Dolby Labs Has Been Short-Changed

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 |  About: Dolby Laboratories, Inc. (DLB), Includes: MSFT
by: Ted Stamas

Dolby Laboratories (NYSE:DLB) has been chaffing under the yoke of a late August announcement that Microsoft's (NASDAQ:MSFT) Windows 8 may not be incorporating its technology. Microsoft dropped a bomb on Dolby. Just two months ago, on October, 3, the stock traded at $26/share, almost equal to its price of $25 during the dark days of late 2008, early 2009. It was priced like it was Mr. Irrelevant, the last pick in the last round in the NFL Draft. If you bought at the October low, you may have been involved in a legal bank heist.

Even at today's closing of $32, Dolby Laboratories is still selling at a decent valuation. Yahoo Finance consensus earnings estimates gives it $2.57/share for fiscal year 2012, which closes in September of next year. This calculates into a P/E Ratio of 12. When you take into consideration the projected 5 year compound annual growth rate of 15%, you come away with a manageable, if not compelling PEG Ratio.

However, this not to say Dolby Laboratories will be the high-flyer it once was, at least not near-term, only that it's a blue chip technology with an established, world-wide brand. Patient investors could do well with this security if they don't have a short attention span. Is it a value trap? Maybe, but if you look out a few years from now, I believe the stock will be much higher. Dolby's average annual P/E Ratio has been 25 for the last five years, with the exception of 2009, when it was 16. The voice of reason would tell you that there is a very good probability that this equity will move up in value.

The projected loss of revenues from the exclusion of Dolby technology in the Windows 8 operating system will not be a factor until 2013. CEO Kevin Yeaman clarifies this in the August 4, 2011, Q3 conference call:

We don't think this has a discernible impact on 2012 when we're still going to be on a Windows 7 year. We see Windows 8 coming into play during 2013. Once we are at Windows 8 adoption, if Windows 8 does not include our technologies, then we would expect the world to migrate to a place where there is one Dolby Digital decoder per PC, which is, of course, something the world had begun migrating to.

The missive from Microsoft came out of left field, and, without question, put some pressure on Dolby. But, you don't stay in business for 45 years without a Plan B. In addition, let's not forget that DVD drives in laptops and PCs are not necessarily ancient history, but are being phased out with the advent of streaming. You know anybody with a floppy drive on their computer?

But going back to the Q3 conference call, CEO Yeaman spins damage control by stating:

If our technologies are not included in the commercial version of Windows 8, we expect to support DVD playback functionality by increasing licensing our technologies to OEMs and ISVs (independent software vendors), and we will seek to extend our technologies to further support online content playback.

Some of these online content providers include Netflix (NASDAQ:NFLX), VUDU, Amazon (NASDAQ:AMZN) and Apple (NASDAQ:AAPL).

I believe it was Deep Throat who said to Bob Woodward, "Just follow the money." That's exactly what Dolby is doing, following the money which in their business is the technology. In the November 17, 2011, Q4 conference call, CEO Yeaman explains:

Today we are seeing a shift in our core audio business from optical disk playback to digital broadcast in the media content...In fiscal 2011, we estimate that 52% of licensing came from non-optical disk base revenue, compared with 45% in fiscal 2010. This includes revenue from products such as TVs, set-top boxes, mobile phones, as well as our processing technologies on a wide range of devices.

Yeaman expounds on this later on in the Q&A session:

One of the things we have highlighted today is the amount of revenue we have coming from non-optical...which is not engaged in any way in optical disc playback. And that's been growing quite well, 22% in '10, 27% in '11. The biggest drivers, of course, are broadcast and mobile. And we do see growth in those areas in 2012. I think beyond 2012, still in front of 2012 is the bigger adoption in markets like China, India and Russia...This is where we expect a lot of television growth in the future.

I originally wrote about Dolby Laboratories in early April, and, in that posting, broke down its business model. 10-Ks only come out once a year, so I won't go over old material. However, I liked the company but thought the equity was still radioactive, since it had been in free-fall for three months due to a slowdown in global PC shipments. If we don't experience economic blight because of the European financial crisis, my take is that this is a good buying opportunity for those interested in Dolby.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I am short the market with inverse ETFs.