Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)

Dolby Labs (NYSE:DLB)

F4Q06 Earnings Call

November 9, 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

Michael Porter, Hudson Square Research

Steven Frankel, Canaccord Adams

Sam Doctor, JP Morgan

David Biederman, Pacific Crest Securities

Ben Swinburne, Morgan Stanley

Allen David, DA Davidson

Eric Mince, Eagle Asset Management

Adam Rasheed, Eminence Capital

Operator

Ladies and gentlemen, thank you for standing by, welcome to the Dolby Laboratories conference call discussing fiscal fourth quarter 2006 results. During the presentation all participants will be in a listen-only mode. Afterwards you will be invited to participate in a question and answer session. At this time, if you have a question you will need to press * and 1 on your telephone. As a reminder this call is being recorded, Thursday, November 9, 2006. I would now like to turn the conference over to Mr. Kevin Yeaman, Chief Financial Officer for Dolby Laboratories. Mr. Yeaman, please go ahead.

Kevin Yeaman, CFO

Thank you. Good afternoon everybody. Welcome to Dolby Laboratories Fourth Quarter Fiscal 2006 Earnings Conference Call. Joining me today is Bill Jasper, President and CEO. In addition, Tim Partridge, General Manager of Dolby’s Professional Division; Ramzi Haidamus, General Manager of Dolby’s 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 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 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 recent quarterly report on Form 10-Q available at www.sec.gov or on our website at www.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.

In this call, we 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 fourth 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 and fiscal 2007 guidance. So with the introduction behind us I will now turn the call over to Bill.

Bill Jasper, President and CEO

Thank you, Kevin. Good afternoon everyone. I’m very pleased to announce a strong fourth quarter and fiscal year. During the quarter we made progress toward our long-term objective of being an essential element in the best entertainment technologies used by professionals and consumers including in the following four important areas. First, we continue to transition to high-definition by extending Dolby audio technologies across HD broadcast and next-generation DVD. In the fourth quarter, a number of European channels broadcasting in Dolby Digital 5.1 passed 100 including 31 HD channels. The total number of channels outside the Americas using Dolby is now about 135.

In fiscal 2006, the number of operators outside the Americas who chose Dolby Digital to enhance their broadcast services doubled. In addition, a number of semiconductor manufacturers are supporting Dolby technologies in their integrated circuit offerings for HD. Conexant recently announced that its family of high-definition set-top box decoders would support Dolby Digital Plus joining past announcements from Broadcom, a leading semiconductor manufacturer, and MIPS Technologies, a leading semiconductor IP licensor.

In the consumer electronics industry, Toshiba, Panasonic, and Sony each announced new high-definition products that include premium Dolby technologies. Toshiba’s new HD DVD models can decode up to 5.1 channels of Dolby True HD and Dolby Digital Plus. The first Blu-Ray player from Panasonic offers support for 7.1 channels of Dolby True HD and decoding of 7.1 channels of Dolby Digital Plus. Two new Sony HD camcorders delivered Dolby Digital 5.1 encoding and decoding technologies.

Second, we added to the list of PC manufacturers offering a media-rich PC that includes the Dolby PC entertainment experience. Last month, LG announced a new notebook featuring support for Dolby Home Theatre, which includes Dolby Digital, Dolby Digital Live, Pro Logic II, Dolby Headphone, and Dolby Virtual Surround as well as a Dolby Button making it easy to access these features.

Third, as game console manufacturers gear up for the holiday season, we extended Dolby’s technologies to next-generation game consoles. Dolby’s PlayStation 3 will include Dolby Digital 5.1 for gaming and Dolby True HD for decoding of up to 7.1 channels for Blu-Ray movie playback. Nintendo’s Wii console will offer Dolby Pro Logic II technology which creates a surround sound effect from 2 channel stereo content. Microsoft in addition to including Dolby Digital for both game play and video playback in the XBox-360 is offering an external HD DVD drive beginning this month.

Fourth, we continue to work closely with exhibitors in their transition to digital cinema as it gains momentum. To date, we have over 230 Dolby Digital cinema systems deployed worldwide. Three cinema exhibitors, Premier Theaters, Malco Theaters, and Megaplex theaters are creating all digital complexes using Dolby Digital cinema systems exclusively, and we are pleased with the ongoing trials with various exhibitors of our JPEG 2000 digital cinema system.

In summary, as we look to 2007, we are well positioned for the future. Our synergistic business model of providing technologies and products to assist our customers at all levels of the entertainment chain to create, distribute, and playback content has been and will continue to be a key factor in helping drive our success. As we move forward, we remain focused on extending our core technologies across existing and new markets, driving the adoption of new Dolby technologies, and capitalizing on brand, reputation, and experience across the entertainment chain to generate additional long-term growth opportunities.

I’ll now turn the call back to Kevin.

