaking, as a blanket statement, because Dolby is fully aware of all the different things exploding out there, we seek to create as much backward capability as possible so that you don’t run into those kinds of issues.

Moderator

Great. So if there’s no other questions from the audience I think we’re out of time here, but Lewis, thank you for your time.

Lewis Chew

Okay. Thank you guys for coming.

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