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Dolby Laboratories Inc. (NYSE:DLB)

F4Q07 Earnings Call

November 8, 2007 5:00 pm ET

Executives

Kevin Yeaman - Chief Financial Officer

Bill Jasper - President and CEO

Tim Partridge - EVP of Products and Technology

Ramzi Haidamus - EVP of Sales and Marketing

Analysts

Ralph Schackart - William Blair

Mike Olson - Piper Jaffray

Ingrid Chung – JP Morgan

Steven Frankel - Canaccord Adams

Brian Thackray - Deutsche Bank

Paul Coster - JP Morgan

Andy Hargreaves - Pacific Crest Securities

Hunter DuBose - Morgan Stanley

Alan Davis - DA Davidson

Operator

Welcome to the Dolby Laboratories conference call discussing fourth quarter and year-end fiscal 2007 financial results. (Operator Instructions) I would now like to turn the conference over to Kevin Yeaman, Chief Financial Officer for Dolby Laboratories.

Kevin Yeaman

Thank you. Good afternoon, everyone and welcome to Dolby Laboratories fourth quarter fiscal 2007 earnings conference call. Joining me today’s are Bill Jasper, Dolby Laboratories President and CEO; in addition Tim Partridge, EVP of Products and Technology, Ramzi Haidamus, EVP of Sales and Marketing are here to participate in today’s Q&A.

On this conference call, we will be making forward-looking statements that include: projection of future operating results for our fiscal year ending September 26, 2008; market trends for the industries in which we compete and our expectations concerning how those trends will affect our operating results; the capabilities and market acceptance of our products and technologies; and our strategic and operational plans; as well as our expectations regarding the anticipated benefits of the planned acquisition of Coding Technologies.

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 and elsewhere in our most recent quarterly report on Form 10-Q available at www.SEC.gov 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.

As for the structure of this call, Bill will begin with an overview of the business and our recently announced agreement to acquire Coding Technologies, and I will follow with a rundown of Dolby’s financial results.

Now with that introduction behind us, I will turn the call over to Bill.

Bill Jasper

Thank you, Kevin. Good afternoon, everybody. I am pleased to report a strong fourth quarter and fiscal year. Throughout the year, and the period, we continue to benefit from Dolby’s strong position across a range of entertainment markets including cinema, DVD, personal computer, broadcast gaming and automotive. With this strong base, we remain well-positioned for a number of upgrade cycles including Digital Cinema and 3D, Digital Broadcast, next-generation DVD and next-generation gaming.

In each of these markets, Dolby’s technologies help make entertainment more real and immersive, and the Dolby brand has come to symbolize a superior entertainment experience.

True to our strong brand and industry-wide presence, we are well-positioned at a time when digital content is proliferating and the demand for entertainment is growing. Our fundamental opportunity is to extend our brand and technologies to the many new markets arising from this digital proliferation. We believe our planned acquisition of Coding Technologies is an important step towards addressing this opportunity.

On today’s call, I would like to provide an overview of Coding Technologies, also known as CT, and discuss how we believe it positions us better for longer-term opportunities emerging in a digital world. And finally, elaborate on the progress we are making with new initiatives in mobile, Digital Cinema, and video.

I am very excited to announce that Dolby has entered into a definitive agreement to acquire Coding Technologies for a purchase price of approximately $250 million net of cash. We expect the transaction to close very soon, and the closing mechanics are already in process.

I would like to spend the next few minutes discussing CT’s business and technologies and articulating why we are very excited about this transaction.

First, a little bit about Coding Technologies. CT is a licensing company founded in 1997. For the past ten years, it has been focusing on developing and providing innovative audio compression technologies for limited bandwidth platforms such as mobile and digital broadcasts. The company has approximately 70 employees and is headquartered in Stockholm, Sweden, with additional offices in Germany, China and the United States.

CT is best-known for developing audio compression techniques that enrich industry standards, most notably spectral band replication, which enhances the MPEG-4 audio standard. Today, CT’s audio technologies are widely used in mobile handsets, and are increasingly being adopted by next-generation platforms such as broadband TV, mobile TV, video on demand, and next-generation HD broadcast.

We are very excited about CT for a number of reasons. We believe that the acquisition will expand our business into the mobile market, add to and complement our existing broadcast business, and help us penetrate some new markets such as digital radio, where we believe CT’s high compression audio technologies could provide significant value and have already been adopted in several digital radio standards.

In the mobile markets, CT’s success in developing MPEG-4 audio enhancement technologies enables a more efficient delivery of media. CT has traction with mobile handsets, where its spectral band replications and parametric stereo technologies are part of the high efficiency, or HEAAC standard. HEAAC has been selected by mobile music service providers including O2, Sprint, and Telenor. Handset manufacturers that offer HEAAC enabled phones include Nokia, Motorola, Samsung and Sony Ericsson. In fact, more than 100 different phone models support HEAAC.