Kevin Yeaman, CFO

Thank you, Bill. Revenue for the fourth quarter was approximately $102 million, up 29% year-over-year. On a full year basis, Dolby’s revenue was $392 million, up 19% from fiscal year 2005. Revenue for the quarter was comprised of 79% licensing revenue and 21% product sales and production services revenue.

Licensing revenue for the fourth quarter was $80.4 million, an increase of 37% year-over-year and 16% sequentially. This was due in part to $6.7 million in revenue relating to PC products shipped over the past six quarters. You may remember that last quarter we estimated that approximately $10 million was due from two licensees pending resolution of certain contractual matters, and we did not include these amounts in our guidance. This $6.7 million represents the recognition of amounts due from one of these licensees.

Turing to our licensing markets, we experienced year-over-year growth in each of our markets during the fourth quarter. The consumer electronics or CE portion of licensing business experienced growth on a year-over-year and sequential basis. This was primarily driven by standard DVD related products. Even with this stronger than expected growth we continue to diversify our licensing stream across newer markets. For the year, CE made up about 45% of our licensing revenue, down from about 50% in fiscal 2005 and more than 60% in fiscal 2004.

Our PC market made up about 30% of our licensing revenue in fiscal 2006. In the fourth quarter, we experienced strong year-over-year growth on robust shipments of brand named notebooks. The $6.7 million in prior quarter royalties drove sequential growth.

Our broadcast market made up just over 10% of our licensing revenue in fiscal 2006 and about 10% in fiscal 2005, and is comprised of revenue from televisions and set-top boxes. The primary growth driver in this market is the transition to high-definition and digital television.

We continue to further diversify out revenue stream to growth in our other markets which include gaming, automotive, and our VL subsidiary.

Turning to our products and services segment, revenue for the fourth quarter was up 7% year-over-year and down 11% sequentially. The sequential decrease was due to a decline in traditional cinema related products after an exceptionally strong third quarter during which exhibitors accelerated their purchase orders ahead of anticipated price increases. The year-over-year growth was due to an increase in production services revenue.

Let me turn to the details of the P&L for the quarter. Total gross margin was 82% for the quarter, up 2 points sequentially due to an increase in licensing revenue as a percentage of total revenue. Licensing gross margin of 91% for the fourth quarter was flat sequentially. Product gross margins declined to 41% for the quarter, down 5 points sequentially. The decline was due to low production volumes as a result of reduced demand for traditional cinema products during the fourth quarter and to a lesser extent the cost of upgrading previously deployed digital cinema units.

Services gross margin was 60% for the fourth quarter, up 8 points sequentially as a result of higher revenue. SG&A expense was 40% of revenue in the fourth quarter, down 1 point sequentially. R&D was 10% of revenue for the fourth quarter or flat sequentially. In the fourth quarter, we recorded a $3.6 million gain from settlement relating to an audit of a semiconductor manufacturer that embeds our technologies. We recorded the $3.6 million as a gain rather than revenue since we do not collect royalties from semiconductor manufacturers like we do from consumer electronics manufacturers.

Dolby’s effective tax rate for the quarter was approximately 38%. Fourth quarter net income in the 2006 was $25.2 million or $0.22 per diluted share, compared to $16.8 million or $0.15 per diluted share for the fourth quarter of fiscal 2005. For the full year, net income was $89.5 million or $0.80 per diluted share compared to $52.3 million or $0.50 per diluted share for fiscal 2005. Net income for fiscal 2005 on a pro-forma basis giving the factoring of Dolby’s intellectual property contribution in February 2005 as though that occurred prior to the commencement of fiscal 2005 was $63.4 million or $0.61 per share.

Net income also reflects stock-based compensation expense of $4.2 million for the fourth quarter of 2006 and $2.7 million for the fourth quarter a year ago. For the full fiscal year 2006, stock-based compensation expense was $19.1 million versus $14.2 million in 2005.

Turning to the balance sheet, Dolby finished the year with nearly $520 million in cash, cash equivalents, and marketable securities. From operations we added approximately $46 million during the fourth quarter as a result of net income of $25.2 million and changes in the balance sheet. Capital expenditures were $2.3 million in the fourth quarter.

In addition, the balance sheet includes accrued royalty expenses of approximately $10 million related to a patent license agreement. In the third quarter of fiscal 2006, we evaluated whether the payment of royalties under this patent license agreement using the historical method of calculation would constitute an overpayment and subsequently notified the licensor that we no longer intended to pay royalties using this method. We paid the third-party licensor under a new methodology for the third and fourth quarters of fiscal 2006, but have accrued the royalty expense based on the historical method. As of today, we have not heard from the licensor.

