- The market reacted negatively to excellent earnings.
- Shares are between 14%-22% undervalued.
- There is tremendous upside in new product offerings.
- Dolby is expanding from audio into video.
A Virtual Monopoly
Dolby Labratories (NYSE:DLB) is a technology company which works primarily on audio recording, delivery and playback technologies. With over 2,800 issued patents and an additional 2,700 patents pending, the company has a strong portfolio of proprietary technology and intellectual property. In the recording industry, Dolby audio technology has been the regulated industry standard for quality for decades.
The patents are licensed to two separate classes of customers, namely, content creators and original equipment manufacturers (OEM). Notable licensed technologies include Dolby Digital, Dolby Digital Plus and Dolby TrueHD. The technology helps content distributors effectively provide rich-sounding content within bandwidth limitations by efficiently encoding the sound. The OEMs then use licensed Dolby technology to decode the sound for quality playback. Examples of such technology are present in virtually all DVD and Blu-ray discs and players. The company is also developing technology in video and voice technology. In the products and services sectors, Dolby mainly produces servers for storage decryption and decoding of films for projection and provides support to companies with license their technologies.
In a prior article I provided the basis up which I felt shares were valued at $44. After this quarter I am revising that number upwards to $48. On Tuesday, Dolby reported GAAP earnings of $0.73 per share, clobbering the consensus estimate of $0.49 and up from $0.60 a year prior.
Looking at the most recent quarter along with full year guidance it seems that some of the typical Q3 revenues may have been drawn forwards, thus giving the image of weakness in the current quarter. Nonetheless, overall guidance is incredibly strong and there is no sound basis for the 9% drop in share price seen today.
Looking further into this quarter's performance, we see continually improving fundamentals. Dolby ended the quarter with $1.04 billion in cash and cash equivalents, up from $853 million a year ago. Dolby has been actively returning this cash to shareholders through special dividends and share repurchases while maintaining a moat for acquisitions.
Dolby maintains a fortress balance sheet with over $1 billion in cash no long term debt. The TTM free cash flow yield is approximately 7% and rising meaning that Dolby can sustainably pay a healthy dividend in the future should management elect to do so.
Further highlighting the strength this quarter:
- Revenues grew 12% year-over-year
- Operating expenses were flat as a percentage of revenue
- Gross margins were up to 94.5% from 91.7% a year ago
- Operating margins were up to 45.4% from 42% a year ago
Revenue Guidance for the third quarter did come in slightly below analyst estimates of $217 million at $205-215 million, but full year guidance came in well above the $910 million consensus at $930-950 million. For this reason it appears that some of the upside in the quarter was a true earnings beat, and a portion of it was realized earnings which were assumed to be booked in the next quarter.
The earnings call was upbeat on both the management side and on the analyst side. While in my view the boost in the annual outlook numbers shines through the rain cloud of $1 million discrepancy between 3Q outlook versus the analyst numbers, the street begged to differ with a 9% sell-off.
Net of cash, Dolby trades at 16.5 times last year's earnings. To set up our bear case valuation we are going to hold operating steady at 36%. This assumes that costs stay steady as a percentage of revenue just as they have the first two quarters this year. We are also assuming that gross margins drop into the high-80% percent range for the next two quarters bringing the whole-year margin to 91%. Keying in 5% growth and a discounting free cash flows by 11% over five years we get a present share value of $45.42 (a 14% premium to today's closing price.)
Accounting for a more realistic 9% discount rate by considering the fact that Dolby's weighted average cost of capital is considerably low with steady cash flows and no debt, and in consideration of the current interest rates, we get a share value of $48.62 still using our conservative growth rate (a 22% premium to today's closing price.)
A Company With A Vision
One of the most vital growth catalysts is the shift in media consumption from optical formats to streaming formats. The compression technology needed to stream media in sizes compatible with bandwidth availability is ever-increasing. Secondly, with the declining costs of 4K screens, the demand for higher quality content will continue to increase, thereby driving further demand of Dolby's recording technologies.
Dolby also released proprietary conference call technology with BT telecom (NYSE:BT) to improve audio. In management's words:
We are seeing good early adoption. The service not only provides a superior experience, it can also reduce conferencing cost for enterprises. During the quarter at Enterprise Connect we unveiled two new elements that will further enhance the Dolby Voice experience; The Dolby Voice Conference phone and the Dolby voice mobile application. The elegant and intuitive conference phone has received rave views and for the first time will bring the Dolby Voice experience into the meeting room.
The mobile app for Dolby Voice extends the in-person experience to participants on mobile devices. It can utilize a Wi-Fi or cellular data network to join calls on the BT MeetMe with Dolby voice service. We expect to see this available in app stores in May.
Until now, Dolby has liscensed technology exclusively pertainting to audio applications. There is no equivalent to Dolby in the video segment. Dolby has now made taken three seperate actions which clearly convey
In the last quarter Dolby agreed to purchase Doremi Labs for $112.5 million. Doremi manufactures professional A/V equipment and ownspatents in the 4K area. This acquisition, once approved by regulatorybodies, should strengthen Dolby's waning product and servicerevenues. While product margins are lower than licensing margins,this acquisition helps integrate Dolby technology from end-to-end. Now a release can be filmed in Dolby, have its sound mixed in Dolby,be encoded in a Dolby format, be sent to the customer on a Dolby-licensed disc format or through a Dolby-equipped set-top box, andbe decoded with Dolby to be played back on Dolby-licensedspeakers. This acquisition will further engrain the current favorable Dolby standards within the film industry.
Dolby expects its proprietary HDR TV technology, Dolby Vision, to hit shelves prior to year end. This technology greatly increases the dynamic range of colors viewable on a screen and give imagery and lighting a far more realistic feel. Reviews of these screens have been fantastic so far.
Reviews from tests of Dolby's unreleased glasses-free 3-D technology have also been largely positive. Dolby Vision penetration into the high-end TV market will open a completely new revenue stream for Dolby. Let us go back and ask ourselves why Dolby acquired Doremi once again. Doremi makes integrated cinema blocks for sound and 4K. What does this add to Dolby's portfolio?
Until now the company had dealth almost exclusively with sound technology, but these two technologies along with the suite of technology acquired from Doremi should indicate Dolby's expansion into imaging. If Dolby is successful in imaging as it has been in sound, it will be well on its way to monopolizing the entire recording process and not just sound.
As long as Dolby's patents remain the industry standard in the cinema industry, licensing revenues will continue to be strong and gross margins will remain around 90%. The company has a rock-solid balance sheet and is generating excellent free cash flow. With little competition, Dolby should remain the industry leader in its niche for the foreseeable future, and looks like its about to enter another niche.