In the broadcast market, the efficiency of CT’s audio technologies will help us address specific challenges facing some international television broadcasters and operators. In markets such as Norway and Brazil, for instance, industry groups have selected Coding Technologies to address very low bandwidth issues, and the selection of HEAAC will enable multichannel audio delivery at these lower bit rates.

In addition, by delivering both Dolby Digital Plus and HEAAC, we can offer a variety of multichannel solutions to our existing broadcast customers, who have a wider range of requirements pertaining to bandwidth constraints and compatibility with playback devices.

Longer term, we believe CT’s technologies and expertise will help us address some of the opportunities stemming from greater media portability and convergence. Consumers increasingly expect content to port across multiple playback environments such as PC to mobile and mobile to audio, and consumers want to experience high quality entertainment at each playback point. By combining Dolby’s extensive suite of audio processing technologies with CT’s technologies, we believe we will be better positioned to help these customers optimize the portable entertainment experience in various playback environments.

Finally, Coding Technologies and Dolby share similar cultures. Like Dolby, Coding Technologies has a strong engineering team, a passion for technology and entertainment and a record of successful innovation. It is made up of a group of exceptionally skilled audio and software engineers focused on emerging industry demands. We believe that this similar culture, passion and innovation focus will complement and add to Dolby’s existing organization and strategy.

In a minute, Kevin will comment more on the financial profile of Coding Technologies and its impact on the business.

With that, let me turn to some of the initiatives we are focused on in fiscal 2008 starting with mobile. We are making significant progress with our mobile initiative and expect Coding Technologies to complement our existing efforts. In November, we announced a release of the Dolby Mobile suite of technologies. Currently, Dolby Mobile integrates and optimizes a number of technologies for the playback of entertainment on mobile phones, improving the experience.

NTT DoCoMo and Sharp announced that they have licensed and planned to incorporate Dolby Mobile into two handset models to be sold in Japan. NTT DoCoMo is widely regarded as the leader and premier innovator in the mobile industry, so we were pleased to have earned their trust and support with Dolby Mobile. The first Sharp handset model with Dolby Mobile is expected to be available in Japan at the end of this month, followed by a second model expected to be available in Japan in the January to February 2008 timeframe. By combining CT’s technologies and relationships with Dolby Mobile and the Dolby brand, we believe that our time to market in the mobile industry can be improved.

Turning to our initiatives in the Cinema industry, we continue to work closely with studios and exhibitors in their transition to Digital Cinema and Digital 3D. Last month, we began shipping Dolby’s 3D digital system. The Dolby 3D technology utilizes standard white screens already in auditoriums so exhibitors don’t have the added costs nor the image quality compromise associated with the use of silver screens required by competitors.

Additionally, Dolby’s 3D digital system supports both 3D and 2D presentations, without the need for dedicated 3D auditoriums, by adding a retractable color filter wheel accessory to the digital projector. Exhibitors can move a 3D movie to additional auditoriums equipped with Dolby 3D Digital Cinema systems later in the run using the standard screens. This is an important benefit since exhibitors need to migrate a feature film to a smaller screen as it matures, and as new features are prioritized for the main theater.

In the fourth quarter, Dolby announced the sale of 3D systems to Kinepolis Group for 17 screens throughout Europe. In addition to Kinepolis, a number of key exhibitors announced they will be installing Dolby 3D systems in time for next year’s release of Beowulf in 3D. These exhibitors include Carousel Cinemas, Cinema City, Cinetopia, Cobb Theaters, Kiers, Malco, Marcus Theaters, Maya Cinemas, Megaplex, Starlight, Sundance, Warren and Silver City.

At the same time, we continue to make progress in our roll out of Digital Cinema. Last month, Dolby Digital Cinema received the industry’s first US government FIPS level 3 certification which is the highest level of security required by DCI. We believe these is an important milestone as it assures studios and exhibitors that Dolby’s Digital Cinema system is design to maximize the security of their content.

Dolby Digital Cinema and Dolby 3D represent our first push into imaging, but we don’t plan on stopping there. We are equally focused on improving the video of next generation LCD displays. At these year’s fall Japanese conference on advanced technologies, we demonstrated two new video technologies we plan to license: Dolby Contrast and Dolby Vision. Both are aimed at the emerging for LCD displays with LED back lighting and local dimming. While a nascent market, these next generation LCDs are expected to gain momentum as the price for LEDs declines.

Dolby Contrast and Dolby Vision are HDR – high dynamic range imaging technologies -- aimed at enabling the capture, distribution and display of more vibrant video on LED back lit LCD television sets. Dolby Contrast provides enhanced contrast while Dolby Vision combines enhanced contrast with extended brightness and dynamic range for LCD televisions, with LED backlighting technology, resulting in truer blacks, brighter whites, and a vivid image.