With that I will turn to fiscal 2007 guidance. I will start by sharing some high-level assumptions we used in formulating our revenue guidance. We’re assuming that our products and services segment will grow at least 10% on demand for digital cinema and broadcast products as well as demand for our live sound products and production services. In our licensing segment we are expecting growth of 5% to 15%. We are assuming that our CE market will be roughly flat and that growth comes from our PC, broadcast, and other markets on continued demand for notebooks, high-definition and digital televisions, and gaming consoles.

Our guidance now includes the prior quarter revenue expected from the resolution of contractual matters with the remaining licensee as described above. So in total, fiscal 2007 revenue is expected to be $420 million to $450 million. Net income for fiscal 2007 is expected to be $95 million to $105 million. Earnings per diluted share for the full year 2007 are expected to be between $0.83 and $0.92.

While under FAS 123R stock-based compensation expense may vary based on factors such as stock price or volatility, we expect stock-based compensation expense for the full year to be $20 million to $22 million.

That concludes our prepared remarks. I would now like to turn it over to the operator for questions.

Question-and-Answer Session

Operator

Thank you sir. Ladies and gentlemen, if you wish to register a question for today’s question and answer session you may do so by pressing * and 1. If you would like to withdraw you question press * and 2. If you are on a speaker phone please pick up your handset before entering your request. Please be sure to identify yourself and your firm at the outset. To be fair to all participants we ask that you limit yourself to one question and a followup question until all participants have had a chance in the first round. If time allows we will then come back to answer any remaining questions. We will pause for one a moment to allow an opportunity to signal and to set up our queue. And we’ll take our first question from Ralph Schackart with William Blair.

Ralph Schackart, William Blair & Co

Good afternoon, great quarter guys and I’m happy to see the outlook. Can you talk a little bit about extending the Dolby brand and technologies into new end-markets and you talked a little bit in the past about mobile devices and handsets, can you sort of give us a little color where you are in that stage and will that start to roll through the numbers in 2007?

Ramzi Haidamus, General Manager, Consumer Division

Our initiatives continue to be the rollout of new technologies to cover new geographies and new product types as well as the markets that you referred to. So, yes, we’re still on track and have launched our long-term strategy to have product placement in cellular technology, i.e. telephones, as well as portable music devices and portable music initiatives in general. We have some evidence already of some wins as you know through our VL subsidiary with our AP technology in the iPod. That’s a great start for us, so we do intend to take the Dolby technology to the next step over the next year or so.

Ralph Schackart, William Blair & Co

Okay great, and then in terms of the PC market with the delay of Vista until late January, how much of your guidance did you take that into effect and can you see potential larger upside in the PC segment if there is a larger upgrade cycle after Vista? Thanks.

Kevin Yeaman, CFO

So, in terms of the last question, the PC market is a pretty dynamic market for us. We don’t see any big change from Vista affecting us in the ’07 timeframe, obviously the January projected release date would affect our last two fiscal quarters. Ramzi, do you want to add to that?

Ramzi Haidamus, General Manager, Consumer Division

We did mention in the last quarter that there could potentially be some effect related to the dynamic changes in the operating system business since the Vista operating system was delayed. That effect will not be noticed in ’07, you’ll probably hear from us sometime towards the end of the year about this subject matter.

Ralph Schackart, William Blair & Co

Okay great, just one last one if I could. Kevin, can you give us the full year fiscal ’06 CapEx please?

Kevin Yeaman, CFO

I didn’t give that number but we would expect it to be similar…oh I’m sorry, the ’06 number?

Ralph Schackart, William Blair & Co

Yeah.

Kevin Yeaman, CFO

Yeah, I’ll have that for you in a moment. I think it’s about $8 million.

Ralph Schackart, William Blair & Co

Okay, thank you.

Operator

And we’ll take our next question from Daniel Ernst with Hudson Square Research.

Michael Porter, Hudson Square Research

Hi, this is Michael Porter calling in for Daniel Ernst. We’ve heard that there would be some dual format HD DVD Blu-Ray players coming to the market, we’re wondering if you have heard anything along those lines?

Ramzi Haidamus, General Manager, Consumer Division

The last we’ve heard about this trend is that there were some contractual matters regarding some of the DVD formats themselves, in other words the companies who wanted to build those players were under some contractual matters that either let them or did not let them add the other formats. Pending those resolutions we don’t foresee seeing a lot of those types of dual players in the next year. As soon as that changes contraction we might see that happening anytime, because we believe that is probably one way to resolve the format war between these two formats.

Michael Porter, Hudson Square Research

And one followup if I might, to what extent does you fiscal year ’07 guidance break in the next-gen DVD log gen?

Kevin Yeaman, CFO

We’re not assuming much contribution from next-generation DVD in our 2007 timeframe, and as I said in the prepared remarks overall we’ve expecting to see the CE market roughly flat.

Michael Porter, Hudson Square Research

Thank you.