In summary, we remain well-positioned for key upgrade cycles in our DVD broadcast and gaming markets. We are focused on extending our brand and technology into newer market opportunities including mobile, Digital Cinema and video, and we see the planned acquisition of Coding Technologies as an important element to our overall strategy.

With that, I will turn it over to Kevin.

Kevin Yeaman

Thank you, Bill. I would like to start by discussing Dolby’s overall financial performance, followed by highlighting some of the major drivers of our P&L in the fourth quarter of 2007 and in fiscal 2008, and finish by providing our guidance for fiscal 2008.

We had a strong fourth quarter and fiscal year driven by strong revenue growth, a significant increase to our licensing margins and a decline in our tax rate, each of which I will cover.

Revenue for the fourth quarter was $129 million, up 26% year over year. On a full year basis, Dolby’s revenues was $482 million, up 23% from fiscal 2006. Fourth quarter licensing revenue was $103 million, an increase of 29% year over year and 9% sequentially. Growth was primarily driven by strong results from our PC consumer electronics and broadcast markets.

In the fourth quarter, our CE market experienced growth year over year and strong sequential growth on higher reported shipments of DVD, home theater in a box and AVR products, due in part to our compliance efforts. The CE market made up over 35% of our licensing revenues in fiscal 2007, compared to approximately 45% in fiscal 2006 as strong growth from our PCM broadcast markets further diversified our revenues.

Our PC market experienced strong year over year growth in the fourth quarter as many consumer PCs continued to ship with Microsoft Vista Home Premium or Ultimate Editions as well as with third party DVD playback software, each containing Dolby technologies. Our PC market also experience sequential growth, which we attribute to increased PC shipments and the continued strength of Microsoft Vista. The PC market represented approximately 35% of our licensing revenue in fiscal 2007, compared to just over 30% in fiscal 2006.

Our broadcast market experienced strong growth year over year in the fourth quarter on continued demand for digital televisions in North America, and was slightly down sequentially. The broadcast market comprised over 15% of our licensing revenue in fiscal 2007, up from just over 10% in fiscal 2006.

In our other markets category, which includes gaming, automotive and VIA, we experienced year-over-year growth across each market, but a sequential decline led by softness in our gaming market ahead of the holiday season. In fiscal 2008, we will include revenues from the mobile market in our other category, which is where the majority of Coding Technologies revenue will fall.

Fourth quarter product sales were $19.6 million, up 32% year over year, and 14% sequentially. Strong demand for our broadcast and cinema audio products drove sequential growth, while year-over-year growth resulted partly from last year’s price increase for traditional cinema-related products.

You may recall that in the third quarter of last fiscal year, exhibitors accelerated purchase orders ahead of anticipated price increases, which had the effect of reducing orders in the fourth quarter of fiscal 2006.

Fourth quarter services revenue declined 13% year over year and 21% sequentially. The sequential decline resulted largely from seasonality, as the fourth quarter is typically a slow one for film releases. The year over year decline resulted from differences in timing.

Turning to margins, our licensing gross margins improved significantly in the fourth quarter of fiscal 2007. As you may recall, over the past several quarters we had been accruing royalty expense related to an ongoing dispute with an unrelated patent licensor. In the fourth quarter of fiscal 2007, we determined it was appropriate to cease accruing additional royalty expense related to this dispute.

As a result, our licensing margin increased to 98% in the fourth quarter of fiscal 2007. We expect our licensing margins to be approximately 96% in fiscal 2008, as we do not expect to recognize additional expense related to this dispute going forward. The difference between the 98% gross margin in the fourth quarter compared to 96% in fiscal 2008 is due to the estimated amortization of intangibles from acquisitions.

Moving to products, our products gross margin was 49% in the fourth quarter of fiscal 2007, a decline of 4 points sequentially. As you recall, we have deferred approximately $7 million in revenue to date for Dolby Digital Cinema servers until certain [DCI] specifications are clarified and met. Since gross margins on initial Digital Cinema systems are significantly lower than our traditional cinema products, we expect product gross margin to be substantially impacted in the quarter that we recognize this revenue. We now expect to recognize this revenue in the second half of fiscal 2008.

Services gross margin was 53%, down 8 points sequentially, resulting from lower revenue in the fourth quarter.

Turning to tax, our fourth quarter fiscal 2007 tax rate was 21%, which was substantially lower, largely due to the cumulative benefit of a change in estimates governing prior periods to reflect a greater deduction for domestic production and export sales incentives. This resulted in a tax rate of 31% for fiscal 2007. Going forward, we expect our tax rate to be approximately 35%.

Strong revenue growth, improved licensing margins and a reduced tax rate resulted in fourth quarter net income of $44.2 million, or $0.39 per diluted share, compared to $25.2 million, or $0.22 per diluted share for the fourth quarter of fiscal 2006.

For the full year, net income was $142.8 million, or $1.26 per diluted share, compared to $89.5 million or $0.80 per diluted share for fiscal 2006. Net income includes stock-based compensation charges of $5.1 million for the fourth quarter of 2007 and $4.2 million for the fourth quarter a year ago. For the full fiscal year, net income includes stock-based compensation charges of $19.8 million compared to $19.1 million in fiscal 2006.

Turning to the balance sheet, Dolby finished the year with approximately $673 million in cash, cash equivalents and marketable securities. From operations, we have an approximately $55 million of cash and cash equivalents during the fourth quarter.

As Bill discussed earlier, today we announced a definitive agreement to acquire Coding Technologies for a purchase price of approximately $250 million net of cash. Let me share a few more financial data points.

We expect Coding Technologies to add about $20 million of revenue in fiscal 2008. Roughly 80% of CT’s revenue is related to the mobile market, with the remainder mostly related to the broadcast market. CT’s margin structure is similar to Dolby’s license business, since it too is a licensing company. While we have not completed our purchase price valuation work, we currently approximate that the acquisition will result in an increase in amortization of intangibles of approximately $8 million per year, with approximately $4 million in cost of licensing and $4 million in operating expense.

Let me turn to outlining our expectations for fiscal 2008. For licensing, we anticipate revenue of between $455 million and $480 million in fiscal 2008, including approximately $20 million from the acquisition of Coding Technologies. Organic growth is expected to be driven primarily from our PC and broadcast markets.

For products and services, we anticipate revenue of between $105 million and $120 million. The anticipated shift in the market for Digital Cinema makes this a difficult category to predict. We believe we are well-positioned for sales growth in Digital Cinema and 3D products, but the rate of adoption remains uncertain. We are basing our guidance on the assumption that we will have increased sales of Digital Cinema and 3D products, and that we would begin recognizing revenue from Digital Cinema sales in the second half of fiscal 2008. If the Digital Cinema market develops as anticipated, we also anticipate increased competition for our cinema audio processors.

Turning to margins, we expect overall gross margins to approximate 85% to 86% for fiscal 2008. There are a number of key factors that we expect to affect our gross margins in fiscal 2008. Licensing margins were 98% in Q4 and will settle in at approximately 96% in Q1 ’08 and for the remainder of 2008. The drop from 98% to 96% is the result of the estimated amortization of intangibles from acquisitions.

Product margins were 49% in 2007. We expect them to be between 35% and 40% for fiscal 2008. The decrease is largely due to growth in Digital Cinema servers and 3D glasses, which have lower margins than our traditional product sales. Product margins could fall as low as 25% in the quarter we recognize the deferred Digital Cinema revenue.

Turning to operating expenses, we anticipate fiscal 2008 operating expenses to be approximately 46% to 47% of revenues, as we continue to invest in new initiatives such as mobile and video. Our tax rate is expected to be approximately 35%.

In summary, we expect fiscal 2008 revenue to be approximately $560 million to $600 million, including approximately $20 million in revenue from Coding Technologies. We expect GAAP net income for fiscal 2008 to be approximately $148 million to $160 million, which would result in earnings per diluted share of approximately $1.27 to $1.37. We expect stock-based compensation expense for the full year to be approximately $18 million to $20 million.

We are currently in the process of completing our purchase price valuation as it relates to our acquisition of Coding Technologies, and these numbers could change, but we are currently basing our guidance on an estimated $13 million of amortization of intangibles in fiscal 2008, compared to approximately $3 million in fiscal 2007. We are currently assuming that there are no in-process R&D charges as a result of the acquisition of Coding Technologies. To the extent that we determine there is, it will be charged to the P&L in our first quarter fiscal 2008.

This concludes our prepared remarks. I would now like to turn it over to the operator for questions. Please go ahead.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Ralph Schackart - William Blair.

Ralph Schackart - William Blair

Good afternoon, another great set of results, guys. Kevin, I appreciate the color for ’08. First at a high level, Bill, can you help us understand how the Coding is complementary to what you are currently doing with DoCoMo?

Bill Jasper

DoCoMo is Dolby’s technology, we license Dolby’s technologies which we have been putting into what we call the Dolby mobile program going ahead. I assume you say, this technology you are referring to is Coding Technologies, is that correct?

Ralph Schackart - William Blair

That’s right, Bill.

Bill Jasper

They have slightly different technologies which are very useful in very, very low bandwidth applications, but in this particular case with NCC DoCoMo Dolby Digital makes a lot of sense.

It is not actually pure Dolby Digital, it is a suite of products we have developed around Dolby Digital and other technologies that we think will enhance the mobile experience. Ramzi, would you like to add to that?

Ramzi Haidamus

Just to add some color to what Bill said, the Dolby mobile technology is a post-processing audio technology meant to make the phone sound better for playback of media and the Coding Technologies technology, also known as spectral band replication, it is really think of it as a turbo charger attached to a codec such as AAC.