Operator

And just a reminder, ladies and gentlemen, if you would like to ask a question please press * and 1 on your touchtone telephone now. We’ll move next to a question from Steven Frankel with Canaccord Adams.

Steven Frankel, Canaccord Adams

Thank you. Let me just do two quick ones, one for Kevin, what was the cash flow from operations for the quarter and for the year? And then big picture, what’s changed versus the last conference call? I mean you guys had a fairly muted outlook and hinted at a muted outlook for fiscal ’07 and now even with the next-gen DVD stuff not kicking in you seem a little more bullish on the business, what’s changed?

Kevin Yeaman, CFO

Okay, so on the first question, cash flow from operations for the quarter was about $46 million, obviously net income was about $25 million, and the rest was due to changes in the balance sheet. For the year it was about $130 million. In terms of your question regarding guidance, as you know we gave a preliminary outlook of mid-to-high single digit growth on the last call and our guidance comes out to about 7% to 15% on this call. First of all it was preliminary guidance, so we’ve had a chance to spend more time looking through each of our markets. Obviously, we had a good quarter in the fourth quarter and fortunately we have diversified across quite a few markets as you know and therefore there are quite a lot of different growth drivers with a range of outcomes within each sector. Of course in ’07 we referred to the PC market in particular as one that we’re being cautious about and while we still believe that’s a dynamic market and there are some reasons to be cautious, we haven’t seen any impact on our business as of yet and at least we’re into fiscal ’07 now. As I said we see roughly flat for CE, we see good growth in broadcast and our other markets, and we see some good opportunities in the products and services market as well with digital cinema beginning to contribute to share, and broadcast products are still doing well.

Steven Frankel, Canaccord Adams

Is our JPEG 2000 product in test or full release today?

Tim Partridge, General Manager, Professional Division

The JPEG decoders have been out there in the market now for a few months. We kind of still call it test. We’re very happy with the JPEG itself, but there are a couple of other technologies that the studios have requested, so we’re not in full production yet with our final version which we believe will meet all the requirements, not only JPEG of the studios, but that will happen in the near future.

Steven Frankel, Canaccord Adams

Great, thanks very much.

Operator

And we’ll take our next question from Sam Doctor with JP Morgan Securities.

Sam Doctor, JP Morgan

Thank you. A couple of questions first on the gaming market, can you give us some sense of what your outlook is for next year and what do you think the impact would be of the Blu-Ray drives on the PS3 and the XBox-360 HD DVD attachment? What does that do for your growth?

Kevin Yeaman, CFO

Well, we haven’t broken out growth outlook next year by market, but that falls into the category of our other markets in terms of our breakout of revenue and guidance, but we experienced good growth in the gaming market last year. On the release of the XBox and good Christmas season last year, so we are in our guidance expecting good growth again this year given the expected release of the PlayStation 3 in the Christmas season.

Sam Doctor, JP Morgan

So, would you expect that to accelerate from last year?

Kevin Yeaman, CFO

We haven’t given specific guidance on that, but if the question is raised we would expect accelerated growth as a result of the PS3.

Ramzi Haidamus, General Manager, Consumer Division

We do see the PS3 making a significant contribution simply to the fact that there are so many technologies in that platform owned by the company.

Sam Doctor, JP Morgan

And if I may add one more question on the PC side, you know PC revenue has been growing really well for the last couple of years, how much head room do you think there is still left as your growth begins to converge market growth for media-centric PCs?

Ramzi Haidamus, General Manager, Consumer Division

Well, geographically speaking there’s still quite a bit of the world which is growing at significant rate, whether it’s Latin America, EMEA, Asia-Pacific, there are still growth opportunities of us there so that’s where we see the majority of the growth happening for us, whether it happens with the current operating systems out there or with Vista.

Sam Doctor, JP Morgan

So, what would your attach rate or your market share be for media-centric PCs?

Ramzi Haidamus, General Manager, Consumer Division

I’ll give you a high level view of the attach rate. Right now, as you know, most laptops for example ship with a very high level attach rate with DVD players. With the Microsoft Vista as we said last quarter, it’s going to depend heavily on the market adoption of the mix between basic version, home premium version, the ultimate version, and the corporate version. There seems to be some question as what that mix is going to be and our attach rate will be somewhat proportional to that adoption.

Sam Doctor, JP Morgan

Okay great, thank you.

Operator

And we’ll take our next question from Steve Lidberg with Pacific Crest Securities.

David Biederman, Pacific Crest Securities

Good afternoon, this is David Biederman in for Steve, just a couple of quick questions. Can you give a little color on contributions from your licensing, is it north of 5% yet? Also, if you could provide a little color about broadcasting, what percentage of your licensing revenue is that at the moment? Thank you.