So in the case of Dolby mobile with NCC, we are really talking about a post-process technology; in the case of CT technology, it is a codec which is going to be operating at a lower bandwidth and high quality.

Kevin Yeaman

In terms of the complementary nature of the businesses, in addition to the technology aspects, I would just add that given CT’s presence in the handset market, the relationships they have built up and their expertise, we do think that it potentially accelerates our strategy of driving Dolby mobile across additional handset models.

Ralph Schackart - William Blair

Kevin, can you help us think about the earnings impact from the acquisition? I know you gave us some data points on the revenue and amortization. I was just curious if you could help us think about the earnings impact and/or the OpEx of coding.

Kevin Yeaman

At the highest level, Ralph, Coding Technologies is a licensing business and has a very similar margin structure to Dolby’s licensing business, so you can think of it as adding about $20 million in licensing revenue and a similar margin structure.

Now of course, there is as I mentioned about $8 million of amortization for intangibles which is included in our GAAP guidance; roughly half of it in cost of licensing, half of it in OpEx. At the outset, we will have some integration costs and there are some purchase accounting adjustments which affect us early on, and that is included in our GAAP guidance.

Ralph Schackart - William Blair

When you looked at this acquisition in terms of the internal ROI metrics compared to some other deals that you have done, can you help us think about the order of magnitude of what made this deal relevant today, and help us think about that? Thanks.

Kevin Yeaman

I think what makes us relevant for today, Ralph, is we’ve always said we would be focused on companies with strong IP portfolios which we can combine with our expertise and realize complementary benefits. In this case, as we discussed earlier, it is very complementary to our mobile strategy. We think it potentially accelerates the mobile strategy that we already had in place, and it is also very complementary to our broadcast business; we think that as more and more digital media is available and broadcasters look to come up with new applications to get that digital media out there, we think that adding this technology to our portfolio allows us to meet even more of the needs of our customers.

Bill Jasper

We think that the addition of the Dolby brand in this situation will allow for further expansion of that business.

Operator

Your next question comes from Ingrid Chung – JP Morgan.

Ingrid Chung – JP Morgan

Good afternoon, congratulations on your results. My question is just about the three buckets that you have talked about previously, and what do those buckets look like for ’08? And then also, it sounds like you are just starting to recognize some revenue from mobile. Does that go up several times? How much of CT’s revenue do you think will be for the mobile market?

Lastly, in terms of the Internet market, who would you license technology to? Would it be a third party vendor or an OEM? Who would it be?

Kevin Yeaman

Why don’t I start off with the guidance question, and I will turn the Internet question over to Ramzi when I am done. So I assume, Ingrid, that you are referring to how we are thinking about each of our licensing markets?

Ingrid Chung – JP Morgan

Correct, yes.

Kevin Yeaman

So as you know, we separately report on CE, which is where the majority of DVD players are reported for us; PC, and broadcast. Then our other category includes gaming, automotive, VIA, and now mobile. So if I focus for the moment on organic growth, since I told you that $20 million of the revenue was a result, is what we are expecting from the acquisition, the guidance range came out to roughly 12% to just under 20% growth from licensing. We are expecting CE to be flat to slightly up, that is what we are hearing from industry analysts and expecting for that market. We therefore expect most of our growth to come in percentage terms from PC, broadcast and the other market.

So we are expecting close to 20% growth, at least, from each of those markets and we are actually expecting a little more than that out of our broadcast market. Now when we layer in the mobile market in particular, the combination with Coding Technologies, the other market category does grow faster because most of the $20 million drops into that category.

Ramzi Haidamus

On the Internet applications, there's several applications we believe will benefit from the efficiency of spectral band replications that apply in HEAAC, starting with streaming application such as radio on the Internet, TV on the Internet, IT TV, even video on demand on the Internet as well as of course, the large market of music delivery, can all benefit from a lower bandwidth, high quality technology such as CT's.

Target companies, as was mentioned earlier, could be Apple, Real Networks, and the type of companies which provide music players, radio players, all can benefit from technologies which CT offers.

Operator

Your next question comes from Steven Frankel - Canaccord Adams.

Steven Frankel - Canaccord Adams

Obviously, very impressive results. Just to dig into Digital Cinema for a little bit, how many servers do you have installed in the field today, and is there a ramp between now and Beowulf on the server side as well as the 3D equipment side?

Tim Partridge

Servers today, we're in commercial theaters about 550 and another 50 in the studios in their special screening rooms. So that's where we are today. In terms of Beowulf, it opens next week actually, although we are installing as we speak, we're expecting to do between 75 and 80 3D screens for Beowulf by the time it opens. Yes a certain number of those have gone is with new servers as well as obviously putting 3D into existing ones. So that's the kind of ramping we're expecting, but it is all happening within the next week. Does that answer your questions?

Steven Frankel - Canaccord Adams

Does the 550 place you number 2 in the server market? What do you think your market share is?