Kevin Yeaman, CFO

Let me take the last question first. In 2006, broadcast revenue from our licensing segment made up about 12%, broadcast products make up about 25% of our products revenues. So, the broadcast market is a big market for Dolby. We have separately broken out CE which is about 45%, PC which is about 30% and broadcast, and the remainder is made of gaming, automotive, and our VL subsidiary which we have not broken out separately at this stage.

David Biederman, Pacific Crest Securities

Great, thanks.

Operator

And we’ll take our next question from Benjamin Swinburne with Morgan Stanley.

Ben Swinburne, Morgan Stanley

Thanks for taking the call, good afternoon guys. Ramzi, just a point of clarification, you’re saying that the attach rate in a Vista world when we get there could be lower than what you’re seeing today globally in the PC market?

Ramzi Haidamus, General Manager, Consumer Division

Yeah, just to add some more color on my earlier statement. There are about at least four SKU’s if not five that are coming out of Vista. What’s going to be shipping in the home premium version as well as the ultimate version is Dolby technology, i.e. DVD playback. So with those it’s really automatic, it’s embedded, and so we’re kind of 100% attached there. So, the question isn’t so much how much of Dolby technology will be within each SKU, the question is what percentage of the market will each of these SKU’s take over, and that’s the question mark which we have as well as a lot of the analysts out there that have.

Ben Swinburne, Morgan Stanley

I see, okay, thank you. Another point of clarification on the guidance, I think, Kevin, you said that it includes the catchup payment that is remaining on the licensing side in your guidance, is that right?

Kevin Yeaman, CFO

That’s right, last quarter remember we said there were two licensees that we expected these payments from, but we couldn’t predict that time of the year it was going to fit it, so we didn’t include it in our guidance. So now that one is in the numbers for ’06 and we expect the other one to come in ’07, we’ve included it.

Ben Swinburne, Morgan Stanley

Okay, and have given the order of magnitude, is it a similar size?

Kevin Yeaman, CFO

We said $10 million over the two licensees, so somewhere around the order of $5 million.

Ramzi Haidamus, General Manager, Consumer Division

This is Ramzi and I just want to add one more item. There is another attached opportunity to the Vista SKU’s in that the Vista basic version where there is no DVD player shipped automatically there’s always of course the opportunity which the OEMs will have as they have today for the consumer to go ahead and purchase a DVD player as they’re purchasing the laptop or the set-top boxes. That’s yet another opportunity in the PC market for us to have an attach rate even in the basic and corporate version of Vista.

Ben Swinburne, Morgan Stanley

Okay, and just looking back on the guidance last year coming into ’06 and how strong you guys finished up, I believe somewhat back in transfers, I think CE has come in ahead of where you thought it would maybe six or nine months ago, is that correct? And second could you maybe give us some color on what drove that, was it just overall unit DVD player sales were better than you thought or more sort of better revenue per unit, anything you can add there?

Kevin Yeaman, CFO

Well first of all it is true that we came into last year expecting CE to be flat to slightly down and we actually saw some growth and it was driven largely by DVD unit volume. The other area where we did well relative to our guidance last year is we had said flat to slightly up for the products and services segment, it was actually up about 9%, so we are pleased with that.

Ramzi Haidamus, General Manager, Consumer Division

In terms of new growth opportunities, we’re looking at the additional camcorders coming out having quite a large acceptance in the market place. These are camcorders with either 2 channel or multi-channel recording and the growth rate on those have been quite pleasing to us.

Ben Swinburne, Morgan Stanley

Okay, and my last question on the high-def TV side, I think we’re going to be moving to a mandated tuner early next year, can you guys talk about what that means for your business on that broadcasting licensing side and how much of that impacts your guidance for this year?

Ramzi Haidamus, General Manager, Consumer Division

I will comment on the business and I’ll turn it over in terms of guidance over to Kevin. The broadcast market indeed in the U.S. when it comes to the ATSC standard is mandated, so we will see 100% attachment when it some to an ATSC compliant set-top box or digital television or analog television which has an ATSC tuner, so we are very pleased with that, and you are correct on the timeframe.

Kevin Yeaman, CFO

As far as the guidance goes, we do expect that to be a high growth portion of our broadcast licensing in the North American market where ATSC tuners are being delivered through the televisions and set-top boxes. Keep in mind that that’s not the only thing that makes up our broadcast market. We have televisions and set-top boxes that are delivered around the world including North America with other technologies such as virtual speaker and Dolby Digital. And so that is also a good market for us. It doesn’t have quite the same growth dynamic as the ATSC driver, but it’s a good growth market.

Ben Swinburne, Morgan Stanley

Great, thanks.

Operator

We’ll take the next question from Allen David with DA Davidson.

Allen David, DA Davidson

Yes, good afternoon gentlemen, great quarter, just a couple of questions. First off, I just wonder if you can give us a little bit more color on the growth rate in terms of your content for PCs. I don’t know if you want to break it down into laptop and desktop, but just maybe over the last few quarters your content per box, if you could just give me a little more color on the growth rates?

Kevin Yeaman, CFO

Can you explain what you mean by content?

Allen David, DA Davidson

I’m sorry the dollar content per PC, kind of the opportunity that you’ve gotten today and then obviously going forward as well.

Kevin Yeaman, CFO

The first thing I would note is that the substantial majority of our revenues in the PC market today are driven by the sale of software DVD players. But we have announced a number of wins over the last several quarters in terms of more technologies in PCs that are targeted as multimedia platforms.

Allen David, DA Davidson

Okay, can you give us an idea of kind of the upside there relative to maybe down the road in a year in terms of content for PC?

Bill Jasper, President and CEO

We don’t give out any ASPs broken down by category.

Allen David, DA Davidson

Okay, and then a longer term question. I’m curious if you can give us a little more color on your opportunity in the smartphone or wireless handset market?

Ramzi Haidamus, General Manager, Consumer Division

We have technologies that are currently being pushed out into the market, demonstrated in cellphones such as the enhancement of the audio quality, such as a surround sound experience even with two sets of headphones attached to a cellphone, so there is a series of initiatives that we’re pushing which would be actually applicable not only in the cellphone market but as well as the portable music and portable video market. That’s an initiative that covers all three markets.

Kevin Yeaman, CFO

And just so everyone is clear, there have been a couple of questions now on this mobile space; that is not a factor in the 2007 guidance timeframe.

Allen David, DA Davidson

Thank you.

Operator

And just a reminder, ladies and gentlemen, if you would like to ask a question please press * and 1 now. We’ll go next to Eric Mince with Eagle Asset Management.

Eric Mince, Eagle Asset Management

Congrats on a great quarter and year guys. I’m just curious what you’re thinking on digital cinema in ’07, what speaks into the guidance there?

Kevin Yeaman, CFO

Well in terms of guidance we said that we expected at least 10% growth in our products and services segments, and digital cinema kicking in is one of the biggest factors in our growth expectations for products and services, but I’ll turn it over to Tim in terms of some additional breadth on that.

Tim Partridge, General Manager, Professional Division

We will see some activity on the revenue side from digital cinema finally next year. As we said earlier, we have been very pleased with the JPEG trials that we’ve been doing and happy with that, but we’re also incorporating some other technologies that the studios have requested. There have been some minor changes recently to the specs that we’ve had to go out there and incorporate, and there will be probably be some more specifically related to 3D. So, we want to make sure that we capture all these changes. We’ve been encouraged in the market place by exhibitors’ support in us and several of them have actually specifically requested Dolby equipment from the various systems integrators and we are working very closely with all those systems integrators to be able to supply products to those exhibitors, and we expect to have the system as I said earlier that meets all the studio’s requirements very near in the future here.

Eric Mince, Eagle Asset Management

So, if fiscal ’07 is going to be the first year of that cycle, how many years do you think would be in that upgrade rollout for the industry?

Tim Partridge, General Manager, Professional Division

That’s real difficult to say. I don’t know whether you’re talking U.S. or worldwide, for one thing the suspicion is that the U.S. will happen pretty quickly and you’ll hear anything from kind of a 4 to a 10-year period. Worldwide it’s going to happen in small pockets around the world and probably somewhat slower than that.

Eric Mince, Eagle Asset Management

Okay, and then obviously you’re not assuming much in the way of next-gen DVD in fiscal ’07, but that would also be another multi-year cycle that you guys are just on the uptake as well?

Tim Partridge, General Manager, Professional Division

Had there not been a format war as we commented in the last quarter, the uptake would be significantly faster. We believe both technologies actually offer significant benefit over existing DVD formats. What really is at stake here is does one format win over the other or is there a combined tumble player which accelerates it, and if it does we can see accelerated rates similar to what we’ve seen in the standard DVD.

Eric Mince, Eagle Asset Management

And just on the PC, when you guys gave the initial ’07 reading you were a little cautious on PC, I think you highlighted that one major PC OEM was allowing people to opt out of Dolby on the website when they were selecting their features for their PC, have you seen anything from that program how that’s going?

Tim Partridge, General Manager, Professional Division

Sure, let me just clarify a little bit about our comment. The opt out really wasn’t so much about Dolby, the opt out was about whether the purchaser did not want to have DVD playback at all with all of its features, in other words you will not be able to play a movie on the PC and that of course can be use for corporate use or business use. So that was the comment about our technologies not being involved in those products. To the extent that is happening we have seen very little evidence. There are one or two OEMs in select products that give you the opportunity to not purchase a DVD software player. But by and large, in other words 95% of what we’re seeing certainly does not show this trend.