Tim Partridge

Obviously, what I see roll out over the past couple of years has placed a large number of servers out there, so we're clearly behind on market share. But as Kevin mentioned, we do believe that this will be a transitional year for Digital Cinema, which on the one hand makes it very hard to predict, but we do believe we're well positioned if it does happen, which we expect it to. With our server obviously, we've got a number of products that are in this market. We've got the server as you know. We announced at the last trade show, and we'll shortly be introducing an audio processor, a Digital Cinema only version of our flagship, CP650.

We also have a couple of integration products aimed at Digital Cinema, and of course, the 3D as well. So we have a whole suite of products, and the expectation is that Digital Cinema starts ramping this year, we do feel we're well positioned.

Steven Frankel - Canaccord Adams

Looking at the format war in Blue Laser DVDs, do you think the logjam is getting worse or better in the last 90 days?

Tim Partridge

Could you just add some more color what you mean by logjam?

Steven Frankel - Canaccord Adams

In other words, we have a format war and is it getting any closer to getting resolved, or do you think that the situation is getting more clouded given what's going on in the HD DVD camp lately?

Tim Partridge

Well every time it seems that something is going to let up, somebody drops their price and the market becomes even more competitive and we are in a situation where we're seeing very aggressive pricing from both sides, continual generation of content for both formats. Of course as you know, we're in both formats, so we're just kind of sitting back and watching, but at this point we really don't see any letup.

Steven Frankel - Canaccord Adams

On the PC market as you probably now get a little bit of view of what customers are gong to do post-Christmas, do you think the dual installs of being in Vista and in the third-party software DVD players is going to continue post-Christmas season?

Tim Partridge

That is our feel as well. It is really difficult to predict what that trend is going to look like, but at least for the first half of FY '08 we agree that there doesn't seem to be a letup of that trend. Past the first half of FY '08, it's difficult to predict so we're just gong to wait and see how that market plays out.

Operator

Your next question comes from Brian Thackray - Deutsche Bank.

Brian Thackray - Deutsche Bank

On the broadcast market, you talk about growth next year being north of 20%; can you talk within that a little bit about your expectations around government subsidies around set-top box, what you're expecting there?

Kevin Yeaman

We think the big drivers for us next year will be the option of digital television is probably the highest growth areas within our broadcast licensing; set-top boxes is another category for us, we expect to do well there.

I think you're referring to probably the potential for converter boxes as we get closer to FCC mandate. We are not expecting that to be a big driver for us in the 2008 timeframe; we think that's a dynamic that will probably come very close to the mandate in 2009.

Bill Jasper

And don't forget we have the three-month lag.

Brian Thackray - Deutsche Bank

In the PC market, can you guys maybe give a little more insight into what you saw from Vista in terms of the incremental contribution in this quarter and where you expect that to go over the next few quarters? Also from Acer and Toshiba deals in terms of how much momentum or contribution you're seeing from those deals?

Kevin Yeaman

So in terms of Vista, the sequential growth that we saw was driven primarily by increased PC sales and a continued strong attach rate of the Vista Premium Editions in which we're included. As Ramzi said earlier, we do see that continuing at least through the holiday season.

Our guidance actually assumes that there is some lesser incidents of third-party DVD attachments when Premium Vista is sold, so we're leaving a little bit of room there in the second half in our guidance, although as Ramzi said, we don't have any specific evidence of that one way or the other.

In terms of your question about Acer and other manufacturers that have adopted some of our premium PC entertainment experience, we garnered a number of design wins last year, as you know. There was not much revenue last year, it was mostly design win stage, but we do believe that that program will begin contributing revenue in 2008.

Brian Thackray - Deutsche Bank

Last question with regard to CT, can you talk about the revenue run rate, what it's doing today or where it has been in the last 12 months?

Kevin Yeaman

It's been growing at about, as I told you we're expecting about $20 million in our fiscal year. They are on a calendar year. Their last full reported period was calendar '06, which was about $16 million. It's been growing since then at about 20% a year. Of course, as we give our guidance, we factor in purchase accounting adjustments and those sorts of things which affect you in the early stages.

Operator

Your next question comes from Paul Coster - JP Morgan.

Paul Coster - JP Morgan

Kevin, I may not have completely understood your statement about licensing, the upward adjustments to the gross margin expectations. Does that mean that the licensing dispute is resolved, or does it mean that you are just confident it will be?

Kevin Yeaman

What we said is that we determined that there was no need to continue accruing any additional expense, and that was what we said. Is that clear?

Paul Coster - JP Morgan

So there's no residual conflict with the third party there?

Kevin Yeaman

Well as you know, we've been accruing some expenses over the last year. We have an accrual on the books and we think that's sufficient to cover any outcome of the matter.

Paul Coster - JP Morgan

In terms of the cinema business, what should we be thinking about in terms of long-term gross margin targets, please?