Kevin Yeaman, CFO

I should point out our guidance still reflects some caution in the PC market relative to the growth rate we’ve seen over the last couple of years, but certainly the change from our preliminary guidance to now does reflect a little bit of a broader range of outcomes in that PC space given where we are now.

Eric Mince, Eagle Asset Management

Great, thanks a lot guys.

Operator

And we’ll take the next question from Adam Rasheed with Eminence Capital.

Adam Rasheed, Eminence Capital

Hi, thanks. Can you talk about the CE market, you mentioned this year it was I think 45% of the licensing revenues, so it seems like it was up maybe 10%, can you guys talk about kind of the puts and takes, how did it shake up, it’s been low end units, high end units, the amount of technologies incorporated in the players, kind of standard DVD players versus some of the DVD recorders, and how do you expect that to play out next year as well?

Ramzi Haidamus, General Manager, Consumer Division

I’ll give you a bit of an overview on the CE market. First, the receiver market has been somewhat flat. We do see an upgrade in the CE market worldwide as soon as our premium technologies hit the market, and that would be Dolby Digital Plus, multichannel decoding, and 2 HD multichannel decoding. These products are in the pipeline and we will see those show up in this fiscal year, so you’ll see a little bit of a refresh in terms of products there. On the home theatre and the box market, it looks like there’s quite a bit of competition in there, some market manufacturers are pulling out of that market, so there doesn’t seem the big upward trend that the industry thought there might be. As we mentioned earlier, there is a significant growth on the portable digital camcorder market, so we’re encouraged by seeing multichannel camcorders take off to our surprise quicker than we thought we did. And finally on HD DVD players, the comments are in line with what we mentioned earlier today. It’s about the resolution of the format war either by a senior combo player be introduced or by one of the formats running over the other.

Adam Rasheed, Eminence Capital

And if I look at the CE piece that was 45%, can you maybe just provide me a rough estimate, how much were receivers, how much was home theater and box, how much were DVD players?

Kevin Yeaman, CFO

We don’t break it down any further than that.

Adam Rasheed, Eminence Capital

Okay, did each of those categories grow in 2006?

Kevin Yeaman, CFO

I’m not sure whether home theater to box was up or not, but I think it’s safe to say that the other areas were all up year over year. So, I would add, the majority of the CE space is made up of DVDs players whether they are standard DVD players or portable DVD players.

Adam Rasheed, Eminence Capital

Okay. Then, when you mentioned you thought it would be flat next year, where’s the rate of change in each of those groups, is it mostly in the DVDs?

Kevin Yeaman, CFO

Yeah, our guidance is roughly flat for the year. Basically what we are looking at is the potential for moderating demand for standard DVD players in advance of clarity around the next-gen HD formats and not much contribution from next-gen HD formats. This is also a space where we’ve seen some volatility year-to-year. In ’05 the space came in below what industry analyst estimates were tracking, in ’06 we came in at about that rate, so there might be some timing here. The other factor I would introduce into the CE space is that as you know over the last year or so we’ve put quite a lot of effort into our compliance efforts, and while I can’t point to any data which says that that’s what is driving the CE result, we do hope that the results of our efforts would be that people would start reporting for it and that we might not be able to directly attribute it to our compliance efforts. So, it’s an unknown to us whether that is what is driving what we’re seeing, but that’s what we hope to see over the long term.

Adam Rasheed, Eminence Capital

Okay, and just a quick question, can you talk about that royalty approval that you accrued for a higher rate in the fourth quarter and then you actually paid, what was the difference and when could you actually hammer out that agreement?

Kevin Yeaman, CFO

We accrued $10 million over two quarters, that was the third and fourth quarter, and we continue to build our guidance based on the 91% licensing gross margins and that’s what we expect for the foreseeable future, and there’s not much more we can see at this point about that.

Adam Rasheed, Eminence Capital

And what is the nature of the agreement?

Kevin Yeaman, CFO

It’s a patent license agreement.

Adam Rasheed, Eminence Capital

So, you’ve accrued that $10 million is in excess of what you’ve paid or $10 million is the total accrual?

Kevin Yeaman, CFO

Well, $10 million is the total accrual less any amounts that we paid.

Adam Rasheed, Eminence Capital

And my final question, you now have over $500 million of cash and your business generates a lot of cash, maybe can you just update on what you plan to do with that cash?

Bill Jasper, President and CEO

Well, we are continuing to explore areas that would be synergistic with what we’re doing. As we’ve talked in the past, we’re branching into imaging and video, we’re taking a hard look at these areas, we’re beefing up our research and development, we are looking for areas where we can continue to expand the business, and we are pursuing things very aggressively in that regard.

Operator

We’ll go to a followup question now from Benjamin Swinburne with Morgan Stanley.

Ben Swinburne, Morgan Stanley

Thanks. On the product sales side, Tim and Kevin, it sounds like that the revenue mix is going to shift a little bit in ’07 versus ’06 with a little bit of digital cinema and a little less cinema processor revenue, any impact to gross margin in that segment this year or ’07 verus ’06 that you could talk about?

Kevin Yeaman, CFO

Just by way of leaning into that, in ’06 we saw 75% from traditional cinema products, most of the rest was related to broadcast products, and then our live sound products actually were beginning to contribute, but that’s a smaller amount. In ’07 we see growth in broadcast live sound again and digital cinema kicking in. And, yes, in the early stages of the digital cinema rollout we do expect there to be some pricing pressure and that could result in lower product margins; I mean, if you look at it, we’ve been averaging somewhere around 50% and we could see them dip into the 40s during this guidance timeframe.

Ben Swinburne, Morgan Stanley

Is there any material difference, Kevin, between the cinema processor and broadcast margins?

Kevin Yeaman, CFO

I wouldn’t point to any changes that I expect in overall product margins as a result of mix of traditional cinema versus broadcast but digital cinema would have an impact.

Ben Swinburne, Morgan Stanley

Okay and then followup for Tim, can you give us an update on DCI, where we are in the standards process, and do you have any comments you want to make on how the business plans shakes out here in terms of Virtual Print Fees or vendor financing or are the exhibitors more interested in the U.S. and actually starting to pay for some of the stuff, anything along those lines? And as a followup, to the extent your market share in the cinema processor world especially in the U.S. is very high, as we move into digital cinema do you think your share numbers slip and does that impact the cinema processor sales in those theaters or did those work in concert?

Tim Partridge, General Manager, Professional Division

Sure, in no specific order. The business plan seems to have shaken out pretty much here in the U.S. and there are the three major deployment companies who have got business plans, presented them to the industry, things are flexible, one has moved ahead already, Technicolor is about to move ahead next year and MCM sometime soon after that. So the business plan seems to be done here for the U.S. There yet needs to appear a business plan that works internationally along the similar lines. If there is a business plan that funds the equipment from payments from the studios in the guides of the VPS then that yet has to be figured out internationally because the market dynamics are so much more different internationally. So internationally we have seen different approaches to the financing such as straight sales, straight purchases from exhibitors, and we expect to see that more so internationally than here in the U.S. Regarding the DCI spec, as you know that was published last year, but as I’ve said earlier there have been some minor tweaks to that recently which we’ve have to go back and upgrade all our systems that out there. There are over 230 systems we have out there now that we need to try to keep up to spec. So, we’ve upgraded those, we’re in the process of upgrading them to JPEG of course, we have about 60 JPEG systems out there right now, and as I said that’s doing real well, and then there are a couple of other technologies that we need to get into a final system before we can do a final upgrade across all of the units and then get into real production. The specs even though they come out of DCI as I’ve said before, some of them need to be standardized within the standard bodies such as SMPTE, so we’re working on that front with many others to actually get them written down as well, and some of the specific ones we’re very interested in getting done quickly are obviously 3D standards as we’ve seen 3D has been very well accepted by the cinema going public and Hollywood has renewed interest in 3D, a number films planned for the future. Dolby announced the 3D initiative just a few months ago and we hope to get into that business also. In terms of the market share, it will be a long time as I’ve said before, before every theater in the world is a digital theater. Therefore, there will still be a need for print and while ever there are prints there are needs for the Dolby technologies that are on those prints. Therefore, there’ll still be a need for the audio processor. Over and above, the proprietary technology is in there, so there’s always going to be a need for a central audio processor, so we certainly expect that market to continue. Whether our overall digital cinema market share will be the same as it has been traditionally, obviously we’ll be trying to achieve that.

Ben Swinburne, Morgan Stanley

Just to clarify it, if one of your competitors on the digital cinema side were to sell into a screen or into an entire theater, it doesn’t necessarily mean they would then be ripping out the cinema processors you’ve got in there even if they were to get rid of the film, there would still be a role for Dolby there with someone else’s product?

Tim Partridge, General Manager, Professional Division

Absolutely the cinema processor includes a number of technologies none of which are included in the digital cinema equipment. It’s all about taking the audio, processing the audio, routing to the correct speakers, and all that will still be needed in additional cinema world.

Ben Swinburne, Morgan Stanley

Thank you guys.

Operator

And there are no further questions. Mr. Jasper I’ll turn the conference back over to you for any closing comments.

Bill Jasper, President and CEO

Thank you very much. I’d like to thank everybody for joining us on today’s call. We’ve got a great quarter and a great year and we look forward to speaking with you in the future. Thanks.

Operator

And that concludes today’s conference call. Thank you everyone for joining us, you may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Dolby Labs F4Q06 (Qtr End 09/28/06) Earnings Call Transcript

Check out Seeking Alpha’s new Earnings Center »

This Transcript
All Transcripts