Kevin Yeaman

Sorry, I missed the beginning. Did you say cinema in particular?

Paul Coster - JP Morgan

Yes.

Kevin Yeaman

Obviously it's the early stage of the product cycle, and we've been focused on the quality of the product and customizing it to what we think the market needs. So the early sales are at relatively low margins. I said we expect that our overall product margins this year will probably be in the range of 35% to 40%.

Paul Coster - JP Morgan

And longer term, what should we be thinking about?

Kevin Yeaman

Over the longer term, once we're talking about at volume, and if we're fully considered I would expect them to get back into the 40s again.

Paul Coster - JP Morgan

You were looking forward to some acquisitions this year, and you started off in a correct manner, but I was expecting it to be video-related; it's video still strategic for the company on a go-forward basis.

Bill Jasper

Yes Paul, video is extremely strategic. We just could not pass up the opportunity to bring Coding Technologies on board because it complements everything we're doing, especially giving some additional inroads into the broadcast market, as well as supporting the mobile market. We continue to focus on video; we're investing the infrastructure to bring products to the market, to take those technologies out to license, and video is a very key strategy for the future.

Paul Coster - JP Morgan

As we think about fiscal year '08, should we expect tuck-in acquisitions, or something more transformational in nature?

Bill Jasper

You mean transformational in term of products or technologies?

Paul Coster - JP Morgan

That plus scale of the acquisition.

Bill Jasper

Well we're just starting to, we think, take advantage of the acquisition of BrightSide last spring, working very closely to bring their technologies to market and complement with some other technologies we've been developing for the last couple of years at our Imaging Group. We fully expect to start seeing some technologies and products out in the marketplace, as well as some license products in FY '08.

Paul Coster - JP Morgan

You haven't bought your way into video codec technology, so is that likely to figure in your strategy going forward?

Bill Jasper

Well, as you probably know, the video codecs which are out there; H.264 is pretty much one of the standards being used. We have technologies which we can wrap around that which we think will enhance the experience, so that is the approach we're following. You said, “bought into” the video technologies; I'm not sure what you mean there, but our approach is to take the standardized options which are available and build on them.

Operator

Your next question comes from Andy Hargreaves - Pacific Crest Securities.

Andy Hargreaves - Pacific Crest Securities

Another question about new products, on Dolby Volume, have you had any traction there, and does that contribute to your CE, your broadcast growth in '08?

Ramzi Haidamus

We've had a very positive response from our licensees in terms of demand for the technology. They continue to be excited about it; the demand is there. We do foresee having some prototype product on display at the upcoming CES.

In terms of revenue growth, we haven't really built much for FY '08.

Andy Hargreaves - Pacific Crest Securities

Broadcast in the quarter, you pointed out TV growth as being a primary driver. Did I hear you right there, or was set-top box really strong as well? Can you give us any sense of what the mix within that broadcast business is of U.S. versus international?

Kevin Yeaman

To your first question, I was commenting earlier on reflecting on fiscal 2007 growth, the drivers being digital TV growth as well as set-top box growth. Those are the two main drivers. But we haven't provided any geographic information by segment and typically we're getting reported to by our licensees and we don't always have perfect information on end user.

Andy Hargreaves - Pacific Crest Securities

Lastly, you mentioned, I think I heard you right, that there's a potential for increased competition in Digital Cinema on the audio side if it gains traction? Can you just explain the dynamics there?

Tim Partridge

Yes that's correct, to the extent that the industry does transition to Digital Cinema and away from traditional film products than our current CP650 of course has technology in it that takes us to the traditional film, 35mm film. So to the extent that we transition to Digital Cinema, there could be a decrease in demand for traditional film products, which is why I mentioned we have recently shown and will soon introduce a Digital Cinema only version of our CP650. But of course, with that not having the Dolby Digital proprietary technology in there, we do anticipate increased competition for that product.

Operator

Your next question comes from Hunter DuBose - Morgan Stanley.

Hunter DuBose - Morgan Stanley

Could you tell us what the economics of the 3D deployments for Beowulf look like in terms of revenue and gross margin?

Just coming back to the gross margins on the licensing business, I wanted to clarify whether the 96% gross margins you're guiding towards for 2008 are representative of the gross margins beyond that period or simply for 2008?

Beyond that period, could you give us just a bit more color why they stepped up quite meaningfully from the low-90% level they've been at since 2002 on a pro forma basis? Thank you.

Tim Partridge

Hunter, on the 3D deployment the equipment that we supply for 3D is some hardware, some software and the color wheels that Bill referred to in his opening remarks. That whole package is approximately $15,000 and of course, we also supply many pairs of glasses for each screen and they are a little bit under $50.

Margin-wise, the margins on the 3D products which go into the projector, are typically of our regular product margins. However, on the glasses, Kevin referred to in his remarks, that's clearly almost a consumable item and therefore much lower margins on that.

Kevin Yeaman

In terms of the licensing gross margins, I'm sure you remember that over the past several quarters, we had been accruing royalty expense related to an ongoing dispute with an unrelated patent licensor, and so our licensing margins have stayed at their historic levels of about 91%.

This quarter, or the fiscal fourth quarter of 2007, we determined that it was appropriate to cease accruing those additional royalty expenses. That's what resulted in the 98% licensing margins for the quarter.

As we look to 2008, the change from 98% to 96% is really due to amortization of intangibles for acquisitions, so that was our guidance for 2008 and we don't have any guidance beyond that.

Hunter DuBose - Morgan Stanley

Is there any reason to believe that it would stay at the higher level versus reverting to the historic lower level of around 90%?

Kevin Yeaman

All else held equal, it would stay at the 96% level. The only changes would be if we entered into any sort of additional licensing agreements as we introduce new technologies, new products, so all else held equal, that is what we're guiding for, 96% in 2008.

Operator

Your next question comes from Mike Olson - Piper Jaffray.

Mike Olson - Piper Jaffray

On the DCI spec, I know this is somewhat out of your hands but is there a risk that this looks beyond second half '08 and what could cause that to be delayed or lead to it getting completed on time?

The root of my question is what really needs to be done here to get that done, and do you feel that the timing of when you've assumed you'll be able to recognize Digital Cinema revenues conservative or more aggressive? Thanks.

Tim Partridge

As you said Mike, it is a little out of our hands. Specifically, what needs to be done is we need the industry standards bodies to agree upon a standard or some elements that are written into the DCI spec. So specifically we're waiting for the SMPCE body to publish a spec, and as soon as they do so, we'll start writing the code to implement that spec.

So we have an anticipated publish date but standard bodies and publishing standards sometimes takes longer than you require. But we're expecting to be able to do all the work that's necessary and be able to recognize in the second half of the year.

Operator

Your next question comes from Alan Davis - DA Davidson.

Alan Davis - DA Davidson

Kevin, are you willing to share for the impact of CT next year, the bottom line and net impact excluding the amortization of intangible increase?

Kevin Yeaman

Like I said, it's about $20 million of revenue. If you exclude the amortization of intangibles and again there are some early effects of integration costs and purchase accounting it basically looks like the same type of margin structure as Dolby's licensing business.

Alan Davis - DA Davidson

Do your underlining assumptions for the number of Digital Cinema screens getting rolled out globally in your fiscal '08?

Tim Partridge

Alan, we're looking to the deployment agencies that are talking about deploying this year, and a number of them are talking about deploying in the March timeframe. As we've seen in the past, not everything that is anticipated comes to pass and there are many issues, the DCI one that we just mentioned being one of them. That could slow that down, but we do anticipate that people will start moving this year and as for the actual numbers, it's very dependent on whether these things come to pass or not.

Alan Davis - DA Davidson

Fair to say you're taking a conservative approach with your assumptions?

Tim Partridge

I think we're taking a realistic approach, yes.

Alan Davis - DA Davidson

On the M&A side, jus curious how you might characterize your activity there? I know you just obviously acquired CT but looking forward, could you characterize the size of future deals, how big are you willing to go, depending on the technology you're acquiring and is there a minimum cash balance that you would like to have on the balance sheet that you wouldn't go below? Just trying to get a characterization of maybe the size of the deals in the pipeline.

Bill Jasper

Well, any potential acquisitions obviously have to fit into what we're doing from a technology standpoint whether they be in the audio field or video field or other. Coding Technologies was obviously our biggest acquisition to date, but we did acquire BrightSide earlier this year, as you well know, which was much smaller. We don't have any specific parameters in terms of acquisitions and don't comment upon anything we may be looking at. But suffice it to say we will go after any acquisition which we believe we can absorb financially.

We don't have any set fixed number for cash on the balance sheet, but we obviously believe that cash is an important asset and we will make sure that if and when we find any proposed acquisitions which fit from a technological standpoint that we would make certain that transaction fits in with our overall financials.

Alan Davis - DA Davidson

For fiscal '08, what's the projected amortization on intangibles and then the total D&A?

Kevin Yeaman

The projected amortization of intangibles is about $13 million, and that's the estimate as it relates to the Coding Technologies acquisition. It is preliminary at this stage, but our current estimate is $13 million. I haven't given a total D&A estimate yet, but we expect that to be in the neighborhood of just over $25 million.

Operator

We have no further questions at this time. Mr. Jasper, I would like to turn the conference back over to you for closing remarks.

Bill Jasper

We feel we've had an excellent year and we look forward to talking to you next quarter at the end of our December quarter, first quarter fiscal 2008. We appreciate your interest, and again thank you very much.

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Source: Dolby Laboratories F4Q07 (Qtr End 9/28/07) Earnings Call Transcript
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